This briefing summarises some of the requirements in MiFID II1 that will apply to investment firms that operate in the FX derivatives and contract for difference (CFD) sectors.
Compliance with MiFID II is required from 3 January 2018.
MiFID II makes a number of changes to the inducements regime which will require investment firms to review, extend and amend their existing policies, procedures, controls and third party agreements (including client agreements) regarding the receipt and payment of third party commissions and benefits.
The new regime will pose significant challenges to trail commissions, and investment firms will need to consider how their commission and third party benefit arrangements meet the “enhanced quality of service” test and appropriately document this. The UK Financial Conduct Authority has made it clear that payment for order flow is not compatible with the provisions of MiFID II. Payments or benefits paid to EU independent advisers and portfolio managers may be prohibited unless they are minor, non-monetary benefits.
The changes to the best execution regime under MiFID II will require investment firms that execute client orders to (a) make significant changes to their policies and front office capability, (b) strengthen their systems and controls to enable the detection of potential deficiencies in best execution, and (c) improve monitoring not only of execution quality obtained but also the quality and appropriateness of their execution arrangements and policies to identify circumstances under which changes may be appropriate.
Use of data analytics will be required in order to scrutinise the methodologies and input underpinning any valuation process and pricing models with respect to OTC products. Disclosure to clients must be customised by class of instrument and type of service provided. Standard generic disclosure will no longer be sufficient. Investment firms will have to annually disclose the top five execution venues used as well as data relating to the quality of execution.
Multilateral venues and systematic internalisers
MiFID II will significantly increase the regulation of almost all types of secondary market trading activities and functions. It will introduce a new multilateral trading venue, known as an organised trading facility (OTF), which will sit alongside the existing regime for multilateral trading facilities (MTF) and regulated markets (RM).
MTFs and OTFs are multilateral trading venues. However, unlike an RM or an MTF, an OTF operator will have discretion over the execution of transactions on its platform (i.e., it decides if, when and how much of two or more client orders it wants to match two or more client orders within the OTF. Businesses which carry out voice broking may fall within the definition of being an OTF and thus be subject to extensive new regulatory requirements.
Generally, operators of MTFs and OTFs will not be permitted to deal on own account or engage in ‘matched principal trading’. However, an OTF operator can deal on own account in relation to illiquid sovereign debt. In addition, an OTF operator can conduct matched principal trading provided that both sides of the trade are executed simultaneously and the client consents. Such matched principal trading cannot be conducted by an OTF operator specifically in relation to derivatives, which are subject to mandatory clearing under EMIR. This restriction on dealing on own account also applies to any entity that is part of the OTF operator’s corporate group, which means that while market makers can access an OTF, they must not be part of the same group as the OTF operator.
An OTF operator cannot operate as a systematic internaliser (SI) or connect with another OTF or SI. This may require some firms to reorganise their business from a legal and operational perspective to ensure that the functions of an SI and OTF are housed in separate legal entities. Equities are not permitted to be traded on an OTF.
The bilateral SI regime will be extended beyond equity instruments to capture certain investment firms that trade in other products including derivatives. Broadly speaking, an SI is an investment firm that executes client orders on own account on an “organised, frequent, systematic and substantial basis” outside an RM, MTF or OTF. MiFID II introduces new quantitative criteria for determining an investment firm’s status as an SI on a specific financial instrument basis. SI status will apply where the pre-set limits for the frequent/systematic test and for the substantial basis test are both crossed.
Investment firms should consider whether their trading activity falls within any of these definitions (i.e. RM, MTF, OTF or SI regime) and ensure that they are appropriately authorised.
Investment firms operating an MTF or OTF, or acting as an SI, will have to comply with the applicable MiFID II organisational, conduct and market requirements.
Mandatory on-exchange trading: derivatives
MiFID II also imposes an obligation on financial counterparties2 (including investment firms) and certain non-financial counterparties to execute standardised derivative contracts ‘on-exchange’, including when they enter into contracts with certain non-EU counterparties, in which case they are subject to clearing under EMIR and are deemed sufficiently liquid by the Commission unless an exemption applies (e.g., the group exemption).
It is important to note that only derivatives trades that are executed by way of an RM, MTF, OTF or equivalent third-country venue will qualify as on-exchange for these purposes (i.e., trading with an SI will not qualify as on-exchange).
MiFID II introduces a new EU product governance regime which imposes specific oversight, control and governance obligations on manufacturers and distributors of all financial instruments under MiFID II (including FX derivatives and CFDs) to ensure that the interests of investors are considered during each stage of the life cycle of the product.
A manufacturer is as “a firm which creates, develops, issues, and/or designs investments, including when advising corporate issuers on the launch of new investments” and a distributor is an “investment firm that offers, recommends or sells investment products or provides investment services to clients”.
Manufacturers will be required to identify a target market for the product, undertake an assessment of all relevant risks to that identified target market, and ensure that the intended distribution strategy of each product is consistent with the identified market.
Distributors will be required to implement adequate product governance arrangements to ensure that the products and services they intend to offer and recommend are compatible with the needs, characteristics and objectives of an identified target market and that the intended distribution strategy is consistent with that identified target market.
Treatment of clients
Protections are being strengthened under MiFID II so that, for example, firms dealing with public authorities will need to treat them as retail clients by default, although it will be possible for them to opt-up to professional status (i.e., firms will not be able to treat them as eligible counterparties).
It will no longer be possible to treat an elective professional client (i.e., a retail client who has opted-up to professional status) as an eligible counterparty. The FCA proposes to extend this change to non-MiFID II businesses. Firms dealing with eligible counterparties also need to be aware that additional obligations will apply when dealing with these clients under MiFID II. For example, certain rules on reporting to clients and the provision of information to clients will apply when dealing with eligible counterparties. Also, firms will be required to ensure that they act honestly, fairly and professionally and communicate in a way which is fair, clear and not misleading when dealing with any type of client, and not just retail and professional clients.
These changes mean that firms will need to review not only their client classification procedures, but also the existing classification of current clients (in particular elective professional clients who have opted up to eligible counterparty status, and public authorities) to ensure that they are categorised appropriately under MiFID II. This will also require a wider review of the impact re-categorisation has on the treatment of relevant clients, and may require firms to check they have the appropriate permissions to deal with the relevant types of client.
Authorisation and variation of permission
MiFID II extends the scope of activities (e.g. operating an OTF and changes to the SI and investment advice definitions) and instruments (e.g. physically settled derivatives relating to emission allowances and commodity derivatives that are traded on an OTF and can be physically settled) that will be subject to regulation and narrows or removes certain exemptions that were available to market participants under the MiFID I framework (e.g. the commodity dealer exemption, the own account exemption and the ancillary activities exemption). Firms should review the scope of their business activities to determine whether they need to apply for authorisation from the FCA or to vary the current scope of their authorisation permissions.
The FCA has warned firms that they should submit any authorisation or variation of permission applications by 3 July 2017 to ensure that they have the necessary licences when MiFID II is implemented. The FCA in its recent statement has reminded firms that carrying on a regulated activity without the necessary authorisations or permissions could result in the firm facing civil, regulatory or criminal action.
What Reed Smith can do to help
- Review your existing arrangements to determine whether they are in scope and whether any exemption is available, and if not, advise you on what is required to ensure compliance.
- Update your policies, procedures, client and third party communications as well as any relevant agreements.
- Provide training to staff on the new requirements, as necessary.
- MiFID II consists of a recast directive and a new regulation, known as MiFIR.
- Entities whose trading activities in derivatives exceed certain thresholds.
Client Alert 2017-146