The second incarnation of the European Markets in Financial Instruments Directive (MiFID II) adds a whole new meaning to the song lyric “Getting to know you” as financial firms and their clients tackle the new rules of onboarding.
For financial firms the increased amount of required client data and documentation will prompt changes to their know-your-customer processes, repapering of many client accounts and updating onboarding technology to meet the new MiFID standards. Customers will benefit from the extra detailed information required, because financial firms will presumably know considerably more about their risk profiles, as well as being prepared to explain the appropriate investment products.
Laura Glynn, director of regulatory compliance for Dublin-based customer onboarding software firm Fenergo, parallels the process of following MiFID II’s rules to that of FATCA. “Under FATCA, there are a series of due diligence requirements for new and pre-existing accounts,” she says. “Likewise, a core part of complying with MiFID II will involve collecting the data and documentation required to classify the client correctly. Existing client accounts must also be reviewed, particularly when it comes to local and public municipalities.”
Under MiFID II, financial firms can still bucket their clients in one of three categories — retail client, professional client, or eligible counterparty, but they will need to prove to regulators they made the right choice. Fund management firms, pension plans, and other financial firms will likely fall under the category of professional clients or eligible counterparties while individuals will likely fall under the category of retail clients. Retail clients will receive the most investor protection while eligible counterparties will receive the least.
With the US Foreign Account Tax Compliance Act (FATCA), anti-money laundering regulations and the European Market Infrastructure Regulation (EMIR) all requiring more diligent client monitoring, MiFID II will be one more burden for European and foreign firms alike. Although MiFID II is a European regulation, US broker-dealers executing orders on behalf of European customers or US-headquartered fund managers with European investors must also comply.
Making the Changes
Selecting a particular category for the client will require the financial firm to do some extra digging into their financials and risk appetite. It could take anywhere from a day to a few weeks to review each customer account, collect the data and documentation required, and make any necessary changes.
Financial firms will need to come up with a customer outreach program quickly in time to meet the requirements of MiFID II. Clients can’t be placed into one of the three buckets without their understanding of the criteria used and their explicit consent.
“The customer outreach outreach program, to meet MiFID II’s requirements, needs to address what the firm will do if it has not received a response to its initial correspondence with the client about its categorization,” says Darren Thomas, managing director of customer management software provider IHS Markit in London. “The entire lifecyle of the communications process is a workflow that must be documented and signed off by the relevant customer onboarding manager and compliance manager.”
Customers must received written information about why they have been placed in a particular category and what they will receive in return. Retail and professional clients are guaranteed best execution and trade-by-trade explanations of why an investment is suitable for the risk profile. That profile takes into account the size of the client’s assets, the amount of risk it wants to assume, and whether it understands the investment risk of the trade involved. Eligible counterparties don’t receive any guarantee of best execution, nor any explanations of why a particular trade is suitable for them.
Clients are allowed to “opt-up” or change their category to a level granting them less protection. However, under MiFID II, financial firms will no longer have the option to assign local authorities and municipalities as professional clients or eligible counterparties. They will automatically fall under the category of retail investors. Local authorities and municipalities may choose to “opt-up” to the professional cient status, if they feel they have the necessary knowledge and investment experience. Member countries of the European Union have the discretion to add their own criteria for local authorities and municipalities to opt up. The UK Financial Conduct Authority has decided that at a minimum the local authority or municipality must have £10 million in assets to opt up its category.
Likewise, financial firms must follow more formal procedures for changing client classifications. Clients must make a written request to alter their designation. Professional clients wanting to become an eligible counterparties must also receive written warning from their firms about the loss of protection. The client must confirm in writing that it is aware of the consequences of its action.
What if the client doesn’t agree on its classification? Retail investors who can’t be opted-up into the category of professional clients may have to be offboarded, or in the case of new clients, not signed on.
Because of the intense amount of interaction and consents required from customers, financial firms will need to adapt their automated customer onboarding software to track the entire workflow of account review, customer communications and consents. Fenergo and IHS Markit say they offer software packages to handle this.
Mandatory ID Codes
Clients must also have legal entity identifiers (LEIs). Trades executed without an LEI or other identifier must be cancelled or unwound because they cannot be reported. For individuals, an identifier called the natural person identifier must be used. That could either be a passport number, a national ID, or some a simple concatenation of name and date of birth.
“From an operational perspective, many financial institutions are currently examining their client data to identify clients without a valid LEI, and performing an outreach program to these clients to encourage them to apply for the LEI from their local numbering agencies,” says Glynn. “There is expected to be a run on LOUs in an attempt to attain an LEI before January 3, 2018.”
Many firms are already using LEIs for swap trading and reporting, but the expanded range of products covered under MiFID II, such as fixed-income instruments and commodities, will likely mean that most client investment accounts will require LEIs. Financial firms may ultimately be forced to help their clients fill out the paperwork in order to open or retain an account. “From a technology perspective, financial firms will need to consider updating their client onboarding software to include the LEI, the status of the LEI, legal name, and legal address of the client,” says Glynn.
Client agreements must also be reviewed and potentially revised to comply with MiFID II. Under the original version of MiFID, financial firms were only required to enter into written agreements with retail clients when providing investment advice. That is now also the case for professional clients and eligible counterparties. The new agreements must now include a complete description of all of the services offered and, in the case of portfolio management services, the client agreement must include a description of the types of financial intruments that may be bought and sold and the types of transactions that can be executed.
Although most firms will already be in compliance with the enhanced standards, they will need to verify that the content of their agreements comply with the MiFID II framework. “The firm has to find the relevant client contract, then allow for a reasonable response time, anticipate client questions around the terms of their agreements, and anticipate that the client may want to change some of the terms of the best execution policy,” says Thomas.
Direct electronic access clients — or those who can electronically acess a trading venue’s order book using a member’s trading code — must also be identified for the first time. That is because they will be required to undergo an annual due diligence review that is similar to a know-your-customer refresher. Firms must analyze clients to determine whether the DEA service is suitable and whether any changes must be made to pre-set trading or credit thresholds.