In this MiFID II Q&A, we look at some of the commonly asked questions around MiFID II, using simple and accessible language to help organizations make sense of this new law before it comes into effect on 3 January 2018.
What Does MiFID Stand For?
MiFID is shorthand for the Markets in Financial Instruments Directive.
What Happened to MiFID I?
MiFID I was implemented back in 2007 and, since then, has provided the framework for financial services regulation across Europe. MiFID II seeks to address the shortcomings of MiFID I – specifically, the lessons learnt from the financial crisis and the need to increase investor protection to the levels that were envisaged by MiFID I but which were, perhaps, not wholly achieved in practice. MiFID II encompasses a revised MiFID I as well as the new Markets in Financial Instruments Regulation (MiFIR). References to MiFID II generally include both.
What Are the Main Aims of MiFID II?
MiFID II has three main aims. Firstly, enhanced market transparency and integrity, and the creation of a level playing field for all market participants. Secondly, higher levels of investor protection. Broadly, the enhanced investor protections address two concerns:
- mis-selling to clients – ensuring that clients are better informed about products and services (so they can make fully informed investment decisions)
- the fair treatment of clients throughout the client life cycle
The third and final aim of MiFID II is increased regulatory harmonization across the EU, including a significant step towards a single European regulator by strengthening the European Securities and Markets Authority’s (ESMA) supervisory powers.
Related reading: 'MiFID II Implementation: A Perfect Storm?'
What Is the Scope of MiFID II?
MiFID II has a broad scope. It extends the definitions of both ‘Investment Services and Activities’ and the ‘Financial Instruments’ covered under MiFID I. For example, emission allowances are now included.
When Does MiFID II Come Into Force?
MiFID II will apply within EU Member States from 3 January 2018. It is worth remembering that MiFID II will also have relevance for non-EU countries in the European Economic Area (EEA), like Norway. Any firm in the EEA that conducts investment services or activities in financial instruments in scope for MiFID II will be subject to new rules.
How Will Brexit Affect MiFID II?
There is likely to be no immediate impact resulting from Brexit. The triggering of Article 50 that initiated the UK’s exit from the EU began a two-year negotiation period. MiFID II will be implemented before the end of this negotiation period.
How Does MiFID II Fit Into the EU Regulatory Landscape?
It is important to see MiFID II in its context. For example, MiFID II and the Market Abuse Directive both address competition, efficiency and market integrity, and MiFID II contains part of the regulatory framework on which the Market Abuse Regulation, MAR, is based. Also, the forthcoming Packaged Retail Investment and Insurance Products Regulation (PRIIPs) and the Insurance Distribution Directive (IDD) both aim to achieve similar investor protections to those in MiFID II for the packaged product and insurance markets.
What Are the Key Challenges for Firms?
To quote from the Chairman of ESMA, “the magnitude of this change should not be underestimated.” The changes are both material and far-ranging. They will impact the business side of firms as well as IT and Operations and change the way in which firms interact with markets, clients and regulators.
INVESTOR PROTECTION
What Are the Main New Mis-Selling Protections?
In order to ensure that the right clients get the right products, new governance provisions will be introduced for new products. The new rules focus, in particular, on the identification of ‘target markets’, i.e. the types of clients for whom a product is designed. As a consequence, firms must carefully define the parameters of each target market’s population, including levels of knowledge and experience, appetite for loss, tolerance for risk/reward, investment objectives and investment needs.
There are enhanced Suitability requirements, including the provision of Suitability Reports, for all advisory Retail Clients. These reports will detail how advice is suitable for the client and explain the basis on which that advice is provided, for example by making it clear whether it is provided on an independent or non-independent basis.
There will be further restrictions on the types of products that can be sold on an execution-only basis. Firms will only be able to deal in ‘non-complex’ products with clients in this way. Examples of non-complex products include exchange-traded equities and money market instruments.
What Are the Main Changes in Relation to Client Information?
There are many, but here are some examples. Clients must be provided with additional information about costs and charges. They must also be notified of a depreciation of 10% or more of the value of an investment (for portfolio management services and for Retail Client accounts that include positions in leveraged financial instruments or contingent liability transactions).
These new protections are underpinned by increased record-keeping requirements, including requirements to record and retain telephone conversations and electronic communications. In particular, records of all telephone conversations and electronic communications relating to client orders. This includes communications intended to result in transactions, even if no transaction is concluded. As it includes orders placed through any channels, face-to-face meetings will have to be recorded in written minutes.
What About the Changes to the Inducements Rules?
This is one of the key new provisions designed to ensure that customers are treated fairly. When providing independent advice or portfolio management services, a firm will be prohibited from receiving any monetary and non-monetary benefit from third parties, such as commission, subject to a limited exception for minor non-monetary benefits, such as hospitality of a minimal value.
How Does This Impact Research?
Currently, payment for research produced by investment firms for clients is funded by the commission they pay when they trade with brokers. The stricter inducement rules will mean that the payment for the research will have to be separated – the term used is 'unbundled' – from payments for execution or other services. This will impact all producers, distributors and consumers of research. Research will have to be paid for by the firm or from a separate, dedicated Research Payment Account (RPA) to which clients contribute and which meets very tight conditions, including a stringent “quality enhancement” test.
What About Best Execution?
This is another significant area designed to ensure that clients are treated fairly. The current rules will be upgraded from an obligation to take all ‘reasonable’ steps to an obligation to take all ‘sufficient’ steps. Although this undoubtedly introduces higher standards, it does not mean that a firm must obtain the best possible result on each occasion. Execution factors, such as price, costs, speed, likelihood of execution and settlement and size, will continue to be taken into account in establishing ‘best’.
MARKETS
How Will MiFID II Change Market Structure?
There are a number of structural changes that will present challenges for market participants as well as opportunities for new trading strategies. In line with G20 objectives, some trading in OTC derivatives will be moved onto multilateral trading venues. There will be three multilateral trading venues post-MiFID II – Regulated Markets, Multilateral Trading Facilities (MTFs) and the new Organised Trading Facilities (OTFs). In brief, Regulated Markets are exchanges that list their own products, MTFs operate like exchanges but can admit OTC products to trading and OTFs are designed to capture broker crossing networks. Trading on OTFs will be restricted to non-equity instruments, specifically bonds, derivatives, structured finance products and emission allowances. Orders on OTFs must be executed on a discretionary basis. Other trading will take place via bilateral trading mechanisms, namely Systematic Internalisers and OTC trading.
What is a Systematic Internaliser?
Systematic Internalisers were introduced by MiFID I and are investment firms that deal on their own account when executing client orders on an ‘organised, frequent, systematic and substantial basis’ outside of a trading venue. Specific volume thresholds under MiFID II have been introduced to determine whether a firm is a Systematic Internaliser. In some cases, firms may also elect to act in this capacity for commercial reasons, even when not obliged to do so. Systematic Internalisers are not new but they are subject to an increased level of regulation and obligation under MiFID II. For example, they will be required to publish firm quotes. Non-equities will also become tradable through Systematic Internalisers for the first time.
What Are the Main Changes to Pre-Trade Transparency Requirements?
The financial crisis exposed specific weaknesses in the way information on trading opportunities and prices in financial instruments, other than shares, are made available to market participants. As a result, the transparency regime will be extended to cover non-equity instruments.
All trading venues, that is Regulated Markets, MTFs and OTFs will be required to make pre-trade transparency publicly available on a continuous basis during trading hours. The requirement includes actionable Indications of Interest (IOIs), current bid/offer prices and depth of trading interest, including Requests for Quote (RFQs) and voice trading. Systematic Internalisers will be required to provide firm quotes in response to a Request for Quote from a client and will be required to publish and share that quote with other investors, as long as it is below certain volume thresholds and the instrument is sufficiently liquid. This is similar to the situation for market makers in exchange-traded equities. Pre-trade transparency waivers will be available in some situations, such as large orders relative to normal market size and instruments with no liquid market.
What About Post-Trade Transparency?
The post-trade transparency regime has been broadened to embrace non-equity and equity-like instruments. Firms should not underestimate the technical and IT challenges in this area. The requirements will apply to all trading venues and investment firms trading OTC. There is a material increase in the number and types of the data fields to be included and enhanced governance and record-keeping requirements. The new fields include Legal Entity Identifiers (LEI). Firms will not be able to execute a trade on behalf of a client who is eligible for a LEI if they have not been set up with one. Post-trade transparency must be close to real time – T+15 minutes from execution (which will move to T+5 minutes from January 2020). There will be some provision for deferral for up to 48 hours, but no permanent waivers.
Approved Publication Arrangement firms (APAs), will publish trade data via a consolidated tape. APAs will be subject to authorization and a degree of regulation.
Are There Any changes to High Frequency Trading?
There will be a range of new restrictions and controls for High Frequency Trading firms, including enhanced testing of algorithms and built-in circuit breakers.