MiFID II implementation challenges
17 March 2017
The second Markets in Financial Instruments Directive (MiFID II) is one of the most ambitious regulatory reforms introduced by the European Union (EU) following the 2008 financial crisis. The outcome of that crisis led to a political reaction on how far the EU should go in policing the safety and soundness of the financial system which was translated in this regulation.
MiFID II is a scheduled review of the old MiFID I directive and addresses the downsides of MiFID I, harmonizing rules in the EU through the creation of a ‘single rule’ book. It also implements G20 commitments in the EU, such as trading of OTC derivatives on various trading venues.
What are the key changes introduced by MiFID II?
MiFID II can be broken down into five key themes: market structure, market transparency, trading regime, investor protection, internal controls and governance.
While MiFID I only addressed equity markets, MiFID II virtually covers all financial instruments. This new regulation introduces a new trading platform for non-equity instruments, the organised trading facility (OTF), to capture smaller broker to broker networks. This complements the multilateral trading facilities (MTFs) and systemic internalisers (SIs) that exist for regulated markets.
In the context of the European Market Infrastructure Regulation (EMIR), there is an obligation to trade clearable derivatives on organised trading platforms. It introduces a harmonised EU regime for non-discriminatory access to trading venues, central counterparty clearing houses (CCPs) and benchmarks.
MiFID II extends pre- and post-trade transparency requirements to non-equity instruments. This means there are not only changes in the instruments that have to be reported, but also a significant increase in the scope of the reporting data required. Additionally there is also the introduction of the “consolidated tape” for trade data: a requirement to submit post-trade data to authorised reporting mechanisms (ARM).
The new trading regime introduces trading controls for algorithmic and high frequency trading and will move to a stricter commodity regime: the inclusion of commodity instruments as well as the introduction of a harmonised position limits regime to improve transparency, support orderly pricing and prevent market abuse.
MiFID II builds directly on MiFID I in terms of investor protection, but is now and introduces a more restrictive regime for inducements with a ban for independent advisers, new suitability reporting obligations and a wider mandatory scope for the appropriateness test.
Internal controls and governance
MiFID II is introducing a new management body to ensure good corporate governance, ensuring new recording obligations for telephonic conversations and electronic communications are being met. Stricter monitoring of sales, staff remuneration is also to will be introduced.
How has MiFID II evolved over the last six months?
Policymakers, regulators and stakeholders have delayed the introduction of the new rules to the 3 January 2018. One of the reasons resulting in the delay was the fact that the European Securities and Markets Authority (ESMA) had to collect about 15 million financial instruments from more than 300 trading venues, which could not be achieved with the previous timeline. These rules will require a new and extensive electronic data collection infrastructure within and between ESMA, national regulators and market participants.
At the same time, back in 2016, the European Commission adopted detailed rules on a wide range of topics including the definition of systematic internalisers, best execution, record keeping and conflict of interest. Final - and mainly scenario-based - guidelines on transaction reporting were also which have been published by ESMA in October 2016 and must be taken into account.
What will be the implications on the banks’ business and infrastructure?
The changes within the market structure will reduce over-the-counter (OTC) trading significantly and will be characterised by less liquid and more bespoke products. The increased competition in trading and clearing markets should improve services to market participants and reduce fees in both trading and clearing. Banks will have to connect to the new organised trading facility (OTF) where applicable. The introduction of swap execution facilities (SEFs) under Dodd-Frank may present an opportunity to reuse a number of technology infrastructure concepts in order to comply with the trading obligation described in MiFID II.
Banks should integrate an automated workflow to facilitate all in-scope trades are transacted on a venue. The transparency requirements will increase significantly. There will be a substantial focus on financial institutions’ data management to support the requirements on trade, best execution and transaction reporting including increased regulatory and client reporting for all asset classes including near-time reporting requirements to regulator. The impact is primarily defined by the type of investment firm it decides to be. If the investment firm is going to apply for a SI or OTF/MTF status then the impact is higher. While a number of reporting requirements, for example transaction reporting and post-trade transparency, will have an impact on all investment firms.
Commodity desks will have to integrate new position reports and limits with respect to all eligible commodity instruments, which can have a potential negative effect on liquidity. Better investor protection means that banks will have to enhance their client portals and include more transparent client reports, costs and charges. Last but not least, MiFID II will strengthen the new internal control function and criteria for the board directors and enlarge the scope and role of compliance - helping to establish a compliance culture with a clear “voice from the top”.
Which other regulations will need to be considered in parallel?
MiFID II has a lot in common with other European regulations that are in different stages of implementation such as EMIR, the Market Abuse Regulation (MAR), the Regulation on Wholesale Energy Markets Integrity and Transparency (REMIT) and the regulation on Securities Financing Transactions (SFTR). EMIR uses the MiFID definition of derivatives. Changes in MiFID II financial instruments and exemptions will require firms to check their categorisations and re-calculate their clearing threshold. MiFID transaction reporting will also overlap with position reporting to trade repositories and with SFTR reporting that will increase the transparency of products like repurchase agreements, securities/commodities lending where the length of the phase-in period will differ, depending on the type of counterparty.