for asset managers
Key business impacts Duties to clients Dealing in the markets Organisational requirements
The revised Markets in Financial Instruments Directive and the related Regulation (together, MiFID 2) are due to take effect on 3 January 2017. MiFID 2 will have a significant impact on asset managers in the EEA, both as regards the management of collective investment schemes (fund management) and the management of individual portfolios (portfolio management). ESMA published a discussion paper and a consultation paper in May 2014 which give important information about the likely content of the Level 2 implementing measures needed to complete MiFID 2. ESMA has received a great deal of feedback and its proposals are likely to be refined, perhaps significantly in some areas. The Commission is not bound to accept ESMA's final advice, but it is likely that what ESMA has said so far indicates the direction of regulatory policy.
This briefing considers the main issues. A number of these potentially affect a firm’s distribution and sales strategies. Others relate to the way in which trades are executed for clients, with new restrictions on OTC trading and internal crossing systems. Some hedge fund and commodity fund managers will be particularly affected by new rules on algorithmic trading and commodity derivatives position limits. Other changes in areas such as best execution and transaction reporting will necessitate some adaptation of a firm’s systems and controls.
The impact of the changes is different for portfolio managers and fund managers because fund managers are largely regulated under the UCITS Directive or the AIFM Directive rather than MiFID. However, MiFID 2 does have implications for fund managers and these are identified below.
Key business impacts
· Use of dealing commission – The ability of portfolio managers to obtain investment research from brokers or third parties without having to pay for it separately, is likely to be significantly curtailed or terminated altogether.
· Other commission payments – Portfolio managers will not be able to receive commission from product providers without paying it on to the client.
Similarly, investment advisers will not be able to accept commission from asset managers without paying it on to their clients.
· ‘Appropriateness’ test required for more products – The requirement to assess whether a particular investment fund is appropriate when a non- advised sale is made to a retail client will be extended. It will now cover structured UCITS, for example.
· Restrictions on OTC trading – There will be new restrictions on OTC trading of equities and derivatives which, among other things, will affect a firm’s ability to use internal crossing systems.
David Rouch T +44 20 7832 7520
Edavid.email@example.com Jonathan Baird
T +44 20 7832 7197
Ejonathan.firstname.lastname@example.org Matthew Cosans
T +44 20 7832 7073
Ematthew.email@example.com David Scott
T +44 20 7832 7379
Edavid.firstname.lastname@example.org Piers Reynolds
T +44 20 7716 4111
· Greater transparency of market dealings – A wholly new pre- and post-trade transparency regime is being introduced for bond, derivative and other non- equity trading. More generally, a European consolidated tape for post-trade data is envisaged, although there is still a lot of work to be done to make this a reality.
· Commodity derivative position limits – Regulators will impose position limits for commodity derivatives, including both OTC and venue trading.
Asset managers will need to disclose their clients’ positions for monitoring purposes.
· Other – Changes to the rules on best execution, suitability, trade reporting, transaction reporting, and portfolio and cost information for clients will require changes to a firm’s systems and controls.
Duties to clients
Commission and other inducements
Portfolio managers will be banned from accepting and retaining fees, commissions or any monetary benefits from any third party (for example, issuers and product providers) relating to the provision of their services to clients.
This is a change both from the current MiFID rules (under which such payments or benefits may be received and retained in limited circumstances) and from the UK rules implementing the Retail Distribution Review (which do not apply to receipt of commission by portfolio managers). Strictly, what will be prohibited is only the retention of such commissions. So it would be permissible for a portfolio manager to receive commission provided it credits it to the client’s account as soon as possible – it may not offset it against the firm’s own charges.
The MiFID 2 level 1 text allows an exception for the receipt and retention of ‘minor non-monetary benefits’. These must be of a scale and nature such that they could not be judged to impair compliance with the firm’s duty to act in the best interest of its client and must be clearly disclosed.
ESMA proposes to advise the Commission to set out an exhaustive list of acceptable
‘minor non-monetary benefits’. These would include participation in conferences, seminars and other training events on the benefits and features of a specific financial instrument, and hospitality of de minimis value.
ESMA also specifically addresses the question of portfolio managers receiving investment research in return for dealing commission. ESMA states that any research that involves a third party allocating valuable resource to a specific portfolio manager would not constitute a minor non-monetary benefit. The UK FCA believes that this would effectively require the ‘unbundling’ of research from dealing commission except for the most generic, widely available commentary. In a discussion paper published in July 2014 the FCA says that it supports that position. However, it is not clear that ESMA intends to go quite that far, as its draft advice to the Commission (as opposed to its preceding analysis) simply says that the list of acceptable minor non-monetary benefits should include ‘information or documentation relating to a financial instrument (including financial research) or an investment service. This information could be generic or personalised to reflect the circumstances of an individual client.’
ESMA's proposals have generated a good deal of opposition because they will create an unlevel playing field internationally and potentially within Europe; portfolio managers will be at a competitive disadvantage relative to fund managers. ESMA says it will advise the Commission to consider aligning the requirements of the UCITS and AIFM Directives with MiFID 2. It also appears to be the case that these proposals will require unbundling of research in debt markets where there is no explicit commission.
It seems more likely than not that MiFID 2 will significantly curtail the ability of portfolio managers to continue to receive research without explicitly paying for it. (It is also possible that the FCA may unilaterally adopt more stringent rules if it does not think MiFID 2 goes far enough, but its work is at an earlier stage than ESMA's and it has said that it recognises the advantages of EU or even global consensus on the issue.)
MiFID 2 will also strengthen the rules regarding the payment by a firm of
commissions or non-monetary benefits. For asset managers this will be relevant in relation to payments to financial advisers or other intermediaries for fund distribution or for portfolio management introductions. The first point here is that independent investment advisers in the EEA will no longer be able to receive these payments - or, if they do receive them, they will have to pay them on immediately to the client. (The UK already has such a prohibition – more wide-ranging in some respects - which extends to all financial intermediaries, whether or not independent.) This could clearly have important implications for a firm’s distribution arrangements.
In cases where the intermediary is able to accept commissions, a portfolio manager will continue to be able to pay them provided that the three existing conditions are met. These are that the payment is designed to enhance the quality of the service to the client; that it does not impair compliance with the portfolio manager’s duties to act in its client’s best interests; and that there is adequate disclosure to the client. The disclosure requirement is being strengthened so that the portfolio manager will have to disclose to the client the actual amount of the payment it is making before it can act for the client. If the actual amount cannot be ascertained at that point, the method of calculating it must be disclosed. The current derogation that enables a firm to disclose only ‘the essential elements of the arrangements’ in advance will no longer apply.
ESMA’s draft advice to the Commission would expressly prohibit the payment of on- going commission unless it relates to the provision of an on-going service to an end- user client.
It will no longer be possible for portfolio managers automatically to treat
municipalities and local public authorities as professional clients. In future this will only be possible if they have opted to be treated as such and the firm has assessed them as having the requisite knowledge and experience.
The MiFID 2 changes regarding best execution are not major, but there will be some significant changes in the detail.
A portfolio manager’s execution and order placing policy will need to be more detailed and specific, both as regards the venues and brokers used for particular classes of instrument and as regards the factors used in the selection. The summaries of execution and order placing policies that must be given to retail clients should focus on the total known costs associated with trading in particular ways. Some of the information required is likely to be burdensome or overly detailed for a large portfolio manager and it is to be hoped that ESMA will introduce some materiality thresholds.
A portfolio manager will also need to make public annually the top five execution venues on which it has executed client orders in the preceding year for each class of financial instrument. This will apply to trades executed by the firm itself rather than to those passed to a broker for execution.
A portfolio manager will not be permitted to receive any remuneration for routing clients’ orders to a particular execution venue. (The new rules on a manager’s receipt of benefits from a broker are discussed above.)
Trading venues and systematic internalisers (SIs) will be required to publish annual data relating to the quality of execution. A portfolio manager will be expected to take this into account in its execution policy.
There will be a significant extension to the range of products for which a firm must conduct an appropriateness test when it sells to a retail client on a non-advised basis.
In particular, the test will apply to structured UCITS and to investments in a non- UCITS investment fund. However, in its response to ESMA, the IMA has pointed out that the intention was not to make the latter kind of fund automatically non-complex, but rather to subject it to the additional Level 2 tests which determine whether something is complex or not. It will be interesting to see whether ESMA agrees.
This could have significant implications for managers of products brought within the appropriateness test for the first time that are currently sold to retail clients on a non- advised basis. In these cases the distribution strategy will need to be reassessed.
Costs and portfolio information for clients
MiFID 2 is intended to improve the information available to clients on costs and charges. In this respect its concerns are similar to those highlighted by an FCA review earlier this year which concluded that most asset managers were failing to provide retail investors with clear ‘all-in’ figures on fund charges. In particular, MiFID 2 requires that clients should be given an aggregated overview of all the firm’s costs and charges and should be able to obtain an itemised breakdown on request. The
information should also enable the client to understand the cumulative effect of costs and charges on the investment return. And information should be provided not only at point of sale but also at least annually thereafter.
ESMA's proposals, if not amended, may result in some mismatched and overlapping regulation. There is some potential conflict with the UCITS Key Information Document (KID) requirements. It will also be important that the final form or the MiFID 2 requirements do not pre-judge the contents and format requirements of the Packaged Retail and Insurance-based Investmentment Products KID. ESMA is proposing that the new MiFID requirements regarding a portfolio manager’s disclosure of costs and charges should apply in relation to professional and retail clients – at present MiFID requirements apply only for retail clients.
ESMA has also proposed that a portfolio manager will have to report to its client on the content and value of the portfolio on a quarterly basis (compared with twice a year under the existing MiFID).
Suitability requirements look set to remain largely unchanged. ESMA is proposing a new focus on costs, and in particular that a portfolio manager should be able to justify a decision to switch investments or to invest in complex or high-cost products. It also proposed that a portfolio manager’s periodic reports to its client should include a statement on ongoing suitability.
Conflicts of interest
ESMA proposes to make clear that disclosure of conflicts to clients should be used only as a last resort and that effective organisational and administrative arrangements to avoid or manage conflicts should be used first. Disclosure and informed consent will remain important, as a matter of English law, where a fiduciary duty is owed. The FCA’s concerns about the management of conflicts of interest by asset managers were highlighted in the results of a thematic review published in November 2012.
Duties owed to ‘eligible counterparties’
MiFID already requires a firm to act honestly, fairly and professionally towards its clients and to communicate with them in a way which is fair, clear and not misleading.
A portfolio manager therefore owes this duty to its clients, and is in turn owed this duty by MiFID-regulated brokers who execute orders on its behalf. Under MiFID 2 a firm will owe this duty to its ‘eligible counterparties’ also. A portfolio manager which executes a transaction itself with a counterparty in the market will therefore owe this duty to the counterparty, and will be owed it in return if the counterparty is also regulated under MiFID 2.
Dealing in the markets
Trading and clearing requirements
MiFID 2 will push more trading of shares and derivatives onto regulated trading venues. Shares that are admitted to trading on a Regulated Market (RM) or Multilateral Trading Facility (MTF) will generally have to be traded on one of those venues or with an SI, or an equivalent non-EU venue. A firm will only be able to execute elsewhere if that trading is non-systematic, ad hoc, irregular and infrequent, or if the trade is carried out between eligible and professional counterparties and does not contribute to the price discovery process.
As regards OTC derivatives, ESMA will require certain standardised derivatives to be centrally cleared under the European Markets Infrastructure Regulation (EMIR).
MiFID 2 goes further and will require sufficiently liquid clearable derivatives to be traded exclusively on RMs, MTFs, Organised Trading Facilities (OTFs) or equivalent
non-EU trading venues. This requirement will apply to fund managers as well as portfolio managers.
Portfolio managers that currently execute trades through in-house crossing systems will need to review these arrangements in the light of the new requirements. In future a crossing system will generally need to qualify as an MTF for equities (if retail clients are involved), or an MTF or OTF for derivatives.
Pre- and post-trade transparency
Equities - The MiFID pre-trade transparency regime for equities will be expanded to cover equity-like instruments (e.g. depository receipts and ETFs). It will also cover equities admitted to trading on MTFs, not just those admitted to RMs as at present.
The types of trade for which national regulators will be able to grant pre-trade transparency waivers – i.e. ‘dark pool’ trading - will be more constrained. In
particular, the reference price and negotiated trade waivers will be subject to volume caps. These will be assessed for each trading venue as well as overall EU trading. No individual trading venue will be able to execute trades covered by these waivers exceeding four per cent of total trading in the relevant instrument on all EU trading venues. And no more than eight per cent of all trades in a particular instrument on all EU trading venues can be covered by these waivers. If the limits are breached the relevant national authorities for the trading venues will suspend operation of the waivers. The caps will not apply to negotiated transactions in illiquid instruments.
Post-trade transparency requirements have also been expanded as regards the types of instruments and the trading venues covered (i.e. including MTFs and OTFs).
Operators of trading venues must make details of transactions public as close to real time as technically possible, although deferred publication may be authorised for block trades.
Non-equities – One of the major changes in MiFID 2 is the introduction of pre- and post-trade transparency requirements for non-equities (i.e. bonds, structured finance products, emission allowances and derivatives) that are admitted to trading on RMs, MTFs and OTFs.
As regards pre-trade transparency, trading venue operators must make public current bid and offer prices, as well as actionable indications of interest and the depth of trading interest at those prices on a continuous basis during normal trading hours.
Waivers will be permitted for some types of hedging transaction, for block trades, orders held in an order management system of the trading venue, actionable indications of interest in request for quote (RFQ) and voice trading systems that are above certain sizes, as well as derivatives that are not subject to the mandatory trading obligation and other illiquid financial instruments.
Relevant national authorities may temporarily suspend the pre-trade disclosure obligations for a class of non-equity instrument for which the liquidity falls below a specified threshold.
Post-trade transparency requirements also apply to these non-equity instruments, with operators having to make details of transactions public as close to real time as is technically possible, although deferred publication may be authorised for block trades, illiquid instruments or trades above a specific size that would expose liquidity
providers to undue risk. As with pre-trade transparency, competent authorities responsible for trading venues can temporarily suspend the post-trade transparency obligations for a particular class of non-equity instrument for which the liquidity falls below a specified threshold.
The SI regime is also being extended to non-equities that are admitted to trading on an EU trading venue. SIs will have to make public firm quotes for the instruments for which they are SIs. But this requirement will apply only when the SI is prompted for a quote which the SI agrees to provide and there is a liquid market in the instrument.
The requirement also applies only for dealing below certain sizes (specific to the instrument). The quotes must reflect prevailing market conditions and orders must generally be executed at the quoted prices, although price improvement will be permitted in limited circumstances. Quotes may be updated at any time and, in exceptional market conditions, may be withdrawn.
MiFID 2 envisages that a ‘consolidated tape’ - giving the price, volume and time of all trades in financial instruments subject to the post-trade transparency regime as close
to real time as possible - will be available at the beginning of 2019. Trading venues will have to make trade data available to the consolidated tape providers ‘on a reasonable commercial basis’, and they will in turn have to make the consolidated tape available to the market ‘on a reasonable commercial basis’. ESMA has power to clarify what this means, but there is still a lot of work to be done before a consolidated tape becomes a reality.
MiFID 2 includes specific requirements for investment firms engaging in ‘algorithmic trading’. This is defined quite widely and will catch any trading where a computer algorithm automatically determines individual parameters of orders (e.g. whether to initiate the order, timing, price or quantity of the order) with no, or limited, human intervention. Specific provisions apply to firms carrying out a ‘high frequency algorithmic trading technique’.
Investment firms will have to notify relevant regulators that they are using algorithmic trading strategies. The firm’s home state competent authority is then entitled to ask for further information, which it may pass on to the regulators of relevant trading venues. However, MIFID 2 stops short of earlier suggestion that firms would need to disclose their actual algorithms routinely to regulators.
Trading venues’ fee structures must not create incentives to ‘place, modify or cancel orders or to execute transactions in a way which contributes to disorderly trading conditions or market abuse’. Trading venues will also be able to impose higher fees for high frequency algorithmic traders.
There will be an entirely new minimum tick size regime under MiFID for venues trading shares, equity-like instruments and other types of financial instruments identified by ESMA. The details of the regime remain to be developed by ESMA.
Firms that use algorithmic trading to pursue a ‘market making strategy’ (effectively posting firm, simultaneous two-way quotes on trading venues) will have to carry out their market-making activity continuously during a specified proportion of a trading venue’s trading hours in order to provide liquidity on a ‘regular and predictable basis to the trading venue’. They will also have to enter into a binding written agreement with the trading venue which specifies the firm’s obligations.
Direct market access
Trading venue members which offer clients direct electronic access to the markets through their systems will have specific new obligations to ensure the suitability of clients. They will also have to ensure that such trading does not exceed appropriate pre-set trading and credit thresholds and is monitored so as not to create or contribute to a disorderly market or constitute market abuse. And they will have to notify their home state regulator, as well as that of any relevant trading venue, that they are offering direct market access.
Commodity position limits and reporting
National regulators will be required to set position limits for commodity derivatives traded on RMs, MTFs and OTFs, as well as economically equivalent OTC derivatives, based on a methodology to be developed by ESMA. The limits will apply to investment funds as well as to clients of portfolio managers, although there will be exemptions for commercial firms’ hedging transactions. Trading venues will have to apply position management controls, which must include certain minimum powers such as the ability to obtain information regarding positions, to require a person to terminate or reduce a position, or to require a person to provide liquidity back to the market to mitigate the effects of a dominant position.
Persons trading on a venue will have to provide daily information to the venue on their own positions in contracts traded on that venue, as well as on the positions of their clients, their clients’ clients and so on until the ultimate holder of the position is reached. Firms that trade OTC must provide equivalent information on venue-traded and OTC contracts to the relevant national regulator. Venues must publish weekly reports of aggregate positions held by different categories of persons, and ESMA will publish an aggregated version of those reports.
National regulators will also have power to intervene on an ad hoc basis, including by requiring information regarding the size and purpose of a position or exposure entered into through a commodity derivative, requesting any person to reduce the size
of a position or exposure or limiting the ability of any person to enter into a commodity derivative.
Non-discriminatory access to clearing
MiFID 2 contains provisions to prevent discriminatory practices and to remove various commercial barriers that could be used to prevent competition in the clearing of transactions in financial instruments.
In principle, a clearing house will be obliged to clear transactions in certain financial instruments executed on any trading venue provided it satisfies the clearing house’s operational and technical requirements. Conversely, a trading venue will, in principle, have to allow access to any clearing house that wishes to clear transactions executed on that venue. However, both these provisions are complex, the access rights are qualified and there are extensive transitional provisions.
Transaction reporting to the regulator
MiFID already requires a firm that executes a transaction in a financial instrument that is admitted to trading on a RM to report that transaction to its national regulator.
MiFID 2 expands this to include financial instruments that are admitted to trading on any EU trading venue (i.e. a RM, MTF or OTF). It will also apply to the execution of a transaction in a financial instrument which has an underlying that is admitted to trading on an EU trading venue. The reports will also have to disclose additional information, such as whether a transaction in shares or sovereign bonds is a short sale and whether a transaction took place under an applicable waiver.
When passing orders to a broker for execution a firm will need to indicate whether a short sale flag needs to be included in the broker’s transaction report. The other new requirements will mostly only be relevant to portfolio managers when they execute client transactions themselves rather than give orders to brokers for execution. Even here, in appropriate cases firms will still be able to rely on the trading venue or other third party (provided it is an ‘Approved Reporting Mechanism’) to report on its behalf.
Only some of these MiFID 2 changes will be new for UK firms as the scope of the FCA’s transaction reporting requirements already goes substantially further than the existing MiFID.
The board of directors
MiFID 2 expands the existing MiFID provisions regarding a firm’s governing body. In particular, a firm’s directors must be of sufficient calibre and must act with honesty and integrity. There will be limits on the number of different directorships they can take on (multiple directorships within a corporate group will count as one for this purpose). A larger firm will have to have a nomination committee which must, among other things, have a policy for promoting diversity on the board. The board will be held responsible for the effectiveness of the firm’s governance arrangements.
MiFID 2 requires a MiFID firm to have explicit arrangements for product governance, whether as manufacturer or as distributor. ESMA's proposals are likely to be familiar in substance to those subject to FCA regulation. However, there are some important points which need to be clarified or refined. For example, the scope needs to be carefully delineated. On the whole, they do not make sense in the context of a product (for example, shares in an investment trust or an exchange-traded fund) where there is an active secondary market. First, it is difficult to discern a ‘target market’ and secondly the ‘manufacturer’ may not have any control over the distributors in the secondary market. The proposals also do not seem to recognise that many products are designed to form part of a larger portfolio, not as stand-alone investment solutions. Further, the roles of distributor and manufacturer may not always be as clear cut as the proposals imply; the distributor may well have dictated some of the essential design parameters of the product.
MiFID 2 will ensure that regulators have power to restrict or prohibit the marketing of particular financial products. In the UK the FCA already has such powers.
It appears that ESMA may be proposing to extend complaints handling requirements to all clients. Currently they are restricted to retail clients.
It is unclear whether an asset manager placing an order with a broker will be required, in future, to record that order. As has been pointed out to ESMA in responses, this would be duplicative because the broker executing the order will generally need to record the conversation.
Remuneration and sales targets
Requirements on remuneration build on existing ESMA guidelines and are aimed at ensuring that employees are not incentivised in ways that may conflict with the firm’s obligation to act in the best interests of its clients.
Freshfields Bruckhaus Deringer LLP is a limited liability partnership registered in England and Wales with registered number OC334789. It is authorised and regulated by the Solicitors Regulation Authority. For regulatory information please refer to
www.freshfields.com/support/legalnotice . Any reference to a partner means a member, or a consultant or employee with equivalent standing and qualifications, of Freshfields Bruckhaus Deringer LLP or any of its affiliated firms or entities. This material is for general information only and is not intended to provide legal advice.
© Freshfields Bruckhaus Deringer LLP 2014