Last month MiFID came into effect, but what does the new directive really mean for the investment industry? Nick Dewhirst looks into some potential pitfalls
The introduction of MiFID on 1 November has been widely touted as the biggest improvement to financial regulation since Big Bang. That means it is also likely to cause the biggest unintended consequences.
Once again, it looks like poor investors will be the greatest victims. How can that be, when one of MiFID's main objectives is to extend a uniform high standard of consumer protection across Europe?
The basic principle is that clients are to be categorised as retail clients, professional clients or market counterparties, by a process of elimination. If they are not counterparties, they may be professional or retail. If they do not qualify as professionals, they must be retail.
To qualify as professional, a client may either be a regulated investment institution, or what was previously called an expert investor in the UK - the former are professionals per se, while the latter are elective professionals. In order to have the right to elect, clients must pass certain financial tests.
If the client is a company, it must pass two of these three tests: balance sheet total of €20,000,000; net turnover of €40,000,000; and/or own funds of €2,000,000.
So sorry, if you are a longestablished closely held company, whose sole business is to manage the investments of a family, we can't treat you as a professional, unless you get regulated, as you are poor.
If the client is an individual, he must pass two of three different tests: the client has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters; the size of the client's financial instrument portfolio, defined as including cash deposits and financial instruments, exceeds €500,000; and/or the client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged.
So sorry, if you are an active, small investor with great experience, we can't treat you as a professional, because you are poor.
Suitability of investment
That is great, if clients wanted to be treated as retail investors in order to receive the consumer protection benefits. Essentially this means that investment firms must take into account the suitability of any investment when providing personal advice. That in turn is specifically defined as (a) relevant knowledge and experience in that investment field; (b) financial situation; and (c) investment objectives.
So sorry, if you say that is none of our business - you are an adult and responsible for your own affairs - unless you give us documentary evidence, we can only give you generic advice. That means we can only tell you what investments we like, but we can't advise you how much you should invest in them.
The problem is that customer protection equals supplier risk. Rational suppliers will seek to protect themselves against the risk of being sued. Professional indemnity is only temporary cover, until claims pour in, so that means avoiding claims, which in turn means recommending investments that are generally accepted as safe.
The problem is we only know what was safe with hindsight, so the conventional solutions to reducing such supplier risk are recommending bonds, managed funds and lowvolatility equities. Each comes at a price.
Bonds are risky if they are overpriced. That has been amply demonstrated by AA-rated US mortgage- backed securities, whose ABX index has halved in value only this year. Corporate bonds suffer defaults in recessions, but are often priced as if none is likely. Even the best known of government bonds, War Loan, can be risky. Since 1990 its price has doubled and fallen by a quarter, twice. It also fell by 80% between 1945 and 1975.
On average, managed funds will reflect consensus asset allocation. That means the proportion in equities will rise, the more overvalued the world's stockmarkets, and will fall the cheaper equities become. One would hope that conservative managers lean against the wind, but in truth they blow with it.
A double-edged sword
Volatility is crudely equated with risk, because it is quantifiable, but firstly that quantification is calculated with hindsight, not foresight, and secondly volatility is a double-edged sword. As equities have a long-term tendency to rise, low-volatility equities will underperform, and underperformance means earning less and/or losing more.
Picture this imaginary scene between a client and an adviser at the height of the next bubble. "Sorry, you are poor. My compliance officer says that I can only make personal recommendations to you which I sincerely believe will keep you poor. You could of course try lying but then you would have to put it writing. Lots of people do that when borrowing other people's money, so why shouldn't you when it is your own money? May I point out that this is a self-certification form…" n
Nick Dewhirst is CEO of www.investors-routemap.co.uk
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