IBM Business Consulting Services Financial markets Launch, assess, wait. A practical guide to preparing for MiFID
Launch, Assess, Wait: The MiFID project stages Category MiFID Action Level of staff Level of organisation Regulation or project area resources at which project is Directive required co-ordinated Launch Transaction reporting Proceed to gap analysis High Business unit Regulation Safeguarding client assets Proceed to gap analysis High Business unit Directive Assess Pre- and post-trade Support key business and Medium Group Regulation reporting Client classifi cation Support key business and Medium Group Directive Client agreements Support key business and Medium Group Directive Best execution Support key business and Medium Group Directive Order handling Support key business and Medium Group Directive Suitability and Support key business and Medium Group Directive appropriateness Confl icts of Support key business and Medium Group Directive interest Record-keeping Support key business and Medium Group Directive Wait Best execution OTC Support lobbying activities Low Group Directive Notes High: Requires suffi cient full-time staff resources to complete detailed gap analysis and subsequent project planning. Medium: Requires full-time staff resources to support key business and compliance policy decision-making. Low: Requires full- or part-time staff resources to support lobbying to infl uence the outcome of still-undecided MiFID measures. 2
Executive Summary Fundamental, far-reaching and disruptive three words that sum up the Markets in Financial Services Directive (MiFID). When it comes into force in November 2007, it will impose a comprehensive regulatory regime on investment services firms and markets throughout the European Union. It is causing increasing concern in the investment community. Firms are now realising the potential impact of the directive and time is running out. Planning for MiFID is complex. Key compliance and business decisions need to be made that will significantly affect the nature of MiFID projects, there is uncertainty about the directive s requirements and there are interdependencies between projects that require correct sequencing if timelines are to be achieved. This document is a practical guide for project managers in investment firms who have the daunting task of planning for MiFID. It is based on the idea that some of the level 2 draft implementing measures published in February 2006 can be grouped into three categories. They are: Launch: Areas where detailed gap analysis can commence. Assess: Areas where key compliance and business policy decisions are required before detailed gap analysis can commence. Wait: Areas where there is insufficient detail in the implementing measures and projects should not be launched until further guidance is provided. This approach should help project managers understand what resources will be needed and the level within an organisation at which the projects should be co-ordinated. Take resources: at Launch, high staff levels may be necessary to conduct detailed gap analysis; at Assess, fewer staff will be required; and at Wait, senior executives will need to liaise with regulators, trade associations and lobbyists to influence the regulatory process. As for the organisational level: at Launch, projects are likely to be run from the business units; at Assess, projects will include other business units and compliance departments; and at Wait, the number of business units involved may be limited, but there will be significant input from compliance departments. Another important factor to bear in mind is that the level 2 measures have been presented in two forms: as an Implementing Regulation and as an Implementing Directive (see table on inside front cover). Measures in the Implementing Regulation, once they have been finalised during the current consultation, are unlikely to change when transposed into national regulatory frameworks. On the other hand, measures in the Implementing Directive are principles-based and could be changed by each country when they are transposed into national regulation. Projects based on the Implementing Directive will therefore be more complicated, and will require robust change-management controls.
MiFID is not simply a question of compliance. For some fi rms it creates a number of commercial opportunities too, and these need to be incorporated into well-thought out strategies that involve every relevant part of the organisation. Such business opportunities will include outsourcing services from investment fi rms that will struggle to comply with MiFID, building trading platforms capable of competing with existing regulated markets and multilateral trading facilities, and using a common regulatory framework in a more transparent market as a basis to gain greater market share. This paper therefore outlines the key requirements for each project category and the decisions that need to be taken to comply with the directive. It then examines some of the key business opportunities and suggests ways in which IBM may be able to help. What is MiFID? MiFID comes into effect in November 2007 and will replace the Investment Services Directive, which was adopted in 1993. It is a central element of the European Commission s Financial Services Action Plan and sets out a comprehensive regulatory regime covering investment services and financial markets. It contains measures that will change the organisation and functioning of investment firms, facilitate cross-border trading and encourage the integration of EU capital markets. At the same time, it will also improve investor protection, especially as it includes a comprehensive set of rules governing the relationships firms have with their clients. Source: Frequently Asked Questions on MiFID: Draft Implementing Level 2 Measures, European Commission, 6.2.06 4
Chapter 1. Launch Implementation projects for Transaction Reporting and Safeguarding of Client Assets should be able to proceed to gap analysis because the measures have been published in sufficient detail and because they are not dependent upon key compliance and business policy decisions. Transaction Reporting Currently, traders in debt and equity securities have to report their transactions to the competent (ie relevant ) national regulatory authority of the regulated market where the transactions take place. MiFID will require transactions in all instruments admitted to trading on a regulated market to be reported to the competent authority in the host country of the trading firm, not to the competent authority in the country of the exchange on which the instrument is traded. As a point of clarification, transaction reporting is about reporting to regulators; it is therefore not to be confused with the requirement to publish share trade information to the market under the post-trade transparency rules. The transaction reporting requirements are extensive. All transactions must be reported to the competent authority no later than close of business the following day. As reporting will be extended under MiFID to include all instruments traded on regulated markets, it will apply to commodities firms trading commodities on commodities exchanges. But, the buy-side may not be affected at all. The UK Financial Services Authority, for example, has stated that investment managers on the buy-side will not be subject to these reporting requirements where they can confirm that the sell-side will deal with them. Safeguarding of Client Assets Firms will be obliged to make adequate arrangements for the safekeeping of clients funds and financial instruments. The rules state that clients assets should be segregated from the firm s; adequate records must be kept; the expertise and market reputation of external firms with which clients assets are deposited must be periodically reviewed (except for money deposited with central banks); and, in certain circumstances, the depositing of clients financial instruments with external firms in jurisdictions not having similar regulation will not be allowed. In addition, a list of suitable categories of institution is outlined for the depositing of clients money, together with certain conditions relating to qualifying money market funds. Finally, the firm s external auditors must report to the competent authority at least annually on the adequacy of the safeguarding of clients assets arrangements.
Chapter 2. Assess Projects in the Assess category require key compliance policy and business decisions to be made before they can proceed to detailed gap analysis. Business decisions are required because MiFID allows firms to make choices in their approach to compliance. The projects to be assessed can be further split into two sub-categories: those where compliance with MiFID could be a competitive advantage, and those where there are other possible business opportunities (see table). Compliance as a competitive advantage and other business opportunities are covered in Chapter 4. Sub-category Compliance could be a competitive advantage Possible business opportunities 1. Client classification Project Client classification Client agreements Best execution Order handling Suitability and appropriateness Record-keeping Pre-trade reporting Post-trade reporting The way in which clients are classified under MiFID is different from current classification regimes and the regulations apply differently to each client class. Clients are grouped into three categories, each with a different level of sophistication: eligible counterparties being the most sophisticated, followed by professional investors and then retail investors. Clients must be told which category they have been put into and be made aware of how much protection they have. In some business areas, firms will have to decide how they classify clients. they will need to make are: Whether to classify clients accurately and provide a differentiated service. Not to classify them accurately and provide a service appropriate for the least sophisticated investors, which will carry with it the greatest level of investor protection. Whether to classify them as eligible counterparties and provide a service appropriate for the most sophisticated investors, which will carry with it the lowest level of investor protection. Professional clients will need to request eligible counterparty status or they will not be able to continue as clients. 2. Client agreements Client agreements will need to be updated to ensure they comply with MiFID and a record kept of all documents. This may be a purely mechanical exercise, simply informing clients of a change to best execution policy, or it may include communicating with them to obtain their agreement to the changes in how they are being treated. The main decisions for investment firms to make are: How to communicate with clients. Should clients be told how they will be treated under MiFID, or should a dialogue be entered into to obtain their agreement? Whether to treat all clients the same when communicating with them, or to differentiate by value or importance. Whether to communicate with large clients at group level in addition to communicating with them at the various departmental levels. 6
3. Best execution Firms will be obliged under MiFID to secure best execution when trading financial instruments for clients. This means that when firms execute orders they must take all reasonable steps to deliver the best possible result, taking into account factors such as the price of the instrument, speed of execution and the trading costs. This requirement will entail regularly reviewing the best available execution venues (exchanges, multilateral trading facilities, etc), routing orders to the best venue on a trade-by-trade basis, demonstrating to clients that orders have been executed according to the firm s policy and monitoring the effectiveness of the execution arrangements. However, certain business lines dealing solely with eligible counterparties (the most sophisticated category of client) may be able to exempt themselves entirely from the best execution rules. Firms will have to make the following decisions: What data to retain to prove their best execution policy. Whether to change their best execution policies for eligible counterparties, who are the most sophisticated clients. Whether they are able to provide best execution for retail clients if they are executing at arm s length through an in-house desk, or are outsourcing execution to another firm. 4. Order handling Under MiFID, investment firms must execute client orders promptly and fairly. Firms must set up procedures to ensure that orders received through the same channels are treated in the sequence they arrive, but absolute sequential treatment will not be required across all channels; they must publish client limit orders that are not immediately executed; and they will not be allowed to benefit from the information they obtain from their clients order flows by trading ahead of them. The rules on order handling allow for no flexibility within each client class. This area is significantly affected by decisions made during client classification and by decisions made on the level of investor protection to be provided to clients. 5. Suitability and appropriateness Firms must obtain certain information from clients to ensure the services and products they offer to those clients are suitable and appropriate. The rules apply to retail and, to a lesser extent, professional clients; eligible counterparties are exempt. Broadly speaking, the rules are more onerous the less sophisticated the client, the greater the advisory nature of the service and the more complex the financial instrument This area is significantly affected by decisions made during client classification and by decisions made on the level of investor protection to be provided to clients. 7
Chapter 2. Assess 6. Record-keeping Records must be kept in a durable medium for fi ve years. It must be possible for each key stage of the transaction processing to be reconstituted, any amendments made to transactions must be recorded and it must not be possible to alter the records. Most fi rms will have to invest in new technologies to meet these requirements. to make are: Whether to retain all records in-house or use a third party to store and manage data (or a hybrid of both). Whether to retain only suffi ent data to meet the regulator s requirements or the full context of each trade for defence against claims of not providing best execution. 7. Pre-trade transparency for shares MiFID introduces comprehensive rules on the information that must be published before shares are traded on regulated markets (RMs), on multilateral frading facilities (MTFs) or by systematic internalisers (SIs). This requirement will be particularly burdensome for SIs defi ned as fi rms dealing in shares on their own account outside an RM or MTF on an organised, frequent and systematic basis as they will be required to make fi rm quotes in liquid shares and to publish those quotes to the market. If a fi rm is a SI in a particular share, then it must make a fi rm quote to the market. it must take are therefore: Whether to increase or decrease the number of stocks for which it is a SI. Which method it uses to publish such quotes. Its decisions will be infl uenced by the extent to which it wishes to exploit a business opportunity (see Chapter 4), or wishes to withdraw from a business area. 8. Post-trade transparency for shares RMs currently have to follow strict post-trade transparency rules for share trading. MiFID will extend those rules to MTFs and investment fi rms trading outside RMs and MTFs. Under these rules, the venue, time, volume and price of share trades must be published to the market as close to real-time as possible, and in any event not longer than three minutes from the time of the trade. Investment fi rms executing transactions in shares admitted to trading on a RM, outside of that RM, either acting on their own account (as SIs) or on behalf of their clients, will have to publish these details. In the case of SIs, they will not have to identify themselves as the execution venues so long as they provide three-monthly summaries to the market. The decision There is only one key decision to make: What method of publication to use for this posttrade information. 8
Chapter 3. Wait There are some measures in the Implementing Directive where there is great uncertainty about what exactly is required. In such cases, investment firms ought therefore to Wait before taking any action. To launch, or even attempt to assess, projects in these areas at this time would probably be a waste of effort and money. The only realistic option is to wait until the national regulators start interpreting the measures in readiness to transpose them into national laws, rules and guidance. The most significant measure in this respect is over-the-counter (OTC) best execution. Best execution in OTC markets The requirement to provide best execution when trading financial instruments for clients will be much harder to comply with in the OTC markets than in RMs or MTFs. One of the reasons is that OTC markets are less transparent than other markets. When a firm has to take all reasonable steps to obtain the best possible result for the client, as the Directive states, that process is made harder for OTC deals because there is little preand post-trade transparency with which to benchmark the price of a trade. Another reason why OTC best execution will be a difficult requirement to meet is that there is an inherent conflict of interest between the firm and the client. The firm trading on its own account will have a duty to shareholders and other stakeholders to quote a price that maximises its profits; but it will also have a duty under the best execution rules to quote a price that is most favourable to the client. How will the right balance be struck? Although MiFID recognises that there will be difficulties in providing best execution in OTC markets, it does not exempt those markets. The issue has not been fully thought through by the European Commission. It is only likely to be resolved once national regulators start to interpret the directive and issue detailed discussion papers on how they propose to transpose it into national rules and enter into a dialogue with investment firms and trade associations. Even if these discussion papers do not provide definitive answers to the questions raised, they are likely to be more enlightening than the directive.
Chapter 4. More than compliance: the commercial opportunities Although MiFID is primarily a regulatory compliance issue, there is much more to it than that. There are commercial benefits to be gained for the more ambitious and lateral-thinking investment firms that are quick off the mark to seize the opportunities. The European Commission claims the directive will change and improve the organisation and functioning of investment firms, facilitate cross-border trading and thereby encourage the integration of EU capital markets ( Frequently Asked Questions on MiFID, February 2006). But where will those opportunities be found and what strategies should a firm follow to exploit them? Providing outsourcing services Larger investment firms, particularly investment banks, may find that MiFID creates a market for providing smaller investment firms with outsourcing services. These smaller firms may struggle to meet the Directive s requirements and find that it is less troublesome and less costly to outsource some of what they do to a larger partner. A small firm may have a healthy retail client list and top-rate sales staff, but as there are no exemptions under MiFID for dealing with retail clients, they will be hit by the full force of rules like best execution, order handling, and suitability and appropriateness. Larger firms should be on the look-out for such opportunities. Competing with stock exchanges MiFID will allow investment firms to compete more widely and effectively against stock exchanges for two reasons. First, it will abolish the concentration rules that exist in certain countries that require all products to go through an exchange so investment firms in countries that currently do not have OTC markets will be able to start OTC trading. Second, the creation of the concept of systematic internalisation, along with the requirement for pre- and post-trade transparency, could make it attractive for a group of banks to create their own MTF and drop all their quotes and transaction details into that entity. This could create an extremely good pool of liquidity, separate from any exchange that exists at the moment, on a pan-european basis; and it could allow the banks to keep control of their data, instead of handing it over to an exchange, another MTF or a third-party. Pan-European growth opportunity for large firms Because MiFID will create a common regulatory framework and increase market transparency across Europe, it will create a more beneficial backdrop for large investment firms to expand their share of European business. Although the Directive may be expensive and complex to implement, and reduce margins in some areas, it is widely expected that trading volumes will increase, all of which will favour the larger players over the smaller ones. For example, systematic internalisation could create a new leading index in 500 liquid shares and encourage some firms to expand their market-making activity. Compliance as a competitive advantage Finally, effective regulatory compliance should be seen as a commercial benefit in itself. Firms with the best compliance regimes will be less likely to fall foul of the regulators and therefore less likely to suffer reputational damage and commercial loss. Some firms may even consider there is a specific advantage in super-equivalence going further than the rules require by, for example, providing best execution to clients who would not normally require it. 10
Chapter 5. How IBM can help IBM can help firms prepare for MiFID in a number of ways through early-stage project management, conducting an impact analysis, providing a diagnostic tool, facilitating the understanding of how a MiFID project interacts with other projects, and advising on and implementing IT solutions. Project management With our pan-european presence in 28 countries, our financial markets resources and expertise in programme management, we can advise on project set-up and assist with project management. The firm s project team that has been, or is about to be, put in place to handle the MiFID project should be the right one it should include not only people from compliance, legal, operations and IT, but also from the business lines. Impact analysis IBM can carry out an impact analysis to look at how MiFID will affect particular business divisions, operational functions and IT systems, and identify any gaps in compliance. An impact analysis is an essential component of any MiFID project. Diagnostic tool IBM can provide a diagnostic tool, which goes through every article of MiFID, highlights everything that needs to be known and asks hundreds of questions about the firm. The results will demonstrate the most likely areas of impact on IT, policy or processes. They will reveal project synergies and help avoid unnecessary costs. Using such a tool can be the first step in determining an overall project plan for MiFID. Interaction with other projects We can assist clients in their understanding of the interaction between MiFID and other ongoing projects, such as Know Your Client (KYC). To implement MiFID, a firm needs to understand how its clients are classified, but there are very few that have KYC systems in place to allow them do this. Systems solutions And then there s technology and its many uses. We are developing specific capabilities and solutions that will support clients in various areas of MiFID implementation such as best execution, compliance monitoring, data storage and retrieval, and trading systems enhancements working with both internal software and external data vendors. We can also assist with service-oriented architecture and enterprise content management. Contact us If you would like to know more about MiFID, and how we can help your implementation projects, please contact: Paul Barry, IBM Corporation +44 (0)20 7202 5603 paubarry@uk.ibm.com 11
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