KPMG Financial Risk&Regulation

Background

In 2021, the European Commission observed that only a very small proportion of household investors' savings are invested in securities, and a significant proportion of retail investors do not trust financial advice. This is due to a poor value proposition, the lack of value-for-money, and the difficulty of comparing of performance and costs. In many cases, practices such as retrospective commissions (e.g. trailer fee) between product manufacturers and distributors has been identified as problematic.

To remedy this, on 24 May 2023, the European Commission launched its "Retail Investment Strategy"^[1] initiative to encourage retail investment, under which a number of pieces of legislation may be adopted this year. The European Commission's Retail Investment Strategy aims to create a more transparent, fair and secure investment environment for retail investors in the European Union, while increasing investor protection and confidence in financial markets and ultimately deepening the Capital Markets Union.

We will briefly summarize the key aspirations of this legislative phase.

The Retail Investment Strategy is a multi-legislative framework for retail investment that aims to improve the transparency of these services, reduce conflicts of interest and associated costs, and ensure fair treatment throughout the investment process. Overall, the goal is for retail investors to make decisions based on clear and accessible information.

At the same time as the Strategy, it also adopted a package of regulatory programmes as part of it. On the one hand, it planned to adopt a so-called "Omnibus Directive"^[2] (i.e. to amend several pieces of legislation with a single document, a kind of "omnibus legislation"), including the amendment of MiFID II, the UCITS Directive, the AIFMD, Solvency II and the IDD. In addition, it initiated the amendment of the PRIIPS Regulation on packaged investment products in a separate document. The main elements of the regulation aim at a uniform level of transparency of investment services at EU level and adapted to the digital environment, as well as rules on investor protection for retail investors.

The legislative proposal introduces amendments to product governance rules to ensure that product manufacturers and distributors do not incur undue costs and thereby ensuring that products offer adequate value for retail investors' money. For all existing and new products, it would be mandatory to identify and quantify the costs and fees for production, distribution and consultancy, as well as performance. This will also mean a new obligation to report costs to supervisors. Investment firms would be required to reimburse investors for any unjustified costs.

This essentially introduces a new pricing process in the product management system of the product manufacturer and distributor, by requiring them to compare product costs and performance with a wider range of reference data, and by requiring distributors and intermediaries to report distributor fees to the supervisor. It is expected that products other than the relevant benchmark cannot be approved unless the producer can demonstrate that the costs and fees are justified and proportionate. ESMA and EIOPA would be responsible for developing appropriate benchmarks and updating them annually.

Regarding costs, the regulation package would also tighten the regulation of incentives. The draft regulation would eliminate the possibility of accepting the incentive (which means all monetary or non-monetary payments not originating from the client, e.g. commissions received from the manufacturer of the product, distribution fees) in the case of all activities that do not include investment advice (such as execution only, typically the execution of an order for or on behalf of a client, or the forwarding of an order for execution).

In cases where it would still be possible to accept incentives (services linked to advice), the current set of criteria would be replaced by a new, uniform test to determine whether the adviser is acting in the best interests of the client (which is called the introduction of the 'best interests' principle). Furthermore, the incentive should not provide an incentive to recommend a product to the investor instead of another product, it should not be disproportionate to the value offered, and incentives provided within the group should be treated in the same way as external incentives.

Poor marketing practices (to avoid one-sided behaviours that overemphasise the benefits over risks or even mislead) would require service providers to have a specific policy on marketing communications and practices, and that marketing strategies and communications should also be compatible with the target market.

In the case of all investment products (including insurance), the digital form will be made the default and detailed rules are planned to be developed for it.

The publication of costs will be modernised and uniform for the sake of transparency, which will include standardising the presentation of information on costs, related fees and payments made by third parties.

An annual statement will be mandatory, which has to include information on costs and fees, including payments made by third parties, as well as performance. They also set minimum requirements for the information to be included in the annual statement, depending on the investment products offered.

It would introduce mandatory risk warnings, especially for particularly risky investment products.

The general expectation for marketing communications is that they should be clear, fair and non-misleading, regardless of the channel through which they are published, even if they are not published directly by the investment firm (e.g. in the case of influencers)

Changes are also expected in the PRIIPS KID^[3] document, including a dashboard, a digital presence (layering), a new sustainability section and information about multi-option products.

During these tests, consultants will need to consider the diversification of the portfolio as a new aspect in addition to examining the existing aspects. It must also ensure that retail customers have an adequate capacity to absorb all or part of their losses and their risk tolerance. If not, the transaction may only be carried out with a warning if the customer concerned expressly requests it.

To increase financial literacy, the European Commission has launched various programmes and initiatives aimed at helping retail investors to better understand how financial markets work and the specificities of investment products. This enables them to make more informed decisions, which contributes to the stability and efficiency of the markets. In this context, Member States can also organise awareness-raising programmes themselves, in addition to initiatives made by the Commission and the OECD.

Overall, these changes are very favourable for investors, as information about investment products and services will become more accessible and understandable, and in accordance with pricing and cost charging practices, costs will be reduced and the value obtained will be increased through performance.

From the point of view of service providers, a number of tasks can be identified. The justification of costs and the regulation of inducements will probably cause the most headaches and pose the greatest challenge to service providers. In this area, one of the main objectives of the Strategy is to limit the supply of products that provide poor value for money or no value for retail investors. Once in force, the new rules will impose serious obligations on investment firms and insurers. Mostly in the context of ensuring the justification of costs (in the field of strategy, pricing and product development), but they also have to harmonize their internal regulations with the new regulations, and it may even be necessary to develop new regulations (e.g. in the field of pricing, marketing). This also entails the strengthening of compliance functions. In addition, risk management systems will be mandatory to monitor the sustainability of investments. In many cases, testing rules and disclosure and expense statement obligations may require IT development. Last but not least, targeted training should be organised for investment advisers, with a particular focus on sustainability preferences and a better understanding of client interests.

Please note that investment fund managers, investment firms and insurers producing investment products and their intermediaries will also be subject to the RIS.

On the Commission's proposal presented in May 2023, Parliament managed to reach the main political positions by April 2024 and the Council by June 2024. Negotiations between the three legislative institutions are currently underway, and the consensus and adoption of the legislation are expected to be achieved by the end of 2025. It is planned to apply from 2027, but this will depend primarily on when the 3 co-legislators reach an agreement on the final text.

Full implementation will only be possible after the adoption of numerous delegated regulations (RTS, ITS), which will contain the detailed rules. Although the implementation of MiFID II has largely already taken place, the operation in accordance with it has become part of the "business-as-usual" mode, but some of the far-reaching new rules introduced by RIS – due to the strategic, financial and customer relationship elements of investment services (sometimes involving IT development) – foreshadow a long legislative process and an even longer compliance process.

^[1] Retail investment strategy - European Commission
^[2] EUR-Lex - 52023PC0279 - EN - EUR-Lex (Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Directives 2009/65/EC, 2009/138/EC, 2011/61/EU, 2014/65/EU and (EU) 2016/97 as regards Union rules on the protection of retail investors)
^[3] EUR-Lex - 52023PC0278 - EN - EUR-Lex Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Directives (EU) 2009/65/EC, 2009/138/EC, 2011/61/EU, 2014/65/EU and (EU) 2016/97 as regards the Union retail investor protection rules