The Markets in Financial Instruments Directive 2 (MiFID II), took effect in January 2008, revising the original Markets in Financial Instruments Directive (MiFID I) of November 2007. Its purpose? To strengthen investor protection and establish a harmonised market after the financial crisis of 2008.
In a G20 Leaders’ statement in London on 2nd April 2009, a shared sentiment was echoed for a need of greater transparency in the market. Something that could reduce over-the-counter trading or dark pools. Regulations were needed to strengthen the framework, protect investors and increase transparency.
The regulation is made up of:
If you want to see a full-length glossary of terms relating to MiFID II, you can visit the European Commission website. For the purposes of this article and the points I raise in it, I have summarised the terms that will come up most often..
A type of financial instrument whose value is based on the change in value of the underlying asset.
A private and unregulated exchange with a basic lack of transparency. As of spring 2014, there were 45 dark pools in the USA. They were estimated to account for 15% of all trades in 2014.
An asset or evidence of ownership of an asset as well the contractual agreement to receive or deliver ownership of an asset. As Annex I, section C states, this extends as far as:
Multi-lateral trading facilities or (MTFs) were introduced by MiFID to replace Alternative trading systems (ATSs), which were not subject to specific EU regulation. An MTF brings together multiple third-party buying and selling interests in financial instruments in a way that results in contracts. They could be operated by market operators or investment firms.
Examples of MTFs include:
Over-the-counter trading does not take place in any regulated financial market or MTF. Transactions conducted directly between two parties without the need for an exchange. In 2008, approximately 16% of all trades were considered “off-exhange”; by April 2014, that number increased to 40%.
A facility operated by an investment firm or market operator that brings together third-party buying and selling interests relating to financial instruments. Equities are not permitted to trade in an OTF. According to the European Commission:
“Examples of organised trading facilities would include broker crossing systems and inter-dealer broker systems bringing together third-party interests and orders by way of voice and/or hybrid voice/electronic execution.”
A system which conducts transactions that results in a contract by bringing together multiple third-party buying and selling interests in financial instruments. The London Stock Exchange or the Frankfurt are examples of a regulated market.
Client’s payment for research must be reported on and funded by research payment accounts.
Trading venues are where securities are exchanged. This can include MTFs and RMs.
Investment firms are required to report to competent authorities all trades in financial instruments on an RM regardless of whether that trade takes place on the market or not. It covers OTC trades. Unlike pre and post trade transparency, it does not require public reporting or extensive details of the trade.
Firms which systematically deal with clients outside of an RM, OTF or MTF.
According to the FCA, MiFID II applies to:
The European Securities and Markets Authority (ESMA) issued consultation papers on MiFID in April 2010 and shortly after, in December 2010, the European Commission released a consultation relating to the review and in October 2011 the European Commission published a formal proposal for the Regulation on Markets in Financial Instruments (MiFIR), which amended the European Market Infrastructure regulation (EMIR).
MiFID II and MiFIR entered EU law on 2nd July 2014 with the initial date of implementation for member states being 3rd January 2017. In February 2016, the European Commission set the date back until 3rd January 2018 to allow more time and investment for technology.
MiFID II seeks to strengthen MiFID I by focusing on investor protection, best execution, unbundling research and transparency through reporting.
MiFID II looks to strengthen the relationships with investment firms and their clients by introducing investor protections through governance and strengthening the conduct of business. It covers the following areas:
In March 2015, the Financial Conduct Authority published the Thematic Review 15/2, which says:
“Retail consumers generally struggle to understand the relative merits of structured products and the factors driving potential returns. They find it difficult to compare alternatives and to make full use of analytical information. It is essential that firms take steps to bridge this gap.”
The MiFID II has set out to establish a clear set of guidelines around product governance with a focus on management bodies approving and overseeing these policies. Guidelines will see that boards and executive committees get involved in product approval, selection of markets and ongoing review of how the product is distributed.
The Financial Conduct Authority analysed improper advice and found that there were likely three reasons for poor advice:
More regulations for firms will provide “due diligence” solutions in an unregulated market where they will be required to ensure they understand the nature and features of products they select for their clients. They will also be required to assess whether alternatives are available that would better meet their client’s objectives.
MiFID II will introduce a new inducement regime for firms providing independent advice or portfolio management, like requirements already introduced in the UK under RDR to address the risk of advice being based on biased recommendations.
MiFID II seeks to add additional stipulations to the already existing Remuneration Code, stating that:
This is an important policy that will help to protect the consumer.
MiFID I primarily dealt with equities whereas MiFID II focuses on fixed income, non-equity instruments and equity light transactions that are not traded on a MTF. Under MiFID I and MiFID II, Article 27, firms must take sufficient steps to obtain the best results for their client, considering:
Under article 64 of MiFID II adds that firms must consider:
This could mean, using more than one venue of execution, publishing annual reports of the top five execution venues or brokers by trading volume and gather market data and compare product pricing.
The goal of trading transparency is to reduce opaque parts of the market such as derivatives being traded privately. It also set about to reduce the use of dark pools. As a result, venues, and that includes regulated markets, multi-lateral trading facilities and organised trading facilities must publish current bid and offer prices and the depth of trading interest on a continuous basis.
A continuous basis means every minute for equity and equity-like instruments and every fifteen minutes for fixed income instruments.
In MiFID 1 transaction reporting only applied to financial instruments trading on a regulated market. Current UK rules extended this to trading on a UK prescribed market and UK derivatives, for example contracts for difference or total return swaps.
Under MiFID II, the reporting requirement will be extended to all instruments traded on RMs, MTFs, OTFs, or to which the underlying security is admitted like an option or swap (where the security is in the third-party). The number of reporting fields has also increased from 23 to 65 under MiFID II.
ESMA stipulate that all reporting is done using a Legal Entity Identifier or LEI. Issuance of an LEI code to identify counterparties in reporting transactions also helps to increase transparency by identifying relationships between parties. This gives greater power to the investor to make an informed decision. To find out more about Legal Entity Identifiers, read my last post: ‘What is a Legal Entity Identifier?’.
There are increased requirements for client reporting and transaction reporting in MiFID II to competent authorities through the approved publication arrangements. Any financial instrument admitted to trading on a EU trading venue is required to conduct post trading reporting.
Trade review may look at how transactions are taking place in the market, yet transaction reporting looks at the parties within a trade. Fields include asking for:
Transaction reporting doesn’t need to be nearly as frequent as trade reporting.
Equity and non-equity waivers have been introduced through an application process as MiFID II does recognise that public disclosures, especially immediate ones, can result in a reduced liquidity and increase cost of execution for investors. As such, the FCA and other competent authorities are granted permission to authorise post-trade deferrals. Ability to defer, under MiFID II, has been extended to OTFs who meet certain requirements.
EU investment firms will no longer be allowed to take part in any third-party benefits, monetary or not. Research would constitute under such benefits. Under MiFID II, this could be viewed as an inducement which could create conflict of interest between the investment firm and its clients. Investment firms must now explicitly separate out these research charges.
In addition to unbundling, MiFID II requires a written policy covering at least:
Research payments accounts or RPA’s are separate accounts which will be client funded. The charges should be separately identifiable to the client and may be per transaction or via a fixed periodic fee from the accounting model.
Client funds in an RPA must be controlled by the investment firm, meaning they may not be carried on a research firms balance sheet. Regular quality assessments must be carried out by the manager to demonstrate specific benefits which accrue to the funds of investors and shareholders.
Lastly, before providing investment and services, the firm must project overall charges as well as reporting annual information.
It would be difficult to summarise MiFID II, a thousand-page document, without skimming over some points. If you’re reading this and you know MiFID II concerns you, get some legal advice right away! I am not a lawyer.
Summarising the regulation isn’t easy but I think in a briefer note, we can conclude that MiFID II seeks to strengthen MiFID I with the principles of:
Each area works together to set a firm stance on the future of economic stability. Our current practices are not good enough and evidence is wrought in our history. We must take responsibility and start practising accountable and ethical trading. Thanks to regulations like MiFID II, we can at least make a start.
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