MiFID - Threats and Opportunities
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Speech by Dan Waters, Director of Retail Policy & Asset Management Sector Leader, FSA
The Insurance Institute of London,
9 January 2008
Good afternoon Ladies and Gentlemen. I am delighted to have been invited to speak at the first of these sessions in 2008 and in such a historic venue.
1 November 2007, the day MiFID came into effect, seems a long time ago. Maybe it's because we’ve all had a few other things on our minds. But looking back, I remember the expectations in the days leading up to M-Day. The Financial Times ran a week of daily articles about MiFID to coincide with implementation. Many firms were burning the midnight oil to make sure that they had done what they needed to do. For regulators and for firms, this was the culmination of several years of intensive planning, negotiation, development - and of course spending.
And then, the sun still came up on 1 November, the Northern Line was still erratic on my way into work, the markets still opened on time, and sub-prime was again more widely and urgently discussed than MiFID 'systematic internalisation'. Firms were asking us and each other whether there had been problems. Had everything gone smoothly? I think that the fact that the transition did appear to go smoothly is a credit to firms and their representatives who worked so hard to achieve this. I'd like to think that the FSA's approach to implementation, our openness and constant dialogue with the industry, also helped.
Admittedly, I think there would have been a greater sense of European "Big Bang" if all Member States had fully implemented on time. As it is, change will be more phased, as implementation across Europe is embedded first in laws and rules, then in firms' procedures, then reflected in behaviour in the markets.
Partly for this reason, I think it will take a while for the 'MiFID effect' to be felt. In the UK, MiFID has largely been about refining, finessing and tweaking our existing regimes for the wholesale and retail markets. But in many other Member States, it heralds a revolutionary change in market models, business models and in regulation. Some have described it as a more 'Anglo-Saxon' model: for example, introducing customer classifications as the basis for a risk-based differentiation in protections; making rules in respect of conduct of business, including regulating investment advice; and no longer forcing trading to be conducted on-exchange. For many States, where some or all of these changes have had to be implemented for the first time, it is indeed revolutionary. I do think that over the months and years ahead it has the potential to fundamentally transform European markets in investment services and create a range of business opportunities.
That said, I also know that for some of you here today, MiFID has no direct impact at all. But most of you will, I think, have been directly affected by the broader changes to our investment business conduct of business regime, "COBS", which we introduced simultaneously with MiFID on 1 November. MiFID was one of the drivers, though only one. Many of you will also be keeping at least one eye on other EU developments relating to retail investments and insurance. MiFID is by no means the end of the story: many other chapters are still unfolding.
So, with this in mind, in my talk today I want to roam beyond just MiFID. I want to offer some thoughts on other elements of the wider EU agenda that are particularly relevant to financial advisers, insurance brokers, and the markets in which you operate. I will also address the important question of how the EU agenda squares with the FSA's own regulatory agenda – the RDR, the new ICOB Sourcebook and the rest.
MiFID - threats and opportunities?
But let me start with MiFID, so that I'm not answering a completely different question from the one set by the examiners.
As I've said, some of you are automatically covered by MiFID because of the business you are doing and because you are operating in a way that's not exempted from the Directive.
Others of you may have chosen to 'opt in' to the MiFID regime in order to be able to passport – to carry on MiFID business in other Member States on the basis of your FSA authorisation alone. I want to return to the passporting issue in more detail a bit later.
And others of you may only be affected indirectly by MIFID, where MiFID-derived changes to our rules have been applied to all firms doing investment business (including non-MiFID investment business such as life and pensions).
For each of these three groups, my sense is that the relevant changes resulting from MiFID have been fairly focused in nature and, in the main, basically manageable. The UK authorities have tried to deliver on our promised proportionate, pragmatic and cost-effective approach to implementation.
But before I get into some of the key changes, what would I pick out as threats and opportunities from MiFID for your businesses?
Threats?
Well, I don't really see any significant threats for you from MiFID, even with the passporting issue. As far as the retail investment market is concerned, from my perspective the biggest threat was that MiFID would force us to remove some specific retail investor protections that we thought were important components of our regime. MiFID required regulators to notify the European Commission, under the MiFID Article 4 mechanism, of requirements that could be seen as going beyond the Directive. In principle, that is fair enough, as a measure to avoid deliberate "gold-plating" that would frustrate the harmonising ambitions of the directive. But where there are particular national market characteristics and regulatory issues that the directive doesn't adequately cover, there needs to be controlled flexibility to preserve desirable consumer protections.
We were pleased that the European Commission took a sensible and proportionate line in discussions with us about the very few and focused extra requirements we submitted to them, and that we were able to carry forward those few we thought we needed to. This outcome enabled us to minimise the level of disruption in the retail market last year, and to allow time for a considered debate on any desirable changes over the longer term – including in the context of the debate around the Retail Distribution Review, and the review of depolarisation, for example. I will return to these issues later.
Opportunities?
In terms of new opportunities in the retail markets from MiFID, I think it's probably fair to say that the short term opportunities may be fewer than in the wholesale markets. As I want to consider later in these remarks, I think it is generally agreed that the retail markets currently remain more nationally focused, with less appetite for cross-border business. I think MiFID creates a framework that provides more potential for commercial opportunities. I'm just not sure there's currently always a business case to seize the retail market opportunities.
But within this framework for opportunity, one thing MiFID has changed in the retail space is that investment advice has become authorisable in every Member State and as a result also passportable. So financial advisor firms can now passport advisory services in respect of MiFID-scope investments alongside insurance products covered by the Insurance Mediation Directive.
MiFID changes
So what are the main changes for your businesses from MiFID?
First, you have had to change the titles of the categories into which customers are put for conduct of business purposes. Instead of Private Customers, Intermediate Customers and Market Counterparties, we have Retail Clients, Professional Clients and Eligible Counterparties. I know there are some differences in thresholds around the edges, but hopefully the mapping across of your private and expert customers has proved reasonably straightforward. This is an example of where, in the light of industry views, we have essentially applied the change across all investment business covered by COBS, both MiFID and non-MiFID business, so as to minimise customer confusion and the unnecessary costs for firms of running different systems in parallel for what are often substitutable investment products.
Best execution is another change. I want to flag this one because the MiFID-derived changes to the best execution regime can easily be overlooked by firms who think these requirements will not apply to them because they don't actually execute trades. This is mistaken. Financial advisers – whether MiFID firms or not - who receive orders from clients involving MiFID investments and transmit those orders to others for execution will still be covered by the revised best execution regime in COBS. They will need to have a policy in place to ensure that they achieve the best possible result for their client orders, and they'll need to check whether this outcome is actually being delivered. The changes applied to MiFID advisers from 1 November 2007 but will also apply to non-MiFID advisers from 1 May 2008 (1 November 2008 in respect of orders for units in collective investment schemes, subject to the outcome of our promised consultation on this aspect, scheduled for Q2 this year). Again, given today's audience, I should make clear that the best execution regime still does not apply to investments that would be outside the scope of MiFID, such as insurance products or pensions contracts.
The third area of change on my list is inducements and the different emphasis in the new rules in terms of fuller disclosure and firms being able to demonstrate that commissions or other potential inducements received from product providers are designed to enhance the quality of service the client receives and do not bias any recommendations made.
I know there are some differences in the way that the new inducements requirements apply to MiFID and to non-MiFID business. But the central desirable outcome, applying to all firms, is to prohibit them from paying or receiving benefits that would conflict with their duties to act in the best interests of their customers.
Another MiFID innovation that's prompted a fair number of questions is the new Appropriateness test for non-advised activities – that means investment services other than investment advice or discretionary portfolio management. Again, this doesn't affect insurance products or pensions contracts, because in implementing the requirement we chose not to extend it much beyond MiFID firms and products. So this one really bites on what we've always referred to as Execution Only investment business and some direct offers, and is about firms establishing whether retail clients have the experience or knowledge to understand the risks involved in a transaction they want to do. My guess is that for most of you here today, non-advised business is not a big issue. And if it is, I hope you've got to the bottom of it. The FSA has worked hard to get the right information out to the market and to respond to the questions firms have raised.
In other areas of conduct of business, MiFID implementation sat pretty well with our parallel initiatives to simplify our conduct of business rules for investment business, and to use the new COBS as a flagship for more principles-based regulation. Overall, MiFID is fairly principles-based.
So we were able, for example, to use copy-out of the MiFID suitability rules as the basis of our simplified new suitability regime in COBS for both MiFID and non-MiFID business and products such as pension contracts. We do not see these as significantly different in effect, but as a reinforcement of existing standards. We also sought to integrate better the relevant Insurance Mediation Directive provisions about customers' demands and needs into a single, more coherent, suitability regime for investment business.
And we were able to use the high level MiFID standards for firms' communications with clients, including marketing and promotional material, as the basis for our simplified - and much shorter - Financial Promotions regime.
Finally on this list, it has become a bit of an urban myth that MiFID killed off the IDD and the Menu. This simply isn't true. While MiFID implementation did accelerate the timeframe for our review of these documents, the key element was the external research that we commissioned and published in July last year to investigate the benefits arising from the Menu. The research suggested that it was not having the market impact envisaged. As a result, we put the Menu and IDD in 'safe harbour' guidance to our copy out of the MiFID rules requiring firms to disclose information on their services and remuneration. Meanwhile, we continue our work on determining an effective model for these disclosures for the future. We'll be consulting on ideas soon.
Passporting and Financial Advisers
I said I'd say a bit more about the issue that has arisen about whether financial advisers with clients abroad can be non-MiFID firms or have to "opt-in" to the Directive.
As many of you will know already, a number of questions have come up about the effect of the UK's decision to use the "Article 3" MiFID exemption for certain financial adviser and arranger firms. The MiFID exemption in question carries forward a similar provision under the predecessor Investment Services Directive. The effect is that financial advisers who do not hold client money or assets, who advise or receive and transmit orders only in respect of transferable securities and collective investments, pass such orders to authorised firms, and who operate solely in the UK will normally be exempt from MiFID automatically. Investment advisory firms holding client money will usually be caught by MiFID automatically, as would those passing orders directly to entities such as unregulated collective investment schemes for execution or processing.
The questions have arisen in respect of firms that have clients in other member states. Financial adviser firms who are covered by MiFID and who offer advice to clients residing either temporarily or permanently in other EEA states will need to do so under a MiFID passport. That's straightforward.
But financial advisors who are taken out of MiFID by the Article 3 exemption, but who also have such clients in other EEA states will either need to 'opt' back into MiFID to acquire the ability to carry out this business under their FSA authorisation via a MiFID passport, or they may need to seek local authorisation in the State in which the client resides in order to carry on the business.
Furthermore, different passports may be required, depending on whether a firm is advising on investment products (covered by MiFID) or insurance-based products (covered by the Insurance Mediation Directive – the "IMD"). And if the business in question falls outside any EU legislation, so that there is no passport available for it, then the firm will need a local authorisation in the EEA State in question for that business, if a local authorisation requirement exists.
Unfortunately, because of the cross-border angle to this, and the fact that MiFID-exempt firms - by definition – are not covered by MiFID, the position is not wholly our call. A firm will need to have regard to how the law of the client's State applies, as well as how the FSA interprets the situation. We cannot give guidance on the law of those other countries. Whether or not a non-MiFID firm might need a local authorisation for advice or for arranging will also depend on precisely what activities local law says require authorisation in that territory. This is why we have said that firms may feel they want to take professional advice if they think that their business may be affected by these issues.
What we have done, though, is to publish on our website a Factsheet that aims to set out the issues and questions firms need to consider and what action firms might need to take. If any of this is an issue for you and you still have questions, please take a look.
The position may also be affected by exactly how a firm is dealing with its clients, as to whether the firm would be regarded as carrying on cross-border business in the other State. For example, if your clients always visit your UK offices to conduct business, this might not be regarded as cross-border business. But if you are actively contacting your clients while they are in another member state, or you travel out to visit clients in another state, then you may well be regarded as providing cross-border services.
As I say, depending on the position, a firm may have to choose whether to opt into MiFID in order to continue to advise clients based in other EEA States. Or it may of course choose not to continue doing the business in the way it currently does.
If you were to "opt in" to MiFID, there are of course some consequences.
Most significant, potentially, are the capital adequacy requirements that would apply. Again, our Fact Sheet provides the detailed breakdown, which partly depends on whether the adviser/arranger firm is also covered by the Insurance Mediation Directive in respect of insurance intermediation business. Some of the required capital levels can be met in part by holding professional indemnity insurance, but it is true that the regulatory capital requirements may be higher if you are opting into MiFID. Initial capital of at least £10,000, plus PII, is probably as low as it can go. But that doesn't necessarily mean that these requirements are higher than you already hold anyway.
Firms opting in would also have to meet our so-called "common platform" standards for systems and controls. These are very similar to our previous SYSC systems and controls standards, but tweaked to reflect particular points from MiFID and the CRD. But firms also need to bear in mind that in December we launched a consultation exercise on the possible extension of the common platform to firms who are not currently subject to it because they are outside MiFID and the CRD. So, in future, differences in the treatment of MiFID and non-MiFID firms may narrow.
Opting back into MiFID will also have some conduct of business implications. Where UK rules apply, this will reflect differences in the way that some conduct of business requirements apply to MiFID and non-MiFID business. And firms will also need to ensure compliance with any applicable local requirements in the client's member state.
So please review the material we've published, talk to your colleagues and industry associations, and use your normal FSA points of contact - within the usual parameters for our providing advice to firms about what they might do.
Supervisory priorities
Two months on, MiFID is fast becoming integrated into our routine ongoing activity – including supervisory work. Understandably, firms have been concerned to know our expectations in terms of supervision and monitoring of their compliance with the changes stemming from MiFID and COBS. I suspect that some firms had visions of an army of supervisors on their starting blocks ready to sprint into offices on November 2nd.
To allay unreasonable fears and to clarify our line, in September we published a statement on this. We recognised that given the volume of change, and consistent with our risk-based approach, we needed to set clear priorities and to make these public. This also served to amplify our Business Plan commitment that in Q1 2008 we would begin a risk-based review of how firms had implemented MiFID requirements.
I don't think there are any surprises in the list of priority issues of most relevance to you: disclosure, inducements, suitability, appropriateness, financial promotions and best execution. Of course, there will inevitably be different emphases and approaches for different types of firms and for individual firms.
As far as possible, our approach is to integrate our oversight of changes with 'business as usual' supervisory activity, both firm-specific and thematic work like Treating Customers Fairly. Few of the priority areas for supervisory attention involve new areas of regulatory intervention, but rather changes in existing requirements.
IMD and ICOB
I've mentioned the Insurance Mediation Directive a number of times already. But it's timely that I say a little more, not only because it is important to many of your businesses, but also because on this past Sunday [i.e. 6 January] our new Insurance Conduct of Business sourcebook ("ICOBS") came into effect, though with a six month transitional period allowed, to 6 July, if firms want it.
To some extent ICOBS re-implements the IMD in our rules, based on a greater degree of "copy out" of the directive, a move to a more principles-based approach and our removal of 'super equivalent' rules except where we think they're needed to correct a particular, identified failure.
As you'll have seen, we have greatly simplified ICOB in those areas of the general insurance markets where outcomes for consumers are generally good. So, for products such as household, motor, pet and private medical insurance, where markets are generally working well, the emphasis is on high-level rules, except where detailed provisions are required by EU Directives or are the only practicable way to protect consumers. While this will mean more flexibility for firms, the FSA will require the same standards of conduct and essential consumer safeguards remain.
In a few areas, however, we have responded to continuing market failures and consumer detriment by introducing carefully targeted rules to help ensure that consumers achieve a fair deal. This means, in particular, seeking to improve selling practices for what we've called 'protection products' – by which we mean: critical illness, income protection, term assurance and payment protection insurance (PPI). It also means a stronger framework of rules to back the FSA's drive to improve selling standards in the PPI markets.
The ICOBS changes therefore represent another important development in risk-based and more principles-based regulation. We will also seek to draw on our analysis and conclusions from the ICOB Review when contributing to the European Commission's coming review of the IMD.
Beyond MiFID – the forward EU agenda
Now, as I promised, I'd like to leave the specifics of MiFID and the IMD and look across the wider EU horizon. In particular, I want to consider the future agenda as it will affect you, and how this sits with the domestic UK agenda.
MiFID and the IMD are, of course, part of the European Commission's ambitious Financial Services Action Plan, launched in 1999 and aimed at making a single integrated European market in financial services a reality.
Measuring progress towards integration is not straightforward, but the Commission seeks to monitor this and to publish regular updates. Its December 2007 update on financial services is broadly positive about the degree of integration in the EU wholesale capital markets. But in the retail markets, the Commission sees integration as lagging behind, and is keen to do what it can to improve the situation. It wants to promote greater competitiveness and efficiency, and less fragmentation, to unlock the opportunities it sees from a better integrated retail financial market; including in terms of lower prices, more choice and better products.
So while there will continue to be a huge amount of work going on in relation to existing major projects like Solvency 2 - which I don't have time to get into today - it seems clear that the next area of focus in respect of new EU financial services initiatives is likely to be in the market for retail financial services.
The future EU retail agenda
In November, the Commission published some specific ideas for future work to deliver results here. In terms of a high level agenda, the four headings sound very familiar to us in the UK:
- improving customer choice and mobility
- making retail insurance markets work better – with a particular focus on cross-border motor insurance
- moving towards adequate and consistent rules for the distribution of retail investment products; and
- promoting financial education, financial inclusion and adequate redress for consumers.
There's clearly the potential here for some important work which could have some significant outcomes.
In particular, the retail distribution work promises to be an important and interesting area. The Commission wants to examine whether the current framework of EU law and regulation promotes a coherent approach to product transparency and distribution requirements for competing or substitutable retail investment products, or whether differences pose risks to investor protection and market integration. Retail investors are able to choose between a variety of different product types to meet their investment needs – including unit-linked life insurance, investment funds, structured funds, index-linked bonds, or structured term-deposits. But the current EU legislative framework imposes some different requirements, including on levels of product and fee disclosure, and different selling rules, depending on the legal form the product takes. The Commission is currently in listening mode and the work will develop, on the basis of views and evidence it receives, through 2008.
We are, of course, keen to work with the Commission on its retail agenda. But I also think that all stakeholders need to be realistic in their expectations and what can be done through legislation to encourage consumers to do more direct cross-border business. I think we need to understand the so-called cultural barriers to much cross-border retail financial services business and the reasons why many consumers may not necessarily feel comfortable investing cross-border. It's a reality that the industry has generally tried to work with.
We must continue to ensure that obstacles to the creation of a single market in financial services presented by regulation are removed. But we need to distinguish between removing obstacles, and using legislation to create markets that do not exist.
The European mortgage market provides a good case study. There have been suggestions of an ambitious new EU mortgage directive for several years. Yet, following a thorough consultation process, the Commission is now looking at a much more targeted and measured approach that envisages working with Member States and the industry to improve matters by non-legislative means. The Commission has acknowledged constraints on the potential for integration in the retail mortgage sector, commenting that factors such as language, distance, consumer preferences, and lenders' business strategies cannot be underestimated. It recognises that consumers predominantly shop locally for mortgages and that the majority will probably continue to do so for the foreseeable future.
So, the Commission has decided that it would be premature to bring forward legislative proposals at the moment and it will look in more detail at whether legislation would actually add value. This will involve rigorous impact and cost-benefit analysis and further stakeholder consultation.
These conclusions very much chime with the arguments that both the FSA and the UK industry have advanced during the debate. EU regulatory intervention should be seriously considered only where sound market failure and cost/benefit analysis demonstrate a case for action. With increasing prominence being given by the European Commission to the discipline of market failure and cost/benefit analysis, and vocal support from Commissioner McCreevy for principles-based EU regulation, we are more confident that the Commission will take a considered, temperate approach to looking at the EU retail agenda. The FSA for its part will remain vigilant and constructive in its approach to these important issues.
The UK Retail Distribution Review
Listening to all this, you may well be asking how on earth this crowded EU agenda sits with our own Retail Distribution Review. Indeed, some of you may be wondering whether EU initiatives could undermine any conclusions we draw from the RDR - for example, in relation to ideas such as Customer Agreed Remuneration, Primary Advice or professional standards.
Well I don't think so.
When we published the RDR Discussion Paper in June, we were at pains to set out at some length that any new regulation arising from the RDR, or the removal of regulatory barriers, will need to be compatible with these requirements of relevant EU Directives – just as they will need to be compatible with other domestic legal considerations such as tax law, competition law and general law.
In the paper, we singled out the main financial services directives that could affect the regulatory aspects of the RDR outcomes. They are essentially those I've touched on today. Of these, MiFID may present the most significant set of considerations we need to factor in, for many of the reasons I've mentioned. While MiFID supports our own principles-based approach to regulation, it imposes strict conditions on regulators’ ability to introduce new detailed rules for firms conducting MiFID business. Where MiFID operates, our requirements must not fall short of its standards.
There are also level playing field issues to consider, as we did with the implementation of MiFID in COBS. This would embrace both the distinction between Directive and non-Directive business, and between UK authorised firms and firms passporting into the UK. As we said in the June paper, we would need to consider the regulatory and competition implications of allowing different standards for different types of firm.
But we are determined to improve market outcomes for consumers and will therefore consider all practicable means of achieving the aims of this review. And while our preference is for industry-led solutions, there may be opportunities to remove regulatory barriers and to underpin these solutions through regulatory enablers to encourage good practice and support firms as they begin to change. But at this stage of the review we are still a long way from firming up on precisely what these 'solutions' should be and so even further away from determining the regulatory framework that might be needed to enable these solutions to deliver their intended outcomes. So it is premature to speak of MiFID or indeed any other directive as presenting an insuperable barrier for the RDR.
We are now embarking on analysing the many hundreds of contributions to the debate that we have received so far and we will not rush to premature conclusions. Certain themes are beginning to emerge, but it is too early to draw any firm conclusions about where we go next. We intend to publish an Interim Report in April to set out the areas where we intend to do more work ahead of publishing full feedback, together with our conclusions on where we now go, in October.
Conclusion
So where does this leave us? Well, on MiFID and COBS we'll continue to integrate the changes into our business as usual supervisory relationships and conversations with you, so that firms can feel confident in exploring what opportunities the Directive may create for them.
Beyond MiFID, there are obviously some significant issues ahead to be tackled, including bigger picture issues around the future shape of the EU retail markets. The European Commission's ambitions are to promote opportunities for firms and consumers. If the outcomes are proportionate, consistent and workable they should avoid new threats. As always, all stakeholders need to remain engaged in the process and register their views.
I've tried to bring out the degree of common ground in the EU and the UK retail agendas. Not just in scope, but also, hopefully, in an approach based on robust market failure and cost-benefit analysis and the promotion of a more principles-based regulatory philosophy. Because of this, the key challenges for the FSA are to influence constructively, and where we can shape, the developing EU priorities and agenda, and to contribute fully through our membership of the key committees and our working relationships with our fellow regulators and the Commission. We look forward to continued, close collaboration with all of you in these important efforts.
Thank you.