This is the second in a series of articles on the implementation of Directive 2014/65/EU, (MiFID II), in Cyprus. Below we explore changes to the local industry that mandates greater investor protection. The Investment Services and Investment Activities and Regulated Markets Law 2017 (New IS Law) gives full effect to MiFID II in Cyprus and will from 3 January 2017 repeal and replace the legislative framework currently in place which implements Directive 2004/39/EC, or (MiFID I).
Increased safeguarding of client assets
The New IS Law bans the use of title transfer collateral arrangements (TTCAs) with retail clients for the purpose of securing or covering present or future, actual or contingent, or prospective obligations.
CySEC has also recently released directive DI87-01 on the safeguarding of client financial instruments and funds, product governance requirements and rules on the provision or receipt of payments, commissions and other monetary or non-monetary benefits (CySEC Directive), which implements Commission Delegated Directive (EU) 2017/593 (Delegated Directive). The CySEC Directive provides that firms must now also consider the appropriateness of using TTCAs with non-retail clients. In addition, a single officer of sufficient skill and authority must now be appointed with specific responsibility for matters relating to the firms’ compliance with their obligations on safeguarding of client assets.
Tightening of remuneration policies
The New IS Law introduces a number of restrictions on the incentives and rewards which may be given to sales staff working with both retail and professional clients. Key requirements in this respect include the following:
- A remuneration policy must be put in place and approved by the management of the investment firm, with the purpose of the policy being to encourage responsible business conduct, fair treatment of clients as well as avoiding conflict of interest in the relationships with clients
- Investment firms are now prohibited from making any arrangement by way of remuneration, sales targets or otherwise that could provide an incentive to its staff to recommend a particular financial instrument to a retail client when the investment firm could offer a different financial instrument which would better meet that client’s needs.
The CySEC Directive also provides further guidance in line with the provisions of the Delegated Directive in this respect, including for example on cases where the provision of research may not be considered to constitute remuneration.
Restrictions on inducements and commissions in advised sales
The new regime expands on the existing provisions restricting or prohibiting inducements. The New IS Law introduces a crucial distinction between the provision of independent and non-independent advice. When investment advice is provided, investment firms are required to inform clients in good time prior to providing the investment whether or not the advice is provided on an independent basis, and further whether the advice is based on a broad or on a more restricted analysis of different types of financial instruments and, in particular, whether the range is limited to financial instruments issued or provided by entities having close links with the advisor or any other legal or economic relationships which pose a risk to impartiality of the advice.
Of particular note is the fact that for investment advice to be considered independent, an advisor cannot accept fees, commissions or other benefits. Only minor payments may be accepted in certain very restricted circumstances. The CySEC Directive further provides that any remuneration, commissions or monetary benefits which a firm receives from the third parties in relation to providing investment advice on an independent basis or portfolio management must be passed on in their entirety to the client.
Changes to appropriateness assessment requirements
The legislation currently in place provides that investment firms are not required to carry out an appropriateness assessments where the service provided is ‘execution only’ and the relevant financial instruments are listed shares, money market instruments, bonds or other forms of securitised debt, UCITS funds or other non-complex financial instruments. The New IS Law modifies the financial instruments in relation to which an appropriateness assessment is not required, as follows:
- Shares admitted to trading on a regulated market, an equivalent third country market or a multi-lateral trading facility, where these are shares in companies (except shares in non-UCITS collective investment undertakings and shares that embed a derivative)
- Bonds and other forms of securitised debt admitted to trading on a regulated market, an equivalent third country market or a multi-lateral trading facility and money market instruments (except those that embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved)
- Shares or units in UCITS (except structured UCITS)
- Structured deposits (except those that incorporate a structure which makes it difficult for the client to understand the risk of return or the cost of exiting the product before term)
- Other non-complex financial instruments
Developments in relation to eligible counterparties
The New IS Law seeks to extend the investor protection obligations of investment firms towards with eligible counterparties. Under the current legislative framework, investment firms are not required to observe a number of investor protection requirements when dealing with eligible counterparties. The New IS Law expands such investor protection requirements on investment firms when dealing with eligible counterparties to include the following key obligations:
- To act honestly, fairly and professionally in their dealings with eligible counterparties
- To communicate in a way which is fair, clear and not misleading
- To provide certain reports and periodic communications to eligible counterparties
The New IS Law also introduces a new regime for product governance, with particular focus on the obligations of product manufacturers and distributors.
More specifically, an investment firm which manufactures financial instruments is now required to maintain, operate and review a process for the approval of each financial instrument and significant adaptations of existing financial instruments before it is marketed or distributed to clients. The product approval process must specify an identified target market of end clients within the relevant category of clients for each financial instrument and should ensure that all relevant risks to such target market are assessed and that the intended distribution strategy is consistent with the identified target market. Manufacturers must also provide distributors with all appropriate information on the financial instrument and the product approval process.
Manufacturers are also required to ensure that financial instruments are designed to meet the needs of the identified target market of end clients within the relevant category of clients, that the strategy for distribution of the financial instruments is compatible with the identified target market. To this end, the investment firm is required to take reasonable steps to ensure that the financial instrument is distributed to the identified target market.
In turn, investment firms which offer or recommend financial instruments which they do not manufacture must have in place adequate arrangements to understand the characteristics and identified target market of each financial instrument. An investment firm must 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 clients, and ensure that financial instruments are offered or recommended only when this is in the interest of the client.
Investment firms are also required to undertake regular reviews of the financial instruments they offer or market.
Under MiFIR, transaction reporting requirements for investment firms have been expanded, both to cover a greater range of financial instruments but also to require additional mandatory information to be provided. In particular, increased transaction reporting will be required in respect of financial instruments admitted to or traded on a trading venue. Certain obligations are now also imposed on firms which only receive and transmit orders, but do not execute such orders.
Product intervention powers
MiFIR grants to ESMA (under Article 40) and to EU national competent authorities such as CySEC (under Article 42) certain product intervention powers allowing them to intervene. Measures adopted by ESMA under Article 40 are temporary and cannot exceed 3 months. However, at the end of the 3 months, ESMA may renew a measure.
Measures adopted by ESMA apply across Member States in the same manner.
Measures adopted by EU national competent authorities can be permanent. Measures adopted by a national competent authority may apply to market participants established in the jurisdiction of the national competent authority adopting the measure as well as to market participants established in other Member States that carry out business in that jurisdiction. Accordingly, any product intervention powers exercised by CySEC would apply to CIFs or to market participants carrying on business in Cyprus.
ESMA announced its intention to consider exercising its product intervention powers under Article 40 of MiFIR in relation to contracts and binary options for retail clients in a public statement on 29 June 2017. ESMA further published a statement on 15 December 2017 on its preparatory work in relation to CFDs and binary options offered to retail clients.
Most recently, ESMA released a call for evidence on 18 January 2018 which lasted until 5 February 2018 (Consultation). In relation to CFDs, the restrictions being consulted on include the imposition of leverage limits, a margin close-out rule, negative balance protection to provide a guaranteed limit on client losses; a restriction on benefits incentivising trading; and a standardised risk warning. In relation to binary options, a prohibition on the marketing, distribution or sale of binary options is being considered.