Cayman Islands: MiFID II And The Cayman Islands

Last Updated: 13 June 2018
Article by Lucy Frew (Walkers)

Most Read Contributor in Cayman Islands, July 2018

The second EU Markets in Financial Instruments Directive and the EU Markets in Financial Instruments Regulation (together "MiFID II") are in force from 3 January 2018. There has been much comment on the extra-territorial reach of MiFID II generally. However, this piece is written from the perspective of the Cayman Islands.

WHAT IS MIFID II?

The scope of MiFID II is rivalled only by the US Dodd-Frank Wall Street Reform and Consumer Protection Act. Together with its EU secondary measures, MiFID II is very many thousands of pages long. While the EU Alternative Investment Fund Managers Directive ("AIFMD") provides the legislative framework for alternative investment fund management, MiFID II covers virtually all other investment services and activities. MiFID II also encompasses market structural reforms and trading obligations, enhanced transparency requirements both pre- and post-trade and numerous investor protection-type requirements which extend to product design and governance to conflicts of interest and inducements.

SHOULD A CAYMAN ISLANDS ENTITY CARE ABOUT MIFID II?

The Cayman Islands is not part of the EU and has not implemented MiFID II. Nevertheless, MiFID II has extra-territorial reach beyond the EU and does impact some non-EU entities, largely dependent on business model and extent of nexus with the EU. Taking the example of a typical fund structure, the impact is likely to be more at the level of the US manager than the Cayman Islands fund. However, Cayman Islands entities, or more likely their managers or parents, may be reviewing their EU connections to, perhaps, avoid some of implications of MiFID II.

DIRECT EXTRA-TERRITORIAL IMPACT?

In contrast to, for example, the EU Market Abuse Directive or UK Bribery Act, MiFID II is not explicitly intended to have direct extra-territorial reach to non-EU entities. Nevertheless, certain MiFID II requirements do so. In particular, any EU or non-EU person, including for example a Cayman Islands fund, that transacts in commodity derivatives traded on an EU trading venue or economically-equivalent OTC contracts must comply with new MiFID II position limits restricting the size of positions held, potentially at aggregate group level, and position reporting regimes. Another example, albeit unlikely to affect typical Cayman Islands entities, is that even non-EU branches of EU MiFID investment firms must submit transaction reports to the latter's EU regulator.

CONTRACTUAL EXTRA-TERRITORIAL IMPACT

There are areas where MiFID II compliance is exported contractually to a non-EU entity by an EU MiFID investment firm in order that the latter can comply with its own MiFID II obligations. Cayman Islands entities may be required to amend various agreements and offering documents. This means gaining a sufficient understanding of MiFID II to understand what amendments are genuinely required and whether there may be scope to push back.

For example, EU MiFID investment firms, which include distributors, are now required to ensure that financial "products", such as Cayman Islands funds, are directed at the appropriate target market and suit the needs of clients. Thus a distributor which wishes to sell a Cayman Islands fund, not "manufactured" under the MiFID II product governance regime because the "manufacturer", for example a US manager, is outside the EU, will likely seek to amend its distribution agreements to enable the EU distributor to fulfil its obligations under MiFID II and also require MiFID II compliant "product" information in respect of a Cayman Islands fund.

EU MiFID investment firms, which include broker-dealers, are obliged to comply with MiFID II requirements such as best execution, inducements and the "unbundling" of research in relation to all clients globally, not just those in the EU. MiFID II will make changes to the current method of bundling research in with transaction costs, which is regarded as constituting a material inducement to trade.

The prospect of EU MiFID investment firms being obliged to make direct separately accounted for payments for research in hard dollars presented potential issues for US research providers because payment in hard dollars could cause the US research provider to be deemed an investment adviser. However, recent announcements by the European Commission and the US Securities and Exchange Commission have gone some way to respond to concerns, which are in any case unlikely to be faced at the level of Cayman Islands entities.

With regard to transaction reporting under MiFID II, EU MiFID investment firms are required to obtain a global Legal Entity Identifier ("LEI") from each of their clients, wherever located, before providing services which would trigger reporting obligations in respect of transactions carried out on behalf of those clients. Failure to obtain an LEI in respect of, say, a Cayman Islands fund, prevents the EU MiFID investment firm from being able to comply with its own transaction reporting obligations in respect of that Cayman Islands fund. The process to obtain an LEI (by either the EU MiFID investment firm or its client) is straightforward.

ACCESS TO TRADING

MiFID II extends the scope of trading activities potentially requiring authorisation as an EU MiFID investment firm, which is only possible for an entity with a head or regulated office in the EU. In particular, this could impact an entity which uses a high frequency algorithm trading technique or which is provided with direct electronic access to an EU trading venue. In practice these rules restrict access by non-EU entities, so may be regarded more accurately as barriers than extra-territorial. A new mandatory trade execution obligation means that when entering into OTC derivatives contracts with certain EU counterparties, non-EU entities may be required to execute these trades on an EU trading venue. There are certain circumstances in which even two non-EU counterparties may be required to execute OTC derivatives transactions on an EU trading venue.

However, affected non-EU entities may consider restructuring their trading activities to avoid any need for authorisation or execution on EU trading venues.

ACCESS TO CLIENTS

MiFID II introduces a new regime which goes some way in harmonising access by non-EU entities to EU clients for the first time, by either establishing a physical branch in the EU or by providing cross-border services. In due course this will be very useful for Cayman Islands entities which wish to provide investment services, such as advice, arranging, dealing or management of individual portfolios, to EU clients. As regards branches, an EU member state may opt to require a non-EU entity to establish a branch in its jurisdiction if the entity wishes to provide investment services to retail and elective professional (in other words, less sophisticated) clients in that state.

If the EU member state applies this requirement, the branch must be authorised by that member state and will be subject to similar requirements as if it were an EU investment firm. The branch will then be eligible for a passport to provide its services to per se professional clients and regulated financial institutions (or "eligible counterparties") in other EU jurisdictions, something not currently possible under the current MiFID passport regime.

If the EU member state does not exercise its option to impose these MiFID II requirements, the member state's national law will apply.

A non-EU entity may also provide cross-border services to professional clients and eligible counterparties clients in the EU without the need to establish a branch and without being subject to supervision of an EU regulator, provided that it registers with the European Securities and Markets Authority.

However, firms will not be eligible for registration unless the European Commission has determined that the relevant third country has rules that are equivalent to key EU regulations and has an effective equivalent system for recognition of investment firms authorised under third-country laws.

In practice, the process to open this route would likely require the Cayman Islands to enact "opt-in" MiFID II equivalent provisions similar to its approach to AIFMD.

The determination of whether any non-EU member state is deemed "equivalent" for MiFID II purposes is likely to be similarly political. Finally, MiFID II also allows reverse solicitation by a non-EU entity without authorisation but defines this narrowly as being at the "exclusive initiative" of the client.

ABOUT THE AUTHOR

Lucy Frew is a Partner based in Walkers' Cayman Islands office and heads the Regulatory & Risk Advisory Group. She joined in 2016 and brings more than 16 years' experience as a specialist financial regulatory and risk management advisory lawyer. Prior to joining Walkers, Lucy headed the financial regulatory practice at her former firm in London.

As well as having advised financial institutions in private practice in international law firms in London since 2001, she also brings in-house experience as legal counsel at UBS and was also seconded for ten months to the UK Financial Conduct Authority.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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