By Norton Rose Fullbright
1. Where are we now?
The Markets in Financial Instruments Directive (recast) (MiFID II) and the Markets in Financial Instruments Regulation (MiFIR) were published in the Official Journal of the EU on 12 June 2014 and entered into force 20 days later. Both apply from 3 January 2017.
Whilst the framework legislation has been agreed for some time we are now entering a critical period in which the Level 2 implementing measures, which add the detail to the framework legislation, need to be finalised and Member State regulators have to prepare for the transposition of the new regime.
On 19 December 2014, the European Securities and Markets Authority (ESMA) published two key papers which follow up on its work in the summer of 2014 concerning the possible content of the Level 2 implementing measures which will take the form of delegated acts and technical standards (regulatory technical standards and implementing technical standards). ESMA published a final report containing its technical advice to the European Commission (the Commission) on the possible content of the delegated acts. It also published a consultation paper seeking stakeholders’ views on the draft technical standards. The deadline for comments on the consultation paper is 2 March 2015. In addition, an open hearing on the consultation will be held by ESMA in Paris on 19 February 2015.
It is worth noting that in the third section of the consultation paper covering transparency, ESMA presents an analysis of non-equity instruments aimed at calibrating the new transparency rules through appropriate thresholds. However, the analysis does not cover foreign exchange derivatives, credit derivatives, other derivatives and contracts for difference. For these asset classes ESMA will produce a separate consultation paper with a similar analysis to that undertaken for the other asset classes. It is expected that this consultation paper will be published in early 2015.
2. Product governance
In its technical advice to the Commission ESMA has clarified the definition of ‘manufacturer’ and ‘distributor’, thus making it clearer to whom MiFID II’s product governance obligations apply to. A ‘manufacturer’ will be a firm which creates, develops, issues and/or designs investment products and is intended to capture a broad range of firms (including corporate issuers on the launch of new securities). A ‘distributor’ will be a firm that offers and/or recommends investment products and services to clients. In this context, ‘offers’ has a wide application and is to be read in a broad sense. Where firms are involved in both the manufacture and distribution of products, both set of rules on product governance apply.
ESMA also notes in its technical advice that the product governance requirements set out in MiFID II are intended to apply to investment firms authorised under the Directive. However, ESMA also notes that the requirements could equally apply to other entities subject to MiFID, such as UCITS management companies and alternative investment fund managers, when such entities are authorised to perform MiFID investment services and only in connection with the performance of such services. Going forward ESMA believes that the Commission should consider the possibility to align the relevant articles under the UCITS Directives and Alternative Investment Fund Managers Directive with the product governance obligations of manufacturers.
ESMA also notes in its technical advice that the majority of respondents disagreed with the proposals in its earlier consultation to require distributors to periodically inform the manufacturer about their experience with the product. ESMA states that, in its view, such reporting can be beneficial for the functioning of product governance obligations. However, this does not mean that distributors need to report every sale to manufacturers, or that manufacturers must confirm that each transaction was distributed to the correct target market. According to ESMA, the relevant information could include, for example, information about the amount of sales made outside the target market, summary information of the types of client, a summary of any complaints received or by posing questions suggested by the manufacturer to a sample of clients for feedback. For distributors, ESMA states that the obligation is to provide the data that is necessary for the manufacturer to be able to review the product and check that it remains consistent with the needs, characteristics and objectives of the target market as defined by the manufacturer themselves. ESMA also considers that it should be possible for a distributor to use the scenario analysis of products conducted by manufacturers in order to comply with their obligation to provide fair, clear and not misleading information to clients.
3. Using dealing commission to pay for research
In its earlier discussion paper ESMA made certain detailed comments regarding how investment research could amount to a minor non-monetary benefit. ESMA’s original proposals effectively meant that, in practice, firms might have been prevented from their current practices of receiving ‘free research’ paid from dealing commission. Whilst ESMA has now retracted certain elements of its proposals in its consultation paper (for example it has declined to include the list of items by which research could amount to a ‘minor’ non-monetary benefit), it is now proposing that portfolio managers and independent advisers can only receive research by paying for it directly from their own accounts or from a separate research fund (paid for by fees charged to clients). Furthermore, it is proposed that the payment of research is not to be linked to the payment for executing transactions. In essence, it appears that dealing commission may need to be unbundled. Also, ESMA is recommending to the Commission that it considers similar requirements for UCITS and alternative investment fund managers.
4. Complaints handling
Despite earlier market push-back, ESMA has retained its requirement that complaints handling guidelines apply to both retail and professional clients (both per se and elective professional clients). ESMA has also tried to clarify what amounts to a ‘complaint’ by stating that it is “a statement of dissatisfaction addressed to a firm by a client or potential client relating to the provision of investment services”. However, such a high level description may not be of material assistance. In addition, despite market push back, complaints handling applies to potential clients as well as clients.
ESMA also notes that a number of respondents to its earlier consultation queried the role of the compliance function in managing the complaints-handling process. In its technical advice ESMA responds by stating that in order to ensure that the complaints are handled in an independent manner it is important that a complaints management function is established and that the compliance function should be able to perform this role. In addition, ESMA states that the compliance function should consider complaints as a source of relevant information in the context of its general monitoring responsibilities and that a management body has clear oversight of how its firm handles complaints.
5. Market making
In its consultation paper ESMA departs from its previous analysis on market making agreements and market making schemes. In particular, ESMA proposes to apply the controversial continuous quoting obligation to all financial instruments. Trading venues allowing or enabling algorithmic trading would be required to have market making schemes in place for investment firms engaged in algorithmic trading.
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;
exceptional circumstances are expansively defined and include volatility, but only where all trading on a venue is interrupted. So called “stressed market conditions”, including ‘fast markets’ would not be considered exceptional circumstances;
there will be no upper limit on 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; and
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 technical standards allow trading venues to establish “negative incentives” for non-compliance with market making requirements.
6. COFIA approach for liquid market definition
In the consultation paper ESMA has elected to use the classes of financial instruments (COFIA) approach for the liquid market test for pre- and post-trade transparency for non-equity instruments, as opposed to the per-instrument basis (IBIA). COFIA requires segmenting asset groups (for example bonds and derivatives) into more granular classes that shape largely homogeneous liquidity characteristics. Subsequently, ESMA assesses the liquidity of these classes based on the liquidity of all the instruments within the specific asset class. ESMA believes that COFIA has certain advantages including that:
* the assessment of newly issued financial instruments is straightforward;
* it gives greater certainty to the market and allows taking into account instruments with a very short lifespan; and
* it is consistent with, but not identical to, the approach taken under European Market Infrastructure Regulation (EMIR).
7. Trading obligation
In the consultation paper ESMA concludes that as they serve different regulatory purposes it is neither desirable nor feasible to align the liquidity assessment for the clearing obligation under EMIR with the trading obligation under MiFIR.
In relation to the alignment of the criteria under the definition of liquid market under article 2(1)(17)(a) MiFIR with the trading obligation criteria under article 32(3) of MiFIR, ESMA agrees with the majority of respondents who argue that these assessments should follow a similar approach although the thresholds should not necessarily be the same. ESMA emphasises that any application of the liquidity test for the purposes of the trading obligation will require it to make an assessment of which liquidity factors are relevant on a case-by-case basis and then apply them to each specific class or sub-class of derivatives. ESMA asserts that the ultimate application of the trading obligation under article 32 of MiFIR will always be based on an overall assessment of whether a class or sub-class is sufficiently liquid to support the introduction of the trading obligation.
8. Section C 6 Annex I of MiFID II
In its final report concerning its technical advice on delegated acts ESMA provides an analysis of section C 6 of Annex I. It states that the definition of section C 6 of Annex I under MiFID I has been changed significantly under MiFID II by classifying options, futures, swaps and other derivative contracts relating to commodities that can be physically settled and are traded on an organised trading facility (OTF) as financial instruments, in addition to those instruments that are traded on regulated markets and multilateral trading facilities. However, section C 6 of Annex I excludes wholesale energy products within the scope of the Regulation on wholesale energy market integrity and transparency (REMIT) that are traded on an OTF and that must be physically settled. Wholesale energy products within the scope of REMIT which are derivatives contracts, and are therefore within the scope of the exemption, are derivatives with electricity (or power) or natural gas as the underlying.
C 6 energy derivatives contracts are defined as options, futures, swaps and any other derivatives with coal or oil as an underlying and which are traded on an OTF and must be physically settled. Whilst ESMA feels that derivative contracts with coal as an underlying are an easily identifiable section of instruments the position is different for oil as an underlying. Following its earlier consultation ESMA has proposed a wider definition of oil in its technical advice so that it covers different grades of crude oil and also other contracts where the underlying is derived from crude oil. In this regard ESMA considers that pure biofuel could not be classified as oil, but biofuel as a mandated minority component to gasoline or diesel would not prevent such gasoline or diesel being caught by the wider definition of oil. Also, ESMA has also decided to include broad definitions of coal as an underlying to a derivative contract as well as of the wholesale energy products caught by the C 6 exemption by reference to the derivative definitions in REMIT.
In relation to when a contract is assessed as “must be physically settled” ESMA has taken on board some of the comments received to its earlier consultation. In particular, in its technical advice ESMA notes its understanding that operational netting does not prevent a contract from being considered as “must be physically settled”. ESMA considers that a C 6 wholesale energy product contract can only be categorised as “must be physically settled” when the parties entering into the contract are actually capable of delivery or receipt of the agreed amount of gas, power, oil or coal. The terms of a C 6 wholesale energy product contract or the rules of the OTF on which it is traded must require that both the buyer and seller should have proportionate arrangements in place to make or receive delivery of the underlying commodity upon the expiry of the contract.
ESMA is also of the view that the term “physically settled” has to be further specified by clarifying that it can incorporate a broad range of delivery methodologies including:
physical delivery of the relevant goods themselves;
delivery of a document giving rights of an ownership nature to the relevant goods or the relevant quantity of the goods concerned (such as a bill of lading or a warehouse warrant); or
another method of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of goods without physically delivering them (including notification, scheduling or nomination to the operator of an energy supply network) that entitles the recipient to the relevant quantity of the goods.
9. Post trading issues
MiFIR extends the scope of the clearing obligation to all derivative transactions concluded on a regulated market and requires clearing members to ensure that derivatives are submitted for clearing acceptance as quickly as technologically practicable.
In the consultation paper ESMA has listened to stakeholder comments which noted the importance of getting certainty on clearing at an early stage and when possible before trade execution. ESMA proposes to require the set-up of checks before the execution of trading orders placed on a trading venue in particular when the clearing obligation would apply. The draft regulatory technical standards (RTS) prepared by ESMA provide that the clearing member would provide the credit limits of its clients to the trading venue which would check the orders placed against these limits. Such checks would limit the situations in which a transaction is entered into but then be rejected by the central counterparty (CCP).
ESMA proposes that the pre-check related to derivative transactions subject to the clearing obligation entered electronically should be performed within 60 seconds from the receipt of the order by the trading venue. For others, ESMA proposes that the check should be performed within 10 minutes from the receipt of the order. ESMA also proposes that the trading venue provide the information on a real time basis for orders that would be executed electronically and within 5 minutes following the pre-check of others.
ESMA also proposes that the timeframe for the transfer of information from the trading venue to the CCP for derivative transactions subject to the clearing obligation should also be different for those entered into electronically and the others. The transaction should be submitted to the CCP within 10 seconds of execution when it is concluded on a trading venue in an electronic manner, and within 10 minutes of execution when it is concluded on a trading venue in a non-electronic manner, within 30 minutes of execution when it is concluded on a bilateral basis.
ESMA proposes that the CCP should provide to the clearing member the information related to bilateral transactions that they have received for clearing. The clearing member should receive the information within 60 seconds from the receipt by the CCP.
In respect of the timeframe for a CCP to accept or reject the clearing of a derivative transaction, ESMA proposes within 10 seconds from submission or from the receipt of the clearing member acceptance. This is along the lines of the US approach where the Commodities Futures and Trading Commission has determined that “as soon as technologically practicable” would mean 10 seconds.
In relation to indirect clearing ESMA has listened to concerns raised by the industry about the feasibility and attractiveness of indirect clearing in the OTC derivatives space and proposes that clearing members should be offered a choice between a net omnibus account (the same under the EMIR RTS on OTC derivatives) and a gross omnibus account. ESMA has also removed the requirement to port indirect client positions.
In its technical advice on the delegated acts ESMA has reviewed the position concerning portfolio compression and has listened to the industry’s request to keep the requirements at a relatively high level and sufficiently flexible. ESMA has also replaced the distinction between multilateral compression and bilateral compression with a distinction between portfolio compression performed between two or more parties with a service provider and performed directly between counterparties.
The Commission will prepare the delegated acts on the basis of the technical advice that has been delivered by ESMA. However, when preparing the delegated act the Commission does have the right to depart from ESMA’s advice although this would be unusual. Once it has adopted the delegated act the Commission has to notify both the European Parliament and the Council of the EU. Both of these EU institutions will consider the delegated act and have the power to object to it within three months (which may be extended by a further three months).
The deadlines that ESMA is working to on the technical standards are:
it must submit draft RTS to the Commission for adoption by 3 July 2015; and
it must submit draft implementing technical standards (ITS) to the Commission for adoption by 3 January 2016.
Once the Commission has received:
the draft RTS, it must within 3 months determine whether or not to adopt it. If the Commission adopts the RTS without amendment the European Parliament and Council of the EU may then object within one month of the adoption (which may be extended by another month). If the Commission adopts the RTS with amendments the European Parliament and Council of the EU may then object within 3 three months of the adoption (which can be extended by another three months); and
the draft ITS, it has three months in which it determines whether or not to adopt them (this can be extended by a further month). It is worth noting that the European Parliament and Council of the EU have no power of objection.
Article 93 of MiFID II states that Member States shall adopt and publish, by 3 July 2016, the laws, regulations and administrative provisions necessary to comply with the Directive. Member States are to apply those measures from 3 January 2017 (except for a small number of provisions). MiFIR, a Regulation with direct effect on Member States, also applies from 3 January 2017.
The FCA has stated on its website that the changes to the FCA Handbook will need to be in place by the middle of 2016. It is likely that the FCA’s formal consultation on Handbook changes will not take place until the end of this year. However, the FCA will be engaging on certain aspects of the changes it needs to make before then. In particular, the FCA states that it expects to issue a discussion paper towards the end of Q1 2015 which will seek views on various issues relating to conduct of business.
The FCA also states that HM Treasury is looking to consult on the changes in Q1 2015. The FCA mentions that the topics covered by the HM Treasury consultation will be disparate but will include: changes to the boundaries of UK regulation through amendments to the Regulated Activities Order; 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.