MiFID returns. What lies ahead?
Seven years after the publication of MiFID (Directive 2004/39/EC), four years after it entered into force in the European Union, a draft recast Directive was published by the European Commission on 20 October 2011.
1. Long expected update
As “principles based regulation”, MiFID leaves room to interpretation as well as to “gold plating” by some Member States. This leads to discrepancies in the implementation of MiFID from one Member State to another, and from one financial institution to another inside Member States.
Different Consultation Papers from the CESR contributed to the clarification of different aspects of the Directive, but were not legally binding. An update was therefore necessary. The current draft is composed of a Directive (MiFID) and a Regulation (MiFIR).
This article will focus on a high-level summary of key novelties introduced by the Draft MiFID II, likely to have the most impact on typical Luxembourg banks and investment companies.
2. A focus on market transparency and trading operations
The majority of updates introduced by MiFID II relate to market operators (regulated markets or multilateral trading facilities), systematic internalisers, rules applicable to financial instrument trading as well as pre- and post-trade transparency requirements.
MiFID II not only introduces updates to the current MiFID framework; it also introduces fully new concepts, such as the creation of the SME Growth market, the setup of improved data reporting services (incl. Consolidated Tape Providers), the introduction of a new kind of market: the Organised Trading Facilities, typically designed for derivatives trading and that will complement the current MTF framework.
A major proposal from the new Directive is to significantly reduce the OTC trading of derivatives. Derivatives that are “sufficiently liquid” should be traded on OTF, while the remaining (non-eligible) derivatives should be moved to systematic internalization.
Few investment companies in Luxembourg (besides brokers) have their own Trading Desk, so that this part of the new Directive is likely to have a limited impact on most of them. We therefore do not further develop this aspect in the following lines. Investment companies will nevertheless be indirectly impacted as investors in derivate instruments.
3. Clarification of selected rules of conduct
New instruments are included into the scope of MiFID, such as structured deposits, emission allowances, but also to credits granted in order to finance a transaction on financial instruments. Luxembourg investment firms will therefore have to go through their client files in order to identify the clients newly included into MiFID scope.
The classification criteria as Retail, Professional or Eligible Counterparty remain mainly unchanged. The main change consists of excluding from the Eligible Counterparty regime some public bodies, such as municipalities. Numerous claims started by French municipalities over the year 2011 against major banks with regard to the sale of structured deposits demonstrates that municipalities not always have an in-depth knowledge of the inherent risks of financial markets. Investment firms will have to go through their client files and perform a reclassification exercise.
Product classification as simple or complex
Numerous products that were systematically considered under MiFID I as simple products, such as listed equity shares, bonds, money market instruments and investment funds (including UCITS) will be considered as complex under MiFID II if they meet one of the following conditions:
- They incorporate a derivative,
- Their structure makes it difficult for the investor to understand the inherent risk.
The current wording of the Directive remains unprecise and leaves significant room for interpretation. “Structured UCITS”, as defined by ESMA, will certainly fall into the complex category, which represents an important marketing challenge (especially cross-broder) for the UCITS industry. Luxembourg investment companies can expect a reclassification and redocumentation exercice of their authorized products list in their IT systems, but also some awareness training to their Client Relationship Managers.
Investment advice & execution only
Investment firms that provide investment advice will have to inform the client about whether this advice is provided “on an independent basis” or not. “Independent advice”, under MiFID II definition, means:
- The adviser must have assessed a “sufficiently” large number of “sufficiently diversified” instruments (precise quantification is still pending),
- The adviser does not provide or receive any inducement for providing investment advice.
This requirement implies updates to the IT systems, significant changes in certain financial flows, and an important effort laid on raising awareness among CRMs.
Key principles of “execution only” services remain unchanged, but its application scope is reduced. Some services will not be exempted any more from the Appropriateness Test, among other the purchase of financial instrument newly considered complex (such as structured UCITS) or the granting of credits for financing transactions on MiFID-relevant products.
With regard to best execution, the novelties remain limited for financial institutions without a Trading Desk. MiFID II requests some more detail in the formalization of the Best Execution Policies, as well as the annual publication, by the financial institution, of the top five execution venues used during the year. In most cases, the impact will be limited to some redocumentation of existing procedures.
The weighting principles of the best execution criteria are further clarified. This leaves significant room for interpretation on a major topic of the MiFID framework, so that we will certainly continue to observe significant implementation discrepancies from one bank / broker to another.
MiFID I definition of inducements remains unchanged, while some specific situations are clarified. Inducements are now expressly banned when providing investment advisory or discretionary portfolio management services. This clarification confirms an already widespread understanding of MiFID I. These new requirements will nevertheless certainly represent an important commercial and financial challenge for many investment companies in Luxembourg.
Extension of transaction reporting requirements
Post-negotiation transaction reporting to the CSSF is extended in:
- The scope of its application,
- The level of detail of required information.
The scope of application of the reporting, currently is limited to orders on financial instruments admitted to trading on a European regulated market, is to be extended to instruments admitted to trading on an MTF or an OTF. Since OTFs should replace part of the current OTC market, we can expect this new transaction reporting to include numerous new instruments. The reports themselves will have to include additional fields, such as identification of the client, of the trader and of the person(s) responsible for the transaction execution inside the investment company. Several reconfiguration efforts of the current reporting IT systems are to be expected.
Some issues identified over the last years in relation to the effectiveness of transaction reporting have unfortunately not been addressed – for example the fact that the reporting chain is fully inefficient when non-EU broker (resp. the mother-company’s Trading Room, as often the case) is used for accessing a EU market.
Adequacy and substance of resources
MiFID I requirements regarding material and human resources of the organization, as well as the required expertise from members of the board, require significant interpretation. The new Directive clarifies a number of organizational requirements, for example regarding the segregation of duties, the concept of “sufficient time” dedicated to the exercise of functions, the concepts of qualification, adequate experience, diversity, appropriate financial and human resources... More details on the concrete implementation of these notions should be given by the ESMA by 2014.
4. The opportunity to revisit MiFID implementation
The operational implementation of MiFID I still creates operational difficulties in many Luxembourg banks and investment companies, for example around monitoring of best execution criteria and documentation of deviations, signature of formal investment advisory agreements, monitoring of asset allocation agreements in advisory or discretionary mandates, or missing client information.The draft Directive is therefore an excellent opportunity for financial institutions to review their compliance with MiFID I, identify the main outstanding issues, and prepare an impact analysis of the MiFID II propositions on their Luxembourg entity, but also on Group entities outside EU that provide outsourced services on their behalf.
By Christophe Wintgens, Partner, Financial Services Advisory Leader, and Romain Leroy-Castillo, Manager, Financial Services Advisory, EY Luxembourg