Client Protection at the Heart of MiFID II

This article was contributed by Michel Hodson, Director of Asset Management Supervision, Central Bank of Ireland. 

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In the majority of cases, even when dealing with a professional client, the ultimate beneficiary of these products is a retail investor. It is therefore incumbent on investment firms to ensure they are providing suitable products.

Markets in Financial Instruments Directive (MiFID) II introduces and strengthens a wide range of conduct of business requirements. First, its product governance framework aims to ensure entities act in the best interests of clients at all stages of the product life cycle. For example, product manufacturers must ensure that, in designing financial instruments, they do not adversely affect the target market or create problems with market integrity. Moreover, distributors are responsible for ensuring the investment offering is compatible with the needs, characteristics and objectives of the client. As a regulated entity, businesses must first consider whether they are a product manufacturer, distributor or both.

Turning to the client life cycle, correct client categorization remains the starting point to ensure clients receive the appropriate level of service and protection. Communication with prospective and existing clients must be fair, clear and not misleading.

In this regard, as the client relationship develops, MiFID II also introduces enhancements aimed at tackling the risks to the delivery of fair client outcomes. For example, the definition of non-complex instruments has narrowed. This will increase the appropriateness testing that firms must undertake. Furthermore, the MiFID II regulations apply significant changes to the suitability requirements, with a number of the European Securities and Markets Authority (ESMA) Guidelines placed on a statutory footing. Finally, MiFID II introduces new requirements, such as the need to ascertain information from clients regarding their risk tolerance and capacity for loss.

It is important to note that the regulations recognize that investing is not without risk. Firms are not expected to mitigate all risks. Rather, in providing a service to clients, they are responsible for ensuring the level of risk is appropriate to the client and that the client is aware and understands this risk. Taking this a step further, the way firms frame and present their investment offering to a client can greatly influence the client’s approach. There is a growing body of work in behavioral economics, and firms should use this to understand a client’s needs and risk tolerance, rather than to simply direct clients into products sold by the firm.

The time and money put into preparing for MiFID II have been significant for the industry and regulators. Both should strive to achieve the maximum possible return from this. At its core, MiFID II aims to improve standards of service to clients, increase investor protection and avoid client detriment. Firms that have embraced the new regulatory requirements should find they are in a stronger position to build long-term, mutually beneficial relationships with their clients.

To prosper over the long term, a firm’s goals and its clients’ must be aligned. Embracing MiFID II and putting client protection at the heart of the firm’s culture will play no small part in delivering this prosperity.