SUITABILITY, APPROPRIATENESS AND ADMINISTRATION IN A COMPLEX WORLD A DST White Paper: August 2015 1
Table of Contents Introduction... 3 Current MiFID Model... 4 Complex Becomes Complicated... 5 Model Under MiFID II... 7 A Model for Appropriateness Testing... 8 Closing Thoughts... 10 2
Introduction While the rules for financial services seldom make the world more violent, Schumacher might have observed the recent direction of the European Union (EU) financial regulations and questioned the courage that such developments display. He might also have reflected upon the products that stoked the fire of sub-prime lending and similarly questioned whether their complexity was necessary. Any intelligent fool can make things bigger, more complex and more violent. It takes a touch of genius and a lot of courage to move in the opposite direction. Ernst F. Schumacher Our aspiration for this article is to help readers navigate their own path through the changes to Suitability and Appropriateness rules, without becoming the embodiment of Schumacher s Intelligent Fool. Markets in Financial Instruments Directive (MiFID) introduced the language of complex instruments, and the distinction between Suitability Tests and Appropriateness Tests. All these terms remain relevant under MiFID II, and the fundamental needs of Suitability and Appropriateness are largely unchanged. However, we will see that the new regulation increases the proportion of assets that seem destined to be complex. The Appropriateness Test requires the product provider to consider the knowledge and experience of the investor and establish whether the asset being purchased is appropriate to such an investor. The Firm is able to reuse information already held about the investor, and can request additional information to support the test. While the client might not provide the information requested by the Firm, in such cases the rules permit the Firm to proceed having first informed the client that the Appropriateness Test could not be completed. This differs from Suitability, as a Firm cannot complete business where a Suitability Test initiated has not been completed. 3
Current MiFID Model Diagram 1 shows a simplified summary of the current obligations. A Firm is performing MiFID business where it performs a MiFID Activity in respect of a MiFID Asset. Collective Investment Scheme (CIS) Operators and Pension Managers are exempt from MiFID and so are not obliged to perform Appropriateness Tests. The same is true of other firms not performing MiFID business. Firms performing MiFID Advice or Management services must satisfy the Suitability rules instead of Appropriateness. A Firm can potentially avoid performing an Appropriateness Test where it knows some other Firm has performed a Suitability Test though such a position might be difficult to accurately build into administrative processes. There is one further scenario where Appropriateness Tests are not required, which I ll refer to as the Scenario Exemption. This scenario requires three conditions to be satisfied: The Firm is only Executing trades or performing Reception & Transmission of Instructions; The Firm has informed its Client that the Firm bears no responsibility for Suitability; The activity relates to certain types of investment asset considered Non- Complex. CIS Manager / Pension Manager Other Firms Exempt from MiFID Not Performing MiFID Business Suitability Assessed By Another Firm Performing MiFID Business Advice / Managing Execution or 'Reception and Transmission' Other MiFID Business Perform Suitability Test Clearly Inform Client: "No Suitability Test" Listed Shares Bonds / Debt UCITS Other / Non- Complex Other Derivatives Most NURS Potential liability exceeds loss Insufficient public information Little opportunity to redeem No Appropriateness Test Required Perform Appropriateness Test Diagram 1: Current MiFID Model 4
Complex Becomes Complicated Under MiFID II most of the above situation remains unaffected though firms performing Advice and Management services must decide if they will provide an ongoing assessment of Suitability. While the fundamental obligations continue, the important change under MiFID II is that the divide between Non-Complex and Complex assets is moving. It is true that the financial services industry suffered significant issues arising from the use of complicated structures within certain mortgage-related assets. It is no surprise that the EU bodies have since sought to protect retail investors from being exposed to such structures without sufficient transparency. The danger is that, following the blunt segmentation imposed under the Alternative Investment Fund Managers Directive (AIFMD), assets that are broadly similar to an Undertakings for Collective Investment in Transferable Securities (UCITS) scheme seem destined to be defined as Complex under MiFID II. The UK regulator the Financial Conduct Authority (FCA) - recognised this shift, and stated in its March 2015 Discussion Paper: We therefore want to highlight this issue now with firms, clearly setting out our expectation that the types of products that are considered non-complex will be significantly limited. Of particular relevance to the UK, non-ucits collective investment schemes (such as [Non-UCITS Retail Schemes] NURSs) are likely to be considered complex, and therefore subject to the appropriateness test. The FCA is correct, although careful reading shows the above statement is only the FCA s expectation. The actual outcome is not yet fixed, and the polarised nature of language (that an asset must either be non-complex or complex ) has I feel been unhelpful as firms approach this issue. MiFID included definitions of the types of asset that could automatically be exempted from the Appropriateness Test by virtue of the Scenario Exemption, and under Article 25(4) of MiFID II each of these definitions is narrowed. The following table (diagram 2) summarises the shift. MiFID I Article 19(6) MiFID II Article 25(4) Shares admitted to trading on a regulated market or in an equivalent third country market... or on a MTF, where those are shares in companies, and excluding shares in non- UCITS collective investment undertakings and shares that embed a derivative Money market instruments... excluding those that embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved Bond or other forms of securitised debt (excluding those bonds or securitised debt that embed a derivative) Bonds or other forms of securitised debt admitted to trading on a regulated market or on an equivalent third country market or on a MTF, excluding those that embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved UCITS Shares or units in UCITS, excluding structured UCITS as referred to in the second subparagraph of Article 36(1) of Regulation (EU) No 583/2010 - Structured deposits, excluding those that incorporate a structure which makes it difficult for the client to understand the risk of return or the cost of exiting the product before term Diagram 2: MiFID definition comparison 5
In each case, the EU s distrust of structured investment products has narrowed the range of assets. Even where the firm s activity is limited to either Execution or Receipt and Transmission, and the firm has confirmed that no Suitability obligation arises, the range of assets that can be exempt from Appropriateness testing is reduced. This is the effect highlighted by the FCA. Consider Investment Trust Company (ITC) shares, which many investment platforms currently make available for purchase by their clients. MiFID originally enabled the firm to recognise the ITC shares as shares admitted to trading, creating an automatic route to exemption. However, MiFID II amends the definition excluding shares in non- UCITS collective investment undertakings which in the light of AIFMD is generally accepted as including ITC shares. Therefore, where MiFID allowed ITC shares to be recognised as Listed Shares, MiFID II builds on AIFMD to instead consider ITC shares as Non-UCITS collectives. But before we get too depressed by this change, there is one extra category I have not shown on the table the category of Other non-complex financial instruments for the purpose of this paragraph. ESMA has been asked to develop guidelines to help firms determine when a product is deemed complex, which are due to be published in January 2016. In addition to the types of asset which by definition may be excluded from an Appropriateness test, there is another category and we do not yet know what it will contain under MiFID II. FCA noted this point also in Discussion Paper DP 15/3: ESMA has been asked to develop guidelines to help firms determine when a product is deemed complex, which are due to be published in January 2016. While certain assets may no longer be non-complex by pure definition, some of those may yet be capable of recognition in this category of Other non-complex financial instruments. Rather than two categories (complex / noncomplex), we in effect have three: Non-complex by definition; Non-complex by attribute (currently unknown); and Complex. 6
Model Under MiFID II One practical difficulty indicated by diagram 3 is that Security Master File data structures may come under pressure. Where under MiFID I all Listed Shares would receive the same treatment, under MiFID II some Listed Shares may require different processes from others. Similarly, the presence of derivatives within a UCITS fund will change the requirement for Appropriateness. Firms may approach this difficulty in various ways, and so need to start considering how such issues will affect their customer interactions and investor journey. With an expectation that many firms will need to commence Appropriateness tests for the first time, or widen the scope of their existing tests, firms need to consider whether to structure their administration processes to perform all Appropriateness effort at the point of client inception, regardless of whether the client s initial instruction requires any Appropriateness test to be performed. Other firms might decide to request information from investors only at the point needed to perform an Appropriateness test relevant to the current activity. Such decisions will be influenced by the expected balance of business activity. The difficulty for Firms is that with ESMAs guidelines only due in January 2016, one year prior to the planned implementation of MiFID II, waiting for certainty is a dangerous game. Therefore it is prudent for Firms to consider how they might perform Appropriateness Tests across a wide range of supported assets. CIS Manager / Pension Manager Other Firms Exempt from MiFID Not Performing MiFID Business Suitability Assessed By Another Firm Performing MiFID Business Advice / Managing Execution or 'Reception and Transmission' Other MiFID Business Perform Suitability Test Clearly Inform Client: "No Suitability Test" Confirm re Ongoing Suitability Listed Shares Bonds / Debt UCITS Other / Non- Complex Other Non- Deriv Deriv Non- Deriv Deriv Non- Deriv Deriv TBC Derivatives Potential liability exceeds loss Insufficient public information Little opportunity to redeem No Appropriateness Test Required Perform Appropriateness Test Diagram 3: MiFID II mapping of Appropriateness and Suitability. 7
A Model for Appropriateness Testing Firms keen to assess the implications of Appropriateness testing on their business activities might consider the following 5-step process as a starting point: 5 Step Process Why is the asset valid in your offering? In many cases Firms will previously have performed Asset Due Diligence and confirmed that an asset is a valuable addition to its product offering. The Firm should review the attributes that make it a good asset to make available to its clients. Does any sub-category of the Firm s client-base have needs opposed to those attributes? The Firm should consider whether the positive attributes it has identified are not aligned with any types of client it services. Any potential mis-match indicates the area where Appropriateness may be a concern in respect of that asset. What information is needed to identify if the particular Client fits into the identified sub-category? Consider how you could best assess whether a given client could be in the population for which the asset is therefore not Appropriate. What additional information would the firm need to collect? The Firm can re-use information already held, provided such information is current, complete and correct though additional information might be relevant for the different assets that a client might wish to purchase. How should this be implemented? The Firm might seek to collect at the start of the client relationship all information that may in time become relevant for Appropriateness purposes. Alternatively it might prefer to seek information only at the point of need. Similarly, implementation needs to consider how different communication channels might be impacted: requesting information via postal channels will often produce a delay in the process; telephone scripts can be readily updated to seek immediate information, though there is a risk of call duration being extended; web interaction leads to a different shape of process implementation. 8
For some firms, implementation will be an in-house project. Other firms however are serviced by third party administrators. Even though one benefit of such outsourcing arrangements is the ability to share project implementation costs across a wider community of system users, firms should remain mindful of the need to ensure that the implementation supports their own business context and approach to customer engagement. Perhaps the approach you require may differ from what your administrator has previously been asked to service, and such a conclusion will have commercial implications, you must ensure your cultural values are upheld. So how would this model handle the ITC shares or NURS assets noted earlier as potentially falling into the Appropriateness regime under MiFID II? Diagram 4 offers a simplistic (and hopefully provocative) example for a nonstructured NURS. The responses are deliberately written so that many readers will not agree with all parts of the table. My rationale is that when you identify the points at which you would disagree and want to go deeper into a response, you have successfully identified a key requirement of your own Appropriateness solution. Question Why is the asset valid in your offering? Possible Response for a non-structured NURS It s an FCA-regulated Collective investment Scheme, subject to rules defined for the Retail market. It is broadly the same as a UCITS, though with slightly wider investment limits. Does any sub-category of the Firm s client-base have needs opposed to those attributes? I am allowed to assume that a Professional Investor has the relevant knowledge, and compliance with the NURS standard is sufficient for me to conclude the asset s attributes are aligned with a Retail investor. What information is needed to identify if the particular Client fits into the identified sub-category? I already know if my client is a Retail investor (whether by definition or because I treat all clients as Retail investors). What additional information would the firm need to collect? Probably little or nothing. I will have categorised the client already, and if my earlier steps identified no additional information requirements... How should this be implemented? I will need to update investor documentation, call scripts, and web pages etc. to ensure the completion of this Appropriateness Test is clearly documented as part of the customer journey. However, the impact on overall processes is limited where I have not identified any need for additional information to be collected. Diagram 4: Simplistic example for a non-structured NURS Working through this example demonstrates that the first step is vital. Knowing why a given asset is valid and valuable to your product offering sets the scene and defines the parameters for all action that follows. 9
Closing Thoughts It is worth considering how the current interest regarding Robo-Advisers might have application to the issue of Appropriateness. Leaving aside the question of whether Robo-Advice constitutes regulated advice or a personal recommendation, it seems pertinent to note that the Robo-advice services taking shape in the market seem well-placed to deliver Appropriateness tests. These services collect information about the client; their investment outlook; and their understanding of and appetite for financial risk. Such knowledge can all play a valuable part of any Appropriateness test subsequently required, and it will be interesting to see how MiFID II impacts the emergence of these services in the UK. "Understanding the likely shape of your MiFID II product proposition is important to any effort to understand the potential implications of introducing or expanding Appropriateness testing in your organisation." There are many aspects of MiFID II that firms will need to engage with in the coming months, though the potential impact of Appropriateness on the customer journey makes it an important item for engagement. Understanding the likely shape of your MiFID II product proposition is important to any effort to understand the potential implications of introducing or expanding Appropriateness testing in your organisation. Recognising the likelihood that ESMA s guidelines will not enable many types of assets to be viewed as non-complex, the Tax Incentivised Savings Association (TISA) is looking to initiate industry effort to formulate an approach to Appropriateness that can be proposed to the FCA as an Industry model. Let us hope that the UK industry as a whole will show the courage highlighted by Schumacher, and find an approach to complexity that does not simply make the administration burden bigger and more complicated. About DST DST Systems, Inc. (NYSE: DST) is a leading provider of specialised technology, strategic advisory, and business operations outsourcing to the financial services industry. We assist clients in transforming complexity into strategic advantage by providing tools and services to help them stay ahead of and capitalise on ever-changing customer, business and regulatory requirements in the world s most demanding industries. Copyright 2017 DST Systems, Inc. All rights reserved. The DST logo is a registered trademark of DST Systems, Inc. Other brand and product names mentioned in this document may be trademarks or registered trademarks, in various jurisdictions, of DST Process Solutions Limited, DST Systems, Inc. or their associated companies. All third party brand and product names are trademarks or registered trademarks of their respective owners Inc. DST Systems, Inc. (DST) has provided the information in this Product Brochure for general informational purposes only, has a right to alter it at any time, and does not guarantee its timeliness, accuracy or completeness. All obligations of DST with respect to its systems and services are described solely in written agreements between DST and its customers. This document does not constitute any express or implied representation or warranty by DST, or any amendment, interpretation or other modification of any agreement between DST and any party. In no event shall DST or its suppliers be liable for any damages whatsoever including direct, indirect, incidental, consequential, loss of business profits or special damages, even if DST or its suppliers have been advised of the possibility of such damages. 10