Greater transparency and greater investor protection

The issues that shaped the year 2017 included the implementation of MiFID II, the European Union's second Markets in Financial Instruments Directive¹, whose provisions have been in force since 3 January 2018. The amendments are aimed at improving the functioning and transparency of the financial markets and providing better protection to consumers in the European Union (EU)². German legislators transposed MiFID II by way of the German Second Act Amending Financial Markets Regulations (Zweites Finanzmarktnovellierungsgesetz).

MiFID II assigns a number of new responsibilities to securities supervision, such as the authorisation and supervision of organised trading facilities (OTFs). These types of trading platforms were not regulated before. In addition, positions in commodity derivatives will become more transparent. Market participants will in future have to disclose such positions if they exceed a defined level. The supervisory authorities will moreover also supervise data reporting services. The aim is to make market data – for example on transactions in financial instruments that have been completed – more transparent and provide such data more cost-effectively.

Apart from these market-related amendments, MiFID II also contains a number of rules to improve investor protection.

Investor protection improved

For example, MiFID II ensures that clients receive better information about the cost of financial services. Investment firms have to inform clients about the total cost of investing and its impact on the yield, broken down into product costs and service costs.

What is more, MiFID II promotes independent investment advice. The directive prohibits banks and other financial services providers that give independent investment advice from accepting inducements from third parties. The German Fee-Based Investment Advice Act (Honoraranlageberatungsgesetz), which entered into force at the beginning of August 2014, already contains rules to this effect. The prohibition in MiFID II also covers remuneration that the issuer of a financial instrument pays to the undertaking as sales commission.

Identifying the target market

Moreover, MiFID II specifies comprehensive EU-wide rules for the product approval process. The directive covers the entire value chain, from product provider to client, and specifies new guidance for the associated organisational requirements and conduct of business rules. The aim is to ensure that financial products are manufactured in such a way that they meet client needs. Issuers will therefore have to specify the target market, i.e. the clients, for which the product is intended, at the time of creating a product. To this end, issuers have to use certain criteria, such as client category (retail client, professional client), the clients' knowledge and experience, their financial situation and risk-bearing capacity, their risk tolerance, investment objectives and needs.

MiFID II requires the distributor to conduct a critical review of the target market specified by the manufacturer, narrow it down in respect of its client base, and implement it in its distribution practice. The reason for this is that manufacturers can often take account of the above criteria only in very general terms. These requirements are supplemented by product governance requirements, including after the distribution process.

German product manufacturers and their associations have used the new regulations as an opportunity to formulate a market standard, which creates a consistent basis for distribution in different business models and product universes of the German financial market.

Record-keeping requirements

Clients will notice the changes introduced by MiFID II especially in relation to investment advice. Investment advice minutes are a thing of the past. They have been replaced with the statement on suitability, which has to present, among other things, how the advice has been tailored to the preferences, objectives and other characteristics of the retail investor. The agreement on the recommended transaction may only be entered into after the client has received the statement on suitability, unless the agreement has been entered into using distance communication, in which case exemptions apply.

The record-keeping requirements of investment firms do, however, cover more than the statement on suitability. If clients give an order to their adviser subsequent to receiving advice, the time and place of the meeting, the individuals in attendance, the initiator of the meeting and information on the order itself have to be documented. Investment firms now also have to record external and internal electronic communication and telephone conversations relating to client orders (taping). Clients have to be informed of this in advance and may object to the conversation being recorded. If they do object, the undertaking must not provide the service through this channel. The records must be retained for a period of five years. Clients may demand that (copies of) the recordings are made available to them.

Employee qualification

MiFID II also expands and harmonises the requirements for the qualifications of employees. New requirements in Germany relate to the knowledge and experience as well as the reliability of portfolio managers. Unlike investment advisers, they make independent investment decisions for clients and are authorised to dispose of client funds.

The existing reporting requirements remain unchanged, however. The only persons to be reported for inclusion in the Employee and Complaints Register will continue to be investment advisers, sales representatives and compliance officers.

MiFIR regulates product intervention

MiFID II is complemented by the Markets in Financial Instruments Regulation (MiFIR). As a European regulation, MiFIR is directly applicable. It now gives national competent authorities throughout Europe the power to prohibit or restrict the marketing, distribution and sale of financial instruments. The European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) are now also authorised to do so in certain circumstances. In addition, the powers of intervention set out in MiFIR are complemented by the European PRIIPs Regulation³, which has been directly applicable since 1 January 2018. This regulation gives the European Insurance and Occupational Pensions Authority (EIOPA) and national competent authorities similar powers relating to certain insurance-based investment products, for example.

German legislators had introduced the right to product intervention in 2015 – by way of the German Retail Investor Protection Act (Kleinanlegerschutzgesetz). BaFin has already made use of this right by restricting the marketing, distribution and sale of contracts for difference (CFDs)⁴. BaFin can continue to take intervention measures, although they will be put on a new legal basis as a result of MiFIR.

MaComp revised

BaFin has brought its Minimum Requirements for the Compliance Function (Mindestanforderungen an die Compliance-Funktion – MaComp) in line with MiFID II and published the new version in March 2018⁵. BaFin amended existing and added new modules, thus implementing ESMA's guidelines pursuant to Article 16 of the ESMA Regulation. The wording and contents of all modules have been adapted to the new legal bases in the German Securities Trading Act (Wertpapierhandelsgesetz) and in Commission Delegated Regulation (EU) 2017/565.

• The module dealing with the lists of inducements and of inducement applications, which replaces the previous module AT 8.2, has been entirely rewritten by BaFin. The following amendments were made in particular:
• There will no longer be a sampling process for monitoring employee transactions (BT 2)⁶, because under Article 29(5b) of the Implementing Regulation investment firms will in future have to be informed about each personal transaction immediately. Investment firms that do not have a process for keeping copies or have not introduced a reporting or consent requirement will have to adapt their arrangements accordingly.
• The revised module BT 5 implements ESMA's product governance guidelines⁷ of June 2017. The guidelines focus on a process that is consistent throughout the EU for determining the target market, which is the centrepiece of the requirements for the product approval process set out in MiFID II.
  
  The obligations to define the target market are addressed to both manufacturers and distributors. In addition to the above criteria for determining the target market⁸, the product features also play a part. The more complex the product, the greater the detail required for defining the target market in order to prevent unsuitable target client groups from being targeted. Distributors have to specify the target market and define in this process in particular the service through which a certain product can be offered.
  
  Manufacturers and distributors also have to define a distribution strategy. The guidelines also stipulate an exchange of information between the two parties in this context with regard to the client information which the distributor is required to have and the services through which the products can be distributed, before the concept developer defines the distribution strategy.
  
  The compliance function must be involved in the product governance process and is obliged to inform senior management about the financial instruments designed and recommended by the investment firm, especially about the distribution strategy.

• The revised module BT 9 specifies that sliding commissions must be disclosed explicitly in the firm's policy on how it deals with conflicts of interest. The module is the result of work on the issue of sliding commissions carried out in 2017. BaFin found in this process that the sliding commission models use different approaches, some of which make it impossible to rule out conflicts of interest.
• MiFID II also expands and harmonises the requirements for the qualification of employees. New requirements in Germany relate to knowledge and experience as well as the reliability of portfolio managers and sales representatives. Unlike investment advisers, employees in portfolio management make independent investment decisions on behalf of clients and are authorised to dispose of client funds. Sales representatives are employees who inform clients about financial instruments, structured deposits, investment services or ancillary services.
  
  The existing reporting requirements remain unchanged, however. The only persons to be reported for inclusion in the Employee and Complaints Register will continue to be investment advisers, sales representatives and compliance officers.
  
  BT 11 deals with the qualifications of investment firm employees, implements the corresponding ESMA guidelines dating from 2015 and complements the provisions of the German WpHG Employee Reporting Regulation (WpHG-Mitarbeiteranzeigeverordnung). Using examples and other tools, BT 11 describes good procedures with which investment firms can make sure for the long term that their employees meet the professional requirements and maintain their levels of qualification.

• BaFin plans to publish the modules on the suitability assessment and the requirements for remuneration systems as soon as ESMA has issued the relevant guidelines.

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