The impact of inflation in the context of investment services to retail clients
By: Ganado Advocates
On October 3 2022, the Malta Financial Services Authority (the “MFSA”) published a circular relating to the public statement released by the European Securities and Markets Authority (“ESMA”) to investment firms on the impact of inflation in the context of investment services to retail clients.
Inflation poses a risk for retail investors as they might not fully appreciate or understand the link between inflation and financial markets, including how considerations on inflation should be factored in investment decisions. In April 2022, ESMA had received an own-initiative advice from its Securities and Markets Stakeholder Group (SMSG) on the topic of inflation on investor protection.
Further to the above, ESMA indicated that investment firms principally need to consider the following matter under the Markets in Financial Instruments Directive (Directive 2014/65/EU of the European Parliament and of the Council)(“MiFID II”):
1. Fair, clear and not misleading information
In their public statement, apart from referring to Article 24(3) of MiFID II and Chapter III of the MiFID II Delegated Regulation (Commission Delegated Regulation 2017/565), ESMA stated that the information which investment firms address to retail clients, or which the firm disseminates, must reflect the inflation risks or the possible effects it may have on the value and return of the investment. An example of this would be that the investment firm should explain that when offering a financial instrument with a guarantee or capital protection, this will not protect investors from the effect of inflation over time, and thus, the return when adjusted for inflation might be negative.
The assessment of suitability is an important requirement for investor protection as it applies to the provision of any type of investment advice and portfolio management.
Investment firms need to carefully consider the risk that inflation will have in the performance and/or value of investments. In doing this, firms must assess and understand the clients’ ‘investment horizons’. Additionally, firms should ensure that their policies enable them to take account of risk diversification and ensure that the client has an adequate understanding of the relationship between risk and return (including, where relevant, the impact inflation might have on nominal returns, the necessarily low remuneration of risk-free assets and the incidence of time on this relationship, and of the impact of overall costs and charges on the investments).
3. Product governance requirements
Investment firms need to ensure that product governance arrangements are sound and in accordance with the clients’ best interest. This may be achieved through comprehensive product reviews and scenario analyses.
A well-diversified portfolio, regular rebalancing, and the incorporation of a system which ensures that investments remain aligned with long-term goals, are some of the tools which investment firms may implement to cater for inflation. Continuous monitoring of the financial markets and their participants will also be undertaken by the MFSA and ESMA to enhance investor protection and the promotion of stable and orderly financial markets.