Changes and Impact
The main objective of the Markets in Financial Instrument Directive (“MIFID I”) was to open up European financial services markets through the harmonization of Financial Markets Regulation in European countries and to create a genuine single market for investment services and equity trading. Introduced in 2007, MiFID I became a core pillar of the European Union (“EU”) financial markets regulatory system as it completely restructured EU financial markets. The abolishment of the concentration rule for national exchanges led to a fragmentation of the markets improving their competitiveness and efficiency, and, among others, bringing about lower trading costs per transaction, reduced bid-ask spreads as well as technological innovations.
In the course of these sweeping changes the trading environment became more fragmented and complex. MIFID I could not keep pace with the swift developments in markets and trading systems incited by the advances in technology and the increased innovation of financial products. Furthermore, the financial crisis exposed weaknesses in the regulation of certain instruments traded off-exchange between professional investors such as derivatives. The loopholes detected in MiFID I led the European Commission to propose the draft of a revised Markets in Financial Instruments Directive (“MIFID II”) and a new Markets in Financial Instruments Regulation (“MIFIR”). MIFID II and MIFIR sit within a set of crisis-era regulatory reforms “aimed at establishing a safer, sounder, more transparent and more responsible financial system”. The two legislations shall impact all areas of business and shall result in a major change in the market structure rather than just a compliance exercise as the new regulatory approaches shift away the focus from a micro prudential supervision of the single firm to a macro prudential market oversight. With view to these changes, trading models will need to be redesigned and impacts on business strategies to be reassessed.
In January 2014, representatives of the Council of Europe, the European Parliament and the European Commission reached a high level agreement on updating the rules for the revised MIFID II and MIFIR.
Requirements of MIFID II
MIFID II addresses a wide range of issues and introduces significant changes for many of the market participants.
The financial crisis has shown that market structures defined in MiFID I are no longer compliant with the market reality as important financial products are not captured under the current provisions and therefore remain outside the regulated MiFID I trading landscape. The introduction of MIFID II will lead to changes in these market structures designed to ensure that trading takes place on regulated trading venues. In order to create a more level playing field between products and trading venues, all systems enabling market participants to buy and sell financial instruments shall be required to operate under the MiFID rules. Therefore, in addition to the existing regulated trading venues (regulated markets (“RM”), where
mainly equities are traded, multilateral trading facilities (“MTF”), on which more complex products like structured products are bought and sold and systemic internalizers (“SI”), which are the trading systems for own account trading) there shall be a new category of trading venue called an organized trading facility (“OTF”). OTFs are defined as any system or facility in which multiple third party buying and selling interest in financial instruments interact in the system in a manner that results in a contract. This new trading venue has been designed to capture
trading venues with a more specific trading strategy for example broker crossing-networks and interdealer broker systems and any other systems trading clearing eligible derivatives, emission allowances, bonds and structured products.
The inclusion of these market participants into MIFID II has mainly been driven by the G20 commitment to improve the regulatory oversight of OTC derivatives markets and to move trading in standardized OTC derivatives to more transparent, regulated trading venues.
The market liberalization created by MIFID I led to the fast development of algorithmic trading and high frequency trading activities, relying on efficient software and super-fast computer connections in order to match orders within the fraction of seconds. In the course of the financial crisis and after several market disruptions, the regulators determined that these types of trade execution processes and technologies imposed possible systematic risks as well as market abuse risks. The large volume of orders that enter and exit the system could provoke a system or market overload which could lead to a system breakdown and market panics (as it was the case for the 2010 “Flash Crash”) or traders could engage in automatic split-second interventions based on mathematical models in order to exploit small price fluctuation. MIFID II therefore introduces new safeguard measures which impact both market participants and trading venues and which include:
- Regulating algorithmic traders;
- Subjecting algorithmic programmes to prior regulatory approval and pre-testing on trading venues:
- Subjecting algorithmic traders to provide liquidity when pursuing a market-making strategy.
Furthermore, investment firms providing direct electronic access to trading venues shall be
obliged to establish systems and risk controls (such as circuit breakers) to prevent trading which may contribute to market volatility or abuse.
Transparency in capital markets is a central issue in policy making since it impacts both price formation and market efficiency. Therefore, MIFID II and MIFIR will include several measures to improve market transparency.
The introduction of the OTF trading venue category shall improve the pre-trading transparency of trading activities involving various new financial instruments. Many of the products that have traditionally been traded in so-called “Dark pools”, which are defined as alternative trading venues where identities and prices are not displayed to the public before execution, will now have to be shifted to OTFs and will therefore be subject to the same or similar transparency conditions as applicable for other venues. Existing pre-trade transparency waivers, which led to the increased usage of dark pools for professional markets in the first place, will be removed. Hence, trading venues will only be allowed to operate in such dark pools if a previous waiver application was granted by the national authorities and exemptions shall be given only under precisely prescribed circumstances.
MIFID II intends to introduce such pre-and post trade transparency requirements for the trading of most non-equity instruments (for example
derivatives and bonds). The transparency regime shall be tailored to the instrument in question and the pre- and post trade requirement shall be specified in further implementing legislation and technical standards.
Furthermore, the regulated trading venues and firms shall be required to publish pre- and post trade data and to issue trade reports through approved channels to ensure reliable data is available to all market participants.
Stronger Investor Protection
MIFID II enhances investor protection by strengthening the role of the management bodies, introducing additional provisions on client information and – with
view to the “best execution” principle – establishing the duty of financial service providers to compile and disclose data on execution quality to its clients.
In addition, formerly exempted market participants like firms not holding client money, firms only providing investment advice, portfolio managers or market actors arranging transactions shall newly be subject to the investor protection regulation of MiFID II. Regulations regarding so called “execution-only” sales where a consumer has requested a specific investment and has chosen not to receive any advice shall be strengthened, as under MiFID I such orders could have been carried out without complying with consumer protection duties if the order concerned a non-complex product.
Under MIFID II, independent advice shall be clearly distinguished from dependent advice and limitations are imposed on the latter especially with view to the receipt of commissions or retrocessions (so-called “inducements”). Thus, firms shall need to specify if investment advice is being provided on a dependent or on an independent basis.
Furthermore, regulatory authorities may ban the use of certain financial products if they identify them as giving rise to significant investor protection concerns and firms will have to withdraw them accordingly.
Lastly, firms shall need to comply with stronger investor protection rules for professional clients and eligible counterparties and they shall also be obliged to ensure that any marketing information is clearly identified.
Harmonized regime for granting third-country firms access to EU markets
The Commission’s draft for MIFID II planned for a harmonised regime for granting access to EU markets to third-country firms which aim to benefit from an EU passport. Under this regime, it was previewed, that the Commission would centrally assess whether the third country in
question has the equivalent arrangements and the necessary supervision for reciprocal recognition. For the offering of services to retail and professional clients a branch in a European member state should have been necessary. At present, each EU member state applies their own national rules when granting a third-country (or an EWR-country) firm access to EU markets.
As this amendment of MiFID I was one of the cornerstones of the review, it was quite a surprise – but received with some relief by third countries – that in the compromise between the Parliament and the Commission reached on January 10, 2014, this harmonised third country access system has been overruled. In the end, everything stays the same: Each member state will decide independently on the equivalence of the regulations of any third country.
Effective and Harmonized Administrative Sanctions
MIFID II also sets a harmonised regime of administrative sanctions for breaches of the said directive. This shall eliminate the current disparities in the powers of national regulators of EU member states to impose administrative sanctions for breaches of MIFID. Under the new directive, every EU member state shall be obliged to furnish its national authorities with
common administrative sanction powers and to establish common criteria for determining the type and level of administrative sanctions that should apply. An effective detection of breaches of MIFID II shall also be guaranteed through greater transparency of such sanctions.
MiFID II for Switzerland?
In the two and a half years during which the MiFID II draft has been debated, the proposed regulation of the third-country access was by far one of the most important changes for Switzerland. In anticipation of the new European Equivalence Test, the Swiss regulator has done – e.g. for the Collective Investment Schemes Act with view to UCITS and AIFM – and continuous to do the upmost to re-enact European legislation and to make its national laws “Europe-compatible”. The new Federal Financial Services Act (FFSA) and the planned Financial Market
Infrastructure Act (FMIA) are clearly meant to update Swiss laws with view to an envisaged equivalence with MiFID II and the European Markets Infrastructure Directive EMIR. In this regard, the decision that has been taken by the European regulatory body earlier this year challenges the existing Swiss strategy for access to the European market and – above all – sheds new light on the Swiss referendum against “mass immigration” that has been adopted by the Swiss electors on February 9, 2012. As it will now remain in the hands of the individual EU member states and their financial market authority to decide on regulatory equivalence, this new constitutional provision limiting the freedom of movement of persons between Switzerland and the EEA might prove to be – in some form or another – an obstacle for bilateral talks and agreements.
Where is MIFID II going?
The initial Commission’s proposal for MIFID II has been launched 27 months. A formal approval of the final version is now expected by the end of the current term of the Parliament in May/June 2014. Nonetheless, the general deadline for implementing MIFID II shall be 2016 and some specific provisions shall have an even longer time limit for implementation. In 2014, proposals for detailed implementing and technical standards shall be issued by the European Securities and Markets Authority (“ESMA”).
Taking into consideration the amount of time spent analysing and setting the final text of MiFID II, market participants are now hoping that the aims of the directive are obtained and that markets will ultimately benefit from the increased transparency and safeguard measures.
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