- Extending MiFID regulation of investment firms and credit institutions.
- Tougher conduct of business and prudential requirements.
- Extending EU regulation of markets and trading venues.
- Increasing the powers of ESMA and national supervisors.
Background and timetable
The MiFID regime (which came into effect on 1 November 2007) harmonised EU1 rules for investment business; it applies to investment firms, banks, other credit institutions as well as to exchanges and trading platforms.
The EC consulted2 on amendments to MiFID and drafts of the new legislation have been circulating for some time. On 20 October 2011, the EC finally published the official level one proposals which comprise a directive (to amend the level one directive i.e. the framework legislation known as MiFID I) and a new EU Regulation (which will have direct effect without national implementing measures being required).
It is anticipated that there will be new level two measures and the complete reform package will take at least a couple of years to implement, given the raft of further measures and technical details which have to be produced by the EC and European Securities and Markets Authority (“ESMA”).
The proposals will make a large number of changes to the current MiFID regime. We summarise some of these changes below and briefly consider the likely impact on firms and other market participants.
Extending the scope of MiFID regulation of investment firms and credit institutions
A radical new EU authorisation regime for third country firms – a new services passport for firms from countries that pass the ‘equivalence’ test.
Third country investment firms i.e. those incorporated outside the EU/EEA do not currently enjoy a MiFID passport. They must apply for separate authorisation in each member state (for services/ cross border business or to operate a local branch). The regulatory ‘perimeter’ varies from one member state to another and different authorisation requirements apply. In relation to UK business, many third country firms without a UK branch, rely upon the ‘overseas persons’ exemption’ in Article 72 of the Regulated Activities Order to avoid authorisation.
Third country firms will not be able to obtain authorisation to provide any MiFID services to retail clients unless they have established a branch within the EEA.
The EC will consider whether a third country passes equivalence and reciprocity tests -
- Equivalence test: does the third country have an equivalent3 regulatory regime to the EU/MiFID/CAD (including equivalent regulation in a broad range of prudential areas including market abuse, capital and organisational requirements and supervision)?
- Reciprocity test: does the country give equivalent reciprocal recognition to the EU prudential framework?
A firm from a third country that has passed both tests will be able to establish a branch in any member state by applying for authorisation from the authority in the relevant state. There will be a harmonised process (including harmonised requirements as to cooperation agreements with the third country regulator) and a harmonised set of MiFID rules (conduct of business, prudential and other MiFID requirements) will apply to the third country firm branch.
Once authorised, the third country firm branch will be free to provide services in/to other member states without the need to establish a local branch or branches. It will have the benefit of an EEA wide services passport (i.e. it will able to conduct services business in other member states and only need complete a simple notification process to the member state authority which has granted its EEA authorisation, similar to the current passport regime for EEA firms).
Third country firms providing services to eligible counterparties would not have to establish a branch, but will need to register with ESMA.
All third country firms will need to review their EEA entity operating structure across all relevant states. They will need to assess the impact of the changes on their current operations and consider the optimum structure for their business under the different models which will be available. Much will depend on whether their home country passes the equivalence and reciprocity tests.
Third country firms from countries that pass the equivalence and reciprocity tests will be in a much improved position. They will be able use a single EEA branch authorisation to provide services from that branch to clients across the EEA, and they will have a harmonised set of MiFID rules to follow. Third country firm groups may even switch from a local EEA subsidiary (perhaps originally established to take advantage of the MiFID passport and avoid current difficulties for third country firms) back to a branch of the third country firm.
Third country firms from other non-equivalent/reciprocal countries cannot set up a branch and will have to incorporate an EEA subsidiary and obtain authorisation as an EEA firm. They will be precluded from dealing with retail clients other than via an authorised subsidiary. It is not clear whether or not the UK’s overseas person exemption will be permitted to remain to allow a third country firm to provide services on a remote basis to professional clients and eligible counterparties.
Regulating structured deposits and ‘own issue’ financial instruments
(a) MiFID conduct of business rules may not currently apply to transactions where the firm is not giving advice and the investment is by way of primary transaction involving the firm itself issuing a new financial instrument to the client, and (b) the regime does currently apply to structured deposits.
(a) In future, the issue of financial instruments will generally be treated as the ‘execution of a client order’ by a firm and will therefore be MiFID regulated, and (b) certain MiFID rules will in future apply to banks/credit institutions and other firms when they are selling or advising on certain structured deposits (i.e. those falling within the definition of ‘packaged retail investment products’ under the EC’s PRIPs proposals).
(a) Firms subject to MiFID which issue their own financial instruments (such as bonds) will need to comply with MiFID conduct of business rules and conflicts of interests rules when carrying out these activities and, (b) structured deposits will now be subject to more coherent harmonised rules across retail products than the proposals on PRIPs. The main debate is over the definition of those ‘structured deposits’ caught by the change; if this is drawn too broadly it will cause confusion and difficulty.
Bringing more own account dealers into regulation
Certain firms fall outside MiFID regulation as a result of (a) an exemption for own account dealers in commodities and commodity derivatives or (b) other exemptions for own account dealing.
(a) The commodity dealers exemption is to be removed, and (b) another own account dealer exemption is being changed and the definition of the MiFID activity of ‘executing client orders’ is also being amended.
Some firms which currently fall outside of MiFID will in future be caught; they may need to become authorised and/or comply with additional requirements. This is a particular issue in the commodities sector where firm may have been protected by the exemption which is being removed.
Algorithmic trading and market protection
There are concerns, within the EU and beyond, about algorithmic trading, particularly about the dangers of high frequency automated trading.
There will be new requirements on regulated markets regarding systems resilience, circuit breakers and electronic trading; these include a prohibition on giving direct electronic access to any firm that is not authorised under MiFID.
Extensive new requirements will apply to firms engaged in algorithmic trading including the obligation to report to its supervisor on its trading strategy and parameters as well as its related and risk/compliance controls. Additional requirements apply to firms with direct electronic access to trading venues and general clearing members.
There are significant impacts for regulated markets and for firms involved in these forms of trading. There is particular alarm at the implications of needing to report details of highly sophisticated and confidential algorithmic trading strategies.
Bringing physical emission allowance trading into regulation
Whilst emission allowances derivatives are currently caught by MiFID, dealings in the physical market are not.
Emission allowances are to be added to the MiFID definition of financial instruments.
Firms involved with physical emission allowance business that are not currently authorised for financial business, will need to consider their position carefully and may need to apply for authorisation and/or restructure their carbon market operations to take advantage of those exemptions which will continue under MiFID II. Those that are authorised will need to extend their compliance regime.
Tougher conduct of business and prudential requirements
There has been much discussion about the failures of corporate governance as a cause of excessive risk taking by financial institutions.
There are enhanced governance provisions with new and some rather specific obligations; these will all apply to investment firms and some to banks, other credit institutions and regulated market operators. For the first time, the legislation places a clear responsibility on each member of the board – both executive and non-executive – to assess and challenge the decisions of senior management. They are also obliged to commit sufficient time with hard limits on executive and non-executive directorships – a maximum of one executive with two non-executive or four non-executive (with no executive roles).
Collectively the board must have the knowledge, skills and experience to understand the business and the main risk involved. Larger and more complex businesses must have a nomination committee responsible for assessing compliance with these obligations. Firms must use diversity as a selection criteria for the board and must have a policy (taking account of the size of the board) to promote gender, age, educational, professional and geographic diversity. Firms will have to report to the regulator presumably on its policy and the ‘diversity’ achieved.
There are further broad obligations on the board relating to effective management of the firm and effective oversight of senior management. This includes broad governance obligations to define, approve and oversee and to monitor and periodically review the firm’s strategic objectives, organisation, systems, personnel, resources and policies on risk tolerance, stress testing and client profile/products/services.
Immediate concerns may focus on the limits on directorships, which seem to run counter to FSA’s emphasis on the value of attracting non-executives with broad and continuing business experience, although it does reflect concerns on the level of attention paid by non-executive directors to each of their roles.
The specific obligations on board responsibilities will add to the existing governance processes in many firms including more formalised board level policies, monitoring and review.
There will be many issues for directors to consider individually in relation to their personal position and exposure.
Commission ban and other obligations for independent advisors and portfolio mangers
Firms that provide investment advice are not required (under MiFID at least) to explain the basis on which they provide advice and the scope of their service. Although the inducements rules apply, advisers and portfolio managers may still receive commission for a product for which they give advice/effect discretionary transactions.
When investment advice is provided, the client must receive information that specifies if the advice is provided on an independent basis, whether it is based on a broad or more restricted analysis of the market, and if the adviser will provide an on-going assessment of suitability of his recommendations.
If advice is notified as being provided on an independent basis the adviser is required to assess a sufficiently large number of financial instruments available on the market, and is not permitted to receive fees, commissions or any monetary benefits from third parties.
Portfolio managers are also not permitted to receive third party fees, commissions or monetary benefits.
The FSA has already legislated for many changes under the RDR in relation to advisers in the UK, which are to some extent similar to the MiFID proposals, and will take effect by the end of 2012. However, to the extent that the FSA’s rules go further than the proposals (for example by banning commission payments to restricted advisers as well as independent advisers), this raises the question as to whether the UK will be ‘gold-plating’ the directive which would require a justification to be made to the Commission.
MiFID confirms the recent UK move to ban title transfer financial collateral arrangements for retail clients, strengthening the protection for retail client money. Firms will now have to summarise and make public on annual basis, for each class of financial instruments, the top five execution venues where they executed client orders in the preceding year. The definition of non-complex instruments (for which execution-only services can be provided without assessing appropriateness) is narrowed and now excludes structured UCITS.
Extending the scope of regulation of markets and other trading venues
Extending market regulation – organised trading facilities.
MiFID I introduced a three tier classification for the regulation of trading venues. Regulated markets (RMs), such as the main stock exchanges, are subject to the highest standards – for example in relation to the listing of investments; only dedicated market operators can run a RM. One of the policies behind MiFID I was to increase competition for the RMs. MiFID I therefore introduced a new category of ‘multilateral trading facilities’ (MTFs). These can be primary trading venues – for example AIM , which is a primary market for junior stocks not listed on the main market/RM; this is operated by the LSE (i.e. an RM operator) and is an example of an ‘exchange regulated market’ (ERM). Some MTFs such as Chi-X are secondary or alternative trading venues (which might be operated by an investment firm) that offer a competitor platform for instruments traded on an RM. The third category was a ‘systematic internaliser’ – for example a bank offering an off-market dealing facility where the bank buys and sells as principal.
There are concerns that trading venues have evolved which are not caught by the current categories.
There will be a new category of ‘organised trading facilities’ (OTF) which will require specific authorisation and which will be subject to trading venue rules (e.g. relating to organisation and transparency). As with MTFs, OTFs can be operated by a market operator or an investment firm. OTFs are prohibited from executing orders using the operator’s proprietary capital and must justify why they cannot operate as an MTF or SI (or RM).
Various trading arrangements may be conducted by authorised firms but without MTF or SI status, thereby escaping trading venue rules (e.g. broker crossing networks). This reform will drive these into regulation and subject them to greater transparency requirements. In some cases they may adjust e.g. to operate as an MTF, as the regulatory arbitrage opportunity to avoid trading venue regulation falls away.
Moving OTC derivatives transactions onto exchanges
There is a global push towards how derivatives are traded, and this was the subject of G20 commitments in 2009. In Europe, delivery of these commitments has been split between two regulations: the requirement to trade through a CCP is found under the European Market Infrastructure Regulation (“EMIR”), while the new MiFID regulation requires firms to use certain trading venues. Up until now, standardised derivatives were being traded outside of MiFID’s perimeter, which meant that regulators had no oversight of them.
Standardised derivatives will now have to be traded on a regulated market, OTF or MTF.
The push of OTC trading on to regulated markets, OTFs or MTFs, should be viewed in tandem with firms’ requirements under EMIR (see a previous RegZone article on EMIR here) and the proposals on reforms to the Market Abuse Directive (see latest RegZone article on MAD II here). Put simply, there will be greater transparency and regulatory oversight of trading of standardised derivatives, and many existing business models and operating structures will need to be overhauled as a result of the changes.
Non-discrimination rules clearing
CCPs and trading venues demanded that certain requirements were met before they agreed to trade. This meant that firms would either have to restrict which CCP/trading venue they operated on, or use multiple CCPs/trading venues. Given that all firms are required to use a CCP and operate on certain trading venues, firms should be able to use any CCP/trading venue without having to meet criteria specific to each CCP/trading venue.
CCPs must not discriminate between trading venues when deciding whether to accept financial instruments for clearing. CCPs can only refuse to clear financial instruments if certain, limited criteria are met. Similar provisions will open up trading venues.
CCPs and trading venues will have less scope to refuse to clear financial instruments. This will prevent firms having to avoid complying with multiple sets of admission criteria or having their choice of CCP/trading venue restricted.
Extension of pre- and post-trade transparency, broader and more detailed data provisions, arrangements to facilitate central publication of trade data, obligations on SIs and trading venues to publish transparency data and annual data on execution quality, broader transaction reporting requirements for firms, new ‘SME growth market’ category for admission to trading facilities.
More powers for ESMA and national supervisors
Banning financial products
Authorities wanted increased powers to control financial products, activities and practices.
ESMA and competent authorities now have the power to ban certain financial products, activities or practices, where there is a threat to investor protection, or to the orderly functioning and integrity of the financial markets, or to the stability of the financial system.
The authorities have the power to intervene with the provision and management of financial products, activities and practices. Firms may have to adapt their businesses in line with such potential intervention, ensuring that their businesses are flexible enough to respond to the regulators’ requests. We have already seen the potential impact of this type of practice through recent short selling bans.
Limiting derivative contracts and exposures
Authorities wanted more powers to monitor derivative positions to prevent the build up of firm-specific, sectoral or systemic risk.
Authorities are given powers to request information on a wider range of products (including derivatives). Authorities will also enjoy a wider range of remedies open to them. In respect of commodity derivatives, the markets and trading venues, the EC and national regulators will all have different powers to set position limits to support liquidity, prevent market abuse and support orderly markets, and more detailed position reporting by trading venues will be required.
Firms may find that authorities will request more information, and intervene at an earlier stage, to prevent the build up of risk. Firms not only face limits, but could be asked to reduce existing positions.
Member states’ enforcement of MiFID rules and the penalties imposed vary from one country to another.
For certain listed breaches (e.g. failing to meet MiFID requirements on conflicts of interest), there will be new EU requirements for effective sanctions and remedies to be available to the domestic authorities in each state, including a maximum sanction of at least EUR5 million against individuals and at least a maximum sanction of 10% of group world-wide turnover for companies. The authorities must have the power to apply sanctions to the directors and other individuals involved, in addition to sanctions against the company. Sanctions are generally to be published. Whistle blowing processes are also required.
These changes are likely to lead to tougher enforcement with higher penalties, particularly in those states with a weak enforcement record. The reference to 10% of turnover is modelled on EU competition rules where the record fine is over EUR1 billion. This is of a different order to FSA’s current fines which rarely exceed £10 million (although the compensation paid to customers is often much greater).
MiFID legislation refers to the EU but the regime is extended geographically and applies across the 30 countries of the EEA.
See the 2010 consultation paper here.
The concept of regulatory ‘equivalence’ is also used (but in a more limited way) in Solvency II.