Sum up the key rules meant to safeguard investors in financial instruments, among them MiFID, MiFID II and Dodd-Frank.
The idea
Investor protection rules share a core logic: know the client, sell only what suits the client, get the best result, manage conflicts and disclose costs. MiFID, the EU directive in force from 2007, introduced client categorisation (retail, professional, eligible counterparty). It also brought suitability tests for advice and portfolio management, appropriateness tests for execution-only sales of complex products, and best execution and conflict-of-interest rules. MiFID II, applied from January 2018 with MiFIR, widened scope to commodity derivatives and non-equity instruments. It added organised trading facilities and extended pre- and post-trade transparency. It also introduced product governance and target markets, tightened inducement rules, and increased cost disclosure and record keeping. Under the inducement rules, independent advisers cannot keep third-party commissions. Dodd-Frank (US, 2010) created the Consumer Financial Protection Bureau and the Volcker Rule. It also brought central clearing, exchange or SEF trading and trade reporting for standardised OTC derivatives, and a whistleblower programme. Exam point: match each rule to its trigger, for example suitability for advice versus appropriateness for execution-only.
Formulas
Total consideration for best execution
total consideration = (price + fee) × shares
- price
- the price per share at the venue
- fee
- the execution cost per share
- shares
- the number of shares traded
For retail clients best execution is judged on total consideration. Choosing the venue with the lowest quoted price but higher fees is the trap.
A practice question
Which of the following is a change introduced by MiFID II relative to MiFID I?
- It introduced the categorisation of clients into retail and professional categories for the first time in EU lawWhy not: Client categorisation already existed under MiFID I; MiFID II refined it rather than introducing it.
- It removed the best execution obligation for retail client ordersWhy not: MiFID II strengthened best execution, requiring all sufficient steps, rather than removing it.
- It restricted the transparency regime to equity instruments only, abandoning the rules for other instrumentsWhy not: MiFID II extended transparency to non-equity instruments such as bonds and derivatives, not restricted it.
- It created organised trading facilities and extended transparency beyond equities - correct
MiFID II added the organised trading facility category and extended pre- and post-trade transparency and trading rules beyond equities. Client categorisation and best execution already existed and were reinforced.
A harder one
A European bank receives a telephone order from a retail client who asks it to buy a structured note with a capital-at-risk feature. The bank gave no advice and the order is at the client's own initiative. Under MiFID rules, which action is required?
- Assess appropriateness and warn the client if the product looks inappropriate - correct
- Carry out a full suitability assessment covering the client's financial situation and investment objectivesWhy not: Suitability applies to advice and portfolio management; this is execution-only, so only appropriateness is assessed.
- Execute with no assessment, because any execution-only order is exempt from testingWhy not: The exemption covers only non-complex products; a structured note is complex, so appropriateness must be assessed.
- Refuse the order, because retail clients may never buy complex productsWhy not: MiFID does not ban sales of complex products to retail clients; it requires a warning when the product is not appropriate.
Execution-only orders in complex instruments trigger the appropriateness test, not the suitability test. If the client lacks the knowledge and experience, the firm must warn but may still proceed at the client's insistence.
The hardest tier
A US asset manager enters a highly customised interest rate swap with a dealer. The swap is not accepted for clearing by any clearing house and is not made available to trade on a swap execution facility. Which statement best describes the requirements under Dodd-Frank Title VII?
- The swap must be cleared through a central counterparty because all swaps must be clearedWhy not: Only swaps that a clearing house accepts and the regulator requires to be cleared are subject to the mandate; customised swaps are not.
- The swap must be traded on a swap execution facility to satisfy the trading mandateWhy not: The trading mandate applies only to swaps that are subject to clearing and made available to trade.
- It stays bilateral but is reported to a swap data repository; margin rules may apply - correct
- The swap is outside Dodd-Frank, because customised swaps are exempt from reportingWhy not: Reporting applies to all swaps, cleared or not; customisation does not give an exemption.
Dodd-Frank pushes standardised swaps to clearing and SEF trading but leaves customised ones bilateral. All swaps are reported to swap data repositories, and uncleared swaps face margin and dealer-registration requirements.
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