Response to ESMA's guidelines on certain aspects of the MiFIDII

Following amendments to the MiFID II Regulation with regard to ESG financial products, the ESMA opened a public consultation in order to complete and update its guidelines. At Neuroprofiler, we are keen to make the coming impactful legal framework more accessible and clearer for all stakeholders.

Hence, we are particularly involved in the ESMA’s events and communications. This is why we seized the chance to address them our observations about their guidelines.

Here is the copy of our response to the ESMA’s consultation.

Q1. Do you agree with the suggested approach on the information to clients about the purpose of the suitability assessment and its scope? Please also state the reasons for your answer.

We agree that investors should be informed about the purpose of the suitability assessment.

Given the very limited general level of financial literacy of retail investors^[1], we are convinced that investors should also be educated about the notions of sustainability, Environment, Social and Governance (ESG) and about the different objectives of the Taxonomy (biodiversity, circular economy…).

Q2. Do you agree with the new supporting guideline in relation to the information to clients on the concept of sustainability preference or do you believe that the information requirement should be expanded further? Please also state the reasons for your answer.

Current guidelines are very helpful to understand what is expected by the regulator. However, some clarifications are necessary.

Difference between a), b), c)

For instance, regarding article 1 of the Delegated Act 2021/1253, it would be interesting to know more about the difference between point a (Taxonomy Regulation) and point b (SFDR Regulation). More precisely, does point b) include the Taxonomy Regulation or is it completely independent from point a)? If so, this means that the minimum proportion of alignment to the Taxonomy should be systematically lower than the percentage of alignment to point b).

Flexibility in term of matching regarding Taxonomy alignment

We would also like to question the ESMA about its position regarding the allowed margin of error in the matching between the sustainability preferences of an investor and the financial product. For instance, if an investor wants a product with a minimum proportion of alignment to the Taxonomy equal to 80%. This percentage is extremely high and even impossible to find on the current market. Let’s imagine that the most sustainable product that can be offered in his/her financial institution has a proportion of alignment to the Taxonomy of 20%, which is already very high given what is available on the current market, could this product be recommended without asking the client to update his/her sustainability preferences?

Flexibility regarding the PAIs

Let’s imagine that an investor wants 4 PAIs to be considered in his/her investment and that one of the financial products offered by his/her financial institutions takes 3 out of these 4 PAIs into consideration. This is already a very good matching given the multiple combinations of possible PAIs and the current ESG market. In such a situation, could the product be recommended without asking the client to update his/her sustainability preferences?

If not, given the numerous potential combinations of ESG characteristics (between PAIs, SFDR and Taxonomy alignment), the matching between the investors’ preferences and the financial products will most probably be impossible, which would lead systematically to the modification of the investors’ preferences.

This will be a source of strong frustration and can have the perverse effect of discouraging investors to share their sustainability preferences if they know that they will have to modify them anyway at the end of an already long questionnaire.

Categorization of PAIs

Which categorization of PAIs should be used? The EIOPA guidelines about the assessment of sustainability preferences, published in April 2022, suggests a first list while some local regulators, like in Germany or Spain, have published their own approach.

Then, how to do the matching with the financial products? If an investor wants to take into consideration the category A of PAIs and if a financial product considers only one PAI of the category A, can the investor be recommended the product without asking him/her to update his/her preferences?

Reference base for portfolio

If a virtual portfolio includes two funds: one fund considering all the PAIs and another fund which does not consider any PAI. Which PAIs do the portfolio take into consideration globally?

The EIOPA’s position on this point is that the whole portfolio should be considered as taking into consideration the PAIs, even if this is the case for only one of its funds.

Does the ESMA adopt the same position?

Taxonomy alignment and the market

If not, the risk is that the offer will systematically not correspond to the investors’ preferences. Most investors will indicate that they want a 100% alignment to the Taxonomy if there is no tradeoff in terms of profitability, pricing or risk.

This will be a great source of frustration for advisors and clients to have quasi-systematically to ask to clients to modify their sustainability preferences.

Hence, what is the flexibility margin in the matching of investors’ sustainability preferences and the recommended financial products?

Q3. Do you agree with the suggested approach on the arrangements necessary to understand clients and specifically with how the guideline has been updated to take into account of the clients’ sustainability preferences? Please also state the reasons for your answer. Are there other alternative approaches, beyond the one suggested in guideline 2, that you consider compliant with the MiFID II requirements and that ESMA should consider? Please provide examples and details.

The ESMA in its last recommendations said that investors’ sustainability preferences can be assessed through self-assessment.

This is not very consistent with the previous recommendations about the assessment of risk preferences and financial knowledge. It is moreover in contradiction with findings from the behavioral finance and psychometric literature which underline that many cognitive and implicit biases influence our sustainability preferences and that self-assessment will most of the time fail to capture investors’ true sustainability preferences.^[2]

Q4. Do you believe that further guidance is needed to clarify how firms should assess clients’ sustainability preferences?

Current guidelines are very helpful to understand what is expected by the regulator regarding clients’ sustainability preferences assessment.

However, some elements are still not clear.

Difference between a), b), c)

For instance, regarding the article 1 of the Delegated Act 2021/1253, it would be interesting to know more about the difference between point a (Taxonomy Regulation) and point b (SFDR Regulation). More precisely, does point b) include the Taxonomy Regulation or is it completely independent from point a)? If so, this means that the minimum proportion of alignment to the Taxonomy should be systematically lower than the percentage of alignment to point b).

Categorization of PAIs

Which categorization of PAIs should be used? The EIOPA’s guidelines about the assessment of sustainability preferences, published in April 2022, suggests a first list while some local regulators, like in Germany or Spain, have published their own approach.

Reference base for portfolio

If a virtual portfolio includes two funds: one fund considering all the PAIs and another fund which does not consider any PAI. Which PAIs do the portfolio take into consideration globally?

The EIOPA’s position on this point is that the whole portfolio should be considered as taking into consideration the PAIs, even if this is the case for only one of its funds.

Does the ESMA adopt the same position?

Taxonomy alignment and the market

Qualitative and quantitative elements to qualify PAI

In the EIOPA’s guidelines published in April 2022, the regulator recommends to ask to the investor the list of PAI s.he wants to take into consideration and to explain for each of them the qualitative and quantitative elements as mentioned in point c).

The ESMA is not very clear on this point.

Is it sufficient to capture the list of PAI (or PAI categories) that the investor wants to consider or is it necessary, on top of that, to ask to the client the quantitative and qualitative elements he wants to use to qualify the PAI?

The second approach would be extremely abstract and difficult to understand for retail investors. The requirements to assess sustainability preferences are already extremely complex and granular given the current ESG market and the level of financial education of retail investors.

Our view is thus not to take the approach of the EIOPA but rather to ask only to financial institutions to capture the PAIs that the investor wants to take into consideration without more details at this stage.

Q5. Where clients have expressed preference for more than one of the three categories of products referred to in letters a), b) or c) of the definition of Article 2(7) of the MiFID II Delegated Regulation, do you think that the Guidelines should provide additional guidance about what is precisely expected from advisors when investigating and prioritizing these simultaneous / overlapping preferences?

Current guidelines are very helpful even if some clarifications would be necessary.

Difference between a), b), c)

Matching between preferences and products

If clients express sustainability preferences for a), b), and c), a configuration which would be very frequent based on our latest surveys about the appetence of retail investors for sustainability[3], the number of possible combinations would be very high (at least more than 1000, if we multiply the constraints of the list of PAIs and the percentages of Taxonomy/SFDR alignment). If we add the additional elements like risk appetite and financial expertise, the number of possible investment profiles will rapidly increase to more than 10 000…

Even when more data about financial products will be available, a major challenge for financial firms will be to match this very granular profiles with products. Very few financial institutions can offer more than 10 000 different products to retail investors.

Our suggestion is to give further details in the final guidelines about the level of flexibility which is allowed for this matching and the possibility to use a more qualitative approach for a) and b).

For instance, if a client wants an alignment to the Taxonomy of 50%, it could be in the category “High interest for the Taxonomy” corresponding to a range of alignment of “20%-100%”. If a client wants an alignment to the Taxonomy of 7%, it could be in the category “Medium interest for the Taxonomy” corresponding to a range of alignment of “5%-100%”.

As for the assessment of risk appetite today, these ranges could be determined by the firm based on their offer and types of clients.

Categorization of PAIs

Which categorization of PAIs should be used? The EIOPA published in April 2022 a first list and some local regulators, like in Germany or Spain, have published their own approach.

Then, how to do the matching with the financial products? If an investor wants to take into consideration the PAI category A and if a financial product considers only one PAI of the meta-category A, can the investor be recommended a product without asking him/her to update his/her preferences?

Reference base for portfolio

If a virtual portfolio includes two funds: one fund considering all the PAIs and another fund which does not consider any PAI. Which PAIs do the portfolio take into consideration globally?

The EIOPA’s position on this point is that the whole portfolio should be considered as taking into consideration the PAIs, even if this is the case for only one of its funds.

Does the ESMA adopt the same position?

Taxonomy alignment and the market

Currently, on the market, the maximum percentage of the Taxonomy alignment of financial products is often around 20%. Thus, is it possible to limit the investors’ preferences to this percentage? If not, the risk is that the offer will systematically not correspond to the investors’ preferences. Hence, what is the flexibility margin in the matching of investors’ sustainability preferences and the recommended financial products?

Qualitative and quantitative elements to qualify PAI

In the EIOPA guidelines published in April 2022, the regulator recommends to ask to the investor the list of PAI s.he wants to take into consideration and to explain for each of them the qualitative and quantitative elements as mentioned in point c). The ESMA is not very clear on this point. Is it sufficient to capture the list of PAI (or PAI categories) that the investor wants to consider or is it necessary on top of that to ask to the client the quantitative and qualitative elements he wants to use to qualify the PAI?

Our view is thus not to adopt the approach of the EIOPA but rather to ask only to financial institutions to capture the PAIs that the investor wants to take into consideration without more details at this stage.

Q6. Do you agree with the proposed approach with regard to the assessment of Sustainability preferences in the case of portfolio approach? Are there alternative approaches that ESMA should consider? Please provide possible examples.

If a fund included in a portfolio does consider a given PAI, should we consider that the whole portfolio does consider this specific PAI? The EIOPA in its guidelines privileges this approach. Does the ESMA follow the same approach?

Additionally, we would suggest the guidelines to explain more precisely how to calculate the level of alignments for point a) and b) in the case of a portfolio. The EIOPA guidelines mentions the weighted average methodology. Does the ESMA follow the same approach?

Q7. Do you agree with the suggested approach on the topic of ‘updating client information’? Please also state the reasons for your answer.

We completely agree with the suggested approach to update clients’ information frequently. Research in cognitive science have shown indeed that, as for risk preferences, sustainability preferences (and more generally social values) evolve in time. A frequent reassessment (every year or for every new transaction) is thus necessary.

Q8. Do you agree with the suggested approach with regards to the arrangements necessary to understand investment products? Please also state the reasons for your answer.

Recent academic research and surveys have underlined the low level of financial literacy in Europe and the urge for more financial education. For a better protection of the investors, it is essential for them to understand the mechanisms of the products in which they invest, not only complex products, but also simple products (fund, shares, bonds…).^[4]

We are thus strongly in favor of promoting financial education, especially for retail investors. Financial education could be the responsibility of the advisor or could be supported by a digital e-learning platform, potentially gamified, to make learning more interactive and attractive.

Q10. Do you agree with the additional guidance provided regarding the arrangements necessary to ensure the suitability of an investment concerning the client’s sustainability preferences? Please also state the reasons for your answer.

Current guidelines are very helpful even if some clarifications would be necessary.

Matching between preferences and products

If clients express sustainability preferences for a), b), and c), a configuration which would be very frequent based on our last surveys about the appetence of retail investors for sustainability[5], the number of possible combinations would be very high (at least more than 1000, if we multiply the constraints of the list of PAIs and the percentages of Taxonomy/SFDR alignment). If we add the additional elements like risk appetite and financial expertise, the number of possible investment profiles will rapidly increase to more than 10 000…

Even when more data about financial products will be available, a major challenge for financial firms will be to match this very granular preferences and profiles with products. Very few financial institutions offer more than 10 000 products to retail investors.

Our suggestion is to give further details in the coming guidelines about the level of flexibility which is allowed for this matching and the possibility to use a more qualitative approach for a) and b).

Taxonomy alignment and the market

Qualitative and quantitative elements to qualify PAI

Q11. Do you agree with the approach outlined with regards to the situation where the firm can recommend a product that does not meet the client’s preferences once the client has adapted such preferences? Do you believe that the guideline should be more detailed? Please also state the reasons for your answer.

Given the dispositions of the regulation, the adaptation of the investors’ sustainability preferences will be quasi-systematic given:

The lack of ESG information about most products, at least until 2023;
The still limited number of sustainable financial products considered as such under MiFID II available on the market for retail investors;
The granularity of the assessment required by the regulator and its rigidity regarding the product matching (potentially more than 10 000 possible combinations if no flexibility is allowed).

This adaptation, if it becomes quasi-systematic, could generate strong frustration amongst advisors and clients. Asking to a client to change his or her sustainability preferences is very intimate and even aggressive. Investors do not expect their financial advisor to ask them to change their values and deep believes. This can have different perverse effects such as:

The non-application of the regulation by some financial institutions
The incentive for advisors to discourage their clients to share their sustainability preferences, to avoid to spend 5/6 minutes on a technical questionnaire, knowing in advance that the client will have anyway to modify his/her preferences in the end because no products will match in details his/her preferences.
The incentive for the clients to say that s.he has no sustainability preferences, to avoid to take a long and complex questionnaires, knowing in advance that no suitable products will be recommended in the end.

Our suggestion will be to either simplify the current regulation to avoid the situation where no suitable products are available (see our suggestions in the previous questions: use of ranges, flexibility in terms of PAIs…) and/or to ask to the client to sign a suitability report, where the differences between his/her preferences and the product are clearly described, but without asking him/her to change his/her sustainability preferences (which will be the equivalent of changing a personality and personal values).

Q12. Do you agree with the approach outlined with regards to the situation where the client makes use of the possibility to adapt the sustainability preferences? Please also state the reasons for your answer.

Given the dispositions of the regulation, the adaptation of the investors’ sustainability preferences will be quasi-systematic given:

The lack of ESG information about most products, at least until 2023;
The still limited number of sustainable financial products considered as such under MiFID II available on the market for retail investors;
The granularity of the assessment required by the regulator and its rigidity regarding the product matching (potentially more than 10 000 possible combinations if no flexibility is allowed).

This adaptation, if it becomes quasi-systematic, could generate strong frustration amongst advisors and clients. Asking to a client to change his or her sustainability preferences is very intimate and even aggressive. We do not expect our financial advisor to ask us to change our values and deep believes. This can have different perverse effects such as:

The non-application of the regulation by some financial institutions
The incentive for advisors to discourage their clients to share their sustainability preferences, to avoid to spend 5/6 minutes on a technical questionnaire, knowing in advance that the client will have anyway to modify his/her preferences in the end because no products will math in details his/her preferences.
The incentive for the clients to say that s.he has no sustainability preferences, to avoid to take a long and complex questionnaires, knowing in advance that no suitable products will be recommended in the end.

Q13. Could you share views on operational approaches a firm could use when it does not have any financial instruments included in its product range that would meet the client’s sustainability preferences (i.e. for the adaptation of client’s preferences with respect to the suitability assessment in question/to the particular transaction and to inform the client of such situation in the suitability report)?

See further elements in our response at Q12.

Currently, the recommended process generates frustration for the investors who have to spend 10 minutes on a questionnaire to finally, in most cases, have to update their preferences to correspond to sustainable financial products considered as such under MiFID II Regulation available on the market.

Even though more flexibility would be appreciated, we imagined two ideas to compensate the generated frustration:

1^st approach: If an investor’s sustainability preferences assessment highlights that s.he wants a 100% Taxonomy-aligned investment (which is almost impossible), consider that the client has a very high interest for Taxonomy-aligned financial products and then recommend him/her the available product with the highest Taxonomy-alignment rate without asking the investor to modify his/her preferences;
2^nd approach: Offer investors the possibility to sign a disclaimer through which the characteristics of the product would be explained clearly and through which they would acknowledge that the recommended financial product does not match with their respective sustainability preferences assessment, without having to modify their sustainability preferences in a view to avoid frustration.

Q14. Do you agree with the proposed approach for firms to be adopted in the case where a client does not express sustainability preferences, or do you believe that the supporting guideline should be more prescriptive? Please also state the reasons for your answer.

It is not clear in the current guidelines if an investor can have the possibility to skip the questionnaire about sustainability preferences assessment or not. We would like the ESMA to give its position about that.

Also, it would be interesting to know if the process is the same in the two different situations where (1) the investor does not want his/her sustainability preferences to be assessed, and when (2) the assessment of an investor does not highlight any sustainability preferences. We would also like the ESMA to give its position about that.

Q15. Do you agree with the proposed approach with regard to the possibility for clients to adapt their sustainability preferences in the case of portfolio approach? Do you envisage any other feasible alternative approaches? Please provide some possible examples.

The EIOPA’s guidelines suggest to ask at the end of the sustainability preferences assessment process if the client wants to apply his/her sustainability preferences for his/her full portfolio or only for a part of it (ex: only for non-government products).

A major issue is that the level of financial education is extremely limited among retail investors. Based on our surveys, most of them do not know the difference between government and non-government products.[6]

What is the position of the ESMA on this point?

Our suggestion would be to give the option for financial institutions to apply their clients’ sustainability preferences for their full portfolio/investment or not.

If not, the financial firm should be free to determine on which relevant proportion these preferences should apply, since the retail investor will have difficulties to determine him- or herself the right level.

Q16. What measures do you believe that firms should implement to monitor situations where there is a significant occurrence of clients adapting their sustainability preferences? What type of initiatives do you envisage could be undertaken to address any issues detected as a result of this monitoring activity?

We thought about two different options:

First option: more flexibility in the matching

Given the numerous potential combinations of preferences collected to point a), b) and c), the update of the investors’ sustainability preferences may become systematic. More flexibility in the product matching is really needed.

For instance, the use of qualitative ranges could be used (ex: range 1 of “High Appetite”, corresponding to a 10%+ alignment to the Taxonomy, range 2 of “Moderate Appetite”, corresponding to a range between 5%-10% alignment to the Taxonomy…). These ranges could be adapted based on the products offered by the financial institution.

This is already the case today for risk preferences. If the ideal volatility for a client assessed during a standard client suitability questionnaire is 17%, then the client may be in the category “Very aggressive” (corresponding, for instance, to any products with a volatility higher than 10%) in the Financial institution 1. In Financial Institution 2, which offers products with a higher volatility than in Financial Institution 1, the same client may belong to the category “Aggressive” (corresponding, for instance, to any products with a volatility between 10% and 20%). In the first case, the client may end up with a product with a volatility of 10% and in the second case, with a product of a volatility of 20%. In both cases, the products will be the most suitable for the clients in the current offering of Financial Institutions 1 and 2.

This kind of principle is common today in the financial market for risk preferences assessment and well accepted. A suggestion would be to apply a similar mechanism for the assessment of sustainability preferences.

Second option: validation of a suitability report rather than a modification of sustainability preferences

As an alternative, instead of asking the investor to modify his/her sustainability preferences, a clear sustainability report underlining the potential differences between his/her preferences and the product features could be shown to him/her.

This report could simply be signed by the client.

From a cognitive perspective, this may reduce the client’s frustration. Asking the client to change his/her preferences is very strong and intimate. It is like asking a client to change his/her values and deep beliefs. Accepting by a signature that a product is different from what the investor wanted in terms of sustainability is much less engaging.

Q18. Do you agree with the additional guidance regarding to the qualification of firms’ staff or do you believe that further guidance on this aspect should be needed? Please also state the reasons for your answer.

Based on our last surveys, given the limited level of financial literacy of advisors regarding sustainability and ESG, this additional guidance is very relevant[7].

Q21. Do you have any further comment or input on the draft guidelines?

We have additional questions that the current guidelines draft does not address:

How could the European financial market participants distribute non-European Union financial products which would not be classified according to the MiFID II Regulation, Taxonomy Regulation nor to the SFDR Regulation? What about alternative investments such as private equity or art?
Today, the main and easy-to-understand difference between point a) and b) is the difference of objectives (Taxonomy objective for point a) and non-Taxonomy but still sustainable objectives for point b). However, there is also a difference of sustainability intensity between point a) and b). Taxonomy-aligned products are supposed to have a greater sustainable impact than products aligned with b). For retail investors, these two imbricated concepts are too complicated to understand (even with an active financial education level).

Our question is the following: Is it then more important that retail investors understand that the difference between point a) and point b) is mainly a question of objectives or of sustainability intensity?

Q22. Do you have any comment on the list of good and poor practices annexed to the guidelines?

The ESMA in its last recommendations said that investors’ sustainability preferences can be assessed through self-assessment.

Could the ESMA explain its position about self-assessment for sustainability preferences?

Response to ESMA’s consultation on its Guidelines on certain aspects of the MiFID II suitability requirements

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