Demonstrating suitability and appropriateness in relation to MiFID II

January 28, 2021
Greg

Greg

Globally recognised expert in applied decision science, behavioural finance, and financial wellbeing, as well as a specialist in both the theory and practice of risk profiling. He started the banking world’s first behavioural finance team as Head of Behavioural-Quant Finance at Barclays, which he built and led for a decade from 2006.

Much like the standards set by the FCA in 2011, for the UK market, advisory firms wishing to do business in Europe will be required to fulfil these new requirements. However, under MiFID guidelines, the suitability and appropriateness standards will also apply to 'Rob-advisers', a major difference to existing standards. MiFID II equates the responsibility of advice to all providers, irrespective of how they interact with the investor.

This is most likely a response to the boom in fintech firms, and the confirmation of the anticipated shift of investors to robo-advice rather than traditional face-to-face advice, that was much discussed in the aftermath of the financial crisis. Considering the number of recently launched online investment services, particularly those offering 'robo-advice', it is unsurprising that regulation is expanding the responsibility of suitability to this segment as well.

To abide by the regulation, advisory firms will need to provide a suitability report for retail clients. The report mostly consists of elements which can be easily provided by the firm, such as continuous reporting on the investor journey, and the value of their investments over time. The challenge, and concern for most, arises from determining suitability, specifically including 'risk tolerance and ability to bear losses', or risk capacity.

Appropriateness must be determined when the investor is proven to be an experienced investor, defined by their current or previous employment, or relevant education. In this case, the suitability analysis is reduced.

These elements require specialist understanding of how to be properly and defensibly assessed. When correctly appraised, they can provide the foundation of fulfilling the suitability requirements. Many firms are currently unable to meet these requirements internally, and will require additional support to ensure compliance.

You can find out more information on the specifics of the new policy on the ESMA website:  https://www.esma.europa.eu/policy-rules/mifid-ii-and-mifir

Fortunately, we are able to offer solutions to the compliance requirements. The Oxford Risk Rating Online (ORRO) platform is an investor risk rating system that covers attitude to risk, capacity for loss and knowledge & experience. It also retains a record of all assessments for future referencing and comparison.

During the suitability assessment process, the adviser will ask pertinent questions regarding the investor's objectives and personal circumstances with reference to investment. For fintech firms, this can pose an issue as the investor will be using their system without a face-to-face advisor. In this instance, the most appropriate option would be for the advisor firm to use our IP and to integrate ORRO into their own platform. This would grant access to our Risk Tolerance Assessments, and our Suitability analysis, which in unison provide a defensible and empirically derived risk profiling process. Once the investor has answered their risk tolerance assessment, the calibrated output will indicate which investment option available would be generally preferred by similar investors.

For advisor firms that do not operate as a fintech, the standard ORRO platform is generally the ideal solution although some firms prefer to integrate the IP into their own system, either option is available.

ORRO uses a psychometric questionnaire as the basis for determining the investor's attitude to risk, built of years of academic research in collaboration with the University of Oxford. Our Suitability Analysis uses continues research of investor preferences to test which risk level/portfolio would be generally preferred by investors in each risk tolerance categories. Oxford Risk has extensive experience in providing best practice risk profiling processes to 'robo-advisers', and working with such firms to ensure a growing understanding and monitoring of the behaviour and preferences of their investor clients. Our diligence to defensible academic research that is industry appropriate has led to Oxford Risk being one of the most respected authorities on investor risk tolerance profiling.

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