Is a server a branch and other Mifid II musings

First, here's the thought - when (if ever) will the EUprovide a definitive answer to the question of whether a prop firm, which isoutside scope of Mifid II under Article 1, is brought into scope by theexemption from the exemption in Article 2(1)(d)?

I doubt that such an answer is likely in anything like thetimeframe necessary for any firms to plan on becoming authorised and regulatedin the EU in time for January 2017. And there will always be those who can(pretty reasonably) argue that on the text of Mifid II, a third countryprincipal trading firm is not in scope of Mifid II at all. 

Let me explain: Mifid II Article 1 says that the directive appliesto “third-country firms providing investment services or performing investmentactivities through the establishment of a branch” in the EU.

If a third-country firm has no “branch” in the EU, it cannotbe covered by Mifid II.

So the argument goes that the ‘exemption from the exemption’in Article 2(1)(d) - which says that prop firms are not in scope of MiFID2unless they are market makers, are members of a trading venue, have DEA to atrading venue, are HFT or deal on own account when executing client orders -cannot apply to firms which are not caught by Mifid II under Article 1.

And second, here's the issue - EU politicians (the mastersof Mifid II Level 1 text), want there to be a ‘level playing field’ for allparticipants on EU markets.

This, to my mind, means not just ‘no unregulated market andno unregulated product’ but also ‘no unregulated participant’.

That regulation doesn’t necessarily need to be EU regulation- firms authorised and regulated in the US, Canada, Singapore etc areauthorised and regulated after all.

But let’s be fair, supranational bodies don’t have a greathistory of agreeing with one another about cross-border regulatory equivalence.

Also, don’t forget that Germany rejected ‘equivalence’ of UKlocals’ regulatory regime under the German HFT law because they were notsubject to the same regulatory capital requirements as full Mifid firms.

So ‘level playing field’ therefore means ‘regulated in theEU under Mifid II’.

Possibly.

Probably.

OK, I’ll go out on a limb and say ‘definitely’.

Where was I?

Oh yes: a UK-based principal trading firm has a servercolocated in Frankfurt to trade Eurex; if it is HFT under German law, then itrequires a Mifid-passport to do so.

No such passport is required (or available) if it is not HFTbecause its activities fall within one of the exemptions under current theMifid and do not fall under the German HFT law.

So for what type of passport should the firm apply if itneeds one - a cross-border services passport or a branch passport?

Most firms in this position do not have personnel inGermany. It is physically difficult to squeeze a human being into a serverrack. Feeding him/her when they’re there would be even more challenging.

But is a server a branch nonetheless?

The Germans never came up with a satisfactory or unequivocalanswer - their approach was that they would process any passport notification afirm from another EU state’s regulator sent them; be it for a branch or forcross-border services.

As long as there was a passport, that firm could conduct HFTprop trading in Germany.

The OECD tax plans seem to be going in the direction of makinga server a branch (as drawing a distinction between e-commerce businesses like[insert reader's own choice of household name here] and a colocated tradingfirm with an in-country server is a difficult one for legislators).

Latest OECD and IOSCO papers state that HFT firms, operatingin a member country, would struggle to do so but for the colocated servers and(so the argument goes) those firms might have a taxable establishment in thatcountry.

The amount of tax attributable to that establishment is immaterialto the argument - an establishment for tax purposes is a permanentestablishment and a branch.

Neither the OECD nor IOSCO seems to have come to aconclusion as to how to deal with this; at the moment, we’re at a place wherethey recognise the issue and state that they have to do something about it.

But the hint is strongly that servers will be permanentestablishments.

It might matter whether the firm owns, licenses or merely‘uses’ the server (ie where it belongs to an intermediary or service provider),but given the heat and light generated by news of ‘tax avoidance’ etc, mymoney’s on that being disregarded in the long term.

Also to be disregarded will be that a branch constituted bya server should have personnel. That’s an inconvenient mismatch between taxlaws and regulatory requirements which I guess everyone will pretend not tosee.

So let's say for sake of argument that a server will be abranch.

If so, then it requires a passport permitting it to provideinvestment services in the country in which the server is located. It's likely to be subject to local tax on its profits.

And ... it's likely to provide politicians with the'solution' they need to ensure that there is a 'level playing field' in EUmarkets for EU-regulated participants and firms based outside the EU which arenonetheless colocated at trading venues in the EU.

There’s then no disparity between Article 1 and Article 2 ofMifid II; a third-country firm has a branch in the EU and needs to beauthorised and regulated.

So we shouldn’t wait for the EU to pronounce on whetherthird-country prop trading firms which cannot claim exemption under Article2(1)(d).

People will have waited for Godot more fruitfully.

We should plan on being told (eventually) that allthird-country prop firms that would not be able to claim an exemption underArticle 2(1)(d) have to be authorised and regulated in the EU.

Now we just need someone to let us know what definition ofHFT we'll have to use...!