We highlight some of the regulatory and legal developments in the MiFID sector in 2021 and consider the likely implications of these changes for MiFID investment firms into the future.
New Prudential Investment Firm Regime for investment firms
The EU’s Investment Firm Regulation (IFR) and Investment Firms Directive (IFD) puts in place a new prudential framework for investment firms. This framework aims to ensure that firms are properly managing customer and market risk. The new framework does so by applying enhanced rules relating to capital and disclosure requirements, regulatory reporting, and remuneration. It allows for differentiated regulation of firms by categorising them as:
- Class 1
- 1 minus, or
- 2 or 3
Classification will depend on their particular business activity, risk profile and structure.
A relatively low number of firms will be subject to European Central Bank supervision, while the remaining firms are subject to a harmonised set of prudential requirements. Class 1 and Class 2 firms will be required to use quantitative indicators, known as K-factors, to capture the level of risk to clients, markets, and the firm.
The IFR was directly applicable in Ireland from 26 June 2021 and the IFD was to be implemented by Ireland by the same date. However, the IFD was not transposed by the until 3 September 2021 by the EU (Investment Firms) Regulations 2021 (S.I. 355/2021) and the EU (Investment Firms) (No. 2) Regulations 2021 (S.I. 356/2021). This transposition was a partial transposition of the IFD, noting that Article 62(6) of IFD, which requires Member States to impose an obligation on Class 1 firms to seek reauthorisation as credit institutions, remains to be transposed into Irish law.
Environmental, Social and Governance
Due to the current regulatory focus on Environmental, Social and Governance (ESG) factors, firms can expect to see more intense supervisory engagement in respect of their ESG risk management practices. Amendments to the MiFID framework were applied during 2021 to incorporate ESG considerations into the investment decision making process.
The Commission Delegated Regulation (EU) 2021/1253 introduces requirements for investment firms providing financial advice or portfolio management. They must carry out assessments of the sustainability preferences of clients and take this into consideration when recommending financial products. The Commission Delegated Regulation (EU) 2021/1269 also establishes sustainability considerations for investment firms when manufacturing and distributing financial instruments. These new measures were published in August 2021 and will apply from August 2022.
The Central Bank issued a letter on 3 November 2021, setting out its supervisory expectations of firms regarding climate and ESG related issues, with an emphasis on five key areas:
- Proper governance of climate risks affecting firms and promoting a culture which emphasises climate and other ESG issues
- The enhancement of existing risk management frameworks to deal with climate risks
- Scenario analysis and stress testing to assess the impact of potential future climate outcomes
- Business model analysis to determine the impacts of climate risks on the firm, and
- Transparent disclosure to consumers and investors to protect their interests and wider market integrity
Dear CEO Letter
The Central Bank issued a ‘Dear CEO’ letter to investment firms on 1 December 2021 in relation to ‘Common Supervisory Action on MiFID II Suitability Requirements’.
During the course of 2020, the Central Bank undertook a review of investment firms’ compliance with the suitability requirements of MiFID II. The review was conducted as part of a Common Supervisory Action coordinated by the European Securities and Markets Authority (ESMA).
The Dear CEO letter outlines several the Central Bank’s findings, the main points being:
- That investment firms must take a more client focused approach
- That investment firms must improve their assessment of clients’ knowledge and experience, financial situation and investment objectives
- That suitability reports need to be sufficiently detailed and personalised, and
- There must be tighter controls on ‘exception’ processes applied by investment firms, whereby a client insists on proceeding with the transaction at their own initiative.
On foot of the Dear CEO letter, all Irish authorised MiFID investment firms, and credit institutions, who provide portfolio management and advisory services to retail clients must conduct a thorough review of their individual sales practices and suitability arrangements.
Firms are required to document this review and include details of actions taken to address findings in the ESMA public statement and the Dear CEO letter. This review must be completed, and an action plan discussed and approved by the board of each investment firm by the end of Q1 2022.
Senior Executive Accountability Regime
The Irish Finance Ministry’s publication on 27 July 2021 of the general scheme of the Central Bank (Individual Accountability Framework) Bill will create Ireland’s first comprehensive senior executive accountability regime (SEAR). It will introduce prescribed responsibilities for senior managers and strengthen firms’ obligations to undertake due diligence on staff. It will also impose more onerous conduct standards that can be enforced directly by the Central Bank against staff.
Initially, SEAR is intended to apply to banks, insurance undertakings, and investment firms which underwrite on a firm commitment basis, and/or deal on own account and/or are authorised to hold client assets. It may be extended to other types of financial service providers at a later point in time. Therefore, certain categories of investment firms can expect to be the first to have to comply with the new regime.
Investment firms should take steps to consider the impact of the developments outlined above on their business models.
The IFD and IFR introduce significant changes that require careful consideration and amendment to policies in certain instances.
There are also positive obligations on firms to take steps to incorporate ESG considerations into their business models. The imminent introduction of SEAR is the latest example of the current prominence of cultural and conduct issues in financial regulation.
Firms must also take immediate steps to document their approach to the Dear CEO letter from November 2021 and carry out a review of their individual sales practices and suitability arrangements.
If you would like to discuss any of the points highlighted, please contact a member of the Financial Regulation team.