Global | Publication | June 2016
Even though the revised Markets in Financial Instruments Directive (MiFID II) and the Markets in Financial Instruments Regulation (MiFIR) have been delayed by a year and won’t come into effect until January 3, 2018, the first half of 2016 has been a particularly busy period with the Commission adopting a number of Delegated Acts that contain regulatory technical standards and implementing technical standards that add further detail to the framework Directive and Regulation. Indeed, many firms have found it difficult keeping pace with the volume of paper being published but in June the European Securities and Markets Authority (ESMA) helpfully published a table setting out the status of each technical standard.
On April 7, 2016, the Commission adopted a Delegated Directive supplementing MiFID II as regards the safeguarding of financial instruments and funds, product governance obligations and inducements. The fact that this Level 2 measure is a Directive rather than a Regulation potentially leaves some room for interpretation for Member States but this may be limited as ESMA is expected to issue guidance or FAQs on a number of areas including product governance.
It is also worth noting that in addition to MiFID investment firms the Delegated Directive will apply to management companies under the UCITS Directive and the Alternative Investment Fund Managers Directive when performing investment services that they are authorised to provide.
The product governance rules introduced by MiFID II concern both investment firms that manufacture financial instruments as well as investment firms that distribute them to clients. The product governance provisions that appear in chapter 3 of the Delegated Directive (articles 9 to 10) seem to follow ESMA’s technical advice although there are some notable exceptions.
For example, despite push back from the industry the product governance rules apply to all products sold on both primary and secondary markets, irrespective of the type of product or service provided and of the requirements applicable at the point of sale (see recital (18) of the Delegated Directive). However, Member States are to apply these requirements in an “appropriate and proportionate” manner taking into account the nature of the financial instrument, the investment service and the target market for the product.
Another important point to note is that article 9(7) of the Delegated Directive provides that where an investment firm ‘collaborates’ with a firm that is not within the scope of MiFID II (including UCITS managers and third country firms) so as to create, develop, issue and/or design a product there needs to be a written agreement in place which outlines mutual responsibilities.
It is worth remembering that the requirements are also relevant to firms dealing with professional clients as well as retail clients and to all types of financial institution. This includes derivatives, which is a world which firms have not necessarily thought about in terms of manufacturing and distribution. Trading venues and firms selling derivatives are therefore going to have to think carefully about how these obligations can be made to work and probably have a lot to learn from their retail colleagues.
It is also worth noting that the investment firm will ensure that the compliance function monitors the development of the product governance arrangements and conducts periodic reviews.
Chapter 2 of the Delegated Directive covers the safeguarding of client financial instruments and funds (articles 2 to 8). The drafting of chapter 2 appears to follow ESMA’s technical advice very closely and the impact of the provisions on the UK may be negligible given that firms are already subject to most of these obligations.
As mentioned above it is worth noting that the Commission has chosen the Delegated Act to be in the form of a Directive so that, where applicable, measures and arrangements can take into account national legal regimes that could affect clients’ rights and their rights to property in particular. For instance article 2(1) of the Delegated Directive sets out a list of obligations that Member States shall place on investment firms when safeguarding client financial instruments and funds. Where these requirements cannot be satisfied due to applicable domestic law Member States are to put in place arrangements that meet the ‘objectives’ of article 2(1). Similarly where certain obligations under article 2(1) (sub-paragraphs (d) and (e)) cannot be met due to national law the Member State must prescribe requirements that have an ‘equivalent’ effect in terms of safeguarding clients’ rights.
Of particular importance is that chapter 2 specifies the measures for ensuring the appropriate use of title transfer collateral arrangements (TTCAs) when dealing with non-retail clients (article 16(10) MiFID II prohibits TTCAs with retail clients) and wholesale firms will have to take into account certain factors when deciding whether it is in their clients’ best interests.
Recital (6) of the Delegated Directive notes that firms should be allowed to use TTCAs only if they can demonstrate the appropriateness of the TTCA in relation to the client and disclose the risks involved as well as the effect on the clients’ assets.
Firms should also have in place a documented process for TTCAs.
Chapter IV of the Delegated Directive covers inducements (articles 11 to 13) and there appears to be significant changes to ESMA’s technical advice.
For example article 11 of the Delegated Directive contains provisions concerning the quality enhancement test. Previously ESMA's technical advice mirrored the existing requirements of MiFID I closely, namely that an inducement would not generally be regarded as enhancing quality if any of the items listed in the test applied. This meant that notwithstanding an item may be triggered; a firm might be able to get itself comfortable on the facts. Now the Commission has turned the test around in the sense that quality enhancement only occurs if all of its limbs are satisfied. Arguably, this is an unusual result as quality enhancement may occur for other reasons and if one of the limbs is not relevant for a particular payment, it is unclear how it will be satisfied. Further, it appears that the Commission has not taken ESMA up on its desire to develop Level 3 guidelines to further specify the circumstances where the quality enhancement test has/has not been met.
Another interesting point relates to article 12(1) of the Delegated Directive which states that investment firms providing investment advice on an independent basis or portfolio management can only accept minor non-monetary benefits where they are ‘acceptable’ minor non-monetary benefits meeting the conditions set out in article 12(3).
Article 13 of the Delegated Directive covers inducements in relation to research by third parties. The provision of research by third parties to investment firms providing portfolio management or other investment or ancillary services to clients will not be regarded as an inducement if it is received in return for direct payments by the investment firm out of its own resources or payments from a separate research payment account controlled by the investment firm. Where a research payment account is established firms will need to regularly assess their research budget as an internal administrative measure. The research budget will also be subject to appropriate controls and senior management oversight. Such controls include a clear audit trail of payments made to research providers and how the amounts paid were determined with reference to the quality enhancement criteria.
In terms of research, what is acceptable is a very narrow range of research. It can only be written material which is commissioned by/paid for by a corporate issuer/potential issuer to promote a new issuance by the company, or, it must be contracted for and paid for on an on-going basis (even then the relationship with the paid research provider must be disclosed in the material and made available at the same time to firms wishing to receive it or to the general public). So essentially, apart from in the context of corporate issuances, it appears that all research must be paid for in some way.
On April 25, 2016, the Commission adopted a Delegated Regulation supplementing MiFID II as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of the Directive. Accompanying annexes were also published.
The definition of algorithmic trading is found in article 4(1)(39) of MiFID II. The definition itself provides:
“‘algorithmic trading’ means trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention and does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post trade processing of executed transactions.”
Article 18 of the Delegated Regulation seeks to provide further clarity as to where a system shall be considered as having no or limited human intervention. This is where for any order or quote generation process or any process to optimize order-execution, an automated system makes decisions at any of the stages of initiating, generating, routing or executing orders or quotes according to pre-determined parameters.
It is also worth noting that the recitals of the Delegated Regulation (recital 22) provide that algorithmic trading should encompass smart order routers where such devices use algorithms for optimization of order execution processes that determine parameters of the order other than the venue or venues where the order should be submitted. Algorithmic trading does not encompass automated order routers where, although using algorithms, such devices only determine the trading venue or venues where the order should be submitted without changing any other parameter of the order.
Article 4(1)(40) of MiFID II sets out a definition of high-frequency algorithmic trading technique (HFT) by reference to three cumulative criteria. One criterion is high message intraday rates which constitute orders, quotes or cancellations. Article 19 of the Delegated Regulation sets out the basis for determining whether there is a high message intraday rate being one of the following:
It is also worth noting that only instruments for which there is a liquid market should be included in the calculation of high intraday message rate. Messages introduced for the purpose of dealing on own account and not for the purpose of receiving or transmitting orders or executing orders for clients should be included in the calculation. Messages introduced through other techniques other than trading on own account should be included in the calculation where the firm’s execution technique is structured in such a way as to avoid the execution taking place on own account. For the calculation of high message intraday rate in relation to direct electronic access (DEA) providers, messages submitted by their DEA clients shall be excluded from the calculations.
Please refer to our webinar of June 16, 2016.
Chapter II of the Delegated Regulation (articles 21 to 43) sets out the organizational requirements for investment firms. In particular it sets out procedures in relation to compliance, risk management, internal audit, the responsibility of senior management, complaints handling, remuneration, personal transactions, outsourcing and conflicts of interest. Each of these topics is important in their own right but the headlines include the following:
Chapter III of the Delegated Regulation (articles 44 to 79) sets out the operating conditions for investment firms. In particular it sets out further information in relation to satisfying the requirement that information addressed to retail and professional clients is fair, clear and not misleading (article 44).
MiFID II introduces the concept of “independent” versus “non-independent” advice, for firms which provide the service of investment advice to their clients. The Delegated Regulation (articles 52 and 53) sets out further information concerning the related disclosures, policies and processes that are required, depending on the status selected by the firm.
The provisions in the Delegated Regulation concerning best execution (articles 64 to 66) are useful in the sense that they: (i) set out the criteria that investment firms should take into account when determining the relative importance of factors to establish best execution; (ii) note that when executing orders or taking a decision to deal in OTC products, investment firms are required to check the fairness of price proposed to the client, by gathering market data used in the estimation of the price of such product and, where possible, by comparing with similar or comparable products; (iii) provide further detail as regards the expectations placed on investment firms when carrying out portfolio management and reception and transmission of orders to act in the best interests of the client; (iv) set out the requirements for review of the execution policy and what investment firms must provide to clients on the policy. In terms of client order handling (articles 67 to 70) the Delegated Regulation sets out general principles which are then followed by the conditions that must be met when investment firms wish to aggregate orders and allocate trades, including for own account and the publication of unexecuted client limit orders.
The Delegated Regulation also provides further detail regarding the new telephone taping requirement (article 76). Importantly, this specifies the content requirements of the written telephone taping policy and the fact that the arrangements instituted to comply with the recording requirements are “technology neutral”. It also covers the client disclosure requirements.
On record keeping generally it is also worth noting that the annexes set out a prescriptive list of detailed record keeping requirements.
The Delegated Regulation (articles 84 to 89) provides guidance on data provision obligations for reporting services providers (approved publication arrangements (APAs) and consolidated tape providers (CTPs)). The transparency framework under MiFID II provides that reporting services providers are required to provide market data on a reasonable commercial basis.
The articles in the Delegated Regulation discuss the provision of market data on the basis of cost. This is where the price of market data is to be based on the cost of producing and disseminating such data and may include “a reasonable margin”. The costs of producing and disseminating market data may also include an “appropriate share” of joint costs for other services provided by the APA or CTP.
APAs and CTPs are also required to make market data available at the same price and on the same terms and conditions to all customers falling within the same category in accordance with published objective criteria. Any differentials in prices charged to different categories of customers is to be proportionate to the value which the market data represent to those customers taking into account: (i) the scope and scale of the market data including the number of financial instruments covered and trading volume; and (ii) the use made by the customer of the market data, including whether it is used for the customer’s own trading activities, for resale or for data aggregation.
The Delegated Regulation also discusses per user fees where the APA and CTP can charge for the use of market data on the basis of the use made by individual end-users of the market data although a derogation from this is also set out and relates to instances where such charging would be disproportionate to the cost of making market data available. However, should an APA or CTP refuse to make market data available on a per user basis it mist publish the grounds for its refusal on its website.
Finally, the Delegated Regulation covers the transparency obligation, where APAs and CTPs are to disclose and make easily available to the public the price and other terms and conditions for the provision of market data. The Delegated Regulation (article 89) sets out what the disclosure should include.
At the very end of the Delegated Regulation (article 90) further guidance is given for regulators when determining whether the operations of a regulated market, an MTF or OTF are of substantial importance to a host Member State. The background to this provision can be found in article 79(2) of MiFID II and concerns the establishment of cooperation arrangements between a trading venue’s home and host Member State competent authorities.
In terms of MTFs and OTFs the Delegated Regulation refers to the trading venue being registered as an SME growth market or having a market share of at least 10% of trading in terms of total turnover in monetary terms in on-venue trading and systematic internaliser trading in the host Member State in at least one asset class subject to the transparency obligations in MiFIR.
On May 18, 2016, the Commission adopted a Delegated Regulation Regulation supplementing MiFIR with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions. An accompanying annex was also published.
Chapter 1 of the Delegated Regulation (articles 1 to 5) contains criteria in relation to the determination of a liquid market for shares, depositary receipts, exchange traded funds and certificates.
The criteria are based on specified amounts of free float, average daily number of transactions and average daily turnover, taking into account the specifics of each instrument. Importantly, each criterion has to be satisfied. For each instrument, guidance is given on how Member State competent authorities (NCAs) should make their calculations, and what to do where fewer than five instruments are considered to have liquid markets.
The Delegated Regulation also sets out (article 5) when NCAs of the most relevant market should assess liquidity and in summary these are:
It also covers the provision of information by trading venues (see also the Annex) and the way in which relevant information must be used.
Chapter 2 of the Delegated Regulation (articles 6 to 11) contains specifications for the purposes of specifying the obligation of trading venues and systematic internalisers to provide market data on a reasonable commercial basis, which is part of the transparency framework under MiFIR.
These specifications concern the requirement that fees are set on the basis of cost and may include a reasonable margin, non-discriminatory provision of market data, the obligation to unbundle and disaggregate data and a transparency to the public obligation around the fees as well as cost accounting methodologies.
The Delegated Regulation of April 25, 2016 as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of the Directive contains similar provisions for reporting services providers to provide market data on a reasonable commercial basis (see above).
“The product intervention powers contained in this Delegated Regulation are a big milestone for consumer protection. European supervisory authorities will be equipped with a new and powerful toolkit allowing them to intervene in case financial instruments turn out to be harmful for investors or financial markets at large.” (The European Parliament’s Rapporteur for MiFID II, Markus Ferber, MEP).
Chapter 5 of the Delegated Regulation (articles 19 to 21) sets out the criteria and factors to be taken into account by ESMA, the European Banking Authority (EBA) and NCAs when intending to use their product intervention powers. It is worth noting that the Delegated Regulation (recital 19) mentions that the need to assess all criteria and factors that could be present in a specific factual situation should not prevent NCAs, ESMA and the EBA from using a temporary intervention power when only one of the factors or criteria leads to such a concern or threat.
The long list of criteria includes:
Article 22 of the Delegated Regulation covers the position management powers of ESMA and sets out a list of the criteria and factors for determining the existence of a threat to the orderly functioning and integrity of financial markets. Such factors include the existence of serious financial, monetary or budgetary problems which could lead to the financial instability of a Member State or a financial institution deemed important to the global financial system.
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On 21 August 2024, the Supreme Court of NSW handed down its decision in Seaforth Securities Pty Limited v Zoya Investments Pty Limited [2024] NSWSC 1061.
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