What are the main differences between the first and second markets directives?The second Markets in Financial Instruments Directive (MiFID II) will revise the existing MiFID I, which took effect in November 2007, and will comprise a single legal effect regulation (called MiFIR), as well as a directive (called MiFID II), which will be embedded into each European Union (EU) member state’s local laws. The combined new measures will have a wider scope than MiFID I, affecting a broader range of instruments, channels (including computer-assisted or ‘algorithmic’ trading) and venues, such as the so-called dark pools of non-public displayed liquidity.
MiFID II will change the balance between buy-side, sell-side and established and new entrant financial market infrastructures. It will also change client classifications, so that certain investors, such as local authorities or private clients, must ‘opt-up’ to having professional status – that is, they will be no longer classified as ‘per se’ professionals.
The number of fields firms will have to fill in when reporting transactions, compared to about 25 currentlyWhen MiFID II comes into force, there will also be important revisions to market structures, with particular implications for quote-driven markets, such as fixed-income or over-the-counter traded derivatives. There could also be new areas of complexity to manage. For example, rules around investor protections, such as inducements and product suitability measures, might vary from country to country, given that they fall under the directive component of MiFID II (rather than MiFIR).
One thing to bear in mind is that MiFID II will be introduced into a crowded regulatory space. Its implementation will overlap with adjacent regulatory measures, such as the European Market Infrastructure Regulation on derivatives, the forthcoming Market Abuse Regulation, the Packaged Retail Investment and Insurance Product measures, the Insurance Distribution Directive, and the Securities Financing Transactions Regulation. The measures will also coincide with the introduction of key Financial Conduct Authority (FCA) rules, such as the Fair and Effective Markets Review and the Financial Advice Market Review.
When MiFID II comes into force, what will be some of the first effects investment managers will see?
If MiFID II does take effect in some (perhaps partial) form from 3 January 2018, as is being suggested, I would expect to see a focus on the business conduct aspects of the regulation. So, things like compliance controls, knowledge and competence, remuneration, classifying client and products correctly (including product restrictions), ensuring that information is fair, clear and not misleading and ensuring the correct treatments for client assets.
Firms have been reading more than 5,000 pages of text since the original MiFID II Level 1 pages were published in April 2014. From that reading, they have arrived at a consensus that they can do the relative ‘no-regrets’ work – make changes that are unlikely to be revised in later iterations of the rules – without waiting for the final Level 2 or Level 3 measures to drop.
Relatively low-risk implementations that firms can get started on include structuring their governance/management bodies, upgrading the role of compliance, upgrading complaints-handling procedures – particularly for retail-classified clients – and upgrading product governance arrangements. They might also ensure that all telephone recording of conversations takes place – in the form set out by the regulation, of course (see below).
How will the rules surrounding transaction reporting change when MiFID II becomes binding? Is reporting likely to become more arduous and costly?
I imagine it will be more complex. Not only will there be 65 fields to fill in when reporting transactions – an increase from the current 25 or so in the UK under MiFID I – the fields must also be populated with more precise data. For example, firms will have to input International Organization for Standardization-configured Legal Entity Identifiers, (LEIs) (see boxout). As things stand, it looks like firms will also have to include personal details in certain data fields – buyer field 7, seller field 16, portfolio manager field 57 and so on.
The expanded meaning of execution of a transaction specified under MiFIR Article 26 and elaborated within the draft RTS 22 Article 3, coupled with the precise definition of transmission of an order under RTS 22 Article 4
has triggered a debate in the industry about who will be responsible for reporting what when it comes to the end of the day in a T+1 transaction.
One current talking point is the requirement under MiFID II for investment firms that execute transactions in financial instruments on behalf of a client to include that firm’s legal entity identifier (LEI) within its transaction report. The London Stock Exchange issues LEIs in the UK for a fee of about £100, plus a yearly renewal cost.
Born out of the Regulatory Oversight Committee’s (ROC's) decision that financial markets need a better way of identifying counterparties in market transactions, the rule as it stands means that if an investment firm is unable to issue an LEI for its client, then the client cannot trade – for corporate client entities this shouldn’t be a problem. So far, so feasible.
But one sticking point is that the Global Legal Entity Identity Foundation (GLEIF) includes trusts in its definition of legal entities. Unlike corporate firms, trusts often lack the publicly available information needed to validate an LEI application. So, the current iteration of the rules means that the common and useful trust would be left in the cold.
The story doesn’t end there – but it doesn’t go much further. The Exchange has recognised this as a significant issue and has sought recourse from the FCA. The regulator, however, has so far been seemingly reluctant to question GLEIF or ROC.
Firms that are headquartered and booking trades in countries such as the US, Switzerland and Singapore are keen to understand the extra-territorial reach of the MiFIR measures. Although this applies to trade reporting, research and market abuse monitoring too, it is transaction reporting where the level of confusion is the most significant. This should be clarified once the Level 2 measures are finalised.
With all that in mind, to me it is clear that transaction reporting will become more arduous and costly if firms in the UK are no longer allowed to take advantage of the FCA Handbook’s provision
allowing them to report through brokers. The heavy lifting may involve firms needing to link their reference data structures located within databases such as Know Your Customer, Customer Relationship Management and Order/Execution Management Systems, as well as their books and records. This will present a huge data-retrieval headache for most firms, not to mention the extra cost of building new reporting engines.
What impact will the regulation have on investment research?
This is a complex subject that hinges on the precise definition of investment research. If you are talking about its formal definition, investment research is information recommending or suggesting an investment strategy, explicitly or implicitly, concerning one or several financial instruments or the issuers of financial instruments, including any opinion as to the present or future value or price of such instruments, intended for distribution channels or for the public, provided: (a) it is not provision of investment advice and (b) it is labelled or described as investment research.
It is not clear whether the FCA’s substantive research test (in the Conduct of Business Sourcebook) will carry forward. This says research must be capable of adding value and providing new insight, represent original thought, have intellectual rigour or involve analysis or manipulation of data to reach meaningful conclusions. As things stand, the European Securities and Markets Authority (ESMA) proposes a requirement for payments for research to be fully unbundled from payments for execution services, and an end to bundled broker commissions and shared commission arrangements.
Firms will be able to charge clients directly for research, providing a set of specific requirements are met. Among other things, these include that they establish a research budget for each client and that they must establish a framework for allocating research costs to each client. Open issues at this juncture include ‘what is permissible as a minor, non-monetary benefit?’ and ‘what is market colour?’ The latter is a particular consideration for fixed-income research where there is an absence of commission.
About the expert
Dr Anthony Kirby was appointed Director of Regulatory Reform and Risk Management at EY in 2008. Before that he was responsible for regulation and compliance at Accenture, where his responsibilities included several initiatives, including MiFID I, Know Your Customer and Basel II. A true markets directive expert, Dr Kirby helped co-found the MiFID Joint Working Group in 2005.
Dr Kirby has 20 years' experience in the global marketplace across the business, operations and technology sectors, and has worked at Merrill Lynch, SWIFT, Instinet, Deutsche Börse and Reuters.
He received his Phil. MA and PhD from the University of Cambridge in 1987.
Many firms are looking at options, such as setting up specific research payment accounts to enable them to comply with MiFID II measures. This is quite a burden for buy-side firms in particular, and the precise impact will depend on how the final text is shaped by the EU Commission, but it is clear that it will become more difficult to pay for research through broker commissions charged to client portfolios.
What are the new rules regarding voice call recording and how are wealth management firms likely to be affected?
According to ESMA’s draft technical advice
, investment firms need to establish, implement and maintain effective recordings of telephone conversations in a durable medium, including relevant internal telephone conversations and electronic communications. As things stand, there will also be a requirement to record information related to relevant face-to-face conversations with clients (at the discretion of the firm), including the date, time and location of meetings, the identity of the attendees, the initiator of the meetings, and relevant information about the client order. That would include the price, volume and type of order.
According to MiFID II Level 1, firms must provide records to the client involved when requested, and they can be kept for a period of five years and, on occasion, up to seven years.
This is likely to be burdensome for private wealth managers and private banks that take such matters ‘on trust’ and don’t resort to evidential techniques. There are also likely to be sensitivities over maintaining privacy versus the desire to share information cross-border.
Another thing to bear in mind is that the requirement to record minutes from face-to-face meetings will be more common in some cultures, contexts or client situations than others. The recording of prescriptive information from voice records (for example, to provide evidence that conflicts of interest were at all times avoided) will, I think, present challenges for both the buy- and sell-sides.