David Green: MiFID II – deadline looms for action

The way that local authorities access financial services will change in January 2018 as a result of the European Union’s second Markets in Financial Instruments Directive (MiFID II).

If the current proposals are adopted, many local authorities will find it more difficult and/or more expensive to use the services of banks, advisers, brokers and fund managers. We therefore strongly recommend that local authorities reply to question 16 of the Financial Conduct Authority’s consultation, which closes on 4th January 2017.

Among many other changes, MiFID II seeks to provide additional protections to local authority investors due to supposed “limits in their ability … to appreciate the risk of their investments”.

And although we’ve voted to leave the EU, MiFID II will still be implemented here, not least because UK firms will wish to continue providing financial services across Europe, and so will need to comply with equivalent regulations.

Retail

Unfortunately, the additional protections will not be anything useful like exemption from bank bail-ins, or eligibility for the Financial Services Compensation Scheme, as those are ruled by separate EU directives.

Instead, the “protection” comprises classing all local authorities as “retail clients”, the same as individual investors. This could mean completing forms on your incomings and outgoings, questionnaires on risk appetite, reading notices about firms’ complaints procedures and reams of other paperwork, taking extra staff time for both you and the financial services provider, which means they will inevitably charge you more. In fact many firms refuse to deal with retail clients at all, due to the significant administrative burden.

There is a small glimmer of hope though. Local authority retail clients will be allowed to opt to be “professional clients” and retain their existing status, providing they meet certain criteria to be set by the FCA in the UK. They have been engaging with local authority stakeholders on this subject since early 2012, culminating in their current consultation.

Unfortunately, during this time they have developed some serious misunderstandings, for example that parish councils hold an average investment balance of £10m, and that all local authorities administer a pension fund, and they are setting the new rules based on these flawed beliefs.

The FCA therefore intends to rule that only local authorities with investment balances above £15m will be allowed to opt up to be a professional client and continue to access financial services as they do now.

While this is certainly high enough to meet the FCA’s aim of excluding parish councils, the government’s own data shows that it would also exclude around a quarter of principal authorities, including some with multi-billion pound budgets, but sensible use of internal borrowing to keep investment balances low.

In addition, local authorities will only be allowed to opt up if they are already familiar with the investments they wish to make. This can be demonstrated either by transacting “on the relevant market at an average frequency of 10 per quarter over the previous four quarters” (a complicated way of saying 40 times a year), or by the treasury manager having “worked in the financial sector for at least one year in a professional position which requires knowledge of the transactions or services envisaged.”

Form filling

Now, I don’t know about you, but I don’t know many local authority treasury managers who used to work in the financial sector dealing with million pound investment portfolios. And while you might make 40 money market fund transactions a year, I doubt you make anywhere near that number in property funds or corporate bonds.

So, the FCA is going to resign you a life of form filling, signing to say you understand that “your home may be repossessed if you do not keep up repayments on your mortgage” and that “the value of your investments may go down as well as up” just as if your authority was an individual with a few thousands to invest rather than the largest employer in the area with many millions.

Unless, that is, as many authorities as possible reply to the FCA consultation and get them to apply more sensible opting up criteria instead.

One obvious solution would be to apply the same criteria to local authorities that they do to companies and base it on their financial statements.

Private sector organisations are professional clients if they have at least two of a €40m annual income, €20m of assets and €2m in reserves, the so-called “large undertakings” criteria. Using this for local authorities too would enable districts, counties and unitaries to remain professional clients, but meet the FCA’s aim of treating most small parish councils as retail clients.

Another solution would be for local authorities to borrow extra money to keep their investment balances artificially high and to frequently trade their bond and pooled fund holdings. According to the FCA proposal, that would turn you into a professional. But I don’t think anyone else considers those activities to be the hallmarks of professional treasury management. A robust response to the consultation is therefore in order.

The FCA consultation can be accessed here in chapter 4, and closes on Wednesday 4^th January 2017.

David Green is Client Director at Arlingclose Limited. This is the writer’s personal opinion and does not constitute investment advice.