MiFID II is designed to build upon the framework of MiFID I, addressing perceived gaps and dealing with market developments since MiFID I was penned over a decade ago. Although there are only a few headline changes to the activities and instruments to which MiFID applies, and the lists of investment services and activities and financial instruments remain largely unchanged, there are plenty more nuanced changes that need to be considered.
Investment services and activities
Some of the key changes relate to market infrastructure. One obvious change is the addition of the new investment activity, operation of an organised trading facility (OTF). This is to reflect the fact that a new trading platform, the OTF, is being introduced, to sit alongside the other MiFID trading venues: regulated markets and multilateral trading venues. Next week’s alert will provide further details on the new OTF trading platform.
Further, the definition of “systematic internaliser” (essentially, a bilateral trading venue) has been widened to include more objective criteria than under MiFID I. It is expected that this will result in more than the present handful of firms being caught by this definition and needing to comply with the consequent obligations. We will examine the change to this definition in next week’s alert.
Although at first glance other investment services and activities do not appear to have changed, upon closer inspection it becomes evident that the meaning of several activities has in fact been extended.
A change in the Level 2 measures means that now the MiFID investment advice activity includes recommendations given through a distribution channel. Although the equivalent UK regulated activity of advising on investments is already much broader than the MiFID activity, meaning that UK authorised firms should not need to adjust their regulatory permissions, this extension will mean that much more investment advice is classed as MiFID business and consequently that MiFID conduct of business rules will apply to the provision of that advice.
A recital to the MiFID II Directive explains that issuers of financial instruments should be within scope of the activity “execution of orders on behalf of clients” in relation to primary issues of their own financial instruments when distributing those instruments themselves, even when they do not provide any advice. This means that potentially any company issuing its own capital (whether or not already a MiFID investment firm by virtue of its other activities) could need to be authorised to carry on this activity.
Although draft FCA guidance sensibly indicates that “it cannot be the case that raising capital by issuing its own capital causes an ordinary commercial company to become an investment firm”, it does not explain on what basis companies not otherwise carrying on investment activities might successfully exempt themselves from this activity (and regulation under MiFID II). Without any firmer steer as to where the boundaries of this activity have been redrawn, this expansion has potentially far-reaching consequences.
Another change, again tucked away in the recitals, is that “dealing on own account” will capture firms engaging in “matched principal” or “back-to-back” trading. Consequently, traders that execute orders from different clients on a matched principal basis (where the trader acts as an intermediary between the buyer and seller, without being exposed to market risk) will be regarded as acting as principal.
Under MiFID II, they will need to be authorised to perform both the activity of execution of orders on behalf of clients and the activity of dealing on own account. Thankfully there may be little practical change here for UK firms, which already need UK permissions to deal as agent and as principal if trading on a matched principal basis. Although the change at an EU level might be expected to impact firms’ regulatory capital position, draft FCA guidance confirms that firms that do not otherwise deal on own account will not be considered as dealing on own account for the purpose of determining their regulatory capital requirements.
Physically settled derivatives relating to emission allowances are now within scope (only cash settled were caught under MiFID I). Emission allowances consisting of units recognised under the EU Emissions Trading Scheme Directive have been added as a new category of financial instrument, fully bringing them within scope of MiFID, in alignment with the scope of the new EU Market Abuse Regulation.
Commodity derivatives that can be physically settled and that are traded on an OTF have also been brought within scope. Wholesale energy products that are traded on an OTF and must be physically settled remain exempt (these are already regulated under the EU Regulation on wholesale energy market integrity and transparency (known as REMIT)). Level 2 measures provide further detail on the meaning of the expression “must be physically settled”, which is intended to avoid the above exemption being exploited.
Although structured deposits are not financial instruments under MiFID II, certain provisions of MiFID II (relating to organisational requirements, conduct of business requirements and powers of competent authorities) will be extended to MiFID firms when selling, or advising clients in relation to, structured deposits. This means that firms acting as intermediaries in relation to such products need to be mindful of the fact that additional obligations may apply to these activities, and may need to adjust their policies and procedures accordingly.
Steps for firms to take
Firms need to familiarise themselves with these changes to scope and analyse whether and how these will affect both their regulatory permissions and the way their business is regulated. Firms need to ensure that they are prepared for these changes, and that they have the correct permissions, in time for 3 January 2018.