The Markets in Financial Instruments Directive II (MiFID II) entered into force on July 2, 2014, and must generally apply within Member States by January 3, 2018. MiFID II will drive significant changes to wholesale markets in the EU and impacts virtually all participants in those markets, some of them very significantly. MiFID II and its sister regulation the Markets in Financial Instruments Regulation (MiFIR) significantly builds upon the original MiFID (which they replace) in number of areas.
Some of the MiFID II changes are aimed at increasing market stability following the financial crisis, but many will significantly increase the scope of the regulatory perimeter, bringing transparency to previously opaque markets and new regulations across a wide range of activities.
With major implementation efforts required, firms should take action now. Below we set out the key changes.
1. Transparency in wholesale markets
The current MiFID transparency regime for equities is being extended to cover liquid instruments in the fixed income and derivative markets. New regimes will govern both pre- and post-trade transparency, with waivers (for pre-trade) and deferrals (for post-trade) structured in a similar way to the equity market rules.
Action: Firms should examine how the changes will affect the different asset classes they trade, new transparency obligation they may have and how their business model could be affected.
2. New regulated trading platforms
The original MiFID introduced a regime governing for regulated markets and multi-lateral trading facilities (MTFs) for the trading of equities. That regime is now being expanded under MiFID II to govern all multi-lateral mechanisms on which equity, fixed income and derivative products are traded. This means that many of the activities of inter-dealer brokers, regardless of whether they use electronic, voice or hybrid models, will be regulated as trading venues alongside the exchanges and MTFs.
Action: Firm should examine their current and future business models to ascertain whether they require additional permissions to operate one of the new MiFID II trading venues.
3. Commodity markets
MiFID II will bring in new position reporting requirements covering all market participants and a position limits regime, which will allow regulators to cap the positions held by firms in particular commodities contracts. The aim of the new rules is to ensure that underlying supply and demand in the physical commodity markets is not distorted by financial speculation in commodity derivatives.
Action: Firms that trade commodity derivatives should prepare themselves for position reporting obligations and the potential impact of position limits.
4. Algorithmic trading
There will be enhanced scrutiny by regulators of algorithmic and high frequency trading including the direct regulation of any previously unauthorized firms engaged in such activities. Firms using algorithms will have obligations to have the appropriate systems and controls in place to prevent market disruption and a new regime will govern high-frequency electronic market making.
Action: Firms using algorithms to trade should analyze how the legislation may impact them.
5. Best execution
MiFID II requires firms to enhance their execution policies and level of disclosure of those policies to their clients. The legislation also requires trading venues to publish significantly more data about execution quality.
Action: Firms will need to revise and update their best execution and order routing policies.
6. Research and dealing commission
MiFID II seeks to address the potential conflict of interest that arises when an asset manager trades with a broker or bank that provides it with research that is paid for using execution commissions. The new regime will govern the purchase of research using execution commission much more closely and will oblige asset manager both to budget for and to value the research they receive across all asset classes.
Action: Firms will need to revisit their current Commission Sharing Arrangements (CSAs) to ensure they meet the MiFID II requirements and develop new governance arrangements for the purchase of research.
7. Transaction reporting
The scope of transaction reporting to the FCA is increased significantly by MiFID II and the amount of detail required in the reports is markedly greater. In addition, many buy-side firms that have not previously had to report to the FCA will be obliged to do so.
Action: Firms should identify whether they will need to transaction report under MiFID II and plan accordingly. The lead times in relation to such system issues may be significant.
8. Retail investor protection
MiFID II contains measures governing suitability and appropriateness assessments, as well as new product governance rules for developers and distributors of financial products. In addition, the requirements when disclosing costs and charges to customers will be considerably more prescriptive.
How Duff & Phelps can help
Our highly qualified team of former regulators and experienced consultants can provide assistance with:
- Conducting a gap analysis and impact analysis enable firms to identify how MiFID II and MiFIR will affect them
- Budgeting and planning for MiFID II changes, in particular those with major system implications such as transaction reporting
- Advising firms on updates to procedures and policies governing best execution, dealing commission and client communication
- Obtaining the relevant authorizations and permissions to operate under the new MiFID II regimes
Duff & Phelps provides in-depth insight into current and upcoming regulations that impact the financial services industry.