Regulation Including PROD
6 min read 7 Dec 18
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Chris Sutton looks at the critical role of communication and how platforms can help Advisers and DFMs meet the requirements of the MiFID II 10% drop rule.
One of the biggest challenges around the new MiFID II rule on 10% drop reporting is a deceptively simple one: communication.
First, let’s briefly recap how the 10% drop rule works. It applies to investment firms, either DFMs or advisers with discretionary permissions, that provide portfolio management. They must inform clients if the overall value of their portfolio depreciates by 10%, and thereafter at multiples of 10% compared to the beginning of each quarterly reporting period. Where a breach has occurred, clients are to be informed by close of that business day or, if the threshold is exceeded on a non-business day, the close of the next available day.
Under this new regulation, the responsibility for reporting principally lies with the portfolio manager. But where a client's assets are managed via a platform, a DFM (whether providing portfolio management via a model portfolio or bespoke arrangement) won’t typically have access to client data. Apart from data protection questions, the platform route greatly assists the clarity of the client relationship (and ownership) and responsibility for advice when compared, potentially, to a traditional DFM portfolio.
Additionally, while a particular model or strategy may depreciate by 10%, this might not represent all of the client’s relevant assets. Ultimately, only the adviser is in a position to understand whether a breach has been made and therefore if the client should be informed.
Platforms have put in place reporting mechanisms to identify, at the wrapper level, whether any 10% depreciation has occurred and to notify both the adviser and DFM. Armed with this information, the adviser is in the position to establish if a breach has occurred and, not only communicate this to their client, but also be able to record and evidence that they have done so.
Markets can be volatile over short periods of time, which has led to concerns of inducing short-term knee-jerk reactions. However, it also prompts the adviser to be visible with their clients at times when this may be most difficult but also most valuable. 10-15% market corrections may be expected, and can even be healthy, in normal markets. Therefore reporting a 10% drop, while not welcome, also shouldn’t be feared, particularly for those clients with higher risk strategies likely to contain 75% or more allocated to equities.
From a DFM's perspective, there are two main ways to support advisers during this time. The first is to monitor their strategies with a view to forewarning the adviser if a potential 10% breach is being approached, while also providing information as to why this may be about to occur. In particular, whether the breach has been driven by markets and overall allocation, and therefore should be expected to an extent. Alternatively, it may be that performance reflects a more fundamental breakdown in the strategy (perhaps due to the particular approach or asset type the manager invests in), or because of investment specific issues, particularly if managers are holding listed investments.
This information forearms the adviser with an understanding of whether the investment solution remains suitable, or if the client's overall investment position needs to reviewed, and therefore facilitates a meaningful discussion between adviser and client.
Questions have also been raised as to whether the DFM should be confirming notification of the 10% breach directly with the adviser. The DFM should already have been notified by the platform, who are the party providing the reporting system. The regulatory responsibility lies with the DFM as provider of the (discretionary) portfolio management. So the DFM should also confirm any potential breach with the Adviser, who can then decide whether a client notification is needed.
Another possibility is to ask the platform to advise the client directly. Doing this raises some problems, not least the possibility of unnecessarily alarming the client before the Adviser has had the opportunity to assess and explain the full picture, and to suggest appropriate action, if any. A better course is for the platform to alert the adviser (and the DFM), not the client directly. This is because the platform doesn’t know the client’s complete circumstances. It may be reporting at the wrapper level or, at the most, across the (discretionary) portfolio that the client holds on its platform, but that may not be the complete picture. Only the Adviser has this and, as above, once alerted, the Adviser can decide if a client notification is required.
Although the primary duty to report falls lies with the DFM, the additional platform-to-adviser notification is useful in that it is better to be informed twice given the significant penalties that can result from failure to comply with these regulations. And, crucially, it highlights the importance of the DFM being visible and assisting advisers that are outsourcing to their services, just as much as the adviser needs to be visible with their underlying client.
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