What is MiFID II?

MiFID II entered into force in January 2018. Under the existing framework, firms providing investment advice and portfolio management services must obtain information on their clients’ financial circumstances and investment objectives — such as a clients’ risk tolerance and ability to bear losses. There are more requirements under the legislation unrelated to this educational, read more here.

The new sustainability requirements add to these elements, and cover internal processes, client preferences and the product creation lifecycle.

Who do the amendments apply to?

The amendments apply to investment firms — this includes financial service firms, banks, fund managers, investment advisors, traders, brokers and exchanges

The amendments, as with MiFID II itself, apply to investment firms whose products and services are available in the European Union. 

The amendments 

Definitions of the sustainability terms used in this regulation are provided at the end of this Educational.

The European Commission updated MiFID II to integrate sustainability risks and factors. One set of amendments entered into force in August 2022, with the second set applicable from 22 November 2022. 

MiFID II has been amended to integrate sustainability through two delegated regulations:

• 2 August 2022 — (2021/1253) on organisational requirements: this regulation incorporates sustainability preferences into requirements for client-facing staff, internal processes and the undertaking of suitability assessments
• 22 November 2022 — (2021/1269) on product governance requirements: this delegated directive will require firms to consider sustainability while designing and distributing financial products. Each financial product created will need to have sustainability objectives considered for the target client group, with performance reviews on this basis

Financial products in-scope

The term ‘financial products’ in this piece refers to any financial instrument defined by the regulation, notably securities, funds and derivatives

Changes applying from 2 August 2022

Delegated Regulation 2021/1253 (amending Regulation 2017/565)

All firms in scope for MiFID II must implement the following changes to internal processes, client suitability assessments, client reporting and product assessments:

Organisational requirements

These requirements apply to all MiFID II firms — that is, any financial service firm, including banks, fund managers, investment advisors, traders, brokers and exchanges providing services in the European Union

• Risks related to sustainability must be integrated into these existing policies and processes:
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Investment firms should:

• Have proof that their staff have an internal understanding of policies and processes that consider sustainability risks, factors and responsibilities
• Train staff to understand responsibilities related to sustainability in products, services and processes
• Train staff adequately or ensure they are qualified to understand clients' sustainability risks, factors and preferences 
• When giving investment advice or services, identify possible conflicts of interest due to integrating clients' sustainability preferences. This will include mapping out the possible scenarios where a conflict could arise that may impair the client's or end-clients’ sustainability preferences. For example, a firm’s product development or marketing team could be motivated to exaggerate the ESG credentials of either itself or its products when providing the product to distributing companies. End clients may then be misled into buying/investing based on false information, and the products may not satisfy their sustainability preferences where relevant

Pre-contractual disclosures (firms providing investment advice only)

• Include in pre-contractual information which sustainability factors are used in the selection of products (where relevant), along with risk, cost and complexity considerations 

Suitability assessment

These amendments apply to portfolio managers, wealth managers, private banking providers and advisers working with retail clients; they may apply to professional clients where the collection of sustainability preferences or investment objectives is relevant.

• After completing the already-established MiFID II suitability assessment (which considers the client's understanding of investment risk, financial position, and investment objectives/risk tolerance), investment firms must now follow a process to understand the client's sustainability preferences and record all discussions about these. 

The sustainability-related requirements are:

• Supply the client with information on sustainability preferences using non-technical language (EU 2021/1253, Recital 6). This includes:
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• Find out the clients' sustainability preferences to determine what investments remain suitable for these. Firms can use a paper or online approach. The client must express the minimum proportion of investments they want that are:
  
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Reporting to retail clients

• Provide a suitability report to retail clients explaining how the recommendation:
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Assessment of products

These amendments apply to portfolio managers, wealth managers, private banking providers and advisers working with retail clients; they may apply to professional clients where the collection of sustainability preferences or investment objectives is relevant.

You Cannot

• Recommend products that do not meet your client's sustainability preferences

You Can

• Re-recommend products to the client that were previously incompatible — if the client changes their sustainability preferences. You must record this decision and the reasons for it. For example, if none of your products meets the clients’ new sustainability preferences, you may inform them of their right to change these to access investments you make available
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• Consider your client 'sustainability-neutral', if they answer 'no' or provide no answer to having sustainability preferences. In this case, you may recommend products with and without sustainability features
• Consider your client 'sustainability-neutral' if they have not stated their sustainability preferences, and they do not request them to be updated

You Must

• Collect and assess sustainability preferences when agreeing on the client’s mandate and investment strategy. If you cannot meet the client’s preferences, ask if they wish to adapt them (and take a record of the discussion)
• Have processes and policies for clients with sustainability preferences but no specific requirements. This also applies to online or ‘robo’ processes and platforms

Changes applying from 22 November 2022

Delegated Directive 2021/1269 (amending Directive 2017/593)

All firms in scope for MiFID II must implement the following changes to the financial product lifecycle:

Financial product design

These requirements apply to firms that manufacture or distribute investment products, including their creation, development, issuance or design. Products include equities, commodities, debt instruments, futures and options, exchange-traded funds, and currencies.

When designing financial products:

Include the possible sustainability objectives of the target customers and register these with the target customer's possible financial objectives, needs and risks.

• You do not need to identify target customers incompatible with your products regarding sustainability considerations. This is simply a renunciation (with regards to sustainability) of the current MiFID II requirement to identify a ‘negative market’

Consider if the product's sustainability factors are compatible with the needs and objectives of your identified target customers. 

• It will be essential to record the sustainability credentials of your products because indirect customers will demand this information. For example, you sell derivatives to a portfolio manager with an institutional customer. The customer states that it only wants products in its portfolio that align with its sustainability preferences. The portfolio manager will require information from you to establish whether the product meets their customer’s needs (see preferences section above)

For ongoing design and monitoring:

Include sustainability-related objectives in your product governance structures to ensure products and services are compatible with customers’ sustainability objectives. For example, if a firm targets clients (or end-clients) with ESG preferences regardless of how they are described or formulated, it must demonstrate ESG considerations in the product approval process, product governance and oversight configurations

Financial product reviews

During periodic reviews of financial products, assess whether the products still meet the sustainability-related objectives and needs of the target market

Distributors (firms that offer or sell financial products and services to clients)

When distributors are used, provide them with clear information about the product’s sustainability factors

Additional ongoing requirements

Have processes to regularly review client sustainability preferences and objectives to ensure they do not become out of date

• Check whether changes in sustainability preferences trigger a rebalancing of portfolios

Appendix of sustainability terms

MiFID II and this article reference several sustainability terms. We define them below:

Sustainability preferences

a) Environmentally sustainable investments in economic activities that contribute substantially to one or more of the six taxonomy environmental objectives*; do no significant harm to any of the other environmental objectives; meet the minimum taxonomy safeguards (aligns with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights), and complies with the Taxonomy technical screening criteria(specific criteria for each type of environmental objective)

b) Sustainable investments (SFDR article 9 investments) in economic activities that contribute to environmental or social objectives – provided that investments do not significantly harm any objectives and that investee companies follow good corporate governance practices (sound management structures, employee relations, remuneration of staff and tax compliance).

• Environmental objectives can include: key indicators on the use of energy, renewable energy, raw materials, water and land; on the production of waste and greenhouse gas emissions; impact on biodiversity; and the circular economy
• Social objectives can include: tackling inequality; fostering social cohesion, social integration and labour relations; or investments in human capital or economically/socially disadvantaged communities

c) Financial products considering principal adverse impacts (PAIs) on sustainability factors, with the client choosing the qualitative or quantitative components demonstrating this consideration. The SFDR regulation standards define PAIs as 64 negative impacts based on environmental, social and governance factors.** 

Sustainability factors: environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters.**

Sustainability risks: environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment.**

Sustainability-related objectives: Clients' investment objectives that relate in any way to sustainability risks, factors or preferences

*The six taxonomy environmental objectives are:

• climate change mitigation;
• climate change adaptation;
• sustainable use and protection of water and marine resources;
• transition to a circular economy;
• pollution prevention and control; and
• protection and restoration of biodiversity and ecosystems.
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**Environmental, social and governance & employee matters are ESG factors. A list of potential ESG factors can be found on the CFA ESG Analysis webpage here.

The industry response

Reception to the changes in the financial markets sector has been mixed. Some insiders highlight potential roadblocks to the successful implementation of the sustainability requirements, while others see it as a catalyst for change:

• Capital Monitor writes that financial professionals fear that the changes will cause products to be mis-sold as both the finance sector and its clients do not fully understand the terminology
• Morningstar cites the persistent lack of issuer ESG data as a potential barrier to financial firms implementing the MiFID II changes. The firm also undertook research which found providers’ ESG approaches to be misaligned, with too much room for interpretation in defining and building ESG products
• More positively, fund and index providers such as EQ Investors and Borsa Italia see the MiFID II changes as a benefit for the ESG investing industry — which they expect to grow with clients given more information about what is available to them