Following the Investment Services Directive in 19931 and its replacement by the Markets in Financial Instruments Directive (“MiFID”) in 20082, the third significant reform of the rules governing the trading of many types of financial instrument is set for 3 January 2017. On that date the so-called MiFID II3and the complementary Markets in Financial Instruments Regulation4 (“MiFIR”) will apply in the law of each EEA Member State.
MiFID II addresses topics that are to be reflected individually in the national law of each Member State (in Ireland, probably by statutory instrument). These include authorisation and organisational requirements for investment firms, relevant credit institutions and trading venues, investor protection provisions and the framework of sanctions for breach of the amended rules.
As an EU Regulation, MiFIR has direct effect in each Member State (and is being applied by non-EU EEA states also) and there is likely to be a limited need for supplementary national legislation. Typically such supplementary national legislation will address national procedures and sanctions only. MiFIR addresses matters such as the public disclosure of trade data, the reporting of transactions to the competent authorities, the obligation to trade derivatives on organised venues and removing barriers to entry to trading venues.
The European Securities and Markets Authority (“ESMA”) is to prepare draft technical standards for many of the obligations in MiFID II and MiFIR.
This briefing explains the principal changes that the modified regime will entail, focusing on ten broad initiatives:
- changes to market structure;
- increased transparency in trades;
- enhanced supervisory powers;
- increased competition between trading venues;
- controls on algorithmic trading activities;
- strengthened investor protection;
- enhanced and harmonised sanctions for breach;
- harmonised regime for granting access to EEA markets for firms from non-EEA states; and
- conduct of business requirements.
The MiFID II and MiFIR regulatory regime will extend beyond the varieties of financial instrument to which MiFID applies and encompass also emissions allowances, structured deposits and physically settled commodity contracts (which are traded on a MiFID venue).
MiFID II also will amend the Insurance Mediation Directive5 to enhance protections that apply in the case of an insurance-based investment product.
Also, any OTC derivative that is subject to the clearing obligation under the OTC Regulation6 will have to be traded on a MiFID II-regulated venue, ie a regulated market, a multi-lateral trading facility (an “MTF”), an organised trading facility (an “OTF”) (a new concept recognised by MiFID II) or an approved third country market.
MiFIR will require that derivatives of standardised types must be traded on a market, whether that is a regulated market, an MTF, an OTF or an approved third country market. The types of derivatives that will be subject to this obligation have yet to be specified. The European Commission will take the advice of ESMA before making that specification. Shares will also be subject to this trading obligation.
An OTF will be a multi-lateral trading venue for non-equity financial instruments, the operator of which (as with the operators of regulated markets and MTFs) will be prohibited from trading against its proprietary capital. A key feature of an OTF will be that the execution of orders on an OTF will be carried out on a discretionary basis. An investment firm that operates an internal matching system that executes client orders in financial instruments on a multi-lateral basis will have to be authorised as an MTF.
Transparency in Trades
MiFID II and MiFIR together require (for equity and certain equity-like instruments, bonds and derivatives):
- a trading venue (a regulated market, an MTF and an OTF) to make increased pre-trade and post-trade disclosure of the detail of orders submitted to that market, and of transactions conducted on the relevant market; and
- the comprehensive reporting of transaction data to national competent authorities.
Waivers from pre-trade transparency will continue to be possible, such as in respect of large-size transactions and for referential pricing mechanisms.
Investment firms and relevant credit institutions will also have to provide to competent authorities and publish publicly information on the entity’s positions in commodity derivatives (including emission allowances and derivatives of emission allowances).
In certain circumstances EU authorities (such as the European Banking Authority and ESMA) and national regulators will be empowered to impose restrictions on, or prohibit, the marketing or sale of financial products.
The new regulatory regime will also entail the setting – by the national competent authorities – of harmonised position-limits for commodity derivatives, based on a calculation methodology that ESMA will develop.
Competition between Trading Venues
MiFID II will establish a harmonised EEA regime for non-discriminatory access to trading venues and central counterparties and to benchmarks for trading and clearing purposes.
Controlling Algorithmic Trading
A major initiative in MiFID II and MiFIR is to regulate algorithmic trading and high- frequency algorithmic trading in particular. It is intended that the regulatory regime will apply to all algorithmic traders and will require such a trader, when pursuing a market-making strategy, to provide specified levels of liquidity.
An investment firm that provides direct electronic access to a trading venue will be obliged to ensure that its control systems prevent trading that constitutes market abuse or which may contribute to a disorderly market.
Apart from the protections that will derive from enhanced supervisory powers (above), MiFID II is intended to enhance investor protection by:
- increasing the standards and governance requirements of investment firms and financial products;
- expanding the responsibilities of the management bodies of investment firms and relevant credit institutions; and
- increasing the conduct of business responsibilities of a regulated entity (below).
Sanctions for Breach
MiFID II will require Member States to apply a harmonised approach to breaches of MiFID II and MiFIR through the imposition of standardised administrative sanctions. These will be separate from any criminal consequences of such a breach, under national law, although Member States may choose to apply only a criminal sanction to any prescribed provision, and not also an administrative sanction. MiFID II also provides for enhanced co-operation between national competent authorities in the investigation and detection of breaches of MiFID II and MiFIR.
MiFID II will require EEA Member States to permit firms that are established in approved non-EEA states to provide MiFID II services in an EEA Member State (a “passport” arrangement). They will be entitled to do this either by establishing a branch in an EEA Member State (essential if dealing with a retail client or a retail client opting up to professional client) or (if dealing with professional clients or eligible counterparties) on a cross-border basis. Such a cross-border provision of services will be permissible only in a case of regulatory reciprocity between the relevant states.
It will also be possible for a prospective client in the EEA to, at that person’s “exclusive initiative”, request a non-EEA firm to provide MiFID II services to that prospective client.
Conduct of Business Requirements
MiFID II and MiFIR together will make a large number of changes to conduct of business requirements of investment firms and relevant credit institutions. These include:
- an expanded obligation to act in the best interests of the client;
- more onerous obligations to provide information to clients;
- stricter rules on conflicts of interest;
- an outright prohibition on the receipt of inducements in certain circumstances, such as in the case of independent advice;
- a more onerous “best execution” obligation; and
- an expanded obligation to ensure the suitability of a financial instrument or product to a client, in the context of the client’s capacity to absorb losses and tolerate risk.
MiFID 2 must be reflected in national law by 3 July 2016 and the bulk of both MiFID II and MiFIR must apply in national law from 3 January 2017.