Categorizing clients correctly has become so complex that it is no wonder so many financial institutions get it wrong. However, it is absolutely critical to categorize clients correctly from the outset to know which products and services to sell to them, to protect both the financial institution and the client, and to avoid significant fines for regulatory breaches.
Essentially – and for most countries in Europe – there are three key categories: Retail Client; Elective Professional Client/ Professional Client Per Se; Eligible Counterparty Opt-Up/ Eligible Counterparty Per Se. While Retail Clients have the highest level of protection and are the main category to be protected by the Financial Ombudsman, there are a number of reasons why financial institutions (and the clients themselves) may wish to be ‘pushed up’ the chain to the next category.
Firstly, the financial institutions need to segregate money for Retail Clients; for lower-tier financial institutions, this can be an issue as they need this money for credit lines with Liquidity Providers, and many simply do not have the in-house resources to handle the whole aspect of segregation. Secondly, as a result of ESMA’s temporary product restrictions – which most national authorities have now taken as permanent measures, restricting the marketing, distribution, and sale of CFDs to Retail Clients – clients can access more products if they are not in this category, and financial institutions also have more sales opportunities.
To move higher up the chain from Retail, clients need to pass two tests: a qualitative test assessing their expertise, experience, and knowledge, and two out of three parts of a quantitative test. Sounds straight forward but it isn’t – largely due to lack of standardization and clarity.
Flaws in the categorization tests
With the qualitative test, many financial institutions ask a simple question such as ‘Do you have the correct knowledge and experience to trade with us?’ In response to this, it is very easy for the client – keen to be onboarded – to simply tick ‘Yes.’ However, financial institutions ought to gain more of an understanding of their expertise, experience, and knowledge by asking questions such as ‘what types of transactions have you previously done?’, ‘which instruments have you traded?’ and how relevant are they to the instruments to be traded with us?’, ‘what is your experience in trading in a particular market?’, ‘what is your educational background?’, and in general, testing the client’s knowledge specific to the instrument(s) and service(s) they wish to trade with the financial institution. This is a time-consuming exercise and should be done properly.
Miscategorisation at this point should not be taken lightly – if clients complain that they were not ‘screened’ correctly at the onboarding stage and should have been categorized as Retail Clients, not Elective Professionals, they can be entitled to reversal of their trades and their funds back.
With the quantitative test, the lack of clarity is even more concerning. For example, the first criteria is ‘The client has carried out transactions in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters.’ On the surface, this may seem clear – but what does ‘significant size’ mean? In France, for example, it refers to an amount exceeding EUR 600 per transaction, in Slovakia it relates to volume exceeding EUR 6,000 per transaction and in the UK, significant size is not defined at all, leaving it open to interpretation.
Many make the assumption that once they comply with MiFID, they comply with all EU markets in this regard. This is an incorrect assumption as the financial institution needs to defer to the status of the client’s domicile. If they aren’t aware, for example, of the specific guidelines for onboarding Slovakian clients, then they could easily and inadvertently breach the regulation, resulting in the need for a reversal of the transaction and/ or fines from the regulator.
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When financial institutions onboard clients from the rest of the world, they also need to comply with the legislative provisions of their client’s domicile as well as their own jurisdiction. This is highly complex and differs significantly from the EU.
There are so many examples of anomalies across different countries – for example, Poland now has an extra client category of ‘Experienced Retail Client,’ which enables the client to trade outside ESMA’s CFD product restriction measures. If you are a UK-based financial institution onboarding a Polish client, you should bear this in mind during the categorization process as this can open up business opportunities amongst Polish clients. It truly is a minefield for financial institutions to be aware of all the anomalies, and I believe it is impossible for them to categorize clients correctly without having automated RegTech systems in place which cover off all these parameters.
As a lawyer and former Head of Legal and Compliance at a number of global Financial Institutions, I’ve seen many cases of Retail Clients complaining to the financial institutions about being incorrectly categorized and the financial institutions having to compensate them, rather than getting the regulators involved.
How do you prove the correct categorization selection to the regulators?
Once again, there is so much room for confusion, especially given the issues outlined above relating to the qualitative and quantitative tests. The FCA, for example, states ‘a firm must make a record in relation to each client of the categorization established for the client, including sufficient information to support that categorization’ – but what do they mean by ‘sufficient information?’
ESMA makes it clear that financial institutions ‘should avoid relying solely on self-certification by the client and should consider obtaining further evidence to support assertions that the client meets the identification criteria at that point in time’ – however, this is a guideline and not a legal requirement – and what does ‘further evidence’ mean without clearer guidelines?
Clearer frameworks are needed
In summary, financial institutions are taking on a huge amount of risk, with Compliance Officers being increasingly accountable. We need stronger laws from the regulators and clearer frameworks for categorization – and I believe these changes will happen.
Currently, some financial institutions are wrongly ‘opting up’ retail clients, and some aren’t taking the opportunity to allow them to opt up, limiting opportunities to sell them a wider range of products and services.
And, as highlighted above, miscategorization is a fast-track way for financial institutions to lose money, as a result of potentially having their trades reversed and needing to return funds to clients, pay significant fines for regulatory breaches, or not realizing the potential of their client base. Client categorization also has a huge impact on Suitability and Appropriateness assessments. Getting it wrong will impact the regulatory assessments, which are triggered by the legislative framework based on the category of the client. If the categorization is wrong, then the entire flow is wrong too, and the assessment of whether to enable the client to trade a financial product in a particular financial service will also be wrong, leaving the financial institution at risk of mis-selling.