MiFID2 and MiFIR – What you need to know · PDF fileMiFID2 and MiFIR – What you need to know 1 ... n Introduction of a new multilateral, discretionary trading venue, the Organised

MiFID2 and MiFIR – What you need to know 1

MiFID2 and MiFIR – What you need to knowAlmost four years since the Commission began its review of the original Markets in FinancialInstruments Directive (MiFID), the final texts of MiFID2 and MiFIR are about to be published in theOfficial Journal. The protracted legislative process is testament to the scope and complexity of thesecomprehensive reforms. If, as expected, publication occurs in the second week of June, the new ruleswill enter into force in mid July 2014 and will start to apply to firms 30 months later, early in 2017.

Focusing on the Level 1 text, this briefing provides an overview of the structure and major features ofthis multi-faceted legislation, highlights key areas of concern and illustrates some of theimplementation issues likely to face the market in coming months.

Briefing note June 2014

Sea of ChangeRegulatory reforms – reaching new shores

MiFID2 in a nutshell – the main elements of the reformsMarket structuren Introduction of a new multilateral, discretionary trading venue, the Organised Trading Facility (OTF), for non-equity instruments

n Expanded scope of Systematic Internaliser (SI) category with increased transparency requirements

n Requirement for investment firms to trade listed equities on a Regulated Market (RM), Multilateral Trading Facility (MTF) or SI and effective limitation of“pure” over the counter business for cash equities

n New systems and controls requirements for organised trading venues

n Introduction of trading controls for algorithmic trading activities

n Obligation to trade clearable derivatives on organised trading platforms

n Introduction of a harmonised EU regime for non-discriminatory access to trading venues, CCPs and benchmarks

Transparency and transaction reportingn Equity market transparency to be increased

n New transparency requirements for fixed income instruments and derivatives with scope of requirements calibrated for liquidity

n “Consolidated Tape” for trade data. Requirement to submit post-trade data to Authorised Reporting Mechanisms

n Widening scope of MiFID transaction reporting obligations

Conduct, supervision and product scopen Increased conduct of business requirements to improve investor protection

n Regulatory perimeter extended to cover structured deposits

n Strengthened supervisory powers with new powers to ban products or services that threaten investor protection, financial stability or the orderlyfunctioning of markets

n Strengthened administrative sanctions to ensure effectiveness and harmonisation

Commoditiesn Change in scope of regulatory perimeter for commodities business

n Introduction of a harmonised position limits regime for commodity derivatives to improve transparency, support orderly pricing and prevent market abuse

Third countriesn Limited attempt to harmonise regime for access to EU markets by third country firms

Prior to formal publication of the Level 1

text, ESMA has already begun the

process of developing Level 2 measures,

publishing two important documents on

22 May. The first ESMA document is a

discussion paper that sets out ESMA’s

proposals in a number of areas where

ESMA is empowered to draft technical

standards including investor protection;

transparency; data publication; micro-

structural issues; data publication and

access; requirements applying on and to

trading venues; commodity derivatives

and market data reporting. The objective

of the discussion paper is to obtain initial

stakeholder feedback before ESMA

launches a separate consultation on these

technical standards later in the year.

MiFID2 and MiFIR – What you need to know2

© Clifford Chance, June 2014

The second recent ESMA document is aconsultation paper in which ESMA setsout its draft advice to the Commission onall the topics on which the Commissionhas asked ESMA to provide technicaladvice for the adoption of delegated actsby the Commission (including in relation toconduct of business). The consultationpaper is relevant to a range of firmsengaged in the production and distributionof financial products, including structureddeposits. ESMA is required to finalize itsadvice to the Commission by December2014, following which the Commission willdraft the relevant delegated acts anddiscuss them with the European SecuritiesCommittee before they are sent on to theParliament and Council for adoption.

Why is there new legislation?There were several driving forces behindMiFID2 and MiFIR. The starting point wasthe scheduled review of MiFID, two yearsafter implementation. This routine reviewcoincided with the financial crisis andresulted in aspects of the G20 reformagenda, most notably in relation to

increased market transparency and tradeexecution of OTC derivatives, beingincluded as part of the package ofreforms. The financial crisis has clearlyshaped the objectives of policy makersand MiFID2 has been framed with asmuch of an eye to the stability of thefinancial system as a whole as to theprotection of the individual investor orconduct of an individual firm.

Other elements of the new legislation,such as controls on algorithmic trading,have been introduced as a directresponse to market developments andtechnical innovations since MiFID.Overlaying these drivers was the desirefor further harmonisation of theEuropean financial regulatory frameworkin the wake of the de Larosière Reportand further moves towards a singleEuropean rulebook. This multipartagenda has resulted in an extremelybroad set of rules.

Legislative structureThe existing MiFID framework will bereplaced by two pieces of legislation: aDirective (MiFID2), which will repeal andpartly recast MiFID and a Regulation(MiFIR), which will partly replace MiFID.This Directive-Regulation split at Level 1reflects a common approach in recentEuropean legislative initiatives. The newdirective covers many of the topicsincluded in the original one, such asscope, authorisation, organisation andconduct of business rules, as well assome of the newer topics such asOrganised Trading Facilities (OTFs) andcommodity derivative position limits. Theregulation, which will (unlike the directive)have direct effect, focuses mainly on themarkets reform agenda in order toachieve maximum harmonisation.

There is provision in many areas for theframework legislation to be supplementedby implementing measures. In contrast toMiFID implementation, it is likely that thebulk of the Level 2 measures, in particularthe Regulatory Technical Standards (RTS)

MiFID2/MiFIR: expected timeline

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

2014 2015 2016 2017 2018

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

Consultation on nationalimplementation

Notes:n Legislation in force 20 days after publication in Official Journal

n Commission has requested ESMA to provide advice on delegated actsby December 2015

n Very limited transitional provisions

n Equivalence assessments required for non-EU states

n Market Abuse Regulation (MAR) expected to be published at same timeand to apply from 24 months after it comes into force, i.e. from Q3 2016

ESMA consults onadvice/RTS/ITS

ESMA delivers draft RTS/ITS to

Commission

12 months 6 months

Publication inOfficial Journal

and in force

New rulesbegin to apply

Nationaltransposition

deadline

6 months24 months



and Implementing Technical Standards(ITS) will be issued as regulations, with arelatively limited role for nationalimplementation. Consequently, at Level 3,there will a greater need for ESMAguidance and FAQs. This has also beenthe case with the European MarketInfrastructure Regulation (EMIR) and theAlternative Investment Fund ManagersDirective (AIFMD), where a lack of clearguidance in some areas has causedpractical implementation difficulties.

Implementation challengesAs outlined in the Level 1 text, theproposals present a number ofimplementation challenges. For example,firms will be faced with an array of strategicdecisions – what businesses will they

undertake in the new regime? How shouldfirms help clients with implementation?

Systems implementation issues shouldnot be underestimated. Where MiFID2subjects businesses to totally newrequirements (such as transparencyrequirements for fixed income) or brings aline of business firmly within the regulatoryperimeter for the first time (for examplecertain commodities business) firms willhave to undertake significant systemsbuild ‘from scratch’. By contrast, even forbusiness lines already accustomed to theMiFID regime (most notably equities)changes to market structure will have aprofound impact on how firms interactwith their clients, likely requiring thedismantling of existing systems and theirreplacement with new ones. Thesestructural and operational challenges willhave a knock-on effect on documentationand compliance procedures, with adegree of ‘re-papering’ inevitable. All firmsaffected by the legislation will face theadded complication that the preciserequirements (essential for effectiveimplementation but largely dependent on

Level 2 and Level 3 measures) may not beknown until relatively late in the process –potentially leaving firms with relatively littletime to implement and comply.

Finally, these new rules, in common withother recent regulatory reforms such asthe EMIR and the AIFMD will haveextra-territorial impact. This goes beyondthe direct implications of third countryaccess issues, to the broader question ofEurope’s competiveness compared withother locations – will financial servicesfirms stay, move or be attracted to Europeas a result of the new rules?

Implementation challengesn Strategy

n Clients

n Systems

n Documentation and compliance

n Third country impact

Recast Markets in Financial Instruments Directive (MiFID2)n Scope: instruments, services, exemptions

n Authorisation, controllers, governance, passporting, branches ofthird country firms

n Organisational and conduct of business rules

n Obligations of MTFs, OTFs, regulated markets

n Commodity derivatives position limits, management, reporting

n Data reporting services providers

n Regulatory powers

n Reviews, reports

Markets in Financial Instruments Regulation (MiFIR)n Definitions

n Pre- and post-trade transparency and waivers

n Platform trading obligations for shares and OTC derivatives

n Transaction reporting

n Clearing of derivatives on regulated markets

n Access issues

n Cross-border business by third country firms

n Product/practices intervention powers

n ESMA position management powers

Level 1

Delegated/implementing acts (regulations or directives):n Drafted and adopted by Commission following advice from ESMA

Regulatory/implementing technical standards (regulations): n Drafted by ESMA and endorsed by the Commission

Level 2

ESMA guidelines and ESMA/Commission FAQs

National implementation: n Primary or secondary legislation, regulatory rules

n Penalty regimes

Level 3

Structure of the legislation



One of the key objectives of MiFID2 is toaddress perceived failings in marketregulation in the period leading up to thecrisis. Post 2007, use of MiFIDtransparency waivers had led to asubstantial volume of equities activitymigrating to ‘dark pool’ MTFs whilstfixed income and derivatives productswere not subject to transparencyrequirements under MiFID at all. Whenthe financial crisis hit, it was perceivedthat the prevailing market structuredeprived regulators of the visibilityrequired fully to appreciate risks in the

financial system and that opacity insome markets may have frustrated theirresponse to the crisis.

MiFID2 deals with these concerns by:

n Creating a new venue for multilateraldiscretionary trading – the OrganisedTrading Facility (OTF)

n Widening the scope of the existingMiFID ‘Systematic Internaliser’category (SI) and bolstering thetransparency requirements for SIsacross a range of instruments

n Requiring standardised derivatives tobe traded on an organised andtransparent venue i.e. on regulatedmarkets (RMs), Multilateral TradingFacilities (MTFs) or OTFs

n Requiring investment firms to tradelisted equities on an RM or MTF orwith an SI

n Enhancing transparency requirementsfor platform traded equities andintroducing transparency requirementsto fixed income markets

n Aligning requirements for RMsand MTFs

Organised Trading Facilities In early drafts of MiFID2, the OTFappeared as a new venue specificallydesigned to to capture broker crossingnetworks for equities. However, in the

Part 1 – Markets

“The financial crisis has shifted the objectives of policymakers… MiFID2 has been framed with as much of aneye to the stability of the financial system as a whole asto the protection of the individual investor or conduct ofan individual firm.”

RMs MTFs OTFs1 SIs OTC

Operator Exchange Exchange or Firm Exchange or Firm Firm Firm

Non-discretionary execution Yes Yes No Where quotes binding No

Conduct of business rules No No Yes Yes Yes

Operator can use own capital No No No Yes Yes

Access to facilitiesTransparent, non-discriminatory rules,objective criteria

Transparent , non-discriminatory rules,objective criteria

Transparent, non-discriminatory rules,objective criteria

Commercial policy (inobjective, non-discriminatory way)

Commercial policy

Admission to tradingClear, transparent rules(+ other criteria)

Transparent rules(+ adequate PAI2)

Transparent rules(+ adequate PAI2)

N/A N/A

Resilience, circuit breakers, tick size Yes Yes Yes No No

Surveillance required (MAR) Yes Yes Yes No No

Pre-trade transparency Yes (incl. non-equities) Yes (incl. non-equities) Yes Yes (incl. non-equities) No

Pre-trade waiver available Yes (incl. non-equities) Yes (incl. non-equities) Yes No N/a

Post trade transparency Yes (incl. non-equities) Yes (incl. non-equities) Yes Yes (incl. non-equities) Yes (incl. non-equities)

Publish execution quality data Yes Yes Yes Yes No

Eligible OTC derivs platform Yes Yes Yes No No

Authorities can suspend trading Yes Yes Yes Yes Yes

Record orders Yes Yes Yes Yes Yes

1. Non-equities only; 2. Publicly available information



legislation’s final form equities are notpermitted to be traded on OTFs. Thecategory is framed broadly, to capture allforms of organised trading in non-equities that is not caught by the existingMiFID venue categories. OTFs will besubject to the same core requirementsfor the operation of a trading venue asthe existing organised platforms. Orderexecution on an OTF must take place ona discretionary basis but the operator’sdiscretion is limited to the followingcircumstances: (a) when deciding toplace or retract an order on the systemthey operate; and (b) when deciding notto match a specific client order withother orders available in the systems at agiven time.

Operators of OTFs will be barred fromcommitting their own capital to trades,although matched principal trading ispermitted to a limited degree for nonequity instruments (but not for derivativeswhich are subject to the clearingobligation under EMIR) provided that theclient has consented. The legislation alsoprohibits a firm from running an OTF andan SI in the same legal entity. The latterrestriction could pose a substantialimplementation challenge for firms,particularly in view of the likely increasedimportance of the SI category (see below).

Systematic Internalisers MiFID introduced the concept of a“Systematic Internaliser” to describe afirm that executes client orders against itsown book or other client orders.Ostensibly, the MiFID2 definition of an SIdoes not diverge much from itspredecessor, now referring to “aninvestment firm which, on an organised,frequent systematic and substantial basis,deals on own account when executingclient orders outside a regulated market,an MTF or an OTF without operating amultilateral system”.

Critically though, the definition iselaborated to provide more objectivecriteria against which to measure the“frequent and systematic basis” (by

reference to the number of OTC trades inthe financial instrument carried out by theinvestment firm on own account whenexecuting client orders) and “substantialbasis” (either by the size of the OTCtrading carried out by the investment firmin relation to the total trading of theinvestment firm in a specific financialinstrument or by the size of the OTCtrading carried out by the investment firmin relation to the total trading in the Unionin a specific financial instrument). Thesecriteria will be set at Level 2.

Under the existing rules, these thresholdcriteria are framed in much more subjectiveterms and relatively few firms determinedthat they met them. In practice therefore,the changes heralded by MiFID2 meanthat many more firms are likely to find thatthey meet the criteria. The SI category isalso broadened in terms of product scope,capturing trades in a variety of instruments,including cash equities, depositoryreceipts, ETFs and also non-equities suchas bonds, structured financial productsand derivatives.

MiFIR contains pre-trade and post-tradetransparency requirements for SIs inrespect of both equity and non-equityinstruments. On the equities front, pre-trade, investment firms will be required tomake public firm quotes on shares,

depositary receipts, ETFs, certificates andsimilar financial instruments traded on atrading venue for which they are SIs andfor which there is a liquid market. Therequirements apply to dealings up to thestandard tick size.

In terms of fixed income instruments,investment firms will be required to makepublic firm quotes for bonds, structuredfinance products, emission allowancesand derivatives traded on a trading venuefor which they are an SI and for whichthere is a liquid market when promptedfor a quote by a client and the SI agreesto provide the quote. When those criteriaare fulfilled, the SI has to make the samequote available to other clients while alsoundertaking to deal at that price for tradesbelow a specified size threshold. Thelegislation allows the SI to set limits on thenumber of transactions that theyundertake to enter with their clientspursuant to any given quote as long asthe limits that the SI sets are based ontransparent and non-discriminatorycriteria. Beyond threshold deal sizescalibrated for a particular fixed incomeinstrument, the pre-trade transparencyrequirements for SIs will not apply.

Post-trade, all investment firms (includingSIs) must make public the volume and priceof those transactions traded on a trading



venue and the time they were concluded forboth equities and non-equities.

Equities trading obligationUnder MiFIR, no investment firm mayexecute an equity trade unless it is on aRM, an MTF, with an SI or an equivalentthird country trading venue. This tradingobligation applies to all shares ‘admittedto trading on a regulated market or tradedon a trading venue’ unless the trades arenon-systematic, ad hoc, irregular andinfrequent or carried out between eligibleand/or professional counterparties and donot contribute to the price discoveryprocess. In effect therefore, the obligationwill substantially limit the ability of firms totrade equities on a “pure” OTC basis(other than as an SI).

Coupled with the ban on equities tradingon OTFs, these changes effectively shutbroker crossing networks out of equitiestrading altogether. Equities order flowcurrently routed through firms’ brokercrossing networks will have to find a newhome, either by firms registering as MTFsor executing via SIs. This is not anaccident. The clear intention is to closebroker-crossing network for equity tradingand drive as much equities business aspossible onto rule-based trading venuesor transparent SI execution. In certainrespects then, the post-MiFID2 landscapefor equities trading could resembleanother era, with the increasinglyimportant Systematic Internaliser of thepost-MiFID2 world looking very much likethe modern equivalent of the “jobber” ofthe pre-Big Bang age.

Aligning the requirements forregulated markets and multilateraltrading facilitiesThe requirements for RMs and MTFs arebeing aligned as much as possible asRMs and MTFs are viewed as essentiallysimilar, organised trading functionalities.This will affect requirements in a numberof areas, for example conduct of businessrules, access to facilities and surveillance.

Equity markets transparencyAlthough equity markets were a key focusof MiFID, further reforms are included inthe new legislation, largely focused onincreasing transparency. This is to beachieved primarily via the obligation totrade equities on organised venues (seeabove). However, the new legislation alsoaugurs new pre- and post-tradetransparency requirements for equitiesand equity like instruments such as ETFsand depository receipts whilst re-framingthe terms of transparency waivers thatcurrently apply to equities business. Inresponse to the fragmentation of tradedata that followed from the introduction ofvenue competition under the originalMiFID, the new rules also contemplate theintroduction of a consolidated tape forequities and equity like instruments.

Pre- and post-trade transparencyrequirements for trading venues MiFID introduced harmonised pre andpost-trade transparency requirementson shares admitted to trading onregulated markets. The transparencyrequirements have now been expandedto include equity instruments other thanshares admitted to trading on tradingvenues including depositary receipts,ETFs, certificates and other similarfinancial instruments.

Pre-trade, trading venues will have tomake public their current bid and offerprices, depth of interest information andactionable indications of interest on acontinuous basis during normal officehours. The precise requirements will becalibrated to cater for different types ofequity instruments. Much of the detailedrequirements are to be specified in theimplementing measures.

Post-trade, trading venues have to makepublic the price, volume and time oftransactions in as close to real time as‘technically possible’.

Waivers from pre-trade transparency willcontinue to be permitted, providing thisdoes not cause competitive distortionsand reduce the overall efficiency of the

“The imposition of the newcategory of OTFs, coupledwith a wider scope for SIs,will result in a change to thecomposition of the marketwith more activity on SIsand OTFs and reducedactivity in OTC markets.”



price discovery process. Under the currentregime, there are four pre-tradetransparency waivers. Two such waivers,the ‘large in scale waiver’ and the ‘ordermanagement system waiver’ remain intact.However, the ‘reference price waiver’ andthe ‘negotiated price waiver’ are both nowsubject to volume caps (4% of the total EUvolume of trading in an instrument on asingle venue or 8% of the total EU volumeof trading in an instrument across all EUtrading venues). In addition, the use of thereference price waiver is subject to a priceimprovement mechanism, which meansthat the orders must be matched at themidpoint within the current bid and offerprices of the trading venue. When themidpoint price is not available, the orderscan be matched at the open or closingprice of the relevant trading session.

ESMA is to issue rules in this area, so thatprecise detail of how the waiver will workin practice will become clearer as theESMA rulemaking process is conducted.It is likely that determining what ispermitted to trade ‘off market’ is likely tobecome more difficult for investmentfirms. Non investment firms will be able totrade off market.

Fixed income and derivativemarkets transparencyMiFIR introduces pre- and post-tradetransparency requirements for non-equities (e.g. bonds, structured financeproducts, emission allowances andderivatives). The introduction oftransparency requirements for the fixedincome and derivatives markets is a newconcept and likely to pose implementationchallenges for firms on an operationallevel. In addition, the comparativefragmentation and relative lack of liquidityin fixed income markets have already ledto concerns about the implications(particularly for market makers and theprice at which they can hedge) of thetransparency requirements on fixedincome markets. In this regard, Level 2measures and Level 3 guidance that helpto define the boundaries as to what fixed

income instruments are considered liquidenough to be subject to the regime will beof critical importance.

Pre- and post-trade transparencyrequirements for trading venuesUnder MiFIR, RMs, MTFs and OTFs andfirms operating these trading venues willhave to publish bid and offer prices and‘depth of trading interest’ information. Theywill also be required to disclose actionableindications of interest. It is worth noting thatthe data will have to be published on acontinuous basis during normal tradinghours. From an operational standpoint, thatrequirement could pose a significantimplementation challenge.

The legislation sets out a set of waiversfrom the pre-trade transparencyrequirements. There are three grounds onwhich the waiver might be granted:

n Orders large in scale, compared withnormal market size

n Indications of interest in requests forquotes and voice trading systemsabove a size specified for a particularinstrument, such that disclosurewould expose liquidity providers toundue risk

n Derivatives not subject to the tradingobligation and for any instruments forwhich there is not a liquid market

The waiver regime is to be overseen bynational regulators acting in consultationwith ESMA. The scope and range ofexemptions from fixed incometransparency requirements stands incontrast to the narrower US exemptions.Until Level 2 measures are finalized,

question marks may remain over theequivalence of the new European fixedincome transparency regime with itsUS counterpart.

On the post-trade front, MiFIR requirespublication of price, volume and time oftrade data in as close to real time aspossible. The legislation does contemplatea deferral regime which may be employedto ensure that the increased transparencyrequirements do not adversely impactmarket-making. Features of the regimeinclude time delays and volume omissionsto allow market-makers to avoid the risk ofadverse price movements on theannouncement of their trades. The regimefor deferrals bears some similarities to thepre-trade waiver requirements, havingthree broad categories for deferral.However, the precise operation of thepost-trade deferral regime will not becompletely clear until the Level 2legislation and Level 3 guidance hasbeen issued.

Transaction reportingMiFIR expands the original MiFIDtransaction reporting obligation. Underthe new rules, which will also involve asignificant increase in the volume ofreportable data, investment firms thatexecute transactions in financialinstruments must report complete andaccurate details of the transactions to thecompetent authority as quickly as possible,and no later than the close of the workingday following the trade. The obligationapplies to the following types of instrument(though in each each case regardless as towhether or not the transaction wasexecuted on the trading venue):

n financial instruments which areadmitted to trading or traded on atrading venue or for which a request foradmission to trading has been made

n financial instruments where theunderlying is a financial instrumenttraded on a trading venue

“Until Level 2 measuresare finalized, questionmarks may remain overthe equivalence of the newEuropean fixed incometransparency regime withits US counterpart.”



n financial instruments where theunderlying is an index or a basketcomposed of financial instrumentstraded on a trading venue

Transaction reports can be made tonational competent authorities directly bythe investment firm itself, via an approvedreporting mechanism (ARM) or by therelevant trading venue. While investmentfirms generally have responsibility for thecompleteness, accuracy and timelysubmission of the reports, the rulesprovide that firms will not be responsiblefor failures in the completeness, accuracyor timely submission of the reports whichare attributable to an ARM or tradingvenue (though firms are neverthelessobliged to take reasonable steps to verifythe completeness, accuracy andtimeliness of the transaction reportssubmitted on their behalf).

Derivatives trade executionUnder MiFIR, a class of OTC derivativeswhich is subject to the clearing obligationsunder EMIR may also be declared subjectto mandatory platform trading obligations,requiring that class of derivative only betraded on an RM, MTF, OTF or anequivalent third country market. Tobecome subject to this mandatory tradingobligation the class of derivatives must beadmitted to trading on at least onerelevant trading venue and be sufficientlyliquid. The mandatory platform tradingobligation does not apply to transactionsthat are exempt from the EMIR clearingobligation under either the intragroupexemption or the EMIR transitionalprovisions regime.

OTC derivatives may become subject tothe mandatory trading obligation viaeither a ‘top down’ or a ‘bottom up’process. The latter is driven by a class ofOTC derivatives becoming subject to theEMIR clearing obligation, following whichESMA will consult on whether to applythe mandatory trading obligation to thatclass (or a subset of it). Under the top

down process, ESMA will monitor activityin OTC derivatives not yet subject tomandatory clearing to identify potentialsystemic risks or regulatory arbitrage andwill notify the Commission of derivativesthat ESMA thinks should be subject tothe trading obligation but for which noCCP is authorised to clear the contractsor which are not yet admitted to tradingon a platform.

ESMA will also be required to maintain aregister of derivatives that are subject tothe trading obligation, which venues theyare to be traded on and the date onwhich the trading obligation came intoeffect. Level 2 and Level 3 measures willbe important to the calibration of themandatory derivative trading obligation sothe precise details of the obligation mayremain unclear for some time.

Unlike the majority of the other obligationsunder MiFID2 and MiFIR, the derivativestrading execution requirements do notapply only to investment firms. Themandatory trading obligation has a similarscope of application as the clearingobligation under EMIR, applying tofinancial counterparties and non-financialcounterparties over the threshold, wherethey are dealing in mandatorily tradable

derivatives, either with another financialcounterparty or another non-financialcounterparty over the threshold.

The mandatory trading obligation forderivatives also has importantimplications for financial counterpartiesand non-financial counterparties dealingwith third country entities that would havebeen subject to the obligation if they werein the EU and for third country firmsdealing with other non-EU firms. If thetransaction has a direct, substantial andforeseeable effect in the EU, or if it isnecessary or appropriate to preventevasion, ESMA can also apply themandatory trading obligation to atransaction between two third countryentities, much in the same way that theEMIR clearing obligation can apply totrades between two such entities.

In terms of identifying the permittedplatforms for derivatives subject to theobligation, the Commission will beresponsible for determining theequivalence of third country venues,making its assessment against criteriasuch as the third country rules on venueauthorisation and supervision, disclosureand transparency rules as well as themarket abuse regime.


Algorithmic and highfrequency tradingThe MiFID2 requirements on algorithmictrading have been driven bydevelopments in the market and as aresponse to incidents such as theinfamous ‘flash crash’ that struck in May2010 in the United States. Regulatorsbelieve that algorithmic trading causessystemic risks and, in order to addressthis, MiFID2 establishes a series ofrequirements for investment firms whouse algorithmic trading and for tradingvenues where algorithmic trading or high-frequency algorithmic trading takes place.

The requirements cover:

n Extension of licensing to investmentfirms that are members of RMs orMTFs, have direct electronic access totrading venues or apply high frequencyalgorithmic trading techniques

n Enhanced information requirementsby regulators, for example on thestrategies of algorithmic traders

n Stricter checks on direct electronicaccess/sponsored access to tradingvenue systems

n Investment firms engaged in algorithmictrading pursuing a market makingstrategy to have appropriate systemsand controls for such activity and tohave a liquidity provision obligation

n Trading venues to have circuitbreakers and robust controls in place

To ensure consistency, the requirementsfor algorithmic trading interact withthose of the Market Abuse Regulationand the Market Abuse Directive 2, wherethe definition of market manipulation willexpressly refer to certain algorithmic orhigh frequency trading strategies.

Open accessAnother key feature of the MiFID2 marketreforms is open access, requiring all tradingvenues (RMs, MTFs and OTFs) to establishtransparent and non-discriminatory rules onaccessing the facility. The new rules also

contemplate that investment firms shouldhave access to clearing and settlementsystems throughout the EU, regardless asto whether transactions have beenconcluded through regulated markets inthe member state concerned.

The new rules aim to foster competitionamongst trading venues and CCPs. Tradingvenues are to have non-discriminatory andtransparent access to CCPs. Venues arealso entitled to enjoy non-discriminatorytreatment by CCPs in terms of collateral, thenetting of economically equivalent contractsand cross-margining with correlatedcontracts cleared by the same CCP, as wellas non-discriminatory clearing fees. Inaddition, CCPs are to have rights to clearinstruments traded on trading venues on anon-discriminatory basis and trading venuesand CCPs are to have non-discriminatoryaccess to information and licences frombenchmark proprietors. However, there areextensive transitional provisions, in particularfor exchange traded derivatives, new CCPsand benchmark proprietors.




Third country firms – branchand cross border regimeCurrently, there is no harmonised regimegoverning access by third country (i.e.non-EU) firms to EU markets. Instead,each member state operates its ownregime, subject to the general principlesof the EU treaties. MiFID2 and MiFIRmake a limited attempt to introduce amore harmonised framework for businesstargeted towards certain types of client.

The new rules allow (but do not compel)member states to require third countryfirms to establish branches whenproviding services to retail or electiveprofessional clients. If a member statedoes impose a branch requirement, thenauthorisation criteria and conduct ofbusiness rules will apply. Alternatively,member states may choose to allowservices to be provided on the basis ofexisting national rules.

In addition to the third country branchregime, MiFIR introduces a harmonisedthird country equivalence regime, whichwill allow access by third country firms tothe EU when providing services toprofessional investors and eligiblecounterparties on a cross-border basis.

The main requirements are:

n Third country firms must register withESMA to provide services on a cross-border basis

n The Commission must have decidedthat the third country has rules andsafeguards ‘equivalent’ to those inthe EU

n Reciprocity by the third countryis necessary

n Regulatory cooperation agreementsmust be in place between ESMA andthe competent authorities of thethird country

The Commission will determine whether aparticular third country is equivalent,based on whether the third country’s

regulatory and supervisory frameworkachieves the same objectives as EUlegislation. The third country’s frameworkalso needs to provide for an effective,equivalent system for the recognition ofinvestment firms authorised in otherjurisdictions, i.e. there must be reciprocityin the treatment of EU firms.

Once the Commission has adopted anequivalence decision with respect to aparticular country and ESMA hasestablished cooperation agreements withthe competent authorities there,investment firms from that country will beable to provide services on a cross borderbasis to per se professional clients andeligible counterparties, provided that theyhave registered beforehand with ESMA.For three years after an equivalencedecision is made, member states cancontinue to apply national rules. Nationalrules will also continue to apply until suchtime as an equivalence decision is taken.

The new cross-border provisions relateto per se professional clients and eligiblecounterparties. Member states willcontinue to apply national rules withrespect to retail clients. This mightinclude a requirement for the thirdcountry firm to establish a branch, asdescribed above, but it is important tonote that this is entirely optional and themember state may continue to operateits existing rules.

To this extent, the rules around thirdcountry access, especially as they relateto retail investors are not harmonised. Itmay also be some time before we see thepractical effects of the new provisions, asunderpinning the new cross borderregime is the equivalence assessment bythe Commission, which in turn dependson reciprocity. Experience with EMIR hasshown that these decisions may not beissued speedily and might not be issuedat all. In any event, member state rules oncross border business will continue toapply for three years, even after anequivalence decision has been reached

and it is only after that period has expiredthat ESMA-registered third country firmscan provide services to eligiblecounterparties and professionalsthroughout the EU on the basis of theirown home state rules. As a result, it islikely that the provision of services on across-border basis will continue alongcurrent lines for the foreseeable future.

Conduct of business andinvestor protectionThe conduct of business provisions ofMiFID2 are the primary means by whichthe directive achieves improvements ininvestor protection. These provisions havebeen subject to heated debate andconstant evolution during the legislativeprocess, in response to a litany of differentmis-selling scandals. The result issomething of a ‘patchwork’ ofmodifications to existing rules. In commonwith other parts of MiFID2, much of thedetail on the new conduct of businessrules will not be known until the Level 2and Level 3 measures are available.

The main changes to conduct of businessrules relate to:

n Extending the scope of the conductof business rules to includestructured deposits

n Product design

n Title transfer with retail clients

n Conflicts of interest

n Execution only business

n Best execution performance andpublic disclosure

Structured depositsMany of the conduct of businessrequirements under MiFID will beextended to cover structured deposits, sothat investor protection requirements willnow apply when a firm sells or advises inrespect of structured deposits (i.e.deposits where repayment is linked to anindex, MiFID instrument, commodity orother non-fungible asset or FX rate).

Part 2 – Firm Regulation



Product designThese provisions are clearly a response byEU lawmakers to recurrent mis-sellingscandals. The legislation imposes a newset of requirements firms that manufactureinvestment products, covering:

n Pre-sale internal approval processes

n Identification of target market toensure all relevant risks assessed

n Distribution strategies – they must beconsistent with the identified targetmarket (retail and/or professional)

n Requirements for periodic reviews

n Ensuring distributors haveinformation on product design andintended markets

The recitals to the legislation make clearthat the new rules are not intended to putthe burden of responsibility exclusively onthe manufacturer. The new rules do noteliminate responsibilities of distributors,but rather increase the significance of themanufacturer’s regulatory obligations.

Title transfer with retail clientsThe directive establishes a requirementfor investment firms holding client fundsand assets to make adequatearrangements to safeguard clients’ownership rights, especially in the eventof the investment firm’s insolvency, and toprevent the use of a client’s financialinstruments on the firm’s own accountexcept with the client’s express consent.The directive also introduces a prohibitionon investment firms entering into titletransfer financial collateral arrangementswith retail clients.

Conflicts of interest Conflicts of interest is one of the majorbusiness rules that has been expandedunder MiFID2. Now, the focus is on morestringent rules in respect of inducementsand remuneration structures within firms.The extent to which these requirementsapply to professional clients, in addition toretail, will be a key consideration.

The main requirements include:

n Firms to ensure that remunerationand third party inducements do notconstitute conflicts (for example, firmswill not be able to operate salestargets for retail clients that could leadto an omission to offer a moresuitable product)

n Inducements disclosures mustexplain how the benefit is to betransferred to client

n Disclosure to the client as to whetheror not investment advice is providedon an independent basis;

n Regard to the requirements of theintended target market when marketingand distributing financial products;

n Aggregation of all cost and charginginformation (and provision of a detailedbreakdown to the client on request) toallow the client to understand theoverall cost as well as the cumulativeeffect on return of the investment

n Prohibition on accepting and retaininginducements from third parties, otherthan minor non-monetary benefits

n Where investment services arebundled, informing the client whetherthe different components can bepurchased separately

Execution only businessUnder the new legislation the scope ofactivities that can be carried out on an‘execution only’ basis and hence withouta suitability assessments has beennarrowed considerably in relation tocertain products e.g. margin trading,embedded derivatives, complexstructures and structured UCITS.

Best execution performance –public disclosureUnder MiFID2, the key development inrelation to best execution is a requirementthat firms disclose publicly, on an annualbasis, information on which are the topfive execution venues by volume inrespect of a particular type of instrument

used by that firm. The new rules alsorequire trading venues and systematicinternalisers to publicly discloseinformation on the quality of executionthey provide, including details about price,cost, speed and likelihood of execution.

Regulatory interventionpowers and administrativesanctionsAs part of its objective to raise the bar forinvestor protection standards, MiFIRextends very wide ranging regulatorypowers in the arena of productintervention, authorising ESMA, the EBAand national regulators to imposetemporary bans or restrictions on themarketing, distribution or sale of certainfinancial instruments (including structureddeposits) or types of financial activity orpractice. The ability to impose limits on “atype of activity or practice” appears to bea very broad power indeed, with scope toimpact not only the regulated activities offirms but potentially the activities of theircustomers as well.

There are a number of conditions forproduct or activity intervention includingthat the intervention addresses asignificant investor protection or financialstability concern and that existingrequirements inadequately address thethreat. Interventions are also subject to aproportionality requirement.

Firms are already familiar with regulation atthe point of sale, such as rules relating tofinancial promotions, selling practices,product disclosures etc. However, theMiFIR intervention powers are novel and at

“In the post MiFID2world… there is likely tobe much more regulatoryscrutiny – and potentiallyregulatory challenge –even before a productreaches the market.”



this stage, it remains uncertain what anintervention might look like in practice. Inthe post-MiFID2 world though, there islikely to be much more regulatory scrutiny -and potentially regulatory challenge – evenbefore a product reaches to the market.

New regulatory intervention powers willpresent a range of questions andconcerns for firms: will pre-approval forproducts be required? What is required interms of systems, documentation andcompliance? What is the best marketingstrategy? Will different nationalinterventions fragment from single market?What is already clear, however, is thatfirms will need to review their systems andcontrols and look at product governancestrategies in a lot more detail in the future.

In response to quite wide disparity ofscope and level of sanctioning powersused by national regulators acrossdifferent member states, the new rulesalso seek to encourage a moreharmonised approach to administrativesanctions, requiring competent

authorities to have regard to relevantcircumstances when setting the typeand level of an administrative sanction,including (but not limited to) the gravityof infringement, the financial strength ofthe person responsible, the importanceof profits gained or losses avoided andany previous infringements. Sanctionsare also required to be sufficientlydissuasive and it is envisaged that infuture, regulatory fines should be highenough to offset any benefit of aninfringement, in some cases up to 10%of consolidated turnover.

Commodity derivativesThe MiFID2 package of reforms marks astep change in the regulation ofcommodity derivatives in the EU. Themain developments relate to:

n Scope – MiFID2 will bring morecommodity derivatives within theregulatory perimeter

n A reduction in the number ofexemptions available forcommodities dealers

n Introduction of position limits andposition management controls forcommodity derivatives

ScopeCurrently, under MiFID, contracts tradedon an RM or MTF that can be physicallysettled are within scope as “MiFIDinstruments”. Under MiFID2, this isexpanded to cover physically settledcommodity derivatives traded on an OTFas well. There will however, be anexemption for certain energy contracts.

Exemptions for commodities dealersThe existing exemptions have beennarrowed to increase regulatory oversightand transparency. The current exemptionin Article 2(1)(k) of MiFID (for dealerswhose main business consists of ownaccount dealing in commodities orcommodity derivatives) has been deleted,effectively bringing many commoditiesdealers who currently rely on thisexemption within the regulatory perimeterfor the first time. Additionally, the Article2(1)(d) exemption (which currently

Scope – what is a commodity derivative?

‘wholesale energy products’ is defined in REMIT tomean the following contracts and derivatives,irrespective of where and how they are traded:

(a) contracts for the supply of electricity or naturalgas where delivery is in the Union;

(b) derivatives relating to electricity or natural gasproduced, traded or delivered in the Union;

(c) contracts relating to the transportation ofelectricity or natural gas in the Union;

(d) derivatives relating to the transportation ofelectricity or natural gas in the Union.

Continuance of existing definition of specifiedunderlyings and “characteristics of other derivativefinancial instruments” under Article 38 MiFIDImplementing Regulation?

n Cash settled commodity derivativesn Cash settled forwards now expressly included

n Physically settled commodity derivatives traded on aregulated market, MTF or OTF

n Carve-out for wholesale energy products under REMITtraded on an OTF that must be physically settled*

n Other derivatives on commoditiesn Not for commercial purposes, which have the

characteristics of other derivative financial instrument [...]

* Plus competent authorities can give temporary exemption from EMIR clearing/clearing threshold for physically settled oil/coal derivatives traded on an OTF. Thedefinition of commodity derivative is also extended to include commodity derivative warrants and similar instruments and certain other derivatives on non-financialunderlyings (C(10)).

C(5)

C(6)

C(7)



provides conditional exemption for certainfirms who do not provide any investmentservices apart from own account dealing)has been amended so as not to apply todealers in commodity derivatives,emissions allowances and derivatives inemissions allowances. The remainingexemption, currently in Article 2(1)(j) isretained for ‘ancillary activities’, albeitreduced in scope: the exemption won’tbe available if executing client orders,market making, or employing highfrequency or algorithmic trading strategiesfor commodities.

Position controls for commoditiesderivativesMiFID2 introduces a new regime ofposition limits for commodity derivatives,outlined in the diagram below.

The imposition of position limits is likely tocause significant implementation issues.Competent authorities regulating thetrading venues will impose position limitson the net position held at any time incommodity derivatives traded on tradingvenues and economically equivalent OTCcontracts. The limits are to be set on thebasis of all positions held by a person andthose held on its behalf at the group level.A group wide position limit is likely torequire complex calculations, which maydiffer by delivery month. This represents amajor implementation requirement for anyfirm which trades in these markets.

Another significant aspect to thelegislation relates to the obligation fortrading venues to report aggregatepositions by class of persons, including

daily breakdowns of positions (e.g. byparticipants, clients, clients of clients) tocompetent authorities. Firms have to beable to provide that information to thetrading venue; a participant may have toget that information from its clients to beable to pass that on, posing a substantialoperational burden.

Position controls for commodity derivatives

Position limitsCompetent authorities shall impose position limits on:n Net position that a person can hold at all times;

n In commodity derivatives traded on trading venues andeconomically equivalent OTC contracts;

n Limits to be set on the basis of all positions held by aperson and those held on its behalf at an aggregategroup level

Except that: Limits shall not apply to positions held by or on behalfof a non-financial entity, and which are objectivelymeasurable as reducing risks directly related to thecommercial activity of that non-financial entity.

Other powers for competent authoritiesn Temporary additional position limits in exceptional cases

(valid for up to 6 months)

n Additional supervisory powers (including power to requirea person to provide information on commodity derivatives,to reduce their position or to limit the ability of a person orclass of persons to enter into a commodity derivative)

Position managementOperators of trading venues trading commodityderivatives must apply position management controls,including powers to: n Monitor open interest;

n Access information about size and purpose of a position;

n Require a person to terminate or reduce a position;

n Require a person to provide liquidity

Position reportingOperators of trading venues trading commodityderivatives must:n Weekly: make a public report of aggregate positions by

class of person

n Daily: provide a complete breakdown of all positions(participants, clients, clients of clients) to competent authority

n Require participants to provide them with necessaryinformation to enable them to report

ESMA powersn Market monitoring and power to ban products / activities

n Co-ordination of national measures

n Additional position management powers



Simon CrownPartnerLondonT: +44 20 7006 2944E: simon.crown@

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Notes

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Documents

MiFID2 and MiFIR – What you need to know · PDF fileMiFID2 and MiFIR – What you need to know 1 ... n Introduction of a new multilateral, discretionary trading venue, the Organised