Within MiFID II, the EU determines the operating conditions for investment firms and defines provisions to ensure investor protection, including the requirements for pre-trade (or ex-ante) cost information.
Institutions have to provide cost information to the client in advance, encompassing not only the transaction costs but also the cost of ancillary services. That’s a challenge because the cost calculation is typically based on executed prices. If given in advance, the effective cost will be an estimate that could end up being inaccurate.
MiFID II pre-trade cost information requirement is closely related to Packaged Retail and Insurance-based Investment Products (PRIIPs) regulation. PRIIPs regulation calls for firms to report cost information on the key information document (KID) that provides retail investors with information on the costs embedded in the financial instrument. Under MiFID II, compliance with PRIIPs regulation should not result in additional or contradicting requirements; however, the cost information requirement will be extended to all financial instruments and all clients, not just structured products for retail investors as required under PRIIPs.
Although the investor protection articles of the directive are mainly focused on retail investors, the information, per Article 24, needs to be provided to all clients in general. According to Delegated Regulation by the EU Commission limitations on the level of detail of cost information are only permitted towards professional clients and eligible counterparties upon a mutual bilateral agreement. The final decision therefore lies with the client and not the investment firm.
But which cost information must be reported to each client? ESMA has provided a detailed breakdown of requirements in its consultation papers (see Table 1).
A major challenge is determining whether information on transaction-specific costs needs to be given to the client or whether generic information, such as a pricing table, is sufficient. That could be an obstacle for certain asset classes and firms, particularly high-frequency and algorithmic trading, as a result of delays in the order process.
In general, on standardized products and execution channels via electronic trading venues, regulators have given statements on the acceptance of generic cost information to be provided via electronic channels /portals to the clients.
An indication of what firms need to supply can be seen in the distinction between cost for investment services (Table 1) and cost for financial instruments (Table 2). The cost of financial instruments or products is very similar to the cost information provisions under regulation PRIIPs. Generic cost information is possible (e.g., NN EUR per share/per nominal, etc.). Still, the cost of investment services has to be transaction-specific.
What’s more, the ongoing costs associated with financial instruments are problematic because they depend on the holding period. But which time frames need to be taken into account when providing cost information to clients? Is it one day, one week, one month or one year? This is a special challenge for the creation of generic pricing tables. Within affected firms, discussions are ongoing regarding which holding periods should be applied across different asset classes.
While the PRIIPs regulation requires the cost information to be included in a KID, there are open questions about other financial instruments with regard to content, format and timing of the information. How is the cost information transmitted? Can it be a cost display on an entry screen of an online application? Does the client have to acknowledge receipt? For generic cost information and pricing tables, many investment firms prefer to receive, at the least, an annual submission by e-mail or letter, to have a minimal certainty the client has received the information.
Beyond delivering cost information in a single amount, institutions may have to deliver an itemized breakdown (related to the distinction between product and service cost) to clients. Although the cost components are defined in the tables, ESMA hasn’t established which components have to be itemized.
It is also very likely that the cost details will vary among market participants. ESMA states that the transaction price needs to include mark-ups. There are different approaches to provide this information, such as only disclosing trading profits as mark-ups (the difference between purchase price and sales prices) and only disclosing the sales spread (the difference between midpoint/fair value and sales price) as product cost. In some business streams and asset classes, a certain level of transparency on cost and cost components already exists, but final clarity on the cost components that are compliant with the cost model set out in Table 1 and Table 2 have to be defined. For example, are initial and/or variation margin payments considered costs?
While by definition initial margin is regarded as collateral, it may also be treated as a cost and the return of initial margin, when the position is closed, may be regarded as a negative cost, in which case the client also must be informed. There have been various different statements from different regulators including ESMA.
Implementation and outlook
While some of the pre-trade cost information requirements remain unclear, MiFID II client reporting will likely require firms to alter their business processes and IT systems. In contrast to MiFIR there are no detailed technical standards (RTS, ITS) under MiFID II.
For business processes, firms must ensure that the cost information given to the client is recorded. The scope of that information must expand from pure order reporting to include additional cost information. Otherwise, a client could ask for the unwinding of a position that has resulted in a loss or an investment with a lower return than expected simply by demanding it because the relevant cost information was not disclosed.
In contrast to the pure transaction reporting under MiFIR, the framework of MiFID II additionally extends the recording and archiving requirements to encompass any activity (e.g., client orders and telephone conversations) leading to an investment decision. This includes pre-trade cost information.
In the past, the KID only included abstract and generic product information. The impact now is that the KID must be client- and transaction- specific, restricting the creation of a single KID for one product. For online orders, it may also be necessary to change IT systems in order to provide the client with the appropriate cost information.
Missing or non-compliant cost information client reporting may lead clients to demand the unwinding of transactions and regulators to charge fines or even revoke the permission to conduct business.
As with many other aspects in connection with the MiFID II delay, institutions can’t afford to wait for ESMA to fully define the regulation’s client reporting obligations. Although discussions are ongoing and delegated acts have been published, firms need to start by altering their business processes and systems with the facts rather than waiting for each consultation and final legislation. The time left until the legislation comes into effect is insufficient to implement a compliant solution. Prior experiences from EMIR and similar regulations have shown that manual workaround solutions in the end are far more expensive than a proper front-to-back solution.