The financial crisis of 2007–2008, which is considered by many economists to have been the worst since the Great Depression of the 1930s, has exposed weaknesses in the transparency of the financial markets. In order to restore investor confidence, strengthen transparency, and improve the functioning of the internal market for financial instruments, the European Union ("EU") has started to draft a new regulatory framework for financial markets following the financial crisis. After seven years in the making, the Markets in Financial Instruments Directive II 2014/65/EU, and Markets in Financial Instruments Regulation 600/2014 (hereinafter together referred to as the "MiFID II") entered into force on January 3, 2018.
As outlined, above, the new legislation includes both a directive and a regulation. While the regulation has a direct effect within the EU, the directive is to be applied by the member states in national law where there may be national discretion. This article aims to focus on the key aspects of the MiFID II and its eventual impact on third country firms i.e. on Turkey.
Scope of Application
MiFID II affects stock, bond, commodity and derivative markets, and everyone who works, trades or invests in those markets, i.e. banks, exchanges, trading venues, hedge funds, brokers, pension funds, retail investors, and fund managers across the EU. Moreover, some aspects of the MiFID II are extra-territorial.
For instance, the equivalence rule allows third country investment firms to operate in member states on similar terms like an EU investment firm. The following criteria should be met for the equivalence rule to apply: (i) third country investment firms must be authorized and be subject to effective supervision in their home country in respect of the provision of the relevant service; (ii) cooperation arrangements must have been entered into between the European Securities and the Markets Authority ("ESMA") and the third country supervisory authority which, in particular, relate to coordination of supervisory activities and exchange of information; and (iii) the European Commission must have adopted an 'equivalence decision' upon the ESMA recommendation stating that the legal and supervisory arrangements of the third country ensure that its investment firms comply with legally binding prudential and business conduct requirements of equivalent effect to MiFID II. Member states may, however, require a branch to be established in their respective jurisdictions where firms are dealing with retail customers.
In addition, these firms may be indirectly impacted in their dealings with business partners that are obliged to comply with the MiFID II.
Independent Investment Advice and Ban of Inducements
MiFID II draws distinction between the provision of investment advice on an independent basis, and the provision of investment advice on a non-independent basis. Where an investment firm informs the client that investment advice is provided on an independent basis, that investment firm shall assess a sufficient range of financial instruments available on the market that must be sufficiently diverse with regard to their type and issuers or product providers to ensure that the client's investment objectives can be suitably met, and must not be limited to financial instruments issued or provided by: (i) the investment firm, itself, or by entities having close links with the investment firm; or (ii) other entities with which the investment firm has close legal or economic relationships, such as contractual relationships, so as to pose the a risk of impairing the independent basis of the advice provided, and not to accept and retain fees, commissions, or any monetary or non-monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the provision of the service to clients. Minor non-monetary benefits that are capable of enhancing the quality of service provided to a client, and are of a scale and nature such that they could not be judged to impair compliance with the investment firm's duty to act in the best interest of the client must be clearly disclosed and are excluded from that point onward.
According to this rule, research provided by any third party to an investment firm within the EU shall be regarded as an inducement and subject to the above-mentioned ban, unless the research is either directly paid from the EU investment firm's own funds, or paid from a separate research payment account funded by a research charge to individual clients. In this context, firms should not accept research for free.
Consequently, the business partners within the EU may roll out new policies regarding the provision or receipt of research and other services due to the unbundling rule that the MiFID II brings.
Best Execution Requirements
MiFID II imposes best execution requirements on the markets wherein the transactions are executed at and on the firms that execute orders on behalf of their investors. When executing orders, investment firms should take all sufficient steps to obtain the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature, or any other consideration relevant to the execution of the order. The firms must publicly disclose best execution data related to their pricing structures and disclose prescribed information on commissions, execution costs, and research-related expenses to their clients. Even third country firms are not directly subject to the best execution requirement, and non-compliance with this requirement provides a competitive disadvantage. Revised policies complying with the best execution rule should also be expected from the business partners within the EU.
Strict Disclosure Requirements
In order to give all relevant information to investors, investment firms providing investment advice should disclose the cost of the advice, they must clarify the basis and reasons of the advice they provide, in particular, the range of products they consider in providing personal recommendations to clients, and whether they provide investment advice on an independent basis, and whether they provide the clients with a periodic assessment of the suitability of the financial instruments recommended to them. The disclosure requirement is to be fulfilled at least once in a year, not just at the investment point.
Organized Trading Facilities ("OTF")
MiFID II has introduced a new trading venue category of organized trading facility ("OTF") for bonds, structured finance products, emissions allowances and derivatives to ensure that the off-exchange markets are appropriately regulated. The OTF is broadly defined and complements existing types of trading venues.
Restrictive Regime for Algorithmic Trading and Direct Electronic Access ("DEA")
MiFID II aims to regulate risks arising from algorithmic trading where a computer algorithm automatically determines aspects of an order with minimal or no human intervention. Third country firms engaging in algorithmic trading are subject to different regulations in each member state, and in some cases, they are required to be locally licensed to access an exchange in some member states. The competent authority of the member state may also require the investment firm to provide, on a regular or ad-hoc basis, a description of the nature of its algorithmic trading strategies, details of the trading parameters, or limits to which the system is subject, the key compliance and risk controls that it has in place, and details of the testing of its systems.
On the other hand, DEA means an arrangement where a member or participant or client of a trading venue permits a person to use its trading code so the person can electronically transmit orders relating to a financial instrument directly to the trading venue, and includes arrangements that involve the use by a person of the infrastructure of the member or participant or client, or any connecting system provided by the member or participant or client, to transmit the orders (direct market access) and arrangements where such an infrastructure is not used by a person (sponsored access).
Following an applicable equivalence decision, third-country firms can offer DEA services to access trading venues within the EU by complying with the laws of the respective member state. But MiFID II mandates the investment firm providing DEA to monitor the client closely, ban the provision of DEA to markets for their clients where such access is not subject to proper systems and controls. Irrespective of the form of the DEA provided, firms providing such access should assess and review the suitability of clients using that service and ensure that risk controls are imposed on the use of the service, and that those firms retain responsibility for trading submitted by their clients through the use of their systems, or using their trading codes.
Order Record Keeping and Transaction Reporting Requirement
MiFID II broadens the scope of transaction reporting and covers all financial instruments, such as depositary receipts, exchange traded funds, certificates, bonds, structured finance products, emission allowances, derivatives and package orders. Moreover, financial instruments traded on OTFs are also covered. Plus, transactions do not need to have been executed on an EU trading venue for the reporting requirement to exist. Financial instruments where the underlying is a financial instrument that is traded on an EU trading venue shall have to be reported, as well.
Investment firms should also keep records of all their orders and all their transactions in financial instruments, and operators of platforms are required to keep records of all orders submitted to their systems. The ESMA should coordinate the exchange of information among the competent authorities to ensure that they have access to all records of transactions and orders, including those entered on platforms that operate outside their territory, in financial instruments under their supervision. The records shall be provided to the client involved upon request and shall be kept for a period of five years and, where requested by the competent authority, for a period of up to seven years.
Legal Entity Identifiers ("LEI")
The LEI is a twenty character alpha-numeric code used as an international standard for reporting and identifying underlying counterparties to transactions. All entities subject to the MiFID II need LEI data on all their business partners to make required transaction reports to their regulators. Therefore, the investment firms and listed corporations in Turkey should obtain this number. Applications for an LEI may be made to an accredited issuer in the home country or an LEI issuer that offers cross-border services. In Turkey, this service is provided by Takasbank1.
Since a large number of corporate investors that invest in Turkey are established in the EU, there may be changes in commercial behavior. Therefore, even the investment firms and listed corporations in Turkey are not directly subject to MiFID II, and those adapting to this new framework shall provide a competitive advantage.
Regarding the extra-territorial application and third country assessment of the MiFID, Turkey still needs to meet the equivalence rule. In this manner, Capital Market Law No. 6362, prepared in accordance with the MiFID I and ESMA announcement on the equivalency of Turkish share prospectuses2, may be taken into consideration.
1 https://www.gleif.org/tr/about-lei/get-an-lei-find-lei-issuing-organizations (Access date: 30.03.2018).
2 https://www.esma.europa.eu/press-news/esma-news/esma-assesses-turkish-laws-and-regulations-prospectuses (Access date: 30.03.2018).
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.