The COVID-19 pandemic has caused significant shifts in global stock markets, with many seeing significant falls since the outbreak began. Current regulations state that any Investment Firms providing portfolio management and operating within the European Union (EU) must report within 24 hours if a client’s portfolio falls 10% or more in a reporting period.
FinoComp has a microservice – TierDrop – that is specifically designed to help firms comply with this regulation. It is the most advanced product of its kind in the market.
What is the 10% depreciation regulation?
The 10% depreciation rule was introduced as part of the MIFID II regulation on the 3rd January 2018. The intent was to protect retail investors and to standardise practices across the EU. This regulation states that clients are to be notified within 24 hours if a discretionary managed portfolio falls 10% or more in a reporting period, and thereafter at multiples of 10%. The wording that relates explicitly to the 10% drop rule is under Article 62.1 of the regulation and states:
“Investment firms providing the service of portfolio management shall inform the client where the overall value of the portfolio, as evaluated at the beginning of each reporting period, depreciates by 10 per cent and thereafter multiples of 10 per cent, no later than the end of the business day in which the threshold is exceeded or, in a case where the threshold is exceeded on a non-business day, the close of the next day.”Article 62(1) of MiFID II delegated regulation (EU) 2017/565
Leading up to MiFID II implementation, there was a debate as to how these returns were to be calculated and the potential impact on investors. The concern was that it might invoke panic selling, although research conducted by FinoComp on some real platform data proved that unlikely.
The European Securities and Markets Authority (ESMA) published guidance that included a suggested calculation method which, in mathematical terms, is very basic and is widely considered to be not fit for purpose for accurately calculating portfolio performance. The industry therefore sought more accurate calculation methods which required more complex processing and computing.
How do these rules affect you?
The 10% depreciation regulation applies to discretionary portfolios for MiFID Investment Firms and Products. For platforms and discretionary fund managers the requirement to report to the client within 24 hours is a challenge. Platforms need to run calculations daily to detect where any reportable incidents have occurred and initiate the reporting process. While it sounds simple, running the 10% depreciation calculation over tens or hundreds of thousands of portfolios requires a considerable amount of data and has some tricky edge cases:
- Introduction and removal of capital throughout the reporting period. Retail investors frequently contribute and withdraw capital, and this needs to be considered as part of the performance calculation.
- A clients portfolio may contain assets held independently to the model which should be excluded from the calculation.
- Clients move between models and even between discretionary investment managers within three months.
When the rule was introduced, there was a perception that an investors discretionary managed portfolio dropping by 10% or more would be a rare event. Many participants were poorly prepared for the substantial market fluctuations we are experiencing now. Essentially, many firms didn’t implement scalable and robust reporting processes due to a belief that this would be such a rare event. With volatile global financial markets, the operational burden for firms who have not invested in technology is growing. This is the reason the FCA recently introduced some temporary alterations to the rules.
What problems does TierDrop solve for the market?
FinoComp’s TierDrop is explicitly built for this regulation and is the most advanced product of its kind in the market.
It facilitates seamless detection and reporting to the end investor; from its highly accurate calculation through to automatically initiating delivery of notifications. TierDrop removes any form of manual intervention from the process. It caters for massive scale, accurate calculations and the automation of notifications. The software also provides early warning facilities. These enable early preparation of the communication to clients and considers the complex edge cases mentioned above.
A choice of industry recognised calculation methods is available including Simple Dietz, Modified Dietz and the more complex internal Rate of Return (IRR) algorithm, giving platforms and DFMs the ability to compare and select a standard calculation method to suit their businesses.
As a distributed software module, TierDrop has no impact on the performance of wealth management platforms and DFMs core systems. Data is updated daily, with accuracy delivered through a suite of data hygiene checks as the information is imported.
Against a backdrop of extreme market turbulence, the operational challenges and manual effort to keep up with the significant number of reportable events will be debilitating for many platforms and DFMs. There will no doubt be substantial additional expenses, vast amounts of manual effort and late reporting to clients at a time when the industry can least afford it.