MiFID II – product governance and impact on primary market

The much-touted objectives of transparency and fairness, amongst others, aimed at by the EU’s new Markets in Financial Instruments Directive (MiFID) II regulation will, as has already been amply highlighted in recent articles on the local media and elsewhere, create a marked impact on a number of business areas for regulated persons.

On 20 December 2017, the MFSA issued the new Conduct of Business Rulebook, a 274-page document of rules and guidelines which regulated persons are required to adhere to and which essentially transpose the main EU Directives which apply in the area of conduct of business. Chapter 2 of this rulebook deals specifically with financial product governance with clear new requirements applicable to regulated persons which manufacture and/or distribute investment products including at the primary market stage.

Primary market issuance, in other words, the new issue of bonds or equities via initial public offerings (IPO’s) is likely to be impacted in view of new obligations on manufacturers and distributors or both (product governance). These manufacturers and distributors can be issuers, managers, placement agents and intermediaries.

 

Primary market issuance

While the new rules admittedly address several areas that should ultimately seek to better protect investors interests, the question is which type of investors are really set to benefit? From my initial reading of the regulation surrounding the changes necessary to processes and procedures affecting new issuance and the impact these new regulations may have on distribution, I have my firm doubts whether it will be the small retail investor who will be the main beneficiary.

Domestically, the impact is likely to be even more pronounced given the historically strong and vast participation rate by the retail market in subscriptions of new bond and equity issues. Local issuance has almost always been very widely distributed, and the resultant allocation fragmented, to the extent that bond registers have now, in the main, totalled thousands in number of retail allocations. This may change.

Given the increased onus on regulated persons in respect of their responsibilities towards small retail investors, we are likely to witness a shift of preference towards less fragmentation and more focused allocation of newly issued paper towards investors having managed portfolios, institutional investors and asset management firms. In other words, regulated persons are likely to steer towards the path of least resistance given the material new responsibilities and costs it will have to bear as a result of this new regulation – costs that will invariably need to be recovered from the investor in return for the service rendered. The result is likely to create a shift of small retail demand in the secondary market where execution-only transaction processing is more likely to prevail.

This will no doubt be the least costly and therefore most affordable option relative to the average ticket size for this category of investor. But it will also create a culture shift that will take time to filter through to the typically small investor who, until a short while ago, would happily talk a potential investment through with his/her preferred intermediary prior to making an investment decision. The new vast responsibilities may direct a segment of the industry to put an almost complete stop to this, unless the regulated person is adequately compensated for the time it will now take to meet each client and complete extended formalities when investment advice is expressly requested, even in its simplest form. In most cases, this is unlikely to be affordable relative to the typical average investment size leaving this category of investor with no door to knock on.

Disclosure in new issuance is also set to increase as the new regulation now requires additional information made available via manufacturers and distributors or both in the area of, for example, the identification and management or prevention of any possible conflicts of interest that may arise in cases such as the combined role of placement and underwriting.  Furthermore, there are now additional requirements for the provision of additional specific information and arrangements in relation to advice, pricing and placement methodology. The fact that increased disclosure will improve transparency is not debatable however will investors, especially retail investors, really benefit materially from this? It remains to be seen.

 

Product Governance

The principal scope of this area of regulation is to try to ensure that small retail investors in particular are provided with the appropriate information to better understand the potential risk and reward profile of investment products through new governance arrangements that target matters such as identification of target market for specific products, product oversight during their life cycle and strict policies that regulated persons need to have in place to ensure continued suitability of the product to the investor targeted.

We now have two identifiable roles for investment services firms – those of ‘distributor’ and ‘manufacturer’ of investment products. In certain instances, firms may well be both manufacturers as well as distributors. Recital 15 and Articles 9(1) and 10(1) of the MiFID II Implementing Directive (EU) 2017/593 define these roles in the context of the product governance requirements as follows: “investment firms that create, develop, issue and/or design financial instruments, including when advising corporate issuers, on the launch of new financial instruments, should be considered as manufacturers while investment firms that offer or sell financial instruments and services to clients should be considered as distributors”.

Firms acting as either manufacturers and/or distributors now have new obligations that need to be adhered to and must prepare all that is necessary in order to be compliant prior to the distribution of investment products. The result is that investors should benefit from more targeted investment products being offered to them and should have more information, more specific detail and a more transparent way of getting hold of new products. Only time will tell whether the attainment of heightened protection and knowledge (though the better understanding of risk and return) will really be achieved.

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