Bumf and bumf-ability

Each time a directive is altered in the run-up to implementation, the resulting rewording and reprinting of documentation can prove almost as challenging as getting the changes accepted by the industry. When that directive is as large as Mifid, a whole new level of pain is introduced. By Duncan Wood

THE collective term is 'bumf': brochures, leaflets, pamphlets and other marketing material and product documentation. The financial services industry churns out vast amounts of the stuff and, in the run-up to Mifid's implementation, getting it all reworded and reprinted is just one of the many headaches facing some institutions.

Nic Gordon, a senior manager in Bearing Point's London office, says one of his clients - a medium-sized European bank - has determined it will need to alter somewhere in the region of 6-7,000 different pieces of documentation. "Each one will need to be reworded, reprinted and resent," he says. "It's going to be very laborious and very time-consuming."

The industry calls this process 'repapering'. The need to go through it is a consequence of Mifid's new conduct of business (COB) regime, one pillar of which is the classification of clients into three tiers - retail, professional and eligible counterparty - each representing different levels of financial expertise, and each demanding different levels of protection from the firms that serve them.

In the UK, the existing COB regime is also based on a three-tier system. Although the classification criteria will change significantly for each tier, the Financial Services Authority (FSA) plans to allow firms to transition to the new rules by ignoring these changes and simply assuming the lowest tier of clients in the current system would correspond with the lowest tier in the new one - and so on up the chain. When the FSA announced these plans last year, they were welcomed partly because they offered a way out of the repapering nightmare.

Richard Stones, a London-based consultant in the financial services group at law firm Lovells, says this 'creative' grandfathering policy won't help everyone. "Some people had already got themselves worked up to reclassify their customers and so are tempted to continue. Others feel unhappy about their current classifications and feel this is an opportunity to tidy it up."

More importantly, many of the 29 other Mifid countries have no pre-existing client classification scheme or have not offered the grandfathering get-out, so firms outside the UK (such as the Bearing Point client) will therefore have to print or reprint large amounts of documentation. As a result, while Mifid may be causing much wailing and gnashing of teeth among financial services firms, companies who print bumf for the industry must think they have struck gold.

Repapering is just one of the more tangible burdens associated with the new COB rules. Hand-in-hand with new client categories comes a significant shift in the suitability and appropriateness guidelines telling firms how to look after their customers. Mifid's COB rules also cover conflicts of interest and inducements, among other topics, that firms will need to get to grips with before the November 1 EU-wide implementation date. In aggregate, the cost involved in complying with all the COB changes, for UK firms, has been estimated at £275-375 million by the FSA - a figure KPMG claims is likely to prove an underestimate.

These costs are supposed to be offset by Mifid's benefits. Chief among these is the removal of Europe's existing patchwork of national rules. From November onwards, firms that want to do business in a number of different jurisdictions will have to comply only with the rulebooks written by their home-country regulator - in theory. In practice, says Bernadine Reese, a director with KPMG in London, it was not possible to persuade 30 national regulators to agree to the same set of rules: "The EU tried to ensure maximum harmonisation, tried to limit the scope of discretion, but there are still some areas where each member state will have some options."

PJ Di Giammarino, London-based chief executive of EU technology think-tank JWG-IT, says the final ('level two') version of Mifid at EU level was "about 60% regulation - which means member states are compelled to copy it straight into their rule-books - and then 40% directive where there is more discretion". There is still a lot of uncertainty about exactly how each country will implement the latter portions of Mifid - the UK is one of the few countries to have published much of this 'level three' detail. As a result, the promised land of harmonious, consistent cross-border regulation seems a long way off for many firms, while the assorted compliance hurdles and costs are far more immediate: the new COB regime has prompted a lot of griping.

Repapering has been one target for critics of the client classification rules. Migration between client classification levels has been another. Mifid envisages a system in which the population of the three client categories is somewhat fluid - customers can hop down a level at their own request, receiving the greater protections that go with it, but also cutting themselves off from the products and services available to more sophisticated investors. Firms can also 'opt up' a client, but there are restrictions on when this can be done.

This fluidity makes a lot of sense, but for large banks with multiple business lines and a variety of customers within each business, it's a huge practical challenge, says Di Giammarino: "It's one thing to have as a grand aspiration the idea of allowing a client to opt up or down from their current classification, but it's another matter entirely to have the reference data across the different desks, legal entities and firms to be able to manage a standardised list of which client had what classification at what time, and record how they were dealt with."

The FSA's grandfathering provisions will help UK-based firms make the transition from old categories to new, but they won't do anything to assist with the ongoing task of tracking and managing classification shifts within the customer base. Some banks have invested heavily in state-of-the-art customer databases, and will claim their system is robust enough to cope with Mifid's demands, but Di Giammarino is not completely convinced by those claims: "My doubts come from having slogged through the quagmire of different customer scenarios in the new regime. We've modelled eight different factors - such as client classification, physical location, legal entity type, relationship type and jurisdiction - that could all be involved in a particular trade and, in theory, there could be up to 2.5 million permutations of the key variables which define the rules that govern customer interaction."

This complexity has prompted some large firms to opt for a 'quick and dirty' solution, says Bearing Point's Gordon. Rather than having a range of differently classified customers within each business unit and allowing individual customers to migrate from one tier to another, a handful of institutions have decided instead that certain business units will only deal with certain classes of customer, with no opting up or down allowed. "It's a shortcut, but it's extremely effective," he says. "The downside is that some customers may want the ability to opt up or down and may decide to take their business elsewhere - but the banks taking this approach are sufficiently large that they probably don't need to worry too much about that kind of attrition."

Client classifications matter because of the differing protections firms are obliged to give each tier of customer. Mifid's controversial rules on best execution, for example, do not apply to top-tier clients. However, pretty much all products and transactions offered to clients have to be assessed against one of two different standards: appropriateness is the simpler of the two and means a firm has to judge whether the customer understands a product's risks. Suitability goes beyond that, requiring a firm to not only assess the customer's understanding of the product, but also to determine whether the product fits the client's investment objectives and financial position.

In the UK, the industry already has to bear suitability in mind when offering financial advice to retail customers or acting in a portfolio management role, but suitability has not been a consideration when dealing with middle-tier clients. Mifid changes that. By contrast, the appropriateness test is wholly new and applies to execution-only services where no advice is given - hence the somewhat lighter standard.

Both tests have raised a host of questions. For example, says KPMG's Reese, firms worry about exactly what qualifies as advice. It might seem like a semantic point, but because it determines what level of care a firm has to offer, it has serious implications. A company might believe it had not advised the client and that only an appropriateness test was required. A disgruntled client might later dispute that - claiming it had been advised and was therefore due a higher standard of care. "The directive defines advice as a 'personalised recommendation'," she says. "But at what point during a sales conversation does something stop being a generalised recommendation, and become personalised?"

One potential remedy currently being discussed by the FSA and the industry is an up-front disclaimer to the effect that sales patter should not be considered advice. "If a client had clearly been advised, the disclaimer would be ineffective - you can't say that black is white. But it might help resolve borderline cases where no-one is sure where precisely to draw the line," says Reese.

Some firms will have to execute a cultural u-turn. "For execution-only businesses, the concept of appropriateness is all new. It's probably safe to say that most firms currently don't do anything of that nature. In fact, they might feel it was dangerous to do so," says Lovells' Stones. He says many brokers and dealers tend to absolve themselves of responsibility for client missteps by hiding behind the 'buyer beware' principle: if a client gets stuck with a losing position, it's not the trader's fault. Mifid sounds the death knell for this hands-off attitude, forcing firms to actively decide whether a client knows enough about a transaction to be allowed to go through with it, even when the trading venue might be a supposedly hassle-free online platform on which trades are supposed to be placed, executed and confirmed in seconds with no human interaction between the firm and its client (see our Case Study).

Firms also have to fill in gaps in their customer information. For advisory and portfolio management businesses, much of the data should already be in-house, but it may need to be supplemented or gathered together in a way that makes it instantly accessible at any point where there is customer contact. Non-advisory businesses are likely to have some serious catching up to do, says Chris Borg, a partner in the financial markets and regulatory group with Denton Wilde Sapte in London. "At a very basic level, if you've got a non-advisory service other than for non-complex products, it's unlikely to be getting anything like the level of information needed for the post-Mifid world. Typically they'll be collecting some money-laundering information and some details on credit risk. Now they need enough information to work out whether a retail client understands a particular product."

Gathering this information isn't straightforward. For one thing, Mifid doesn't spell out what details firms should consider when making their suitability and appropriateness assessments. For another, it also inserts a new layer of awkwardness between the company and its customers, says Borg: "The factors that matter in Mifid - like the complexity and level of risk in a transaction, the nature and extent of the service provided, and a client's past experience - could turn into an annoying questionnaire. The last thing you want to do when you're trying to win business is start quizzing people about whether they're up to it." He expects firms to look for acceptable shortcuts - by assuming a client that trades exotic equity products is also up to speed on exotic fixed-income products, for example.

Assumptions of this kind could come back to haunt a firm, says Borg. Because Mifid doesn't allow firms to discharge their suitability and appropriateness obligations by ticking a series of boxes, it will be difficult to know that the correct standard has been applied - the risk is that the question may be answered when an unhappy client accuses a firm of providing a service it just didn't understand or that didn't match its investment objectives. "In theory, it's possible for a client to lose a lot of money and for a firm still to be able to show suitability or appropriateness," he says. "In reality, the quality of the information-gathering and the decision-making may all be judged with hindsight."

Currently, says KPMG's Reese, firms "are looking at what criteria they want to check for each product type. For example, whether the client has dealt with them before, or whether the client used to work as a trader themselves."

But are firms doing enough? That's a question that Denton Wilde Sapte's Borg says is difficult to answer. "If a client asks me 'how do I make sure I'm getting all the information I need?' The bottom line is - what would the firm do if the client says the trade was not appropriate? What can the firm say? What information does it have to hand to show the trade actually was appropriate? Merely relying on anti-money laundering or credit information may not be enough." OR&C

Case study: ABN Amro ABN Amro started to make real progress on Mifid at the start of 2006, says Nick Gibson, head of the regulatory stream of the bank's Mifid programme. A central Mifid implementation team of 16 people has set the pace and helped to co-ordinate the work of project teams in each of the bank's businesses, which are spread across 18 EU countries. One of the difficulties that the team has had to confront is the continuing lack of detail about how individual countries are going to interpret the Mifid directives. With the implementation date now closing in rapidly, the bank couldn't afford to wait for clear guidance. Instead, Gibson says, the decision was taken to work from the material produced at EU level and make assumptions about how member states would write that material into their own rulebooks. The gap analysis performed by the bank was done using a mixture of level one and two detail supplemented by educated guesses. Essentially, he says, "we've had to construct an ABN Amro European standard, cross our fingers, and hope our assumptions hold good. This does demand a robust change control process in the event that they might not". So far, says Gibson, the bank's expectations have been more right than wrong. Suitability and appropriateness has been a major focus of the bank's work in the conduct-of-business area. Gibson sees it as a matter of formally documenting existing - sometimes intuitive - practices. "If you ask a relationship manager, an old-style broker or a private banker, they will all tell you that they know their clients inside out and that's probably true - but we need to formalise this in order, if challenged, to demonstrate to a regulator or client that a piece of specific advice or transaction was suitable for the individual, and to lay out our grounds for that judgement. We already store risk profiles and objectives for all our retail investor clients. It's largely a case of enhancing this information and creating additional client records in support of the service provided." In practice, he says, that may mean "being able to make customer information available electronically, at the touch of a button, on the screen in front of a salesperson at the time they make their decision or offer advice to a client - and keeping a record of it all." Appropriateness has raised some particularly taxing questions. In the past, if the client of a wholesale business researched a product in their own time, decided it was a good move and then placed an order with an execution-only channel, the trade would be done without the issue of appropriateness ever raising its head - and banks have invested serious resources in creating online and electronic trading platforms specifically to service the growing demand for quick and easy trading. Now, says Gibson, "we're going to have the responsibility to decide whether the trade is appropriate - we have to interject that judgment into the chain at some point - and, in an online channel, how do you do that?" The answer is likely to involve "pre-qualifying" clients, rather than making a separate assessment every time a trade comes through, he says. Customers will have to provide information about their experience and understanding of risk before using a service and will then be able to use it more or less freely. If they then want to use a more complex type of product or a new set of structures, for the first time, additional, very clear information will be required to show that the new risks and product characteristics were explained and understood.