Suitability assessments - ESMA responds to Commission consultation

ESMA’s letter to the European Commission (the Commission), dated 13 April 2022 though not published until 19 April, gives a useful insight into the supervisory authority’s views on the Commission’s proposals for the suitability and appropriateness assessments under MiFID.

Although not binding on the Commission, ESMA would expect its views to carry some weight as the work in this area progresses. As such, the letter marks a helpful marker as to ESMA’s overall approach on the topic.

What’s the background?

In its February 2022 consultation, “Targeted Consultation on Options to Enhance the Suitability and Appropriateness Assessments”, the Commission stated that its suggested approach might

• modify the current MIFID II/IDD suitability and appropriateness tests with the view to no longer differentiate among the various investment services offered to retail investors”; and
• replace the current “’per product’ approach with a new element, a personalised asset allocation strategy.”

We’re fully behind you …

ESMA’s letter notes that it supports both the Commission’s objective of taking a holistic view of investor protection rules and the emphasis on a client-focused approach. Furthermore, it notes that it has focused plenty of attention over the past few years on the suitability and appropriateness assessments - two key investor protection requirements in the MiFID II framework. These topics have been the subject of two sets of ESMA guidelines, various Q&As and two supervisory briefings, while ESMA has also launched two Common Supervisory Actions to ensure consistent implementation and application of EU rules and to enhance the protection of investors.

But …

The primary purpose of ESMA’s letter is to bring a number of points of concern to the Commission’s attention:

• Does ‘one size fit all’?

  Applying a single, standardised retail investor assessment regime which doesn’t differentiate between different investment services raises the question of the effectiveness of a “one size fits all” approach in serving all different types of retail investors and situations. The existing regulatory regime encompasses services such as

  • portfolio management which implies a full delegation of investment decisions to the investment firm
  • investment advice, based on a personal recommendation proposed to the client and
  • reception, transmission and/or execution services that allow investors to independently make their own investment decisions (with or without an assessment of the client’s ability to understand the risk of a given investment opportunity).

  While ESMA supports simplifying the regulatory framework, it considers that the design of any new standardised regime would have to fully take into account the needs of the different kinds of investors and safeguard the principle of proportionality.

• Implementing a new regime

  Adopting the new framework would have a significant impact on the current model for providing services. Clients would need guidance and information to help them understand the implications of the changes and firms would need sufficient time to implement any new rules. ESMA also notes that the Commission’s proposals would seem to require significant IT changes to existing systems – and adds that firms are already in the process of adapting their systems in order to integrate clients’ sustainability preferences into the suitability test.

• Intermediaries

  ESMA backs the aims of increasing competition amongst intermediaries and of allowing investors to easily switch between or use multiple brokers/financial intermediaries.

  The Commission proposals, though, imply that retail clients will be willing to fully share their personal investor data. Experience and evidence from the recent ESMA Call for evidence, on the other hand, show that, for various reasons, clients can resist sharing personal information and ESMA believes that these concerns need to be taken into account for the Commission initiative to be successful. In addition, ESMA raises the issue of GDPR implications which must be further assessed since the right to data portability (Article 20 of GDPR) does not seem to include personal data derived, computed or inferred from the data provided by the client.

• Proper alignment of regimes

  ESMA believes that aligning distribution requirements for investment products that currently fall within different regimes (MiFID and IDD), would be an important step in creating a level playing field and avoiding regulatory arbitrage – so long as it doesn’t lead to the erosion of existing investor protection safeguards under either regime.

  However, if MiFID and IDD instruments were assessed jointly for the purpose of the suitability assessment, it would also be essential to ensure that a number of other requirements were also aligned, such as disclosure of information on costs and charges and reporting requirements on the depreciation of the client’s portfolio.

  If different parts of the client’s portfolio (managed under a unique asset allocation) ended up subject to different disclosure and reporting requirements, this would be operationally difficult for firms as well as very confusing to clients.

• Assessment of suitability

  Under the current regime, firms assessing suitability must

  • take into account cost and complexity of products, in order to assess whether equivalent financial instruments can meet their client's profile and
  • undertake an analysis of the costs and benefits of any switch recommended to the client, so they can show that the benefits of switching are greater than the costs.

  ESMA regards these controls as an important (though not perfect) part of the suitability assessment and queries how they could be performed by firms under the new regime, especially when providing non-advisory services to self-directed investors.

• Knowledge and experience

  Finally, the letter points out that the Commission’s consultation makes no mention of collecting information about clients’ knowledge and experience – in the existing regime, this information is assessed under both the suitability and appropriateness tests and plays an important role in accurately determining a client’s profile. For this reason, ESMA “expects that knowledge and experience is included in the key components of a standardised personal investment plan”.