The European Commission's MiFID II legislative proposal

Wholesale change or sequel with the same cast and similar plot?

On 20 October 2011, the European Commission published its legislative proposal to revise the Markets in Financial Instruments Directive (better known as “MiFID”). The proposal is divided into two parts:

• an amended and enhanced version of MiFID covering market structure, the authorisation perimeter and organisational and conduct of business requirements for investment firms and trading venues; and
• a new Markets in Financial Instruments Regulation (“MiFIR”) which sets out requirements for trade transparency, the mandatory trading of derivatives on organised venues and also confers certain new powers on European regulators.

These two components are collectively referred to as “MiFID II” or “the MiFID review”.

A regulation like MiFIR (and the recently agreed regulation relating to short selling and Credit Default Swaps) is directly applicable across the Member States as soon as it is finally approved without a need for further implementing measures. Use of a regulation denotes a desire to achieve a uniform set of rules in the relevant sphere.

However, a directive or amended directive must be transposed into national legislation, which confers an element of discretion to national regulators in determining the choice of form and methods in achieving the desired result of the directive. The role of the UK regulator in implementing the revised MiFID requirements nationally, taking into account the existing rulebook and structure of the UK market, should provide investment firms with some comfort.

What’s in MiFID II?

The MiFID review could be (and indeed has been) described as a fundamental overhaul of the EU’s financial markets, covering every aspect of the trade lifecycle, from pre- and post-trade transparency, through to execution and clearing and settlement. However, market participants are likely to remember similar seismic predictions being made in the mid-noughties prior to the implementation of the original directive which in the main did not lead to radical alterations to most investment firms’ trading and operating procedures. Although some change was required to compliance and governance procedures in order to comply with new and enhanced rules.

The headlines are:

• authorisation requirements extended
• conduct of business and enforcement provisions toughened
• increased transparency and transaction reporting obligations
• more derivatives will be required to be executed "on-exchange" and centrally cleared
• the activities of derivative market participants will be subject to greater scrutiny and oversight.

Extended authorisation requirements

There will be increased regulatory scrutiny and more extensive compliance obligations for firms not currently regulated under MIFID including data providers, some commodity firms (in respect of whom exemptions will be narrowed) and third country (i.e. non-EEA) firms.  Firms outside the EEA will be required to meet an ‘equivalence’ standard before they can request to provide services to EU based clients.

Response to technological innovations

The proposals contain a requirement for all algorithmic traders to become “properly regulated” as well as new rules requiring algorithmic traders to have appropriate systems and risk controls.

Investor protection/enhanced conduct of business rules

Where investment advice is provided on an independent basis, firms will not be able to accept or receive fees, commissions or any monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the provision of the service to clients. This will also apply to portfolio management with the exception of limited non-monetary benefits on the condition that the best interest of the client is not compromised. There will also be additional best execution disclosure requirements.

More intervention

New powers are proposed for ESMA and the competent authorities to ban specific products, services or practices in case of threats to investor protection, financial stability or the orderly functioning of markets on a temporary or permanent basis.  Trading in commodity derivatives will be subject to new position limits. Other rules will introduce circuit breakers to markets.

Market transparency and transaction reporting

Existing equity pre- and post-transparency requirements will be extended to equity like and non-equity instruments like bonds, structured finance products and derivatives.  Transaction reporting obligations will be extended to a wider range of financial instrument

MiFID II for asset managers

We list below the MiFID II proposals of most relevance to asset managers.

• the “management body” of an asset firm will be subject to express requirements relating to corporate governance (MiFID-scope private equity firms will have a particular interest in provisions limiting directorships)
• the proposed ban on accepting “fees, commissions or monetary benefits” from third parties
• enhanced disclosure obligations relating to best execution and a requirement that firms publish annually their top five executions venues for each asset class
• algorithmic asset managers will already be authorised but will be subject to the proposed requirements to have various systems and controls in place and also the need to disclose strategies annually to their regulator
• mandatory telephone recording by investment firms within the EU.  The UK version of these rules has an exemption for asset managers which should be able to continue.  Indeed, there is the potential for the exemption to be broadened as it currently only applies to managers that mostly call UK brokers.  Post implementation all EEA brokers will be subject to the requirement to voice record, which might permit extension of the exemption
• transaction reporting applies to a wider range of financial instruments
• non-EU asset managers providing services to clients in the EU will be impacted by the equivalence requirements applicable third country (non-EEA) firms.

Why is MiFID being reviewed now?

The overarching objective of MiFID was to further the integration, competitiveness, and efficiency of EU financial markets and related services. It abolished the ability of Member States to require all trading in financial instruments to take place on central exchanges and enabled Europe-wide free competition between traditional exchanges and alternative venues. It also granted banks and investment firms an enhanced "passport" for providing investment services across the EU subject to compliance with organisational, conduct of business and reporting requirements. A review of its effectiveness had always been intended and MiFID II also seeks to respond to the lessons of the financial crisis as well as recent market developments such as new trading new venues and products and technological developments, like high frequency trading.

The European Commission is also following through on G20 resolutions made in 2009 to improve the transparency and oversight of less regulated markets (the finger being pointed in this respect at derivatives markets) and to also address undesired price volatility in commodity derivatives markets.

What will be the costs of MiFID II?

Rather like last year’s movie Wall Street 2, MiFID II is presented as a revisit that has been updated in accordance with and as required by the times. But unusually this sequel claims to involve a much smaller budget. According to the European Commission, MiFID II is estimated to impose one-off compliance costs of between €512 and €732 million and ongoing costs of between €312 and €586 million per year, a fraction of the costs imposed at the time of the introduction of MiFID.

Timeline and next steps, likely 2015 implementation

The amended MiFID and MiFIR drafts contain numerous provisions authorising the European Commission and also the European Securities and Markets Authority (“ESMA”) to produce more detailed technical rules. Not until these are published will the full impact of the MiFID review become clear.

The proposals now pass to the European Parliament and the Council (Member States) for negotiation of agreed versions via the intricate trialogue process. Based on recent experience, most notably the evolution of the Alternative Investment Fund Managers Directive, significant amendments to the Commission’s proposals during both the trialogue negotiations and the subsequent legislative process are to be expected.

It is currently anticipated that the amended MiFID directive and MiFIR will be implemented throughout the EU simultaneously on or after 1 January 2015. The final implementation date will depend on the progress of negotiations between the European institutions and the pace at which the technical standards are drafted.  The various EU institutions, in particular ESMA, currently have a very large workload at a time of both substantial regulatory change and volatile capital markets.

IMS will keep you informed of material developments and implementation dates relating to MiFID II and all other impending EU Directives and Regulations

If you have any questions regarding this subject, please contact Peter Moore, Stephen Burke or Alan Leale-Green. Alternatively telephone 020 7408 2448 to speak to your usual IMS contact.