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Eighteen months remain until the "go live" date for MiFID II, January 3, 2017.
So far, there have been the two primary pieces of legislation — the Markets in Financial Instruments Directive (MiFID II) and the Markets in Financial Instruments Regulation (MiFIR), in force from July 2014 — and a full round of the secondary implementing measures from the European Securities and Markets Authority (ESMA), last December. Although some important issues, such as the use of dealing commissions (softing) have still to be settled (further detail is expected from ESMA and the UK Financial Conduct Authority (FCA) in due course), the overall picture is becoming clearer. In this summary of the MiFID II reforms from the perspective of buy-side managers, here are the "top five" areas that will need to be addressed:
1. The recording of telephone and electronic
communications: investment manager exemption to end
Not strictly speaking a MiFID II reform, this was a bombshell delivered by the FCA in March in Discussion Paper 15/3 (DP15/3) on the conduct of business and organisational requirements arising from MiFID II. At the moment, FCA rules allow for discretionary investment managers to disapply the recording requirement where a conversation or communication is with another firm which is itself subject to the obligation (e.g., an FCA-regulated broking firm) or with firms not subject to the obligation, provided these are made only on an infrequent basis and represent a small proportion of the total relevant communications. The FCA has proposed to remove both these exemptions, citing the need for a "level playing field" with similar firms.
MiFID II has also extended the definition of "relevant conversations" that must be recorded to include all those intended to result in a client transaction (previously, only those that actually did were included), and to increase the retention period from six months to five years. So the recording obligation is getting broader and the retention period longer. If adopted, this will impose significant new technology requirements on many investment managers who currently do not need to record such communications.
2. Paying for research: an end to bundled commissions
MiFID II prohibits firms from accepting "fees, commissions or any monetary or non-monetary benefits paid or provided by any third party", in other words, "inducements" which at the moment includes original, meaningful research. At first sight, this points to a total ban on all dealing commission arrangements to pay for company research. Although ESMA's technical advice on this subject (published in December) was initially viewed as a retreat from a total ban, its latest proposals still amount to a radical break with past practice.
There will be two permissible methods of paying for company research: either the investment manager pays for research itself, or it is paid for out of a "research payment account". This type of account will have to be operated under strict conditions, including the requirement for a research budget, based on a reasonable assessment of need, to be pre-agreed with, and funded by, the client, and a regular assessment of the quality of research purchased.
Above all, there must be no link between execution volumes and research spend. Opinions vary on whether this spells the end for the way in which commission sharing agreements (CSA) are structured: in the authors' opinion (and more importantly the FCA’s) it does.
3. Best execution: new data, new disclosures
Best execution was a concept introduced to the European Union by the first MiFID, but its impact has been patchy, at best. There have been difficulties regarding the objective measurement of best execution in nearly all asset classes save liquid shares (where, by definition, poor execution is unlikely). Hedge fund managers have also struggled to see why their performance in this narrow area should be under the microscope when they have every incentive to achieve the best possible returns for their clients.
MiFID II should enhance this regime in two ways: first, via the new transparency and publication requirements across a wide range of instruments. These will include a "consolidated tape" of transactions across all EU trading venues, thus greatly enhancing market participants' ability to see what is trading, and at what price.
The execution venues themselves will have to publish annually the quality of execution provided, assessed by factors such as price, costs, speed and likelihood of execution, giving investment managers hard data on which to base their execution venue decisions. Firms themselves (including investment managers) will also have to justify these decisions by publishing annually their top five execution venues in terms of volume, and information on the quality of execution actually obtained, thus adding another layer of transparency to underlying investors.
4. Transaction reporting: new data fields and delegation becomes harder
To be clear, transaction reporting under MiFID should not be confused with the reporting of derivatives transactions under the European Market Infrastructure Regulation. EMIR reporting is concerned with systemic risk, whereas MiFID transaction reporting was introduced primarily to assist in the investigation of possible market abuse. Under MiFID II, MiFIR broadens the scope of transaction reporting to all financial instruments traded on an EU trading venue, plus those whose underlying is such an instrument. The previously exempt bonds, interest rates, commodity and FX derivatives thus all come into scope, plus all over-the-counter derivative contracts traded on the new organised trading facilities (OTF).
The number of data fields has increased from the original 23 to 81. These include short sale flags and the ID of either the individual trader or the algorithm responsible for the decision to trade. Delegation of transaction reporting will still be permitted, but this is likely to be harder, particularly in view of the ID requirement. Many investment managers are expected to conclude that taking transaction reporting back in-house is a cleaner solution. At the very least an investment manager will need to understand how its counterparties will comply with the new reporting requirements.
MiFID II greatly expands the scope of financial instruments caught by pre- and post-trade transparency requirements.Equity-like instruments such as depositary receipts, exchange-traded funds (ETF) and certificates are included for the first time, as are bonds, structured finance products, emission allowances and derivatives traded on a trading venue.Trading a UK government bond, for example, after January 2017, will look much more like trading a UK share does now in terms of a visible order book and trade tape. There will still be exemptions for the publishing and reporting of illiquid shares, large orders and transactions (similar to the current MiFID regime for equities).
Where this becomes somewhat controversial is in the calibration of thresholds for such waivers, and particularly the definition of what is liquid. If ESMA gets this wrong, market makers in certain instruments will conclude that greater transparency shifts the risk/reward balance to the point where they withdraw liquidity altogether. If they go too far in either direction, investors could end up paying more, not less, for executing their strategies.
Previous experience would suggest that, with European legislative packages, the devil is in the detail; in their final implemented form they can look vastly different from what was originally proposed. There is scope for further evolution between now and 2017 and there are unlikely to be prizes for first movers. That said, the broad structure is now largely fixed, and the direction of travel is clear.
When MiFID came into force in November 2007, its impact was quickly lost in the travails of 2008, and the protections it sought to implement looked outdated very quickly. MiFID II is not just about updating legislation to reflect market developments, however, and the opportunity has also been taken to reflect on the financial crisis, and so to address two areas that were seen to be lacking: transparency (both for the client and regulators) and protecting the interests of clients. It is those areas where the impact of MiFID II will be felt most by the investment management community.
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Martin Lovick and Adam Palmer are, respectively, Compliance Consultant and Managing Director with ACA Compliance(Europe) Ltd, the compliance consultancy firm for wholesale financial services companies with a client focus on hedge fund managers, private equity managers and institutional brokers. The views expressed are their own.
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