10 things you need to know about Mifid II draft

ByNorton Rose Fullbright

1.Where are we now?

The Markets in Financial InstrumentsDirective (recast) (MiFID II) and the Markets in Financial InstrumentsRegulation (MiFIR) were published in the Official Journal of the EU on 12 June2014 and entered into force 20 days later. Both apply from 3 January 2017.

Whilst the framework legislation has beenagreed for some time we are now entering a critical period in which the Level 2implementing measures, which add the detail to the framework legislation, needto be finalised and Member State regulators have to prepare for thetransposition of the new regime.

On 19 December 2014, the EuropeanSecurities and Markets Authority (ESMA) published two key papers which followup on its work in the summer of 2014 concerning the possible content of theLevel 2 implementing measures which will take the form of delegated acts andtechnical standards (regulatory technical standards and implementing technicalstandards). ESMA published a final report containing its technical advice tothe European Commission (the Commission) on the possible content of thedelegated acts. It also published a consultation paper seeking stakeholders’views on the draft technical standards. The deadline for comments on theconsultation paper is 2 March 2015. In addition, an open hearing on theconsultation will be held by ESMA in Paris on 19 February 2015.

It is worth noting that in the thirdsection of the consultation paper covering transparency, ESMA presents ananalysis of non-equity instruments aimed at calibrating the new transparencyrules through appropriate thresholds. However, the analysis does not coverforeign exchange derivatives, credit derivatives, other derivatives andcontracts for difference. For these asset classes ESMA will produce a separateconsultation paper with a similar analysis to that undertaken for the otherasset classes. It is expected that this consultation paper will be published inearly 2015.

2.Product governance

In its technical advice to the CommissionESMA has clarified the definition of ‘manufacturer’ and ‘distributor’, thusmaking it clearer to whom MiFID II’s product governance obligations apply to. A‘manufacturer’ will be a firm which creates, develops, issues and/or designsinvestment products and is intended to capture a broad range of firms(including corporate issuers on the launch of new securities). A ‘distributor’will be a firm that offers and/or recommends investment products and servicesto clients. In this context, ‘offers’ has a wide application and is to be readin a broad sense. Where firms are involved in both the manufacture anddistribution of products, both set of rules on product governance apply.

ESMA also notes in its technical advicethat the product governance requirements set out in MiFID II are intended toapply to investment firms authorised under the Directive. However, ESMA alsonotes that the requirements could equally apply to other entities subject toMiFID, such as UCITS management companies and alternative investment fundmanagers, when such entities are authorised to perform MiFID investmentservices and only in connection with the performance of such services. Goingforward ESMA believes that the Commission should consider the possibility toalign the relevant articles under the UCITS Directives and AlternativeInvestment Fund Managers Directive with the product governance obligations ofmanufacturers.

ESMA also notes in its technical advicethat the majority of respondents disagreed with the proposals in its earlierconsultation to require distributors to periodically inform the manufacturerabout their experience with the product. ESMA states that, in its view, suchreporting can be beneficial for the functioning of product governanceobligations. However, this does not mean that distributors need to report everysale to manufacturers, or that manufacturers must confirm that each transactionwas distributed to the correct target market. According to ESMA, the relevantinformation could include, for example, information about the amount of salesmade outside the target market, summary information of the types of client, asummary of any complaints received or by posing questions suggested by themanufacturer to a sample of clients for feedback. For distributors, ESMA statesthat the obligation is to provide the data that is necessary for themanufacturer to be able to review the product and check that it remainsconsistent with the needs, characteristics and objectives of the target marketas defined by the manufacturer themselves. ESMA also considers that it shouldbe possible for a distributor to use the scenario analysis of productsconducted by manufacturers in order to comply with their obligation to providefair, clear and not misleading information to clients.

3.Using dealing commission to pay for research

In its earlier discussion paper ESMA madecertain detailed comments regarding how investment research could amount to aminor non-monetary benefit. ESMA’s original proposals effectively meant that,in practice, firms might have been prevented from their current practices ofreceiving ‘free research’ paid from dealing commission. Whilst ESMA has now retractedcertain elements of its proposals in its consultation paper (for example it hasdeclined to include the list of items by which research could amount to a‘minor’ non-monetary benefit), it is now proposing that portfolio managers andindependent advisers can only receive research by paying for it directly fromtheir own accounts or from a separate research fund (paid for by fees chargedto clients). Furthermore, it is proposed that the payment of research is not tobe linked to the payment for executing transactions. In essence, it appearsthat dealing commission may need to be unbundled. Also, ESMA is recommending tothe Commission that it considers similar requirements for UCITS and alternativeinvestment fund managers.

4.Complaints handling

Despite earlier market push-back, ESMA hasretained its requirement that complaints handling guidelines apply to bothretail and professional clients (both per se and elective professionalclients). ESMA has also tried to clarify what amounts to a ‘complaint’ bystating that it is “a statement of dissatisfaction addressed to a firm by aclient or potential client relating to the provision of investment services”.However, such a high level description may not be of material assistance. Inaddition, despite market push back, complaints handling applies to potentialclients as well as clients.

ESMA also notes that a number ofrespondents to its earlier consultation queried the role of the compliancefunction in managing the complaints-handling process. In its technical adviceESMA responds by stating that in order to ensure that the complaints arehandled in an independent manner it is important that a complaints managementfunction is established and that the compliance function should be able toperform this role. In addition, ESMA states that the compliance function shouldconsider complaints as a source of relevant information in the context of itsgeneral monitoring responsibilities and that a management body has clearoversight of how its firm handles complaints.

5.Market making

In its consultation paper ESMA departs fromits previous analysis on market making agreements and market making schemes. Inparticular, ESMA proposes to apply the controversial continuous quotingobligation to all financial instruments. Trading venues allowing or enablingalgorithmic trading would be required to have market making schemes in placefor investment firms engaged in algorithmic trading.

The main elements of the revised marketmaking provisions are:

an investment firm will be considered to bepursuing a market making strategy and must enter into a market making agreementwhen it quotes in at least one financial instrument on a single trading venuefor no less than 30% of the daily trading hours during one trading day;

the market making agreement will requirethe market maker to quote for no less than 50% of the daily trading hours;

only trading venues or market segmentswhere algorithmic trading may take place shall be subject to the obligation tohave a market making scheme in place;

exceptional circumstances are expansivelydefined and include volatility, but only where all trading on a venue isinterrupted. So called “stressed market conditions”, including ‘fast markets’would not be considered exceptional circumstances;

there will be no upper limit on the numberof investment firms that can take part in a market making scheme. However,access to incentives should be proportional to the effective contribution ofthe market maker to liquidity in the market measured in terms of presence, sizeand spread; and

trading venues have an obligation toincentivise the presence of firms engaged in a market making agreement duringstressed market conditions and must make publicly available the conditions ofthe market making scheme. The draft technical standards allow trading venues toestablish “negative incentives” for non-compliance with market makingrequirements.

6.COFIA approach for liquid market definition

In the consultation paper ESMA has electedto use the classes of financial instruments (COFIA) approach for the liquidmarket test for pre- and post-trade transparency for non-equity instruments, asopposed to the per-instrument basis (IBIA). COFIA requires segmenting assetgroups (for example bonds and derivatives) into more granular classes thatshape largely homogeneous liquidity characteristics. Subsequently, ESMAassesses the liquidity of these classes based on the liquidity of all theinstruments within the specific asset class. ESMA believes that COFIA hascertain advantages including that:

* the assessment of newly issued financialinstruments is straightforward;

* it gives greater certainty to the marketand allows taking into account instruments with a very short lifespan; and

* it is consistent with, but not identicalto, the approach taken under European Market Infrastructure Regulation (EMIR).

7.Trading obligation

In the consultation paper ESMA concludesthat as they serve different regulatory purposes it is neither desirable norfeasible to align the liquidity assessment for the clearing obligation underEMIR with the trading obligation under MiFIR.

In relation to the alignment of thecriteria under the definition of liquid market under article 2(1)(17)(a) MiFIRwith the trading obligation criteria under article 32(3) of MiFIR, ESMA agreeswith the majority of respondents who argue that these assessments should followa similar approach although the thresholds should not necessarily be the same.ESMA emphasises that any application of the liquidity test for the purposes ofthe trading obligation will require it to make an assessment of which liquidityfactors are relevant on a case-by-case basis and then apply them to eachspecific class or sub-class of derivatives. ESMA asserts that the ultimateapplication of the trading obligation under article 32 of MiFIR will always bebased on an overall assessment of whether a class or sub-class is sufficientlyliquid to support the introduction of the trading obligation.

8.Section C 6 Annex I of MiFID II

In its final report concerning itstechnical advice on delegated acts ESMA provides an analysis of section C 6 ofAnnex I. It states that the definition of section C 6 of Annex I under MiFID Ihas been changed significantly under MiFID II by classifying options, futures,swaps and other derivative contracts relating to commodities that can bephysically settled and are traded on an organised trading facility (OTF) asfinancial instruments, in addition to those instruments that are traded onregulated markets and multilateral trading facilities. However, section C 6 ofAnnex I excludes wholesale energy products within the scope of the Regulationon wholesale energy market integrity and transparency (REMIT) that are tradedon an OTF and that must be physically settled. Wholesale energy products withinthe scope of REMIT which are derivatives contracts, and are therefore withinthe scope of the exemption, are derivatives with electricity (or power) ornatural gas as the underlying.

C 6 energy derivatives contracts aredefined as options, futures, swaps and any other derivatives with coal or oilas an underlying and which are traded on an OTF and must be physically settled.Whilst ESMA feels that derivative contracts with coal as an underlying are aneasily identifiable section of instruments the position is different for oil asan underlying. Following its earlier consultation ESMA has proposed a widerdefinition of oil in its technical advice so that it covers different grades ofcrude oil and also other contracts where the underlying is derived from crudeoil. In this regard ESMA considers that pure biofuel could not be classified asoil, but biofuel as a mandated minority component to gasoline or diesel wouldnot prevent such gasoline or diesel being caught by the wider definition ofoil. Also, ESMA has also decided to include broad definitions of coal as anunderlying to a derivative contract as well as of the wholesale energy productscaught by the C 6 exemption by reference to the derivative definitions inREMIT.

In relation to when a contract is assessedas “must be physically settled” ESMA has taken on board some of the commentsreceived to its earlier consultation. In particular, in its technical adviceESMA notes its understanding that operational netting does not prevent acontract from being considered as “must be physically settled”. ESMA considersthat a C 6 wholesale energy product contract can only be categorised as “mustbe physically settled” when the parties entering into the contract are actuallycapable of delivery or receipt of the agreed amount of gas, power, oil or coal.The terms of a C 6 wholesale energy product contract or the rules of the OTF onwhich it is traded must require that both the buyer and seller should haveproportionate arrangements in place to make or receive delivery of theunderlying commodity upon the expiry of the contract.

ESMA is also of the view that the term“physically settled” has to be further specified by clarifying that it canincorporate a broad range of delivery methodologies including:

physical delivery of the relevant goodsthemselves;

delivery of a document giving rights of anownership nature to the relevant goods or the relevant quantity of the goodsconcerned (such as a bill of lading or a warehouse warrant); or

another method of bringing about thetransfer of rights of an ownership nature in relation to the relevant quantityof goods without physically delivering them (including notification, schedulingor nomination to the operator of an energy supply network) that entitles therecipient to the relevant quantity of the goods.

9.Post trading issues

MiFIR extends the scope of the clearingobligation to all derivative transactions concluded on a regulated market andrequires clearing members to ensure that derivatives are submitted for clearingacceptance as quickly as technologically practicable.

In the consultation paper ESMA has listenedto stakeholder comments which noted the importance of getting certainty onclearing at an early stage and when possible before trade execution. ESMAproposes to require the set-up of checks before the execution of trading ordersplaced on a trading venue in particular when the clearing obligation wouldapply. The draft regulatory technical standards (RTS) prepared by ESMA providethat the clearing member would provide the credit limits of its clients to thetrading venue which would check the orders placed against these limits. Suchchecks would limit the situations in which a transaction is entered into butthen be rejected by the central counterparty (CCP).

ESMA proposes that the pre-check related toderivative transactions subject to the clearing obligation enteredelectronically should be performed within 60 seconds from the receipt of theorder by the trading venue. For others, ESMA proposes that the check should beperformed within 10 minutes from the receipt of the order. ESMA also proposesthat the trading venue provide the information on a real time basis for ordersthat would be executed electronically and within 5 minutes following thepre-check of others.

ESMA also proposes that the timeframe forthe transfer of information from the trading venue to the CCP for derivativetransactions subject to the clearing obligation should also be different forthose entered into electronically and the others. The transaction should besubmitted to the CCP within 10 seconds of execution when it is concluded on atrading venue in an electronic manner, and within 10 minutes of execution whenit is concluded on a trading venue in a non-electronic manner, within 30minutes of execution when it is concluded on a bilateral basis.

ESMA proposes that the CCP should provideto the clearing member the information related to bilateral transactions thatthey have received for clearing. The clearing member should receive theinformation within 60 seconds from the receipt by the CCP.

In respect of the timeframe for a CCP toaccept or reject the clearing of a derivative transaction, ESMA proposes within10 seconds from submission or from the receipt of the clearing memberacceptance. This is along the lines of the US approach where the CommoditiesFutures and Trading Commission has determined that “as soon as technologicallypracticable” would mean 10 seconds.

In relation to indirect clearing ESMA haslistened to concerns raised by the industry about the feasibility andattractiveness of indirect clearing in the OTC derivatives space and proposesthat clearing members should be offered a choice between a net omnibus account(the same under the EMIR RTS on OTC derivatives) and a gross omnibus account.ESMA has also removed the requirement to port indirect client positions.

In its technical advice on the delegatedacts ESMA has reviewed the position concerning portfolio compression and haslistened to the industry’s request to keep the requirements at a relativelyhigh level and sufficiently flexible. ESMA has also replaced the distinctionbetween multilateral compression and bilateral compression with a distinctionbetween portfolio compression performed between two or more parties with a serviceprovider and performed directly between counterparties.

10.Timing

The Commission will prepare the delegatedacts on the basis of the technical advice that has been delivered by ESMA.However, when preparing the delegated act the Commission does have the right todepart from ESMA’s advice although this would be unusual. Once it has adoptedthe delegated act the Commission has to notify both the European Parliament andthe Council of the EU. Both of these EU institutions will consider thedelegated act and have the power to object to it within three months (which maybe extended by a further three months).

The deadlines that ESMA is working to onthe technical standards are:

it must submit draft RTS to the Commissionfor adoption by 3 July 2015; and

it must submit draft implementing technicalstandards (ITS) to the Commission for adoption by 3 January 2016.

Once the Commission has received:

the draft RTS, it must within 3 monthsdetermine whether or not to adopt it. If the Commission adopts the RTS withoutamendment the European Parliament and Council of the EU may then object withinone month of the adoption (which may be extended by another month). If theCommission adopts the RTS with amendments the European Parliament and Councilof the EU may then object within 3 three months of the adoption (which can beextended by another three months); and

the draft ITS, it has three months in whichit determines whether or not to adopt them (this can be extended by a furthermonth). It is worth noting that the European Parliament and Council of the EUhave no power of objection.

Article 93 of MiFID II states that MemberStates shall adopt and publish, by 3 July 2016, the laws, regulations andadministrative provisions necessary to comply with the Directive. Member Statesare to apply those measures from 3 January 2017 (except for a small number ofprovisions). MiFIR, a Regulation with direct effect on Member States, alsoapplies from 3 January 2017.

The FCA has stated on its website that thechanges to the FCA Handbook will need to be in place by the middle of 2016. Itis likely that the FCA’s formal consultation on Handbook changes will not takeplace until the end of this year. However, the FCA will be engaging on certainaspects of the changes it needs to make before then. In particular, the FCAstates that it expects to issue a discussion paper towards the end of Q1 2015which will seek views on various issues relating to conduct of business.

The FCA also states that HM Treasury islooking to consult on the changes in Q1 2015. The FCA mentions that the topicscovered by the HM Treasury consultation will be disparate but will include:changes to the boundaries of UK regulation through amendments to the RegulatedActivities Order; an authorisation regime for data reporting service providers;changes to the FCA’s supervisory powers (including for position limits);implementing the third country branching provisions; and changes to therequirements to be met by recognised investment exchanges.