If you have clients who are fund-of-hedge-funds, or especially manager-of-managers, prepare for an onslaught of questionnaires and visits as part of due diligence processes. MiFID makes very particular demands of these firms. And the big players will be passing that pressure on to you. MiFID demands of people who have outsourced parts of their operation (and that includes investment management) to maintain the same duty of care and internal controls as if they ran it themselves.
MiFID Level 1 Article 13.5. “An investment firm shall ensure, when relying on a third party for the performance of operational functions which are critical for the provision of continuous and satisfactory service to clients and the performance of investment activities on a continuous and satisfactory basis, that it takes reasonable steps to avoid undue additional operational risk. Outsourcing of important operational functions may not be undertaken in such a way as to impair materially the quality of its internal control and the ability of the supervisor to monitor the firm’s compliance with all obligations.”
In the run-up to the MiFID compliance deadline on 1 November, you will see an increasing volume of questions coming from your most important clients – firms who might have left their own MiFID projects a little bit late – and are now hoping that you can provide all their answers in less than aweek.
The size of the overall MiFID impact on you will depend on three key factors:
Here are eight activities, which you need to begin now:
Funds with performance fees, and funds with significant manager investments in them, are identified as bringing conflicts of interest. Firms who started off with a single fund and now run a range of strategies and managed accounts with different fee structures will be particularly at risk. A conflicts of interest policy should show that you recognise the conflicts exist, and also that you have active safeguards and regular monitoring and correction in place.
Both your administrator and your prime broker are service providers. The MiFID article 13 also applies to you directly – you must have the expertise to supervise any outsourced functions and to manage the risks involved. This means that you should check the duties which you have outsourced and look at how you are reviewing and managing these relationships. You should specifically check their contingency plans, their PA dealing rules and the conditions for cancelling the relationship.
Broker agreement documentation can quickly get out of date, but your client relationship with all of your brokers is also covered by MiFID. Each relationship needs to be re-agreed and documented. In particular, you need to decide whether you could request professional status for any of your relationships, or for some of the products you buy. You also need to agree that the broker will be doing the necessary transaction reporting, and for equity managers you need to discuss the publication of unfilled limit orders. Brokers will be obliged to publish these orders unless they are large, or unless you expressly tell them not to. You will need to agree with them how this will work in practice – and it may be different with different brokers.
Your dealing policy needs to explain how you intend to achieve best execution, what your approach to best execution is, and how you monitor and review it. If your fund has an active dealing policy, it is more likely that you will be making active choices of venues and transaction management methods, and therefore you will be retaining responsibility for achieving best execution rather than passing it through to a broker. MiFID does not insist that you achieve best execution on every deal, but it does require you to show how you try to achieve it overall.
MiFID recognises that some investment firms are smaller than others, and that in some cases it is impractical and unreasonable to insist on complete segregation of duties. However, it still insists that risk management and compliance monitoring duties are performed and that the senior management of the firm review the output.
Your clients needto see details of all fees, commissions and non-monetary benefits – including broker services provided free of charge. You also need a policy for managing inducements, demonstrating that you make sure the inducement is designed to enhance the quality of service for your clients.
MiFID specifically insists that managers must have business continuity plans to preserve data and keep the business going. Although this is not the most significant requirement in the whole piece of regulation, it is one of the easiest for your clients to ask to check.
For buy-side firms, MiFID is not a deeply technical project, and the size of the technology impact will vary enormously depending on how automated your firm is. Many vendors are promoting the latest version of their system as being ‘MiFID compliant’ in a hope of selling you a quick upgrade. MiFID changes do require a couple of extra fields to be added to the system, to store more information about the venue and the order type, and you will probably be receiving details of these changes from your brokers. It is entirely possible that you can accommodate these within the existing system, using fields which are already there.
Perhaps less obviously, you need to change the way you use the systems to support your own MiFID compliance. For example, the order management system can produce a report showing that you are not front-running your headline funds at the expense of the managed accounts.
Much of this work we have outlined is not rocket science and it does not appear particularly urgent. But if you start it now, you will be ready when those questionnaires start to land, and it will be a very important tick in the box for prospective clients.