MiFID II / MiFIR series

1 | What has happened?

On 27 March 2015, HM Treasury published a consultation document which set out in draft form the following statutory instruments which are considered necessary to transpose into UK law the Markets in Financial Instruments Directive (recast) (MiFID II):

• The Financial Services and Markets Act 2000 (Markets in Financial Instruments) Regulations 2016. Amongst other things the statutory instrument creates the position limits regime that is imposed by MiFID II;
• The Financial Services and Markets Act 2000 (Data Reporting Services) Regulations 2016. This statutory instrument provides for the UK regime which requires persons operating data reporting services as listed in Section D of Annex I of MiFID II to be regulated;
• The Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) Order 2016. This Order makes a number of amendments to the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO). Such amendments include making operating an organised trading facility a regulated activity; and
• The Financial Services and Markets Act 2000 (Qualifying EU Provisions) (Amendment) Order 2016. This Order makes certain changes to the Financial Services and Markets Act 2000 (Qualifying EU Provisions) Order 2013 to make the Markets in Financial Instruments Regulation (MiFIR) a qualifying EU provision for various parts of the Financial Services and Markets Act 2000 (FSMA) to ensure that the FCA and PRA have the appropriate powers to perform their roles arising from MiFIR.

In addition to the above HM Treasury set out a draft statutory instrument which would provide that certain binary options are regulated and supervised by the FCA rather than the Gambling Commission.

A day before the HM Treasury consultation document the FCA published a discussion paper which discussed the implications of certain MiFID II conduct of business and organisational requirements for firms, primarily those requirements contained within Articles 24 and 25. The discussion paper also set out certain proposed changes to the FCA’s rules to implement the new regulatory framework required under MiFID II for those firms that are exempt under Article 3, and suggested options for alternative domestic criteria for the categorisation of local authorities.

2 | Third countries

It is clear from the HM Treasury consultation document that the UK Government considers the third country branch regime for retail clients and elective professional clients under Article 39 of MiFID II to be an optional regime. The UK Government proposes not to exercise its option and instead remain with its current regime insofar as it is permitted by MiFID II. Whilst acknowledging that UK branches will not have the benefit of an EU passport the UK Government feels that its current regime is “sufficiently tailored to client types and to the risks in question and balances the need to maintain investor protection, market integrity and financial stability, while remaining open to business internationally.”

The third country regime that is set out in Articles 46 to 49 of MiFIR and concerns third country firms providing services to per se professional clients and eligible counterparties without the establishment of a branch (but with direct registration with the European Securities and Markets Authority) is unaffected by the HM Treasury consultation document as MiFIR is a directly applicable EU Regulation and the UK has no discretion as to its implementation.

Also, the third country regimes in MiFID II and MiFIR do not cover the authorisation of third country exchanges. Therefore, HM Treasury confirms that the UK’s recognised overseas investment exchange regime will continue.

3 | Data reporting

Article 59(1) of MiFID II places an obligation on Member States to require that the provision of data reporting services (DRS) as a regular occupation or business be subject to prior authorisation. The DRS are set out in Annex 1, Section D of MiFID II and are: consolidated tape providers (CTPs), approved publication arrangements (APAs) and approved reporting mechanisms (ARMs).

The HM Treasury consultation document states that the UK Government proposes to create a specific regime for the DRSs which is independent of the RAO and will be set out in the draft FSMA (Data Reporting Services) Regulations 2016 (the DRS Regulations).

The consultation document discusses each DRS and how the DRS Regulations will apply to them. Also, the UK Government proposes to amend the derogation to authorisation contained in Article 59(2) of MiFID II (Member States may allow an investment firm or a market operator operating a trading venue to operate an APA, CTP and/or ARM and such service is to be included in their authorisation) so that it is extended to credit institutions (as well as investment firms) that are operating a multilateral trading facility or an organised trading facility.

4 | Position limits

Article 57 of MiFID II sets out a position limit regime for commodity derivatives traded on trading venues and for economically equivalent over-the-counter (OTC) contracts. The regime requires Member State regulators to establish the size of a net position in commodity derivatives traded on a trading venue in that Member State and economically equivalent OTC contracts which any person can hold. Also, MiFID II gives new powers to Member State regulators so that they can require information on commodity derivative positions; to request a person to reduce the size of their position; and limit a person from entering into a commodity derivative.

In the HM Treasury consultation document the UK Government proposes to create a “standalone” regime for the MiFID II position limit requirements on the basis that they apply to persons holding positions in relevant contracts whether or not they are authorised. The relevant legislation will be contained in Parts 3 and 5 of the draft FSMA (Markets in Financial Instruments) Regulations 2016.

MiFID II also requires trading venues that offer trading in commodity derivatives to have appropriate position management controls which mitigate the effects of a large or dominant commodity derivatives position. For investment firms and credit institutions operating trading venues these obligations will be set out in FCA rules made under FSMA powers. To the extent that they relate to trading venues operated by recognised investment exchanges (RIEs) these obligations will be added to the schedule to the FSMA (Recognition Requirement) Regulations 2001.

The same applies to the transposition of the MiFID II position reporting requirements. These requirements will be set out in FCA rules made under FSMA powers for investment firms and credit institutions and inserted into the schedule to the FSMA (Recognition Requirement) Regulations 2001 for RIEs.

5 | Organised trading facilities

In the HM Treasury consultation document the UK Government mentions that organised trading facilities (OTFs) will be operated by investment firms, credit institutions and/or RIEs. For RIEs the specific MiFID II requirements in relation to operating an OTF will be set out in the FSMA (Regulated Activities) (Amendment) Order 2016 which amends the schedule to the FSMA (Recognition Requirements) Regulations 2001. These amendments also propose to give the FCA powers to make rules which will provide further details on the obligations on RIEs when operating trading venues. The MiFID II requirements for OTFs operated by investment firms or credit institutions will be transposed through FCA rules.

The HM Treasury consultation document notes that Article 20(2) MiFID II provides that “Member States shall permit an investment firm…. operating an OTF to engage in matched principal trading in bonds, structured finance products, emission allowance and certain derivatives only where the client has consented to the process.” In addition, OTF operators may engage in dealing on own account other than matched principal trading with regard to sovereign debt instruments for which there is not a liquid market. The HM Treasury consultation document notes that there is a question of whether an OTF operator requires a separate permission to deal in investments as principal to carry on these activities or whether a notification regime will be sufficient. The UK Government is of the view that a separate permission is not needed and that how OTF firms conduct matched principal trading and principal trading in illiquid sovereign bonds will be more appropriately dealt with by FCA rules. On this basis, the FCA will be consulting in due course on how it considers best to approach the identification of firms with an OTF permission that conduct matched principal trading and principal trading in illiquid sovereign bonds.

6 | Receipt of commissions and other benefits for discretionary investment managers

MiFID II bans discretionary investment managers from accepting and retaining third party commissions, fees and monetary and non-monetary benefits, effectively applying requirements similar to aspects of the UK’s retail distribution review’s (RDR) adviser charging rules to discretionary investment management activities. However, unlike the RDR rules applicable to investment advisers, MiFID II allows discretionary investment managers to receive payments from third parties if these are passed onto clients in full (in effect allowing rebating).

In the discussion paper the FCA notes that allowing rebating for discretionary investment managers may create the potential for consumer confusion and regulatory arbitrage. In light of this the FCA is seeking feedback from firms on the practical implications of banning rebates. The FCA adds that it would expect that “many discretionary investment managers will be applying RDR standards to their existing business for various reasons and will prefer regulatory consistency.” The FCA also asks for views from fund managers and platforms believing that to retain “separate classes of funds that pay commission may create additional costs and complexities for these firms.”

The FCA also asks for views on whether it should develop a regime similar to that which is applied to platforms, banning cash rebates (other than small amounts) but allowing rebates to be given back to clients in units.

7 | Adviser independence

In the discussion paper the FCA notes that where independent advice is sought, it continues to believe that consumers should receive advice that considers all types of products that may be suitable for their needs. However, the FCA states that it has come to its attention that some stakeholders consider that MiFID II’s standard – a “sufficient range” of products from a sufficient diverse group of providers – may allow independent financial advisers to redefine the breadth of the products they need to consider before providing a personal recommendation. The FCA asks for views on this point, in particular on how far MiFID II’s standard is practically different to its existing standard, particularly from firms holding themselves out as ‘independent financial advisers’.

The discussion paper also contains a diagram which shows the overlap between the FCA’s existing independence requirements in relation to retail investment products, and the products that MiFID II’s independence standard covers. The diagram shows that MiFID II will require the FCA to deliver an independence standard for advice on products that currently sit outside its definition of retail investment products - shares, bonds and derivatives. However, the FCA states that it does not consider it proportionate to include these products in its existing definition of retail investment products and states that it wishes “to explore an appropriate way of implementing MiFD II’s standard for these products domestically.”

8 | Complex and non-complex products and application of the appropriateness test

MiFID introduced a distinction between products that are deemed to be ‘non-complex’ or ‘complex’. The appropriateness test applies to all complex products, so these products cannot be sold execution-only.

Article 25(4) of MiFID II sets out an updated list of the types of products that are classified as ‘non-complex’. The FCA states in the discussion paper that it understands that the European Commission is taking a strict interpretation of the revised criteria for non-complex products and that in the future it is likely that any shares and bonds that embed a derivative, structured UCITS, non-UCITS collective investment undertaking and even some structured deposits, will be considered to be complex.

In the discussion paper the FCA takes the opportunity to suggest how firms may be able to apply the appropriateness test to particular types of financial products noting that not all complex products come with the same risks, and do not require the same level of knowledge and experience.

9 | Local authorities

MiFID II puts particular focus on increasing protections for local authorities and municipalities. The changes that MiFID II will introduce will mean that it will no longer be possible for the FCA to treat local authorities as per se professional clients on the basis of meeting the large undertakings test.

Whilst local authorities would be re-categorised as retail clients under MiFID II the FCA proposes to exercise its discretion and give them the option to opt-up to elective professional client status for both MiIFD and non-MiFID business. The discussion paper discusses three possible options as to how the FCA could achieve this.

10 | Next steps

The deadline for comments on the HM Treasury consultation document is 18 June 2015. The deadline for comments on the FCA discussion paper is 26  May 2015.

On its website the FCA states that it will be holding its second MiFID II annual conference this Autumn. At this conference the FCA is expected to outline the main implementation issues and focus on helping firms understand their new obligations and the regulator’s expectations of them.

In December 2015 the FCA expects to publish its main consultation paper on the proposed Handbook changes to implement MiFID II and MiFIR. In June 2016 it expects to publish a feedback and policy statement confirming the final changes to the Handbook.