By Heinrich Degener (MIFM), Associate at Delta Capita
D-day for one of the most comprehensive regulation changes for European financial markets is fast approaching as corporate South Africa winds down for its festive season break.
Come January 3 2018, Europe’s Markets in Financial Instruments Directive II (MiFID II), or ‘Directive 2014/65/EU’, will kick into gear.
MiFID II has been seven years in the making and certain aspects of this new regulation will affect companies operating outside of the EU. Regulators see MiFID II as bolstering protection for investors, improving the functioning and efficiency of financial markets, and injecting transparency into all asset classes.
New rules on the unbundling of research, legal entity identifiers, client categorisation and pre- and post-trade transparency and reporting obligations are among aspects whereby South African financial market players will be impacted if they do business with EU counterparties from 3 January onwards. Virtually every investment bank, asset manager or broker that does business with Europe will have to comply, with non-compliance meaning everything from an inability to conduct business to being subject to the hefty MiFID II fines of up to 5 million euros or 10% of annual turnover.
The original Markets in Financial Instruments Directive (MiFID, Directive 2004/39/EC) has been a cornerstone of European Union financial markets regulation since 2007.
MiFID provided consistent regulation across member states of the European Economic Area, impacting 28 EU members as well as Iceland, Norway and Liechtenstein. It improved their competitiveness by creating a single market for investment services and activities while ensuring a high degree of protection for investors.
Provisions around best execution, systematic internalisers, pre- and post-trade transparency, passporting and client categorisation come to mind — this was further combined with largely increased reporting requirements.
But, the Global Financial Crisis (GFC) sparked a rethink of MiFID, and in 2009 the G20 Pittsburgh Summit decided that the regulation needed to be changed.
Based on input from the European Securities and Market Authority (ESMA) and further public consultation, legislative proposals for the amendment of the original MiFID were published by the European Commission in 2011.
After much consultation and heated political and public debates, MiFID II and MIFIR (Markets in Financial Instruments Regulation) were published in 2014, with an original effective date of 3 January 2017.
Subsequently, this deadline has been pushed back to 3 January 2018 to allow for adaptations of IT systems.
Key Objectives and Measures of MiFID II
Before delving into aspects of MiFID II that are relevant for South African market participants, it’s important to understand the wider context of how it addresses the shortcomings of the original MiFID and responds to lessons learned during the GFC.
The objective of MiFID II is to strengthen investor protection and improve the functioning, efficiency, resilience and transparency of financial markets. As such, the relevant provisions occur across the following categories:
Market Structure A chief consideration is the creation of a level playing field among market participants to ensure that increased competition benefits retail and institutional clients. Key measures include limitations on trading away from regulated market or multilateral trading facilities (MTF) in so called ‘dark pools’. It further includes the introduction of Organised Trading Facilities (OTF) for non-equity instruments as a new trading venue category, open access to trading venues, CCPs and benchmarks; and a more restrictive regime regarding algorithmic or high-frequency trading (HFT).
Market Transparency Increased pre- and post-trade transparency for all market participants is intended to counter the largely increased cost and complexity which was an unintended side effect of the original MiFID regulation. This comes with largely increased regulatory and client reporting requirements for all asset classes, near-real-time reporting requirements to regulators and the development of European consolidated tape. Regulated markets — including MTFs and OTFs — are required to publish bid-ask spreads as well as the depth of the book per product. All trading venues and members need to further operate on a synchronised clock.
Investor Protection To counter the rapid innovation and growing complexity in financial instruments, regulatory oversight of products (including bans or limitations on marketing to retail investors) will be introduced. This also includes a ban of inducements to independent advisors and tightened disclosure rules for payments made. This further involves a revised suitability and appropriateness regime for complex products with embedded derivatives, ultimately targeted at reducing mis-selling.
External Controls / Reporting This category constitutes a comprehensive refresh of controls for trading where developments in the markets, products and technology have outpaced existing regulatory provisions. Core provisions in this area include certain trading bans and position limits for commodity derivatives, additional reporting requirements to regulators, and the provisions around third country access, which have been subject to heated debates and numerous revisions.
Internal Controls / Record Keeping Weaknesses in the regulation and transparency of non-equity financial instruments, both at trading and retail investment advice levels, are set to be addressed. The provisions comprise extensive record keeping requirements, enhanced governance on governing board and committee compositions, as well as prescriptive time commitments that will need to be adhered to.
Relevance for South African Financial Markets Participants
In light of these new regulations, there are pertinent extraterritorial implications for South African market participants dealing with Europe or EU counterparties.
Legal Entity Identifier (LEI)
The Legal Entity Identifier (LEI) is a 20-digit, alphanumeric code that enables clear and unique identification of legal entities participating in financial transactions. LEIs, like other identifiers, are needed by firms to fulfil their reporting obligations under financial regulations and directives. LEIs are also key for matching and aggregating market data, both for transparency and regulatory purposes.
The LEI is already required under a number of existing EU regulations: European Markets Infrastructure Regulation (EMIR), Market Abuse Regulation (MAR), Capital Requirements Regulation (CRR), Alternative Investment Funds Directive (AIFMD) to name just a few.
As recent as 9 October 2017, ESMA published a briefing (ESMA70-145-238) to clarify certain aspects around the LEI.
The new regulation introduces requirements for several entities, and the briefing makes explicit references to the following:
investment firms that execute transactions in financial instruments;
the clients (buyer, seller) on whose behalf the investment firm executes transactions, when the client is a legal entity;
the client of the firm on whose behalf the trading venue is reporting under MIFIR Article 26.5, when the client is a legal entity;
the person who makes the decision to acquire the financial instrument, when this person is a legal entity e.g. this includes investment managers acting under a discretionary mandate on behalf of its underlying clients
the firm transmitting the order;
the entity submitting a transaction report (i.e. trading venue, ARM, investment firm); and
the issuer of any financial instrument listed and/or traded on a trading venue
All the above entities must have an LEI, even if they had no previous legal obligation to obtain one, and regardless of where they are operating from or legally based. Without an LEI, they would not be able to trade.
Third Country Rules
Of all provisions within the MiFID II regulation, the Third Country Rules are among the most hotly debated components, with numerous revisions to drafts. These rules affect ‘third country firms’, which are entities incorporated outside the EU.
The regulation attempts to harmonise the provision of investment services by third country firms operating within the EU. However, this harmonisation is limited in scope and depends on, among other things, the operation model the firm decides to employ (via local branch or on a cross-border basis) and the type of clients it seeks to serve.
Cross-border For a third country firm to provide investment services to eligible counterparties and professional clients, it needs to be registered with ESMA. Registration is subject to conditions relating to the existing regulations in the respective home country of the third country firm. For example, this requirement would consider whether an equivalent conduct or prudential regulation exists, or if there is authorisation and supervision of the service provision.
Local Branch A member state may require third country firms to open a local branch to provide investment services or perform investment activities to clients. The respective national regime and regulations will continue to apply to such branches. As for the cross-border model, the branch authorisation by the member state is subject to a number of conditions relating to home country authorisation and supervision, home country provisions on AML and general adherence to Financial Action Task Force (FATF) recommendations. It also considers the likes of cooperation agreements among respective regulators.
Exclusive initiative of the client Under certain conditions, a third country firm may also provide services to a client based in the EU without authorisation or registration in the EU. This is applicable to cases where the service is provided upon exclusive initiative of the client. However, this comes with a series of complications, especially in terms of the provision of follow-on services. That is, the initiative needs to be exclusive on a per service basis and not on a relationship basis, and it is generally regarded as a risky approach for any third country firm.
MiFID II doesn’t necessarily change the existing client classification that was introduced in MiFID. As per the original directive, clients either constitute ‘retail clients’ or ‘professional clients’ with professional clients having a subcategory of ‘eligible counterparties’ as the most experienced players in the financial market. As such, retail clients benefit from the highest level of protection under MiFID II, whereas professional clients enjoy less protection.
Eligible counterparties are professional clients who are active in the financial sector and who are deemed to have the required experience to take investment decisions. This category only applies in respect of certain investment services, and has the lowest level of protection under MiFID II.
There are, however, changes in the default categorisation of certain entities, as well as changes to the opt-up / opt-down provisions. All firms impacted by the extension of MiFID II are advised to review their client base and categorise accordingly.
Best execution refers to the obligation of the investment firm to achieve the best price and execution modalities (including post-trade) for their clients.
In a fragmented market like the EU — which has numerous trading venues, multilateral trading facilities or systematic internalisers — this is already quite a daunting requirement for investment firms.
Within South Africa, though, the market has historically been monopolistic in nature and new exchanges have only recently been licensed. Of the new South African exchanges, only one is offering secondary listings for entities listed on the dominant exchange. And to date, only a few companies are listed on this new exchange, with market participants still needing to join as members. So the topics of interoperability and best execution will soon come into play in the South African market, and players will need to familiarise themselves on smart-order-routing to achieve best execution across multiple trading venues in the near-term.
Under MiFID II, EU firms using South African firms for local execution will likely require the companies to have an order execution policy, and also demonstrate that sufficient steps are taken for best execution. This may include supplying execution reports to show that they are executing in their clients’ best interest
Unbundling of Research and Trading Commissions
MiFID II demands an unbundling of research cost from the actual trading cost or trading commissions. Research, therefore, can no longer be received as a ‘free’ value-added service on the back of commissions paid for brokers and investment banking services such as trading and execution.
These costs will need to be explicitly covered, for instance, from a separate research payment account. The research received is separately priced and must not correlate to the trading volume or value. The onus for compliance is on the investment firm receiving the research — not on the providing party.
EU firms then will require their executing brokers to either unbundle the price of research or move to an execution-only fee to comply with MiFID II rules. There may also be implications to agree on specific or dedicated research budgets up-front.
Recording and Clock Synchronisation
With regards to increased pre-trade transparency, MiFID II dictates that all interactions that lead to a transaction must be recorded and securely stored. This requires financial market participants to capture and retain all communication among sellers, buyers and investment mediators. Records will have to be kept for a minimum of five years.
In today’s omni-channel environment, market participants will have to cater for the various communication channels, from voice to email, instant messaging and even video-chat.
Another technical requirement is the clock synchronisation with its related time-stamping provisions. This requires firms and venues to timestamp events accurately relative to Coordinated Universal Time and to an appropriate level of granularity, under the Commission Delegated Regulation (EU) 2017/574 (best known as Regulatory Technical Standard RTS-25).
Granularity depends on the type of activity. For example, the requirement for voice recordings is at the second-level granularity and maximum divergence. Meanwhile, high-frequency trading activities will need to be captured in microsecond accuracy with a maximum divergence of 100 microseconds. All other activities need to be time-stamped on millisecond-level with a maximum divergence of 1 millisecond.
Outlook for South African Regulation
The provisions and implications covered in this article are just a starting point for firms to assess their readiness for MiFID II compliance.
Some provisions impact South African market participants with clients and contracts in the EU directly, whereas others are more indirect in nature, or may only evolve as the regulation is enforced and transition periods for certain provisions lapse.
Market participants that currently do not have business in the EU must consider that South Africa, as a G20 member, tends to adopt global best practices. There is a high likelihood that much of the local financial markets regulation will be further harmonised with MiFID II in years to come.