The European Council adopted a set of legislation on 13 May 2014 regulating the trade in financial instru- ments and the investment services sector. The new measures, known as MiFID II and consisting of a directive and regulation, are expected to be published shortly. The existing directive (MiFID I) will be replaced. Most of MiFID II will have to be applied in all member states within 30 months after it comes into force, probably 1 January 2017. De Brauw organised a seminar on 15 May 2014 about MiFID and its practical implications. At this well-attended event Gerben Everts, executive board member at the Dutch financial supervisor AFM, gave a keynote speech which can be viewed on the AFM website (in Dutch only).
MiFID II is mainly relevant to investment firms, and of course to banks that provide investment services or engage in investment activities. These organisations will have to start preparing for a number of changes to their governance and business organisation. As MiFID II significantly extends not only the scope but also the detail of the regulation, most investment firms will have to review existing activities and may need to adjust their compliance monitoring accordingly. Under MiFID II they will have to take into account that supervisory authorities will have a greater set of supervisory tools at their disposal and that stricter sanctions will apply.
Investment firms will have to provide more information to their clients, e.g., about the total cost of an invest- ment service or the cost of a financial instrument that they recommend or market. Where investment advice is provided, the client must be told beforehand if the advice is provided on an independent basis. If it is, the financial instruments included in the advice may not be limited to instruments of entities that the service provider has a close link with. And even if the client is a professional investor, providers of independent in- vestment advice or asset management may not pay or receive any commission. “Execution only” services will be subject to additional restrictions, and services providers will therefore need to reassess the terms of their agreements with clients.
Trading in a greater range of financial instruments will be subject to transparency requirements, and executed transactions in more financial instruments will have to be reported to the supervisory authorities. MiFID II introduces strict rules for high-frequency trading and introduces an obligation to execute transactions in derivatives on a trading platform: a regulated market, MTF or the new OTF. Parties that are active in commodi- ties markets and trading in commodity derivatives will, much sooner than is currently the case, fall under the licence and supervision regime for investment firms.
Why MiFID II? The answer is to a certain extent simple: because MiFID I has been evaluated.
The key principles of MiFID I were:
integration of the retail investment services market
Evaluation has shown that not all principles have been met and highlighted new problem areas. For example, the increased choice in trading platforms has led to market fragmentation, where “best execution” obligations do not ensure sufficient compensation. In addition, much trading appears to take place in “unlit” circumstances. Think of “dark pools” where equity instruments are traded and of a wide use of pre-trade transparency waivers. MiFID II’s main purpose is to bring about more transparency.
Another objective of MiFID II is to realign regulation with the many technological developments that have taken place. An important element is the newly introduced regulation and supervision of investment firms using computerised algorithms to determine order parameters, notably high-frequency traders.
In adopting MiFID II, the EU is furthermore meeting agreements made in a G-20 context to resolve issues in the OTC derivatives trade which emerged on a large scale and with immense impact after the fall of Lehman Brothers in 2008. The same applies to measures concerning the commodity derivatives trade, where MiFID II also implements G-20 agreements to intervene in positions taken by commodity derivatives traders, counter excessive price volatility on the commodity markets and consequently limit negative effects on food prices,
by widening the powers of national as well as European supervisors.
MiFID II contains a Level 1 directive (MiFID) and a Level 1 regulation (MiFIR). There is a great deal of Level 2 and Level 3 regulation in the pipeline, setting out the MiFID II principles in further detail. The European Commission will adopt various delegated acts. And ESMA will develop a wide range of binding technical standards, to be subsequently adopted by the Commission. In addition, ESMA will issue the necessary guidelines to safeguard uniform application of the Level 1 and 2 principles in the member states. Investment firms would be wise to follow the various consultations.
The first step in further developing MiFID II was taken by ESMA when it published a consultation and
discussion document on 22 May 2014.
The Commission has asked ESMA for advice on the delegated acts to be adopted on the basis of MiFID.
, ESMA is putting forward for public consultation a set of draft delegated acts that it has prepared.
Both the directive and the regulation assign the development of various binding technical standards to ESMA. These are Regulatory Technical Standards (RTS) and Implementing Technical Standards (ITS).
, ESMA is asking the public for feedback on a few important elements of these technical standards. Based on the response to the discussion document, ESMA will then hold a consultation about the draft technical standards ultimately to be adopted by the Commission.
Especially since the technical implementation is of the greatest practical relevance, it could be useful to provide feedback during the consultations. The deadline for this is 1 August 2014.
This question is mainly relevant in three areas:
•market infrastructureand rulesfor tradingin financialinstruments
MiFID II sets out a regulatory framework for a market infrastructure that will close perceived loopholes.
It introduces a new type of trading platform: the organised trading facility, or OTF. As regards dealing on own account, MiFID II brings the necessary clarification, particularly where execution of client orders is concerned. Dealers on own account applying high-frequency algorithmic trading techniques will no longer be exempted from licence requirements and supervision. Investment firms using algorithmic trading techniques will have
to comply with far-reaching internal control and business conduct rules, provide a considerable amount of information to supervisors – including data on algorithms and strategies used – and comply with administrative requirements. Additional conditions are imposed on high-frequency traders, investment firms executing a market making strategy while using algorithmic trading techniques, and investment firms
providing their clients with direct electronic access to trading platforms. Transactions in equity and derivatives
must, where possible, be executed on “lit” market places.
Transparency rules are extended. Existing pre-trade and post-trade transparency obligations will also apply to “equity-like” instruments and to non-equity capital instruments such as bonds and derivatives. The use of pre-trade transparency waivers is limited via a “double volume cap” mechanism. Mandatory reporting to supervisors of executed transactions is extended from instruments admitted to trading on a regulated market
to instruments traded on any trading platform or the underlying value of which is such instrument or an index or basket composed of such financial instruments. And more data will have to be provided as part of this reporting, including client IDs.
All this means that investment firms will need to take the following concrete steps to prepare for
implementation of MiFID II:
Firms operating certain multilateral systems for trading in financial instruments will have to assess whether they are subject to the rules for the OTF, the new type of trading platform, or the existing MTF. An important factor in this is that an OTF operator will generally have to meet “best execution” obligations towards its clients, because order execution on an OTF must take place on a discretionary basis. This is not the case on an MTF.
Investment firms working with algorithmic trading techniques will have to adjust their business practices, and in particular their compliance monitoring, to a large number of new rules. They will also have to face changes to their relationship with trading platforms that they are active on. This is the result of new requirements imposed by MiFID II on market operators and investment firms operating trading platforms. Agreements between investment firms working with algorithmic trading techniques and pursuing market making strategies and the trading platforms on which they do this will need to have a specific content under MiFID II.
Direct electronic access
Where investment firms provide their clients with a trading code, allowing them to submit direct electronic orders to a trading platform, they will have to closely review their contractual arrangements with those clients. For example, contracts will have to show that the investment firm itself remains responsible, even for its clients’ compliance with MiFID II and the relevant platform’s rules.
Wider scope of transparency and transaction reporting
Investment services providers executing orders in financial instruments will have to be aware of much wider post-trade transparency and transaction reporting requirements under MiFID II. IT systems will have to be drastically revised. Even investment firms that only receive and transmit client orders will have to deal with the extensive transaction reporting requirements. If they do not report themselves, they will have to ensure that the necessary information is passed on to the investment firm executing the transactions.
Data services providers
MiFID II introduces three types of data services providers that generally require a licence: the Approved Publication Arrangement, the Approved Reporting Mechanism, and the Consolidated Tape Provider. Firms will need to use the services of an APA to comply with post-trade transparency requirements. For compliance with reporting requirements, they may use the services of an ARM. In general, firms will need to decide how to organise post-trade publications and transaction reporting.
Information to clients
The duty of investment firms to provide fair, clear and not misleading information to clients and potential clients remains unchanged in MiFID II. The consultation document (see above under “More regulation is on its way”) shows that ESMA wants to tighten this obligation. Investment services or financial instruments may state potential benefits, but must also clearly indicate the risks involved. This proposal is in line with the increased emphasis placed by supervisors on adequate supply of information. An example of that emphasis is
for – among other things - failing to clearly communicate the risk of using derivatives to clients. MiFID II introduces an obligation to inform clients about all costs connected with an investment service or ancillary service, including the costs of advice and the costs of a financial in- strument that is recommended or marketed. All costs charged by third parties must be aggregated so that the client understands the overall cost and its cumulative effect on return. ESMA is advocating that the aggre- gated amount in costs should be stated both as a total amount and as a percentage.
MiFID II requires that investment firms, before giving investment advice, inform their clients whether the advice is provided on an independent basis. Firms should also communicate whether the advice is based on a broad or more restricted analysis of various financial instruments, and in particular if they have only con- sidered financial instruments of entities that they have close links with. If advice is provided on an independ- ent basis, the range of financial instruments included in the advice should be sufficiently broad and diverse. Those financial instruments may not be limited to instruments issued or provided by entities that have close links with the investment firm. Investment firms may give both independent and non-independent advice but if they provide both, ESMA wants different persons to give each type of advice so as to avoid confusion. Clients must be informed in advance if the investment firm is planning to periodically assess suitability of the recommended financial instruments. If the investment firm has indicated that it will carry out this periodical assessment, this should be done at least once a year, according to ESMA. A higher frequency will depend on risk profile and types of financial instruments.
As a complete ban on commissions is already in place in the Netherlands, the new restrictions introduced by MiFID II on this point are no longer radical. But for services provided to professional investors the MiFID II restrictions on commission are of importance because these services are not subject to the current ban in the Netherlands. Once MiFID II is implemented, commissions may no longer be paid or received when providing independent investment advice and asset management to professional investors.
MiFID II provides that local public authorities, including municipalities, are not considered professional investors. They may, however, elect to be treated as professional investors provided that conditions already set out in MiFID I are met. Member states may impose other or additional conditions on local governments in order to qualify as professional investors.
MiFID II limits the option of not carrying out a suitability assessment when only executing orders or receiving and transmitting orders. These “execution only” services may not be provided if credit is granted or if they concern shares or units in collective investment undertakings. Execution only will be allowed for shares or units in a UCITS provided that the UCITS is not deemed a “structured UCITS”. It is not yet clear if an ETF using swaps to this end will be deemed a structured UCITS.
Investment firms arranging for client funds to be held in accounts at third parties should verify as part of their due diligence whether the funds are spread among several third parties. ESMA wants to impose a 20% maximum on accounts held by group companies of the investment firm.
European passport for investment services by AIFMs
MiFID II amends the AIFM Directive to enable AIFMs authorised to provide investment services to provide these services cross-border within the EEA. This European passport should be implemented within 12 months after MiFID II comes into force, but it is already issued and recognised by member states such as the Netherlands, the United Kingdom, and Ireland.
Licence for trading in commodity derivatives on own account
Firms taking positions in commodity derivatives must review their portfolios and verify for each position:
- Does the derivative qualify as a financial instrument within the meaning of MiFID II?
A number of elements are relevant in this analysis, including whether the contract is settled in cash or physically. In the case of physical settlement, the derivative will only be a financial instrument if it is traded on a regulated market, MTF, or OTF. Commodity derivatives that are settled physically are concluded on an OTF and fall under REMIT do not as a general rule qualify as financial instruments within the meaning of MiFID II.
- Is an investment service provided or an investment activity conducted as referred to in MiFID II?
This is the case more often than not. If a contract is concluded in one’s own name and account, this will qualify as “dealing on own account”. Dealing on own account is an investment activity within the mean- ing of MiFID II. A licence must be applied for to carry out this type of activity, unless an exemption can be relied on (see 3 below).
- Can an exemption be relied on?
Companies belonging to a group the main business of which is (i) providing investment services, (ii) providing banking services, or (iii) acting as market maker in commodity derivatives cannot benefit from an exemption under MiFID II. If the dealing in commodity derivatives on own account is not deemed an
ancillary activity, no exemption can be relied on either. ESMA will further specify in technical standards
when an activity qualifies as an ancillary activity.
If the answer to questions 1 and 2 is “yes” and the answer to question 3 is “no”, the entity in question will have to apply for a licence as an investment firm pursuant to MiFID II. But this is not the only consequence. These entities will also be qualified differently under EMIR: from non-financial counterparties to financial counterparties. In addition, they will become subject to the capital requirements set out in the Capital Re- quirements Regulation (EU) 575/2013).
Position limits and position management
To promote an orderly operation of markets where commodity derivatives are traded, national supervisors are given new powers, including the power to:
In addition, trading platforms where commodity derivatives are traded should carry out position management controls, including monitoring open positions held by market participants and gathering information about matters including the objective of the position and the beneficial owner. This means that market parties taking positions in commodity derivatives on behalf of clients or third parties should arrange with those clients or third parties how this information is to be collected and agree that it may be supplied to trading platforms.
If you have any questions or require further information regarding this Legal alert please contact:
Kees Groffen | T +31 20 577 1025 | E firstname.lastname@example.org
Mariken van Loopik | T +44 20 7562 4369 | E email@example.com
René Maatman | T +31 20 577 1551 | E firstname.lastname@example.org
Francine Schlingmann | T +31 20 577 1564 | E email@example.com