Addressing heightened risks for retail clients

As the coronavirus pandemic swept Europe, ESMA warned firms not to forget their conduct of business obligations under MiFID II. The Cyprus Securities and Exchange Commission has also reaffirmed its approach, reports Aki Corsoni-Husain.

The COVID-19 outburst has shaken the economy and financial markets globally. Heightened uncertainty has led to high market volatility and an increase in market credit and liquidity risks.  Within these exceptional financial market circumstances, several National Competent Authorities (NCAs) have noticed, and reported to the European Securities and Markets Authority (ESMA) a significant increase in the number of retail investment accounts opened as well as a surge in trading by retail clients in Europe.

In this respect, on 6 May 2020, ESMA issued a public statement emphasising the risk for retail clients when operating under these uncertain and extraordinary circumstances and prompting investment firms to remember their conduct of business obligations as set out in the EU Markets in Financial Instruments Directive 2014/65/EY (MiFID II) and transposed across the Union under member state law.

In light of the surge (of both Covid-19 and trading), ESMA notified the industry of its view that firms have “even greater duties” when providing investment or ancillary services to investors, especially when these investors are new to the market, or have limited investment knowledge and experience.

In this context, ESMA has reminded firms of their obligation to act honestly, fairly and professionally in accordance with the best interests of their clients when providing investment or ancillary services and to comply with all relevant MiFID II conduct of business and related organisational requirements. ESMA also pointed to the product governance, information disclosure, suitability and appropriateness requirements.

In the case of more complex financial instruments, the target market should be identified with more detail. Firms must tread with caution to the extent that they permit retail clients to engage in such products.

In determining the distribution strategy for such financial instruments, firms should be mindful of the more limited level of investor protection afforded by the appropriateness test than by the suitability test required when providing investment advice and portfolio management to clients.

Amongst others, firms must provide information on the financial instruments in which their clients or potential clients can invest. This information must include an appropriate description of the nature and risks of financial instruments to enable the client to take investment decisions on an informed basis. The description shall also explain whether the financial instrument is intended for retail or professional clients, taking account of the identified target market.  

Firms must provide appropriate information in good time to clients or potential clients with regard, among other things, to the particular circumstances of the firm and the financial instruments offered. All information, including marketing communications, provided to clients should – of course – be fair, clear and not misleading, as necessitated under Article 24(3) and (4) of MiFID II. 

Under certain conditions, when providing the investment services of execution or reception and transmission of client orders with respect to the financial instruments specified in Article 25(4)(a) of MiFID II (non-complex financial instruments), firms are allowed to provide those investment services without the need to undertake an appropriateness assessment. However, ESMA stresses at the same time that firms providing execution-only services still need to comply with the other requirements such as in respect of product governance and the provision of adequate information to clients.

ESMA emphasised that firms should pay particular attention to the possible ramifications of the COVID-19 crisis for the client’s personal situation and the risk profile of their financial instruments to ensure suitability requirements are met.

Alongside ESMA, various NCAs have also made statements with respect to the pandemic.  Here we focus on those interactions between the Cyprus Securities and Exchange Commission (CySEC) and ESMA, especially considering that Cyprus is a hub for many investment firms specialising in complex financial instruments touching on the retail market. CySEC’s approach, as stated in its recent Circular No. 386, is that measures must be taken to adequately protect the investing public – no doubt including the continued conveyance of high quality market data from firms to NCAs and ultimately to ESMA.

In this respect the NCAs and ESMA, seem keen to continue to monitor retail clients’ involvement in the financial markets and firms’ compliance with their conduct of business obligations and related organisational requirements under MiFID II.

Further, under its Circular CySEC additionally reminded Cypriot Investment Firms that they must review their policies and arrangements to ensure full compliance with the approach adopted by ESMA in its public statement – in particular with regard to their conduct of business obligations and related organisational requirements under MiFID II.

ESMA’s statement and CySEC’s Circular reaffirm that despite the operational challenges created by Covid-19, regulators around Europe continue to expect full, or indeed heightened, compliance with financial services regulation under MiFID II. It is imperative to ensure firms’ systems and controls are operating properly and are fit for purpose, especially where retail clients are involved.

ESMA’s public statement can be found here.

CySEC’s Circular No. 386 can be found here.

This article appeared first in Compliance Monitor.