FW moderates a discussion on MiFID II between Michael Thomas, a partner at Hogan Lovells, Kara Cauter, a partner at KPMG, and Marius Floca, global head of Logistics Compliance and Regulatory Change at RBS.
FW: Rolling back the clock to 2004, could you provide some context by outlining the primary objectives of MiFID I, and the reasons for its implementation? In your opinion, how successfully did it achieve these objectives?
Thomas: We could argue that MiFID I has been a success in terms of its original ambitions to move towards creating a single European market in financial services. It has reinforced common parameters so that regulators and firms now have a shared frame of reference across the EU’s financial markets. However, one of the areas where MiFID I has fallen down is in the complex interaction between some of its provisions. For example, MiFID I’s insistence on best execution encouraged the rise of algorithmic trading – which MiFID II is now having to control. Similarly, MiFID I successfully removed the monopoly of regulated markets, but firms are now forced to connect to multiple trading venues in order to offer best execution to their clients, thus increasing costs for firms. With these kinds of unintended consequences, MiFID I has arguably become a victim of its own success.
Cauter: MiFID I set out to achieve broadly three things – spur more competition in the ways in which market participants could trade in securities by unlocking the monopolies of national regulated markets, while at the same time providing for more transparency in markets through harmonised transaction reporting and setting consistent principles for market conduct. It is a mixed bag as to how well these were achieved. Mixed across its objectives, and mixed across its implementation in individual EU countries. Competing trading platforms have multiplied, bringing down transaction costs – but their volume has also introduced some fragmentation and also more opacity given the widespread use of waivers and exemptions to keep significant trades ‘in the dark’. Investor protection principles were also not consistently well implemented across the EU, which has left work to do. Passporting is probably the most successfully implemented feature of MiFID I – although it excluded commodities derivatives.
Floca: Early attempts to establish a single market for financial instruments in the EU can be traced back to the Investment Securities Directive (ISD). Adopted in 1993, the ISD sought to develop a common legislative framework for investment firms and securities markets in the EU including high-level conduct of business requirements and a ‘passport’ which would allow firms to provide services on a cross-border basis from one member state to another. Since then, the increasing global integration of financial markets, technological improvements, and the creation of the eurozone, required the creation of a strong regulatory framework governing the operation of capital markets. The result was MiFID1. The overarching aim of the Directive was to enhance the single market in financial services by creating a regulatory EU regime aimed at improving cross-border investment business, strengthening the rules governing conduct of business, increasing competition, and improving transparency in the trading of financial instruments. MiFID I was successful in meeting a number of its objectives. Across the EU, we have witnessed an increase in investor protection. The equities markets have seen increased competition and innovation, with a reduction in trading costs per transaction, and a reduction in bid-ask spreads. However, in recent years the MiFID regime struggled to maintain its effectiveness in financial markets which have witnessed a significant proliferation in the range of products traded and in the extent of retail investor participation in these markets.
“In recent years the MiFID regime struggled to maintain its effectiveness in financial markets which have witnessed a significant proliferation in the range of products traded and in the extent of retail investor participation in these markets.”
FW: What is the significance of MiFID II? What issues does it seek to address in its key provisions?
Cauter: I see MIFID II as much more wide ranging – extending more requirements to more venues and more product sets, to make it much harder to escape regulatory requirements by reshaping how and where you trade. On investor protection, it seems more reinforcing than revolutionary – but given poor MIFID I implementation and much closer supervisory scrutiny of these issues now, I think it will still drive major re-work for most firms. Finally, it is touching whole new areas like position limits and high frequency trading, which will be operationally challenging and strategically difficult for impacted institutions, and aligning governance requirements across investor firms and trading venues. We are also likely to see business impacted in a way that is probably not foreseen by regulators – for instance, reduced activity in equities products as HFT firms find alternative ways to make money.
Floca: The financial crisis and the accompanying collapse in trading volumes that followed focused the attention of policy makers on the need for additional measures to enhance the stability of the financial system, all under the G20 auspices. The result is a broad global regulatory agenda. Within this raft of sweeping regulatory changes, MiFID II will try to address the key aspects of increased market transparency, organised trading of OTC derivatives, product standardisation, and improved investor protection. MiFID II introduces an obligation for all clearing-eligible and sufficiently liquid derivatives to trade on a MiFID venue. It also creates a new type of trading venue, known as an Organised Trading Venue (OTF) which is expected to accommodate trading of standardised derivatives subject to the trading obligation. The new rules also attempt to tighten up weaknesses in the pan-European investor protection framework which have been exposed during and after the financial crisis – for example, swaps mis-selling, LIBOR manipulation, and so on. Overlaying these drivers is the desire for further harmonisation of the European financial regulatory framework.
Thomas: MiFID II covers a very wide range of issues, which makes sense given the different political agendas at play during its inception and negotiation. First, a measure of revision was pre-programmed into MiFID I under article 65 which required the Commission to review the effectiveness of aspects of the directive. Secondly, the global financial crisis meant that the Commission came under pressure to impose controls on the less regulated, less transparent areas in the financial markets. This was evident in the Pittsburgh G20 recommendations, which were critical in driving the MiFID II controls that will be imposed on the derivatives markets. Third, the markets have continued to innovate, with the rise of novel features such as high-frequency trading, algorithmic trading and dark pools, which fall outside the scope of MiFID I. Finally, in June 2009, the European Council recommended the creation of a European single rulebook applicable to all financial institutions across the EU, an aspiration which is embedded in Recital (58) of MiFID II.
FW: Given the extended scope of products and activities covered by MiFID II, what impact do you believe it will have on the European market in the years ahead?
Floca: While the broad-based rules have been laid out, much of the detailed rule making is still to be completed by ESMA. It is therefore difficult to predict at this stage, exactly how MiFID II will impact the European markets in the years ahead. For example, the pre- and post-trade transparency requirements for non-equities could lead to a significant reduction in market liquidity. However, if ESMA is able to sufficiently calibrate the new requirements, and implement them in a manner that is sensitive to the nature and characteristics of the non-equities markets, it may be possible to balance the trade-off between liquidity and transparency and limit the disruption to the European markets. Having said that, we can expect the implementation of MiFID II will have an impact in a number of areas. These include a stronger harmonised supervisory framework across all member states designed to increase investor confidence and reduce market abuse; improved investor protection across a larger set of financial instruments and asset classes; reduced OTC derivatives trading volumes due to increased operational trading costs; and a fall in the number of dark pools with a direct negative impact on market liquidity. We can also expect the potential disappearance of broker crossing networks, and fewer arbitrage opportunities across markets due to increased competition between trading venues and improved fungibility across clearing houses.
Thomas: MiFID II will have a significant impact, although not as dramatically as MiFID I for the majority of firms. It is going to have a particularly high impact on firms operating in certain sectors, such as derivatives trading and commodities, or firms reliant on high-frequency or algorithmic trading, which will be subject to much more intrusive regulation under MiFID II.
Cauter: Operational costs will certainly be higher across the financial sector as a result of applying such wide ranging new requirements, though I expect there will still be variation in how individual national competent authorities interpret and supervise some of the rules. While the provisions for transparency might, on their own, reduce spreads, I think it is possible this reduction could be offset by higher compliance costs. And while it continues the march towards a more ‘open’ and competitive landscape, my worry would be that the complexity and cost of compliance will in fact drive more consolidation in some markets. As a result, the new rules on transparency and investor protection could reduce choice for investors, raise execution costs and reduce firms offering advisory services.
“The new rules on transparency and investor protection could reduce choice for investors, raise execution costs and reduce firms offering advisory services.”
FW: Have any of the new provisions been characterised as particularly harsh or contentious? How can firms soften their impact?
Thomas: The Commission has retreated from some of the most contentious positions put forward in its original proposal in 2011, especially in relation to conduct of business requirements. In terms of the remaining provisions, firms trading in commodity derivatives have been especially concerned about the position limits and position reporting requirements introduced by MiFID II. Another contentious issue is the introduction of trading caps on dark pools. Firms’ concerns have been exacerbated, partly due to uncertainty given the high-level nature of the Level 1 provisions. Now that we have an indicative steer on these issues in the recent ESMA consultation and discussion paper, we have more detail on the exact nature of the provisions and the industry has greater opportunity to influence the outcome.
Cauter: Many of the provisions in MIFIR have been highlighted by industry as having the potential to cause significant market disruption – proposals for HFT look very difficult to comply with in practice, and there are still major concerns that too much tightening of the transparency regime will in fact drive participants out of the market, reducing liquidity and increasing prices rather than the intended reduction in prices. Transaction reporting seems to go beyond the intended scope of being a tool to monitor market abuse, and perhaps is being used to monitor shadow banking and broader macro market trends.
Floca: MiFID II will re-introduce a concentration rule, of sorts, requiring equities trading to take place on a regulated market, multilateral trading facilities or via a systematic internalisers – there is an exemption for equities trades that are ad hoc, irregular and between professional investors and eligible counterparties. It is unclear at this stage how banks’ internal broker crossing systems, sometimes referred to as ‘dark pools’ of liquidity, will continue to be able to operate once MiFIR comes into force. MiFIR’s non-equities pre- and post-transparency requirements continue to be a contentious issue. By extending to derivatives transparency requirements originally developed for the equities market, there are significant concerns amongst industry participants that due consideration will not be given to the fundamental differences between equities and non-equities markets.
FW: What are the implications of MiFID II for investors? How has the Directive been received by this group?
Cauter: A lot of investor advocacy groups see the proposals around transparency and investor protection as a good thing, which will open back up a more level playing field. However, the largest buy side firms – who invest money on behalf of those investors – are as likely to be impacted by restrictions on transparency waivers and also from new rules around algorithmic trading. The cost of compliance with new investor protection rules will also add cost, though the principles of tightening up on product governance and communications with investors are admirable and clearly needed after the recent years of mis-selling and other conduct issues.
Floca: One of the key objectives of MiFID II is to enhance investor protection and curb market abuse. To achieve this, a number of changes have been introduced as a part of the MiFID II package such as refinements to the client categorisation criteria; new governance requirements around the manufacturing and distribution of financial products; enhanced suitability and disclosure requirements; and greater product intervention powers for supervisors and regulators. The scope of activities which can be carried out on an ‘execution only’ basis – that is, without suitability assessments – has been substantially narrowed. The new rules require venues and Sis to publicly disclose information on the quality of execution they provide, including details about price, cost, speed and likelihood of execution. In the context in which the market has recently witnessed an increased number of investment protections scandals – for example, mis-selling, client assets and money infringements – some investors see the above provisions as insufficiently ambitious.
Thomas: MiFID II reinforces the investor protection and transparency provisions in MiFID I, so in theory it should help investors, both retail and wholesale. For retail investors, the most significant recent development in the UK has been the Retail Distribution Review, and the impact of MiFID II is likely to be relatively muted by comparison. There will be increased disclosure of costs, charges, and quality of execution, although the practical impact on investors remains to be seen. In terms of the wholesale market, eligible counterparties will now receive greater protection by being brought within the conduct of business regime. ESMA and national regulators will also have powers to intervene to protect consumers in relation to particular products although, again, we will have to wait and see how effective this will be in practice.
“Don’t forget that there’s still time to engage with and influence the process, but also that this is currently a process at the European level.”
FW: MiFID II is expected to be fully transposed and applied after 2016. Could you highlight some of the key challenges likely to surface as the Directive rolls out?
Floca: Implementation of MiFIR’s pre- and post-trade transparency requirements will present a significant challenge for both firms and supervisors, particular the operational obstacles of calibration. MiFID I transaction reporting and EMIR trade reporting requirements have posed firms significant challenges since their introduction. MIFID II transaction reporting looks set to continue this trend – particularly the requirement to identify in reports the individual who has made the investment decision, and the trader who executes the transaction. There are a number of dependencies between MIFID II and other elements of European legislation, all running to different timescales. For many market participants this is likely to further complicate the task of defining a regulatory business strategy. For example, ESMA will be responsible for defining which OTC derivatives will be subject to the MiFIR derivatives trading obligation. However, this decision is dependent on which OTC derivatives have been defined as clearing-eligible under EMIR – something which has not yet been decided.
Thomas: There are still some unresolved issues, for example in relation to data reporting. MiFID II aspires to introduce an EU-wide consolidated tape of trade reports for all equity and equity-like trades, together with the desire to create a consolidated tape for non-equities to be created at a later unspecified date. These provisions will be crucial to the proper implementation of best execution but they represent a major challenge given the lack of commercial incentive for data providers to create such consolidated tapes. Hence you end up with the possibility envisaged in article 90 of MiFID II that ESMA may have to initiate an expensive and lengthy public procurement process to appoint a consolidated tape provider. This issue is typical of the very complex, knotty challenges faced by the European institutions when trying to put these aspirations into practice.
Cauter: I think there will be significant operational challenges to determine the detailed operational impact on the business given the breadth of MIFID’s scope, and from what we have seen their will be ongoing process and data challenges to deliver against new reporting requirements, and new governance and control initiatives in areas like high frequency trading and investor protection. These will all follow from the broader strategic challenges associated with the changes to trading venues and any operational issues resulting from changes in what or where you trade. Another significant change that needs to be drawn and analysed more is the role of the board in the day-to day-affairs of an investment firm. Current proposals will make the board responsible for the adoption and implementation of sales targets, HFT models and more.
FW: What advice can you offer to financial institutions in terms of planning and preparing for MiFID II? What compliance strategies would you recommend and how can firms assess the Directive’s implications for their business operations?
Thomas: Don’t forget that there’s still time to engage with and influence the process, but also that this is currently a process at the European level. The role of ESMA is crucial, and it has wide-ranging powers granted under MiFID II to produce draft technical standards and technical advice for the Commission. ESMA will also monitor the implementation of MiFID II on an ongoing basis. As we have seen from the recent consultation and discussion papers, ESMA best practice may well become ‘hard’ law at a later date, so it will be ever more important to pay attention to ESMA. In particular, because the process is now at the European level, it can be difficult for an individual firm to have an impact on the discussion, so it will be critical for firms to engage with trade associations and industry groups as they take on greater importance in giving voice to firms’ concerns. In other words, there’s strength in numbers.
Cauter: Make sure you are engaged with the consultation and discussion papers – the challenge of implementation and compliance will be in that detail. MIFID is so wide ranging that a structured impact assessment across the group is critical – silo’ed approaches will only add cost and possibly conflict. Use the impact assessment as well to identify early on where remediation of your existing data and processes is needed, so that you can make a head start while new proposals are finalised.
Floca: The impact of MiFID II will be felt by banks, broker-dealers, trading venues, and to a lesser degree by investment managers, insurance firms, independent financial advisors and custodians. It will also impact on certain non-financial institutions. While, the impact will depend on the size and nature of individual financial institutions and market operators, for most financial institutions it will demand significant changes across a wide spectrum of areas, including business strategy, operating models, systems, processes, and data. Those firms that have already invested in enhancing their data architecture across multiple asset classes will be best placed whilst those who have not will find themselves at considerable competitive disadvantage. One key aspect that financial institutions need to address is assessing the extent to which they comply with the current requirements under MiFID I, as this forms the basis from which the roll out of MiFID II will commence. Given the broad-based rules that have been finalised, firms are now in a much better position to access impacts and consider their strategic response to MiFID II.
Michael Thomas is a partner in the Financial Institutions Group at Hogan Lovells International LLP. Mr Thomas advises firms involved in all financial sectors on a range of regulatory matters (including the rules of the PRA, FCA and Bank of England, together with EU level requirements, such as EMIR and MiFID). He also advises financial institutions on commercial contracts, systems and controls and governance arrangements. Mr Thomas also has extensive expertise in advising market infrastructure providers, including trading platforms and clearing houses, on a range of matters. He can be contacted on +44 20 7296 5081 or by email: michael.thomas@hoganlovells.com.
Kara Cauter has 20 years experience in assurance and advisory work with KPMG, predominantly in the financial sector. She currently leads on delivering regulatory change programs in KPMG’s Banking practice. Over the last five years, Ms Cauter helped to set up and lead a team dedicated to tracking and assessing developments in banking regulation, coordinating and developing impact analysis around coming regulatory initiatives. Ms Cauter regularly engages with regulators, policymakers and the banking industry on the major regulatory and supervisory initiatives designed to improve financial stability, effectiveness and transparency. She can be contacted on +44 20 7311 6150 or by email: kara.cauter@kpmg.co.uk.
Marius Floca is global head of Logistics Compliance and Regulatory Change at RBS. Mr Floca has over 12 years of experience in the capital markets industry. Prior to his role at RBS, he has worked as a KPMG management consultant advising global investment banks, brokerage houses and multinational corporates on the implementation of major regulatory projects such as MiFID I, CRDIV EMIR and Dodd Frank. Mr Floca can be contacted on +44 20 7678 8688 or by email: marius.floca@rbs.com.
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