Investor protection in the UK: New tools, new challenges
The following is the prepared text of the speech delivered by Maggie Hraik, Acting Head of Savings and Investments, at the FCCRA MiFAD II Conference 2014. Please note that the actual delivered version may have varied from this draft.
An analysis of the forthcoming investor protection requirements introduced by MiFAD II, drawing comparisons with existing regulations in the UK and highlighting the practical challenges they may present.
MiFAD II will introduce a comprehensive set of requirements aimed at shaping the conduct of business across the entire supply chain. Some of these requirements will be entirely new to firms, while others will consolidate and formalize principles that may already be familiar, particularly within the UK's domestic policy and supervisory framework.
Upon examining the Directive, we observe a diverse range of requirements intended to influence conduct in various ways:
Top-down requirements emphasize the need for senior management to assume clear responsibility for investor protection.
Detailed organizational and conduct of business requirements specify or prohibit specific responsibilities and practices.
Regulatory intervention in the market is facilitated, notably through the product intervention powers granted to national authorities and EMSA.
Efforts are made to enhance the consumer experience directly, such as by providing them with more information. This reflects a broader objective of strengthening consumer engagement and promoting competition, especially within the retail investment market.
Balancing the objectives of retail and wholesale conduct of business involves making numerous trade-offs. It is essential to avoid assuming that all firms and consumers will respond to the new requirements in the desired or anticipated manner. Fortunataly, MiFaD equips us with a range of tools to address this challenge effectively.
As David mentioned earlier, MiFAD II is an extensive undertaking. It employs various approaches, including persuasion, coaxing, instruction, and market intervention. In this discussion, I will focus on these different approaches and their implications for both firms and consumers.
Furthermore, it is important to clarify that, during the remaining 29 months, our efforts will not solely revolve around collaborating with EMSA on the implementation measures of MiFaD. We will actively engage with the industry and other stakeholders, such as consumer groups, to comprehend and, in some cases, direct or guide implementation decisions. In areas where MiFID grants individual authorities discretion over certain details, we understand the need for prompt clarity regarding the requirements, and we aim to provide such guidance as soon as possible.
Looking at the origins of the new requirements on investor protection
Before delving into the specifics, it is important to take a moment to evaluate how the new investor protection standards align with the markets they aim to regulate.
Regarding the conduct of business, it is not as apparent (compared to other areas) that these new standards are primarily a response to the financial crisis. However, certain aspects of the Directive can be seen as addressing issues that emerged during the downturn. These include:
Increased attention to structured products, many of which are likely to be classified as 'complex.' The aim to safeguard local authorities across Europe from high-risk instruments that they may not fully comprehend.
However, many of the new requirements for investor protection were driven not only by the crisis but also by broader regulatory concerns. MiFaD reflects a desire to enhance various areas, such as:
- Firms' oversight and governance of products.
- Incentive structures surrounding sales staff.
- The overall quality of advice and sales processes.
These topics are familiar, as they have been clearly identified in our supervisory work and the well-known instances of mis-selling that have unfolded in recent years. The new directive presents an opportunity to consolidate the progress we have made in these areas and establish more explicit regulatory expectations.
Looking at the fit with the retail investment market as a whole
However, I also want to address an area where the progress made in the new Directive has fallen short of expectations. To provide context, let's go back to October 2007, almost a year prior to the Lehman Brothers' bankruptcy. At that time, the European Commission issued a call for evidence regarding what it referred to as "substitute" investment products. The Commission expressed concerns about the inconsistent rules that had been introduced by European institutions for different segments of the retail investment market. They criticized what they referred to as the "sectoral" approach to investment distribution.
Fast forward to June of this year when the new Directive and Regulation were incorporated into the Official Journal. We observe that the "sectoral" approach has not been entirely eliminated. While structured deposits have been included in MiFaD on the retail side, the insurance sector is left with the hope that the Insurance Mediation Directive may be able to adopt some of the new standards for insurance-based investments and achieve a similar level of harmonization.
Seven years ago, the Commission acknowledged the convergence of insurance, investment, and savings profiles that had already occurred. However, this recognition has not translated into a substantial improvement in the consistency of the European regulatory framework. Therefore, in the UK, one of our tasks in the coming months is to determine how best to leverage the new tools provided by MiFaD. Given our desire to address the entire retail investment market with our conduct of business rules, this presents a significant challenge.
Other organisational requirements: remuneration of front line staff, taping and conflicts management
I would also like to address other organizational requirements outlined in MiFID. The directive scrutinizes the way firms organize themselves through the introduction of new requirements and modifications to existing ones.
Firstly, the new directive emphasizes the increased responsibility of senior management in ensuring the behavior of their firms, aligning with the proposals in our recent consultation paper on Strengthening accountability in banking. Secondly, it places a greater emphasis on the systems and practices firms must have in place to identify and manage risks. The new Directive makes it clear that if a firm has the ability to avoid risks to consumers, it must provide a clear justification for taking on such risks.
To address investor protection concerns, the new Directive specifies the risks that firms must address through their systems and controls. However, firms should not lose sight of their overall responsibilities to establish appropriate policies and procedures to manage risks and ensure compliance more broadly, regardless of the specificity of the Directive.
Let's also delve into some of MiFID's new organizational requirements:
One area of focus in recent years has been the remuneration of salesforces and front-line staff. In fact, in March of this year, we published TR14/4, an update on our thematic work on risks to customers arising from financial incentives. Therefore, firms preparing for the new MiFID standards should not be surprised by the remuneration requirements. Similar to product governance, firms will witness us codifying our expectations into rules, starting with a fundamental requirement not to remunerate or evaluate the performance of staff in a way that conflicts with the firm's duty to act in the best interests of its clients. In response to the Parliamentary Commission on Banking Standards, we have also made it clear that we will review our approach to financial incentives for sales staff as a whole when implementing MiFID.
MiFID also introduces a new organizational requirement for recording telephone conversations and electronic communications in certain trading activities and proprietary trading. This requirement aims to address investor protection and market integrity concerns. For many UK firms, this requirement is not new. Since 2009, firms engaged in certain trading activities have been obligated to record telephone conversations and retain copies of relevant electronic communications. In 2011, the requirement was extended to include mobile phones. However, firms such as financial advisers and brokers that are currently exempt from MiFID, provided they operate exclusively within national borders and do not hold client money, will find that the terms of their exemption have been tightened, and some organizational and conduct of business requirements now apply to them. This includes the recording rule. While this change undoubtedly incurs costs for some firms, it also brings benefits such as acting as a deterrent to breaches of regulatory requirements and providing evidence in cases of alleged errors.
Managing conflicts of interest is one of the most crucial aspects of the current organizational requirements. With the new Directive emphasizing the importance of preventing or managing conflicts, ESMA aims to ensure that firms cannot simply choose to disclose conflicts that could have been avoided altogether. We fully support this approach.
Conclusions
In conclusion, I would like to revisit the range of new tools that MiFID brings, which I mentioned earlier. For firms, it is crucial to understand that the significance of MiFID goes beyond prescriptive sales standards or new systems—it entails changes across the entire business. The mindset of senior managers, system designers, and staff at all levels within organizations must align with the new responsibilities arising from areas such as product governance and staff remuneration. Implementing MiFID's investor protection requirements should focus on ensuring that both the conduct standards and the organizational structure of firms reflect the interests of consumers and the obligations owed to them.
Moreover, when it comes to more specific requirements like inducements or sales of complex products, it is essential for firms to grasp the driving forces behind these changes in order to effectively implement them. Firms that have expressed dissatisfaction with the inducement standards articulated since the Retail Distribution Review (RDR), for instance, should bear in mind that under MiFID, standards are set to increase, not decrease, reflecting a genuine and sustained desire for change in this area. While a significant portion of the UK market has already experienced heightened regulatory requirements in recent years, the new Directive will still introduce important changes—consolidating, formalizing, and expanding our expectations of firms.