Webinar - Are you ready for MiFID II?

David Nowell spoke on COO Connect Webinar about MiFID II Reporting
Video

Review

  • MiFID II aims to address both the unforeseen consequences of MiFID I of 2007 (notably the boost it gave to fragmentation of equity markets between exchanges, internalisers, multi-lateral trading facilities (MTFs), “dark pools” and algorithmic and high frequency trading)  and the lessons of the great financial crisis (especially about the sources of systemic risk), but MiFID I was due for formal review by the European Commission anyway, and the result is a complete re-building of the MiFID regime across multiple fields (from business conduct to market structure).

  • The measures consist of both a Directive (MiFID II), which is implemented by national regulators  with a degree of discretion and contains mainly the conduct of business provisions (so there is still no single European rule book), and a Regulation (MiFIR), which simply imposes technical provisions (including, most importantly, the regulatory reporting requirements, on grounds data is useless unless it is consistent and standardised across every jurisdiction, unlike MiFID I, where reporting rules varied widely)  on every member-state of the European Union (EU) without any scope for local variation.

  • Consultation on the measures took the form of both a 533 page consultation paper (which covers the legislation being delegated by the European Commission, where the regulator, the European Securities and Markets Authority (ESMA) provides nothing but advice, and to which market participants were supposed to respond by 1 August) and a 311 page discussion paper (which precedes the consultation paper, and also closes on 1 August, and which will lead to second consultation paper on the issues which it raises, probably in December ).

  • MiFID II (like the Alternative Investment Managers Directive, or AIFMD) is part of the new breed of Directive from the European Commission, which is more detailed and prescriptive than pre-crisis legislation, with the aim of eliminating variation between financial markets, and can be seen as part of a trinity of measures covering clearing (the European Market Infrastructure Regulation, or EMIR), settlement (the Central Securities Depositories Regulation, or CSD-R) and trading (MiFIR).

  • Unlike MiFID I, which was aimed primarily at the sell-side, the buy-side needs to worry about MiFID II as well, as do non-financial counterparties above the activity threshold such as corporates and pension funds (in the sense they will have to trade clearable swaps on-exchange – see point 6 below), and market infrastructures such as exchanges and central counterparty clearing houses. For fund managers in particular, it affects how they do business, and who they do business with.

  • MiFID II implements the G20 goal of bringing all EMIR-clearable OTC derivative transactions on-exchange,  although there is a variety of labels for the “exchanges,” ranging from the Multi-Lateral Trading Facilities (MTFS) familiar from MiFID I (which refer to equity trading platforms only) to organised trading facilities (OTFs) (which will host trading of fixed income and OTC derivatives only, and which are distinct from the American swap execution platforms (SEFs), because they have a lot more flexibility in trading methods, including voice trading, while SEFs are allowed to trade electronically only).

  • MiFID II also wants as many instruments as possible to be traded on regulated platforms, and the definition of a regulated platform is being extended for the purpose of comprehensively reforming price discovery and formation. This is part of a wider agenda of as part of reducing fragmentation in the markets and ensuring prices paid by end-investors (as price takers) are open and fair rather than manufactured in a closed environment by the sell-side (as price setters ). This will affect the prices at which managers trade but also the closing prices that go into the net asset value (NAV) calculations fund accountants prepare on behalf of fund managers.

  • Transparency, including trading prices, is a major theme of MiFID II. It extends pre- and post-trade transparency from the equity markets to equity look-alike and non-equity products such as structured products and bonds. OTFs, for example, must publish their traded prices to the market, which eve American SEFs do not have to do. These are major changes for these markets, and greatly increase the pressure on fund managers to collect and report data on transactions to regulators.

  • Oddly, MiFID II is not expected to lead to a consolidated tape, although this has been a major area of discussion in Europe for many years. Instead, there will be multiple providers of consolidated tape services (e.g. Reuters, Bloomberg etc.) that will lead to inconsistent data and formats.

  • A group clearly in the sights of the framers of MiFID II is high frequency traders (HFTs), whose activities regulators clearly wish to shrink. Early expectations that any manager using algorithms would be in scope, and that HFTs would be obliged to quote two-way prices all the time, were not fully realised. However,  HFTs will be regulated and have to report (including disclosure of which algorithms they use), irrespective of whether they meet the MiFID II definition of a market-maker (which really hinges on whether the firm quotes two –way prices all the time or not).

  • Another group which MiFID II is clearly designed to shrink is the dark pools which emerged instead of MTFs and systematic internalisers in the wake of MiFID I, and which are now being forced to be more transparent in terms of publishing prices, making them less attractive as trading venues. They are allowed not to publish prices on an “exceptions” basis only, with valid exceptions defined in ferocious detail.

  • There will be a massive increase in the scope of transaction reporting from 24 fields in MiFID I to 93 fields in MiFID II, and its inclusion in MiFIR rather than MiFID mean there is no scope for national variation at all. MiFIR wants any instrument traded on a regulated venue to be reported, including not just FX, interest rate and commodity swaps traded on electronic platforms (a task of massive volume and complexity) but even OTC swaps whose underlying instrument is traded on a regulated venue, repos, securities loans, primary markets transactions, options and warrants that are exercised.

  • The scale and scope of transaction reporting under MiFID II massively increases risk, if all 93 fields are eventually agreed. Plenty of firms have been fined or sanctioned for reporting transgressions under the much simpler MiFID I regime, and they now have to ensure consistency across AIFMD (Annex IV) and swap reporting under EMIR as well.

  • There are inconsistencies between the regulatory reporting templates of AIFMD, EMIR and MIFIR.Although there  is considerable overlap between what is proposed for OTC and exchange-traded derivatives in the 93 fields of MiFIR and in the 85 field EMIR reporting template, and a Market Data Reporting Working Group is working on how to align reporting templates better, it is unlikely that regulators will ever get to the position where an EMIR or MiFIR report can substitute perfectly for each other. This is because MiFIR has plenty of components that are not in EMIR.  

  • MiFIR makes extensive use of individual identifiers. There are different identifiers (IDs) for individual decision-makers: portfolio managers, members of committees of individual portfolio managers, and individual dealers as executing agents. This raises issues of confidentiality of personal data, such as name and date of birth. There are also national IDs, IDs for identifying individual algorithms used, and a “report matching number” to cover the strings of transactions used to fill a single order. In fact, many of the 93 fields are really to accommodate a series of individual identifiers.

  • There are also differences in who reports between MiFIR and EMIR and how and what is reported.Under EMIR, it is counterparties that must report; under MiFIR, it is the investment firms, so under MiFIR it is executing brokers that must report, while under EMIR it is clearing members that must report. Likewise, under EMIR, the termination or partial termination of an OTC derivative affects only the original transaction, whereas under MiFIR the termination affects an opposing transaction (i.e. if you have a long position, the short position to hedge that out counts as a separate transaction). Again, under EMIR it is counterparties (down to individual funds) that have to report, while under MiFIR  it is fund managers rather than individual funds which must report.

  • Disclosure of transaction costs in general and equity commissions in particular to end-investors (not regulators) is another novel aspect of MiFID II. In the United Kingdom, the Financial Conduct Authority (FCA) has made clear that it expects fund managers to cap the use of equity commissions to buy research at particular firms and then switch to an execution-only relationship (see our webinar on this topic at: http://cooconnect.com/events/webinar-what-fate-investment-research-and-how-will-it-be-bought-future.  The initial approach of the framers of MiFID II was not unlike the Retail Distribution Review (RDR) in the United Kingdom:  in other words, advisory services should never be remunerated by commission. But this was diluted by the major banks, which did not want this to constrain their tied sales forces. In the end the Level I documents said that independent financial advisors and investment managers could not be remunerated by commission other than in relation to certain incidental services, including financial research. ESMA – clearly influenced by the FCA in the United Kingdom - has given a strong steer in its commentary that research other than general, publicly available research will not count as incidental or inconsequential services. In other words, ESMA is hostile to the concept of using equity commissions to purchase research, but resistance to the idea is expected at the national level, because it presages a substantial change in market practice and structure, and an outright ban on using equity commissions would be difficult to execute in one market.

  • Sponsored Direct Market Access (DMA) services, where brokers pay for exchange connections, are also at risk. One possible result is brokers setting a minimum portfolio size or transaction volume.

  • A fund manager exemption currently available under MiFID I (section 17.2.2) is expected to disappear: a fund manager dealing on a discretionary basis with a MiFIR-regulated European investor  does not have to report under MiFID I but will have to report under MiFIR.

  • Conduct of business, particularly in client-facing functions, is another major theme of MiFID II;

  • Implementation will occur late 2016 or early 2017, with reporting starting in 2017, so technical standards will need to be ready the year before (i.e. probably as early as 2015).

  • MiFID II does not yet make it clear who fund managers should report to. It depends on where the manager is offering a service, but on that basis a French fund manager operating in the United Kingdom on behalf of a German investor, for example, might have to report to “national competent authorities” in France, the United Kingdom or Germany, since the service is arguably offered in all three. The present rule of thumb is to report to the local competent authority where you are based, but in future the advice is expected to shift from the “host” state regulator to the “home” state regulator, so in the example above the fund managers would switch from reporting to the Financial Conduct Authority (FCA) in London to the Autorité des marchés financiers (AMF) in Paris.

  • In practice, for most fund managers, trade repositories such as UnaVista and DTCC will act as conduits for reports to “national competent authorities,” as they do already as approved reporting mechanisms (ARMs) under MiFID I, but the repository will have to be licensed by a “national competent authority” as equipped to perform the task before being “passported” across the European Economic Area (EEA).

  • MiFID II and MiFIR will necessitate re-writing client agreements to take account of the changes in areas such as disclosure, liability, product design and the suitability of investments. It remains unclear to what extent rules drawn up primarily to protect retail clients will be extended to professional clients. An intent is being signalled that the European regulators want to extinguish the distinction between the retail and the professional in certain areas, and impose an obligation on managers to “treat customers fairly” (as the  FCA rules have it) whether they are professional or retail.