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Regulation’s Guidance on Investment Advice: Directions for Digitalisation

© Joachim Löning

The regulatory requirements for investment advisory processes have become more and more sophisticated in recent years. Advice should be honest, fair and in the best interests of the customer. But why does it take legislation to regulate something that goes without saying? Because investment advice costs money. Since money, in turn, is a powerful behavior amplifier, possible conflicts of interest to the detriment of the customer should be ruled out. In this article, we would like to take a closer look at the legal conditions under which fees are fair and permissible in the eyes of the regulator.

The introduction of the German Securities Trading Act (WpHG) in 1994 represented the first comprehensive set of regulations for the protection of investors’ interests in Germany. In this context, tetralog was the first provider on the German market to start offering scientifically based methods for matching financial investments and customer profiles. Today, we continue to support securities service companies with our market experience and matured software architecture for systematic investment advice.

Fee Models as Incentive Systems

Fee models or payments from customers can be understood as incentive systems because they lead to benefits for advisors and advising companies. Such incentives are used to induce advisors. However, if advisors only recommend products that are profitable for them but not suitable for the customer, this would not be in the customer’s interest and should therefore be avoided.

The fee-based consulting model generates a remuneration that is usually calculated as a one-off amount independent of the investment amount. The legislator refers to fee-based consulting as “independent” consulting, although conflicts of interest also arise in this consulting relationship. That points already to the fact that Regulation is not free from evaluating basic attitudes. The consulting relationship in commission-based consulting is described as “non-independent” or “dependent”.

In the model of commission-based consulting, the benefits typically consist of a one-off amount at the beginning and a further amount that accrues during the term – both of which are calculated relative to the amount invested. As has been the case since the early days of regulation, the obligation to match client and product also applies here, and all fees (and thus the commission paid) must be disclosed once a year.

A more in-depth look at both advisory relationships can be found in an overview here: Whitepaper “Future of Consulting” by KPMG. Let’s take a brief look at the two main incentive systems in practice.

“Independent” Advice (Fee-Based Advice): Too Expensive

Customers like personal advice on investing because they think the subject of money is complicated. However, if you ask customers what price they would be willing to pay for personal advice, it reveals a significant gap with the price demanded on the market. In other words, the price demanded for personal advice is so high that retail customers are generally unwilling or unable to pay it. In the United Kingdom, the ban on commission-based advice has consequently meant that only relatively wealthy customers tend to use personal advisory services. Retail clients are also not well reached by alternative offerings such as robo-advisory or other self-service services, and are now considered structurally underserved (see, e.g., “Mind the advice gap,” in: money marketing, Jan., 10th, 2022).

Commission-Based (“Non-independent”) Advice: Underperforming

The national beginnings of regulation, as well as the European MIFID II framework in force today, are based on the desire to promote competition among providers while ensuring high product and service quality for as many customers as possible. In addition, commissions must be disclosed. In the customer’s interest, added value should be created for commissions collected and an improved quality of service ensured. If these requirements are met, then commissions are to be regarded as fair and permissible.

Value-Added Services Worth The Money

Disclosure is not enough: The amount of commissions and the client value of the consideration provided by investment advisory firms must be proportional to each other. In order to receive regular payments, the minimum requirement imposed by the regulator is to provide clients with multi-value tools or periodic reports so that they can monitor and adjust the financial instruments sold to them themselves. Alternatively, this service can be provided through annual monitoring and reporting. Receiving permanent benefits for a one-time service is thus prohibited.

Transparency, proportionality and minimum requirements: The set of required quality improvements for the receipt of commissions is set out in the “Regulation on the Concretization of the Rules of Conduct and Organizational Requirements for Securities Services Companies” The required quality improvement for the collection of commissions is specified in the “Verordnung zur Konkretisierung der Verhaltensregeln und Organisationsanforderungen für Wertpapierdienstleistungsunternehmen” (WpDVerOV § 6 Zuwendungen), but also in the explanations of ESMA, the European Securities and Markets Authority. The following are specific value-added services that justify commissions:

  • Access to a wide range of suitable financial instruments from independent providers (“Open Architecture”).
  • Ongoing advice on recommended products.
  • Annual assessment of the fit between client and recommended securities (Suitability Monitoring I).
  • Optimal structuring of assets (Suitability Monitoring II). Portfolio analytics should not only be carried out on asset classes, but should also take into account the investment instruments in the portfolio of the respective customer in detail.
  • Decision-making procedures, for example, by monitoring financial instruments and adjusting them as necessary.
  • Providing research that enables clients to better assess the current market situation.
  • Providing ESG expertise and sustainable or impact-oriented products is a value-added service for all customers with sustainability preferences.
  • Create access for broad customer groups, e.g., through a branch network with advisors.

The rule for all adding value services is that they should be specific, i.e. individually tailored to the respective customer, and actively offered on an ongoing basis. The added value of transaction recommendations must be quantified in advance (“ex ante”) and shown transparently.

However, if it is a one-time contact and the multi-value service required for a provision cannot be provided on an ongoing basis in person by the advisor, digital tools should be made available to the customer. These can be simulation tools, online calculators, and automated reports that help the client monitor and adjust their financial instruments as needed.

How It Can Work

The new Best Fit service from tetralog may serve as an example of value-added digital services. It translates the current portfolio and profile data of the individual customer into a selection of suitable financial instruments and then uses research and market scenarios to determine appropriate buy, hold and sell recommendations for the situation.

The Next Best Action algorithm used takes into account all relevant parameters and all products available to the sales organization for optimization or rebalancing. A buy or sell recommendation is only made if the customer portfolio gains an ex ante demonstrable improvement..

Best fit transaction suggestions can be communicated to customers via advisor cockpits, online tools, personal dashboards, apps and also conversational tools, so that all customer segments, user groups and fee models can benefit. The entire process is documented in the backend in compliance with regulations, so that any reports can be generated.

Regulation as a Functional Driver of Digitization

IIn the currently valid set of rules and the implementation examples for investment advice, the effort to achieve high quality is expressed at the level of the individual portfolio. Functionally, the focus is on the suitability of specific transaction proposals, as is also customary for services available to wealthy private customers, e.g., in family offices. The required service also includes the management of the investment over time, i.e., at best also with a view to the investor’s personal goals.

The tangible regulatory intent of a proportional correspondence between fee and service makes investment advice along the investor’s objectives a logical next step. Financial services companies that have the research and market expertise to map asset allocation over time are in pole position in the race for high-quality, mass customization of investment advice.

Regulatory Regime as a Quality Benchmark for Systematic Investment Advice

In their clarity, the regulatory requirements make the idea behind the regulatory requirements tangible. They are direct input for the digitization strategy of financial service providers. In view of the diverse scientific disciplines that have been incorporated into the design of the regulatory framework, the European regulatory framework discussed here can be used generically, i.e., it is also viable in other regulatory regimes. Systematic investment advice understood in this way represents a sustainable investment in the quality of advice and increases efficiency in sales.

With the tetralog finance backend, the suitable services library is available for all value-added processes of customer-specific investment advice. The consistent view of the fit between customer and portfolio leads to secure and steady commission income. The customer can trust his advisor because the advice is honest, fair and in his best interest, as required.

Dr. Lothar Jonitz & Matthias Brabetz

München, 26th of March, 2ß22

To get started with systematic investment consulting, we recommend an analysis of business potential of your customer base. Results can be directly used to create more suitable customer portfolios and greater success in the active securities business.

Weiterführende Links:
Gesetz über den Wertpapierhandel (WpHG)
KPMG Whitepaper „Zukunft der Beratung“
„Mind the advice gap“, in: money marketing, Jan., 10th, 2022

Potenzialanalyse von tetralog systems
Q&A der ESMA zu MiFID II und MiFIR

Wertpapierdienstleistungs-Verhaltens- und -Organisationsverordnung (WpDVerOV) § 6 Zuwendungen)


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