20 September 2017
Subhasis Bandyopadhyay

Compliance

Subhasis Bandyopadhyay - Mindtree Ltd

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MiFID

MiFID

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Guide to implementation of client suitability and appropriateness framework for MiFID II

04 September 2017  |  3815 views  |  0

Introduction 

The genesis of the Client suitability and appropriateness framework lies in Markets in Financial Instruments Directive (MiFID II) regulation. MiFID II is scheduled to be implemented in January 2018. The aim of MiFID II is to increase efficiency and transparency in the European financial markets and to increase protection for investors. This blog focuses on ‘suitability’ and ‘appropriateness’ aspect of the MiFID II regulation.

 For many financial institutions, designing, implementing and executing the obligatory assessments which can test the suitability and appropriateness of the prospective client into their company processes in a client-oriented and efficient way, is a major challenge.

 To test the client for suitability/appropriateness, Investment firms will have to gain an increasingly better insight into the financial situation of the client, including the client’s investment knowledge, experience, and investment objectives. Providing this insight often requires frequent interaction with the client and the consulting of various systems in order to form a properly substantiated picture.

 This blog is intended to suggest guidelines for the proper implementation of client suitability and appropriateness framework as per MiFID II regulation. The analysis focusses on the possibilities offered by the MiFID II framework. The blog also explains the impact that the suitability and appropriateness framework will have on investors and trading firms, and how they would need to prepare, regarding this part of the MiFID2 legislation.

           MiFID II: Context to Suitability and Appropriateness

 The first version of MiFID came into effect on 1 November, 2007. This directive replaced the Investment Service Directive (ISD). ISD mandated a minimum set of rules for Investment firms, leaving a majority of directions to be conducted as individual member states. This arrangement meant that majority of the rules remained country specific and thus resulted in a lack of harmonization. This proved to be an impediment to ‘Cross Border Trades’. The introduction of MiFID was primarily done to overcome the harmonization problems. MiFID emphasized consistent regulations in Investment services across all member states of the European economic Area.

 The financial crisis of 2008 exposed some issues in the MiFID provisions, in particular, a lack of transparency in the non-equity market. In addition, innovation in the type of investment products offered and increase in the technology usage, led to a review of MiFID by the European Commission in 2009-10. This review led to a formal proposal for an enhanced directive. After the necessary reviews and legislative process, the final version of MiFID II was published in June 2014.

 The key aspects which MiFID II touches in terms of catering to Investor protection are as follows:

ü  Aligning certain asset classes and Market Infrastructure to reduce Investor risk

ü  Mandating Investment firms to provide more detailed information to Investors on costs and charges

ü  To evaluate the client for suitability and appropriateness when providing investment advice or execution only services

ü  Explaining the basis on which investment advice is being given

ü  To determine that the investment advice is being provided on an independent basis 

This blog intends  to explain the concepts of suitability, appropriateness, and their impact on trading firms and broker/dealers.

           Suitability and Appropriateness

 Suitability:

When Investment firms cater to the role of providing investment advice to their clients or managing the client’s investment portfolio, it becomes the investment firms’ responsibility to extract the requisite information from the client so that a suitable recommendation can be made to the client.  The following table gives the requirements for assessing suitability:

Areas under which information needs to be obtained

Information Required

Client Knowledge and Experience

  • Types of service, transaction and the regulated investments with which the client is familiar with
  • Nature, volume, frequency of the client’s transactions with regulated investments
  • Level of education and profession of the client

Client Financial Situation

  • Source and extent of the client’s regular income
  • Client’s assetsincluding liquid assets, investments and real property
  • Client’s regular financial commitments

Client Investment Objectives

  • Client’s investment horizon
  • Client’s risk preferences, risk profile and risk tolerance
  • Purpose of the investment

The suitability requirements apply to both institutional as well as individual investors. In case the investment firm does not receive sufficient information from the client on the above mentioned areas, it should not be allowed to recommend investment services to the client. MiFID II also enforces the requirement to provide individual investors with suitability reports as defined in the ESMA technical advice. Reports to clients of the investment service should take into account the type and complexity of the financial service and the nature of the investment service delivered. This statement of suitability has to be sent either just before the transaction is carried out, or immediately after the client becomes bound. The statement would specify how the advice provided to the client meets the client’s investment objectives and preferences. Investment firms also have the liability to ensure that the bundle of financial instruments that they are suggesting to the client, is in line with the client’s risk tolerance and ability to bear losses.

To collect reliable information from the client, Investment firms must do the following: 

  • Clients should be aware of the need to provide accurate and up to date information
  • Client’s knowledge, experience and risk tolerance should be measured through reliable assessments
  • Clients should have a clear understanding of the questions asked
  • Ensuring that the information provided by the client is consistent

              Appropriateness:

If investment services are being provided without advice (such as execution- only services), the requirement of suitability does not apply. In this case, Investment firms must assess if the financial instrument or service is appropriate for the client. Hence, the Investment firm tests the individual client’s (institutional clients not subject to appropriateness requirements) relevant knowledge and experience on the complex financial instrument. The client’s performance on the Appropriateness test enables the investment firm to judge whether the financial services and instruments envisaged for the client are appropriate or not.

The following table gives the requirements for assessing appropriateness: 

Areas under which information to be obtained

Information Required

Client Knowledge and Experience

  • the types of service, transaction and the regulated investments with which the client is familiar
  • the nature, volume, frequency of the client’s transactions with regulated investments
  • the level of education and profession of the client

If the service provided is an execution-only service, the appropriateness test is deemed to be unnecessary under the following conditions. This is mandated as per the current MiFID (I) regulation itself: 

  • The client wants to invest in non-complex financial instruments (shares traded on regulated markets, bonds, debt instruments, investment funds or money market instruments)
  • The service is performed on client’s initiative
  • The client is made aware that the investment firm is not obliged to perform the appropriateness test
  • The investment firm has fulfilled its obligations with regard to conflict of interest 

MiFID II has narrowed the list of ‘Non Complex’ instruments (compared to the definition of ‘Non Complex’ as per MiFID I) which has resulted in an increase in the scope of appropriateness assessment. 

MiFID II has also given new requirements in the record-keeping and auditing areas. These requirements are meant to ensure that investment firms must keep records of the appropriateness assessments that they conduct. The records should include:

  • The result of the appropriateness assessment
  • Any record of the warning given to the client that a service or product purchased was assessed as inappropriate (as per the appropriateness assessment) and record of client having overridden the warning
  • Any record of warning given to the client that he has not provided enough information to enable the firm to undertake the appropriateness assessment and record of client having overridden the warning

          How Investors and Trading Firms need to prepare

Investors 

Investors should take the suitability framework as an opportunity to share a closer relationship with the trading firm. They will have to ensure that they share a clear picture about their knowledge, experience, financial situation, risk profile and investment objectives so that the investment firms can provide advice/manage portfolio in the most client- centric way. Investors will have to be more prepared with the knowledge of asset classes and the order types in which they want to trade in.

Also, if the investor is not able to qualify as per the appropriateness standards, there must be a realization, that persisting with trading in that particular asset class will make the client liable for any losses that occur. This is in case the reason for the loss is accounted to be a lack of knowledge or experience. 

Trading Firms 

For the Trading firms, increased suitability and appropriateness demands will require a different approach to data gathering. This could, in the future, lead to integrated systems and advanced and predictive customer analytics based on static and dynamic data. However, at this stage and in the near future, the expectation is that investment firms will reduce complexity in current legacy way-of-working rather than facilitate complexity with advanced tooling. This might bring pressure to bear on profitability of investment firms as well, because of a lack of innovation.

Trading firms will also have to ensure that questionnaires are created to ascertain investor’s knowledge and experience in the asset class in which the investor desires to trade. As and when the Investor chooses a particular asset class to trade in for the first time, trading firm has to ensure that a questionnaire containing questions to test the client’s knowledge and experience is presented to the investor. Once the investor answers the questionnaire, the trading firm will have to ensure that the answers are evaluated and the total score calculated. In case the total score is above a pre-decided threshold, the investor is taken directly to the Order Placement screen where the trade can be placed in the chosen asset class. If the score is below the threshold, the investment firm will raise an online warning to denote that the investor’s knowledge/experience is not up to the mark and that the investor should not go ahead and invest in that particular asset class. However, the investor will have the option to override the warning and invest in that asset class at his/her own risk.

Trading firms will also have to cater to record-keeping and audit trail requirements for client suitability and appropriateness. These requirements will include storing assessment results, along with date and time, storing details or warnings given to the client regarding lack of information provided or inability to pass the knowledge/experience test. 

 

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