Ensuring accurate and updated business entity data has always been one of the three pillars of efficient data management. Broker-dealers must ensure they know who they are trading with and what they are buying and selling to ensure they have an enterprise-wide view of their operational, counterparty and credit risk.
Now European regulators are putting the practices of financial firms to the test by ensuring they know how to classify and update their counterparty records when it comes to complying with the European Markets in Financial Instruments Directive. That’s the European legislation governing “best-execution” adopted in 2007. It’s the continent’s version of the U.S. National Market System regulation, often called Reg NMS.
As part of a potential revamping of MiFID, the Committee of European Securities Regulators last week began seeking industry comment on making changes to the three categories – retail, professional and eligible counterparty (ECP) – financial firms use to classify their customers under MiFID. Comments are due by August 9.
The result: “It doesn’t necessarily mean broker dealers will need to maintain a single database for all counterparty data but a single enterprisewide view of the customer is needed to form an aggregate view of the information stored in multiple silos,” says PJ Di Giammarino, chief executive of JWG, a London-based think-tank specializing in European regulatory issues.
Those silos are typically customer signup applications and trading applications which can be stored at numerous locations of the client and by the type of instrument traded. On average, a large broker-dealer could have more than a dozen repositories for counterparty data.
To ensure that single and consistent view of the client, firms will likely have to invest in counterparty scrubbing software and data aggregation tools. They will also have to continue to annually review whether the categorization of the client is valid and allow clients to move between categories depending on the financial instruments they trade. Firms will also have to pay closer attention to how they categorize clients in the first place.
Depending on the number of clients, and the type of financial firm the cost could easily come to 1 million euros annually in additional headcount, data cleansing and systems development. Firms will also likely have to set up data governance policies as to who will be responsible for ensuring accurate and updated counterparty data and who will access the information. While firms may have done so for reference data – descriptive information on securities- they likely have not done so for counterparty data.
Among the questions CESR is asking: should the category of “professional clients”be narrowed; should the definition of public debt bodies be clarified; should firms be more stringent in the tests they use to categorize their clients and whether they should change client categories when selling very complex products such as asset backed securities and OTC derivatives.
“There are some regulated entities who, in some situations do not have the knowledge and expertise to make their own investment decisions and cannot properly assess the risks they incur,” said CESR in referring to firms which are now classified as professional clients.
In the case of public debt bodies, which include municipalities, just how the term is defined could mean the difference between being classified as a professional firm or an eligible counterparty. “In some member states local authorities are classified as professional clients while in most they are not,” said CESR.
How financial firms categorize their clients translates into just how much protection they are given under MiFID. That typically means how much of a defacto guarantee the broker-dealer has to make that it will ensure they got the best deal possible.
While the U.S. has largely defined best execution as the “best price” under Reg NMS, MiFID has a far-more principles-based approach. Meaning: it’s a lot more open-ended or vague. It’s about price, total cost and speed to execution and unless the fund manager asks for specifics it won’t get any
Retail investors are given the most protection. ECPs – typically investment firms, credit institutions, insurance companies, central banks, and national governments—are considered the most sophisticated investors and are given a “light touch approach.” That means the least protection. What are professional investors? The distinction between ECP and professional appears to be very hazy, except that “locals” are included as professional investors. While MiFID does not define the term :”locals,” CESR says that it means firms which deal for their own accounts – aka proprietary trading shops.
CESR wants to know if firms which are considered professional clients or eligible counterparties should be tested to verify that they really understand the products they are buying. “Should a knowledge and experience test be applied to large undertakings before they can be considered to be professionals or to other categories of clients who are currently considered to be professionals” asked CESR.
Firms which are buying OTC and other complex products, in particular, may not understand the risks of their investment. Therefore, says CESR it may be necessary to either eliminate the ECP status for transactions in “highly complex” products or create a separate category such as “super ECP” for large financial firms wanting to invest in OTC derivatives and asset backed securities.
In addition, firms which may know that an investor classified as an ECP might not be able to properly assess the risks of its investment and should be categorized as professional clients.
This article can also be found at SecuritiesTechnologyMonitor.com.
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