The first half of 2023 has maintained the pace of regulatory developments, with a significant amount of regulatory developments taking up space on investment firms’ agendas. In this update, we will look specifically at the key regulatory updates relating to investor protection, client disclosures, sustainable investments, and significant developments of note in both the UK and EU. From the EU perspective, most focus still sits on both retail investors and driving forward the sustainable finance agenda. From the UK perspective this is a big year requiring the regulator and market to decide which EU rules it wants to keep, amend or remove, alongside the small matter of the Consumer Duty.

The EU Retail Investment Strategy

The European Commission (EC) recently unveiled a sweeping set of proposals aimed at strengthening protection for retail investors across the EU's capital markets. The new Retail Investment Strategy (the “strategy”), published in May 2023, outlines targeted reforms designed to make investing simpler, safer, and fairly priced for retail investors. Key measures include:

• Tougher conduct rules for firms
• Increased transparency around fees and risks
• Raised standards for financial advice
• Easier access to shareholder rights

The strategy also aims to harness the potential of capital markets for retail investors by simplifying investor onboarding through digital ID and electronic signature standards.

The proposed amendments to existing legislation like MiFID II¹ and IDD² will require approval by the European Parliament and Council. According to regulators, consistent implementation of the strategy will provide EU retail investors with an enhanced environment for accessing capital markets. As we know, Europe is currently not a level playing field. So, what are the key themes?

Do products deliver value?

After much market expectation, the EC are looking closely at ensuring investment products deliver fair value to retail consumers under the new ‘pricing process’ proposals. The concern remains that the cost of retail products remains too high across PRIIPs³, UCITS⁴, and AIF⁵ products. Whilst we wait for granular details, the strategy signals expectations for firms to justify their fees and charges based on the value provided to clients. This is not too dissimilar to the product governance focus already in place within the UK through Assessment of Value, and the new FCA⁶ Consumer Duty Price and Value Outcome. There are differences, however, in the EC’s approach. The EC proposes:

1. Firms should make a comparison of cost and performance of a product against benchmarks
2. The benchmarks will be developed by the European Supervisory and Markets Authority (ESMA)
3. There is a quantitative test – products where value aligns to the benchmark can be sold to retail consumers
4. There is a qualitative test – products where value does not align to the benchmark are not permitted to be sold to retail consumers, unless additional testing confirms that it still offers value for money (additional legislation is required for this element)

There are many questions unanswered from the industry. How will ESMA create these benchmarks? How close does the product need to be to the benchmark? Will there be a variety of benchmarks? Does this indicate a move to the regulation of pricing and reduction of competition? There is much still to be considered and The European Fund and Asset Management Association (EFAMA – the EU ‘trade body of trade bodies’) have responded robustly, citing:

• “The proposed introduction of one-size-fits-all, quantitative “value for money” benchmarks contradict the core goal of the investment process, which is to offer tailored solutions to different clients’ needs”.⁷

Value is derived from more than just cost, as different customers have different circumstances, objectives, and views. The UK has seven criteria to assess value, where “comparable market rates” constitutes one metric.

• “Not only would such a benchmarking exercise be extremely complex to execute, with limited benefits for clients (a cost-centric rather than investor-centric approach), but it essentially establishes a regulation-driven price intervention into capital markets”.⁷

The main issue here relates to the impact on market competition as products would be drawn to a similar pricing point.

• “Pricing intervention through benchmarks would pose significant threats to the development of innovative products”.⁷

Where there are limited products in that investment space, or where there is no historic data, there would be limited ability to compare to a relevant benchmark.

EFAMA believe that the proposals in the strategy may have an impact to the appeal of doing business in the EU from an international perspective. There is still time for refinement, and maybe the EU could consider looking to the UK for a view of value, rather than too strong a focus on costs.

Inducements no more?

The strategy proposes amendments to MiFID II rules that would significantly impact inducements paid for investment services and products. There has been significant debate prior to the proposal, with strong arguments for both a complete ban on inducements, and not – the strategy has not gone for the option of a complete ban. The new requirements may include more transparency around inducement payments, stricter conditions on acceptable types and amounts, and tighter links between payments and improvements in quality of service. So, what are we going to see?

1. An inducement ban will be introduced on execution only sales, and ‘reception and transmission of orders’ (RTO) activity.
2. For portfolio management, execution only and RTO activity, there will be a wording change from ‘cannot accept and retain inducements’, to ‘cannot pay or receive inducements’, which would mean that investors would only be permitted in clean share classes.
3. Disclosures will be enhanced to ensure that retail investors understand the concept of inducements, any conflicts of interest that may arise, and potential costs and returns.

In addition, existing MiFID ‘quality enhancement’ test, will be replaced by a ‘best interest’ test for non-independent advisors. This means firms must:

• Assess an appropriate range of products
• Recommend the most cost-efficient products from the suitable range
• Essentially, offer a product without additional features (put simply, one which may incur a higher cost, such as a structured product) which may give rise to higher costs

Firms may have to demonstrate clear investor benefits from inducements and even return payments if sufficient value cannot be shown.

The proposals suggest regulatory scrutiny is increasing on these fees to ensure they do not conflict with investor interests. While details are still being finalised, the industry is concerned that the planned reforms point to tighter controls through enhanced disclosure. There is also some worry over the more prescriptive requirements around the payments and receipt of inducements. This could necessitate changes to current fee and commission models for both distributors and asset managers across the EU.

What about Disclosures?

The strategy puts a strong emphasis on enhancing disclosures to retail investors to enable better decision-making. The EC aims to introduce more standardized disclosures across investment offerings to ensure key details on costs and charges, risks, performance, and sustainability are covered in a common format. This approach intends to facilitate easy comparison by investors looking across potential products. The strategy suggests more granular transparency requirements around costs, including both entry and ongoing charges. While operational details are still being considered, the policy signals that regulators want disclosures to be clearer, more unified across products, and expanded to give consumers a fuller picture of characteristics and risks. Also on the radar is the development of a new category of ‘particularly risky products’, which ESMA will provide identification guidelines and regulatory standards for risk warnings. Firms will likely need to review their documentation approach as a result.

Marketing is also under the spotlight with a requirement to consider digital marketing, given the gravitation toward social media, influencers, and behavioural biases. A new marketing policy will need to be put in place, which will ensure that a target audience is documented and considered. We are awaiting more detail, however enhanced disclosures are expected to ensure that marketing communications and practices remain clear for products, despite a more digitalized approach to consumer engagement.

So, when will this happen?

Despite the long wait on the proposals, the regulatory process still needs to take effect. The legislative package will be issued to the European Parliament and the EC, who will set out their positions. This may take as long as a year before a common position is met between both. The earliest we expect this is one year from publication, but it is worth keeping a keen eye on the European Parliament election, taking place in June 2024, which may cause further delay.

The Consumer Duty begins

Most firms were looking forward to the end of July as the point when you could begin to relax and think about holidays. Unfortunately, this is only the beginning of the FCA’s Consumer Duty and there are three key areas to focus on next:

1. August to October

The 1^st of August was the starting gun for firms and Consumer Duty. Prior to August, the Board should have been presented with an update on the progress over the last year or so, including the efforts to build new, and enhance existing processes, to meet the outcomes and cross-cutting measures.

The next key date is the end of October, and the importance should not be understated. In October 2022, Boards and Consumer Duty Champions had to sign off on implementation plans and the approach. The anniversary should demonstrate the progress that has been made, any ongoing gaps, and how to mitigate against those gaps and associated risks.

2. Effective Oversight

The biggest issue for firms is ensuring that they have effective MI (management information) to evidence their approach to the Consumer Duty outcomes. For some outcomes, like Price and Value, this is mainly quantitative and built on existing data within the business around cost, performance, and market insight into how appropriate they are. For other outcomes, like Consumer Understanding, it is more difficult to achieve effective MI and this can be costly. For Consumer Understanding, you are required to ensure that consumers have the right materials to make good decisions about the product and consider whether the information they receive is appropriate. To gain insight directly from investors may be a costly process and require the use of focus groups. For those firms without the capacity to spend then simpler metrics may be used to assess their literature, such as comparisons to IA⁸ Fund Communication Guidance (2019), readability, reading age, and sentence complexity. It’s not an easy task but metrics are a necessity.

3. The FCA’s next move

So, what do we expect to see next from the FCA? It is hard to predict what the FCA will do but we believe that given their focus, and desire to get Consumer Duty right, then there will be interaction with firms from an early stage. We expect that from the 1^st of August, the FCA will begin to engage with key firms (those with close proximity to retail investors) to assess how they have implemented the Consumer Duty, their ongoing actions, potential gaps, and governance approach. Following this, we would expect to see more granular expectations from the FCA aligned to each outcome and specific areas of challenge. For example, effective information exchange between product manufacturers and distributors. Looking at 2024, we would expect to see a broader review from the FCA, which would provide better insight into their expectations for the industry, highlighting examples of both good and poor practices. In the meantime, expect detailed questions from FCA Supervisors and be prepared with some comprehensive answers.

Where are we with ESG?

Another quarter has gone by with another swathe of developments in the sustainability space, but where do we currently stand? A key development has been the European Supervisory Authorities (ESAs) launch of their Joint Consultation on the Sustainable Finance Disclosure Regulations (SFDR), Principle Adverse Indicators (PAIs), and calculation methodologies. Progress in the UK has been much slower, with the UK FCA delaying their Policy Statement for Sustainable Disclosure Requirements (SDR) from Q3 to Q4 2023 (this being the second delay so far). Additionally, the UK Green Taxonomy is still far from enforcement and not expected until 2024 at the earliest. We believe the FCA are keenly observing the developments of the EU Taxonomy as a “trial” for what will work best for the UK.

While the UK trails behind with SDR, the ESAs hope to address various SFDR-related issues and improve sustainability disclosures through their Joint Consultation on SFDR PAIs. Within the consultation, the ESAs introduce new mandatory and optional indicators, whilst clarifying existing indicator methodologies, and other changes to SFDR reporting templates. Since the Consultation period ended on the 4^th of July, the investment industry will be eagerly awaiting the ESA’s Final Report due at the end of October, and the relevant actions required before amendments enter force by the end of the year.

Despite the speedier progress in the EU, the ESA’s proposed changes have not been received and welcomed in the same way by the industry. EFAMA offered various criticisms in response to the ESA’s Consultation. For example:

• Can SFDR PAIs be effectively aligned with Corporate Sustainability Reporting Directive’s (CSRD) ESRS?
• Why did the ESAs not engage in consumer testing before their consultation?
• Will the ESAs leave sufficient implementation time for their proposed changes?

The biggest concern from the trade body was reiterating the need for a pragmatic and future-proof approach to the ESAs technical work. A review of some fundamental issues within SFDR is planned by the EC “soon”, therefore any changes implemented now must not be made obsolete later.

EC Sustainable Finance Package

The much anticipated Sustainable Finance Package was published by the EC on the 13^th of June – just in time for Summer. The aim here is to strengthen three key areas:

1. Enhancing the EU Taxonomy criteria
2. Creating new proposed rules for ESG Ratings Providers
3. Making recommendations on Transition Finance

Looking more closely at the proposals, the EC has adopted the Taxonomy Environmental Delegated Act, which introduces criteria which covers the remaining four environmental objectives that are not included in the Taxonomy Climate Delegated Act. The purpose of the Taxonomy is to establish the criteria needed for specific economic activities to be branded as ‘sustainable’, or to ‘become sustainable’. Such amendments enable the Taxonomy to cover a greater range of economic activities, for example, through enabling investments in renewable energy and green technologies.

The EC Sustainable Finance Package also focuses on the extremely topical area of ESG Ratings Providers. We have seen a growing focus globally in their operations – including the UK FCA, ESMA, and IOSCO⁹ – to not only regulate providers, but also develop a greater understanding of them. A key theme across these regulators is transparency and its importance for the ESG data ecosystem. To achieve this, the EC is looking to establish ESMA as the authorization and supervision body for the ESG Ratings market in the EU.

In addition to these points, the EC raises the notion of transition finance and its role in creating a climate-neutral and sustainable economy. Transition finance makes a vital link between the EU Taxonomy at the activity level, and environmental targets and transition plans at the corporate level. It aims to clarify the concept of transition finance and mitigate the risk of "transition-washing". The EC providers guidance and examples of how firms can do this, and strongly recommends firms engage on this topic to achieve a climate-neutral and sustainable economy for 2050.

As expected, industry participants have started critiquing the new proposals in the EC Sustainable Finance Package. In terms of the proposed rules for ESG Ratings Providers, industry body EFAMA voiced their support for increased transparency in data sources, quality and methodologies.

TCFD on the Move

We also saw the passing of the torch for TCFD from the Financial Stability Board (FSB) to the International Financial Reporting Standards (IFRS) Foundation, after the launch of the long-awaited IFRS International Sustainability Standards Board (ISSB) sustainability disclosure standards. Both ISSB standards incorporate all of the TCFD recommendations, and their application globally is expected to begin from 2024 – a very eventful year ahead in the ESG space.

Eligible Assets: The future is now

There is a lot of talk about market developments, talk about innovation, and talk about better product innovation for investors from Regulators, but how close is that future? On the 6^th of June, the EC mandated ESMA to consider the UCITS Eligible Assets Directive (EAD). The EAD is the gatekeeper. Its purpose is to safeguard investors and ensure trust in the UCITS brand. It does this by limiting investments in assets that meet a specific criteria, which allows UCITS to meet the required obligations, which include liquidity, net asset value calculation and limits monitoring. The EAD plays an important role but has been in place since 2007, and a lot has changed since this point. So, what do we expect ESMA to do?

• Analyse the merits of linking certain definitions and concepts to other items of EU legislation
• Assess the risks and benefits of UCITS gaining exposures to asset classes that are not directly investable in UCITS, e.g., by way of derivatives and financial indices
• Propose clarifications on key definitions and the criteria against which the eligibility of an asset is assessed
• Conduct a data gathering exercise with national competent authorities ("NCAs"), and market participants. The aim is to obtain insights on the manner and extent to which UCITS have gained direct, or indirect exposures to certain asset classes that may lead to divergent interpretations and, or risks for investors
• Provide recommendations regarding Level 2 requirements under the Eligible Assets Directive.

Given the fairly large mandate, ESMA has been tasked with delivering advice by the 31^st of October 2024 – plenty time to get it right.

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References

1. Markets in Financial Instruments Directive (MiFID)
2. Insurance Distribution Directive (IDD)
3. Packaged Retail Investment and Insurance Products (PRIIPs) Key Information Document (KID)
4. Undertakings for the Collective Investment in Transferable Securities (UCITS)
5. Alternative Investment Fund (AIF)
6. Financial Conduct Authority (FCA)
7. https://www.efama.org/newsroom/news/joint-industry-statement-eu-retail-investment-strategy
8. Investment Association (AI)
9. International Organization of Securities Commissions (IOSCO)