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AFM ESMA

MiFID II: Suitability & Appropriateness

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More than 18 months ago the day had finally arrived. After years of discussions, consultations, draft and ultimately definitive texts, MiFID II entered into force, one year later than planned. Since 3 January 2018, all investment companies in Europe have had to comply with MiFID II.

I can hear you think: “January 2018? Old news! Surely that’s no longer relevant?” In fact, the opposite is true. The European regulator (ESMA), the European Commission and the Dutch regulator (AFM) have not sat idle over the past 18 months.

So what's happened?

ESMA has tightened up and expanded all its MiFID II Q&As, drawn up guidelines about various topics and sent out consultations. The European Commission has published a number of delegated regulations and AFM has performed its supervisory tasks and formulated points to consider for the market.

In short: MiFID II is still just as relevant as it was 18 months ago and still deserves our full attention.

In this Article we will discuss the developments in MiFID II. Don’t worry, we won’t overwhelm you with an endless explanation of the directive itself, the corresponding MiFIR regulation, the delegated regulations, the dozens of documents with technical standards and the endless list of Q&As, guidelines and interpretations.

No, to keep things manageable, we’ll limit ourselves to one central theme of MiFID II: Suitability & Appropriateness.

We’ll start with a review of the publications issued on this theme of Suitability & Appropriateness. We’ll then look forward: which changes and publications are still to come? Finally, we’ll provide a look behind the scenes at AFM. What are AFM’s focal points in the time to come? What should you be aware of? And how can you prepare for this?

MiFID II: Markets in Financial Instruments Directive II

But before we zoom in on this, it’s good to remind ourselves what MiFID II is all about. MiFID II is short for Markets in Financial Instruments Directive II. This is an EU directive, which aims to make the European financial markets more efficient and transparent and to increase the protection of investors.

MiFID II replaces the MiFID I directive, which took effect in 2007, and has made amendments to the regulations in force for investment companies and trading platforms. MiFID II also introduces the MiFIR regulation. MiFID II and MiFIR are both so-called Level 1 legislation. This is the highest level of legislation in Europe. In addition to this Level 1 legislation, MiFID II involves a lot of Level 2 legislation. This legislation consists of delegated regulations and directives.

Finally, European legislation has a third level: Level 3. Although Level 3 regulations don’t have the status of legislation and only count as guidance from the European regulator, this is different in practice. The national regulators – including AFM – use these Q&As and guidelines to perform their supervisory tasks. This means their content is important for you. The Q&As also help to solve specific matters of interpretation.

Europe has not sat idle over the past 18 months with regard to Level 3 in particular, and a large number of Q&As and guidelines have been drawn up.

Suitability and Appropriateness

Well, now that you have a clear picture again of what MiFID II is all about, we can zoom in on our central theme: Suitability and Appropriateness. Let’s start with suitability.  If your company gives investment advice or provides asset management, you must conduct a suitability test of your clients.

Only provides execution-only services? We’ll talk about the appropriateness test later, and you can also derive useful information for your execution-only services from the guidelines for the suitability test.

So, what does the suitability test involve? On the basis of questions about the client’s financial positions, goals, investment horizon, risk appetite and knowledge and experience, you get insight into what the client wants to achieve, the risk they can take and the risk they want to take. You then have to adapt your investment advice or asset management to the client’s requirements.

Is this test new? No, certainly not. It already existed under MiFID I. However, the test under MiFID II has been set out in more concrete terms. Moreover, ESMA had already published guidelines for specific aspects of the suitability requirements on 6 November 2018.

If you think: “but surely those guidelines are for national regulators and not for me as an investment company?” then you are right. However, AFM applies the guidelines in its supervision of your company. So therefore the guidelines are also relevant to you.

What are these guidelines about? The twelve guidelines can roughly be divided into five themes:

  1. Information from and to clients;
  2. Data for legal entities or groups;
  3. Staff knowledge and expertise;
  4. Considerations to be made when making switches in the investment portfolio, and
  5. Record keeping.

Theme 1 (information from and to clients) is relevant to Guidelines 1, 2, 3, 4, 5 and 8. These guidelines are both about the information you get from the client and the information you provide. It must be clear to the client why they need information, what information they need and when. It should also be pointed out to the client that providing honest, accurate and complete information is for their own good. This allows you to get to know your client and enables you to recommend and include suitable products in the investment portfolio.

Theme 2 (data for legal entities or groups) is relevant to Guideline 6. In this guideline, ESMA explains whose data has to be requested when a legal entity wants to invest. And what happens when several people have a joint account? Who should then be asked for information? Although the guidelines are about the suitability test, they can also be used to decide who should be asked for information about the knowledge and experience for the appropriateness test.

Theme 3 (staff knowledge and expertise) is relevant to Guidelines 7 and 11. In these guidelines it is emphasised that staff giving advice on products or managing a portfolio must understand the relevant financial instruments and must have sufficient professional expertise.

Theme 4 (considerations to be made when making switches in the investment portfolio) is relevant to Guidelines 9 and 10. ESMA states that switching should only take place if this is preceded by a careful assessment. The new product’s cost-benefit ratio should be considered, and the costs involved in switching should be taken into account. If the costs of switching do not counterbalance the anticipated return, it is – of course – better not to switch.

Theme 5 (record keeping) is relevant to Guideline 12, which concerns the careful recording of the received data.

What should you do with these guidelines? We advise you to read them carefully and decide whether your suitability test is in line with these guidelines. Is this not the case? Then you can consider adjusting your test, or at least giving a good justification for the reason why you have taken a different direction.

Once you have warned the client, is that enough? Well, no, unfortunately not.

The appropriateness test

If your company provides execution-only services, you must conduct an appropriateness test of your clients. On the basis of questions, you have to obtain information about the client’s knowledge and experience. This always concerns knowledge and experience with regard to the specific financial instrument in which the client wants to invest.

On the basis of the client’s answers you’ll know whether your client can sufficiently understand the operation and risks of the financial instrument. Does it follow from the test that your client has insufficient knowledge and experience about a financial instrument but nevertheless wants to invest in it? In that case it is up to you to warn the client that they have insufficient knowledge to do so. You must point out to the client that due to their lack of knowledge they are insufficiently capable of assessing the product’s operation and risks.

Once you have warned the client, is that enough? Well, no, unfortunately not. Because of MiFID II, we can no longer consider the appropriateness test and the obtained information separate from the rules about product governance. In some cases these rules may mean that warning alone is not enough. Product governance is too big a subject to discuss it here, but we’ll get back to this in a future podcast.

Is the appropriateness test new? No. Like the suitability test, the appropriateness test already existed under MiFID I. However, this test has also been further elaborated under MiFID II. It has been clarified that the client’s knowledge really has to be tested. A company asking the client whether they are knowledgeable about financial instrument X, Y or Z does not do enough. The company must ask objective questions and the client must answer them correctly to demonstrate that they are sufficiently knowledgeable. This test should delve deeper and be more detailed for complex products than for products that are not complex.

ESMA has recently published a supervisory briefing about the appropriateness test. On the basis of this briefing, national regulators can determine whether bodies under supervision meet the obligations from MiFID II.

The reason for publishing this briefing was that ESMA noticed that the different member states gave a different interpretation of supervision of the appropriateness test. ESMA hopes that this briefing will ensure that the different regulators will assess the MiFID II obligations in the same way.

The briefing covers questions like:

  • Is it determined correctly whether the appropriateness test is required?
  • Is the correct information obtained from clients?
  • Is the appropriateness test conducted correctly?
  • Are clients given the correct warnings?
  • Do the staff have professional expertise?
  • Are the records kept correctly?

ESMA explains for each topic what should be done and how. We advise you to read the briefing and assess whether your test complies with the briefing’s content. Again we would like to add: the briefing is directed at AFM, but AFM uses the briefing to supervise your company.

The future

Let’s now continue with Part 2: the future. What will it bring? ESMA has recently started an investigation into the different appropriateness tests in the member states. AFM will cooperate in this investigation, and in turn will ask different investment companies under supervision to take part in it. On the basis of the results, ESMA will assess whether additional guidelines for the appropriateness test are required in order to improve uniformity in the European Union. So this story is to be continued.

 

Behind the scenes at AFM

Now that we have given you an update about the latest developments surrounding the suitability and appropriateness tests, we have arrived at the third and final subject: a look behind the scenes at AFM.

Earlier this year, AFM made it clear in a press release that the transition of the MiFID II standards to practice is inadequate throughout the market with regard to a number of points. AFM is therefore calling on parties to implement improvements.

Exactly what standards are concerned? According to AFM, companies have not yet sufficiently implemented the rules about cost transparency, product governance, transaction reports and professional expertise.

Let’s have a closer look at cost transparency first. MiFID II has completely changed the landscape of rules about cost transparency. Since 3 January 2018, every single detail of the costs has to be made transparent to your existing or potential client, both before the investment service is provided and afterwards.

AFM has indicated that investment companies are currently not yet sufficiently transparent about the costs they charge. Moreover, the costs mentioned in MiFID II have to be specified in both absolute amounts and in percentages. This is not yet happening in practice. The costs must also be tailored to the client’s individual situation, and the effect of the costs on the return must be shown. This is the only way in which an existing or potential client can compare the fees of different service providers.

This takes us to product governance. This is a new topic introduced by MiFID II. Both the developers and the distributors of a financial instrument must have product governance procedures.

What does this mean? In brief, you must define a target group and a distribution strategy for all the financial instruments you produce or sell, and ensure that the product is sold to the right target group. The products must be analysed again in detail each year. According to AFM, parties do not define the target group and the distribution strategy sharply enough, at least where execution-only services and more complex products are involved. As a result, clients risk being offered products that are not at all suitable for them. As we said earlier, we will devote a separate article to product governance.

Reporting on completed transactions already existed under MiFID I, so it’s not new. What is new is that a lot more information has to be send to the regulator. More than 60 fields have to be completed and reported. AFM is of the opinion that neither the completeness nor the quality of the reported data is good enough. So this is something the parties will have to work on.

The last topic highlighted by AFM is the professional expertise of staff. When MiFID II entered into force, no accredited exams, which could demonstrate professional expertise, where available yet. These exams are now available, which means you are now able to demonstrate the professional expertise of your staff. AFM states that investment companies must ensure that their staff have the correct qualifications.

This has brought us to the end of this MiFID II article. But would you like to find out more about this subject in the meantime, for example about the consequences of MiFID II for your company? Or about the rules that are still to come? Please feel free to contact us. Our experts will be happy to help you.