It’s that time of the year again. With the festive season behind us, initiatives blossom and produce another evergreen: the European Commission wants to push for an EU-wide ban on inducements for investment advice.
Some may recall that this is not a novel debate. In fact, prohibiting investment advisors from receiving inducements has been on the table since a decade ago, when the European Commission first proposed what would become MiFID II. Back then, the compromise was to establish a separate label of “independent” investment advice reserved for those advisors who do not accept inducements from third parties, but instead charge fees to provide advice. As the black-letter law states (Art. 24(7)(b) MiFID II):
“Where an investment firm informs the client that investment advice is provided on an Independent basis, that investment firm shall (…) not accept and retain fees, commissions or any monetary or non-monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the provision of the service to clients.”
Alas, the compromise did not deliver on its promise or, as Financial Commissioner Mairead McGuinness puts it: “Our evidence indicates that, despite its original intention, MiFID II has not led to a shift towards independent advice and that inducements-based distribution remains the principal model for the sale of retail investment products.”
And with that the spectre of prohibition is back. Shortly before Christmas, in a letter to senior member of the European Parliament Markus Ferber, McGuiness expressed her preference for introducing a ban on inducements for investment advice in the context of the upcoming Retail Investment Strategy, which is itself part of the European Commission's Capital Markets Union agenda. The legislative proposals could still be published in the first quarter of 2023.
Why is the Commission uncomfortable about inducements?
Inducements are paid by product providers/issuers to investment advisers. They may take different forms, and in their simplest may mean merely that a product provider pays an investment adviser for each referral that results in a client investing into the product providers’ financial instrument.
Opponents of inducements argue that inducements create an inherent conflict of interest for the advisor: if the advisor receives a remuneration from a product provider or issuer for recommending his products, the amount of the inducement may influence which contracts are recommended. Rather than recommending the product that is most suitable in light of the client’s knowledge and experience, financial situation or investment objectives, critics argue that an advisor will recommend what is most lucrative for them. And, while clients may not pay fees to their advisors, they may suffer from more expensive products. In her letter, McGuinness refers to studies that show that products for which sales incentives are paid are on average about 35 per cent more expensive than investment products for which no such sales incentives are paid.
However, the Commission is facing opposition. In his response letter addressed to McGuiness on 9 January 2023, German MEP Ferber, who considers inducements to count as a tangible benefit for consumers, calls for a prudent approach. He argues that the only way small-scale retail customers can get access to investment advice is by going the route of non-independent advice that is partially funded by inducements. Besides, he argued, banning inducements would stop a major source of revenue for banks, which is often used to subsidise branches. Ferber is supported by industry associations and other Member States such as Germany.
While an EU-wide ban would be unchartered territory, some countries have already banned the receipt of inducements under their national implementation. In the EU, the Netherlands has since 2014 prohibited investment firms from providing or receiving any fees relating to the provision of investment services to a non-professional client, while the UK’s ban on inducements for retail investment advice was introduced in 2012. Not a bad precedent, or so the European Commission thinks, as McGuiness argues that product costs in both countries have fallen following the introduction of the inducement ban. In contrast, Ferber emphasises that the practice currently applied in the 26 EU Member States that have not banned inducements is a more relevant reference point.
McGuinness’ position finds support from the European Securities and Markets Authority (ESMA), which generally shares concerns that providing (more) transparency to clients about the level of inducements received by their advisors does not contribute substantially to a well-informed investment decision since retail investors would often not understand the concept and impact of commissions on their investments.
However, in its technical advice, ESMA took a nuanced approach on a potential ban on inducements, and encouraged the Commission to conduct further analysis on the topic rather than banning inducements altogether. The insurance regulator, EIOPA, also advised the EU Commission in its technical advice on retail investor protection to do more to address harmful conflicts of interest but rejected a binary solution between banning or not banning, and rather advocates combining different policy instruments.
The Insurance Distribution Directive
Speaking of insurance, in contrast to MiFID II, the Insurance Distribution Directive (IDD) has only a rudimentary approach to the receipt of commissions. Insurance undertakings and insurance intermediaries must ensure the payment or receipt of commissions does not have a detrimental impact on the quality of their services and does not impair compliance with their duty to act in the best interests of their customers (cf. Art. 29 (2) IDD). Furthermore, it is not required that the commission enhances the quality of the service to the client. However, the Commission had already planned to start an evaluation of parts of the IDD in 2022. One focus will be on Chapter 6 (insurance-based investment products including the above-mentioned inducement regime) with the aim of aligning the IDD more closely with the MiFID II framework. However, a proposal for a review of the IDD has not yet been published.
Stakeholders from the insurance industry are also getting involved in the debate about a commission ban: Insurance Europe, the European insurance and reinsurance federation, has launched a position paper to explain why an outright EU-wide ban on inducements would limit consumers’ access to financial advice, and so undermine the goals of the Retail Investment Strategy. Instead, a combination of measures promoting transparency, value for money principles in product design and financial education would deliver more tangible benefits to consumers.
The discussion in the insurance sector is not yet as advanced as the discussion for investment services. However, we expect preparatory action coming from EIOPA/Commission in 2023 since the revived discussion on banning inducements for investment advice and the outcome of the debate on the payment for order flow will certainly affect the way forward in the insurance space.
That being said, one question inevitably comes up, namely; what about the ‘other’ inducement ban?
The EU’s ‘other’ inducement ban
The ‘other’ debate on inducement bans is slowly grinding towards its conclusion: the proposed EU-wide ban of payments for order flow (PFOF).
PFOF is the compensation that a brokerage firm receives from an execution venue – often a market maker – for directing orders of its clients to a specific party for trade execution. PFOF features most prominently in the retail brokerage market and has become a regular element in the price model of online or ‘neo’ brokers. Where retail brokers have eliminated trading commissions to offer ‘zero commission trading’, PFOF often constitutes one of if not the most significant source of revenue.
First introduced as part of the Commission’s proposal to revise MiFIR in 2021, the PFOF ban has been the subject of considerable debate in the Council, revealing a rift between those Member States in favour of the ban (in particular France and the Netherlands) and those opposed (in particular Germany), with both sides conducting their own empirical studies to assess the impact of PFOF on the execution price of client orders (such as the Dutch regulator AFM and the German regulator BaFin). After the French presidency failed to mediate a common ground solution, the Czech presidency forced a compromise to break the deadlock. According to the Council proposal, investment firms are prohibited from receiving PFOF for the routing of client orders in shares or ETFs to a particular venue, but Member States may deviate in respect of retail clients in that Member State.
The EP is expected to set out its position by the end of January 2023 and it remains to be seen if the EP will come to a stricter approach than the Council and back the European Commission’s original proposal for a complete ban. Once the EP has set out its position, the co-legislators will start trilogue negotiations with a view to agreeing a final position in Q2 of 2023.
Our evidence indicates that, despite its original intention, MiFID II has not led to a shift towards independent advice and that inducements-based distribution remains the principal model for the sale of retail investment products. Mairead McGuinness, Commissioner for financial services, financial stability and Capital Markets Union