40 Minute Briefing MiFID II: are we there yet?

Transcription

1 40 Minute Briefing MiFID II: are we there yet? Jonathan Herbst - Partner Peter Snowdon - Partner Hannah Meakin - Partner Financial Services 6 November 2013

2 Our agenda for this morning s briefing 1. Big themes and EU legislative process 2. The latest on the markets framework 3. The technology debate 4. Conduct of business 5. Third country requirements 2

3 Big themes and EU legislative process 3

4 The big four themes of post-crisis EU regulation Theme 1: a much thicker EU legal framework Links to the issue of a single rulebook and the common standards debate Use of Regulations A tale of two stories as shown in a series of Level 2 powers in the conduct of business arena and in fundamental change in markets regulation: micro versus macro change but cumulative micro costs may be large Theme 2: post-crisis reaction Regaining trust and the banking crisis are at the core of regulatory thinking Product regulation and position limits are good examples of this Reflects change in political consensus away from free market thinking and towards some protections even for ECPs and professional clients Theme 3: keeping up with technology One of the reasons for MiFID II is that the markets have moved on and the EU institutions do not want this to happen again Theme 4: the EU versus world problem 4 Belief that Europe is strongest if it negotiates together but great tensions between institutions Concerns on free rider issues with firms based in the rest of the world and need for level playing field

5 EU legislative process 101: jargon 5 The European Commission: Represents the interests of the EU as a whole and is composed of one Commissioner from each Member State: each Commissioner assigned responsibility for specific policy areas by the President The European Parliament: Members are directly elected by EU citizens every 5 years: the number of MEPs for each Member State is roughly proportional to its population The Council of the EU: Represents the governments of Member States. Presidency of the Council is shared by Member States on a rotating basis lasting 6 months: in each Council meeting each Member State is represented by their minister for the policy field being discussed Don t confuse this body with the European Council which is an institution that comprises of its President, the President of the Commission and the heads of governments from Member States ECOFIN: One of the configurations of the Council is the Economic and Financial Affairs Council, comprised of the economics and finance ministers of Member States Presidency texts: Draft of a EU legislative proposal that may be published in the course of working group discussions at official level under the authority of the Council Presidency Trialogues: Informal tripartite meetings attended by representatives from the European Parliament, the Council and the Commission: purpose is to ensure that amendments to be adopted by the European Parliament are acceptable to the Council

6 EU legislative process 101: procedure Two types of EU legislative procedures: Ordinary legislative procedure: joint adoption by the European Parliament and the Council of the EU of a Regulation or Directive following a proposal from the Commission Special legislative procedure: Regulation or Directive is adopted by the Council of the EU but only after consultation with, or consent from, the European Parliament Both procedures commence with a legislative proposal from the Commission The confusing aspect of ordinary legislative procedure: Preparatory work of the European Parliament and the Council of the EU run in parallel and they are encouraged to exchange information: this means a lot of paper 6

7 MiFID II: key papers and timing 7 Current constitution of MiFID: Level 1 Directive (April 2004) Level 2 implementing Directive (September 2006) Level 2 implementing Regulation (September 2006) Level 3 numerous reports and guidelines from CESR (now ESMA) Why is MiFID being updated: Financial crisis demonstrated weaknesses in some of its underlying principles plus technological change (e.g. algorithmic trading) Useful background found in CESR and Commission consultations published in 2010 The EU legislative procedure for MiFID II: Ordinary legislative procedure The key papers in MiFID II: October 2011: European Commission publishes legislative proposals: MiFID (recast) and MiFIR October 2012: European Parliament texts 18 June 2013: Council published General Approach documents for both proposals Good comparison papers produced by industry bodies e.g. EBF position paper of July 2013 What is next: Parliament plenary vote now scheduled for 11 December 2013 Important to note that we are at the beginning of a process: MiFID II only amends Level 1 text The devil will be in the detail when proposals are made that change the Level 2 texts

8 Timing: MiFID II 1 January 2013: Ireland takes the Presidency 13 December 2012: Council progress report on MiFID II Q4 2013: Council expected to approve Parliament text (at the earliest) Council of the EU 20 June 2012: First compromise proposals published 12 November 2012: Note on progress of negotiations 18 June 2013: General approach documents published by the Council 1 July 2013: Lithuania takes the Presidency European Parliament 16 March 2012: Draft report from Committee on Economic and Monetary Affairs (ECON) 27 September and 5 October 2012: ECON unanimously adopts reports on MiFID II and MiFIR respectively October 2012: Parliament votes on amendments to draft legislation but then refers matter back to ECON for further consideration 11 December 2013: Scheduled plenary session to vote on legislative proposals Q4 2013: Commission consults on Level 2 measures (at the earliest) Expected implementation of MiFID II legislative proposals (at the earliest)

9 How do the key proposals fit together? MAD: EMIR: Broader scope to cover MTF traded instruments and related instruments Conforming the commodities scope to MiFID REMIT: New market abuse provisions for electricity and gas markets based on MAD CRD: Carrot to the EMIR stick MAD REMIT EMIR MiFID Uses MiFID definition of derivatives MiFID transaction reporting links with position reporting to trade repositories Links between clearing eligible derivatives and various MiFID requirements MiFID: Mandatory on-platform trading obligation applies to same counterparties as EMIR and selection of derivatives piggy backs off EMIR process New 2% risk charge on trading exposures to CCPs Layered approach to default fund exposures CRD Broader transparency and transaction reporting obligations for derivatives Position management and limits New trading categorisation of OTF 9

10 The latest on the markets framework 10

11 Trading venues - new concepts and boundaries Regulated Markets (RMs) - Non-discretionary execution of transactions - Managed by market operator -Operating is not an investment activity or service Rules applicable to market operators and firms that operate MTFs and OTFs are similar FCA currently considering scope of MTF definition Multilateral Trading Facilities (MTFs) - Non-discretionary execution of transactions - Operating is an investment service but can be operated by market operators - Few conduct of business rules apply Multilateral systems: Multiple third party trading interests interact in the system in a way that results in contracts Organised Trading Facilities (OTFs) - Discretion over execution of - transactions - Investor protection, conduct of business and best execution requirements - Cannot trade against proprietary capital - Operating is an investment service but can be operated by market operator 11

12 OTFs: scope of concept Political background is the broker crossing system debate Parliament does not want to permit trading on OTFs for equities being discussed in trialogue Broadly defined: All types of organised execution and arranging of trading which does not correspond to RM or MTF Includes: Broker crossing systems (internal electronic matching systems) which execute client orders against other client orders and systems eligible for trading clearing-eligible and sufficiently liquid derivatives Does not include: Facilities where there is no genuine trade execution or arranging taking place in the system, such as bulletin boards, aggregation engines or electronic post-trade confirmation or portfolio compression Bilateral systems There are two different levels of discretion of operator of system: When deciding to place an order on the OTF or to retract it again When suggesting prices and quantities and deciding not to match an order or, for crossing systems, when deciding if, when and how much of two or more client orders it wants to match within the OTF Operator must make clear how it will exercise discretion Commission text prevented execution of orders against proprietary capital: Council text allows operator to do matched principal in bonds and non-cleared derivatives and to deal on own account in sovereign debt where no liquid market being discussed in trialogue 12

13 Mandatory on-platform trading Mandatory on-platform trading for derivatives under MiFIR: Reflects G20 commitment Derivatives that are subject to clearing obligation in EMIR which: are traded on at least one RM, MTF, OTF or third country trading venue; and are considered sufficiently liquid to only trade on these venues. The Commission and ESMA will define eligible derivatives through technical standards ESMA also has an own initiative power to identify derivatives that are not CCP cleared or traded on a trading venue for this purpose If within scope then must be traded on a RM, MTF, OTF (Parliament only accepts OTF trading as a back up if RM or MTF not available) or on certain third country trading venues Same scope as EMIR in relation to counterparties: trades between financial counterparties and in-scope non-financial counterparties; trades between an EU captured entity and third country entities that would be subject to EMIR; trades between third country entities that would be subject to EMIR if they were established in the EU where their transactions could have a direct, substantial and foreseeable effect within EU and necessary to avoid evasion; and excludes certain intra-group transactions The only derivatives contracts that will in future continue to trade OTC are those that do not meet the test of being clearing eligible and sufficiently liquid Parliament proposes that they should be traded through a systematic internaliser The end of the OTC equities market? - Council proposes obligation that investment firms trade liquid shares on a RM, MTF, OTF or systematic internaliser save where they: are non-systematic, ad hoc, irregular and infrequent; and are non-retail and do not contribute to price discovery Parliament proposed provision with similar effect (but omitting OTFs) 13

14 Increased reporting and disclosure: overview Transaction reporting Increased scope and granularity Transparency Extending to additional equity type instruments and derivatives Data consolidation New APA and CTP categories Increased reporting and disclosure OTC derivatives Reporting to trade repositories under EMIR Implications: - Cost, IT spend or dependence on third parties - More EU power Commodity derivatives Platforms to disclose position information to regulators and public 14

15 Extension of transparency regime investment firms Pre-trade Post-trade Applies to SIs: Extended to equity-like instruments such as depositary receipts, exchange traded funds and certificates traded on a trading venue Some amendments including minimum quote size, two way quotes and price improvement for retail as well as professional clients Shares and equity-like instruments Investment firms must make public trades through an Approved Publication Arrangement Applies in respect of instruments traded on a trading venue but if venue can defer, this should also apply to OTC trades Make public volume, price and time of transaction New SI regime extended to bonds, structured finance products, emissions allowances and derivatives Must provide quotes where asked by clients Must make available to other clients and trade if up to certain size Price improvement permitted in justified cases Other instruments Investment firms must make public trades through an Approved Publication Arrangement Detailed information requirements to be set by Level 2 Competent authority can permit deferral, or restricted or aggregated disclosure, and can suspend and this also applies to OTC trades 15

16 Extension of transparency regime trading platforms Shares and equity-like instruments Other instruments Pre-trade Extended to equity-like instruments such as depositary receipts, exchange traded funds and certificates Make public bid and offer prices and depth of trading interest Extended to actionable indications of interest Competent authorities permitted to grant waivers including by reference to price on trading venues and orders that are large in scale but ESMA will opine on use of waivers before their use and has powers to oppose their use Council favours volume cap mechanism to restrict trading under waivers Further work on pre-trade waivers for equity instruments in trialogue Existing waivers to be reviewed against new requirements 2 years from date of MiFIR Post-trade Extended to equity like products As close to real time as possible Deferred publication for large in scale where authorised by competent authority within framework set by Commission Make public price, volume and time of trades 16 Extended to bonds, structured finance products, emission allowances and derivatives Same as for equity-like instruments Competent authority can grant waivers for large in scale orders and illiquid markets subject to ESMA s opinion Competent authority can temporarily suspend disclosure where liquidity drops Extended to bonds, structured finance products, emission allowances and derivatives Deferred publication for large in scale and illiquid where authorised by competent authority within framework set by Commission but may require publication of limited or aggregated details Competent authority can temporarily suspend disclosure where liquidity drops Information must be available on reasonable commercial basis as soon as possible and free of charge within 15 minutes Must offer pre- and post-trade information separately Commission to clarify details

17 Active intervention in markets: position limits The four layer sandwich on position limits for commodity derivatives: Layer 1 Competent authority shall impose position limits to prevent market abuse or support orderly pricing and settlement conditions Does not apply to hedging activity of non-financial entities but Parliament proposes a position checking system (to be developed in regulatory technical standards) for such trades Layer 2 Commission will adopt technical standards to determine criteria regulators should factor in when setting position limits Layer 3 Competent authority can set more restrictive limits where objectively justified and proportionate taking account of liquidity and orderly market for 6 monthly renewable periods Layer 4 ESMA must opine on whether this is necessary ESMA plays coordination role and maintains summaries of measures in force on website Participants on RMs and MTFs must report to market their own positions and those of their clients and underlying clients daily 17

18 Active intervention in markets: position management Trading venues must have position management powers for commodity derivatives: Monitoring open positions Access to information about positions Require a person to terminate or reduce a position Require a person to provide liquidity back into the market Competent authorities can: Require information about size and purpose of position or exposure in a commodity derivative or underlying; and Request a person to reduce positions and exposures in any derivative. ESMA can: Request information about size and position of any derivative and require a person to reduce it Limit ability of a person to enter into a commodity derivative To address a threat to viability of financial system or orderly functioning and integrity or competent authorities actions are inadequate Position reporting by trading venues for commodity derivatives, emission allowances and derivatives on them Weekly report of aggregate positions by category of trader, commercial undertaking, investment firm etc to public Complete breakdown of positions of members and clients to competent authority on request Daily position reporting of own and client positions to trading venue 18

19 The technology debate 19

20 The tough new approach to technology Relevant trading systems Capacity for peak order and message volumes Harmonisation of tick sizes as proposed by Parliament Ensure orderly trading in times of stress Effective business continuity Synchronisation of business checks as proposed by Parliament Must have schemes to incentivise market makers to post firm quotes and provide liquidity: written agreement between venue and RM Parliament proposal of minimum resting period of 500 milliseconds dropped Give competent authority access to order book on request Trading venues - details to be included in technical standards Rules on colocation services and fee structures Identify orders generated by algorithmic trading, different algorithms and persons using them Systems to: reject orders that exceed thresholds or are erroneous temporarily halt or constrain trading if there is a significant price movement cancel, vary or correct transactions Systems to prevent algorithmic and high frequency trading contributing to disorderly trading: limit ratio of unexecuted orders to transactions slow down flow of orders if close to capacity limit net size testing of algorithms (suggested by Parliament) to be added If allowing direct electronic access: to be provided by banks and investment firms only risk controls and thresholds need ability to stop such orders separately from other orders 20

21 Algorithmic trading Systems and risk controls resilient sufficient capacity appropriate thresholds prevent erroneous orders cannot be used for disorderly or abusive trading effective business continuity monitoring and testing Algorithmic trading Detailed requirements to be specified in regulatory technical standards Provide information to competent authorities description of strategies parameters key compliance and risk controls testing systems may also have to keep audit trail of trading activity in approved form Algorithmic trading pursuing market making as a sub-set Text of requirements still being finalised: written agreement with trading venue setting out market making obligations continuous market making during at least a specified proportion of trading hours liquidity provision intended to be regardless of market conditions but may be subject to exceptional circumstances defined in regulatory technical standards or agreement 21

22 Direct electronic access Where member of trading venue permits a client to use its trading code to transit orders direct to trading platform Parliament wanted to ban sponsored and naked access where orders are not routed through member s internal systems Outright ban appears to have been rejected but controls may be reinforced as a result Information to be provided to competent authorities Member remains responsible for ensuring service does not breach market abuse regime Systems and controls to prevent disorderly trading Pre-set trading and credit thresholds Controls Written agreement between member and client Member must assess suitability of clients using service Detailed organisational requirements to be set out in regulatory technical standards Service must be properly monitored 22

23 Conduct of business issues 23

24 Conduct of business: illustrating the themes Thicker layer of EU law: best execution and scope Post-crisis reaction: Product intervention Inducements Tougher stance on execution only Whole COBS and tighter client classification Overall theme is one of a small number of macro changes but a large number of micro changes which taken together will be very significant AIFMD ESMA process is a harbinger of what is to come in a larger form on MiFID 24

25 The thicker layer of EU law: best execution Well functioning pre- and post-trade transparency regime vital to assessing execution quality Execution venues to produce public data on quality of execution of transactions: Improvements in delivering best execution to different category of clients Improvement in the ability of supervisors to monitor firms' compliance with best execution Investment firms to produce annual public data on top 5 execution venues for execution of client orders for each class of financial instruments ESMA to develop draft implementing technical standards on content and format for execution venues and investment firms ties to concern that current policies are too generic Execution policy, ESMA input Possible glossing of the concept of price? Article 27 PFOF provision? 25

26 The thicker layer of EU law: best execution Appropriateness analysis not required for Shares admitted to trading on a regulated market (or equivalent) or MTF but not if they embed a derivative (no increase of risk?) Bonds admitted to trading etc, which do not embed a derivative (no increase of risk) Money market instruments UCITS Other non-complex instruments Where credit is provided, appropriateness analysis will be required (discussions on existing credit facilities, overdrafts and current accounts) 26

27 Broader scope and additional requirements Structured deposits MiFID also applies to investment firms and credit institutions selling own securities: Clarity of position where advice is not being given Disparity between Member State rules no longer tenable in view of the lessons of the financial crisis, the complexity of financial markets and products, and the need for investors to be able to rely on similar levels of protection irrespective of the location or the nature of the service providers Extend MiFID requirements, particularly conduct of business and conflicts of interest rules, to investment firms and credit institutions selling their own securities PRIPS UCITS style disclosure obligations Regulation will embed prescription for KID 27

28 Product intervention Pro-active product monitoring and intervention - MiFIR Competent authority may prohibit or restrict in or from that Member State: Marketing or distribution of instruments A type of financial practice Competent authority may take action if satisfied on reasonable grounds: Significant investor protection concerns or serious threat to orderly function and integrity of financial markets or stability of whole or part of the financial system Existing regulatory requirements do not sufficiently address the risks and the issue would not be better addressed by improved supervision or enforcement of existing requirements The action is proportionate given risk, sophistication of investors or market participants and the effect of the action on investors and the market participants It has consulted with competent authorities in other Member States who might be affected The action does not discriminate against services or activities in other Member States Possible extension to capture certain derivative products if they are judged to have a detrimental effect on price formation in the underlying market 24 hours notice in exceptional circumstances? 28

29 Product intervention - ESMA Product intervention - MiFIR ESMA power to temporarily restrict: Marketing, distribution or sale of financial instruments A type of financial activity or practice ESMA can take action if following conditions are met: Action poses *threat to investor protection or orderly functioning and integrity of *financial markets or stability of whole or part of the financial system in the EU EU regulatory requirements under EU legislation applicable to the instrument or activity do not address the threat Competent authority has not taken action or adequate action ESMA must take into account extent to which the action: Does not have a detrimental effect on the efficiency of financial markets or investors that is disproportionate to the benefits of the action Does not create a risk of regulatory arbitrage ESMA action prevails over any previous competent authority action 29

30 Product intervention - ESMA Do we know when ESMA would move? Word in the market indicates criteria might include: Degree of complexity of a financial instrument when considered in the context of the type of client it is aimed at Impact in the market, for example in terms of size and value of the instruments concerned A product, activity or practice which is particularly innovative Is there a significant element of leverage? 30

31 Remuneration and sales process Inducements: continuing discussion and debate in the EU legislative process, but possible themes include: Restrictions on incentive schemes, internal rewards and sales targets for those in both the retail and professional markets Rumour has it that the Parliament would like an extension to capture remuneration for appointed reps and other investment firms Link to firms knowledge and understanding of their products and how they match the needs of their clients Do products meet the needs of the identified target markets? Possible obligation on firms to ensure that distribution is properly targeted (?) Does firm responsibility for the design of products extend to responsibility for how they are sold by third party distributors? 31

32 Inducements Independent investment advisers prohibited from accepting payments or benefits from third parties: Limited non-monetary benefits permitted e.g. training Services related to research: query exact meaning? But even permitted benefits cannot cut across obligation to act in the best interest of the client Sufficient flexibility for RDR to survive, grey documents are said to provides that Member States may in exceptional cases impose additional requirements on investment firms will have to be objectively justified and proportionate Some market discussion indicates that the key obligations may be qualified, possible new compromise proposals More prescriptive transparency requirements are likely Independent or restricted advice Competence and capability requirements 32

33 Inducements portfolio managers Inducements regime amended to ban receipt of third party inducements: Possible continuance of minor non-monetary benefits capable of enhancing the quality of the service provided to the client But, guiding theme is clients best interest rule Flexibility for super-equivalence but how will current UK approach to investment management arrangements be impacted? Variable relationship between EU policy development and UK dynamics EU process is almost complete at framework level but there are level 2 powers enabling ESMA to develop policy details 33

34 Wholesale COBs debate No significant changes to client classification Obligation to act honestly, fairly and professionally and fair, clear and not misleading: Extended from retail and professional clients to ECPs Impact on communications made to ECPs barely distinguishable from professional clients May impact on cost and complexity of dealing with ECPs Local authorities and municipalities to be treated as retail clients unless opt-up procedure followed to treat them as elective professional clients: Possible additional costs for certain municipalities receiving investment services largely compensated by safer services provided to the entire category Compliance cost for firms compensated by benefits for client because of increased attention to the quality of services provided to them 34

35 Third country requirements 35

36 Access of third country firms to EU Eligible counterparty business (and professionals?) No branch needed Registration with ESMA, firm will need to provide ESMA with information deemed necessary for it registration (second level Commission power to adopt technical standards developed by ESMA) Equivalence analysis, legislative requirements including prudential obligations (conduct?) Firm subject to effective supervision and enforcement in its home state ESMA register of firms Non-registered firms can provide services where solicited Legal disputes to be settled under Member State law? 36

37 Third country firms - branches Third country firms can establish branches in Member States, (must if dealing with retail clients) such firms subject to authorisation process Various restrictions, e.g. firm must be authorised in its home state, cooperation agreement with Member State, OECD Model Tax Convention agreement etc Third country equivalence issue still under discussion? Member State must apply a full authorisation procedure to the branch MiFID II sets out certain detailed requirements relating to process Secondary legislative powers for Commission to adopt ESMA technical standards Third country branch cross-border activity is currently subject to Trialogue discussions 37

38 Pegasus: MiFID 38

39