48
MiFID II and MiFIR academy briefing Jonathan Herbst, Partner and Global Head of Financial Services Tara Mokijewski, Of Counsel February 4, 2015
MiFID II and MiFIR academy briefing Jonathan Herbst, Partner and Global Head of Financial Services
Tara Mokijewski, Of Counsel
February 4, 2015
Introduction
MiFID II / MiFIR: What will this briefing cover?
3
Introduction
Investor protection overview
Markets overview
MiFID II / MiFIR: The big themes
MiFID I was not serious enough
Belief that the letter of MiFID I was not fully implemented in areas such as best execution and conflicts so
that a new, much thicker layer of regulation is needed
Level playing field is the other side of this
Suspicion of the industry
Regulation as a solution to the ills of the principal / agent problem, asymmetric information and too many
regulatory loopholes
Classification of structural entities / players
The organised trading facility (OTF) category is being introduced into an already complex environment,
featuring trading venues spanning all asset classes across the EU
It remains to be seen whether re-classification – of single dealer platforms, broker crossing networks,
MTFs and third country platforms such as SEFs – will represent greater opportunity for flow, or impact
the executable liquidity in non-equity markets
One thing is for certain – the complexity of quote-driven markets is about to increase
End of the OTC, bilateral world?
The implementation of MiFID II will introduce, e.g., auction systems competing with dealer pricing, as
products formerly traded OTC follow equities towards trading on venues
The regulation of retail
Recognition that at the end of the chain stands the retail customer
4
2017 2016 2015 2014
Timing: MiFID II
5
2 July
MiFID II and MiFIR
entered into force
1 August
Level 2 Consultation on
advice on delegated acts
and Discussion Paper on
technical standards closed
19 December
Final advice on
delegated acts and
consultation on
technical standards
commences
March
Level 2 Consultation on
delegated acts and technical
standards closes
3 July
Level 2 delegated
acts and regulatory
technical standards
submitted to
Commission
23 October
Earliest date for Level
2 (delegated acts and
technical standards) to
enter into force
3 January
Level 2
implementing
technical
standards
submitted to
Commission
23 April
Earliest date for
remaining Level 2
(delegated acts and
technical standards)
to enter into force
3 July
Deadline for
transposition of
MiFID II by Member
States (N / A for
MiFIR and Level 2)
3 January
MiFID II and MiFIR
Level 1 and Level 2
implementation date
Consultation
period
Consultation
period
EU implementation
A brief history in time
● MiFID II and MiFIR were published in the OJ on 12 June 2014 and entered into force on the twentieth day following publication – i.e. 2 July 2014
● On 3 January 2017: MiFID II and MiFIR apply
● MiFID II and MiFIR supplemented by implementing measures (Level 2 legislation) consisting of delegated acts and technical standards: ESMA has a key role in producing these
● On 19 December 2014 ESMA published: (1) Final report on technical advice to the Commission on the delegated acts (2) CP on the technical standards - deadline for comments is 2 March 2015
● On 19 February 2015: ESMA open hearing on the CP in Paris
● Reference in the CP to a further ESMA consultation relating to certain transparency issues
Delegated acts
● The Commission will prepare the delegated acts on the basis of ESMA’s technical advice – although it may elect to depart from it
● The power to adopt a delegated act is conferred on the Commission for an indeterminate period of time although it may be revoked at any time by the EP or Council
● As soon as it adopts a delegated act the Commission will notify the EP and Council
● EP and Council will consider the delegated acts adopted by the Commission and have the power to object, provided they do so within 3 months (which can be extended by a further 3 months)
● Once a delegated act is adopted it is published as a Commission delegated Regulation in the OJ. Delegated acts should be adopted by the Commission so that they enter into application by 3 January 2017
Technical standards
● Deadlines which ESMA is working to:
– Must submit draft RTS to the Commission for adoption by 3 July 2015
– Must submit draft ITS to the Commission for adoption by 3 January 2016
● Key difference between RTS and ITS: EP and Council have no power of objection over ITS once adopted by Commission
● On receiving the ITS the Commission has three months to determine adoption (can be extended by one month)
● Within three months of receiving the RTS the Commission must determine adoption:
– If the Commission adopts the RTS without amendment the EP and Council may object within one month (extended by another month)
– If the Commission adopts the RTS with amendment the EP and Council may object within three months (which can be extended by another three months)
● Once adopted the RTS and ITS are published in the OJ as an implementing Regulation or implementing Decision
6
UK transposition
MiFID II implementation
● Article 93 MiFID II: Member States shall adopt and publish, by 3 July 2016, the laws, regulations and administrative provisions necessary to implement this Directive
● HM Treasury will represent UK at Commission organised MiFID II transposition workshops
● FCA states that the biggest practical challenges will be around issues such as transaction reporting, commodities position reporting and the provision of information to ESMA for various purposes
● But a significant part of its work will be about communication so that firms can get to grips with the new legislation and deal with the various notifications, authorisations and variations of permissions
● How to keep informed: FCA MiFID review page - http://www.fca.org.uk/firms/markets/international-markets/mifid-ii/mifid-review
FCA Handbook changes
● FCA states that it is likely that a formal consultation on Handbook changes will not take place until sometime at the end of 2015
● However, it will engage on certain aspects before then – it expects to issue a discussion paper towards the end of Q1 2015 covering various conduct of business issues
HM Treasury
● Looking to consult on the changes in Q1 2015
● The topics covered will be disparate but are thought to include: changes to the regulatory perimeter through amendments to the RAO, an authorisation regime for data reporting service providers, changes to the FCA’s supervisory powers (including for position limits), implementing the third country branching provisions and changes to the requirements to be met by recognised investment exchanges
7
Investor protection
Investor Protection – Overview
9
Where are we at?
Overview of changes
Level 1:
Has been finalised
Came into force on 3 Jan 2014
Takes effect from 3 Jan 2017
Level 2:
ESMA 2014 summer consultation completed
Final draft technical advice issued in
December 2014 and a further consultation
on investor protection
Responses due by March 2015
Thereafter, final technical advice will be
issued to the Commission
UK
FCA consultation expected autumn / winter
2015
Significant number of
micro changes being made
to the existing investor
protection regime
Small number of macro changes being
introduced to the existing investor protection
regime
Together they SNOWBALL into significant
regulatory reform in the way firms conduct
their business
The devil is in the detail!
ESMA’s proposals significantly alter the
agreed Level 1 landscape and overall will
have a material impact in the UK
Conflicts of Interest
EU developments
11
Level 1 Level 2
(Consultation)
Level 2 (Final)
No changes to existing
regime
Amalgamation of Levels 1
and 2 of MiFID I
Express statement that
conflicts include:
− receipt of inducements
from third parties
− firms’ remuneration /
incentive structures
Significant changes
Limitations on use of
disclosure – disclosure is
to be used as a ‘last
resort’
Prescribed content of
disclosure – tailored and
new warning to be
included in disclosures
Review conflicts policies –
at least annually
New presumption – if
disclosing in every case,
presumption that conflicts
policy is deficient
Confirmed
Plus new proposals:
− requirements that apply
to investment research to
also apply to
‘recommendations’ (i.e.
non-independent
research)
− clarification that
operational separation
means physical
separation
− proportionality applies
− if physical separation is
disproportionate, need
alternative information
barriers (potentially
extremely broad)
Moderate impact – some sectors already quite compliant
Impact in the UK
12
Reassess conflicts
that arise from business
activities (bearing in mind
different client categories –
retail, professional, etc.)
and put in place / update
structural and governance
arrangements to try to
prevent conflicts which
should be monitored,
documented and updated
Reassess steps
that need to be
taken to prevent
and manage
conflicts
Focus
on prevention
Reassess
financial
incentive
arrangements
Reassess
when and how
disclosure
is made
to clients
Create separate,
standalone suite of
disclosure documents
(for particular client classes
– e.g. retail clients who
invest in equities, etc.)
and ensure:
disclosures include the
warning
disclosures set out the
steps taken by the firm
to mitigate the conflict
Maintain records
of what disclosure
was made to what
client so as to show
that the disclosure
was tailored, identified
specific likely conflicts
and was not made to
every client
Update conflicts
of interest
policies to set out
more clearly how
the firm has tried to
mitigate conflicts
Ensure
compliance
monitoring
programme
requires policies
to be updated
annually
Review current
operational
arrangements for staff
producing investment
research and
recommendations
(non-independent
research) – is there
physical separation? Issue:
Balancing MiFID II
requirements to not
disclose in every case to
ensure you can prove
disclosure is a ‘last resort’
with need to disclose for
protection from common
law duties
Inducements generally
EU developments
14
Level 1 Level 2
(Consultation)
Level 2 (Final)
No significant change to MiFID I
● Amalgamates existing MiFID I
Level 1 and Level 2 provisions
● No express reference to firms
(other than independent advisers
or portfolio managers) being able
to receive ‘minor non-monetary
benefits’
● Most important change is in the
context of dealing with eligible
counterparties; any disclosures
to ECPs (including in relation to
inducements) will need to be fair,
clear and not misleading
Substantive changes
● Non-exhaustive list of when the
‘quality enhancement test’ it not
met
● Exhaustive list of what amounts to
a ‘minor non-monetary benefit’
(permitted inducement)
● In a questionable extension of Level
1, all firms able to receive ‘minor
non-momentary benefits’
● Additional disclosure obligations
for inducements
● HOT TOPIC! Treatment of
research – far reaching statements
on how research qualifies as a
‘minor non-monetary benefit’ –
essentially proposed that research
as part of commission sharing
arrangements (CSA) would be
banned – firms would need to pay
for it like they pay for advertising
Confirmed with retractions
● Quality enhancement test list
confirmed (with minor tweaks)
● Firms must prove how quality is
enhanced
● Inducements to be disclosed
separately and priced - minor
non-monetary benefits do not
have to be priced
● ‘Minor non-monetary benefits’ list
confirmed (with minor tweaks) -
exhaustive list and to be read
strictly and interpreted narrowly
● New technical advice on
research – despite ESMA
supporting CSAs in theory
Level 3 - guidelines from ESMA
expected
Impact in the UK
15
Overall, significant impact
Minor non-monetary
benefits: FCA may need
to align its list of permitted
benefits in the table to
COBS 2.3 with ESMA’s
table. This may see a
reduction in the types of
payments that UK firms are
permitted to receive
without breaching the
inducements rules
Quality
enhancement:
Firms will need to
keep records in
order to prove
how quality was
enhanced. The
test is to “clearly
demonstrate”
Disclosure: Firms to
develop separate,
standalone inducements
disclosure documents
which contain cash
prices for the
inducements (and refer
to minor non-monetary
benefits generically)
Is this the end of
CSAs?
Storm in a tea cup as
clients still pay for
research but just in a
in different way?
Operational
difficulties with
research
requirements. How
does a manager
separate the benefit
of research from
those customers who
pay for it and those
who do not?
Unworkable?
ISSUE – Research
Can only receive research if:
• pay for it from own funds or
• pay for it from a research account
funding by clients
Cannot be linked to payment for
executing transactions
ESMA wants it extended to apply to
UCITS / AIF managers
Quality
enhancement:
Firms to take
into
consideration
ESMA’s list of
when it is not
met
Inducements (portfolio managers and
independent advisers)
EU developments
17
Level 1 Level 2
(Consultation)
Level 2 (Final)
Significant changes
● NEW COMMISSION BAN
independent advisers and
portfolio managers cannot
receive and retain third party
payments
must be passed on in full
applies to retail and professional
clients
inform clients how payments will
be transferred to them
setting off commission due to
clients from fees owed to firm not
permitted
● New policy required to ensure
commissions are allocated and
transferred to clients
● New exclusion from ban for ‘minor
non-monetary benefits’ (provided
payment complies with clients’ best
interest rule)
● Member States can gold-plate
Additional requirements
● Timing for paying over third party
payments:
no specific time limit
‘as soon as reasonably
possible’ after receipt
can transfer to the client money
account
● Include amounts received / paid
over to clients in regular periodic
reporting statements to clients
● Independent advisers would still
need to consider financial
instruments that pay commission
in order to satisfy criteria to give
‘independent’ advice
● For comments on ‘minor non-
monetary benefits’ – see earlier
slides
Confirmed
● No changes made
● EMSA has not introduced a
specific time limit for paying over
the third party payments as it
acknowledges that payments can
be received at different times
● ESMA has retained the vague
reference to ‘as soon as
reasonably possible’ after
receipt
Impact in the UK
18
Mixed impact – UK has already gold-plated MiFID II with the Retail Distribution Review
Independent advisors – minor
impact:
• Will need to extend RDR
models to professional
clients (but ‘advice’ is not the
same for professional
clients)
• Discrete query on whether
RDR ‘facilitation’ will be
impacted (as set-off
prohibited)
• Will need to extend RDR
models to include ‘structured
deposits’
Restricted
advisory firms –
no impact
UK RDR goes
further than MiFID
II
Portfolio managers –
impact!
• UK RDR only relates
to referral payments
made by discretionary
managers to advisors,
not payments they
receive
• Will apply to all clients
of portfolio managers,
not just retail clients
Product providers –
no impact when
distributing to
advisers
UK RDR goes further
than MiFID II
Product providers –
impact when
distributing to
portfolio managers
Not covered by UK
RDR
ISSUE – MiFID II ban v UK RDR
UK RDR already gold plates MiFID II
ban so FCA unlikely to reduce its
current regime
However, it is unclear how it will
address those bits of the MiFID II ban
not covered by the UK RDR – i.e.
payments received by portfolio
managers
Market commentary is that FCA is
likely to follow MiFID II ban on portfolio
managers and not seek to gold plate
with a ban for portfolio managers that is
similar to UK RDR
Platform
service
providers – no
impact
UK RDR goes
further than
MIFID II
Best Execution
EU developments
20
Level 1 Level 2 (Consultation)
Level 2 (Final TA)
Significant new requirements
● Pre / post trade transparency requirements
● All venues / entities used for execution to be published as well as top 5 execution venues by trading volume and quality of execution to be published annually
● Trading venues and systematic internalisers to publish information on quality of execution
● ‘All sufficient steps’ to be taken to obtain best execution
● Material changes to a firm’s policy to be notified in an ongoing relationship
● Best execution to be demonstrated to NCAs
● Order execution policies to be clear, easily comprehensible and sufficiently detailed
Significant extension
● Consultation Paper: – customised, tailored,
order execution policies – all venues used for
execution to be listed IN policies
– clarity on ‘material change’ to trigger review to policy and on how to satisfy best execution with a single venue / entity
– separate summary for retail clients
● Discussion Paper: – additional transparency
requirements including: – publish more
frequently than annually?
– minimum trading level before publish?
– additional disclosure requirements including: – whether top 5 venues
should be reported? – report ‘directed’ and
‘non-directed’ orders in the same way?
`
Confirmed with tweaks /
retractions
● New requirement to provide information on how execution / other factors have contributed to ‘all sufficient steps’
● No clarity on what “all sufficient steps” means
● No longer need to list all venues / entities used for extension IN policy but somewhere
● Removed requirement on firms charging both participants in a transaction to indicate this in execution policies and specify the fees charged on each leg (potentially via a range or by specifying a maximum level of such fees)
Level 2 (Draft RTS)
Extension
● Publish top 5 venues / entities within one month from year end
● Requirement to annually publish top 5 execution venues extended to RTOs / firms placing orders with third parties for execution
● Publish a vast amount of information – standardised reporting
but sufficient granularity
– for OTC, firm submitting the trade report is an execution venue
Impact in the UK
21
Major impact as UK FCA considers most UK firms merely pay lip service to best execution
Reassess whether steps a
firm takes matches up to
‘all sufficient steps’ to
achieve best execution
and how to prove this to
regulators. Unclear what
“all sufficient steps”
means – new concept for
EU law; used to “best
efforts” or “reasonable
endeavours”
Tailor order
execution
policies
Create separate
summary
disclosure
document for
retail clients and
tailor execution
policies
New procedures to
collect necessary
information so can
publish it – list top 5
venues (for each
parameter) within one
month after year end
Ensure
compliance
monitoring
programme has
‘material change’
triggers to review
policy
Plus FCA TR14/13: Best execution
and payment for order flow (July 2014)
(First time FCA substantively looked at
best execution since 2007)
-- understand which activities covered
by best execution obligation
-- reinforce monitoring capability to
identify best execution failures / poor
client outcomes
-- be clear on who has responsibility
and accountability for best execution
-- additional evidential requirements
when firms use own internalisers or
connected parties
-- consider any PFOF arrangements
List all possible
execution venues or
entities on website
and keep updated,
plus all additional
information required
by draft RTS
Respond on
draft RTS
Information to clients
EU developments
23
Level 1 Level 2
(Consultation)
Level 2 (Final)
Retains existing information
requirements but extends them
● Information on investment
advice
● Information on financial
instruments – e.g. warnings,
risks, tailored for target market
● Information on costs / charges: of services
of advice
of product
with method of payment
disclose inducements
aggregated so client understands
the overall cost and cumulative
effect on return (with itemised
breakdown on request)
provided “in good time” and
annually post-sale
● Information in client agreements
and on client assets
Significant changes
● Investment advice: Detailed
requirements to explain scope
and features of advice
● Financial instruments:
Additional requirements – e.g.
how operates in negative market
conditions, etc. can be provided
in standardised ‘fact sheet’
format
● Costs and charges: Significant
level of detail on costs and
charges – numerous prescriptive
examples provided in CP
● Client agreements: Significant
expansion – applies to
professional clients, in ongoing
advisory relationships and
custody relationships and scope
expanded significantly
Confirmed with tweaks
● Investment advice: Applies to
professional clients as well
● Costs and charges:
firms can rely on the KID
being provided for PRIIPs for
the information on product
costs and charges
disclosure needed to all
clients (including ECPs)
ECPs can agree to receive
more limited information
However, where an ECP
wishes to receive limited
information but will on-sell a
product to its clients (including
retail clients), cannot elect to
receive more limited
information
Impact in the UK
24
Moderate impact
Update systems
and control
Firms need to marry
existing information
requirements to current
UK requirements
Gap analysis of current
information produced for
retail clients and what
needs to go to
professional clients
ISSUE
How will UK FCA approach
MiFID II need to amalgamate
cost of advice and product
charges together, with RDR
requirement to completely
separate advice and product cost
ISSUE
Reliance placed on PRIIPs KID?
Access to KID?
Market structure themes
Market structure themes
26
End of the OTC, bilateral world
derivative
Trading obligations are pushing formerly
OTC trades onto venues – shares and
derivatives
“Futurisation” encouraged by EMIR
Acceptance of SI duties and evolution of
OTC dealers to full market makers or more
hybrid systems
Relevance of liquidity
Opportunities for new trading venues and
models but will competition mean continuing
fragmentation?
Determines pre and post trade transparency
requirements
Trading obligation for derivatives
A more level playing field
• New OTF category
• Little difference between obligations
on three types of trading venue
• But complexity of quote driven
markets is about to increase
Technology and systems
Desire to future proof obligations yet
difficulties in definitions to capture
intended scope
Detailed requirements for algorithmic
trading and direct electronic access
Systems build for reporting
The contours of the market debate
Headlines from the Level 2 Consultation and Final Report
Algos, HFT and market making
Direct electronic access
Transparency
Trading venues / SIs
The global dimension
Tying the big themes together
27
Issue 1: Algorithmic trading
“trading where a computer algorithm automatically determines …
parameters of orders such as whether to initiate the order, the timing,
price or quantity … or how to manage the order after submission, with
limited or no human intervention”
28
It does not include a system only used to:
Route orders to trading venue(s)
Order processing where there is no determination of parameters other than venue
Order confirmation or post-trade processing of transactions
It includes:
Automated trading decisions and optimisation of order execution by automated means
Systems that make independent decisions at any stage – e.g. on initiating, generating,
routing or executing orders
Algorithmic trading: Obligations on investment firms
Internal systems
and controls
requirements
Trading systems must:
– be resilient and have enough capacity
– be subject to appropriate trading thresholds and limits
– prevent the sending of erroneous orders
– not function in a way that contributes to a disorderly market
– not be able to be used for any purpose that is contrary to the rules of the relevant trading venue
Must have effective business continuity arrangements to deal with system failure
Ensure trading systems are tested and monitored
Records sufficient for competent authority to monitor compliance and kept at least 5 years
Regulatory
requirements
Notify competent authority of home member state and trading venue
Competent authority can require details of algorithmic trading strategies (and above systems and controls),
and any other relevant information
High frequency
trading
technique
Keep accurate and time sequenced records of orders, cancellations, executions and quotes
Cannot rely on exemptions so will need to be authorised
Market making
strategies
Must carry out continuously during a specified proportion of trading venue’s hours
Binding agreement with trading venue
ESMA proposes at least quoting and organisation requirements
Draft RTS
highlights
Draft RTS include provisions on governance, staff competence, testing, kill functionality for emergencies,
matching of algos to clients and traders, real time alerts and monitoring by an independent risk control
function, systems to flag potential market abuse suspicions, business continuity, specified pre- and post-
trade controls and IT procurement and security
Risk to run annual validation of trading system, algos and related arrangements to ensure they comply with
MiFID II, taking into account nature, scale and complexity of firm’s business and establish more stringent
requirements if appropriate
Report and supporting documents to be signed off by senior management and audited internally or externally
29
Algorithmic trading sub-sets
ESMA’s options on intraday rates
Option 1 – absolute threshold of average at
least 2 messages per second for any
instrument
Option 2 – absolute threshold of average at
least 4 messages per second for all instruments
across a venue or Option 1
Option 3 – relative threshold of daily lifetime of
orders modified or cancelled shorter than
median on trading venue – threshold between
40th and 20th percentiles
Other technical advice
To start, only liquid instruments
Only proprietary orders – firm can challenge if it
thinks client orders had led to an incorrect
classification
Engaging in HFT on one trading venue or
through one trading desk may trigger
requirements across the EU
High frequency algorithmic trading technique (HFT)
Infrastructure that is intended to minimise
latencies, including at least one of:
− co-location
− proximity hosting or
− high-speed direct electronic access
System determination of order initiation,
generating, routing or execution without human
intervention for individual trades or orders and
High message intraday rates which constitute
orders, quotes or cancellations
30
The new world of market maker obligations
31
Market making strategy
● The material points of analysis:
– ESMA departs significantly from its previous analysis on market making agreements and market making schemes
– Applies the Continuous Quoting Obligation (CQO) to all financial instruments
– Removal of duplicative organisational requirements on market makers, consistent with the industry position
“as a member of a trading venue, its strategy,
when dealing on own account, involves posting
firm, simultaneous, two-way quotes of
comparable size and at competitive prices
relating to financial instruments on trading
venues, with the result of providing liquidity on a
regular and frequent basis”
The new world of market maker obligations
32
• The main elements of the revised market making provisions are:
– An investment firm will be considered to be pursuing a market making strategy and must enter into a market making agreement when it quotes in at least one financial instrument on a single trading venue for no less than 30% of the daily trading hours during one trading day
– The market making agreement will require the market maker to quote for no less than 50% of the daily trading hours
– Only trading venues or market segments where algorithmic trading may take place shall be subject to the obligation to have a market making scheme in place
– Consistent with the industry position, there will be no upper limit of the number of investment firms that can take part in a market making scheme. However, access to incentives should be proportional to the effective contribution of the market maker to liquidity in the market measured in terms of presence, size and spread
– Trading venues have an obligation to incentivise the presence of firms engaged in a market making agreement during stressed market conditions and must make publicly available the conditions of the market making scheme
– The draft RTS allow trading venues to establish “negative incentives” for non-compliance with market making requirements
Issue 2: Direct electronic access
ESMA’s technical advice
Critical test is ability to exercise discretion regarding exact fraction of second of order entry
and lifetime of orders within that timeframe
– Where an order is effectively intermediated, it should be out – e.g. online brokerage
– Automated order router (determines trading venue but doesn’t change other parameters) – not algorithmic trading and would only be DEA if other elements satisfied
– Smart order router (determines parameters of order other than trading venues) – algorithmic trading but would not be DEA if orders routed through SOR of market member
“an arrangement where a member or participant or a client of a trading venue
permits a person to use its trading code so the person can electronically
transmit orders relating to a financial instrument directly to the trading venue
and includes arrangements which involve the use by a person of the
infrastructure of the member or participant or client, or any connecting system
provided by the member or participant or client, to transmit the orders (direct
market access) and arrangements where such infrastructure is not used by a
person (sponsored access)”
33
Direct electronic access: The chain
Main responsibilities Regulatory status
34
Client
DEA User
Underlying Client
DEA User?
Cannot be exempt by Art
2(1)(d) MiFID II but other
exemptions may possibly
apply e.g. Art 2(1)(j)
DEA Provider would have to
take into account regulatory
status of DEA User
Trading Venue
RM, MTF or OTF
Member
DEA Provider
Authorised as RM or
investment firm operating
MTF or OTF
Must be authorised credit
institution or investment firm
Must be a member or
participant of trading venue
Must notify own competent
authority and that of trading
venue – they may require
information on systems and
controls
Only allow member / participant / client to provide DEA if:
– they are authorised credit institution or investment firm
– they retain responsibility for orders and trades in relation to
MiFID II
Ensure clients using DEA comply with the requirements of
MiFID II and rules of trading venue
Must have an agreement with trading venue setting out rights
and obligations but DEA Provider must retain responsibility
under MiFID II
DEA Provider retains responsibility for orders submitted and
trades executed through the use of its DEA systems or trading
codes
Monitoring and reporting to competent authority – breach of
MiFID II or trading venue rules, disorderly trading, market abuse
Systems – to ensure suitability of clients, risk controls,
thresholds
Controls in relation to sponsored access to be at least
equivalent to direct market access
Record keeping – to enable competent authority to monitor
compliance
Direct electronic access: Obligations on investment firms
Internal systems
and controls
requirements
Ensure proper assessment and review of suitability of clients using the service
Clients are prevented from exceeding pre-set trading and credit thresholds
Proper monitoring of trading by clients
Appropriate risk controls to prevent:
– risks to investment firm
– creation or contribution to disorderly markets
– breaches of the market abuse regime
– breaches of the rules of the trading venue
Records sufficient for competent authority to monitor compliance – at least 5 years
Documentation
requirements
Binding written agreement with the client
Investment firm must retain responsibility for its compliance with MiFID II / MiFIR
Regulatory
requirements
Competent authorities of home member state and trading venue
Competent authority can require description of the systems and controls and evidence that they
have been applied
Draft RTS DEA Providers are responsible for client trading – need procedures to ensure compliance
Undertake due diligence – minimum requirements but as appropriate to risks posed by nature of
clients and their activities – annual risk based reassessment of client systems and controls
If user can sub-delegate, provider must ensure user has equivalent due diligence framework
Pre- and post- trade controls including automatic rejection of orders outside certain price and
size parameters and ability to stop order flow and monitor on ongoing basis
Ability to separately identify each DEA user
35
Issue 3: Transparency for non-equity instruments
36
Trading venues
New SI regime
Must provide quotes in liquid instruments where asked by clients and make available to other clients
Must trade if up to certain size and subject to transparent limits
Price improvement permitted in justified cases
Investment firms
Where transaction is concluded outside a trading venie
Firms must make trades public through an Approved Publication Arrangement - seller or SI
Within 15 (5 from 2020) minutes
Same timings, deferrals and suspensions as for trading venues
Make public bid and offer prices and
depth of trading interest
Extended to actionable indications of
interest
Potential waivers for:
– large in scale orders: by reference
to class of financial instrument
– orders held in an order management
facility – minimum tradable quantity
– actionable indications of interest
above a specific size that would
expose liquidity providers to undue
risk: 50% of large in scale (RFQ and
voice only)
– Derivatives not subject to clearing
obligation and other instruments for
which no liquid market: threshold
per class of financial instrument
Competent authority can temporarily
suspend disclosure where liquidity falls
Make public volume, price and time of
transaction etc: trade by trade or
aggregated
Potential deferred publication for:
– large in scale
– above a specific size
– illiquid
for no more than 48 hours but
information other than volume or
aggregated details must be published
during that period
Competent authority can temporarily
suspend disclosure where liquidity
falls: total volume for last 30 days is
less than 20-40% average monthly
volume over last 12 months
Flags should be used to identify use
of deferral
Non-equity instruments:
– bonds
– structured finance products
– emission allowances
– derivatives
that are traded on a trading venue
Pre-trade Post-trade
Transparency: Obligations & Implications
Reporting
type
Report
data
Reporting
parties
Report
recipient
Timing Fees Instrument
Types
Exemptions
Pre-trade
Transparency
Bid and
offer
prices
and
depth of
trading
Trading
Venues
Investment
Firms
Systematic
Internalisers
(pre-trade
only)
Obligatory &
delegation
not permitted
Public
(via
Trading
Venue)
Continuous
basis during
business
hours
Charge for up
to T+15
Commercially
reasonable /
non-
discriminatory
Free after
T+15 min
Equities
OTCD
ETD
Waivers (pre-trade) and deferrals (post-trade) for:
• Illiquid instruments
• Block trades
• Trades above a size specific to the instrument
Post-trade
Transparency
Price,
volume,
time of
trade
Public
(via an
APA)
ASAP
● Additional costs for market participants
● Enhanced technology
● Development of other market infrastructure
● Greater power to the competent EU authorities to monitor systemic risk and market abuse
37
Transparency: Level 2: Key Tests
38
Test References Proposed Classes and
Thresholds
Criteria Consequence
The trading
obligation
MiFIR Article 28
DP section 3.11
CP section 3.11
Draft RTS 11
EMIR classes with further sub-
classification where necessary
• Venue Test: Traded on a TV
• Liquidity Test: Sufficiently liquid to support TV only trading based on:
– Average frequency of transactions
– Average size of transactions
– Number and type of participants
– Average size of spread
Must be traded on a TV or third country
equivalent venue
ESMA has the power to identify derivatives
which are sufficiently liquid to be subject to
the trading obligation
Not a ‘Liquid
Market’
MiFIR Articles 9,
11, 18
DP section 3.6
CP section 3.5
Draft RTS 9,
Annex III
COFIA approach
Thresholds determined according to
class / sub-class
Instrument deemed liquid / illiquid on
a sub-class (COFIA)
ESMA agrees that the pre-trade
transparency waiver under Article
9(1)(c) should be clarified to prevent
this waiver from being used for
derivatives not subject to the trading
obligation (such a misleading
interpretation could suggest that the
waiver applies to a wide population
of derivatives outside the scope of
the clearing obligation under EMIR
(such as securitized derivatives)
which will never be subject to the
trading obligation)
ESMA proposes that Article 9(1)(c)
covers all bonds, derivatives,
structured finance products and
emission allowances deemed illiquid
• Average frequency of transactions
• Average size of transactions
• Number and type of participants
• Average size of spread, where available
Waiver of pre-trade transparency for TV
trading
Deferral of post-trade transparency for TV
trading
Pre-trade transparency obligations for SI
trading only apply to liquid instruments
Issues from the recent Industry Associations / FCA
Transparency meetings
39
• Liquid market test – Consultation at the end of February 2015 on derivatives and FX
• Data: Key issue that should be addressed in the responses – Debate about the data used and if this could be made available
– Confidentiality agreement – could not put the data in public domain
– Challenge to dispute and comment on proposals
• COFIA approach – Argue for more granular COFIA
– Issue: Regulators keen in not allowing too much being illiquid – G20 mandate concerns
Issue 4: The new world of venues
40
Equities
● What? Shares admitted to trading on a regulated market or traded on an MTF
● Where?
– Regulated Market, MTF, Systematic Internaliser
– Equivalent third country trading venue
● Who? Transactions between:
– Two Investment Firms
– Investment Firm & a non-Investment Firm
Only investment firms can be direct members of trading venues
● Trading obligation does not apply to trades that are:
– Non-systematic, ad hoc, irregular and infrequent;
– Carried out between eligible and / or professional counterparties and do not contribute to price discovery;
– In shares or equity instruments not admitted to trading on a regulated market or traded on an MTF; or
– Executed by non-Investment Firms
These parties / instruments can trade OTC
Derivatives
● What? Derivatives that are traded on a trading venue that are sufficiently liquid and declared subject to the trading obligation
● Where?
– Regulated Market, MTF, OTF
– Equivalent third country trading venue
● Who? Transactions between:
– Any combination of FC and NFC+
– An FC or NFC+ and a third country entity that would be subject to clearing obligation
– Two TCEs that would be subject to clearing obligation in certain cases
● Trading obligation does not apply to:
– Non-equity instruments that do not pass the liquidity test
– Any trade with an NFC- (including it trades with an FC or NFC+)
These parties / instruments can trade OTC or with a systematic internaliser (SI)
Advantages of MTFs
Market operators can capture the increased shift in
trade flow with the mandatory trading obligation
Increased competition resulting from more flexible
approach to capture this increased trade flow
Difference in regulatory approach to RMs despite legal
convergence
Whilst many of the new requirements on MTFs align
with equivalent provisions for RMs, MTFs remain
subject to less onerous technology and resilience
requirements (such as those related to systems and
circuit breakers)
From a cost perspective, lighter touch regulation than
RMs
Disadvantages of MTFs
Implication: Is it a one-way journey towards becoming
RMs?
New obligations for operators: New regulations
regarding algorithmic trading, high frequency trading
(HFT), direct electronic access (DEA) and market
making
Lack of uniform definition throughout the EU and cross-
border
Liquidity fragmentation with third country venues
Not clear whether non-CLOB functionality may be
considered an MTF
Reputational issues – does not have gold stamp of an
RM
MTFs: advantages and disadvantages
41
OTFs: The great debate missing at Level 2
Advantages of OTFs
Trading venue operators can concentrate on the
percentage of the market which will trade on an RM /
MTF and, for non-equities, also cater for those who
would use an OTF
Broadly, for non-commodity derivatives, members of
MTFs or RMs must be regulated, whereas unregulated
participants can use an OTF
For commodities derivatives, the position is more
nuanced: it appears that prop traders, e.g., locals, may
be unregulated members of MTFs or RMs provided they
(a) do not execute client orders or (b) perform HFT
An OTF has a greater level of flexibility as it has
discretion on order flow but has to be non-discriminatory
Physically settled gas and power forwards traded on an
OTF but not an MTF or RM will be outside MiFID II and
the EMIR threshold calculation
Disadvantages of OTFs
Equities are not tradeable on an OTF
Counts towards EMIR threshold (if outside narrow
exception for gas / power forwards) unlike contracts on a
RM
Increased bureaucracy (particularly as a “detailed
explanation” may be needed on why a RM or MTF has
not been used)
Full conduct of business rules apply to operator,
including best execution – as well as most requirements
for RMs and MTFs
Issues over whether an OTF can connect with another
OTF
Reputational issues – does not have gold stamp of an
RM (or possibly same reputation as an MTF)
Does best execution mean best execution on your
venue or best execution on venues in general?
42
Systematic Internalisers: Definition
Definition
● “An investment firm which, on an organised,
frequent, systematic and substantial basis deals
on own account by executing client orders
outside a RM, MTF or OTF”
Opt in
● Firms exceeding both thresholds are caught but others can opt into the regime
● ESMA will keep a list of systemic internalisers (SIs)
Why would anyone want to opt in?
● No obvious incentive unlike with equities regime
where an SI counts as a TV
● Clients might perceive benefits
● Although more flexible regime for derivatives
Liquidity
● How is liquidity defined?
● This is part of the transparency regime
Assessments should follow similar approach to
trading obligation but thresholds won’t
necessarily be the same
Derivatives
Frequent and
systematic basis
threshold (liquid
instruments) OR
Number of transactions
executed by the investment
firm on own account OTC /
total number of transaction in
the same financial instrument
in the EU
2 to 3% and
at least once
a week
Frequent and
systematic basis
threshold (illiquid
instruments) AND
Minimum trading frequency
(average during last 6 months)
At least once
a week
Substantial basis
threshold criteria
1
OR
Size of OTC trading by
investment firm in a financial
instrument on own account /
total volume in the same
financial instrument executed
by the investment firm
25%
Substantial basis
threshold criteria
2
Size of OTC trading by
investment firm in a financial
instrument on own account /
total volume in the same
financial instrument in the EU
0.5 to 1.5%
43
Systematic Internalisers: Obligations
Which derivatives?
Those for which an SI deals in sizes that are at or below the size specific to the derivative
Liquid derivatives – SI must:
Make public firm quotes when prompted by a client or when it agrees to do so
Make quotes available to other clients although it may have a policy as to which ones – and undertake to
enter into transactions when size is at or below size specific to derivative
SI can impose limits on numbers of derivatives it will enter into in respect of any quote – must be non-
discriminatory and transparent
Derivatives for which there is no liquid market
SI must disclose quotes on request if it agrees to do so
No obligations if competent authority has waived transparency obligations on TV or if it has temporarily
suspended transparency as a result of a significant fall in liquidity
Quotes
SI can update quotes at any time but can only withdraw in exceptional market conditions
Quotes must enable SI to achieve best execution and reflect prevailing market conditions but may only
price improve if price stays within a public range close to market conditions
44
MTF v OTF v SI v SEF:
MTF OTF SI SEF
Assets All financial instruments Non-equities only All financial instruments
(but OTC only)
Swaps only
Matching
System
Non-discretionary
CLOB, RFQ, RFS
Discretionary
CLOB, RFQ, RFS
Full discretion (bilateral)
RFQ, RFS
Discretionary
CLOB, RFQ, RFS
Restrictions on
Multilateral
trading
Cannot execute against
own capital and no
matched principal trading
Matched principal is
allowed if client is
informed
Market making must be
independent
Cannot operate a
multilateral trading
system
Permits limited matched
principal trading
Other
Restrictions
Can operate an SI and
can connect to SI
Cannot operate an SI and
cannot connect to another
OTF
Cannot operate an OTF Limit on dealer ownership
Participants Regulated only (not for
commodity derivatives)
Can be unregulated Clients only Eligible Contract
Participants
Investor
Protection
Very few COB rules Full COB rules apply
including best execution
Full COB rules apply
including best execution
Core principles apply;
SEF has discretion to
examine best practices
and regulations
Resilience Limited requirements
(mainly HFT focus)
Limited requirements
(mainly HFT focus)
Limited requirements
(mainly HFT focus)
Detailed requirements
Purpose of new
rules
Requirements have been
aligned with those of RMs
in order to create a more
level playing field
Replace broker crossing
networks
Replace broker crossing
networks
Replace broker crossing
networks, as well as
regulate secondary
markets for swaps
45
Issue 5: The global dimension
● Mandatory trading will be permitted on third country equivalent markets under Article 28 of MiFIR
– This will not give markets a “passport”: It is an eligibility criterion but the implicit position is that member states will retain discretion to implement their domestic regimes
– Broad equivalence requirements
● Third country firms providing investment services or activities to ECPs or per se professional clients will need to be on the ESMA register
● Equivalence assessment by Commission of third country jurisdiction’s law: Likely to be same approach as under EMIR, ie voluntary “top up”
● Three year transitional period after equivalence assessment when current domestic regime can be relied on
– Where does this leave the overseas persons exclusion under Article 72 of the Regulated Activities Order?
46
Tying the big themes together
● Global structuring and group structuring
● Where does a market or firm want to position itself?
● New categories of firm or market need to be fitted to the firm’s / market’s business
● Pros and cons of being:
– MTF/OTF
– SI
– APA or ARM
– Market maker
● Pros and cons of different types of algo trading and HFT
● Is the EU too difficult a place to stay in? – The offshore option
47
