Damian Carolan discusses Mifid II: its progress, implications and the still unanswered questions.

​Head of Allen & Overy’s London financial services regulation team Damian Carolan examines a range of issues, including whether Mifid II will achieve its core aim of making things fairer for the end user, how its implementation has been progressing and what unintended consequences Mifid II may have. Among the latter is the risk of inconsistent approaches across jurisdictions, whether the investor safety vs regulatory burden balance has been properly calibrated, what Brexit means for Mifid II and whether genuine third country equivalence is likely.

What perspective do you most often approach Mifid II from and how has this evolved over the last 12 months?

At this stage, everyone is in the throes of implementation and that has been the case for the last six months. Everyone is frankly straining to get as close as they can to a compliant state by end of year, which is tricky when it is not clear what a compliant state is. The work has a range of flavours: there are issues remaining around interpretation and there is also the heavy lifting challenge of changing massive business lines.

My work has moved on significantly from the earlier stages where there was a lot of interpretation, lobbying and shaping of the legislation. Normally you would expect that kind of activity to have ceased completely at this stage in the process, but given the ongoing uncertainty there continues to be an element of actually trying to shape the policy. We are having to react to de facto changes resulting from the European Securities and Markets Authority’s (Esma) Q&A and other examples of policy making on the hoof that continue to come through.

In terms of the demands on the various groups, within the sell-side there is a host of good old-fashioned implementation activities to be carried out. For buy-side, there are new ways of servicing their clients and interacting with the wider markets that they need to get to grips with. We are also helping on the infrastructure side, shaping the whole host of new market venues that will be used.

What does Mifid II represent in terms of the application of extraterritorial and multijurisdictional rules? What are the long-term impacts of this sort of rule-making and is there going to be a point where regulators/market participants say enough is enough?

The extraterritorial impact question has several angles. The overall risk, as each geographical bloc takes an ever-increasing focus on the level and type of compliance expected within their geography, is that the threat of siloisation grows. If any one regime does not ‘bake in’ these concepts of equivalence and the ability to interact globally in a way that is commercially viable but also meets the purposes of the regulation, then we could see problems.

As for the point at which market participants say enough is enough, I do not think we are there yet, but that is based on the premise that in implementing Mifid II there is scope for using the tools available to actually still oil the wheels of international finance. That does not mean open borders, but rather keeping open the channels for doing business that are there today with the right protections around them. It needs an element of pragmatism on the part of the regulators, otherwise one risks seeing genuine impact on market behaviours and liquidity and therefore, client choice, pricing and cost.

We often hear from non-EU lawyers and non-EU firms (such as asset managers) that Mifid II is a European issue that only effects European entities – to what extent is this correct?

I am afraid that is not correct, and I think the wider world is waking up to that now. It is more that we are still learning exactly what the extent of that impact for non-EU firms is, based on certain uncertainties. Within asset management, for example, there has been a debate about how far delegation to non-EU asset managers requires the export of Mifid obligations. That is a live debate and its impact is actually more critical than ever.

Another example is that under Mifid II you will not be able to pick up the phone to your European broker and just do a large trade by phone. That broker will need to think very hard about how it will handle your order, and whether its behaviour attracts European transparency obligations – which of course is something that people are quite sensitive to. The way in which you interact with EU service providers and venues will potentially impact your visibility to the market and the way you achieve execution, so there are a variety of effects – direct and indirect – that will continue to play out as we come to the final stage of implementation.

Do you think it will change the composition of markets with fewer US/Asian participants in Europe than before?

It is hard to say. It is important to note that there probably are not too many direct service providers into the EU from the US and Asia today in fact, because the existing licensing regimes at play do not make it easy for them to provide services directly on onshore clients. In theory, Mifid II harmonises the borders of Europe, so I do not expect that situation to change in a positive way. It may narrow the opportunities.

The only thing that could be a game changer here is the point at which Europe uses the powers open to it to recognise a third country regime as equivalent for all purposes, and those third country firms attract a passport to provide wholesale services across Europe. There is a lot of speculation about whether any non-EU regime will ever achieve that benchmark of equivalence to Mifid II, but if they do, that will open a far wider channel. We will wait to see.

What will likely be the impact on the large research departments of banks?

It is hard to speculate what the research departments of banks will look like in future. There is no doubt that users of research who are regulated entities – like asset managers – will be thinking much harder about its usage and value, rejecting anything which does not bring what they see as the requisite value.

We have seen recently some asset managers giving public indications regarding how they intend to pay for research – whether they plan to pass the cost on to clients by use of research budgets, or pay for it from their own P&L. Particularly where firms are paying for it themselves, or transmitting costs on to clients in a transparent manner, they will think a lot more carefully about what they need and from who. Does that mean that the sheer volume of research generated will reduce? Possibly, but it is still too early to say for sure.

Protecting investors is at the core of Mifid II – do you think Mifid II will make things fairer for the end user? Or will it simply increase costs and reduce choice?

Protecting investors is at the core of Mifid II, and we cannot criticise that as the aim of a piece of regulation. My take is that one always needs to remember that investor protection is part of a balancing act of achieving an effective financial market. You could achieve the highest level of investor protection on the planet, but services would be so restricted and expensive that no one would be able to use them. That, in turn, contradicts other goals.

Investor protection is important but we must also consider its wider effects. To point out an example of the challenges with Mifid II’s approach to investor protection, one is the clear desire to treat professional clients in broadly the same manner as retail clients. That is based on a philosophical view that professional clients are not sophisticated enough to look after themselves. That, when taken on a rigid basis, makes it very expensive to provide sophisticated services to sophisticated users, when in many cases neither service provider nor recipient wants that. So a range of these services will not bring a greater level of protection, but will undoubtedly bring additional cost.

From a purely European perspective, how might Brexit impact Mifid II, if at all?

In theory, the answer should be none at all. Inevitably however, at the practical level, many questions asked about Mifid II now have a Brexit political overlay. One example which has been debated since Mifid I, and continues to be debated, is the ability of an EU firm to utilise its passport to provide services to European clients from a non-EU branch. That has always been an open question, and never had a huge amount of focus. But in a post-Brexit world, where London is suddenly an offshore location, that has critical implications. So, Brexit will therefore play into the interpretation of that question and also the seriousness of the consequences.

This article first appeared in International Financial Law Review