Summary and Implications
Following a review of the Markets in Financial Instruments Directive (MiFID), on 20 October 2011 the European Commission (the Commission) published its proposals for revisions to MiFID. The Commission has stated that the policy objectives for these revisions are to:
- Ensure a level playing field between market participants;
- Increase market transparency for market participants;
- Reinforce transparency towards and power of regulators in key areas and increase coordination at European level;
- Raise investor protection; and
- Address organisational deficiencies and excessive risk taking or lack of controls by investment firms and market operators.
How are the revisions being made?
The EU has previously committed to minimise, where appropriate, the discretion available to Member States when implementing EU financial services measures (this is in line with the creation of a single EU financial services rulebook). In this respect, the revisions to MiFID are being made through a combination of an EU Regulation and an EU Directive.
In short, EU Regulations have direct effect in Member States and do not need to be transposed into domestic law, whereas EU Directives need to be implemented in EU Member States through the usual domestic legislative process.
Extending the scope of investments that fall within MiFID
Derivatives on emission allowances currently fall within MiFID. However, under the proposals MiFID would also catch emission allowances themselves for the first time.
MiFID previously applied certain provisions to credit institutions authorised under the Banking Consolidation Directive when providing one or more investment services and activities that fall within MiFID. The proposed amendments would extend the application of MiFID to credit institutions when selling or advising clients in relation to deposits other than those with a rate of return which is determined in relation to an interest rate e.g. structured deposits.
There is the proposed new MiFID investment service and activity of “Operation of Organised Trading Facilities” (which is discussed in further detail below).
Safekeeping and administration of financial instruments for the account of clients (including custodianship and related services such as cash/collateral management), is moving from being an “ancillary service” to an “investment service” under MiFID. Any firm that is only carrying on safekeeping and administration will now fall within MiFID.
Click here for the provisional MiFID II Directive.
Click here for the provisional MiFID II Regulation.
Click here for the Commission’s press release.
Click here for the Commission’s FAQs.
Changes to the MiFID exemptions
The exemption relating to persons who do not provide any investment services or activities within MiFID other than dealing on own account has been amended. This exemption would no longer be available to those that are members or participants in a regulated market or a multilateral trading facility (MTF).
The exemption which applies to persons whose main business consists of dealing on own account in commodities and/or commodity derivatives, would be deleted under the proposals.
In addition, the exemption which is available to persons that deal on own account in financial instruments where this is ancillary to their main business, has been amended and will no longer be available to those that deal on own account by executing client orders.
The exemption above would also apply to firms that provide investment services (other than dealing on own account) in relation to emissions allowances or derivatives thereof.
The optional exemption
The UK chose to implement the optional exemption in Article 3 of MiFID which provides that firms will not fall within MiFID if they satisfy certain requirements.
This optional exemption is being widened so that a firm will be able to fall within this exemption if they provide advice on any financial instruments under MiFID (not just on transferable securities and units in collective investment undertakings as was previously the case).
New requirements to fall within the MiFID Article 3 exemption
Firm does not hold client money or securities The only investment services that they carry on are:
- the provision of investment advice;
- the reception and transmission of orders in transferable securities and units in collective investment undertakings
What is an Organised Trading Facility (OTF)?
As mentioned above, there is the new MiFID investment service and activity of operating an OTF. This is defined as “any system or facility, which is not a regulated market or MTF, operated by an investment firm or a market operator, in which multiple third-party buying and selling interests in financial instruments are able to interact in the system in a way that results in a contract” in accordance with MiFID.
In summary, OTFs will have identical pre- and post-trade transparency requirements as regulated markets and MTFs, while organisational and market surveillance requirements are also similar.
The Commission has stated that the operator of an OTF has a “degree of discretion over how a transaction will be executed” and consequently will have to comply with the MIFID obligations relating to investor protection, conduct of business and best execution. With this in mind, OTFs would be prohibited from trading against their own proprietary capital.
The creation of the OTF regime has three objectives
- To set up an appropriate regulatory framework for broker crossing systems present in the equities markets.
- To set up an appropriate regulatory framework for different types of trading systems which are currently not regulated as trading venues.
- To have a framework which is dynamic enough to accommodate the future trading systems and solutions that could emerge in the future.
Trading venues – new requirements relating to best execution
While currently under MiFID, assessing best execution rests upon examining the pre- and post-trade transparency data, the proposals require making available other relevant information which the Commission believes is relevant for these purposes.
Execution venues will be required to make available to the public (at no charge and at least on an annual basis) data relating to the quality of execution of transactions including price, speed of execution and likelihood of execution for individual financial instruments. Execution venues that trade commodity derivatives, emissions allowances or derivatives thereof will also be required to produce a weekly report to the public outlining the positions held by the different categories of trader for the different financial instruments. In addition, they will need to provide the regulator with a complete breakdown of the positions held.
Execution venues that trade commodity derivatives must also impose limits on the number of contracts which market members or participants can enter into. The aim of this restriction is to ensure the orderly functioning of the market and settlement conditions for physically delivered commodities.
New sub-category of markets – relating to small and medium-sized enterprises (SMEs)
To complement other European initiatives to assist SMEs in obtaining finance, there are proposals to create a new sub-category of markets referred to as “SME growth markets”. Market operators can elect to register as such a market (provided they satisfy certain conditions) which should raise their profile and help produce Europe wide regulatory standards catering for SMEs.
New authorisation for “data reporting service providers” (Data Providers)
The proposals introduce a new authorisation requirement for those that provide data reporting services as a regular occupation or business.
Data reporting services
- Operating an approved publication arrangement
- Operating a consolidated tape provider
- Operating an approved reporting mechanism
MiFID currently allows investment firms to provide investors with an execution only trading service without undertaking an assessment of the appropriateness of the product concerned. As part of the MiFID review consultation process, the Commission suggested two alternative approaches to amend the execution only regime:
- Amend certain parts of the current regime to create a greater degree of certainty around which products and services may trade execution only; or
- Remove the execution only regime in its entirety.
The Commission is now proposing the former, with certain amendments to clarify the types of investments that may be traded execution only. For example, previously the execution only regime was available to all bonds and other forms of securitised debt (excluding those bonds and securitised debt that embed a derivative). Under the proposals this will now be limited to those that are admitted to trading on a regulated market or an equivalent third country market or an MTF (but in addition also excluding those that incorporate a structure which makes it difficult for the client to understand the risks involved).
Emission allowances trading
As stated above, for the first time MiFID will catch emission allowances themselves, which were previously outside of the scope of MiFID, as well as derivatives on emission allowances. The Commission believes extending the scope of MiFID in this way is justified as a range of fraudulent practices have occurred in the spot markets which could undermine trust in the emission trading system. By falling within MiFID, this means that the Market Abuse Directive would also apply to trading in emission allowances.
The proposals seek to extend the requirement that those who direct and control the investment firm or a market operator are of sufficiently good repute to carry out the task of prudently managing that firm. The proposals also state that ESMA will develop draft regulatory standards to specify, for example, the sufficient time commitment of a member of the management board, adequate collective knowledge, training of members of the management board and diversity in their selection.
The growth in the trading of over-the-counter (OTC) derivatives has led to agreement amongst the G20 that stricter regulation is required. Accordingly, the Regulation proposes that standard form OTC derivatives should be traded either on exchanges or other trading platforms. This approach is consistent with EMIR and the proposal to increase the central clearing of derivatives. ESMA and the Commission will have the task of defining which derivatives are to be subject to the provisions.
Algorithmic and high-frequency trading
Algorithmic trading is defined in the proposals as “trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention. This definition does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the confirmation of orders”.
Firms that engage in algorithmic trading will be required to have certain systems and controls, generally aimed at risk control to mitigate disorderly trading and ensure resilient trading platforms. Firms will also be required to provide information to the regulator at least on an annual basis.
Third country firms
The proposals will amend the current UK regime in the Financial Services and Markets Act 2000 relating to “overseas persons”. Third country firms established in third countries who have received an “equivalence decision” would be entitled to provide financial services in the EU, either through the creation of a branch or through providing services into the EU on a cross-border basis.
Third country firms that carry on investment services within MiFID on a cross-border basis would be required to register with ESMA. The proposals outline different requirements, depending on the type of customer that the third country firm carries on business with within the EEA.
Click here to view table
Although MiFID currently provides for a certain degree of both pre- and post-trade transparency, a large part of the proposed Regulation strengthens the application of the transparency rules. This includes extending the transparency rules to include equity instruments (exchange traded funds, depositary receipts and other financial instruments) and non-equity instruments (bonds, structured finance products and derivatives admitted to trading).
Waivers from the transparency rules will be applied more accurately and consistently under the proposals. Competent authorities will be obliged to inform and receive an opinion from ESMA before granting a waiver, which can be disputed by other Member States.
The Regulation proposes specific transparency rules for investment firms acting as systemic internalisers.
The proposals prohibit discriminatory clearing practices which harm competition. By removing barriers, such as central counterparties refusing to supply clearing services for some trading venues, or, crucial information not being provided to clearers or trading venues, the Regulation is expected to improve competition in the clearing industry.
Under the proposal, Member States should comply with the Commission’s minimum requirements for sanctions. As well as listing a number of possible breaches, the proposals also list the possible penalties including a fine of up to 10 per cent of the total annual turnover of the legal person (or group) in the preceding business year.
The proposals outlined in both the Directive and the Regulation must now be negotiated and agreed by the European Parliament and European Counsel (which consists of representatives of the EU Member States).
The Commission has not stated the proposed timing in this respect. Although, taking into account that these amendments relate to the G20’s commitment to tackle the less regulated and more opaque parts of the financial system, it is possible we will have an agreed draft of the proposed legislation by the end of next year.