Effective on Jan. 3, after a one-year delay to facilitate compliance efforts and regulator preparation, Europe will implement MiFID II, a slate of new rules and disclosure demands for those trading in financial instruments.
Although the reach of the rule is focused on trading, investing, and hedging in the European Union, U.S. firms will feel the effects.
MiFID II aims to improve upon the previous iteration of the Markets in Financial Instruments Directive by:
Ensuring that trading takes place on regulated platforms;
Introducing rules on high-frequency trading;
Improving the transparency and oversight of financial markets—including derivatives markets—and addressing the issue of price volatility in commodity derivatives markets;
Improving conditions for competition in the trading and clearing of financial instruments; and
Strengthening the protection of investors by introducing “robust organizational and conduct requirements.”
In part, the new European regulations acknowledge that the ever-increasing speed of trades requires real-time, transparent data.
U.S. firms, as well as any non-EU party, will face some of the rule’s requirements if they are the beneficial owners of a European firm or are exposed assets bought or sold on an EU exchange.
Among the biggest concerns for firms is that transaction reporting requirements have changed a lot since the original MiFID.
“The amount of information that is required to be reported has changed pretty substantially, as has how firms previously complied with their transaction reporting requirements,” says Paul Yau, senior regulatory counsel for Advise Technologies, a provider of global regulatory reporting software and services to the investment management community. “There has been a whole deluge of regulation since the financial crisis and MiFID II is definitely one of the biggest ones out there.”
A new MiFID II rule requires that asset managers separate trading commissions from investment research payments, establishing a research payment account. This new trend in research unbundling is a big change from past practice that U.S. firms should watch closely.
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Under the original MiFID, an executing or prime broker was delegated for transaction reporting. Among the changes, firms will now need to do the reporting themselves. Other demands include transparency reporting and the imposition of position limits.
In general, U.S. fund managers with no EU presence are not within the direct scope of MiFID II, Yau says.
“It is a European regulation for European markets,” he explains. “However, U.S. firms that trade on EU trading venues or have an EU presence for investors or trade with EU counterparties are good examples of when a U.S. firm may be caught by certain requirements. If they trade financial instruments on an EU trading venue, they are subject to transparency requirements with a post-trade report they have to provide to the public.”
Previously, under MiFID I, only trades involving equity instruments needed to be reported. Under MiFID II, non-equity trades and instruments also need to be reported.
Another area U.S. firms should pay close attention to are transaction reporting requirements, Yau says, as there has been an expansion in the requirements for more reportable data.
“Any major firm that is engaged in any kind of transaction reporting activity—possibly even equity products under the original MiFID regime—are already well-versed in the kind of challenges they are going to be facing.”
Joshua Rosenberg, Regulatory Analyst, AxiomSL
For example, any U.S. manager with a branch in the United Kingdom will be subject to transaction reporting requirements for transactions that are executed by that branch. “That is a big implementation and compliance process that firms are currently preparing for,” Yau says. “There is a huge increase in the amount of data that is required.”
Position limits for commodities and derivatives, unlike the majority of the other requirements under MiFID II, are not limited to EU firms. “Any U.S. firms that trade through an EU trading venue will need to comply with EU position limits,” he says.
Yau’s advice regarding the compliance aspects of meeting MiFID requirements is to have repeatable processes. “You want your data to be consistent so that regulators are able to compare it if they want to,” he says.
A new MiFID II rule requires that asset managers separate trading commissions from investment research payments, establishing a research payment account. This new trend in research unbundling is a big change from past practice that U.S. firms should watch closely.
Some firms, including JPMorgan, have announced that they would be absorbing research costs, says Sandeep Kumar, managing director for Synechron, a business consulting and technology services provider. Others such as Pimco, Vanguard, and T. Rowe Price have been quick to follow suit.
“MiFID II requires specific and transparent payments to be in place between banks or broker-dealers and their clients related to research, with each piece of research having its own price rather than the current bundling of research fees in with other areas such as trading, which will now be seen as being non-compliant under the upcoming regulatory change,” Kumar explains. “Research unbundling remains a challenge due to no traditional standards for pricing of research, or different types of research, and what can be constituted as research in terms of fees, and recordkeeping, especially when information may be less structured in format, such as ‘research’ given over the phone or small sections over e-mail. With many uncertainties and the looming threat of non-compliance, clients will benefit from having this burden taken in on the bank side.”
BETTER REGULATED AND TRANSPARENT FINANCIAL MARKETS
The following is a European Commission summary of MiFID II.
Full title
Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU
Date of entry into force
2 July 2014
Date that the rules apply
3 January 2018 (extended from 3 January 2017)
WHAT IS THE AIM OF THE DIRECTIVE?
It aims at making financial markets in the European Union (EU) more robust and transparent.
It creates a new legal framework that better regulates trading activities on financial markets and enhances investor protection. The new rules, called ‘MiFID 2’, revise the legislation currently in place and will apply from January 2018.
KEY POINTS
Ensuring financial products are traded on regulated venues
The aim is to close loopholes in the structure of financial markets. A new regulated trading platform is established to capture a maximum of unregulated trades. This is the so-called Organised Trading Facility (OTF), which will exist alongside existing trading platforms such as regulated markets.
Increased transparency
The rules strengthen the transparency requirements that apply before and after financial instruments are traded, for instance when market participants have to publish information regarding the prices of financial instruments. These requirements are calibrated differently depending on the type of financial instrument.
Limiting speculation on commodities
Speculation on commodities—a financial practice that can lead to the prices of basic products (such as agricultural products) soaring is restricted by introducing a harmonised EU system setting limits on the positions held in commodity derivatives. National authorities may limit the size of a position that market participants can hold in commodity derivatives.
Adapting rules to new technologies
Under the new rules, controls must be established for trading activities which are performed electronically at a very high speed, such as ‘high-frequency trading’ (a type of trading which uses computer programs to perform trades at high speed using rapidly updating financial data). Potential risks from increased use of technology are mitigated by a combination of rules aiming to ensure these trading techniques do not create disorderly markets.
Reinforcing investor protection
Investment firms should act in accordance with the best interests of their clients when providing them with investment services. These firms should safeguard their clients’ assets or ensure the products they intend to launch are designed to meet the needs of final clients. Investors will also be provided with increased information on products and services offered or sold to them. Moreover, firms must ensure that staff remuneration and performance assessments are not organised in a way that goes against clients’ interests. For instance, this may happen when remuneration or performance targets provide an incentive for staff to recommend a particular financial product instead of another that would better meet clients’ needs.
Source: European Commission
A global regulation. MiFID II shouldn’t be viewed in isolation, but rather as a piece of a global landscape. “It is not just about U.S. and European relationships,” says Joshua Rosenberg, a regulatory analyst at AxiomSL, a global provider of regulatory reporting, risk, and data management solutions.
A meeting of the G20 in Pittsburgh in 2009 kick started a global effort to better regulate derivatives markets and improve trade reporting. One by one, countries around the world have expanded their transaction reporting regimes. In the United States, many of those rules were mandated by the Dodd-Frank Act and are still taking shape at the Securities and Exchange Commission and Commodity Futures Trading Commission.
“If you are trading with any counterparty in Europe in the derivatives space you have done transaction reporting,” Rosenberg says. “Europe has done the most in this space, including exchange-traded derivatives and a broader range of asset classes. MiFID II is a continuation of this theme of regulating transactions. Any major firm that is engaged in any kind of transaction reporting activity—possibly even equity products under the original MiFID regime—are already well-versed in the kind of challenges they are going to be facing.”
“Everybody is well familiar with what the issues are,” he adds. “That doesn’t necessarily mean that the solutions exist to solve the problems that have been identified.”
Rosenberg sees particular areas of compliance concern: customer availability of data and gaps in data that sit within a trading platform that was designed to facilitate trading, not the reporting activities.
Data can also take shape in a variety of forms that may not have the consistent attributes regulators require. Different taxonomies, languages, and even case-sensitive data fields can create MiFID headaches.
One such issue involves Legal Entity Identifiers, unique alpha-numeric codes to identify the entities in a financial transaction.
In the United States, they are using different identifiers for firms to identify third parties. In Europe, they started using the LEI,” Rosenberg. “Now, they started stipulating that you are not allowed to engage in trading activity in a MiFID II reportable instrument if both counterparties don’t have an LEI prior to the execution of the trade.”
The U.S. isn’t necessarily behind the EU,” he adds, “it just has its own set of identifiers.” LEIs are still not readily available for many financial instruments on the market.
The question, as raised by MiFID II, is “how do I take a single trade in my trading system and have all of the relevant attributes and reporting activities that don’t have any affect on my ability to successfully execute that trade?” Rosenberg says.
His advice is to create a data depository within a firm’s own infrastructure that has “the ideal version of the trade, with as much enrichment as possible.”
The “golden standard of that trade” can be used to satisfy the various demands of domestic and international regulatory regimes and frameworks.
“Maintaining the most enriched version on the trade on that system makes downstream reporting activity much easier,” he says. “Bringing the trade and transaction elements of all of these laws into a single place, and reporting all of the information from a single hub, seems to be about the only way to go about doing this in a cost-effective fashion.”
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