MiFID II: The choice at the heart of Europe’s new investment rules

MiFID II, or the EU’s second Markets in Financial Instruments Directive, will present investment advisors, fund managers, banks, brokers and their local authority clients with big challenges. It also demands local authorities decide between being “retail” or “professional” investment clients. Our experts offer their views.

Dennis Gepp

Dennis Gepp

Under MIFID II investment firms are not permitted to automatically treat local authorities as professional clients unless they have opted to be treated as such, and the firm has assessed them as having the requisite knowledge and experience.

The Financial Conduct Authority (FCA) will be adopting transition processes and specific criteria for the assessment of the expertise and knowledge of local authorities and there are a number of factors which should be considered.

We hope that the reported delay of MIFID II’s implementation will give the FCA more time to develop an appropriate implementation plan, one that includes a lengthy transition period, appropriate investment carve-outs, and application on a prospective basis only.

Firstly, the application of any reclassification should be done over a lengthy transition period to provide both local authorities and firms with time to review and implement procedures in a manner which does not lead to severe market disruption or investment reallocation.

Secondly, local authority investors should be deemed sophisticated for any investments in products which are heavily regulated, are low risk and which do not engage in the use of leverage.

An obvious example would be an investment in a money market fund.  Money market funds are highly regulated, invest in only the highest quality securities with short maturities, and are not permitted to use leverage.

Thirdly, any required reclassification should be applied to new investors only.  Current investors who are invested in MMFs, who have observed not only the performance of funds over time, but have also spent time understanding portfolio holdings and meeting with fund management should not be required to have to go back and execute new investment documentation and provide new certifications as to the level of sophistication of the investment team.

A new certification process could be implemented much more cost efficiently going forward if it were to be incorporated into a new investor package.

The principle of investor protection should indeed apply to those which are charged with managing investments on behalf of local authorities, however, the protection needs to be proportional and should focus on the types of investments being made, the complexity of the vehicle being invested in, and the overall risk profile of the investment product.

Dennis F Gepp is senior vice president, managing director and chief investment officer at Cash Federated Investors (UK) LLP.

Cecilie Booth

Cecilie Booth

Under the European proposals in MiFID II, all local authorities will automatically be classified as being retail. 

This classification infers that they are not professionally competent to understand the instruments they are dealing in and so have to rely on the counterparty to advise them in order to safe guard them. 

The key issue is which of the FCA’s three proposed options should apply to how local authorities will be allowed to opt up to professional status.  FCA has discretion under MiFID II to vary the detailed requirements for qualification for the different levels of client classification.  That is why the FCA has recently consulted with interested parties in order to formulate its ideas in how to use this flexibility.

Potential Impact

• Financial institutions may refuse to deal with local authorities as retail customers 
• Retail customers are unlikely to be able to deal in financial instruments like money market funds (MMFs), certificates of deposits, treasury bills, gilts etc.
• Borrowing undertaken under retail status is likely to be at higher rates
• Local authorities as retail customers may not be able to access borrowing provided by banks and other counter parties.
• Retail customers are unlikely to be able to issue bonds

Treasury Solutions opinion

Our view is that the current opt-up criteria under option A are appropriate and should be retained. 

All local authorities in the UK, have to fully comply with all UK statutory and professional requirements laid down by the government’s investment guidance / regulations and CIPFA.

In effect, this means that it would be illegal for local authorities to carry out treasury management activities which were not fully in compliance with these obligations.

Accordingly, it is our view that the more onerous requirements of options B and C could severely limit the treasury management activities of many local authorities.

Cecilie Booth is director of treasury services at Capita Asset Services.

Alan Simkins

Alan Simkins

MiFID II will classify local authorities as retail clients. Local authorities will be able to elect to opt up to professional client status. Whether authorities choose to elect to opt up is an important decision which should not be taken lightly. In particular, they should note:

• Electing to opt up is a non-trivial task. It involves a significant administrative burden with a requirement to exchange documentation with each and every counter party.
• By electing to opt up to professional status local authorities will be losing a number of regulatory protections with regard to client money, suitability & appropriateness and disclosures.

It is important that local authorities carefully weigh-up the pros and cons in making their decision on which classification is most appropriate for their needs.

Likewise, it is important that any company providing a service to local authorities will have to adapt their offering to cover authorities of both classifications.

King & Shaxson will be fully MiFID II compliant and able to offer a service to local authorities that decide to remain as Retail clients, as well as those who decide to elect to opt up to Professional client status.

Alan Simkins is head of local authority dealing at King & Shaxon.

David Green

David Green

It would be rather bizarre if any organisation with a hundred finance staff and many millions of pounds to invest was classified the same as an individual with just a few thousand pounds in savings.

And there seems no good reason to treat UK local authorities any differently from similarly sized companies. The FCA should therefore use the discretion afforded it in MiFID II to allow authorities meeting the “large undertakings” criteria to remain professional clients.

The truth is that local authorities will see few benefits from being classed as retail clients in any case.

For example, they will remain excluded from the Financial Services Compensation Scheme, since that it ruled by a different EU Directive.

Quality providers of financial services already treat their local authority clients with the required standards of professional care and don’t sell them unsuitable products. They just don’t complete all the additional paperwork to prove this to the regulator’s satisfaction.

I doubt local authorities will appreciate the extra administration and consequent higher fees if they get no additional protection from a new status.

David Green is client director at Arlingclose.

Photo (cropped): Bobby Hidy, Flickr.