ESMA Final Report on draft regulatory and implementing technical standards MiFID II: market issues and best execution

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1 Ashurst London October 2015 #6 MiFID Briefing series The MiFID II Review ESMA Final Report on draft regulatory and implementing technical standards MiFID II: market issues and best execution Introduction On 28 September 2015, ESMA published three volumes on its proposed regulatory and implementing technical standards (the RTS and ITS respectively) under MiFID II and MiFIR. These weighty tomes included its final report, the draft standards and a cost benefit analysis. Having been delayed, these standards were eagerly awaited by industry and, despite being labelled "technical", will have a significant impact on how relevant regulated business is currently conducted, particularly on market issues, transaction reporting and best execution obligations. The standards themselves run to over 400 pages and we provide below a summary of the main themes and points, focusing on some of the more significant shifts in position by ESMA from its previous consultation paper proposals. Your Contacts Rob Moulton T: +44 (0) rob.moulton@ashurst.com Ben Hammond Partner, Hong Kong T: ben.hammond@ashurst.com Nicola Higgs T: +44 (0) nicola.higgs@ashurst.com Hubert Blanc-Jouvan Partner, Paris T: hubert.blanc-jouvan@ashurst.com Detmar Loff Partner, Frankfurt T: detmar.loff@ashurst.com James Perry T: +44 (0) james.perry@ashurst.com Jake Green T: +44 (0) jake.green@ashurst.com Lorraine Johnston Senior Expertise Lawyer, London T: +44 (0) lorraine.johnston@ashurst.com María José Menéndez Partner, Madrid T: mariajose.menendez@ashurst.com Anders Malm Senior Legal Consultant, Stockholm T: +46 (0) anders.malm@ashurst.com AUSTRALIA BELGIUM CHINA FRANCE GERMANY HONG KONG SAR INDONESIA (ASSOCIATED OFFICE) ITALY JAPAN PAPUA NEW GUINEA SAUDI ARABIA (ASSOCIATED OFFICE) SINGAPORE SPAIN SWEDEN UNITED ARAB EMIRATES UNITED KINGDOM UNITED STATES OF AMERICA

2 Transparency The level of transparency and how this is brought about has been causing ESMA a headache over the last nine or so months. The calibrations for the pretrade transparency waivers for equity and non-equity alike have been particularly sensitive issues. The following points are of particular note: a. In relation to the large in scale waiver (LIS), ESMA has retained its proposal to use the average daily turnover (ADT) as a proxy for liquidity and market impact in the equity and equity-like field. This approach wasn't short of critics, but ESMA has stuck to its guns suggesting it is a useful metric and operationally straightforward (a virtue that few who face the task of implementing the transaction reporting requirements will sniff at). b. Additional to holding the line on ADT, ESMA has added a new category for shares with an ADT of less than 50,000 with a corresponding LIS threshold of 15,000. Turning to the vexed issue of the double volume cap. Despite many noting that for a number of instruments the caps will be exceeded immediately, there is little ESMA can do about this, save for calling for an amendment to the level 1 text. Given this, RTS 3 is largely procedural, detailing what type of data is required and how this will be gathered by competent authorities and ESMA. In this regard, ESMA has broadly stuck to its initial proposal, requiring collection of data twice a month and retaining the "value" thresholds, rather than opting for a "volume" requirement. There are also a number of references to consolidated tape providers that might be viewed as being slightly heroic (at least until ESMA mandates the establishment of such a provider during 2019). In relation to non-equity, ESMA has shifted its position from Class Of Financial Instrument Approach (COFIA) to an Instrument by Instrument Approach (IBIA) or, more accurately, a position that appears to be an IBIA-COFIA hybrid. To take fixed income as an example, RTS 2 sets out a methodology to: a. define the liquid market of a bond (an assessment will be carried out against individual instruments quarterly against three benchmarks, e.g. is the average daily notional amount at 100,000 or above? Have there been trades over 80 per cent of the period?); and be LIS where its size is 70 per cent or above of the average daily notional amount and 60 per cent for size specific to a financial instrument. However, COFIA remains for newly issued fixed income instruments that will be deemed liquid according to their issuance size, until the quarterly assessment (above) has been made. How will this work? In theory, trading venues are required to submit data to competent authorities who will (for example) collect and presumably crunch the LIS and SSFI numbers yearly. There are a number of problematic issues in relation to the revised draft (which many will, however, view as a significant improvement). For example, in relation to fixed income: a. Where bonds are issued during the first two months of a quarter, the classification of liquidity based on the issuance size will last until the publication of the results of the calculations at the end of that calendar quarter (the issuance sizes are set out at Table 2.3 of Annex III, RTS 2). There is a concern that these issuance sizes will deem instruments liquid which are illiquid (i.e. the problem of false positives identified by some in relation to COFIA). b. ESMA has retained its proposal to exclude transactions under 100,000 from the calibration of the transparency exemptions. Many in industry have suggested that significant institutional trading takes place under this level and to exclude these transactions will seriously distort the application of the transparency exemptions. c. Have the LIS and SSFI numbers been calibrated correctly (a long-running debate)? Micro-structural issues The fact that MiFID II takes aim at algorithmic trading (and its sub-species high frequency trading) is well known. It will surprise few that a number of grey areas still remain; for example, the extent to which these rules apply to third country firms. ESMA has, however, provided some helpful clarity in a number of areas: a. Pure investment decision algorithms that are executed by non-automated means are out of scope of the algorithm testing requirements. b. define the LIS and size specific to a financial instrument (SSFI). Broadly, a bond instrument will b. ESMA has accepted the point that not all changes to an algorithm should require senior management

3 sign-offs, but rather sign-off at an appropriate level. Instead, changes to the production environment should be subject to a review by a responsible party as designated by the senior management of the investment firm. c. ESMA has taken an increasingly reasonable approach in relation to pre-trade controls (although this was in response to near universal critical feedback). However, it has not budged much in other related areas. For example, the proposal that order flows should be monitored in real time with a time delay of no more than five seconds remains. d. ESMA has recognised that a proportionality principle should be observed in implementing automated alerts for the identification of other forms of market abuse, such as insider dealing and unlawful disclosure of insider information. position (often by reference to the level 1 text) where necessary. Additional exclusions A number of exclusions from the reporting obligations have been added, including: a. ESMA has decided to exclude all activity connected with the exercise of reportable financial instruments and extended this to also exclude the conversion of convertible bonds. This represents a change from the CP, which envisioned that while the exercise of a reportable instrument should not be reportable, the resultant transaction in the underlying would. However, ESMA now acknowledges that the significant difficulties involved in reporting the exercise of a reportable instrument do not justify the benefit of the competent authorities possessing this information. e. ESMA has also adopted a more flexible approach to how testing obligations can be fulfilled, whether inhouse, via a venue, or via a third party vendor. Position limits and exchange-traded equivalent OTC contracts Article 57(1) of MiFID II requires Member States to ensure that their competent authorities establish and apply limits on the size of a net position which a person can hold at any time in exchange-traded commodity derivatives and economically equivalent OTC contracts. To those that have been following this particular aspect of the MiFID II text, it will be known that separate position limits must be established for both spot months and other months. ESMA has notably retained its consultation proposal for spot month position limits to be based on deliverable supply, but position limits for other months will now be based on total open interest. The final RTS also proposes a stricter range of limits to a band of five per cent to 35 per cent (of deliverable supply or open interest), rather than the original proposal of ten per cent to 40 per cent. The claim made by ESMA is that this change is balanced out by a more lenient approach to new or illiquid contracts. There is also additional anti-avoidance style rules regarding OTC contracts, which are aimed at preventing the application of position limits for ETD contracts. Transaction reporting b. ESMA has broadened the exclusion for the creation and redemption of an exchange-traded fund by the administrator of the fund to also cover all funds where the asset management company determines the (fixed) issue or redemption price. c. The new rules also confirm that transactions between different firms, with different LEIs, within the same group are reportable and that transactions between branches within the same legal entity are not reportable. This has resulted in the related specific exclusion, previously set out in Article 3(3)(f), to be deleted. d. ESMA has clarified that the exclusion for predetermined contractual terms or as a result of mandatory events, which are beyond the control of the investor, is not intended to be limited to corporate events such as mergers and takeovers, but also applies to other events such as scrip dividends and DRIPs (noting that as a result of this, the specific exclusion for scrip dividends has been deleted). However, ESMA was keen to emphasise its intention to keep this exclusion narrow to avoid "inadvertently excluding activity that is of interest to competent authorities". Areas of no real change In other areas, ESMA ultimately clarified its approach without either extending or narrowing the scope of the relevant reporting obligation, including: In terms of the reporting obligations on firms under Article 26 of MiFIR, ESMA has sought to provide both clarity as to the extent of the obligations (by, for example, including additional exclusions or generally clarifying its approach) as well as reiterating its a. Regarding the transmission of orders, ESMA has confirmed that the specific conditions and timing of the transaction reporting obligation need to be agreed between the transmitting firm and the receiving firm. However, the conditions should be

4 agreed between the transmitting and receiving firm as a commercial arrangement (ESMA has not stipulated any particular terms). b. ESMA has reiterated that the level 1 obligation regarding obtaining information for the client in order to have a designation to identify a short sale is on a "best efforts only basis" and that it is unable to amend or ameliorate this obligation. Areas of change In addition to the above, there are some areas of more significant change as a result of the RTS, including: a. ESMA has agreed to pursue a new and more intuitive transaction reporting framework by replacing the current buy/sell indicator, counterparty and client fields with buyer and seller fields. ESMA believes that this change will increase the quality of transaction reporting data "since the information can be more intuitively populated by reporting entities and interpreted by competent authorities". b. The new rules have modified the existing approach as regards the designation of natural persons, as follows: (i) Article 7 of the RTS provides clearer guidance on the requirement to obtain the priority identifier for each client based on nationality as well as detailed rules for generating the CONCAT code. (ii) Where a client is both an EEA national and a non-eea national, the rules have clarified that the EEA nationality takes priority for designation purposes. (iii) While maintaining the requirement on firms to collect and use client ID codes, ESMA has established limits to the extent of the validation to be undertaken by firms on such codes. However, it is worth noting that ESMA has rejected proposals to allow a phasing in of these obligations; they are intended to apply from January In terms of reporting transactions executed by branches, ESMA has addressed two key concerns expressed by stakeholders by stating that: (i) when identifying the branch that holds the relationship with the client, the correct branch is the one that got the order directly from the client or that has made the investment decision pursuant to a discretionary mandate given to it by the client; and (ii) non-eea firms with EEA branches should report as follows: (1) where there is only one branch in the EEA, all transaction reports should be sent to the competent authority of the Member State in which the branch is located; and (2) where there is more than one branch in the EEA, the branches shall jointly choose a competent authority based in one of the Member States in which the branches are located. Best execution The level 1 text in article 27 of MiFID II requires: (i) markets to publish information on the quality of the execution provided by their market; and (ii) firms that use markets to publish annually information on the venues that they used and to compare it with the information which is made available by different execution markets generally. ESMA was charged with producing standards on the content, format and frequency of these reports. A couple of key issues have now been clarified. Obligation on venues to publish information On the obligation on the markets to publish information (under article 27(10)(a) of MiFID II), ESMA confirms that only trading venues and SIs are subject to the publication of data requirement for financial instruments subject to the trading obligation, not market makers and other liquidity providers. There is also clarification on the data to be published and ESMA has simplified what is required so that information on the cost of execution is at trading venue level, not instrument level. The range of financial instruments on which data is to be published has also been reduced. A key issue for markets was the publication of information on illiquid instruments. Here, again, ESMA has given some comfort that where an instrument is not traded during a day, a venue does not need to report on that instrument with price information. Inconsistency on the timings of publication has also been addressed by ESMA and execution venues now have three months, rather than one month, after each quarter to publish trade level data. In addition, ESMA has said that where a venue operates a number of different markets, the venue should provide the information for each segment they operate. Obligation on firms to publish information On the obligation on investment firms to publish information (under article 27(10)(b) of MiFID II), and

5 to counter respondents' concerns about the publication of commercially sensitive information, ESMA notes that the number and volume of client orders executed on each of the top five venues should be provided as a percentage of the firm's total for that class of financial instrument (although there is some good news that the classes of financial instruments have been reduced). ESMA also makes it clear that the requirement on firms to publish information on the quality of execution should apply for all execution venues for each class of financial instrument, not just the top five. However, information on order flow to the top five venues should be separate to any information in relation to the quality of execution obtained and the order flow data should be split between retail and professional clients. Data must also be split between what was previously referred to as "passive and aggressive orders" which has been changed to refer to "liquidity adding" and "liquidity removing". On this particular obligation on firms, there remain plenty of open questions despite the draft RTS, such as: is only best execution data to be caught? Are only EU-executed (rather than booked) transactions to be caught? Investment firms will be keen to see further clarifications on these issues. Market making agreements There will be a slight, but only slight, sense of relief in relation to the market making obligations. Articles 17 and 48 of MiFID II require entities who enter into market making strategies to enter into written agreement with the trading venue/regulated market. In this respect, the primary headline from the RTS is that firms will only be obliged to enter into a market making agreement where they post simultaneous twoway quotes of comparable size and competitive prices when dealing on their own account in at least one financial instrument on one trading venue for at least 50 per cent of the daily trading hours of continuous trading for half of the trading days over a one-month period. Originally, the requirement had been 30 per cent. ESMA has clarified that it is the market making firm that is required to notify the venue of its intent to pursue such strategy. However, where the venue identifies such a strategy, it must contract with the relevant investment firm. What happens if the investment firm disagrees with the venue's analysis? The venue may be required to report the infringement to the competent authority. The ancillary exemption for commodity firms Commodity firms will have watched closely the shifting forms that the exemptions, set out at Article 2 MiFID, II have taken. The conclusion has been a narrower set of exemptions for firms, particularly those in the commodity space who now have to rely on Article 2(1)(j) that states the regime will not apply to persons: a. dealing on their own account, including market makers, in commodity derivatives, emission allowances or derivatives thereof, excluding persons who deal on own account when executing client orders; or b. providing investment services, other than dealing on their own account, in commodity derivatives or emission allowances or derivatives thereof to the customers or suppliers of their main business. This is subject to a series of additional restrictions including that the relevant activity is an ancillary activity when assessed on an individual basis or on an aggregate basis to the person's main business (if being considered on a group level). What does "ancillary" mean here? ESMA's view is that it means two cumulative tests: a. Trading activity thresholds test: this compares an entity's share in a class of commodity derivatives, by comparing the size of the firm's trading activity to the size of the overall EU market trading activity. ESMA clarified that this test should only consider activities for non-hedging purposes and be applied per individual asset class, with different thresholds for the various categories of assets, as set out in the RTS (for example, coal, gas, oil and oil products). b. Main business thresholds test: compares the activity against the overall activity of the group's main business, without any further reductions (including privileged transactions and transactions executed in an entity of the group authorised in accordance with MiFID II or CRD IV). This approach significantly changes the original proposed calculation methodology based on capital employed ratios. Next steps The technical standards have now been sent to the European Commission, who will have forwarded them to the European Parliament and the Council of the EU.

6 For the draft RTS, the Commission has three months from receipt to reject or adopt them, and must immediately notify the EP and the Council if and when the RTS is adopted. The Council and EP then have a specified period which may be extended from the date of notification by the Commission to raise any objections to the RTS before the RTS will be published in the Official Journal of the EU as Delegated Regulations and officially come into force. For the ITS, the Commission now has three months (which may be extended by another month) to reject or adopt them. Unlike with RTS, the EP and Council have no power of veto over ITS, so once the Commission adopts the ITS it will be published in the Official Journal of the EU and come into force. Further delegated acts are due out in November which are eagerly awaited by the industry as they will contain most of the major conduct rule controversies on, for example, research, product governance, suitability and appropriateness. We will certainly update you when these are produced. For more information Please contact your usual Ashurst contacts or any of those listed on page one. Please also visit our Ashurst MiFID II portal for further resources which can be found here:

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