Markets in Financial Instruments Directive (MiFID II)
The MiFID revision comprises two initiatives—a recast Directive (MiFID II) and a new Markets in Financial Instruments Regulation (MiFIR), which together are usually referred to simply as MiFID II. Whereas the original directive brought greater transparency and harmonization of the equities markets, MiFID II expands the same themes to more asset classes, bringing fixed income and over-the-counter (OTC) derivatives into scope as well as regulating trading venues with the aim of increasing trading on exchange.
Northern Trust clients have diverse business models, face varying challenges and will be impacted differently by MiFID II. The areas that raise the most concern relate to the following provisions:
MiFID II introduces product governance, appropriateness and suitability requirements for manufacturers and distributors of products. Each investment product (financial instruments and structured deposits) must be reviewed, approved and attributed to a particular target market to which the instrument is to be distributed. The products and distribution channels must be reviewed on an ongoing basis to ensure they remain suited to the target market and are in fact distributed to that target market.
As part of the suitability/appropriateness regime, MiFID introduced a distinction between complex and non-complex products with the aim of preventing complex products being sold on an execution-only basis. ESMA has highlighted that it considers any investment in non- UCITS as being complex, regardless of its legal form. In order to introduce a complex product, an appropriateness test must be performed to assess a client’s knowledge and risk appetite, before informing the client whether or not a product is appropriate for them. Under the original Directive, professional clients could be deemed to have sufficient experience so as not to require an appropriateness assessment, but it is currently unclear how this will work under MiFID II. In order to offer investment advice or portfolio management, a more stringent suitability test must be performed regardless of the client categorization.
MiFID II strengthens the current rules. One significant aspect is that research has been brought into scope unless it can be considered as constituting a “minor non-monetary benefit.” Currently, AIFs/UCITS do not fall under the scope of MiFID II, although national competent authorities will have the discretion to choose to address the gap in the treatment of research payment accounts when determining how to incorporate MiFID II into national legislation. The FCA has extended the research and inducements requirements to UCITS management companies and AIFMs.
MiFID II does not significantly alter the requirement to execute orders on the terms that are most favorable to the client. Yet the obligation to evidence adherence to the rule has become more cumbersome, with the need to set out information in a specific format taking account of a number of factors and disclosing it to various parties. Furthermore, from market-wide discussion, it can be inferred that the change from taking “reasonable steps” to “all sufficient steps” to achieve the best possible result for clients signifies that greater emphasis will be placed on this requirement. Investment firms must also publish information on the identity of execution venues and quality of execution on an annual basis.
In line with G20 commitments, MiFID II requires the trading of standardized derivatives (subject to be centrally cleared under EMIR) to be traded on regulated markets: multilateral trading facilities MTFs or organized trading facilities OTFs, or equivalent non-EEA markets, where there is sufficient liquidity. Organized trading facilities are a new type of trading venue regulated under MiFID II. Difficulties will arise in the practical implications of processing an increased number of trades through a trading venue as well as ascertaining which derivatives this trading obligation will be applied to (see the following section titled Relationship with other initiatives).
These provisions are best understood when split into pre-/post-trade transparency and transaction reporting.
THIRD COUNTRY IMPACTS
The term third country within MiFID II refers to jurisdictions outside the EU and third country firms (TCFs) are entities incorporated outside the EU that seek to do business by way of a branch established in the EU, or on a cross-border basis.
Under MiFID II, the ability for a TCF to provide investment services and activities to professional clients or eligible counterparties will change. For retail and opted-up professional clients the national rules will continue to apply unless a member state specifically chooses not to maintain their existing regime; in which case, the rules set out by MiFID II will apply.
Services to eligible counterparties or professional clients
TCFs may provide investment services to eligible counterparties or professional clients on a cross border basis without the need to establish a branch, provided the firm is registered with ESMA. Registration will only be available if the Commission has recognized the third country’s legal and supervisory framework as equivalent to that in the EU.
An ESMA registered TCF must inform prospective EU clients that it cannot provide services other than to professional clients and eligible counterparties and is not supervised in the EU. It must also offer to submit any disputes relating to its services to a court or tribunal within the EU.
Services to retail or opted-up professional clients
Where a member state has implemented the MiFID II provisions on the establishment of third country branches, the TCF will only be able to provide services to retail or opted-up professional clients by establishing a branch in that member state. MiFID II then stipulates the factors that must be considered/criteria that must be met before a member state can authorize a branch. This includes: that the branch has sufficient capital, belongs to an EU investor compensation scheme and has regard to the Financial Action Task Force’s recommendations on anti-money laundering. The TCF must also be authorized and supervised in its third country home to provide all of the services for which it is requesting branch authorization.
If the member state does not utilize the option within MiFID II to require a TCF to establish a branch to provide such services to retail or opted-up clients, the MiFID II requirements will not kick in, and instead, the existing local national regime governing market access in that member state must be complied with.
The only way in which a TCF can provide investment services and activities without undertaking the steps set out above, is if the service provision is on the exclusive initiative of an eligible counterparty or professional client. This reverse solicitation carve-out is very limited in application and only permits the TCF to provide the particular investment service or activity specifically requested by the client, not any new categories of the same to existing clients.
MiFID II will be indirectly applicable to non-EU asset managers that distribute on European trading venues, trade with European counterparties or market their funds through European distributors. These implications essentially result from others needing to directly comply with MiFID II and therefore likely to require certain information from non-EU managers in order to do so. For example, there will be no obligation on non-EU managers to transaction report but EU counterparties will need to do so. As a result EU counterparties will require data including the LEI of the non-EU manager to fulfil this requirement. As another example, EU regulated firms will be obliged to execute most trades on EU trading venues or equivalent third country venues. This will limit non-EU managers’ ability to trade off-exchange with an EU counterparty. Non-EU managers should begin discussions with EU counterparties to understand where the expectation is that processes or data provision will change following MiFID II implementation.
RELATIONSHIP WITH OTHER REGULATORY INITIATIVES
EMIR introduced a clearing obligation for certain OTC derivative contracts. MiFID II will extend the scope of this obligation to all derivative transactions concluded on a regulated market. Counterparties will clear their transactions by becoming a clearing member, by becoming a client of a clearing member or by establishing an indirect clearing arrangement with a clearing member. In May 2016, ESMA issued two final draft regulatory technical standards on indirect clearing under MiFID II and EMIR to clarify the provisions of indirect clearing arrangements for OTC and exchange-traded derivatives, and to help ensure consistency and an appropriate level of protection.
Once a class of derivatives has been mandated as subject to the clearing obligation under EMIR, ESMA must determine whether those derivatives (or a subset of such) should be subject to the trading obligation, meaning they can only be traded on a regulated market, multilateral trading facility, organised trading facility or a third country trading venue deemed to be equivalent. The Commission has adopted a delegated regulation supplementing MiFID II which sets out whether or not a class of derivatives subject to the clearing obligation, should also be made subject to the trading obligation.
NORTHERN TRUST ACTIONS
We are involved in various market discussions through numerous industry associations and are keeping a close eye on all aspects of MiFID II as it progresses. We created a working group within our product team with the task of reviewing all aspects of MiFID II from a client perspective. This has led to the creation of new products to assist those of our clients in scope of the upcoming requirements, including a transaction reporting service, client reporting and transaction cost disclosure as well as a research payment account solution. Please contact your Northern Trust representative if you would like to discuss these, or the broader non-EU implications of MiFID II further.
IMPACTS: Global asset managers trading within the EU.
KEY TAKEAWAY: The rules surrounding the provision of services in the EU will change for TCFs who should analyze how this might impact their strategy.
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