First, here's the thought - when (if ever) will the EU provide a definitive answer to the question of whether a prop firm, which is outside scope of Mifid II under Article 1, is brought into scope by the exemption from the exemption in Article 2(1)(d)?
I doubt that such an answer is likely in anything like the timeframe necessary for any firms to plan on becoming authorised and regulated in the EU in time for January 2017. And there will always be those who can (pretty reasonably) argue that on the text of Mifid II, a third country principal trading firm is not in scope of Mifid II at all.
Let me explain: Mifid II Article 1 says that the directive applies to “third-country firms providing investment services or performing investment activities through the establishment of a branch” in the EU.
If a third-country firm has no “branch” in the EU, it cannot be covered by Mifid II.
So the argument goes that the ‘exemption from the exemption’ in Article 2(1)(d) - which says that prop firms are not in scope of MiFID2 unless they are market makers, are members of a trading venue, have DEA to a trading venue, are HFT or deal on own account when executing client orders - cannot apply to firms which are not caught by Mifid II under Article 1.
And second, here's the issue - EU politicians (the masters of Mifid II Level 1 text), want there to be a ‘level playing field’ for all participants on EU markets.
This, to my mind, means not just ‘no unregulated market and no unregulated product’ but also ‘no unregulated participant’.
That regulation doesn’t necessarily need to be EU regulation - firms authorised and regulated in the US, Canada, Singapore etc are authorised and regulated after all.
But let’s be fair, supranational bodies don’t have a great history of agreeing with one another about cross-border regulatory equivalence.
Also, don’t forget that Germany rejected ‘equivalence’ of UK locals’ regulatory regime under the German HFT law because they were not subject to the same regulatory capital requirements as full Mifid firms.
So ‘level playing field’ therefore means ‘regulated in the EU under Mifid II’.
OK, I’ll go out on a limb and say ‘definitely’.
Where was I?
Oh yes: a UK-based principal trading firm has a server colocated in Frankfurt to trade Eurex; if it is HFT under German law, then it requires a Mifid-passport to do so.
No such passport is required (or available) if it is not HFT because its activities fall within one of the exemptions under current the Mifid and do not fall under the German HFT law.
So for what type of passport should the firm apply if it needs one - a cross-border services passport or a branch passport?
Most firms in this position do not have personnel in Germany. It is physically difficult to squeeze a human being into a server rack. Feeding him/her when they’re there would be even more challenging.
But is a server a branch nonetheless?
The Germans never came up with a satisfactory or unequivocal answer - their approach was that they would process any passport notification a firm from another EU state’s regulator sent them; be it for a branch or for cross-border services.
As long as there was a passport, that firm could conduct HFT prop trading in Germany.
The OECD tax plans seem to be going in the direction of making
a server a branch (as drawing a distinction between e-commerce businesses like
Latest OECD and IOSCO papers state that HFT firms, operating in a member country, would struggle to do so but for the colocated servers and (so the argument goes) those firms might have a taxable establishment in that country.
The amount of tax attributable to that establishment is immaterial to the argument - an establishment for tax purposes is a permanent establishment and a branch.
Neither the OECD nor IOSCO seems to have come to a conclusion as to how to deal with this; at the moment, we’re at a place where they recognise the issue and state that they have to do something about it.
But the hint is strongly that servers will be permanent establishments.
It might matter whether the firm owns, licenses or merely ‘uses’ the server (ie where it belongs to an intermediary or service provider), but given the heat and light generated by news of ‘tax avoidance’ etc, my money’s on that being disregarded in the long term.
Also to be disregarded will be that a branch constituted by a server should have personnel. That’s an inconvenient mismatch between tax laws and regulatory requirements which I guess everyone will pretend not to see.
So let's say for sake of argument that a server will be a branch.
If so, then it requires a passport permitting it to provide investment services in the country in which the server is located. It's likely to be subject to local tax on its profits.
And ... it's likely to provide politicians with the 'solution' they need to ensure that there is a 'level playing field' in EU markets for EU-regulated participants and firms based outside the EU which are nonetheless colocated at trading venues in the EU.
There’s then no disparity between Article 1 and Article 2 of Mifid II; a third-country firm has a branch in the EU and needs to be authorised and regulated.
So we shouldn’t wait for the EU to pronounce on whether third-country prop trading firms which cannot claim exemption under Article 2(1)(d).
People will have waited for Godot more fruitfully.
We should plan on being told (eventually) that all third-country prop firms that would not be able to claim an exemption under Article 2(1)(d) have to be authorised and regulated in the EU.
Now we just need someone to let us know what definition of HFT we'll have to use...!