Worldwide: MiFID II – State Of Play

On Jan. 3, 2018, the long-anticipated overhaul of European Union (EU) financial markets legislation will come into effect. The second Markets in Financial Instruments Directive (MiFID II) will broaden the scope of EU regulatory coverage and have significant impacts on the trading environment for a wide variety of counterparties. For the purposes of this article, we will focus on U.S. firms trading in the EU, either through interactions with EU-regulated entities such as direct electronic access providers or through products traded on EU trading venues.

Increased Scope

One of the more significant aspects of MiFID II is its extended scope. In particular, certain additional products will now fall within its scope and therefore attract additional regulatory treatment, including, but not limited to, reporting, transparency and requirements exported to other EU legislative regimes by virtue of being within the scope of MiFID II.

One primary example is spot FX and FX forwards. It should be noted for FX forwards that this is a significant deviation from the U.S. regulatory regime, given that these products will be covered by MiFID II and that they will therefore fall within the EU margin regime. In contrast, in the U.S., FX forwards are specifically excluded from the swap margin rules, and therefore where a non-EU FC or NFC+ (as defined in the European Market Infrastructure Regulation, or EMIR) is able to decide between facing a U.S. dealer counterparty or an EU dealer counterparty, facing the EU dealer counterparty will come with the significant disadvantage of daily margin obligations.

Commodity derivatives have also been included within the scope of MiFID II, and these will be discussed later in this article.

Expansion of Retail Coverage

Under the current MiFID regime, local authorities (i.e., towns, counties etc.) are considered professional clients. Professional clients are afforded more limited protections under the MiFID regime, and as a result may be offered a wider range of financial products. In addition, MiFID-regulated firms are required to perform more limited suitability and appropriateness assessments when selling financial products to professional clients. Under MiFID II, the scope of business that may be done with a local authority will significantly change. In particular, a local authority will be treated as an unsophisticated retail investor. As a result, in order to sell any MiFID-covered financial product to a local authority, a MiFID-regulated firm must determine that the product is both suitable and appropriate for a retail investor and must ensure that the local authority has received sufficient explanation and description for the local authority to understand the product and any risks associated with it.

Another expansion of increased protections for retail investors under MiFID II is the recategorization of UCITS as "complex" products suitable only for professional investors and retail investors receiving professional advice in connection with their investment in the UCITS. As a result, the population of investors will, in principle, be significantly smaller for the purposes of marketing UCITS. That being said, typically UCITS require significant capital contributions, and therefore the contraction of the investor population should not have an enormous impact as it is likely that retail investors of this type will habitually receive professional investment advice.

Exemption of AIFMs and UCITS Managers

Despite the general expansion of coverage under MiFID II, one limitation under the new regime is the exclusion of AIFMs and UCITS managers from compliance with MiFID II. Such limitations are likely to lead many EU managers and sub-managers to become more inclined to register as AIFMs. However, the application of such limitations may be narrower than expected. Certain jurisdictions (e.g., United Kingdom) have indicated an intention to "gold plate" MiFID II, making them generally applicable, including to AIFMs and UCITS managers. Conversely, some jurisdictions have indicated that they do not intend to gold plate MiFID II (e.g., Ireland and Luxembourg). As a result, where an entity does business in a jurisdiction and is considering converting to an AIFM in order to take advantage of such exemptions, it would be wise to understand the legislative agenda of the individual member state and any intentions to gold plate MiFID II provisions.

Investment Research

MiFID II will specify that MiFID investment firms are not permitted to provide "inducements" to investment/asset managers. In practice, this is likely to impact the documentation and cost of EU research; given that research has historically been offered for free or bundled into transaction costs, the inference under MiFID II is that the research is being offered as an inducement for business.

These changes are likely to cause significant changes to how transaction costs are documented by EU investment firms. Notably, transaction costs are required to be "unbundled," with items such as research being priced separately from the transaction costs. Significantly, the dealer community in the EU has indicated that spreads are unlikely to contract in light of such changes, meaning that research can be charged only on top of current spreads, thereby increasing transaction costs. Should this indeed be the case, the consequences will be an amplification of the trajectory of increased costs and more pressure on providing value to investors. For firms with EU-based funds, the unbundling of research will come in stark contrast to the provision of research under the U.S. regulations.

The extra-territorial application of research unbundling remains somewhat subject to member state implementation. In its policy statement of July 3, 2017, the U.K. Financial Conduct Authority (FCA) has clarified that it will not require MiFID II firms dealing with non-EU counterparties to unbundle research costs for anything provided to those counterparties. While not definitively indicative of an EU-wide approach, the FCA policy on the matter appears consistent with both the legislation and the thinking of other regulators. As a result, U.S. funds transacting with dealers in the U.K. (and potentially across the rest of the EU) should not be impacted by the unbundling of research costs and should not see any changes in their existing relationships in this respect.

Transaction Reporting and Transparency

Under the current MiFID regime, transaction reporting applies only to financial instruments admitted to trading on a regulated market, plus any OTC contract that derives its value from any such instrument. MiFID II widens the scope of transactions that must be reported, to include:

  • Financial instruments admitted to trading or traded on an EU trading venue, or for which a request for admission has been made. Trading venues now include multilateral trading facilities (MTFs), organized trading facilities (OTFs) and regulated markets. OTFs are likely to include trading platforms facilitating the trading of OTC derivatives.
  • Financial instruments where the underlying instrument is traded on a trading venue. This essentially widens the scope to capture all OTC transactions in such instruments.
  • Financial instruments where the underlying asset is an index or a basket comprising instruments traded on a trading venue. This means that just one component of either an index or a basket will make that financial instrument subject to the reporting obligation.

The information that must be reported remains largely unchanged and consists mainly of transaction information (e.g., price, volume, duration). However, MiFID II increases transparency with respect to transaction counterparties. For example, under the current MiFID regime, reporting the investment manager as the counterparty is acceptable. However, under MiFID II, the direct counterparty legal entity identifier will have to be reported, along with the person and/or algorithms making the investment decision and executing the transaction. For U.S. firms, the additional disclosures may cause some discomfort initially as information such as address and passport information for individuals making trading decisions will likely be gathered by trading venues in order for the trading venues to comply with their respective reporting obligations.

Transaction reporting is not directly applicable to non-EU firms. However, EU trading venues will be required to report transactions executed on such venue, and as a result, non-EU firms trading on EU trading venues will likely need to provide the same required information to such EU venues. Non-EU firms should therefore be aware of trading venue reporting requirements and be aware of the information that such venues will be reporting to EU regulators.

The MiFID II regime will seek to ensure that transactions in dark pools for fixed income and derivative products are subject to both pre- and post-trade transparency. Although there are waivers and deferrals available for certain trades (such as those in illiquid instruments and certain large orders), this is a significant increase in trade transparency. U.S. firms should therefore be aware of any implications that may arise from the reporting of positions traded in dark pools and whether this alters the investment strategy landscape.

Derivatives Trading Obligation

Where an entity classified as an FC or NFC+ under the EMIR trades derivatives subject to MiFID II with another FC or NFC+ (or entity that would be an FC or NFC+ if it were incorporated in the EU), such transactions must be carried out through an EU trading venue (i.e., regulated market, an MTF or an OTF) or through an "equivalent trading venue." Non-EU firms will therefore be subject to these requirements only to the extent the firms would be an FC or NFC+ if they were incorporated in the EU. Given that these classifications are currently determined for the purposes of EMIR, we would not expect to see a party becoming subject to the trading obligations if the party is not currently an FC or NFC+. However, in the event a counterparty changes that classification, it should be noted that the trading obligation presents additional burdens.

Presently, it appears that ESMA will seek to have MiFID II cover all derivatives currently covered by EMIR, and therefore derivatives subject to clearing are likely to also be subject to mandatory trading on an EU trading venue or equivalent. However, it is not yet clear how wide the "equivalent venue" net will be cast. In particular, questions remain as to whether the clearing of derivatives through a central counterparty clearing house (CCP) will satisfy the MiFID II trading obligations or whether a transaction simply cleared through a CCP will not be deemed to be "carried out through an equivalent trading venue". The equivalence classification of CCPs has been under consideration for some time but is subject to ongoing delays. In the event that clearing does not satisfy the trading obligation, counterparties may be forced to identify an EU trading venue on which to execute their transactions. Naturally, the position the European Commission (the "Commission") takes in this regard could have a potentially significant impact on the routing of trades and the overall execution process.

Position Limits on Commodity Derivatives

While it is currently unclear whether MiFID II would obligate non-EU firms to comply with the position limits requirements, MiFID II refers to "any person" trading a commodity derivative through an EU trading venue, and therefore even non-EU firms should be subject to position limits.

The new regime will effectively split the setting of position limits into two parts. First, the Regulatory Technical Standards (RTS) published with respect to position limits set out a methodology that is to be followed by a member state when setting position limits. Second, using that methodology, individual member states will be tasked with setting the position limits for each contract traded on a domestic trading venue. The second part of the setting of position limits will involve the member state determining the deliverable supply and/or open interest for a particular commodity derivative.

Under the RTS methodology, the default position limits are 25% of the deliverable supply (for spot months and where available) and 25% of open interest (for non-spot months or where a deliverable supply cannot be determined). However, member states are permitted to alter those thresholds to be as low as 5% or as high as 35%.

Unlike the U.S. regime that covers only physically settled derivatives, cash-settled and securitized derivatives will also be included in position limits under MiFID II. Moreover, certain economically equivalent OTC derivatives are also included in the calculation of position limits. Such inclusions are, however, narrow and require identical contractual specifications and/or terms and conditions other than size, delivery dates (i.e., less than a calendar day difference) and post-trade risk management. Somewhat unhelpfully, ESMA and some domestic regulators (including the FCA) have already indicated that they will not publish a list of economically equivalent OTC contracts.

MiFID II does provide firms with certain exclusions from the calculation of position limits. Most significantly, firms are permitted to net the long and short positions held and to report the overall net positions with respect to these calculations. Moreover, and perhaps of most interest to funds, an entity is required only to aggregate positions that comprise "group undertakings." A group undertaking for these purposes is an entity in which a parent has a 10% ownership interest through any chain of ownership (on a consolidated basis). For many funds, this will enable the investment manager to avoid aggregating positions of the funds they manage, as typically the individual funds would not be comingled.

Firm exemptions from the position limits requirements are also being tightened under MiFID II. Under the new regime, firms dealing for their own account no longer have a blanket exemption. Instead, only commodity firms (all investment firms must be authorized under MiFID II to trade commodity derivatives) that trade commodity derivatives as something that is "ancillary" to their main business are exempt. ESMA's guidance on the definition of ancillary provides that such business must comprise a minority of activities at the group level and that the level of trading compared with the overall market in a particular contract will also be considered. It is not yet clear what proportion of overall market trading would cause a firm's trading in commodity derivatives to fall outside the definition of ancillary.

Equivalence and Substituted Compliance

In order to provide investment services to EU investors, MiFID II requires the third-country regime to which the firm is subject to be deemed equivalent. In addition, in order to provide services to retail clients (note the increased scope of "retail" above), a firm may be required to establish a branch in the EU territory in which such retail investors are situated. For services to professional clients, until such time as the Commission makes a determination as to the equivalence of a third-country regime, a firm will not be able to register with ESMA, and therefore existing treatment of said regime by a member state will apply. There is not yet an indication from the Commission as to the timeline for a determination of equivalence for third-country regimes.

One key factor in the importance of the equivalence framework will be the timeline and ultimate outcome of Brexit. In particular, firms currently domiciled in the U.K. are "passported" for purposes of MiFID II into the rest of the EU. It is almost certain that the passporting of financial services will become a key aspect of negotiation between the U.K. and the EU, and therefore firms relying on U.K. MiFID II authorization should be aware of the possible implications following the U.K.'s exit from the EU. Importantly, U.K. firms may lose the ability to transact with EU investors in the event such entities do not have operations in an EU member state and the U.K. MiFID passport and equivalence are removed upon the U.K.'s exit.

With respect to substituted compliance, there is not much to say at this stage. As highlighted above, there are several areas in which MiFID II will deviate from the U.S. regulatory regime and therefore, without substituted compliance, non-EU firms will have to consider dual regulatory frameworks to the extent they conduct business in the EU. On that basis, the market is eagerly awaiting a determination by the Commission as to whether substituted compliance will be afforded to entities in compliance with, in particular, Dodd-Frank.

Originally published October 2, 2017

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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