MiFID II through the eyes of the retail investor

In October the European Commission is due to unveil its revised proposal for MiFID 2. It is a long and complex piece of legislation, but are three main issues that struck me as having an immense impact on the retail investment industry.

A specialized SME market?

SMEs often face a higher cost of capital than larger enterprises. In order to promote SME markets, the Commission services consider that regulated markets and MTF could be given the possibility of creating a specialised SME market, with a tailored regulatory regime.

SME markets aim at providing smaller, growing companies with a platform to raise capital both through initial offerings and ongoing fund raisings. The framework directive could be amended to include a new definition of an "SME market" and to introduce specific harmonised requirements for SME markets under the provisions on regulated markets and MTFs.

Raising capital is, for an SME, a costly and arduous process. An investment bank has to be involved to oversee any initial public offering, and  it difficult to gauge investor interest, prior to such an offering. This uncertainty, coupled with the sheer complexity of the task, means that many investment banks see little incentive to get involved and accordingly charge high fees for such an undertaking.

A regulated market for SMEs would open SMEs to more opportunities and would make it much easier to find buyers of equity capital. This particular modification of MiFID would thus allow SMEs to raise their capital in a much more efficient manner, while providing private equity investors with a lesser-risk alternative, since they transact their holding on a listed and regulated market.

In my opinion, the only participant that stands to lose are the retail banks, who might not be in favour of the modification. After all, a regulated SME market provides an interesting alternative, and a serious competitor, to the debt services they offer.

2. A ban on execution-only dealing?

Something to worry about is the following excerpt from the consultation: “It may be argued that retail clients – who are essentially concerned by the provision of execution only – should always expect a higher standard of service from intermediaries, including on-line brokerage which is the typical channel for this kind of services”. This would mean that clients would have to pay for compulsory advice. This, in effect, amounts to a ban on execution-only dealing.

In my opinion, this is totally misguided, for several reasons. First of all, it would of course increase the cost of investing and shrink rewards.In Malta, there isn’t any distinction made between advisory and execution-only clients, in terms of transaction costs, but that is not the case in most EU states. If the client has to pay for advice on top of already existing transaction fees, it eats into their margin and makes it much less attractive to be in the stock market. This modification would push an awful lot of investors out of markets altogether. On top of that, it increases the amount of resources that stockbroking houses need to supply to advising every single client on each and every transaction !

I am sure I am not alone in thinking that I have already paid to be educated in the stock market, through time and experience, formal training and resources. I feel that I am well able to manage my money on my own account. People who don't have the same level of confidence should of course be able to avail of competent advice. Yes, they would be eating into their margins, but they would also be mitigating their risk, since they don't have the knowledge required to trade confidently. This potential modification forces informed retail clients who would spend a lot less time with an advisory panel, to subsidize the service of uninformed clients.

It would also have tremendous repercussions at the European level. If the EU decides to eliminate execution-only trading, this would drive an enormous amount of business to other places that allow it at a lower cost.

3. Administering investment advice : increased responsibility for the advisor

(a) Intermediaries providing investment advice are not expressly required to explain the basis on which they provide that advice, but under MiFID 2, advisors would have to provide an explanation, in writing, for every single item of security advice.

While this would certainly increase time and costs, I wholeheartedly agree with it. Having a written statement for every single stock that an investor buys is an excellent idea, for a very simple reason: people forget why they bought stocks in the first place. Such written statements would provide an ideal benchmark.

(b) The firm would be required to report to their clients at least every six months for the market (or fair) value and the performance of the financial instruments recommended to the client, and quarterly in the case of complex products.

Again, I agree with this, clients should definitely expect such a review. It's good customer service and should be (and in many cases, is already) readily available anyway. In 2008 at the onset of the credit crisis, many people were very surprised at the performance of their pension funds and investments over the years, because they had not been keeping up-to-date. Had they had a look at it every six months, they could have asked the important questions: what is happening my investment portfolio? Do I need to take action? What kind of action?

(c) The client would be requested to update their personal circumstances annually, and if the client refuses to do so, the firm would be allowed to assume that these circumstances are unchanged.

Indeed the onus should be on the client to provide accurate information, because this directly affects suitability - and the firm would now be required to confirm, on an annual basis, the suitability of the financial instruments initially recommended. Recent events have made it only too clear that what might have been a healthy collateral (i.e. property or business earnings) in a thriving economy, can decline or disappear in a recession - and the client's portfolio needs to be revised according to their change in personal circumstances. Once again, this is to be welcomed.

(d) The firm would in any case report when material modifications in the situation of the financial instruments recommended to the client occur.

Of course, the client should be informed when anything out of the ordinary happens. But what, exactly, is a material modification? A 5% decline? A 20% decline? And what does "report" mean? If the firm tries to reach the client by phone and they don't pick up, or the firm sends an email that the client claims they never received, does the firm's honest effort qualify as reporting or not? This grey area absolutely needs to be addressed before the MiFID 2 proposal is published in October.

Susan Hayes
The Positive Economist