The MiFID II Review. Ashurst London June #2 MiFID Briefing Series. The ESMA Proposals. Introduction. Contacts

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1 Ashurst London June 2014 #2 MiFID Briefing Series The MiFID II Review The ESMA Proposals Introduction In MiFID Briefing #1, we explained the revised MiFID and MiFIR legislation. This briefing looks in detail at the ESMA proposals that were an integral part of the Directive and the Regulation. ESMA has published two documents a Discussion Paper and a Consultation Paper. The first covers areas where ESMA is empowered to draft technical standards for approval by the Commission, and the second covers areas where ESMA is merely requested to provide draft advice to the Commission so that the Commission can produce the relevant legislation. Between them, the documents run to around 800 pages. Even then, many of the topics receive only brief treatment for example: two pages on investment advice; three pages on the fair, clear and not misleading requirement; two pages on client order handling. Although the actual technical advice probably only covers 100 pages (the advice appears at the end of each sub-section), on occasions the intention behind the advice is not easily ascertained without reading the prior discussion on it. This document identifies and summarises the key aspects of ESMA's work, and will help our clients to identify which, if any, areas of the ESMA proposals ought to be read in full from the original ESMA documents. One development to note is the expansion of retail consumer protections into professional markets. The rules relating to inducements, conflicts, client money, costs and reporting are all examples of this. Indeed, it is arguable that the clearest distinction will soon be between the protections offered to professional clients and eligible counterparties, rather than between retail and professional clients. Contacts Rob Moulton Partner, London T: +44 (0) E: rob.moulton@ashurst.com Hubert Blanc-Jouvan Partner, Paris T: E: hubert.blanc-jouvan@ashurst.com Tobias Krug Partner, Frankfurt T: +49 (0) E: tobias.krug@ashurst.com James Perry Partner, London T: +44 (0) E: james.perry@ashurst.com María José Menéndez Partner, Madrid T: E: mariajose.menendez@ashurst.com Anders Malm Senior Legal Consultant, Stockholm T: +46 (0) E: anders.malm@ashurst.com AUSTRALIA BELGIUM CHINA FRANCE GERMANY HONG KONG SAR INDONESIA (ASSOCIATED OFFICE) ITALY JAPAN PAPUA NEW GUINEA SAUDI ARABIA SINGAPORE SPAIN SWEDEN UNITED ARAB EMIRATES UNITED KINGDOM UNITED STATES OF AMERICA

2 1. Inducements and Research The MiFID inducements rules are to be maintained with little change. ESMA's guidance makes clear that on-going payments (such as trail commission) require an on-going service to be provided before they can be justified. There is a new requirement for there to be an annual disclosure of the overall inducements/benefits received from third parties that relate to business done for a particular client. ESMA has also given detailed new guidance on the ability of firms to provide research to investor clients without breaching the inducements rule. At the moment, such research is usually provided without charge. ESMA sees this as an inducement. It will only be allowed to continue if: there really is no cost (in other words, executiononly rates are being charged comparable to firms who do not provide research at all); the research is widely distributed (this is unlikely to be problematic); and access to analysts is not provided. If these tests cannot be passed, the implication is that the costs must be "unbundled" in other words, research can be sold for a specific price, but not distributed for free. This is a significant change. For instance, it runs contrary to the recently-announced approach of the FCA in the UK to the use of dealing commissions. 2. Conflicts of Interest No major change is proposed on the core issues of identifying and managing conflicts. The new proposals generally relate to the disclosure of conflicts. It is clear that ESMA thinks that this approach is taken too often. Firms will be required to keep a record of the alternatives that they have considered and discounted whenever they disclose a conflict. Given that conflict disclosure is often required for non-regulatory reasons, firms may be surprised to know that ESMA's view is that generic conflict disclaimers are ineffective for all client types for regulatory purposes. So they will still need to be made for other purposes, but firms will not be able to rely upon them as a means of meeting the regulatory requirement effectively to manage conflicts. 3. Independent advice, suitability, and appropriateness MiFID adopts an approach (which is already in place in several Member States) that will require advisers to avoid receiving fees from product providers. They will need to charge for their advice. Advisers will only be able to describe themselves as independent if they meet a test of independence based upon the breadth of the products to which they advise. ESMA's guidance does make it clear that if firms are specialist in a particular area, but can advise generally in that area without ties to a particular provider, then this will still amount to independence. In other words, independent advice does not need to cover products across the board. This approach is not the same as all of the existing national regimes, so may require changes to those regimes. The core rules relating to suitability and appropriateness are largely left untouched. However, two extra product types are now included in the list of complex products, which means that appropriateness assessments will need to be undertaken before they can be sold, even on an execution-only basis. Those are: contracts which permit changes to the nature of a payout to be made by granting discretion to the investment firm or someone acting on their behalf; and products where the level of exit fees means that there is a measure of illiquidity in the product. 4. Client Money MiFID already makes the use of title transfer collateral arrangements problematic for retail clients. In line with the general approach of MiFID, new measures are to be put in place to protect professional clients in similar circumstances. Firms will not be able to operate entire business lines on the basis that all professional clients will be required to undertake title transfer collateral arrangements. A client-by-client consideration of the appropriateness of these arrangements for the client will need to be undertaken; firms will need to be able to demonstrate a strong connection between the potential liability of the client and the amount transferred. Where securities financing transactions are being undertaken, a signature will be required from professional clients before title transfer collateral arrangements can be undertaken. Firms will be required to avoid placing more than 20 per cent of the client money they hold with a group bank, although this will be relaxed where smaller sums are involved that mean diversification would be disproportionate. All investment firms will be required to keep a mini "living will" to enable an administrator to understand what their client money arrangements are.

3 5. Corporate Finance Business The ESMA proposals suggest that when a firm is acting for a corporate on a transaction they will also owe duties to investor clients. In the UK, where this business has benefited from a "corporate finance contact" exclusion (which means that firms generally do not owe any duties to investors), this will be an important change unless an ingenious interpretation can be devised to try to avoid this impact. The ESMA guidance also contains a long list of conflicts, some of which will surprise firms. Did you know that regulators worry that firms recommend financing transactions to corporate clients merely to raise their standing in league tables? 6. Product Governance MiFID contains detailed product governance requirements that apply to both the manufacturers and distributors of products. In particular, manufacturers are required to undertake: target market identification (what do consumers really want?); product risk assessments; excess fee analyses along the distribution chain; the provisions of information to distributors to enable them to distribute the product properly; and product reviews periodically to check whether performance is on track. Distributors are also required to: undertake target market analysis; provide sales information to manufacturers to help to ensure that the intended target market is being sold to; consider whether sales through non-eu distribution channels are appropriate; and recognise that the final distributor in an extended chain is ultimately responsible for compliance with these points. For all firms, the board is required to sign-off on the product approval and governance process, and should be provided with information on specific products that are being approved. 7. Product Intervention A potentially important step taken by MiFID II gives ESMA product intervention powers to go over the heads of national regulators. The ESMA consultation plays this point down. It looks as though ESMA is not keen to overrule national regulators, although it does give a sensible-looking list of circumstances that would need to be considered in relation to any particular product. Suffice to say, if ESMA does start to take action to ban products over the heads of national regulators, we will all hear about it. 8. Costs ESMA proposals contain detailed cost disclosure requirements. All costs will need to be disclosed in a set format to show a total cost amount. This applies to all retail clients, and to professionals and eligible counterparties when advised or discretionary managed services are being provided. In other circumstances, professional clients and eligible counterparties must formally opt out of cost disclosures. The intention is to set out in numbers the aggregated and cumulative effect of costs from both a product and relationship point of view. ESMA considers the increased protection being offered to professional clients in this area as one of the "innovative" steps forward by MiFID II. On top of this, firms will need to make an annual overall costs and fees disclosure to any client with whom they have engaged in more than a one-off transaction. This also needs to include costs incurred by clients as a result of recommendations or introductions to third parties such as custodian, and any inducements that the firm may have received. 9. Best Execution ESMA appears frustrated with the failure of the MiFID best execution regime really to enable investors to differentiate between the services provided by investment firms. Much of ESMA's guidance is driven at improving this position. Where firms choose to execute transactions outside a Regulated Market, firms will be required to adapt their policies to explain the counterparty risk involved given (as ESMA sees it) the unlikelihood of the involvement of a central counterparty. Where OTC execution is involved, firms must check the fairness of the price on behalf of their client presumably, even if they are acting in a proprietary capacity. Where firms act for both sides (such as inter-dealer broking), they have to disclose the actual fees received from one party to the other. Where retail clients are involved, there are extensive new rules around the disclosure of costs. Controversially, ESMA has decided to go beyond its brief and make firms who act as market makers (a non-technical definition that will catch many dealing desks) comply with the data requirements that apply to the Regulated Markets. RMs are well set up to be

4 able to provide this data many dealing desks will not be. ESMA is likely to face criticism and pressure to change this approach. 10. Systematic Internalisers The SI regime was something of damp squib when introduced in ESMA intends to redress that deficiency. It has given detailed consideration to what "frequent and systematic" means in equity markets and two proposals are put forward per cent or 0.5 per cent of EU turnover for liquid stocks, and daily trading for illiquid stocks, will suffice to make a firm fall within this part of the definition. A similar pair of numbers is used for the definition of "substantial". Specifically, if the size of OTC trading carried out by the investment firm on own account is, during the most recent calendar quarter, equal or larger than either: a) (between 15 per cent and 25 per cent) of the total turnover in that financial instrument executed by the investment firm on own account or on behalf of clients; or b) (between 0.25 per cent and 0.5 per cent) of the total turnover in that financial instrument in the European Union, it will be deemed to be undertaken on a "substantial basis". In short, many more firms are likely to be caught by the SI requirements than had previously been the case. These calculations must be undertaken on a quarterly basis and firms will then have one month after triggering a requirement to comply with the SI pre-trade transparency regime. A similar approach is taken for non-equity markets, although the percentages are slightly different. A new definition will be used of what amounts to a liquid market for the purposes of this definition. A share will be liquid if it has a free float of above 100 million, and either of the following two tests is met. The average daily number of transactions is more than 250, or the value of the average daily transactions is more than 1 million. 11. Concentration Rule At the time, it was thought that one of the key steps forward taken by MiFID was the abolition of the concentration rule. This meant that transactions did not have to be undertaken on the national market, but could be undertaken OTC. If that was, indeed, a stepforward, MiFID II will take an almost equivalent step back from it. Equity transactions will need to be undertaken on a Regulated Market unless one of a number of narrow exemptions applies (give-ups and VWAP transactions are mentioned). This will make it difficult to run equity-based broker crossing networks. In relation to derivatives, whenever ESMA decides that a product must be cleared, ESMA will have a further six months to consult on whether or not to require onexchange execution as well. These requirements potentially have extraterritorial effect for firms based outside the EU who benefit from guarantees provided by EU firms, or who have EU branches. 12. High Frequency Trading MiFID II requires entities undertaking HFT to become authorised and comply with compulsory marketmaking rules (so that they hold themselves out to the public as permanently making two-way prices). To do this requires a definition of HFT, which ESMA clearly finds somewhat difficult. It proposes two options. The first is any firm that sends more than 75,000 trading messages a day. The second requires calculating the average lifetime of orders on a particular market, and labelling as high frequency traders anyone whose average order lifetime is below that amount. One helpful piece of ESMA advice is that the compulsory market-making requirement will, however, only apply where it is the investment firm, not its client, which is undertaking the HFT business. So few investment firms will be hit by this requirement, but some of their clients may be. 13. Abusive Trades ESMA gives regulated markets an interesting list of abusive trades, many of which look like nothing of the sort. They include: trades which are attempting to build momentum in a stock which is surely the potential consequence of any trade; trades which affect the volume weighted average price (which is every trade); and trades that have an impact on price (which all trades will do potentially, depending upon the level of liquidity at the best bid and offer price). It is hoped that national regulators will indeed be looking for something more than such conduct, such as abusive intent, before requiring Regulated Markets to report such transactions. 14. Commodity Derivatives MiFID II grants ESMA important powers to limit trading in commodity derivatives. ESMA sets out a list of circumstances where it might take such action to limit the ability of individual firms or the market to hold positions in commodity derivatives. Two of the

5 examples are a rise in demand for a product, or an investor with a significant position. These requirements remain highly politicised and it may be that ESMA never reaches a consensus that any such steps need to be taken. 15. Terms of Business Whilst MiFID does not mandate a repapering of clients, there are some terms of business changes. Terms are required for professional clients for the first time (although professional client terms of business are already very common). There is no requirement to have a terms of business for Eligible Counterparties, although firms are required to have in place a "contract" to cover reporting arrangements (see Reporting below). A transitional measure means that where terms of business are required for the first time, that will not involve existing clients but only new ones. 16. Reporting Where firms are required to provide reports (for example, because they are a discretionary manager), these will need to be provided quarterly (not every six months) and also go to professionals (not only retail). Where the client involved is an Eligible Counterparty, a written agreement to non-report will be needed (see Terms of Business above). 17. Transaction Reporting ESMA suggests changes to the existing MiFID transaction reporting requirements. Given the difficulties firms have in meeting the existing regime, this is likely to require extensive systems work and live testing. There is a new definition of "execution of a transaction" which is only to be used for Transaction Reporting purposes. It includes the receipt and transmission of orders where no execution occurs. In addition, transaction reports will require: trader IDs; client IDs; algo IDs; and committee IDs (where transactions are triggered by the decision of a committee). harmonising measure is that no reporting will be required to host authorities by, for example, branches a single transaction reporting mechanism to the home Member State will suffice. 18. Remuneration ESMA has chosen to add further to the difficulties firms have on the remuneration of staff. Firms will be required to have a policy, signed off by the board, to show how the interests of clients are put first when paying any staff with a direct or indirect involvement in investment business. In particular, where variable pay is involved, commercial considerations must become a secondary concern. The primary interest in calculating variable pay will be whether the individual has been serving the interests of clients, and performing compliantly (potentially giving compliance a leading role, rather than a veto right, when it comes to determining discretionary pay). Relegating commercial considerations to a secondary concern may take some explaining to front-line staff. 19. Records ESMA's guidance adds to the extensive record-keeping requirements contained within MiFID. Where firms provide advice or undertake transactions in face-toface meetings, a written record of the conversations must be kept. Certain information is mandated, such as the date, place, initiator of the meeting and the names of all attendees. ESMA has asked whether it would be a good idea to require firms to send their record to the client to sign to confirm the contents of the meeting. Although this will primarily be an issue in relation to retail advice, the point remains the same when (for example) an investment firm is advising a professional corporate client on a fundraising. 20. Timing and Next Steps ESMA's consultation ends on 1 August 2014 a worryingly short period for such a large number of important issues. ESMA has until May 2015 to complete its consultation, and the Commission has requested that ESMA provide advice on all of the delegated acts by December Firms and Member States will then spend 2016 transposing these requirements into national law, and they are expected to come into effect on 3 January Share issuance and compression transactions will fall within the Transaction Reporting regime. One helpful

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