The Commission’s review of MiFID (known as MiFID II) re-examines a wide range of areas within the original directive. Its consultation sought responses from industry on 148 specific questions by February 2011. Publication of a formal legislative proposal, originally due in May 2011, is now widely expected in the autumn.
In this article, Rosali Pretorius, Josie Day and Emma Radmore look at four key aspects of MiFID of concern to hedge funds and some UK reactions and responses.
Fortress Europe – entry requirements for third-country players
MiFID does not set access requirements to the markets of the various Member States for firms based outside the EU. Member States can set their own requirements but they must not treat such third-country firms more favourably than their European counterparts. This means third-country firms are currently subject to different regulation in different Member States.
The Commission is now looking to create, in its words, “a real level playing field” in the EU financial markets, partly in response to recent market turbulence and the Lehman and Madoff affairs. It proposes a strict equivalence regime for investment firms and markets to access the EU. Equivalence will be assessed in specific areas covered by MiFID and certain other directives, including parity of requirements for authorisation, organisation and conduct, regulators’ powers and anti-market abuse rules.
UK market professionals are concerned at the effects of lost access to EU markets by firms or entities from third countries that cannot – or will not – pass the equivalence test, and the increased threat of the spectre of a ‘Fortress Europe’. The potential consequences include damage to growth, wealth-creation and the functioning of the market, as well as the possibility of similar restrictions being imposed on EU firms by third countries (as at least the U.S threatened to do when it saw similar suggestions in the Alternative Investment Fund Managers Directive). The UK Government expressed its concern over these proposals in its response to the consultation.
Ban on Inducements for selling or distributing products
Both the EU and UK are concerned about the permissibility and transparency of inducements in product distribution. Proposals include abolishing the option to summarise the existence, nature and amount of inducements prior to the transaction. The form and content of summaries are not currently harmonised in MiFID and there is a concern they are often hard to distinguish from ‘full’ disclosure. MiFID does not require disclosure of inducements after the transaction, whether or not disclosed beforehand.
The Commission is considering banning inducements for portfolio managers and for intermediaries providing "independent" advice (not defined), as it considers inducements are incompatible with their roles. However, the Commission may still go further; it could ban inducements for all investment services.
Responses to the consultation reflected broad disagreement with the proposed bans. Respondents suggested alternatives, including rebates, requirements for express consent from clients for firms to receive inducements, and better enforcement of the suitability rules for advice (as banning inducements for "independent" advice could indirectly bring about its demise). There should be differentiation between monetary and non-monetary benefits, which the Commission did not consider. The purpose and value of post-transaction disclosure was also questioned.
In the UK, there are significant parallels with the Retail Distribution Review, and FSA's attitude to commissions. The move towards banning any type of reward from provider to distributor, in favour of the "transparency" of making the investor pay directly, already has a precedent – although FSA has acknowledged it may need to reconsider its position depending on the outcome of the MiFID Review.
Trading Venue Regulation - Organised Trading Facilities (OTF)
Driven by the growth in dark pools and evolving market practices, the Commission proposes to extend MiFID’s scope to all organised trading venues. "OTFs" will be widely defined to capture any facility or system operated by an investment firm or market operator on an organised basis, bringing buying and selling interests together – whether bilateral or multilateral; discretionary or non-discretionary. This includes, for example, broker crossing systems and interdealer brokers. The Commission says “pure over the counter trading” (ad hoc bilateral trades outside an organised system or facility), systems to execute an order on an external trading venue, or routing an order to such a venue, are excluded, as are existing regulated markets, multilateral trading facilities (MTF) and systematic internalisers that are already covered by MiFID.
Feedback from industry generally welcomed catching such organised trading but said a ‘one size fits all’ approach across venues and instruments was inappropriate. The OTF definition is not clear, and it is vital to ensure that the proposed excluded mechanisms remain outside scope. There should be some core requirements but differentiated for specified sub-sections of the OTF segment. The Commission should not try to shoe-horn all types of OTF into the MTF structure, which has not been designed for them.
Execution quality and best execution
The Commission is keen to improve information on execution quality and trading information transparency requirements in MiFID. To do so, and to assist firms comply with their best execution obligations and make their policies more transparent for clients to review, it proposes extending MiFID’s pre- and post-trading disclosure obligations to all financial instruments traded on different types of venue. For professional clients, portfolio managers, and those receiving and transmitting orders, the Commission may also propose detailed execution requirements. Firms using internal matching systems will need to disclose that they do so and explain how best execution is achieved. Firms using a single execution venue will need to explain why they do so. There could also be stronger rules and templates for policies to distinguish between types of instrument, client and order.
More useful policies, providing clients with clearer, relevant information about how their trades are executed, is broadly welcomed by industry. Requiring venues to publish more information about trading quality may be useful for firms when choosing venues, but only if the information is appropriate for doing so. But, industry notes, firms should already be advertising their execution capabilities in the market so requiring them to do so seems unnecessary. Additionally, professional investors are likely to have existing means to assess venues. There is some support from industry for the strengthening of different types of policies to ensure they do more than reiterate MiFID rules and to clarify that firms dealing on own account to execute client trades must provide clients with all MiFID protections. The UK Government's response to the Commission consultation, though, raised concerns that imposing transparency requirements across too broad a range of products might lead to buy-side investors, such as funds, getting a worse price deal on some investments.
There are several parallels between the MiFID Review and other ongoing EU initiatives, not least the AIFMD, EMIR, Solvency II and the Packaged Retail Investment Products proposals. The key emerging themes recur as:
- treatment of third country market participants and the effects of this treatment on EU markets and market players;
- transparency for investors versus viable business models for distribution and advisory services; and
- regulation of trading venues as well as trading.
When the Commission publishes draft legislation, it will need to ensure the markets and their participants can continue to develop and do business competitively, while protecting investors. Hedge fund managers will be concerned at the effects of change on their European and international businesses and investors and will hope the EU and U.S. authorities in particular continue to work co-operatively to address G20 commitments and regulatory concerns.
© 2011 SNR Denton. Rosali Pretorius is a partner, Josie Day is an Associate and Emma Radmore is a senior associate and professional support lawyer in SNR Denton’s Financial Markets and Regulation practice in London. Contact them on email@example.com.
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