MIFID II CLIENT REPORTING: market participants must focus on more than just regulatory reporting

Transcription

1 MIFID II CLIENT REPORTING: market participants must focus on more than just regulatory reporting Authored by: Peter Lehnen, Manager, Sapient Global Markets April

2 MIFID II CLIENT REPORTING: market participants must focus on more than just regulatory reporting 2 MIFID II CLIENT REPORTING: market participants must focus on more than just regulatory reporting 2

3 TABLE OF CONTENTS Introduction 4 Pre-trade Cost Information 5 Post-trade Reporting 7 Outlook 8 About the Author 8 With the reform of the Markets in Financial Instruments Directive (MiFID), the European Union (EU) has extended the reporting requirements on business conduct and investor protection. In contrast to Markets in Financial Investment Regulation (MiFIR), which covers transaction, inventory and valuation reporting with detailed technical standards, the directive only gives a broad framework for client reporting. This paper outlines why MiFID II client reporting deserves equal attention and explains why institutions need to alter their business processes and IT systems in order to mitigate the risk of non-compliance. 3

4 INTRODUCTION Within MiFID II, the EU determines the operating conditions for investment firms and defines provisions to ensure investor protection, including the requirements for pre-trade (or ex-ante) cost information and post-trade (or ex-post) client reporting. As a distinction, the pre-trade requirement is often called cost information, while the post-trade requirement is referred to as cost reporting. These requirements create obstacles for market participants far beyond the regulatory reporting rules. On the one hand, institutions have to provide cost information to the client in advance, encompassing not only the transaction costs but also the cost of ancillary services. That s a challenge because the cost calculation is typically based on executed prices, which depend on the transaction. If given in advance, the effective cost will only be an estimate, leaving open the possibility that the price may be inaccurate. On the other hand, firms need to drill down post-trade reporting costs to instruments or positions held. A challenge here is that part of the costs are not calculated based on an instrument or position but instead are flat service fees based on a whole portfolio or deposit. This type of calculation requires a very detailed analysis of the current cost and revenue flows within the firm, requiring more time and resources. At a time when regulatory scrutiny and compliance costs are rising, institutions need to ensure they are meeting MiFID II s full scope of reporting requirements to avoid regulatory fines and client attrition. PRE-TRADE COST INFORMATION Both the pre- and post-trade requirements under MiFID II have their own unique challenges as well as more detailed reporting requirements that extend past previous regulations. The pre-trade cost information requirement for MiFID II is closely related to Packaged Retail and Insurancebased Investment Products (PRIIPs) regulation. PRIIPs regulation calls for firms to report cost information on the key information document (KID) that provides retail investors with information on the costs embedded in the financial instrument. Within the MiFID II framework, regulators have stated that compliance with PRIIPs regulation should not result in additional or contradicting requirements under MiFID II. However, under MiFID II, the cost information requirement will be extended to all financial instruments and all clients, not just structured products for retail investors as required under PRIIPs. Although the investor protection articles of the directive are mainly focused on retail investors, waiving pre-trade cost information is only possible for clients who are classified as an eligible counterparty, according to the latest consultation between the European Securities and Markets Authority (ESMA) and market participants. As such, firms must also provide cost information to institutional investors in addition to retail investors. But which cost information must be reported to each client? ESMA has provided a detailed breakdown of requirements in its consultation papers (see Table 1). 4 MIFID II CLIENT REPORTING: market participants must focus on more than just regulatory reporting

5 Identified costs that should form part of the costs to be disclosed to the clients 1 Table 1 All costs and associated charges charged for the investment service(s) and/or ancillary services provided to the client that should form part of the amount to be disclosed One-off charges related to the provision of an investment service Ongoing charges related to the provision of an investment service All costs related to transactions initiated in the course of the provision of an investment service Any charges that are related to ancillary services Incidental costs Cost items to be disclosed All costs and charges paid to the investment firm at the beginning or at the end of the provided investment service(s). All ongoing costs and charges paid to investment firms for their services provided to the client. All costs and charges that are related to transactions performed by the investment firm or other parties. Any costs and charges that are related to ancillary services that are not included in the costs mentioned above. Examples Deposit fees, termination fees and switching costs 2. Management fees, advisory fees and custodian fees. Broker commissions 3, entry and exit charges paid to the fund manager, platform fees, mark-ups (embedded in the transaction price), stamp duty, transactions tax and foreign exchange costs. Research and custody costs. Performance fees Table 2 All costs and associated charges related to the financial instrument that should form part of the amount to be disclosed One-off charges Ongoing charges All costs related to transactions Incidental costs Cost items to be disclosed All costs and charges (included in the price or in addition to the price of the financial instrument) paid to product suppliers at the beginning or at the end of the investment in the financial instrument. All ongoing costs and charges related to the management of the financial product that are deducted from the value of the financial instrument during the investment in the financial instrument. All costs and charges that incurred as a result of the acquisition and disposal of investments. Examples Front-loaded management fee, structuring fee 4 and distribution fees Management fees, service costs, swap fees, securities lending costs and taxes, and financing costs Broker commissions, entry and exit charges paid by the fund, mark-ups embedded in the transaction price, stamp duty, transactions tax and foreign exchange costs. Performance fees 1 It should be noted that certain cost items appear in both tables but are not duplicative since they respectively refer to costs of the product and costs of the service. Examples are the management fees (in Table 1, this refers to management fees charged by an investment firm providing the service of portfolio management to its clients while in Table 2 it refers to management fees charged by an investment fund manager to its investor) and broker commissions (in Table 1, they refer to commissions incurred by the investment firm when trading on behalf of its clients while in Table 2 they refer to commissions paid by investment funds when trading on behalf of the fund). 2 Switching costs should be understood as costs (if any) that are incurred by investors by switching from one investment firm to another investment firm. 3 Broker commissions should be understood as costs that are charged by investment firms for the execution of orders. 4 Structuring fees should be understood as fees charged by manufacturers of structured investment products for structuring the products. They may cover a broader range of services provided by the manufacturer. Source: ESMA 5

6 A major challenge with pre-trade cost information is determining whether information on transaction-specific costs needs to be given to the client or whether generic information, such as a pricing table, is sufficient. That could be an obstacle for certain asset classes and firms, particularly high-frequency and algorithmic trading, as a result of delays in the order process. An indication of what firms need to supply can be seen in the distinction between cost for investment services (Table 1) and cost for financial instruments (Table 2). The cost of financial instruments or products is very similar to the cost information provisions under regulation PRIIPs. In its consultation, ESMA has indicated that generic cost information is possible (e.g., NN EUR per share/per nominal, etc.). Still, the cost of investment services has to be transaction-specific. What s more, the ongoing costs associated with financial instruments are problematic because they depend on the holding period (e.g., deposit or custody fees). But which time frames need to be taken into account when providing cost information to clients? Is it one day, one week, one month or one year? While the PRIIPs regulation requires the cost information to be included in a KID, there are open questions about other financial instruments with regard to content, format and timing of the information. How is the cost information transmitted? Can it be a cost display on an entry screen of an online application? Does the client have to acknowledge the receipt of cost information? Beyond delivering cost information in a single amount, institutions may have to deliver an itemized breakdown (related to the distinction between product and service cost) to clients. Although the cost components are defined in the tables, ESMA hasn t established which components have to be itemized. It is also very likely that the cost details will vary among market participants. ESMA states that the transaction price needs to include mark-ups. There are different approaches to provide this information, such as only disclosing trading profits as mark-ups (the difference between purchase price and sales prices) and only disclosing the sales spread (the difference between midpoint/fair value and sales price) as product cost. In some business streams and asset classes, a certain level of transparency on cost and cost components already exists, but final clarity on the cost components that are compliant with the cost model set out in Table 1 and Table 2 have to be defined. For example, are initial and/or variation margin payments considered costs? While by definition initial margin is regarded as collateral, it may also be treated as a cost and the return of initial margin. When the position is closed, it may be regarded as a negative cost, in which case the client also must be informed. Implementation While some of the pre-trade cost information requirements remain unclear, it is clear that MiFID II client reporting will likely require firms to alter their business processes and IT systems. For business processes, firms must ensure that the cost information given to the client is recorded. The scope of that information must expand from pure order reporting to include additional cost information. Otherwise, a client could ask for the unwinding of a position that has resulted in a loss or an investment with a lower return than expected simply by demanding it because the relevant cost information was not disclosed. In contrast to the pure transaction reporting under MiFIR, the framework of MiFID II additionally extends the recording and archiving requirements to encompass any activity (e.g., client orders and telephone conversations) leading to an investment decision. This includes pretrade cost information. In the past, the KID only included abstract and generic product information. The impact now is that the KID must be client- and transaction- specific, restricting the creation of a single KID for one product. For online orders, it may also be necessary to change IT systems in order to provide the client with the appropriate cost information. 6 MIFID II CLIENT REPORTING: market participants must focus on more than just regulatory reporting

7 POST-TRADE REPORTING Post-trade reporting for MiFID II must be completed at least once a year or on demand for the client, although ESMA has yet to provide clarity on the reporting periods for the information that would be included in an ondemand report. Regardless, firms need to start preparing for the posttrade client reporting requirements as they contain three distinct categories that present their own particular set of challenges. 1. Inventory or portfolio reporting Inventory or portfolio reporting is similar to the portfolio reconciliation reporting under EMIR for derivatives. The reporting requirement is extended to all financial instrument classes. Several national legislations also demand annual reporting of securities and derivatives if held in a deposit. However, there is a major discrepancy between EMIR and MiFID II when it comes to structured products. Under EMIR, firms are required to report each component of a structured product (so-called legs ), while MiFID II requires reporting of the structure as a whole so clients can rely on the report to see what they actually traded instead of each leg of the product. Depending on the IT environment within banks and investment firms, this may create a challenge when the legs of a structured product are spread across different systems because the structured product may contain different asset classes. Thus, it s important to identify the components and transactions of a structured product in order to create a consolidated report. 2. Cost reporting While portfolio reporting only details positions held at the reporting due date, cost reporting will extend the content of the report to include a disclosure of all costs that occurred during the reporting period. If a stock was bought and sold during the reporting period or if a position opened and closed, the relevant cost needs to be stated. Subsequently, firms will need to develop the report for closed positions or assets sold during the reporting period. Given these requirements, additional capacities for a repository solution are needed to make the information available either on scheduled due dates or on demand. This creates a major challenge as a far greater amount of data must be available for reporting. A key prerequisite for this reporting will be a front-to-back assignment of costs to transactions and positions. In the past, some cost components were handled as general overall costs instead of instrument- or transaction-specific costs (e.g., a NN EUR deposit flat fee). In the future, these charges need to be broken down to positions or transactions to be able to calculate the impact of these costs on the individual instrument performance. 3. Performance reporting MiFID II demands that costs are aggregated and itemized (when requested) in order to provide the client with a sufficient understanding of the overall cost and effect on their investment return. With the investment return, performance information needs to be given to the client. For some financial instruments, a major challenge will be in the definition of performance. Performance cannot be reduced to changes in the financial instrument s value because, depending on the nature of the financial instrument, changes in its value are also determined by mathematical factors, like changes in time value. A mathematical reduction of a time value is not necessarily a negative performance. Implementation Unlike pre-trade cost information, post-trade client reporting doesn t profoundly impact day-to-day business processes. Post-trade reporting will not necessarily require changes to the systems involved, but rather, the addition of new data fields into cost and performance reports. A change will only occur if non-specific costs need to be broken down to transactions and/or positions. 7

8 OUTLOOK AUTHOR: PETER LEHNEN Many market participants concentrate their efforts mainly (and sometimes only) on regulatory reporting requirements. However, MiFID II reporting is more than just about reporting to ESMA. Missing or non-compliant cost information client reporting may lead clients to demand the unwinding of transactions and regulators to charge fines or even revoke the permission to conduct business. As with many other aspects in connection with the MiFID II delay, institutions can t afford to wait for ESMA to fully define the regulation s client reporting obligations. Although discussions are ongoing and delegated acts are due to be published, firms need to start by altering their business processes and systems with the facts rather than waiting for each consultation and final legislation. The time left until the legislation comes into effect is insufficient to implement a compliant solution even with the one-year postponement. Prior experiences from EMIR and similar regulations have shown that manual workaround solutions in the end are far more expensive than a proper front-to-back solution. Peter Lehnen is an experienced manager with more than 25 years of practice in banking, capital markets and exchange operations. His focus is on regulatory requirements, such as MiFID, MiFIR, EMIR and SFTR, and their impact on business processes, data management and governance, as well as clearing and collateral management. About Sapient Global Markets Sapient Global Markets, a part of Publicis.Sapient, is a leading provider of services to today s evolving financial and commodity markets. We provide a full range of capabilities to help our clients grow and enhance their businesses, create robust and transparent infrastructure, manage operating costs, and foster innovation throughout their organizations. We offer services across Advisory, Analytics, Technology, and Process, as well as unique methodologies in program management, technology development, and process outsourcing. Sapient Global Markets operates in key financial and commodity centers worldwide, including Boston, Calgary, Chicago, Düsseldorf, Frankfurt, Houston, London, Los Angeles, Milan, New York, Singapore, Washington D.C. and Zürich, as well as in large technology development and operations outsourcing centers in Bangalore, Delhi, and Noida, India. For more information, visit sapientglobalmarkets.com Sapient Corporation. Trademark Information: Sapient and the Sapient logo are trademarks or registered trademarks of Sapient Corporation or its subsidiaries in the U.S. and other countries. All other trade names are trademarks or registered trademarks of their respective holders. Sapient is not regulated by any legal, compliance or financial regulatory authority or body. You remain solely responsible for obtaining independent legal, compliance and financial advice in respect of the Services. 8 MIFID II CLIENT REPORTING: market participants must focus on more than just regulatory reporting

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