Page 1 FINANCIAL SERVICES REGULATION MIFID II: PHASE 2 HAS BEGUN The European Securities and Markets Authority (ESMA) is consulting on the implementation of the revised EU Markets in Financial Instruments Directive (MiFID II) and Regulation (MiFIR)1. MiFID II and MiFIR are expected to come into application by end 2016/early 2017 and will apply across the European Union and member states of the European Economic Area. Implementation of MiFID II/MiFIR will significantly impact both the structure and operation of EU financial markets and provide increased protection for investors. In relation to markets, there will be increased regulation of trading venues including organised trading facilities (OTFs), broadening of the scope of systematic internalisers (SIs), requirements in respect of algorithmic and high frequency trading, change in the scope of commodity derivatives and an expansion in scope of pre- and post-trade transparency rules. In relation to investor protection, there are changes for product design and intervention, conflicts of interest, execution-only business and disclosure of costs. MiFID II/MiFIR included more than 100 requirements for ESMA to draft Regulatory Technical Standards (RTS)/Implementing Technical Standards (ITS) and to provide Technical Advice to the European Commission to allow it to adopt delegated acts. ESMA has published: • a Consultation Paper on Technical Advice (CP) which ESMA must deliver to the European Commission by December 2014 (hence a condensed consultation process); and • a Discussion Paper on the draft RTS/ITS (DP) which will provide the basis for a further consultation paper on the draft RTS/ITS (likely to be published in late 2014/early 2015). ESMA will hold open hearings on the published DP and CP on 7 and 8 July 2014 in Paris. Responses to the ESMA Consultation paper and Discussion paper must be submitted by 1 August 2014. This briefing begins with a short update on the review of MIFID and sets the context for the ESMA proposals. We also provide a very brief overview of the ESMA proposals. We will be publishing a series of further briefings focusing in more detail on the areas which are likely to be of most interest to our clients. 1Level 1 texts adopted by the European Council on 13 May 2014. 11 JUNE 2014 London Table of Contents 1. Background to MiFID II 2 2. Timeline for implementation of MiFID II /MiFIR 2 3. The legislative structure 3 4. Level 1: MiFID II & MiFIR 3 5. Level 2: ESMA Consultation and Discussion papers 5 6. Next steps 5 7. Key areas of interest in MiFID II/MIFIR 7 8. Contacts 8 RELATED LINKS > Herbert Smith Freehills > Financial Services Regulation > FSR and Corporate Crime Notes Page 2 1. Background to MiFID II MiFID regulates investment services across the EEA. The original MiFID package came into force in 2007. It replaced the Investment Services Directive (Council Directive 93/22/EEC). It aimed to improve the competitiveness of EU financial markets and ensure a high degree of harmonised protection for investors in financial instruments. MiFID established a new regulatory framework for the provision of investment services in financial instruments and for the operation of regulated markets by market operators. It also set out the powers and duties that national competent authorities required for the regulation of these activities. Whilst MiFID achieved may of its aims such as more competition between venues in the trading of financial instruments, more choice for investors in terms of service providers and a reduction in overall transaction costs, a number of problems surfaced in the run up to its scheduled review: • The benefits of increased competition were not always passed on to end-users of the markets, and market fragmentation made the trading environment more complex, especially in terms of collection of trade data. • Market and technological developments were outpacing various regulatory provisions and the financial crisis revealed weaknesses in the regulation of non-equity instruments. • The 2009 G20 discussions led to a commitment to tackle less regulated and more opaque parts of the financial system, and improve the operation of various market segments, especially in those instruments traded mostly over the counter. Changes to MiFID were also required as a result of other European developments such as EMIR, AIFMD, REMIT and MAD/MAR. The central aim of MiFID II and MiFIR is to tackle these highlighted issues. 2. Timeline for implementation of MiFID II/MiFIR • • 12Cionproposals for MiFIDII/MiFIR1Nov07MiFIDtransposedOct11MiFIDII/MIFIRapproved by EU Parliament15Apr14MiFIDII/MIFIRapproved by EU CouncilESMA CP and DP 13May1422May14MiFIDII/MIFIRpublished in OJResponseson ESMA CP and DP due1Aug14ESMA consultation on technicalstandards Nov14ESMA technical advice on delegated actsend14ESMA submit final RTSESMA submit final ITSJun15Dec1518Member States transposition of MiFIDII2430MiFIDII,MIFIR intoapplicationmid16consultation on RTS/ITSMiFIDIIMiFIRentry into force10 week consultationend 16/early 17Jun14MiFIRprovisions on benchmark open accesslicensing into applicationMonths from entry into force of MIFIDII/MIFIR54end 18/early 196 Page 3 3. The legislative structure The European legislative structure as applied to MiFID is as follows: Level 1: the directive and regulation containing the highest level rules expressed in the most general terms Level 2: more detailed "delegated acts" supplementing Level 1, to be adopted by the European Commission on the advice of ESMA Level 2.5: even more detailed regulatory technical standards and implementing technical standards, in principle to cover non "politically controversial" matters, and to be proposed by ESMA and adopted by the Commission Level 3: guidelines to member states to be proposed and adopted by ESMA itself Levels 1 to 2.5 consist of rules that will, when finally adopted and in force, be binding on member states and firms. For Level 3, however, member states will be required to comply with the guidelines or explain why they are not willing to do so. 4. Level 1: MiFID II & MiFIR The changes to MiFID take the form of a directly binding Regulation (MiFIR) - reflecting the need to achieve uniformity in some areas - and a Directive (MiFID II) - which requires transposition and allows for differences in national markets, legal structures and investor profiles in other areas. Page 4 MiFID II or MiFIR? The table below is a guide to the location of some key MiFID II/MiFIR provisions. MiFID II MiFIR Scope, exemptions & definitions (Articles 1-4) Algorithmic trading & HFT (Article 17) Investor protection – principles and information to clients: including client’s best interest rule, inducements, independence, disclosure and reporting, sales targets and remuneration (Article 24) Cross-selling (Article 24(11) & Article 25(2)-(3)) Best execution (Article 27) Market rules: RM/MTFs/OTF (Articles 18-20, 31-32, 44-56) Position limits, position management controls in commodity derivatives and reporting (Articles 57-58) Competent authorities: powers & sanctions (Articles 67-78), co-operation (Articles 79-88) Corporate governance & organisational requirements: including management bodies, recording of telephone and electronic communications and client assets (Article 9 & Article 16) Conflicts of interest (Article 23) Product governance (Articles 16(3), 24(1)-(2)) Suitability & appropriateness (Article 25) Clients classification (Annex II.II) & transactions executed with ECP (Article 30) Third country access: retail/elective professional clients (Articles 39-43) Data reporting services (Articles 59-66) Amendment of AIFMD (Article 92) & IMD (Article 91) Pre- & post-trade transparency (including waivers & volume cap) (Articles 3-22) Derivatives (Articles 28-34) & Equity (Article 23) trading obligation Transaction reporting (Articles 24-27) Non-discriminatory access to CCP, trading venue & benchmarks (including obligation to licence benchmarks) (Articles 35-38) Product intervention (Articles 39-43) Position management (Articles 44-45) Third country access: ECP & per se professional clients (Articles 46-49) Main changes introduced by MiFID II/MiFIR Some of the main changes introduced under MiFID II/MiFIR include (in very brief outline): • additional financial instruments within scope; • applying further conduct of business requirements, including restricting the taking of inducements, distinguishing independent from non-independent advice, improved information on costs and charges, reducing the scope of execution-only business and further requirements in relation to the duty to provide best execution; • enhanced governance requirements relating to the composition of management bodies of regulated firms and to the design and distribution of products; • product intervention powers for national regulators and ESMA; • provisions enhancing access to CCPs, trading venues and benchmarks; • other organisational requirements for trading venues; • extending the regulation of commodity derivatives, requiring more firms trading in such derivatives to be authorised, and introducing position limits; • new provisions designed to ensure that high frequency trading (HFT) does not have an adverse effect on market quality or integrity; Page 5 • further transparency, trade reporting and transaction reporting requirements; and • data publication requirements including requirements for tape providers in relation to development of the consolidated tape, approved publication arrangements and reporting mechanisms, and definition of a reasonable commercial basis for data sales. These changes will apply further compliance requirements to firms currently regulated under MiFID; and the combined effect of expanded scope and more limited exemptions will bring more firms within the regime. As with EMIR and AIFMD, some provisions will have extra-territorial effect. The impact on end-users will be felt through, on the downside, increased costs; and, on the upside, it is hoped, more efficient operation of the markets. 5. Level 2: ESMA Consultation and Discussion papers The Consultation Paper On 23 April, ESMA was mandated by the European Commission to provide technical advice to assist the Commission on the possible content of the delegated acts (Level 2 above) required by several provisions of MiFID II and MiFIR. The CP poses 245 questions and covers, in 311 pages, the topics on which the Commission has requested ESMA to provide their technical advice: investor protection, transparency, data publication, micro-structural issues, requirements applying on and to trading venues, commodity derivatives and portfolio compression. A fuller list of the topics covered is available here. ESMA will be advising on MiFID II implementing measures relating to organisational requirements and operating conditions for investment firms. ESMA considers some of the existing requirements in the current MiFID Implementing Directive to be in line with the MiFID II framework and adequate in the new regulatory context. It proposes that these should be confirmed in the MiFID II implementing measures. The CP therefore focuses on those areas in which new requirements or modifications to the MiFID Implementing Directive are proposed. The Discussion Paper The DP poses 615 questions covering, in 533 pages, a selection of the topics on which ESMA is empowered to draft technical standards: investor protection areas (authorisation, freedom to provide investment services and activities, establishment of a branch and best execution) and market-related issues (such as transparency, data publication and access, micro-structural issues, requirements applying on and to trading venues, commodity derivatives and market data reporting). It deals with the "more innovative or technically complex" topics in order to receive initial feedback from stakeholders for the preparation of ESMA technical standards (Level 2.5 above). A fuller list of the topics covered is available here. 6. Next steps As indicated in the timeline above, responses to the CP and the DP must be submitted by 1 August. ESMA has included specific questions in both papers, aimed at gathering data from stakeholders on new or more sensitive aspects dealt with in the proposed technical advice to the Commission. It is keen to hear from respondents about expected impacts of the proposed measures and to receive relevant information in support of any arguments or proposals being advanced. ESMA will then consider responses to the CP and will finalise its technical advice for submission to the Commission by the end of 2014. The DP relating to the RTS and ITS will be followed by a more detailed consultation paper, which is expected to be issued in late 2014/early 2015, before those standards are finally submitted to the Commission during the course of 2015. That consultation will cover all the areas for which MiFID II and MiFIR require ESMA to adopt technical standards. ESMA, in consultation with the European Systemic Risk Board, is also required to conduct and report on a risk assessment of the need to temporarily exclude exchange-traded derivatives from the scope of the open access provisions in articles 35 and 36 of MiFIR by mid 2016 (six months before MIFIR comes into application). Page 6 MiFID II and MiFIR also mandate a number of reviews to be undertaken post implementation, many of which are due to be undertaken within 56 months of the date the legislation enters into force (i.e. by early 2019). Firms will already be considering how MiFID II and MiFIR will impact on their business systems, strategies, processes, compliance policies, client documentation, and on their non-EU operations and clients. National regulators will need to consult on national implementation measures, but also face their own implementation challenges in dealing with the collection of transparency data, the very significant increase in the number of reports (now also including position reporting) and the multiplicity of new required data fields for those reports. We plan to cover various aspects of MiFID II and MiFIR, in terms of the Level 1 texts and Level 2 proposals, in more detail in subsequent briefings. As a quick reference guide, the following table presents an overview of the key points within MiFID II and MiFIR that we expect will be of most interest to our clients. Page 7 7. Key areas of interest in MiFID II/MIFIR Markets Investor protection Others Organised Trading Facility (OTF): New category of trading venue (non-equities only); only limited proprietary trading permitted for OTF operator; may need to explain why OTF is not a RM, MTF or SI MTF: Firms operating internal matching systems on multilateral basis in equities must be authorised to operate an MTF Derivatives trading obligation: Transactions in derivatives subject to EMIR clearing obligation required to take place on a regulated market, MTF or OTF (where instrument is sufficiently liquid) Algorithmic trading & High frequency trading (HFT): Authorisation requirement (HFT firms); market-making; order to trade ratio; tick sizes; venue pricing Transaction reporting: Extended scope to include instruments trading on MTFs and OTFs; additional flags in reports (e.g. short sale, waivers) Non-discriminatory access: Same opportunity of access to RM, clearing & settlement systems, trading venue, benchmark; obligation to licence benchmark Systematic Internaliser: Change in definition – executing orders on an "organised, frequent systematic and substantial basis" OTC: Residual category – term undefined Equity trading obligation: Shares admitted to trading on a trading venue to be traded on a regulated market, MTF or SI (unless non-systematic, ad hoc and infrequent or ECP/professional client trades which do not contribute to price discovery process) Pre- & post-trade transparency: Extended to cover equity-like instruments and non-equity instruments; waivers available (but double volume caps for reference price and negotiated trade waivers (4% venue cap; 8% universal cap) – equities) Trade reporting: Consolidated tape; approved reporting mechanisms (ARMs); approved publication arrangements (APAs) Direct electronic access: Systems and controls; written agreement Independent advisors / discretionary portfolio managers: • Inducements banned (some minor non-monetary benefits permitted, subject to disclosure) • Suitability assessment – ability to bear losses & risk tolerance to be considered • Statement of suitability (investment advice to retail clients) • Periodic report (portfolio management or where firm has told retail client it will carry out periodic assessment of suitability) • Enhanced disclosure to clients • Independent advisers must advise on "sufficiently diverse range" of products • Goldplating allowed: e.g. RDR in UK Execution-only: Firms will be able to act on an execution-only basis in respect of a more limited range of products; Certain UCITs, shares, bonds which embed derivatives and structured deposits to be deemed complex Best execution: • Additional information to be provided by brokers (e.g. top 5 execution venues) • New conflicts and inducement references • Ban on remuneration, discount or non-monetary benefit for routing client orders to particular venues Product governance: • Product approval process • Client's best interests rule expanded, in particular in relation to the obligations of manufacturers and distributors to clients • Regular reviews of financial instruments to assess distribution strategy, risks to and needs of target market Management bodies: • Certain CRD corporate governance requirements extended to investment firms • Minimum standards & systems and controls (e.g. boards, diversity, product approval) Clients • Clarification that local public authorities and municipalities are not per se professionals but may be elective professionals • ECPs: modified client's best interests rule to apply to ECPs • Obligations on firms dealing with ECPs increased: certain information and reporting requirements to apply Sales targets and remuneration: Builds on ESMA guidelines; staff incentives must not cause conflicts Telephone/electronic recordings (when executing orders): extended to 5 years (potentially up to 7 years) Scope: MIFID scope widened to include structured deposits, emission allowances, physically-settled contracts on OTF (except wholesale gas/electricity contracts) (NB Level 2 changes in relation to C6, 7 & 10 and Commission review of FOREX) Exemptions: Dealing on own account & ancillary activity exemptions narrowed; commodity derivatives traders exemption removed Third country provisions: Retail/Elective professional • Member States may require third country firms to set up branches (passporting) • Exclusive initiative of client ECP/Per se professional • National private placement and eventually, if equivalent, ESMA registration (passporting) • Exclusive initiative of client Product intervention powers: Available to ESMA/EBA and competent authorities re marketing/distribution of financial instruments or certain activity Commodity derivatives: See “Scope”; Transitional regime for energy derivatives contracts (coal/oil); Position limits and position reporting (NB Commodity firm exemption from own funds requirement (expires end 2017) to be reviewed under CRR) AIFMD & IMD amended Amendment in IMD to include additional customer protection requirements in relation to insurance-based investment products (including inducements and product intervention rules) Sanctions • Minimum set of supervisory and investigative powers for competent authorities • Various sanctions for breach (including, "maximum administrative fines of at least EUR 5 million" (breach by legal or natural person) or up to 10% of turnover (breach by legal person) Cross-selling • Overall bundle must be suitable • Transparency: clients to be told whether bundled products/services can be purchased separately, the cost and charges of each component and risks (where risk from package is different to risk of components individually) Title transfer collateral arrangements: TTCA no longer permitted for retail clients’ assets Page 8 8. Contacts Clive Cunningham (partner) T +44 20 7466 2278 M +44 7989 558 095 Clive.Cunningham@hsf.com Karen Anderson (partner) T +44 20 7466 2404 M +44 780 9200 009 Karen.Anderson@hsf.com Henrietta de Salis (consultant) T +44 20 7466 7490 M +44 7809 200 919 Henrietta.deSalis@hsf.com Patricia Horton (professional support lawyer) T +44 20 7466 2789 M +44 7809 200 880 Patricia.Horton@hsf.com If you would like to receive more copies of this briefing, or would like to receive Herbert Smith Freehills briefings from other practice areas, or would like to be taken off the distribution lists for such briefings, please email firstname.lastname@example.org. © Herbert Smith Freehills LLP 2014 The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. 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