On 24 May 2023, the European Commission
(Commission) published its Retail Investment
Strategy (RIS), a legislative package intended to
empower retail investors to take more informed investment decisions
that would better correspond to their investment needs and
objectives. The RIS was published in response to concerns that, in
the EU, the level of retail participation in capital markets
remains low compared with other advanced economies. For example,
one startling figure that the Commission quoted was that in 2021,
approximately 17% of EU household assets were held in financial
securities (listed shares, bonds, mutual funds and financial
derivatives). There are a number of reasons for this low
participation including inertia but also low levels of financial
literacy and a lack of trust in those providing the products who
stand to receive commissions. Another important factor that the
Commission is also acutely aware of and wants to harness are new
trends, particularly digitalisation which offers easier access to a
wide range of services including low-cost automated sales and
retail investors focussing more on sustainability.
RIS
The RIS comprises of a Directive as regards the EU retail
investor protection rules. This Omnibus Directive amends the EU
retail investor protection framework set out in the:
- Markets in Financial Instruments Directive II (MiFID
II). - Alternative Investment Fund Managers Directive
(AIFMD). - Undertakings for Collective Investment in Transferable
Securities Directive (UCITS Directive). - Directive on the provision of insurance or reinsurance
distribution services to third parties (IDD). - Directive on the taking-up and pursuit of the business of
Insurance and Reinsurance (Solvency II).
Accompanying the Omnibus Directive is a proposed Regulation
which amends the Regulation on key information documents for
packaged retail and insurance-based investment products
(PRIIPs).
Political process
On 5 October 2023, European Parliament rapporteur
Stéphanie Yon-Courtin (Renew, FR) published her two draft
reports concerning the RIS. On 20 March 2024, the European
Parliament’s Economic and Monetary Affairs Committee
(ECON) had considered the rapporteur’s draft
report and adopted it by 32 votes to 21 (with 1 abstention). A
press release was issued although at the time of writing the draft
legislative text was not.
However, the European Parliament will cease its work in April
2024 to prepare for the June 2024 elections. It is therefore
doubtful whether the Council of the EU and European Parliament can
adopt a final text of the RIS before the European Parliament
elections, which could cause significant delay.
This briefing note considers the key points arising from the
Omnibus Directive as it impacts MiFID II. It does not cover changes
to AIFMD, UCITS Directive, IDD and Solvency II.
Measures
According to the Commission’s factsheet concerning the RIS
the intended aim of the legislative package is to:
- Modernise disclosure rules, adapting them to the digital age
and investors’ sustainability preferences. - Develop benchmarks against which the value of financial
products need to be assessed. - Address potential conflicts of interest by banning inducements
for “execution-only” sales and strengthening conditions
where inducements are allowed. - Ensure financial advisors examine retail investors’
financial situation more carefully. - Require that marketing be fair, clear and not misleading also
via digital channels and finfluencers. - Improve both financial advisors’ and retail investors’
knowledge of financial markets. - Improve investor categorisation by reforming the eligibility
criteria for professional investors. - Enhance supervisory cooperation between Member State competent
authorities (NCAs) and European supervisory
authorities.
Disclosure rules
In essence the Commission’s approach to modernising the
disclosure rules is threefold, covering risk warnings, marketing
communications and unauthorised access via digital channels.
Risk warnings
While for contracts for differences there is an obligation to
mention a risk warning (also on social media), there is no such
risk warning for other risky financial services or instruments at
the EU level.
The Omnibus Directive seeks to rectify this by inserting a new
paragraph into Article 24 of MiFID II which will require investment
firms to display appropriate risk warnings in all information
materials concerning particularly risky financial
products. Member States will also ensure that their NCAs have
the power to impose the use of risk warnings for particularly
risky financial products.
Obviously, the key issue for the market will be coming to terms
with what is and what is not particularly risky financial
products. The European Securities and Markets Authority
(ESMA) has been tasked to deal with this and is
provided with a mandate to develop, within 18 months of the Omnibus
Directive coming into force, guidelines which will specify the
concept of particularly risky financial products, as well
as technical standards specifying the content and format of such
risk warnings.
ESMA is also empowered, after consultation with the relevant
NCAs, to impose the use of risk warnings on investment firms in
instances where an absence of risk warnings may have a material
impact on investor protection. How ESMA will utilise this power
remains to be seen particularly in relation to individual Member
States.
In her amendments the rapporteur took a more bullish approach
and suggested broadening the power to impose risk warnings so that
they are not limited to particularly risky financial
products given that NCAs might need to impose risk warnings
for reasons other than excessive risk. She also added a provision
that enabled NCAs to use webscraping tools in order to perform
their monitoring activities of new models of communication emerging
from social networks and online platforms.
Marketing communications
Article 24(3) MiFID II provides that all information, including
marketing communications, addressed by the investment firm to
clients or potential clients shall be fair, clear and not
misleading. Marketing communications shall be clearly identifiable
as such. Supplementing Article 24(3) is Article 44 of Commission
Delegated Regulation 2017/565 (MiFID II Delegated
Directive) which provides further colour on fair, clear
and not misleading information requirements.
For some time the Commission has been concerned that these MiFID
II rules are not sufficiently adapted to the risks associated with
the growth of digital channels offering services. In January 2023,
ESMA launched a common supervisory action (CSA)
with NCAs on the application of MiFID II disclosure rules with
regard to marketing communications across the EU.
The Omnibus Directive therefore introduces new provisions to
address the risk of unbalanced or misleading marketing
communications. In particular the Omnibus Directive inserts into
MiFID II a new Article 24c which:
- Introduces new obligations on investment firms that include
clearly identifying marketing communications and ensuring they are
appropriately attributed to the investment firm by which or on
whose behalf they are made. In addition, the essential
characteristics of the investment product or service is to be
clearly presented in all marketing communications. - Provides that marketing communications and practices should be
developed, designed and provided in a manner which is fair, clear
and not misleading, and should be balanced in their presentation of
risks and benefits as well as appropriate for the target group of
investors they are aimed at. The Commission is empowered to adopt a
delegated act specifying those essential characteristics and the
conditions to an appropriate design. - Provides for the division of responsibility with respect to the
content and use of marketing communications between manufacturers
and distributors of investment products. - Requires Member States to ensure firms’ management bodies
receive annual reports on the use of marketing communications and
strategies aimed at marketing practices, compliance with
obligations on marketing communications and marketing practices,
and on signalled irregularities and proposed solutions with
obligations on marketing communications and marketing practices,
pursuant to MiFID II. - Extends the existing record keeping obligation to all marketing
communications which are directly or indirectly made by investment
firms. The obligation covers a period of 5 years, allowing for a
derogation of up to 7 years at the request of NCAs.
The Omnibus Directive also:
- Amends Article 9(3) MiFID II to include a requirement for
investment firms to have a policy on marketing communications and
practices, which the management body of an investment firm should
define, approve and oversee. - Inserts a new paragraph 3a in Article 16 MiFID to include a
requirement for investment firms to have effective organisational
and administrative arrangements in place to ensure compliance with
all obligations related to marketing communications and practices
under Article 24c. - Amends Article 24(2) of MIFID II by requiring investment firms
that manufacture financial instruments to ensure that the strategy
for the distribution of those financial instruments is compatible
with the identified target market also in relation to any marketing
communications and marketing practices.
The rapporteur generally welcomed the new provisions concerning
marketing communications focussing in particular on the emergence
of so-called ‘finfluencers’ operating on social media and
mobilising mainly younger generations. The rapporteur also proposed
additional elements including imposing a requirement on firms to
sign a contract with finfluencers to ensure responsibility.
Unauthorised activities offered through digital
means
The Commission is aware that digitalisation presents various
risks for retail investors not least that unauthorised investment
services or activities may be offered through them. To this end the
Commission is inserting into MiFID II a new Article 5a which
provides for certain requirements to address unauthorised
activities offered through digital means including updating the
powers in Article 69(2) MiFID II and creating a new ESMA database
setting out the measures that NCAs have taken against entities
offering unauthorised investment services or activities.
Conflicts of interest and inducements
Whilst stopping short of a full ban on inducements, the
Commission is introducing a number of important changes to the
MiFID II rules in this area.
Retail investors may not always get the best
deal
In its impact assessment the Commission noted that retail
investors may not always get the best deal and that the current
economic climate was exacerbating this. It gave the example that in
2021 retail clients were charged on average around 40% more than
institutional investors across asset classes. Retail investors were
also heavily dependent on advised services, and retail investment
products were mostly distributed through a commissions-based model.
Critically the impact assessment asserted that “the
existing rules do not sufficiently mitigate the conflicts of
interest which are inherent in this distribution model, and which
lead to the distribution of more expensive products and deliver
suboptimal outcomes for retail investors.”
MiFID II
Currently, MiFID II allows for the payment of fees, commissions
or the provision of non-monetary benefits (so called
“inducements”) to financial services providers by third
parties (typically the manufacturer of the product). The MiFID II
rules provide the basis for the “commission-based”
distribution model of retail investment products, whereby financial
intermediaries (e.g. financial advisors) are remunerated for their
services not by the retail investors directly, but by the
manufacturers of those products. The rules do not, however, exclude
a purely “fee-based” model, whereby financial
intermediaries (e.g. independent financial advisors) are only paid
directly for their services, including advice, by the retail
client. Under MiFID II, an advisor that informs his/her clients
that the investment advice is provided on an independent basis,
cannot accept commissions from third parties but needs to rely on
fees from the client. The “fee-based” model has had
limited uptake whereas the “commission-based” model is
currently predominant for the distribution of retail investment
products in the EU.
Conflicts of interest at the level of the distributor are
inherent in the “commission-based” distribution model, as
financial intermediaries receive remuneration from persons other
than the retail investor for the products they are recommending and
selling. The existing safeguards, such as the quality enhancement
test under MiFID II, lead to different interpretations across
Member States and firms, despite convergence efforts by ESMA.
Changes
In terms of inducements, the Omnibus Directive introduces three
important measures:
- The existing ban on inducements regarding independent advice
and portfolio management are maintained. However, a new Article
24a(2) MiFID II introduces a ban on inducements paid from
manufacturers to distributors in relation to the reception and
transmission of orders, or the execution of orders to or on behalf
of retail clients. - A new Article 24a MIFD II clarifies that the ban on inducements
in relation to the services of execution of orders and reception
and transmission of orders is not applicable in situations where
the investment firm provides advice to the same client relating to
one or more transactions covered by that advice. The ban on
inducements is also not applicable in relation to fees or
remuneration received or paid from an issuer for placement and
underwriting services. However, such exemption is not to apply as
regards instruments that qualify as packaged retail investment
products. - Further requirements are added to MiFID II as regards advised
sales which oblige a distributor to ensure that the payment or
receipt of inducements does not impair compliance with their duty
to act honestly, fairly and professionally in accordance with the
best interests of their client and to disclose the existence,
nature and amount of inducements to the client.
The European Parliament’s rapporteur took a different
approach in her draft report arguing that the proposed approach on
inducements looked like a first step and did not fully address the
issues. Strong views were expressed against a full ban on
inducements, she did not see the alleged conflict of interest which
the Commission claimed as the reason for banning inducements in
execution only situations and instead she opted for increased
transparency. She also noted that in the absence of a clear and
precise definition of the reception and transmission of orders, the
actual scope of the ban remained unclear.In terms of the review
clause, the rapporteur felt that it should not be biased as to lead
to the automatic introduction of a full inducement ban and proposed
to prolong it for five years starting from the end of the
transposition period of the Omnibus Directive. In addition, the
review clause’s scope should be broadened to provide for an
assessment based on potential conflicts of interest, evolution of
costs, level of retail investment in capital markets, consumer
protection and the relevance of distribution rules.
Quality enhancement test
The so called ‘quality enhancement’ test in MiFID II is
to be replaced. To many this may not come as a complete surprise
given that, for instance, in 2020 the Securities and Markets
Stakeholder Group noted studies by several NCAs which showed that
many investment firms were not fully meeting their obligations
under the test, and that NCAs often had differing interpretations
of the quality enhancement criteria
So that in order for financial advisors to act in the best
interests of their clients (‘best interest’ test), they
must, as a minimum:
- Base their advice on an assessment of an appropriate range of
financial products. - Recommend the most cost-efficient financial product from an
appropriate range of suitable financial products. - Offer at least one financial product without additional
features which are not necessary to the achievement of the
client’s investment objectives and that give rise to additional
costs.
The Omnibus Directive adds a review clause requiring the
Commission to assess the effects of third-party payments on the
retail investor segment three years after the transposition of the
Directive.
As regards the cost efficiency criterion the rapporteur called
for an assessment in practice with the notion of net performance,
taking into account the level of return and not just costs. She
also suggested that ESMA provide further guidance as to the
practical meaning of an appropriate range of suitable financial
products and how to fulfil this obligation in instances of
non-independent advice.
Product governance and oversight
MiFID II’s product governance requirements have proven to be
one of the most important elements of the MiFID II investor
protection framework, aiming to ensure that financial instruments
and structured deposits (products) are only manufactured and/or
distributed when this is in the best interest of clients. Articles
16(3) and 24(2) MiFID II provide that firms that manufacture
products for sale to clients or distribute products to clients
shall maintain, operate and review adequate product governance
arrangements. As part of these arrangements, a target market of end
clients shall be identified and periodically reviewed for each
product, and a distribution strategy must also be consistent with
the identified target market.
In March 2023, ESMA issued a final report updating its 2017
guidelines on MiFID II product governance requirements in light of
various regulatory developments including the 2021 CSA on product
governance which found room for improvement in various areas
including the requirement to perform a charging structure analysis
as required under Article 9(12) of the MiFID II Delegated
Directive.
The updates to the 2017 guidelines have not been enough
though.
Perhaps the most contentious aspect of the RIS is the
Commission’s proposals to develop benchmarks against which the
value of financial products need to be assessed and this has led to
criticism that maximum prices are to be set by the state for the
services of asset managers and banks in the investment sector.
Benchmarks
Among the changes being introduced by the Omnibus Directive is a
new Article 16a MiFID II which seeks to strengthen product
governance rules and regulate pricing processes, and with a view to
limit the offer of products that bear poor or no ‘value for
money’ for retail investors. The changes apply to PRIIPs and at
the level of the product manufacturer and distributor.
The key change is a requirement not to approve products that
deviate from a relevant benchmark unless the manufacturer is able
to establish that the costs and charges are justified and
proportionate. ESMA is to develop and update cost and performance
benchmarks against which manufacturers must compare their products
prior to offering them on the market. To facilitate the development
of the benchmarks certain requirements are placed on manufacturers
and NCAs as regards reporting data on costs, charges and
performance of PRIIPs. Any deviation from a relevant benchmark is
to introduce a presumption that the costs and charges are too high
and that the product will not deliver value for money unless it can
be demonstrated otherwise. Therefore any deviation would need to be
documented setting out the reasons for doing so.
In its impact assessment the Commission asserted that the main
adjustment costs for investment firms resulting from the value for
money process would be one-off changes to IT systems. As
calculations can be automated, the Commission felt that these
additional costs would not be significant. This was on the basis
that most of the data and IT infrastructure are already in place in
order to comply with existing disclosure requirements and product
governance rules. The Commission also accepted that reporting to
supervisors will entail additional administrative costs but did not
say how significant these costs would be as they would be dependent
to a significant extent on how value for money is ultimately
implemented, and the degree of granularity required.
The rapporteur felt that the proposal for value for money could
be disruptive for the market leading to reduced diversity of
products and supressed innovation. Also, she felt that further
discussions were needed given the lack of clarity regarding the
methodology which would be applied to the design of the benchmarks
which prevented any assessment as to how these would unfold in
practice. As such the rapporteur deleted the benchmarks in her
draft report.
However, in the European Parliament’s press release
concerning ECON’s approval the concept of benchmarks had not
been deleted. The press release provided that ESMA and EIOPA should
after consulting NCAs develop common European benchmarks for
products manufactured and distributed in two or more Member States.
Products manufactured and distributed in one Member State would be
subject to national benchmarks. The press release added that the
benchmark should not lead to price regulation and should instead be
used as a supervisory tool, to assess the monetary and non-monetary
benefits of the products and identify potential outliers on the
market.
Other changes
The Omnibus Directive makes further changes to the suitability
and appropriateness tests, investment advisors, the thresholds for
client categorisation and financial literacy.
Suitability and appropriateness tests
The Omnibus Directive amends the Article 25 MiFID II
appropriateness test so as to require investment firms to explain
the purpose of their assessment to their retail investors in a
clear and simple manner. They must also obtain all relevant
information from such investors which may be necessary and
proportionate for these assessments. Retail investors will need to
be informed, via standardised warnings, about the consequences on
the quality of the assessment where they do not provide accurate
and complete information. In addition, the Omnibus Directive will
introduce the possibility for independent advisors to provide
advice although this will be limited to a sufficient range of
diversified, non-complex and cost-efficient financial
instruments.
Investment advisors
The Omnibus Directive contains revised rules which aim to
strengthen and align the requirements on the knowledge and
competence of investment advisors set out in MiFID II and IDD.
Article 24d MiFID II will be amended and certain requirements that
are currently stipulated in ESMA guidelines are to be moved to a
new Annex V of MiFID II. Furthermore compliance with the
requirements will be proved by obtaining a certificate. There will
also be ongoing professional training.
Thresholds for client categorisation
The Omnibus Directive adjusts the eligibility criteria for
professional investors upon request. It does this by lowering the
monetary threshold from EUR 500,000 to EUR 250,000. In addition, a
fourth criterion relating to relevant education or training is
inserted which reads:
‘the client can provide the firm with proof of a recognised
education or training that evidences his/her understanding of the
relevant transactions or services envisaged and his/her ability to
evaluate adequately the risks’
Legal entities will also be able to qualify as a professional
client on request by fulfilling certain total balance sheet
(€10 million), net turnover (€20 million) and own funds
criteria (€1 million).
Financial literacy
In its impact assessment the Commission noted low levels of
consumer financial literacy noting in particular that the OECD/INFE
2020 International Survey of Adult Financial Literacy showed that
on average, consumers could only reply to around 60% of questions
on basic knowledge concepts and financially prudent behaviours and
attitudes. Only 26% of all adults responded correctly to questions
on both simple and compound interest – which are crucial
concepts for investment.
In light of this a new Article 88a MiFID II seeks to promote
financial education measures at the Member State level so that
retail investors are able to investment responsibly. The rapporteur
noted that according to a recent Eurobarometer survey, only 18% of
EU citizens have a high level of financial literacy, 64% have a
medium level and 18% a low level, while there were also huge
divergences among Member States.
Supervisory enforcement
Certain measures are being introduced to strengthen cross border
supervisory enforcement. For example, the Omnibus Directive
introduces a new Article 35a MiFID II which deals with investment
firms reporting on their cross-border activities. A new Article 87a
MiFID II further provides for the establishment of collaboration
platforms that facilitate closer collaboration between NCAs and the
European Supervisory Authorities to address cross-border
issues.
The rapporteur proposed certain amendments to boost cross-border
supervision, including placing an obligation for companies to
register in the same Member State where their head office is
located, in order to avoid forum-shopping. She argued that the
current Recital 46 of MiFID II establishes an anti-forum-shopping
principle by requiring that an investment firm operates effectively
in its home Member State. Until now, it has been a
‘floating’ recital, with no corresponding provision in the
MiFID II articles. This requirement should become more
explicit.
Changes to PRIIPs
The RIS makes several changes to the PRIIPs Key Information
Documents (KIDs) including:
- Introducing a summary dashboard, to make key information on
costs and risks of investment products highly visible at the top of
the document. - More flexibility to display information from PRIIPs key
information documents in a digital and user-friendly way, notably
by allowing the use of layering, i.e. the possibility to click on
the titles of different sections of the key information document
and expand the text of the sections of interest, which complements
the fixed document, such as in PDF format, which exists today. The
package also specifies conditions for more interactive
features. - A new sustainability section in the KID titled ‘How
environmentally sustainable is this product?’. The section will
make information on sustainability-related characteristics of
investment products more visible, comparable and understandable for
retail investors. This section will build entirely on existing
sustainability disclosures, avoiding any new reporting
burdens. - A definition of electronic format.
- A new section in the KID titled ‘Product at a glance’
to summarise and highlight the information on an investment product
type, its costs and the level of riskiness, recommended holding
period and presence of insurance benefit. - Adapted rules for presentation of key information on
multi-option products. - Clarifications intended to provide greater legal clarity on the
exclusion of specific products (e.g. corporate bonds) that were not
originally intended to be captured by the PRIIPs regulation.
Among other things the rapporteur suggested deleting the
‘Product at a glance’ section of the KID. The justification
for this was that such content would be redundant with those of the
KID and would use space in a document that is already very dense.
This addition did not concur to the much-needed simplification of
PRIIPs.
In a separate vote MEPs in ECON approved proposed changes to
KIDs, with 38 votes to 13 (with 2 abstentions).
The UK approach
The reforms to the EU retail sector as set out in the RIS are
still in their early stages. The framework directive has not been
completed and is still going through political discussions. Level 2
measures that provide clarity on the key aspects of the Directive
like benchmarks have not yet been drafted. The UK on the other hand
is much more advanced, having introduced a new Consumer Duty
(Duty) on 31 July 2023 for all products and
services that were open for sale or renewal. The Duty will apply to
all closed products and services from 31 July 2024.
The key question for investment firms operating in both the UK
and EU will be how aligned or how far apart is the Duty from the
RIS.
For example, under the Duty the Financial Conduct Authority
(FCA) expects firms to provide products and
services that, among other things, provide fair value with a
reasonable relationship between the price retail investors pay and
the benefit they receive. But fair value is about more than just
price, the Duty aims to tackle factors that can result in products
or services which are unfair or poor value, such as unsuitable
features that can lead to foreseeable harm or frustrate the
customer’s use of the product. The introduction of benchmarks
and a structured pricing process under the RIS are much more
formalistic. UK firms under the Duty will no doubt conduct
benchmarking but that is only part of the fair value assessment,
firms need to satisfy themselves that the product in and of itself
provides fair value.
The Duty introduced a new FCA principle that firms “must
act to deliver good outcomes for retail customers”. The RIS
introduces certain changes that firms will need to consider when
considering the clients’ best interests but arguably the less
prescriptive UK approach provides for broader application.
The RIS introduces new obligations regarding marketing
communications and updates to the PRIIPs KID. The Duty has
introduced a consumer understanding outcome which builds on
Principle 7 of the FCA’s Principles for Businesses that firms
communicate information in a way which is clear, fair and not
misleading. For example, the Duty adds that firms must tailor
communications taking into account the characteristics of the
customers intended to receive the communication and when
interacting directly with a customer on a one-to-one basis, where
appropriate, tailor communications to meet the information needs of
the customer, and ask them if they understand the information and
have any further. On PRIIPs more generally, the UK is looking to
revoke the regime and put in its place a “future disclosure
framework”. An FCA consultation paper is expected sometime
this year.
Outside of the Duty, the UK and the EU have taken different
paths when it comes to the ban on inducements. The UK has a full
ban on commissions paid from manufacturers to distributors. The EU
currently proposes a partial ban.
Next steps and conclusion
As mentioned above, the European Parliament will cease its work
in April 2024 to prepare for the June 2024 elections. It is
therefore doubtful whether the Council of the EU and European
Parliament can adopt a final text of the RIS before the European
Parliament elections, which could cause significant delay.
The Commission seriously underestimates the additional costs
investment services firms will have to bear even if only the
slimmed-down version of the RIS, as proposed by the rapporteur, is
implemented. For investment firms and their clients, the investment
universe will shrink, as only products that are – based on
hard to test predictions – “cost effective” can be
sold. This is bad enough in the context of investment advisory
services, but not justifiable, from a proportionality viewpoint,
when it comes to execution-only business.
Hopefully, the RIS – which can, if implemented properly,
help investment firms to regain the trust of their clients –
benefits from an extended summer break.
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