On 12 June 2014 the final texts of MiFID II and MiFIR1 were published in the Official Journal of the European Union, comprising the package of reforms and amendments to the Markets in Financial Instruments Directive2 which establishes the framework for the regulation of financial markets and securities across the European Union.
Member States are required to transpose MiFID II and MiFIR into their national legislation by 3 July 2016, with such national rules required to come into effect by 3 January 2017. Although that may seem a long way off, firms operating in the financial services sector need to be mindful of the changes that will be brought about by the new legislation and start acting now to ensure they are ready for those changes and they do not fall behind their competitors. In order to assist with this, we will be publishing a series of alerts over the course of the coming weeks, describing the changes that will be brought about by MiFID II and MiFIR which are most pertinent to our clients.
This first alert focusses on three categories of entity that will be brought into scope of MiFID regulation for the first time: firms specialising in trading commodities and commodity derivatives; firms who engage in high frequency algorithmic trading; and third country firms (including the possibility that third country firms will, for the first time, be able to apply for a “passport” to provide investment services throughout the EU).
Commodity and Commodity Derivative Dealers
Under MiFID, firms dealing in commodity derivatives are able to rely on the Article 2(1)(k) exemption for persons whose main business is dealing on own account in commodities and/or commodity derivatives. Excessive commodity price volatility has been a hot topic at the G20 summits in recent years, however, and the G20 summit in Cannes on 4 November 2011 endorsed the International Organization of Securities Commission’s Principles for the Regulation and Supervision of Commodity Derivatives Markets3 and called for market regulators to have formal position management powers, including the power to set ex ante position limits as appropriate. As a direct result, the Article 2(1)(k) exemption has been removed from MiFID II, bringing specialist commodity and commodity derivative dealers into scope for the first time.
The only commodity derivative dealers who will not be caught by the directive will be those falling within MiFID II Article 2(1)(j), which exempts firms who, ancillary to their main business, deal on their own account in commodity derivatives or provide other investment services to the customers or suppliers of their main business (provided the main business is not the provision of investment services or acting as a market-maker in relation to commodity derivatives). This is subject to the new conditions that they (i) do not deal on own account for the purpose of executing client orders; (ii) do not employ a high frequency algorithmic trading technique; and (iii) notify the home regulator annually that they make use of this exemption and can justify to them why such investment activities are ancillary to their main business.
All other firms dealing in commodities or commodity derivatives will fall within the scope of MiFID II and will be subject to the relevant authorisation, supervision, capital and conduct of business requirements, including new rules on position limits and position reporting. These new rules will be discussed in more detail in a subsequent Bingham alert.
High Frequency Algorithmic Trading Technique Users
Regulators have also expressed a desire to gain greater control over the users of trading algorithms which often submit and/or execute trade orders with little or no human interaction, and particularly those who use high frequency algorithmic trading techniques4. The perception is that such algorithms are capable of exacerbating the rate of decline in a downward market, are a tool by which a market may be manipulated (e.g. used for “layering” or “spoofing”) and could, potentially, lead to the mass execution of erroneous trades.
Accordingly, under MiFID II, firms which conduct high frequency algorithmic trading will no longer be able to rely on the current exemption in MiFID Article 2(1)(d) for firms which only provide the investment service of “dealing in financial instruments on own account”, or the exemption in MiFID Article 2(1)(j) outlined above. This means that they will be required to be authorised by their home state regulator if they are not already so authorised and if they are not able to rely on any other exemption. They will also be subject to the new rules on algorithmic trading, pursuant to Article 17 of MiFID II. Such rules will be explored in detail in a subsequent Bingham alert but they will include rules pertaining to systems and controls, reporting and record-keeping requirements.
It should be noted that the rules in Article 17 of MiFID II will apply to all investment firms engaging in algorithmic trading, not just those applying high frequency algorithmic trading techniques, including those members or participants of regulated markets and Multi-Lateral Trading Facilities who are not required to be authorised under MiFID II by virtue of: (i) the MiFID II Article 2(1)(j) exemption; or (ii) the MiFID Article 2(1)(a) exemption for insurance undertakings; or (iii) the MiFID Article 2(1)(i) exemption for investment undertakings, pension funds and the depositaries and managers of such undertakings5.
New Third Country Firm Regime
EU Branch Requirement
Whereas MiFID did not address the provision of investment services into the EU by third country firms, and therefore it was for each member state to adopt its own rules and requirements, MiFID II expressly allows a member state, should it so choose, to require a third country firm which intends to provide investment services to retail and/or professional clients within its jurisdiction to establish a local branch.
Should a member state decide to adopt this branch requirement, the third country firm branch would be subject to authorisation and supervision in that member state by the relevant regulator. The relevant regulator will only be able to grant such authorisation where: (i) the third country firm is already appropriately authorised and supervised in its home jurisdiction; (ii) certain co-operation agreements are already in place relating to the exchange of information as between the home regulator of the third country firm and the relevant European regulator; (iii) the branch has sufficient initial capital; (iv) one or more persons are appointed to be responsible for the management of the branch (who must comply with the governance and management body arrangements set out in CRD IV6); (v) the home jurisdiction of the third country firm has entered into certain tax agreements with the relevant member state; and (vi) the firm belongs to an investor-compensation scheme authorised or recognised in the EU7.
Member states will not be able to impose requirements for a branch over and above those prescribed by MiFID II and will not be permitted to treat any third country firm branch more favourably than EU authorised firms8. Further, member states will not be permitted to impose the branch requirement on third country firms which provide investment services at the “exclusive initiative of the client”9.
Should the UK decide to adopt the branch requirement for third country investment firms, the current UK financial services exemption for “overseas persons”10 would likely no longer be available.
EU Cross-Border Services Passport
MiFIR allows third country firms to provide investment services on a cross-border basis to eligible counterparties and professional clients throughout the whole of the EU provided they are first registered with ESMA11, thus effectively allowing such firms to benefit from an EU “passport” for the first time.
Registration with ESMA will only be possible, however, once: (i) the European Commission has published an “equivalence decision” which shall only be granted if the European Commission has determined that the legal and supervisory arrangements of the home jurisdiction of the third country firm impose prudential and business conduct requirements which are equivalent to those imposed by MiFID and the European capital adequacy rules; (ii) the third country firm is appropriately supervised in its home jurisdiction for the purpose of ensuring full compliance with such rules; and (iii) the relevant home regulator of the third country firm has entered into appropriate co-operation agreements with ESMA12.
Where a third country firm is registered with ESMA, member states are not permitted to impose additional requirements in relation to the provision of investment services into their respective jurisdictions, and are equally not permitted to treat registered third country firms more favourably than EU authorised firms13.
Where they have not already done so, financial services firms need to start engaging with MiFID II now. Firms should consider whether and how the changes to the scope of MiFID will impact on them and their businesses and plan how they are going to deal with those changes. In the meantime, we will be publishing a series of alerts on the following topics: corporate governance arrangements; trading issues, including new venues and pre- and post-sale transparency requirements; position limits and reporting; the European Market Infrastructure Regulation and how it will operate alongside MiFID II; and algorithmic trading requirements. We do not expect further details regarding the treatment of third country firms to be available for some time; however we will follow these developments closely and will publish further alerts on this issue in due course.
Table setting out at a glance the new categories of entity brought into scope of MiFID regulation
Click here to view table.