Page 1 FINANCIAL SERVICES REGULATION MIFID II: ESMA TECHNICAL ADVICE AND CONSULTATION The European Securities and Markets Authority (ESMA) published the following MiFID II Level 2 materials on Friday, 19 December: • ESMA's final technical advice to the European Commission on delegated acts; and • a Consultation Paper on draft technical standards. The revised Markets in Financial Instruments Directive ((MiFID II Directive) and Regulation (MiFIR) (together "MiFID II") will apply across the European Union and member states of the European Economic Area from 3 January 2017. For an overview of the new MiFID II regime, please click here for our earlier briefing. This briefing highlights some of the key recommendations made by ESMA in its technical advice and helps to navigate the topics covered in the Consultation Paper. Comments on the consultation must be submitted by 2 March 2015. 1. ESMA Technical Advice ESMA was mandated by the European Commission to provide technical advice to assist the Commission on the possible content of the delegated acts required by several provisions of MiFID II and MiFIR, including investor protection provisions, transparency, data publication, micro-structural issues, requirements applying on and to trading venues, commodity derivatives and portfolio compression. The final technical advice has been prepared following ESMA's consideration of the feedback on its consultation paper on draft technical advice published in May 2014. ESMA's final technical advice refers to changes which should be made to the current MiFID Level 2 Directive, but does not give any indication as to the form that the MiFID II Level 2 delegated act will take: a new or recast directive, or a regulation, or a combination of a directive and regulation. Although the European Commission is not required to follow ESMA's advice when formulating delegated acts, it is informative for firms to see how the thinking has developed on some of these topics in Europe over the past six months. The table below highlights some of the key recommendations made in ESMA's final technical advice (with focus on changes from the May 2014 draft advice). TECHNICAL ADVICE - HIGHLIGHTS Inducements; and paying for Investment Research (Ch. 2.15) All firms • Investment research: The final advice has a new section specifically on investment research. ESMA confirms its view that research can be an inducement (on the basis that investment managers etc may be encouraged by such research to act contrary to their clients' best interests when selecting / using execution services). Its advice 22 DECEMBER 2014 London Table of Contents 1. ESMA Technical Advice 1 2. Consultation Paper on RTS/ITS 6 3. UK Implementation 7 Annex I: MiFID II Timeline 8 Annex II: MiFID II Legislative Structure 9 Annex III: Overview of MiFID II Topics 10 Annex IV: Contacts 11 RELATED LINKS > Herbert Smith Freehills > Financial Services Regulation > FSR and Corporate Crime NotesPage 2 effectively requires payments for research to be fully unbundled from payments for execution (or other) services. • Research from third parties will not be considered an “inducement” at all, provided that it is paid for directly by the firm out of its own resources (which can be financed by increased fees to clients) or by payments from a ring-fenced “research payment account” funded by an agreed research charge to the client. The research charge must not be linked to execution volume and/or value; and various conduct and disclosure requirements apply. • To enable portfolio managers/advisers to comply, execution service providers should charge separately for execution services. • “Quality enhancement” condition: ESMA proposes a list (which is more permissive than the draft technical advice) of circumstances which would meet this limb of the qualifying conditions for acceptable inducements. Portfolio managers and independent advisers • Carve-out (from the new MiFID II inducements ban) for minor non-monetary benefits: ESMA still recommends an exhaustive list of benefits which can be considered 'minor' (and therefore acceptable) inducements, but now with flexibility for ESMA to add more items through guidelines. Costs and Charges – Professional Clients and ECPs (Ch. 2.14) Professional clients and ECPs • ESMA confirms that detailed information on costs and charges should be made available to Professional Clients and Eligible Counterparties (ECPs). It rejects the suggestion of an opt-in mechanism. • Firms can agree a limited application of the disclosure requirement with Professional Clients and ECPs, but the technical advice is modified to clarify that ECPs which intend to distribute financial instruments embedding a derivative should not be able to agree to a limited application of the rules. Reporting (Ch. 2.20) Loss thresholds • ESMA is more specific in its final advice. It recommends a 10% loss of initial investment value (and thereafter at multiples of 10%) as a trigger for reporting to Retail Clients. Periodic statement • Investment firms should be allowed (as opposed to required to proposed in the draft advice) to enter into agreements with ECPs to determine the content and timing of reporting which are different from the ones applicable to Retail and Professional Clients. • Basic frequency of reports for portfolio management services remain as proposed in the draft technical advice (quarterly instead of every six months), but firms do not need to provide quarterly reports where there is evidence that a client has accessed an online valuation of the portfolio during the quarter. Recording of telephone conversations and electronic communications (Ch. 2.6) Risk-based monitoring • ESMA has clarified that the requirement on firms to monitor their telephone records and electronic communications to ensure compliance with the recording requirements does not mean reviewing all records of transactions, but rather is risk-based. As requested by respondents, ESMA has removed the requirement to monitor "all" transactions and has instead provided that firms should adopt a Page 3 proportionate risk-based approach to monitoring records. Internal calls • ESMA has clarified that internal calls which result or may result in transactions must be recorded. To avoid firms inadvertently neglecting to record calls, firms are required to record all relevant calls even when part of a transaction chain. Notification to clients • ESMA has added new provisions requiring firms to give prior notification to clients that calls are being recorded. Appropriateness (Ch. 2.18) Complex products • ESMA has confirmed that all instruments that are specifically carved out from the express categories of 'non-complex' products should be considered complex (and cannot be assessed as noncomplex under the article 38 qualitative test). Non-UCITS collective investment undertakings • ESMA has clarified that all non-UCITS collective investment undertakings should be considered complex, regardless of whether they take the legal form of shares or units. This will impact on the sale of NURS in the UK. Conflicts of interest – underwriting and placing (Ch. 2.10) • Although the advice has been tweaked to clarify certain proposals and strengthened (e.g. by replacing words such as "should" and "may" throughout with "shall" and "must"), ESMA's final advice generally confirms the measures proposed in the draft technical advice to manage the risk of conflicts during the various stages of the underwriting and placing process between: – firms undertaking underwriting and placing and the issuer of equity or debt securities; – firms undertaking underwriting and placing and the investors in the issuance of equity or debt securities; – the issuer of the equity or debt and the investors; and – investors in the issue. • ESMA disagrees with feedback that the draft advice on conflicts of interests in underwriting and placing was tailored only to equity/IPO markets; the advice applies to all underwriting and placing services irrespective of the type of financial instrument. • ESMA has included a new requirement for additional information to be provided to clients where self-placement by a financial institution is due to regulatory requirements (e.g. CRD IV/CRR or BRRD). Product governance (Ch. 2.7) Scope • The revised wording makes clear that the regime applies to services as well as products. Identifying target market (and target clients' needs, circumstances and objectives) • ESMA considers that what is required to identify the target market differs between manufactures and distributors. A manufacturer should make an assessment based on its “theoretical knowledge” and past experience of the product (or service). The distributor must use the manufacturer’s general target market assessment and its own information on its clients. Page 4 Manufacturers • The final advice recommends that (amongst various points to consider) manufacturers must check pre-launch whether a product may be a threat to the orderly functioning and stability of financial markets; and that the product risk/reward profile is consistent with the target market. Distributors • ESMA has added three further examples of what constitutes an appropriate action where a crucial event affects the potential risk or return expectations of a product: contacting the distributor to discuss a modification of the distribution process; terminating the relationship with the distributor; or informing the relevant national competent authority. Role of compliance (manufacturers and distributors) • The compliance function must oversee (not just be involved in) the development and review of the firm’s product governance arrangements. Commodity derivatives (Ch. 7) "Financial Instruments" definition • ESMA has taken account of feedback by proposing revised technical advice for the purposes of specifying wholesale energy contracts under C6 and C6 energy derivative contracts. • C6 energy derivative contracts: ESMA has proposed a wider definition of oil and not limited it to crude oil. It has also included a broad definition of coal. • "Must be physically settled": ESMA has slightly amended the criteria to provide more legal certainty including clarifying that operational netting where required by the rules or requests of a Transmission System Operator does not prevent a contract from being considered as "must be physically settled". • C7 and C10: ESMA has confirmed its proposal to delete the clearing criterion from the definition, so the existence of clearing arrangements is not an indicator of whether an investment is a financial instrument. • ESMA has introduced the term "third country trading venue" to provide consistent terminology where "equivalence" is relevant. HFT (Ch. 5.1) High Frequency and Algorithmic Trading • The draft technical advice presented two options for the High Frequency and Algorithmic Trading definition. ESMA has reworked the original proposals to take into account feedback and further analysis to test both options, without making a specific recommendation for one option or the other. • ESMA has recommended a number of clarifications to the definition of algorithmic trading including that: – automated trading decisions and the optimisation of order execution processes by automated means are included in the definition of algorithmic trading: – arrangements are considered as algorithmic trading if the system makes independent decisions at any stage of the processes on either initiating, generating, routing or executing orders; and – the definition excludes automated order routers that only determine the venue(s) where the order should be submitted without Page 5 changing any other parameters of the order. • ESMA advises the Commission to follow one of three options as proxies for the identification of “high message intra-day rates” (with the identification of HFT's focused on liquid instruments): – absolute threshold per instrument; – absolute threshold per trading venue and per instrument; or – relative threshold. • ESMA's view is that only proprietary order flow should be considered for determining whether something is high frequency trading. Systematic Internaliser (Ch. 3.3) General • ESMA has confirmed the definition of a systematic internaliser (SI) does not distinguish between liquid and illiquid instruments. However, a firm which qualifies as an SI for illiquid instruments will be subject to more limited requirements. • ESMA has amended its proposal regarding the period over which a firm should assess their SI activity to calculate the thresholds over a larger rolling period of 6 months and provide a longer period for qualifying firms to comply with the SI regime obligations. Equities • Frequent and systematic: ESMA has set a threshold for liquid instruments at 0.40% of the total number of trades in Europe. • Substantial: ESMA has maintained its proposal that the threshold should be based on the turnover as opposed to the volume of shares traded. • The same threshold will be applied to all equity like instruments (including ETFs) as for shares. Non-equity Instruments • Frequent and systematic: ESMA has adopted its proposal to use a percentage threshold together with a minimum absolute threshold under which a firm would be considered as trading on a non-frequent basis. The absolute threshold will be set in line with the threshold used for illiquid instruments (i.e. on average once a week). • Substantial: To be assessed via two criteria, either the size of a firm's internalisation activity compared to a firm's total trading activity in a particular financial instrument or the size of such activity compared to the total trading in the Union for that financial instrument Classification of Asset-backed commercial paper (Ch. 3.2) • ESMA has amended its advice and removed the reference to assetbacked commercial paper (ABCP) being a structured finance product (as opposed to a money market instrument). ABCP should therefore not be subject to MiFIR transparency obligations. What next? The European Commission will now consider ESMA's technical advice before producing delegated acts1 . The Commission intends to adopt MiFID II delegated acts by July 2015. European Parliament and Council will have up to six months (an initial three month period which can be extended for a further three months) to object to the delegated acts. Firms can expect to see the finalised delegated acts by early January 2016.
1 See Annex I for an explanation of the MiFID II legislative structure.Page 6 2. Consultation Paper on RTS/ITS The Consultation Paper includes draft technical standards on all areas for which the MiFID II Directive and MiFIR require ESMA to adopt technical standards2 . The draft technical standards are based on feedback and responses to the 615 questions set out in the Discussion Paper published by ESMA in May which contained ESMA's initial thinking and understanding of the areas where binding technical standards have been mandated by MiFID II. Structure The Consultation Paper contains 645 pages and 245 questions. It has two standalone annexes: Annex A – Cost benefit analysis – given the limited information collected to date, only a preliminary cost benefit analysis is provided at this stage. It is expected that a comprehensive quantitative impact study will be conducted in due course when more data becomes available. Annex B – The 38 draft technical standards. Key Topics The Consultation is divided into key topics and is structured in the same way as the Discussion Paper (although the numbering of sub-sections has changed). Some of the issues considered under each key topic are set out below: Investor protection (Chapter 2 – pages 19-46): The key topic covered in this section relates to the best execution requirements for trading venues to publish data related to the quality of execution for each financial instrument traded and the publication of data by investment firms. The other areas being consulted on in this section include procedures for granting and refusing requests for authorisation of investment firms, the freedom to provide investment services and activities / establishment of a branch, and the provision of services by third country firms following an equivalence decision. Transparency (Chapter 3 – pages 47-346): This section covers a range of topics, some of which have proved highly controversial, including: • Equities: Pre-trade and post-trade transparency regime for venues and investment firms, the systematic internaliser regime, the double volume cap mechanism and the trading obligation for shares. • Non-equities: Pre-trade and post-trade transparency regime including the scope of non-equity financial instruments and the liquid market definition, the transparency regime for large-in-scale orders and the trading obligation for derivatives. The analysis on foreign exchange derivatives, credit derivatives, other derivatives and contracts for difference is not included in this consultation. ESMA will launch a separate consultation in early 2015. Micro-structural issues (Chapter 4 – pages 347-433): This section is concerned with the requirements relating to algorithmic trading, systems resilience, circuit breakers, electronic trading and tick sizes, including: • Organisational requirements for trading venues and investment firms. • Requirements relating to market-making, including the circumstances when firms are required to enter into market making agreements. • Co-location. • More detail on the tick size regime. Data publication and access (Chapter 5 – pages 434-482): This section consults on access to central counterparties (CCPs) and trading venues, including the grounds for denying access. It also consults on the non-discriminatory access to and obligation to license benchmarks, including the information to be made available to trading venues and CCPs and related confidentiality issues, as well as the standards for proving a new benchmark. Commodity derivatives (Chapter 7 – pages 503-556): This section consults on the draft RTS on the ancillary activity exemption in article 2(1)(j) of the MiFID II Directive, considering the elements to be taken into account when determining the criteria for establishing when an activity may be considered "ancillary" to the main business. The provisions relating to position limits and position reporting are also consulted in this section. Market data reporting (Chapter 8 – pages 557-635): This section consults on the draft technical standards supporting the transaction reporting obligations, including details of what constitutes a transaction and execution of a transaction and the fields of transaction reports (including details on the identification of client, Trader ID and Algo ID, applicable waiver, short sales). This section also consults on the obligations to supply financial instrument reference data and maintain records of orders (including for firms engaging in high-frequency / algorithmic trading) and synchronisation of business clocks. The consultation also covers requirements applying on and to trading venues (Chapter 6) and post-trading issues (Chapter 9).
2 See Annex I for an explanation of the MiFID II legislative structure.Page 7 A full list of the questions posed in the consultation is set out in the reply form for the consultation. A list of the draft RTS and ITS (set out in Annex B of the consultation) can be found here. What next? Firms have just over two months, until 2 March 2015, to respond to the consultation. An open hearing will be held in Paris on 19 February 2015. ESMA will launch a separate consultation on transparency issues for foreign exchange derivatives, credit derivatives, other derivatives and contracts for difference in early 2015. ESMA will review responses from stakeholder before submitting final regulatory technical standards (RTS) and implementing technical standards (ITS) to the European Commission for endorsement: • RTS – by July 2015. • ITS – by January 2016. 3. UK Implementation The FCA has said that it is expecting to consult formally on MiFID-related Handbook changes towards the end of 2015. However, it will be engaging with firms on aspects of the changes required to be made before then. In Q1 2015, it will publish a discussion paper on various issues relating to conduct of business, including the approach which the FCA should take given that its conduct of business rules for investment business currently cover insurance-based investment business as well as business relating to MiFID financial instruments. HM Treasury will also work on transposing the MiFID II Directive by 3 July 2016 – the deadline for transposition of the MiFID II Directive. According to the FCA, HM Treasury is looking to consult on changes in Q1 2015, including in relation to the following: • Changes to the boundaries of UK regulation by means of amendments to the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001. • An authorisation regime for data reporting service providers. • Changes to the FCA's supervisory powers (e.g. position limits). • Implementing third-country branch provisions. • Changes to the requirements to be met by recognised investment exchanges.Page 8 Annex I: MiFID II Timeline Delegated Acts General Transposition RTS & ITS 22 May 2014 2 July 2014 Dec 2014 2 March 2015 3 July 2015 3 Jan 2016 3 July 2016 3 Jan 2017 ESMA submits technical advice to Commission Final delegated acts to be published in OJ by this date ESMA CP on RTS/ITS ESMA submits RTS to EU Commission Deadline for responses to ESMA CP on RTS/ITS MiFID II entry into force End 2015 ESMA CP and DP 1 Jan 2018 Member states transposition of MiFID II (Directive and delegated acts) MiFID II go live date FCA consultation on handbook changes Commission adopts delegated acts (EP/ Council have up to 6 months to object) 3 Jan 2019 3 Jul 2020 MiFIR open access provisions for benchmarks to apply Commission paper on MiFID clearing requirement applicable to exchange-traded derivatives (C6) and its effect on energy market and prices 6 Months 12 Months 18 Months 24 Months 30 Months Commission report on temporary exclusion of exchange-traded derivatives from scope of open access provisions (CCP and trading venue) ESMA submits ITS and guidelines to Commission EMIR clearing obligation/risk mitigation techniques to apply to C6 energy derivative contracts entered into by non-financial counterparties Months from entry into force Q1 2015 HMT CP on transposition/ FCA CP on conductPage 9 Annex II: MiFID II Legislative Structure The European legislative structure as applied to MiFID is as follows: Level 1: directive (MiFID II Directive) and regulation (MiFIR) 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 (see ESMA Consultation Paper) 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. MiFID II (Framework Directive) & MiFIR (Framework Regulation) Level 1 Delegated acts; implementing acts Implementing Technical Standards (ITS) or Regulatory Technical Standards (RTS) Non-binding supervisory guidance Post-implementation enforcement Level 2 Level 3 Level 4 Proposed by the Commission; adopted by Council and European Parliament Drafted and adopted by the Commission (after considering ESMA technical advice submitted to Commission on 19/12/14) Developed and issued by ESMA Developed by ESMA (see Consultation Paper: Final RTS by 3/7/15; ITS by 3/1/16); Adopted by the Commission Directives – to be transposed into domestic law Regulations - directly applicable National supervisory authorities “comply or explain” EU Domestic Regulations or Decisions – directly applicablePage 10 Annex III: Overview of MiFID II TopicsPage 11 Annex IV: Contacts Karen Anderson (partner) T +44 20 7466 2404 M +44 780 9200 009 Karen.Anderson@hsf.com Clive Cunningham (partner) T +44 20 7466 2278 M +44 7989 558 095 Clive.Cunningham@hsf.com Andrew Procter (partner) T +44 20 7466 7560 M +44 7809 200 645 Andrew.Procter@hsf.com Chris Haynes (partner) T +44 20 7466 2106 M +44 778 577 5038 email@example.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.comPage 12 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. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on the information provided herein.11/25399619_2 13