MiFID 2: Transparency and Technology Changing the Financial Landscape

@LawAhead

The amended MiFID, focusing on investor protection and transparency in the financial sector, means financial institutions are considering how to most effectively use technology to comply with regulation and compete in the new financial landscape.

Author: Luis Maldonado, Professor IE University and Senior Advisor at everis

Since the financial crisis of 2008, the EU has taken a second look at some of the regulation put in place to bolster transparency in the financial sector and protect investors. The Markets in Financial Instruments Directive (MiFID) of 2007—first attempt to standarization and increased transparency in the sector throughout the EU—was amended after the financial crisis shed light on some weaknesses in the regulation.

The MiFID 2 has been in effect since January 2018, making a significant impact on the way financial instruments, including banks, look and operate. In an effort to combat complex,harmful financial products such as subprime mortgages and similar failures seen in 2008, the MiFID 2 affects financial, advisory and market services for banks, non-banks and other similar providers for corporate, retail and institutional customers. It has a major impact on all primary and secondary financial and commodity markets in order to strengthen market integrity.[1]

Increased transparency in reporting, and more detailed definitions of both service providers, products and customers means banks (and other financial entities) will need to incorporate technology in order to comply and compete in the new financial setting. The IE Law School and everis joint 2018 report “Technology in Banking: the opportunity to comply and compete” takes a closer look at the objectives of increased regulation and how it might not only protect the consumer, but also increase competition and innovative solutions in the financial sector.

 

Aims of the MiFID 2

The MiFID’s main objectives include protecting the investor and improving the transparency of all financial products and services on the market.

Investor protection:

  • Categorization: In order to better protect investors, the amended directive requires financial entities to categorize clients as eligible counterparties, professional clients and retailers.[2] These categories mean that eligible counterparties (investment firms, for example) and retailers (professionals or non-professionals) can be better protected according to their characteristics and needs.
  • Suitability and appropriateness assessments: Investment firms must assess the client’s experience and knowledge along with their financial situation and investment objectives in order to find products that are best suited to each individual.[3]
  • Define, distinguish and explain products: Financial entities are now required to distinguish between complex and non-complex products, and to inform investors with clarity and impartiality.

Improved transparency:

  • Technology

More efficiency, rigorous reporting and security requirements mean financial institutions will need to integrate technology to help them comply with regulation (including natural language processing and machine learning to be able to meet requirements). These technologies will enable better tracking of operations and transparency.

  • New trading venues

A new category of trading venue (Organized Trading Facilities, or OTFs), which can be considered a multilateral trading venue with an intentionally broad definition, has been created in order to contain as many different forms of organized execution of transactions as possible—so nothing slips through the cracks. The same regulation that applies to other trading venues, applies here, including fair and orderly trading, execution of orders and pre- and post-trade transparency.[4]

Redefined financial advising and investment services

 The cost of working with a financial advisor has not always been completely transparent. Investment firms in the past did not always charge explicit rates, but earned brokerage commissions—so although the service was not free, it may have appeared so to clients. This type of service also created a high potential for conflicts of interest—with investment firms recommending the investments and products that most benefited the firm rather than the client. The new system establishes four different business models that are more open, clear and fair to investors.

  • Execution of orders on behalf of the client

Providers of this service may earn commissions only when 25% of the offer to the client includes products of the same category offered by third party entities, avoiding conflicts of interest.

  • Non-independent advising

Non-independent advisors can also earn commission, if and when they prove they have offered the client either 25% of third party funds or added value above and beyond the execution or orders (guided investment or close monitoring of the suitability of the product for the client, for example).

  • Independent advising

Independent advisors are not permitted to receive retrocessions or commissions from third parties but must establish specific and explicit advising fees.

  • Discretionary portfolio management

This service is a variation of independent advising with the same conditions. In this case, clients sign a management mandate allowing portfolio managers to make investment decisions without the investor’s authorization for each operation.

Financial entities must now clearly communicate the kind of services they offer to clients. Although commissions and retrocession fees are still standard, with many entities in Spain, for example, opting for a non-independent advising model (with commissions just too good to pass up) the new regulation requires these fees and the relationship between the investor and the advisor to be more transparent. Investors can now see where their money is going and why.

Although many entities may be trying to maintain the status quo, the door has been opened to flexible, technology savvy businesses who can quickly adapt to the new regulatory environment. Passive advising carried out by AI or robo-advisors is just one example of how new business models are thriving.

 

Better record keeping

In the name of transparency, financial entities are now required to record telephone conversations and to save email communications with clients regarding the execution of orders at all stages of the transaction. The only exception to this is for services provided by discretionary portfolio managers, since they are given explicit control over investment decisions.

Banks and other service providers must be able to provide specific and structured information about operations and the entire life cycle of a transaction within 72 hours of a request, which can be made by either the client or a regulatory body. Because of this new stringent requirement, many financial entities are incorporating AI and natural language processing (NLP) in order to not only be able to comply with the regulation, but also to be able to innovatively use the information they are now required to collect.

The implementation of the MiFID 2 means banks, and other financial entities are using technology to comply with strict regulation and reporting requirements, and the most future-forward in the sector are changing the financial landscape with innovative new products and services.

 

How MiFID 2 will reshape banks

The look and feel of banks and financial entities will change as a result of the MiFID 2.

  • New bank/client relationship

Banks will no longer be able to create products, then sit back and wait for clients to grab hold. The new regulation, forcing stricter assessment of clients’ knowledge and needs, means financial entities will need to create products that better meet clients’ characteristics.

The concept of independent advising has also entered the playing field, creating a different, more customer-centered relationship where the customer pays directly for a financial service. However, it remains to be seen if banks will choose this business model which renounces commissions.

  • Tech

Technology will play a key role in providing clients with standout products and services. Banks and financial entities that are able to manage and analyze the enormous amounts of transactional data they will need to collect will be able to provide highly valuable and personal advising services that can anticipate clients’ long-term needs like never before.

New technologies like robo-advisors also mean banks can offer new, alternative services for clients looking for affordable, passive management of their portfolios. This type of low-cost, independent advising uses algorithms, eliminates the human factor and is becoming increasingly popular with certain client categories.

The use of natural language processing, generation and understanding (NLP, NLG and NLU), big data and machine learning will also become essential for banks to meet regulation requirements by collecting, storing, processing and fully taking advantage of the enormous amounts of information they will encounter.

The implementation of the MiFID 2 has meant stricter regulations in transparency and investor protection. This not only changes the financial sector by increasing standardization, investor protection and market integrity, but it also means banks, and other financial entities are using technology to comply with strict regulation and reporting requirements, and the most future-forward in the sector are changing the financial landscape with innovative new products and services.

Access the article in Spanish here

Luis Maldonado has developed his career finance, both in the public and private sector. He was advisor to the Minister of Economy in Spain, Director of Strategic Consulting at PwC and CSO for a retail bank. He has also worked for five years at the International Monetary Fund, where he held different positions, as an advisor to the Managing Director and in the Monetary and Financial Markets Department. More recently, he was Managing Director of the PwC-IE Business School Financial Sector Center. Currently, he is professor at IE Business School, Senior Advisor at Everis and Senior Digital Financial Sector Specialist at the IFC (World Bank Group). Luis Maldonado holds a Ph.D. in Economics from Alcalá University, he is State Economist for the Government of Spain, and he holds Degrees in Law and in Business Administration from ICADE University.

[1] http://www.cityandfinancialconferences.com/events/mifid-ii-strategic-and-business-model-implications/event-summary-269627b661d142fbb671759cc3b18905.aspx
[2] https://www.esma.europa.eu/sites/default/files/library/esma35-43-620_guidelines_on_mifid_ii_product_governance_requirements_0.pdf
[3]https://www.fondsnieuws.nl/system/storage/serve/146786/MiFID%20II%20white%20paper%20PwC%2C%20Ortec%20Finance%2C%20VU%2C%20sept.%202016.pdf
[4] https://www.afm.nl/en/professionals/onderwerpen/mifid-2/marktstructuur-otf