The revised EU Markets in Financial Instruments package—known as MiFID II—takes effect on January 3, 2018. Some aspects of this legislation are extra-territorial. New rules on inducements, the unbundling of research, legal entity identifiers and the regulation of algorithmic trading are some of the areas where a non-EU investment bank or non-EU broker may find that it is impacted, directly or indirectly. Non-EU investment banks and brokers should consider how these new requirements will affect how they do business in the EU or with EU counterparties from the start of next year.
The MiFID II package comprises a revised Markets in Financial Instruments Directive II,1 the new Markets in Financial Instruments Regulation2 and supplementary secondary legislation and guidance. These will replace the existing directive and its implementing legislation ("MiFID I")3 from January 3, 2018 (the effective date for the new rules).
A non-EU investment bank or broker without any EU place of business is not generally within scope of MiFID I and usually requires no license in the EU. That position will remain the same under MiFID II, because current national regulatory perimeters are generally preserved. However, certain exemptions that non-EU investment banks and brokers have previously relied on to operate in the EU unregulated have been narrowed4 which, depending on the particular member state and business models, may trigger local licensing requirements. Further, even if a non-EU investment bank or broker is outside the scope of MiFID II, it may be indirectly impacted in its dealings with entities that are subject to the full MiFID II requirements. The way in which this indirect application occurs varies, depending on the relevant requirement, as illustrated in Figure 1.
- Figure 1: MiFID II issues on which non-EU investment banks and brokers should focus, where relevant.
A non-EU investment bank or broker will be affected by MiFID II in the context of:
- Inducements and unbundling research
MiFID II restrictions on inducements mean that entities subject to MiFID II may only provide or receive research, hospitality or corporate access5 which qualifies as "minor non-monetary benefits." Non-EU brokers should be aware that their EU counterparties may implement new policies restricting the provision or receipt of research and other services. There are also new rules restricting the provision of research by brokers to EU investment firms 6 unless these are either directly paid for by the EU investment firm from its own funds or paid from a separate research payment account funded by a research charge to individual clients.
- Direct electronic access ("DEA")7 and algorithmic trading8
Non-EU brokers will need to assess their trading activities to determine whether they need to become locally authorized and/or will be subject to systems and controls requirements. Non-EU brokers which use algorithmic strategies or which utilise DEA services to access EU trading venues may need to cease trading on or accessing some continental EU trading venues, unless they obtain a local license in the relevant member states. The UK is maintaining its "overseas persons" exclusion and so will exempt many foreign algorithmic traders and firms accessing UK trading venues using DEA from local licensing requirements. However, exemptions will not be available in many member states.
- Dealings with EU counterparties
Non-EU investment banks and brokers should expect to receive from EU counterparties revised terms of business which have been updated to take into account MiFID II requirements on conflicts of interest, suitability and appropriateness, inducements and best execution for MiFID II. In addition, non-EU investment banks and brokers providing execution services for EU clients may be asked by clients about whether the standards they apply would comply with MiFID II standards e.g., for execution policy and best execution.
- Transparency and transaction reporting
Non-EU investment banks and brokers fall outside the scope of transparency and transaction reporting requirements. However, non-EU investment banks or brokers which receive execution services from EU investment firms that are subject to MiFID II or provide execution services to regulated EU clients, such as EU fund managers, will be required to provide a valid Legal Entity Identifier ("LEI") prior to placing any order, such that the counterparty may report appropriately.
INDUCEMENTS AND UNBUNDLING RESEARCH
MiFID II restricts the payment or receipt of all fees, commission and non-monetary benefits ("inducements") unless these enhance the quality of service provided to a client, and do not impair an EU investment firm's duty to act in the best interests of its client9. However, there is an exemption for any inducement that is a minor, non-monetary benefit. EU investment firms will be obliged to disclose to each client all fees, commissions and non-monetary benefits received by them in connection with any investment service provided by them to that client. The Financial Conduct Authority has decided to extend the scope of these inducements rules to various types of EU funds managers, including UCITS managers and Alternative Investment Fund Managers ("AIFMs"), with an exemption only for private equity fund managers.
Although non-EU investment banks and brokers are out of scope of MiFID II, they should be aware that their EU clients or counterparties (including UCITS managers and AIFMs, investment banks, brokers and portfolio managers) may not be able to receive inducements unless these qualify as a "minor, non-monetary benefit."
Research10 provided by any third party (regardless of location) to an EU investment firm providing investment services or ancillary services will be regarded as an "inducement" and subject to the above prohibition, unless the research is received in return for either direct payment by the investment firm out of its own resources or payment from a separate research payment account ("RPA"). "Soft dollar" commissions are not allowed, unless these are done through an RPA. These rules may present issues where a US broker-dealer is providing research to EU investment firms or fund managers. Under US laws, the compensation of research with hard dollars generally implicates regulation of the research provider as an investment adviser. US broker-dealers tend to want to avoid being classified as an "investment adviser," in part because of the fiduciary duties and related rules that entails.
All EU investment firms that provide execution and ancillary services, including research, analyst meetings and some corporate access services, will need to identify separate costs and corresponding charges for each service provided. Charges for ancillary services must not be linked to execution volumes or payments. For EU investment firms, these rules will apply regardless of the location of the research provider. Non-EU investment banks and brokers will be indirectly impacted and may find that research costs will be unbundled and separately invoiced by their EU brokers or that their EU clients—especially EU portfolio managers—expect unbundling in this way.
ALGORITHMIC TRADING AND DIRECT ELECTRONIC ACCESS
MiFID II generally requires the regulation of firms engaging in algorithmic trading and seeks to prevent unregulated firms, including those outside the EU, from engaging in such trading on EU trading venues. However, the application of these requirements to a non-EU broker depends on the precise regulatory perimeter in different EU member states.
In the UK, a non-EU broker will be able to continue engaging in algorithmic trading on a UK exchange on a cross-border basis without regulation due to the UK's "overseas persons" exclusion which exempts foreign traders from local licensing requirements. However, if the non-EU broker has a subsidiary established in the UK, that subsidiary may only engage in such trading if it complies with the systems and controls requirements prescribed by MiIFD II (although it will not need to be authorized). The UK's approach to regulating algorithmic trading differs to how many other EU member states are implementing the requirements. Several other European member states require foreign algorithmic traders to be locally licensed as a condition to gaining any access to an exchange in that member state, although the precise model of access varies. There may be some specific exemptions, however. For example, the Netherlands operates a limited equivalence regime, allowing non-EU brokers from the US, Australia and Switzerland to access Dutch exchanges without local licensing.
Direct Electronic Access
Direct Electronic Access refers to arrangements by which non-member users of a trading venue are permitted to access the trading platform. DEA can take the form of either direct market access, where the non-member user uses the infrastructure of the member to transmit orders to the trading venue, or sponsored access, where the non-member user does not use the member's infrastructure. However, where a non-member user "cannot exercise discretion regarding the exact fraction of a second of order entry and the lifetime of the order within that timeframe", there is deemed to be no DEA. ESMA has published guidance11 on this exclusion which clarifies that the issue is whether the DEA user can exercise discretion as to the exact fraction of a second in sending an order, not the exact timing of an order reaching the matching engine.
Providers of DEA access are required to have systems and controls in place to review the suitability of clients using the service, to ensure that users are prevented from exceeding pre-set trading and credit thresholds and to monitor trading by their clients. In addition, firms must ensure that clients that are using their DEA services comply with the relevant requirements of MiFID II and with the rules of the relevant trading venue and will need to enter into binding written agreements with their DEA clients.
Entities outside of the EU may be able to use the DEA services to access EU trading venues depending on the laws of the individual member state. Again, as for algorithmic trading, the UK will allow this on an unlicensed basis for "overseas persons", subject to compliance with systems and controls requirements. Again, DEA is probably impossible for many continental markets by non-EU entities. As with algorithmic trading, national exceptions may still be available: the Netherlands appears to operate a limited equivalence regime and Germany offers a six month transitional period for firms newly subject to local licensing requirements in this area as a result of MiFID II.
Dealings with EU counterparties
Repapering of Brokerage and Other Agreements
MiFID II tightens and harmonizes certain existing conduct of business rules for investment firms, many of which are currently found at national level. Most notably there are revised frameworks for conflicts of interest, suitability and appropriateness, inducements and best execution.
Among the changes are requirements for EU investment firms to disclose more information to their clients. Non-EU investment banks and brokers which use an EU broker to execute trades subject to MiFID II will find that the EU broker will likely repaper them with new terms of business. Non-EU investment banks and brokers may need legal advice as to the proposed revised terms of their brokerage agreements or the effect of certain elections or client categorizations that may be requested.
MiFID II introduces new investor protection rules, including on reporting and disclosure obligations. Entities subject to MiFID II must publicly disclose best execution data related to their pricing structures and disclose to their clients prescribed information on commissions, execution costs and research-related expenses. Although non-EU brokers are not directly subject to these requirements, they may find themselves at a competitive disadvantage if they do not voluntarily adopt information disclosure requirements that their EU competitors will be offering. Non-EU investment banks and brokers which use EU brokers should also expect to receive revised policies complying with the new standards.
Transparency and Transaction Reporting
Transparency refers to public trade reporting. The MiFID I regime only applies to equities admitted to trading on the EU's regulated markets. MiFID II considerably extends this regime to cover equity-like instruments, such as depositary receipts, exchange traded funds and certificates and to non-equity instruments, such as bonds, structured finance products, emission allowances, derivatives traded and package orders. Furthermore, the new transparency obligations will apply to non-equity financial instruments traded on Multilateral Trading Facilities and also Organised Trading Facilities—a new regulatory category of trading venue introduced under MiFID II.
MiFID II requires details of equity and non-equity trading to be reported publicly, pre- and post-trade. Trading venues must make public on a continuous basis during normal trading hours current bid and offer prices and the depth of trading interests in those prices which are advertised through their systems for equity, equity-like and non-equity instruments. The same applies for any actionable indication of interest.
Details of actual transactions in in-scope equity instruments must be made public by EU brokers as close to real time as possible but in any event within one minute of trading. For non-equities, the same "as close to real time as possible" standard applies, but with a backstop of 15 minutes, reducing to five minutes in 2020. All public data disclosed by EU trading venues and EU investment firms pursuant to MiFID II will be anonymized.
Legal Entity Identifiers
Although non-EU investment banks and brokers are outside the scope of MiFID II regulatory reporting and public disclosure requirements, the requirement for an LEI will likely still apply.
All entities subject to MiFID II will need LEI data on all their counterparties to make required transaction reports to their regulators. The LEI is a twenty character alpha-numeric code used as an international standard for reporting and identifying underlying counterparties to transaction. Applications for an LEI may be made to an accredited issuer in their home country or an LEI issuer that offers cross-border services.
1 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (recast).
2 Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012.
3 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC.
4 For example, non-EU investment firms may not rely on the "dealing on own account" exemption if they engage in high-frequency algorithmic trading per Article 2(1)(d)(iii), MiFID II (the updated version of the exemption which was previously Article 2(1)(d), MiFID I).
5 This refers to providing corporate access concierge services e.g., organizing meetings with issuers and investor roadshows.
6 The EU operates a single regulatory regime for most investment business, therefore references to an "an EU investment firm" in this memo would include EU portfolio managers, advisers, investment banks and brokers.
7 Article 4(1)(41), MiFID II defines direct electronic access as "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 which 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)".
8 Article 4(1)(40), MiFID II defines algorithmic trading as "trading in financial instruments where a computer algorithm automatically determines individual parameters of orders, such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention."
9 Article 11, Commission Delegated Directive (EU) 2017/593.
10 This is defined as material or services which "explicitly or implicitly recommend or suggest an investment strategy and provide a substantiated opinion as to the present or future value or price of such instruments or assets" (Recital 28 of Commission Delegated Directive (EU) 2017/593) but would not include "short term market commentary on the latest economic statistics or company results for example or information on upcoming releases or events, which...contains only a brief summary of its own opinion on such information that is not substantiated nor includes any substantive analysis such as where they simply reiterate a view based on an existing recommendation or substantive research material or services" (Recital 29) which are considered to be a minor, non-monetary benefit.
11 European Securities and Markets Authority Q&A on MiFID II and MiFIR market structures topics, 12th September 2017 (p.20).
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