By: Ronan Brennan, chief technology officer, Silverfinch
As at 1st January 2018, the financial services industry will be served a double whammy of regulation – Markets in Financial Instruments Directive II (MiFID II) and Packaged Retail and Insurance-based Investment Products (PRIIPs). While there are key differences between these two regulations, the common characteristics are worth noting as the basis of a strategic view on how to address both.
A common driver in both MiFID II and PRIIPs is investor protection. Specific information must be disclosed to the investor before investment to enable them to compare different products and to acquire a better understanding of the exposure to risk.
PRIIPs is focused on packaged retail and insurance-based investment products – unit-linked funds, structured products and retail investment products – and draws in parties such as asset management firms and structured product manufacturers, as well as distributors and open architecture platforms.
MiFID II, on the other hand, has a broader scope and applies to firms providing investment services and firms that manufacture or distribute financial instruments. While Undertakings for Collective Investment in Transferable Securities (UCITS) managers and alternative investment fund managers are not directly in scope for MiFID II, they are indirectly subject to the product governance regime being promulgated.
- MIFID II is broader that PRIIPs, while PRIIPs is narrower but more prescriptive
- Disclosure requirements in both regulations are highly aligned
- Uncertainty exists with both regulations, but expect this to be fixed
- The dates for both are likely to line up EOY 2017 / SOY 2018
- There is opportunity for the regulator to reduce industry burden by issuing specific written guidance on the overlap areas
The main areas of overlap that firms need to consider when developing a strategy for the regulatory new world are:
Both PRIIPs and MiFID II focus on product cost disclosures, including completeness and sufficiency. PRIIPs has a clear direction on what exact costs should be disclosed, calculated and presented. MiFID II is less rigid and also takes into account disclosures where the requirement is met under a different EU directive. For example, a PRIIPs Key Investor Document (KID) would be sufficient under MiFID II, whereas a UCITS Key Investor Information Document (KIID) might not be because it does not include transaction costs.
Under both regulations, the disclosure of risk must pass the ‘fairness’ test and be prominently disclosed, so no micro-font footnote style disclosure. For PRIIPs, there is a rigid approach to how risks should be outlined. Specific language must be used and a Summary Risk Indicator must be calculated and then continuously reviewed.
MiFID II does not prescribe a particular risk measure to be calculated, but does indicate that one should be developed and used by the manufacturer firm. Firms should have a written policy in situations where a product is in-scope for MiFID II and PRIIPs, and when it comes to disclosing risks to investors they must document which approach has been taken.
In the more recent history of the development of PRIIPs regulation, there has been a consistent move to remove the use of ‘past performance’ data in KIDs. Under the guise of the rejected Regulatory Technical Standards (RTS), PRIIPs proposed the use of forward looking performance scenarios ranging from favourable to moderate to unfavourable. A proviso was introduced to choose an even more unfavourable scenario. New RTS are expected to overhaul the performance scenario calculation, further reducing links to past performance and introduction of a stress scenario.
MiFID II, on the other hand, specifies standards for the use of forward looking performance, including:
- Periods where performance was positive, as well as negative, must be used
- Forward looking performance must not be based on past performance
- It must be based on reasonable assumptions
- It must contain warnings on unreliability of the data, and it cannot be used as an indicator of expected future performance
- It must take into account the impact costs, fees and charges – demonstrating their impact on the performance in question
- And it must reflect the nature and risks of the specific types of instruments included in the analysis.
In PRIIPs, there is a comprehension alert requirement for products that are potentially harder to understand for the average retail investor. In MiFID II, there is also a complex product stipulation that prescribes the mandatory offer of advice before investment. Whether a product is complex, or not, is driven by an understanding of the product framework itself, the percentage weight, or the existence of complex underlying investments – anything beyond exchange traded equity, vanilla fixed income and money markets is potentially complex.
Product governance and target market identification
On the identification of the target market for the product in question, there is an alignment in both regulations. In product governance, PRIIPs only covers investors from the target marget, whereas MiFID II extends across manufacturer and distributor with indications around how each side should reconcile. The lobby groups for both regulations are seeking use of standard language regarding how target markets should be identified and described. This shared language is as important for the investor as the industry, so expect to see very close alignment as the RTS and response to consultation papers solidify understanding.
Timing and nature of document/data delivery
PRIIPs requires a KID to be delivered to the investor before the investment contract. Similarly, MiFID II requires disclosure of key facts before investment and this must be ‘fair, clear and not misleading’. In this way, both regulations hope to level the playing field of the funds space.
So, what does this mean for fund houses and their distributors? While PRIIPs does have some pointers to specific thresholds that would trigger a recalculation/calibration of the performance scenarios, it does not cover all eventualities, for example, the effects of a material change in cost. The KID document and the data therein must be regularly reviewed by the PRIIP manufacturer, with intervention expected when a review indicates that changes are in order and a new KID should be promptly republished and pushed to all distribution channels.
Under MiFID II, the rules are less stringent. Firms are simply required to maintain and operate a review process for the approval of each product before it is presented for sale to an investor.
These regulations have been created in order to deliver a buying experience that allows investors to compare products in a simple manner and to easily understand the risks involved. Of course, bombarding the client with reams of paper is likely to result in greater confusion.
So, before the regulations are finalised, now is the time for the industry to come together and create a joined-up approach to ensure pragmatism wins.