MiFID 2—The Level 2 Legislation Is Starting: Part I

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By Emma Radmore

Early 2016 saw something of a lull in key papers from the European legislators on the revised Markets in Financial Instruments Directive (MiFID 2) and Regulation (MiFIR) package. Now, gradually, the European Commission (Commission) is feeding back to the European Securities and Markets Authority (ESMA) its comments on the technical standards ESMA produced in the course of 2015. And, in April, the Commission finalised two pieces of delegated legislation—a Directive and a Regulation.

What Is the MiFID 2 Framework?

MiFID 2 will, ultimately, comprise several levels of legislation, rules, standards and guidelines. Underneath the “Level 1” Directive and Regulation, the Commission is empowered by several provisions of the Level 1 legislation to make “delegated acts.” The Level 1 legislation also requires ESMA to make several regulatory and implementing technical standards (RTS and ITS), which the Commission endorses before they take effect. There are also certain sets of guidelines for ESMA to develop, some alongside other European Supervisory Authorities. And, of course, although much of MiFID 2 is either in the form of a Regulation or subject to maximum harmonisation, national implementation and exercise of options by Member States still has a role to play. At the time of writing, only the Level 1 legislation has appeared in the Official Journal of the EU. We expect imminently formal adoption and publication of the measures delaying the effective date of the package by one year, and the two Level 2 measures on which this article focuses. We expect one further Level 2 measure (the Commission refers to a MiFIR Delegated Regulation in addition to the currently released MiFID 2 Delegated Regulation and MiFID 2 Delegated Directive).

The Delegated Directive

The Delegated Directive, which the Commission published in final form on 7 April, covers three key elements of MiFID 2, and applies its requirements to firms covered by MiFID 2 and also, as appropriate to UCITS management companies and alternative investment fund managers where they carry out MiFID services. The Commission explains it is based on 2 “empowerments” in MiFID 2.

Safeguarding of Client Financial Instruments and Funds

Article 16 of MiFID 2 requires that investment firms:

• when holding financial instruments belonging to clients, make adequate arrangements so as to safeguard the ownership rights of clients, especially in the event of the firm's insolvency, and to prevent the use of a client's financial instruments on own account except with the client's express consent;

• when holding funds belonging to clients, make adequate arrangements to safeguard the rights of clients and, except in the case of credit institutions, prevent the use of client funds for its own account; and

• do not conclude title transfer collateral arrangements with retail clients for the purpose of securing or covering present or future, actual or contingent or prospective obligations of clients.


In the Delegated Directive, the Commission has embellished on these high level requirements. It explains it felt a Directive was the appropriate legal instrument to impose new standards because all measures and arrangements should take into account any relevant local regime that might affect clients' rights to property—although it also suggests that any local laws which are inconsistent with MiFID 2 should be adjusted or replaced. The Delegated Directive provides that Member States must require firms to:

• keep records and accounts enabling them at any time and without delay to distinguish assets held for one client from assets held for any other client and from their own assets;

• maintain their records and accounts in a way that ensures accuracy that they may be used as an audit trail;

• carry out regular reconciliations between their internal accounts and records and those of any third parties by whom those assets are held;

• ensure any client financial instruments deposited with a third party are identifiable separately from the financial instruments belonging to the investment firm and from financial instruments belonging to that third party, by means of differently titled accounts on the books of the third party or other equivalent measures that achieve the same level of protection;

• ensure that client funds deposited in a permitted bank or qualifying money market fund are held in an account or accounts identified separately from any accounts used to hold the investment firm's own funds;

• introduce adequate organisational arrangements to minimise the risk of the loss or diminution of client assets, or of rights in connection with those assets, as a result of misuse of the assets, fraud, poor administration, inadequate record-keeping or negligence;

• provide information on clients' financial instruments and funds to relevant competent authorities, insolvency practitioners and those responsible for resolution of failed institutions. The information should include internal records, agreements with other entities with whom instruments and funds are held, outsourcing arrangements and details of key responsible individuals within the firm;

• exercise “all due skill, care and diligence” where depositing client instruments with a permitted third party;

• place any client funds received promptly with a central bank, EU or third country bank or a qualifying money market fund, and exercise all due skill, care and diligence selecting any entity that is not a central bank. Specifically, firms must consider the need for diversification of client funds as part of their due diligence. Where funds are to places in a qualifying money market fund, firms must get clients' express consent and must inform clients that these funds will not be held in accordance with the MiFID 2 safeguarding provisions;

• place no more than 20 percent of all client funds with group entities except in exceptional circumstances;

• not enter into securities financing transactions (SFTs) or otherwise use for their own account financial instruments held on behalf of a client, unless the client has given prior express written consent to the specific use of the instruments; and similarly ensure that where the account in question is an omnibus account each relevant client has consented;

• take appropriate measures to prevent the unauthorised use of client financial instruments for their own account of the account of others—it gives as an example closely monitoring ability to deliver on projected settlement dates;

• not enter into title transfer collateral arrangements (TTCAs) with retail clients; and where they are permitted to enter into TTCAs, do so only after considering them in the context of the relationship between the client's obligation to the firm and the assets that are the subject of the TTCA. It gives examples of factors the firm should consider, and requires firms to highlight to professional clients and eligible counterparties the risks of TTCAs and the effect of the arrangements on clients' financial instruments and funds;

• appoint an individual with sufficient skill and authority to be responsible specifically for the firm's compliance with the requirements on client money and assets. Firms should be able to decide whether the individual may also have other responsibilities; and

• ensure their external auditors report at least annually to the relevant competent authority on the firm's arrangements to comply with the relevant requirements of MiFID 2.


Product Governance Requirements

Article 24(2) of the MiFID 2 Level 1 Directive states that “investment firms which manufacture financial instruments for sale to clients shall ensure that those financial instruments are designed to meet the needs of an identified target market of end clients within the relevant category of clients, the strategy for distribution of the financial instruments is compatible with the identified target market, and the investment firm takes reasonable steps to ensure that the financial instrument is distributed to the identified target market.

An investment firm shall understand the financial instruments they offer or recommend, assess the compatibility of the financial instruments with the needs of the clients to whom it provides investment services, also taking account of the identified target market of end …., and ensure that financial instruments are offered or recommended only when this is in the interest of the client.”

Product Manufacturers

The Delegated Directive requires firms to comply with the detailed requirements when creating, developing, issuing and/or designing financial instruments. Firms must comply with the requirements, in an appropriate and proportionate manner, taking info account the nature of the instrument, the investment service and the target market for the product. Firms must:

• establish, implement and maintain procedures and other measures that will ensure product manufacture complies with the requirements on managing conflicts of interest including inducements. The Directive says firms must in particular make sure the product design and features do not adversely affect end clients or lead to integrity issues if firms are able to mitigate or dispose of their own risks or exposure to the underlying assets of the product, if the firm holds those underlying assets on its own account;

• carry out an analysis of potential conflicts each time they manufacture a financial instrument, particularly looking at whether end clients may be adversely affected if they take an exposure different to the one the firm previously held or wants to hold;

• consider whether the relevant financial instrument may be a threat to the orderly functioning or stability of financial markets;

• ensure relevant staff have the expertise to understand the characteristics and risks of the product;

• ensure the management body has effective control over the product governance process, including that compliance reports to management contain information about instruments the firm manufactures and how they are distributed;

• ensure the compliance function monitors development and review of product governance obligations to check they comply with the Directive's requirements;

• agree in writing the scope of responsibilities where they work with other entities on product manufacture;

• identify, at a “sufficiently granular” level what is the potential target market for each instrument and the type of client with whose needs, characteristics and objectives it is compatible. Firms must also identify any groups for whose needs it would not be compatible. Where the manufacturer is not the distributor, they must make this assessment based on relevant past experience;

• carry out an analysis that looks at the risks of poor outcomes for the end client and when they might occur. The Directive sets out examples of negative conditions against which firms should make this assessment;

• determine whether an instrument meets the needs, characteristics and objectives of the target market by looking at its risk/reward profile and the extent to which it is driven by features that benefit the client and do not rely on poor client outcomes to be profitable;

• consider the charging structure for the instrument, including by looking at its compatibility with the needs, etc., of the target market, checking charges do not undermine the return expectations and making sure the structure is transparent enough to not hide charges or be too complex to understand;

• ensure distributors are told about appropriate distribution channels, the product approval process and the target market assessment, in such a way that distributors can understand and sell the product appropriately;

• review relevant instruments regularly, taking into account any event that could affect the risk to the target market and checking it remains consistent with their needs etc.; and

• review relevant instruments before reissuing or relaunch, if they are aware of any even that could effect the risks to investors, and review regularly to ensure the instrument functions as intended. Firms must also identify critical events that would affect potential risk or return and take appropriate action should they occur—this action could include stopping further issues, changing the product terms, or terminating distribution relationships.



A separate set of standards applies to firms deciding what products to offer or recommend to clients, whether or not manufactured by them. The standards apply also in relation to instruments whose manufacturers are not covered by MiFID 2. Distributors must determine the appropriate target market, even if the manufacturer did not do so. Other requirements on firms are that they must:

• have in place adequate arrangements to ensure the products and services they intend to offer or recommend are compatible with the needs, characteristics and objectives of the identified target market and that the distribution strategy is appropriate for it. Firms should identify and assess the circumstances and needs of the clients on whom they are focusing, including identifying any groups of clients for whose needs, characteristics and objectives the product or service is not compatible;

• obtain from the manufacturer all information they need to make their assessment, whether or not the manufacturer is itself subject to MiFID—taking all reasonable steps to obtain the information where the manufacturer is outside MiFID;

• comply with all relevant MiFID 2 requirements on disclosure, conflicts, inducements and assessments of suitability or appropriateness;

• review and update their product governance arrangements to ensure they remain fit for purpose;

• review products and services regularly to take account of any new risks, and reconsider the target market and/or update the governance arrangements if they become aware they have wrongly identified a particular target market;

• ensure their compliance function oversees development and review of the procedures to detect any risk of failure to comply with the Directive;

• ensure relevant staff have the expertise to understand the products they offer and the needs etc of the target market;

• ensure the management body has effective control over the product governance process, including that reports from compliance include information about products and services offered and recommended; and

• as distributors, provide to manufacturers information on sales and any relevant reviews.


Where firms work together on distribution, the firm with the direct client relationship will be the firm primarily responsible for complying with the article, but intermediary firms must ensure information from the manufacturer gets to the final distributor, help to get information for manufacturers and apply relevant manufacturer obligations to the services they provide.


The MiFID Level 1 Directive, specifically Article 24(9) states: “Member States shall ensure that investment firms are regarded as not fulfilling their obligations … where they pay or are paid any fee or commission, or provide or are provided with any non-monetary benefit in connection with the provision of an investment service or an ancillary service, to or by any party except the client or a person on behalf of the client, other than where the payment or benefit:

(a) is designed to enhance the quality of the relevant service to the client; and

(b) does not impair compliance with the investment firm’s duty to act honestly, fairly and professionally in accordance with the best interest of its clients.”

The Delegated Directive adds to these requirements by:

• setting conditions which, if all met, will mean that a relevant fee, commission or non-monetary benefit is to be considered as designed to enhance the quality of the relevant service. These are that:

• it is justified by the provision of an additional or higher level service, proportional to the level of inducements received. There are examples, such as non-independent investment advice on and access to a wide range of suitable instruments including those from providers with no link to the firm; non-independent investment advice combined with either an offer to assess ongoing suitability of products or another service likely to be of value to the client; or provision of access at a competitive price to a wide range of instruments likely to be appropriate for the client, including some from providers with no close links to the firm, with either value added tools or periodic reports;

• it does not directly benefit the recipient firm, its shareholders or employees without tangible benefit to the client; and

• it is justified by the provision of an on-going benefit to the client in relation to an on-going inducement.

• stating that the fee, commission or non-monetary benefit will not be considered acceptable if the provision of relevant services to the client is biased or distorted as a result of it;

• confirming firms will fulfil the requirements for acceptable benefits for as long as they continue to pay or receive them, and requiring them to hold evidence that any such payments are designed to enhance the quality of service to the client by keeping lists of what they receive and how they use it, including explaining the steps the firm takes to ensure it does not impair its duty to act honestly, fairly, professionally and in the client's best interests;

• requiring firms to disclose to clients the information the Level 1 Directive requires before the firm provides the relevant investment or service, and if they cannot ascertain the amount of any payment before the service if provided, giving the information on an ex-post basis. Firms must also give at least annual updates of ongoing inducements received;

• requiring firms to comply with the MiFID 2 costs and charges rules, and requiring that each firm in a distribution chain comply with the disclosure obligations.


Where firms are providing independent investment advice or portfolio management services, they must:

• return to clients any fees, commissions or monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the services provided to that client as soon as possible after receipt,

• transfer to clients the full amount of any such benefits the firm receives in relation to the services;

• set up and implement a policy to ensure the amount of relevant benefits are allocated and transferred to each individual client;

• tell clients about the benefits;

• not accept non-monetary benefits that do not qualify as acceptable minor non-monetary benefits. The Delegated Directive includes a list of benefits that will be acceptable, such as hospitality of a reasonable de minimis value, participation in conferences, certain information or documentation and other benefits that the relevant Member State might deem acceptable. Any acceptable benefits should be reasonable and proportionate and not be likely to influence the firm's behaviour in any way that is detrimental to the client's interests; and

• disclose minor non-monetary benefits to clients before providing the relevant services.


Where research is provided to investment firms, it will not be an inducement if it is received in return for direct payments from the firm out of its own resources, payments from specific accounts meeting certain conditions, for which the firm is responsible, and on which it reports to clients. Firms that operate research payment accounts must also provide information to clients on request by giving a summary of the providers paid from the account, with details of what they were paid, the benefits the firm received and how the amount received compares to what the firm budgeted. The investment management agreement or terms of business should disclose and agree the research charge and how it will be deducted from the client's resources, and the client will be due a rebate if there is a surplus in the account at the end of a set period. The Delegated Directive gives significant detail on the controls and conditions for operation of the account.

Emma Radmore is a Managing Associate and Rosali Pretorius is a Partner at Dentons UKMEA LLP, London. She is also a member of the World Securities Law Report Advisory Board. She may be contacted at emma.radmore@dentons.com.


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