MiFID II is designed to bring greater transparency and investor protection to the financial markets. It introduces more protection for all investor types from retail to professional and extends the types of financial instruments in scope.
Impact beyond Europe
Markets directly impacted include France, Greece, Malta and the UK. Although it is a law in the Euro, the impact of the new rules is far-reaching and effective worldwide. MiFID II is applicable across the European Union (EU) and has relevance for countries in the European Economic Area (EEA) which are not in the EU. This means any firm across the EEA that conducts investment activities or services in financial instruments will be subjected to the new rule.
The regulation will have an indirect impact beyond Europe, such as APAC. MiFID II does not directly apply to non-EEA firms, but it is relevant primarily where there are employees assisting in the origination of EEA underwritten MiFID II products and services, for example, debt and equity insurance.
MiFID II does not generally have an extraterritorial effect, but
- It would apply if a non-EEA entity were carrying out MiFID investment services in respect of FiMID products in the EEA
- Specific provisions have express extraterritorial effect, e.g. transaction reporting requirements apply to all branches of EEA entities
There are four main areas of impacts:
- Research — it is considered an inducement under MiFID II and therefore receipt of free research is banned.
- Reporting — Transaction reporting is to include additional trade details, including cost elements. All periodic statements need to be quarterly at a minimum. An investor will be notified when there is a 10% depreciation of a discretionary portfolio, FX Operations or FX forwarded contact.
- Best execution — investors will now have visibility of the quality of execution received and the venues used.
- Manufacturing and distribution — investors will need to be assigned Target Market attributes. Products will also need to be analyzed for Target Market to ensure not selling products to negative Target Market investors.
1. Research Unbundling
MiFID II adds a further restriction for portfolio managers and independent investment advisers. Research is permitted provided it is paid for separately from execution costs. They can only receive research and sales if both are paid for either
- Directly out of their own resources or
- Through a client funded Research Payment Account (RPA)
Therefore, the fee of analysis report service would constitute the transaction fee, which would be paid separately from execution. The research and execution costs must be disaggregated and disclosed with the agreement relating to the research payment clearly states the budget for research and other services. The new RPA-related agreements allocate research budgets in advance. The research and sales must be logged. This research unbundling prevents potential conflict of interest. Some bank analysts are looking very nervously at the new changes fearing their jobs are about to go. Others analyst at smaller or independent companies sees it as a chance to get pay fairly for the quality of their work.
Independent advisers and assets managers cannot receive inducements unless they are “minor non-monetary benefits”, or they pay for them. The list of “minor non-monetary benefits” is prescriptive and includes generic information and corporate issuer.
MiFID II is introducing Quarterly reports in relation to holdings and discretionary portfolio management. New requirements for firms holding an account that includes leveraged financial instruments (LFIs) or other contingent liability transactions (CLTs) to report to the investor if the initial value of the instrument depreciates by 10%, and thereafter by further multiples of 10%..
LFIs and CLTs include instruments where investors are exposed to any actual or potential liability that exceeds the cost of acquiring the instrument or where exposure to the underlying risks may be magnified. This includes Options, Swaps / Forwards / Futures and Structured Products.
Boarder scope of the financial transaction now needs to be reported. Both counter-parties (investment firms) to trade must report transaction data (65 fields, which include investor details) to regulators. Reportable data includes information on the person or algorithm responsible for the investment decision and execution. Transaction Reporting may be done through an investment firm’s own arrangements, an Approved Reporting Mechanism (ARM) or by the trading venue through which the transaction was completed no later than the close of the following working day.
Best Execution means a regulatory duty for firms to take all enough steps to obtain the best possible result for clients, taking into account price, costs, speed, the likelihood of execution and settlement, size, nature or any other relevant consideration. Also, MiFID II requires venues to provide reports on the quality of execution, free of charge and downloadable in a machine-readable format. The best execution disclosure statement would include execution venues.
MiFID II introduces the new Organised Trading Facility (OTF) for non-equity instruments. It allows counter-parties to cross and the venue operator to exercise discretion. It is a multilateral system where multiple third-party buying and selling interest in bonds, structured finance products, emission allowance or derivatives are able to interact. All venues will be subject to pre- and post-trade transparency requirements.
Systematic internaliser (SI)s are investment firms that deals on own account when executing client orders on an organised, frequent, systematic and substantial basis outside of a trading venue. Specific threads hold has been introduced to determine whether a firm is an SI. The regime applies to all financial instruments.
For algorithmic and electronic trading, investors would have to evidence their ability and disclose the algorithms they are using and are required to have additional controls in place. They would need effective systems and risks controls in place with appropriate threshold and activity/risk limits.
4. Manufacturing and distribution
Investors should be categorised when they are on-boarded for the purposes of conducting investment activities or providing investment services, and this categorisation should be done a legal entity level. An investor categorisation will affect the regulatory obligations of firms. For example, you may be categorised as either An Eligible Counter-party (ECP), a Professional or a Retail investor. Local Authorities and small corporates that are retail by default can request to Opt-Up. Any parties transacting in a MiFID II product requires a Legal Entity Identifier (LEI).
MiFID II introduces the requirement for both manufacturers and distributions to identify a target market for the products they manufacture/distribute respectively. This analysis also needs to consider any negative target market, which is the population of customers that a product should not be sent to. Not all products are in the scope of MiFID II, for example, FX spot is out of scope.