A pair of proposals pertaining to execution-only services put forth by the European Commission (EC) in its working review of the Markets in Financial Instruments Directive (MiFID) has recently created quite a stir amongst self-directed investors and brokers. Whilst the intention of these proposals is benign (they are intended to protect investors) the reasoning behind them seems narrow and short-sighted. And if implemented, either of these proposals could ultimately harm investors.
The first of the proposals put forth by the EC would introduce a “differentiation” for UCITS “in order to further refine the categories of instruments which may be subject to the execution-only regime.” Under the current framework, UCITS are always classified as “non-complex” instruments, and as such, investors utilising execution-only services to trade these instruments are not presently subject to a suitability test to assess their level of knowledge and experience. “Option A” put forth by the Commission would place the “complex” label on certain UCITS-compliant products “in order to take into account the adoption of complex portfolio management techniques in the management of some UCITS.” This “complex” label would be slapped on all exchange-traded products (ETPs). Consequently, investors wishing to use execution-only services to transact in these instruments would be subject to suitability tests.
“Option B” in the EC’s review is borderline draconian, as it “implies abolition of the execution only regime.” This option would leave investors using execution-only services to purchase any and all funds or shares subject to suitability tests.
The implementation of either of these options would ultimately have adverse side effects. First and foremost, the additional costs of administering these suitability tests would initially be borne by the brokers, but it is virtually certain that they will ultimately seek to pass this burden onto their investor customers.
Blindly erecting barriers to investment in ETPs will ultimately harm investors. Failing to distinguish amongst the various ETP structures and their underlying exposures would be a massive mistake. Of course there are ETPs with more complex structures that offer limited investor protection in the event of a sponsor’s default that do require an additional layer of due diligence on the behalf of investors. Un-collateralised exchange-traded notes (ETNs), which are unsecured debt obligations of their issuing bank, are a prime example. The same goes for some of the more complicated and often misunderstood exposures offered by these products. High profile examples of these more complex strategies include leveraged and inverse products, those tracking commodity futures indices, and those linked to volatility indices. But it is important to remember that the vast majority of ETP assets reside in very simple, transparent, and low-cost vehicles that are suitable for virtually all investors.
Furthermore, it is important to note that suitability tests already exist for many of those exchange traded products (ETPs) that could be defined as having very narrow suitability (some of which we’ve listed above) and are only appropriate for those investors that understand the complexities of these structures and acknowledge that they are not meant as long-term stand-alone investments. Expanding these tests beyond this very narrow segment of the market would ultimately be a disservice to ETP investors. Any expansion would serve as a barrier to participation, and ultimately reduce the pool of potential liquidity in shares of ETPs that are perfectly suitable for a broad array of investors. Preventing broader participation in the ETP market would ultimately lead to higher liquidity costs for all investors.
Matters of suitability are best addressed by individual investors or their advisers. Any moves to erect additional barriers to broader participation in the ETP market are unwelcome and would ultimately be detrimental to all investors.
This article was first published in Investment Adviser magazine. Ben Johnson is Director of European ETF Research with Morningstar.
