MiFID II – investor protection

Banking

Published 21 Feb 2024
6 min reading
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Introduced on January 3, 2018, the MiFID II Directive stands as one of the most significant legal acts regulating activity in the financial instruments market within the European Union. Its aim is to enhance investor protection in the capital markets, increase market transparency, and protect clients from investing without adequate knowledge. It imposes additional informational obligations on financial institutions, including those concerning the risks posed by individual products and greater cost transparency. What are the actual changes in terms of investor protection under MiFID II?

What is MiFID II?

The Markets in Financial Instruments Directive II (MiFID II) is a European Union legal act that regulates activity in the financial instruments markets. It was introduced in 2014 and came into effect in 2018, replacing the MiFID I directive. MiFID II has a significant impact on the functioning of financial markets in the European Union. It introduced a series of new rules aimed at investor protection, increasing market transparency, and enhancing competitiveness.

What does the MiFID package include?

The MiFID package comprises a comprehensive set of regulations governing activity in the financial instruments markets within the European Union. The MiFID package consists of two main legal acts:

The Directive of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments - it establishes the general regulatory framework for financial instruments markets in the European Union. It covers a wide range of issues, including financial instruments, financial institutions, investment services, investor protection, and market transparency and competitiveness.

The Regulation of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments. The MiFIR Regulation complements the MiFID II Directive and contains more detailed provisions regarding, among others, the organization and functioning of regulated markets, order transmission, and trading in derivative instruments.

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Implementation of the MiFID II Directive regarding financial instrument markets

Before introducing a product to the market, the MiFID II directive required investment firms to conduct a detailed analysis. This analysis had to consider situations where market conditions could deteriorate, the product could lose value, the producing company could encounter difficulties, and many other factors.

On the other hand, the MiFID II directive clearly specifies the need to create a target group for the product. The type of client for whom the product is intended must be defined, as well as the so-called "negative target market," i.e., for whom the product is not suitable. The directive introduces three categories of clients:

1. Retail client: does not meet the criteria of a professional client or an eligible counterparty. Retail clients are provided with the highest level of legal protection by financial institutions. In other words, financial institutions are obligated to inform retail clients about all risks associated with financial products and services and provide them with access to reliable information.

2. Professional client: a client who meets at least two of the following criteria:

executed transactions worth at least €50,000,
possesses sufficient knowledge and experience in financial instruments,
works or has worked in the financial sector.

They are provided with less legal protection than retail clients. This means that financial institutions are not obliged to inform professional clients about all risks associated with financial products and services to the same extent as they are for retail clients.

3. Eligible counterparty: a client who meets certain criteria that entitle them to waive some of the protections provided for professional clients. Eligible counterparties are provided with the least legal protection by financial institutions.

The MiFID II directive also requires identifying potential risks associated with product development and creating a scenario of actions by the investment firm or bank. MiFID II also requires that the product be aimed at benefiting the client.

urn with the European Union flag

Introduction of changes in MiFID II

The new MiFID II regulations require banks to assess the client's understanding of the proposed product, as well as their general knowledge of investment services and financial products. According to MiFID II, these changes are quite significant, and banks now have an obligation to conduct an appropriateness test, which checks whether a particular service or financial instrument is suitable for the investor. The client must demonstrate, among other things, an understanding of the risks associated with the transaction, and the bank must assess whether the brokerage service or product is best for them based on their investment goals and current financial situation. The aim of the MiFID II directive here is to lead to more cautious matching of products to clients by firms and banks.

book with legal regulations

After entering into an agreement, the bank must provide the client with an appropriateness report. It should include a summary of recommended products and a detailed explanation of why a particular service or product would be best for them. According to MiFID II, providing such a report is necessary before or immediately after a transaction if it has been conducted remotely. In the case of changes in a client's portfolio, the bank or investment firm must prepare a written report each time, which includes a comparison of the exchanged products and assessments of the resulting benefits.

Which financial instruments are covered by the MiFID II directive?

The MiFID II directive encompasses a wide range of financial instruments, including:

Equities: ordinary shares, preferred shares, investment certificates, securities deposits
Bonds: government, corporate, municipal, eurobonds
Derivative instruments: swaps, interest rate futures contracts
Other instruments: investment funds, indices, units of participation in investment funds, commodity derivatives, contracts for difference (CFDs).

It is worth noting that the MiFID II directive does not cover all financial instruments. Some instruments, such as currencies, precious metals, and real estate, are excluded from its scope.

Additionally, the MiFID II directive distinguishes between regulated financial instruments and non-regulated financial instruments. Regulated instruments are those subject to the full requirements of the MiFID II directive, including informational obligations, investor protection, and supervision. Non-regulated instruments are those subject to lesser requirements.

Client Reporting in Light of MiFID II

The directive also introduces changes in the mechanisms for reporting benefits by banks and other financial institutions concerning the sale of a particular product. This must be done in a clear and understandable manner for the client. Additionally, banks are now obligated to provide clients with information regarding the advisory services offered, as well as potential risks.

Furthermore, the MiFID II directive precisely specifies how this should be done - the font must be the same size as other product data, and the information must be presented in understandable language. This is aimed at avoiding situations where clients are misled or where overly complex terminology leads to a lack of awareness of the real risks associated with purchasing a particular product.

Under MiFID II, banks should also provide periodically updated appropriateness reports, confirming the proper alignment of the product with the client and considering the benefits they have achieved in relation to it.

report

MiFID II - Changes in Recording Client Conversations

According to MiFID II, banks are also required to record all conversations with clients related to product sales or the preparation of reports. In practice, this means the necessity of recording all telephone conversations and archiving every email correspondence with the client. The bank must additionally inform the client that communication between them and the advisor is being recorded, as well as the fact that it is accessible for viewing for the next five years.

According to the provisions of MiFID II, changes also apply to communication between supervisors and advisors if it concerns the sale of a product. This communication should also be subject to recording. In the case of face-to-face meetings with clients, in accordance with MiFID II, it is essential to take notes from each meeting. These notes should include the date and location of the meeting, the names of the participants, necessary information about the product, and a brief summary of the meeting's course and outcome. The report must be prepared and stored in such a way that it can be easily made available to the client when necessary.

Presentation of Total Costs

Under MiFID II, banks and investment firms are required to present clients with the full range of costs. This means that before making a purchase, an investor must receive an estimate of the annual cost associated with acquiring and maintaining a particular product. This should be done in the form of several scenarios: baseline, positive, and negative.

The MiFID II directive also mandates that investment firms inform clients annually about all expenses they have incurred and how they impact the overall financial outcome of their investments. Ideally, such a summary should be presented graphically, making it more understandable and transparent for the client. It should also include information about any third-party payments, such as from investment funds, received by the firm in connection with the services provided to the client.

Comarch Wealth Management and MiFID II investor protection

MiFID II investor protection guidelines are covered by Comarch solution for Wealth Management. Starting from the analysis of client needs and client financial health, through to suitability and appropriateness tests with product governance logic, the client gets best product portfolio and full cost transparency. Meeting minutes can also be created, along with MIFiD II summary report or suitability report.

Summary

The implementation of the MiFID II directive represents a significant step towards providing greater investor protection in financial markets. Enhanced protection, transparency, and oversight create a safer environment for investing, fostering the development of the capital market.

However, it is important to remember that the directive does not completely eliminate the risks associated with investing. Investors should still exercise caution and make informed choices based on thorough analysis and a clear understanding of risk profiles.