Including updates on PRIPS, the insurance mediation directive, UCITS, MiFID and intraday liquidity indicators


EC aims to upgrade retail protection through PRIPs, IMD revision and UCITS V

The EC’s latest round of consumer protection proposals are shaking up the €10 trillion retail investment market in Europe.

The proposals, which will probably be implemented over the next 3-4 years, include regulations which cover: The proposed regulation on PRIPS aims to improve the quality of information provided to retail consumers when considering investments in the EU. The EC recognises that many investment products are complex and it can be difficult for consumers to compare them or fully grasp the risks involved.

A Key Information Document (KID), a key proposal at the heart of PRIPS, will provide standard product information. Every manufacturer of investment products (e.g. investment fund managers, insurers, banks) will have to produce a KID for each product providing information on its main features, and the risks and costs associated with it. The EC want to ensure that KIDs have a common structure, content, so consumers can use them to compare different products and ultimately choose the product that best suits their needs. It is suggested that the KID will replace the KIID (Key Investor Information Document) adopted in respect of UCITS within a few years after the Regulation is adopted.

The EC has proposed revising the IMD, which currently regulates selling practices for all insurance products, from general insurance products (e.g. motor and household insurance) to those containing investment elements. Although IMD will remain a ‘minimum harmonisation’ Directive, the possibility of the adoption of delegated acts (most likely regulations) in key areas of detail, particularly in relation to insurance investment products, is hoped to increase the level of consistency across the European Union and to ensure the regime is comparable to MiFID II. The difference in legal basis, however, does raise some questions in this respect.

It is seeking to “upgrade consumer protection in the insurance sector by creating common standards across insurance sales and ensuring proper advice” by improving transparency and establishing a level playing field for insurance sales by intermediaries and insurance firms. The proposals should make it easier for intermediaries to operate cross-border, thus promoting the emergence of a real internal market in insurance services across the EU.

The EC wants to amend IMD to ensure that:
  • the same level of consumer protection applies, regardless of the sales channel used (i.e. insurance firm, broker, agent or other intermediary)
  • consumers are provided in advance with clear information about the professional status of the person selling the insurance product, introducing rules to address more effectively the risks of conflict of interest, including disclosure of remuneration received for sales
  • insurance product sales are accompanied by honest, professional advice.
Next, EC proposes to amend the current EU legislation for investment funds (the UCITS IV Directive). The financial crisis, together with the fraud perpetrated by Bernie Madoff in the United States, highlighted a number of weaknesses in the overall consumer protection which require another look. In particular, the proposal will ensure that the UCITS brand remains trustworthy by ensuring that the depositary's (the asset-keeping entity) duties and liability are clear and uniform across the EU.

The EC has proposed:
  • a precise definition of the tasks and liabilities of all depositaries acting on behalf of a UCITS fund
  • clear rules on the remuneration of UCITS managers - they should not be remunerated in ways that encourage excessive risk-taking, and remuneration policies should be better linked with the long-term interest of investors
  • a common approach to sanctions, including, introducing common standards on the levels of administrative fines, to ensure the fine always exceeds the potential benefits derived from the violation.
The reforms envisaged are significant and will change key aspects of the retail investment market in European. It is unclear how these measures will interact with other national reforms already under way in some Member States (e.g. UK’s Retail Distribution Review). They are likely to be hotly debated over the course of the next few years as the rules are finalised. Clearly, the spate of reforms we saw following the financial crisis shows no sign of abating. However, whether or not regulators can maintain the required momentum to push through these reforms (given the volume of reforms and distractions like the eurozone crisis) remains uncertain. Given the pressing demands placed on the Cypriot Presidency in other areas, it is unlikely that the Council will begin negotiating this package in earnest until early in 2013, suggesting adoption of the texts in early 2014, and a transposition date of the Directives of early 2016.


Basel Committee consults on intraday liquidity indicators

The Basel Committee on Banking Supervision (Basel Committee) has proposed a set of intraday liquidity indicators to help supervisors monitor how well banks manage intraday liquidity risk. This will obviously affect the form and construct of banks’ liquidity systems and the type of information they must collect, collate and disclose to supervisors.

The Basel Committee believes that no single indicator can provide supervisors with sufficient information on intraday liquidity risks or on how well risks are managed. Therefore, it is proposing the following 8 intraday liquidity indicators:
  • daily maximum liquidity requirement
  • available intraday liquidity
  • total payments
  • time-specific and other critical obligations
  • value of customer payments made on behalf of financial institution customers
  • intraday credit lines extended to financial institution customers
  • timing of intraday payments
  • intraday throughput.
The consultation paper outlines the reporting requirements of each indicator and supporting regulatory requirements. Although the indicators will apply specifically to internationally active banks, they have been designed equally to apply to all banks, including those that access payment and settlement systems indirectly via the services of a correspondent bank.

What is the rationale for further liquidity rules on top of what’s in Basel III’s liquidity framework? The Basel III liquidity framework is centred upon two new minimum liquidity standards: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio. Although the LCR is designed to promote the short term resilience of a bank’s liquidity profile, it does not currently include intraday liquidity within its calibration. The Basel Committee highlighted this weakness when the liquidity framework was first devised and later approved. However, they decided to park this issue until a solution was found.

These indicators, if used and handled correctly, should give supervisors a better take on banks’ ability to meet payment and settlement obligations on a timely basis, both in normal times and in stressed conditions. Given the close relationship between the management of banks’ intraday liquidity risk and the smooth functioning of payment and settlement systems, the indicators are also likely to benefit those who oversee payment and settlement systems.

The consultation closes on Friday 14 September 2012.


ESMA publishes final guidelines on MiFID suitability

The European Securities and Markets Authority (ESMA) released final guidelines on 6 July 2012, to ensure common approach to assessing suitability requirements under MiFID. Later this year or early next year, firms across Europe will have to apply consistent processes to ensure that their investment advice or portfolio management service is “suitable” given the client’s risk profile and financial situation. Firms shouldn’t find adapting to these new guidelines too taxing, because they mainly elaborate on existing requirements, but hopefully they will ensure greater consistency product suitability determinations across Europe.

According to MiFID, firms need to collect all ‘relevant’ information about the client and all material characteristics of the investment(s) considered in the suitability assessment. The extent of information that firms collect may vary. In determining what information is necessary, investment firms should consider, in relation to a client’s knowledge and experience: the type of the financial instrument or transaction that the firm may recommend or enter into (including the complexity and level of risk); the nature and extent of the service that the firm may provide; and the nature, needs and circumstances of the client.

ESMA, in its final position, has loosened the language around what information is ‘relevant’ given the practical limitations firms face in obtaining information on conditions, terms, loans, guarantees and other restrictions, especially where these products are provided by competing investment firms. In its December 2011 consultation, it gave an example of what information should be collected for “risky” or “illiquid” instruments without explaining these terms. In the final text, ESMA clarified that it is up to each firm to define a priori the level of risk of the financial instruments and which of the financial instruments included in its offer to investors it considers as being illiquid.

ESMA’s consultation paper stipulated that investment firms should recommend ‘the most suitable product or service for the client’ which goes beyond current MiFID requirements. ESMA has changed the final text from ‘the most suitable product’ to ‘suitable products or services’. It has also accepted that the detailed workings of the risk profile (including calculations) is beyond the understanding of the majority of retail customers and accepted that clients should be only given general information on the process.

Clients are expected to provide correct, up-to-date and complete information necessary for the suitability assessment. ESMA clarified that firms are not responsible for errors or false information. However firms need to take reasonable steps to check the reliability of information collected about clients: firms remain responsible for ensuring they have adequate information to conduct a suitability assessment. For example, firms should consider whether the client has provided information with any obvious inaccuracies. They should also establish and maintain record-keeping arrangements covering the suitability assessment with clients.

All staff involved in material aspects of the suitability process should have the adequate skills to discharge their responsibilities. This may be enforced through professional certification, such as the ones recently launched in the United Kingdom and France and established since the early 2000s in Sweden. However, ESMA leaves it open for national supervisors to determine how to enforce this requirement.

The investment firms should also establish and maintain record-keeping arrangements covering the suitability assessment with clients.

ESMA believes that giving firms and supervisors some direction on suitability under MiFID will result in better outcomes for consumers. However, MiFID does not cover all investment products being sold to European retail investors. Important gaps will be addressed through the proposal on Packaged Retail Investment Products (PRIPs) and the revision to the Insurance Mediation Directive (IMD II) (see separate article) takes this forward, but we are still a few years off these initiatives coming into force. Until then, some consumers may still experience inadequate and unequal protection across Member States and products. This leaves consumers with, in some cases, inadequate and others, unequal protection across Member States and across investment product lines.  

ESMA finalises guidelines on the compliance functions under MiFID

ESMA’s final guidelines on the compliance function under MiFID clarify a number of important areas.

Compliance should be at the heart of the investment firm’s operations, with its tentacles around each business process. The final guidelines call on senior management to promote and enhance a strong compliance culture within an investment firm. However, many respondents felt that ESMA’s original proposals were too far-reaching in some areas. For example, they stated that the compliance function is “responsible for the training of the staff”, when in reality business unit/management is responsible for training; and the compliance function’s role should be limited to advising and supporting the operational function. ESMA has made amendments to the guidelines to take these points into account.

Respondents believe that firms and their compliance officers must find the “necessary balance between resources and risks to determine the focus and the scope of the monitoring, reporting and advisory activities of the compliance function”. They also generally agreed that firms should have adequate stand-in arrangements. Some stated that planning for unforeseeable absences of the compliance officer is difficult in practice. EMSA has adapted the final wording to give firms more discretion on resource planning.

Respondents felt the guidelines should address more explicitly the role of senior management in ensuring that the business is run in a compliant manner and that the compliance function acts as “a second line of defence”. ESMA gave further clarification in the final guidelines on the role of senior management and what it meant by the three lines of defence, which are:
  • compliance controls
  • controls performed by the firm’s business areas
  • reviews by the risk management/internal control function/internal audit function in the area of investment services.
Respondents were also concerned that senior management would receive long and descriptive reports that do not focus on the matters of which they should be aware, such as significant incidents that have occurred, risks that have been identified or grown, actions they need to take, etc. ESMA has amended the final guidelines, and added “risks identified in the scope of the compliance function’s monitoring activities.”

All respondents agreed that the compliance function must be independent, taking decisions without being influenced by other business units. The independence should be “combined with proximity to transactions and operations”. Compliance functions can achieve independence and proximity by a combination of a specific compliance position and by requiring that the senior management appoint and replace the compliance officer.

Respondents generally agreed that, as part of the supervisory process, competent authorities should review a firm’s arrangements for the compliance function to ensure that the compliance function fulfils its responsibilities appropriately. ESMA took on board respondents’ comment that supervisors may prefer to use a risk-based approach rather than routine assessments if resources are scarce.

ESMA confirmed that firms must implement the guidelines’ requirements for all client types. On outsourcing, ESMA reiterated that MiFID outsourcing provisions for critical and important functions “apply in full” to compliance outsourcing in its final guidelines. The responsibility for the fulfilment of the existing requirements rests firmly with a firm’s senior management. They should perform a due diligence assessment before choosing a service provider to ensure it has the “necessary authority, resources, expertise and access to all relevant information in order to perform the outsourced compliance function tasks effectively”.

These guidelines should come into effect at the end of the year or early next year. While most firms should already be applying these guidelines, we believe this exercise is positive. The financial crisis has highlighted the need to further clarify compliance’s role, especially in view of the plethora of evolving legislation and increasing levels of scrutiny from both regulators and consumers.