09 Nov Key elements of MiFID II and MiFIR
The original Markets in Financial Instruments Directive (“MiFID I”) became effective on 1 November 2007 in order to increase competition and consumer protection in investment services, to remove barriers to cross-border financial services within Europe and to ensure appropriate levels of protection for investors and consumers of investment services across the EEA.
MIFID introduced a number of items including the MiFID passport, client categorisation requirements, client order handling requirements, pre- and post trade transparency requirements and requirements relating to investment firms ensuring that clients receive best execution.
In June 2014, the European Commission adopted new rules revising the MiFID framework. These consist (at Level 1) of:
- a Directive (MiFID II) (Directive 2014/65/EU of the European Parliament and of the Council), which partly recast MiFID, and
- a Regulation (MiFIR) (Regulation 600/2014/EU of the European Parliament and of the Council), which partly replaced MiFID
MiFID II/MiFIR which will come into effect on 3 January 2018 seeks to build on the success of the more harmonized investor protection framework introduced in the original directive. In general, MiFID II relates to the framework of trading venues/structures in which financial instruments are traded. MiFIR is concerned with regulating the operation of these trading venues and the processes, systems and governance measures adopted by market participants.
MiFIR imposes record-keeping obligations on both investment firms and operators of trading venues. There is an extensive and non-exhaustive list of information that trading venues will have to maintain. The relevant data must be transmitted to the national regulator upon request. Such data is meant to supplement the data available under the reporting obligation and should enhance market monitoring during any given period of time. Under MiFIR, a transaction report must include ‘details of the identity of the client’ and ‘a designation to identify the clients on whose behalf the investment firm has executed the transaction’.
What Types of Organization are Covered by MiFID?
In general, MiFID II only applies to investment firms that have a physical presence in Europe that are operating under a MiFID permission and regulated by a European regulator. However, non-EU investment firms that manage European mandates or compete for European clients’ assets will face competitive pressure as clients come to expect the level of transparency that they are receiving from investment firms in Europe. MiFID II expands on MiFID and will include investment firms and credit institutions selling structured deposits and emission allowances. In the initial draft, custody services were to become core investment services under MiFID II, but they have since been reinstated as ancillary services.
MiFID II is a package of EU legislation, which regulates both retail and wholesale investment business. It affects in particular investment banks, interdealer brokers. stockbrokers, investment advisers, corporate finance firms and venture capital firms, trading venues including Regulated Markets (RMs), MTFs, and prospective OTFs, prospective Data Reporting Service Providers, investment managers, but equally unregulated entities trading commodity derivatives and emission allowances.
To determine which firms are affected by MiFID and which are not, MiFID distinguishes between investment services and activities (‘core’ services) and ancillary services (‘non-core’ services). Examples of core services include investment advice, receipt and transmission of orders in relation to financial instruments, portfolio management services, dealing on own account, execution of orders on behalf of clients, and operation of multilateral trading facilities (MTFs). Examples of ancillary services include safeguarding and administration of financial instruments, investment research and financial analysis, and underwriting services.
What Types of Product are Subject to MiFID?
MiFID is applicable to transactions in the following financial instruments:
- Transferable securities.
- Money-market instruments.
- Units in collective investment undertakings.
- Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash.
- Options, futures, swaps, forward rate agreements and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event).
- Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market and/or an MTF.
- Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not mentioned above and not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls.
- Derivative instruments for the transfer of credit risk.
- Financial contracts for differences.
- Options, futures, swaps, forward rate agreements. Also any other derivative contracts relating to climatic variables, freight rates, emission allowances or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event). In addition, any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market or an MTF, are cleared and settled through recognised clearing houses or are subject to regular margin calls.
The Key Aspects of MiFID II
The impact of MiFID II can be summarised across five key areas:
- Market Infrastructure/Transparency
MiFID II makes a range of significant changes in relation to market infrastructure. It introduces the concept of an Organised Trading Facility which captures trading in non-equity instruments which previously operated outside the scope of MiFID. The rules around Regulated Markets and Multilateral Trading Facilities have been aligned, and a range of organisational requirements currently applying to RMs and MTFs have been extended to the newly introduced OTFs. Additionally, obligations for SIs have been increased. There are also new requirements for high frequency and algorithmic trading in relation to pre- and post-trade transparency.
- Product Governance
MiFID II introduces significant product governance requirements. Investment firms that create products, so called manufacturers, will be required to identify a target market and take reasonable steps to distribute the product. They will need to put in place a product approval process and review the target market and the performance of the investment products they offer on a periodic basis. They will also need to make sure that the distributors have sufficient understanding of the manufacturers’ products and product approval processes to sell to their own identified target market.
In June 2017, the European Securities and Markets Authority (“ESMA”) issued guidelines on MiFID II product governance requirements. The guidelines outline a number of criteria that need to be analysed by manufacturers when assessing a target market. These include:
- What type of clients are the products being targeted to?
- What are the clients’ objectives and what is their experience/knowledge of the products in question?
- What is the clients’ risk appetite and tolerance to risk?
- Transaction Reporting
Transaction reporting was introduced under MiFID I and concerns trade detail reporting which is provided by investment firms to regulators. It allows regulators to monitor market abuse in financial markets. Under the MiFID II framework, the transaction reporting requirements increased considerably. The scope of products which need to be reported has been extended with transaction reporting now being required for all products traded on European RMs, OTFs and MTFs. In addition to an increase in the number of products that qualify for reporting, the number of data fields required for MiFID transaction reporting has also greatly increased.
Finally, transaction reporting will no longer be an issue only for sell-side firms, such as brokers and dealers, but will also become the responsibility of the counterparty who initiates the transaction, typically buy-side firms.
- Rules on Inducements and Unbundling of Research
This has been a contentious area for investment firms. Pursuant to the MiFID II general inducement rule, most inducements, including commissions and rebates for independent advisors will be banned. This will force investment firms to review how their funds are distributed. There may be some exceptions, for example, where the payment or benefit is designed to enhance the quality of service to a client.
MiFID II also seeks to unbundle the purchase of research from execution services. In order to ensure that the bundling together of investment research and execution services does not occur, MiFID II proposes two methods to pay for investment research:
- The P&L method where investment firms fund the research themselves from their own resources
- The Research Payment Account method where the costs of research would be funded by the client.
- Investor Protection/Best Execution
MiFID II seeks to enhance the best execution framework which was introduced under MiFID I. Under the MiFID I framework, investment firms are required to take “reasonable steps” to obtain the best possible results for their clients. Under MiFID II, the term “reasonable steps” has been replaced with “all sufficient steps”, thus raising the bar.
There are also enhanced publicity requirements. Investment firms will be required to publish data relating to execution quality (i.e. cost, speed, etc.) at least annually without charge. Investment firms will have to publish, on an annual basis, their top five execution venues for the previous year, along with specific data relating to the quality of execution of transactions on that venue.
EIMF provides several learning solutions through its training seminars, workshops, online courses and webinars that can help companies prepare for MiFID II. To view our online training calendar click here to request in-house training seminars please contact our team at firstname.lastname@example.org