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Incremental change or fundamental reform?

The Markets in Financial Instruments Directive (MiFID) review

October 2011

No one is off the hook

The European Commission is not letting anyone off the hook in introducing MiFID II all actors are caught in the new regulatory net: market infrastructures, banks, plus intermediaries such as brokers, IFAs, asset managers and their custodians alike. A common rule book in terms of trading, marketing and offering advice to investors will aim to deliver consistency no matter where the client is based, what products he/she is offered and what one can expect post-sale from the product manufacturers and distributors.
John Liver Ernst & Young

Incremental change or fundamental reform?

MiFID II summary

What is driving the MiFID review (MiFID II)?

The Markets in Financial Instruments Directive (MiFID) has been the cornerstone of capital markets regulation in Europe since its implementation from November 2007. With amendments to MiFID, the European Commission is aiming to address shortcomings of the original MiFID release as follows: While competition has increased, the envisaged benefits of increased competition have not been passed on to end investors, retail or wholesale clients. In addition, increased market fragmentation has made the trading environment more complex, and more opaque. Market, product and technology developments have been seen as outpacing the provisions of the original directive, with structures such as high-frequency trading (HFT) and dark pools falling outside the scope of the original MiFID I. The financial crisis exposed weaknesses in the regulation and transparency of non-equity financial instruments, both at trading and retail investment advice levels. The level of investor protection is being seen as insufficient due to the rapid innovation and growing complexity in financial instruments. Therefore, the European Commission embarked upon the MiFID II process with the market consultation completed in February 2011, and has now released the much anticipated draft text on 20 October 2011.

MiFIRegulation + MiFIDirective = MiFID II: MiFID II will take the form of a directive (transposed into national law, taking up to two years), backed up by a regulation (immediately enforceable as law in all EU Member States simultaneously). The regulation component (MiFIR) has been introduced to ensure a maximum harmonization framework implemented centrally from Brussels, with limited scope for national discretions or derogations, divergent interpretation or Member State gold-plating. MiFID II timeline still in the open: when the effective date for these changes is likely to be late 2013 or early 2014, and much detail is yet to emerge, the magnitude of the changes, and the need to align with other regulations such as Dodd-Frank, the revised Market Abuse (MAD) and Insurance Mediation Directive, the impending Packaged Retail Investment Products Directive, and the European Market Infrastructure Regulation (EMIR), mean that firms cannot afford to be complacent. Leading organizations are already analyzing the impact and planning what needs to be done in 2012.

Alignment with other regulations

Many of the provisions in MiFID II overlap with those of DoddFrank and the revised Market Abuse measures. For those firms impacted by the US measures, common global programs are essential to avoid duplication. However, differences in timing of implementation, and emergence of detailed rules, will prove challenging, as will evaluation of extra-territorial impact. EMIR is likely to take effect from the end of 2012 at the earliest, and precede the MiFID II measures by anything from six months to one year. Whereas the MiFID II measures favor open, nondiscriminatory access to venues and clearing houses especially for exchange traded derivatives thus encouraging the dismantling of parts of some vertical silo market infrastructure models, there is no corresponding suite of measures for EMIR. Bridging these two worlds will be challenging, both operationally and commercially.

MiFID review

Key measures
The amendments within MiFID II are far reaching and will have significant strategic consequences for banks, broker-dealers, investment firms, intermediaries, advisors and trading venues. Most of the key areas from the consultation paper have made it through to the draft text, including some of the more controversial provisions.

Investor protection
Product and client coverage: MiFID II extends the conduct of business rules to new asset classes such as structured deposits, limits the execution-only regime, albeit within the existing client categorization rules, and allows for institutions such as local authorities to elect for retail classification. Market reach: the new MiFID version also extends, and reinforces, business conduct rules to all actors in the retail distribution chain, especially intermediaries, institutions selling their own securities and even non-financial institutions. Complex products: far more intense focus on the list of complex products that cannot be sold to retail-classified investors without stringent suitability or appropriateness tests, accompanied by a limited number of products such as cash equities, money market instruments and simple UCITS, to be considered as non-complex, requiring no advisory input and thus retention of an execution-only model. Exemptions: MiFID II strengthens the rules for exempted distributors of investment funds and introduces far more explicit treatment of inducements. Corporate governance: MiFID II establishes a greatly strengthened corporate governance regime encompassing rules on time commitments and fit and proper criteria for board directors.

Functional and product scope: the key focus of the reforms is on pre- and post-trade transparency, and extending these requirements to equity-like products (such as Exchange Traded Funds (ETFs), Global Depository Receipts (GDRs) and actionable IOIs), fixed income, over-the-counter (OTC) derivatives and commodities. A large proportion of OTC derivatives trading will be forced to migrate onto new electronic trading platforms and existing exchanges where prices are visible to all and be subject to extensive reporting requirements. These requirements include near real time trade reporting through Approved Publication Arrangements (APAs). Going forward, only ad hoc trading in shares, bonds and non-standardized derivatives will continue to be allowed to take place OTC. Market structure: the rules on market structure will be amended, e.g., by introducing a new category of trading venues called organized trading facilities (OTFs) alongside regulated markets, Multilateral Trading Facilities (MTFs) and Systematic Internalizers (SIs). The OTF category could apply to broker crossing networks and dark pools with the same transparency requirements as regulated markets and MTFs. Position limits and trading restrictions: MiFID II implements trade restrictions, position limits on the number of contracts that any given market members or participants can enter into over a specified period of time, to be set by the European Securities and Markets Authority (ESMA) for commodities. Algo trading: while allowed to continue, a more restrictive regime covering high frequency and algorithmic trading will be introduced with business resilience and continuous liquidity provision as particular themes.

Third country access

As with all EU regulations and directives, the issue of third country access (i.e., granting access to the common passport for non-EU/EEA firms domiciled in, for example, the US or offshore) is likely to be one of the most controversial areas by way of impact. A MiFID II draft proposes to introduce a harmonized third country equivalence regime in MiFID for the access of third country investment firms and market operators to the EU. If the MiFID II follows a similar direction to the Alternative Investment Fund Managers Directive (AIFMD), third-country regulators will need to pass several mutual recognition tests and/or operate cooperation agreements with EU/EEA regulators.

Incremental change or fundamental reform?

Third countries remain an unknown

How third countries such as the US will be treated under MiFID II remains one of the great unknowns. The investment banking sector, in particular, needs more clarity on this controversial issue as the continuing uncertainty in this area is hampering international players ability to plan their future in Europe third-country headquartered entities are going to be consulting the MiFID review text on the pros and cons of setting up a branch vs. subsidiary in the EU. Third countries will most certainly need cooperation agreements with EU/EEA Member States or on a multilateral EU regional level as in the case of other directives such as AIFMD a time-consuming exercise.
Anthony Kirby Ernst & Young

MiFID review

What will the impact be?

MiFID II in itself will necessitate significant changes in business models, systems, data, people and processes. Coupled with other related reforms such as EMIR, Dodd-Frank and Basel III, a fundamental transformation is required. The biggest impact will be felt by banks, broker dealers and trading venues, but investment managers, IFAs and post trade organizations will also need to undertake substantial effort, as will custodian banks and other asset servicing entities. Although the European Commission is estimating the costs of MiFID II to be smaller than the cost of MiFID I, the product scope, timing, degree of European harmonization and the need to align with other parallel regulatory developments could still lead to substantial costs.

Business model
Revenue impact: migration of trading to regulated markets, MTFs, OTFs or swap execution facilities (SEFs) in the US, together with increased transparency requirements, should in principle, increase competition and reduce spreads. In other words, the long-term direction will be toward a transparent, higher volume, lower margin, more commoditized market. As was seen in the equity market with MiFID I, fragmentation of liquidity across multiple venues could, in the short term at least, lead to mixed results greater competition but equally greater fragmentation and, crucially for the buy-side, increased market impact costs. In addition, a drive toward greater transparency may deter some investment banks (IBs) from making quotes and placing extra regulatory restrictions on HFT. This will drive valuable liquidity away from the market and concentrate the business in the hands of a smaller number of price makers. The latter scenario will also not be a good result for the buy-side (the price takers). Cost impact: given the cost of the investment required to meet regulatory demands, together with increased capital and liquidity requirements due to Basel III, it is highly likely that some businesses will no longer be profitable. The return on capital employed (ROCE) figures may struggle to reach double digits and many IBs will be hit by both MiFID II and EMIR. This might apply to many mid-tier banks who do not have the capital available to commit or innovate. In contrast, for those firms (banks or market infrastructure providers) able to invest in scalable platforms to meet client needs in the new environment, there are significant opportunities to capture market share. Competition impact: at a macro level, some models such as market infrastructure arrangements and models involving platform distribution and/or bancassurance might require significant modification. Bases of competition may shift, and there could be grounds for divergence with other G20-driven regulatory approaches such as Dodd-Frank. There could be power struggles concerning national regulators and EU-centered bodies such as ESMA and legal powers are likely to be tested.

The MiFID proposals stand to fundamentally change the economics of OTC businesses across Europe. To be able to compete and win in this new uncertain environment, firms will need to invest in technology, offer more services such as outsourcing and set aside more capital in a climate of greater cost consciousness and diminished profitability. The advantage will lie with bigger firms who have the money to invest upfront. Smaller and mid-tier players will find this change very challenging and even the big firms will need to consider divesting from certain parts of their businesses where the return on investment does not stack up.
Kieran Mullaley Ernst & Young

Incremental change or fundamental reform?

Given the tight timetable and the dramatic increase in reporting requirements, firms cannot afford to be complacent. They are going to have to use what information they have to start to plan for MiFID now.
John Kersten Ernst & Young

Systems, processes and controls

Front-to-back infrastructure impact: the implementation of MiFID II, the MAD II and EMIR may usher in significant market microstructure changes, firstly by introducing auction systems into the OTC market, and secondly, by expanding the dealer role both pre- and post-trade. A whole array of system and process changes would be required to cater for the auction models impacting both the sell- and the buy-side, and it is unlikely that some of these structural changes will be quick, particularly in the central counterparty (CCP) space. However, early movers on the sell-side will be able to achieve a competitive advantage and attract market share, from the perspectives of single or crossasset trading and collateralization. Additionally, decisions need to be made around categorization as an OTF or SI, with resulting system and process impact. For those firms acting as SI and owning a single dealer platform, the direction of that platform will need to be reviewed, as the existing transparency rules for SIs will apply to all financial instruments in the scope of MiFID II. Changing trading processes: it is likely that MiFID II and Dodd-Frank will lead to multiple competing trading venues, potentially with both order-driven models (e.g., the introduction of both continuous- and batch-auction systems in the secondary OTC market) and quote-driven models (e.g., OTC dealers could evolve to full market makers or a more hybrid system with dealers taking on similar functions as the NYSE Specialist or the German Kursmakler) and a high degree of change over the next five years. Trading bans and risk impact: to improve investor protection, the current draft allows competent authorities in coordination with ESMA to temporarily or permanently prohibit or restrict the trading of financial products or services. The power to intervene in market transactions would allow the regulating entities to manage positions including setting up position limits. Systems and processes will need to be adjusted accordingly to allow for a time efficient implementation of these restrictions. Each financial institution will have to implement internal risk assessment measures to minimize the impact when these restrictions come through.

Data and reporting

Harmonized EU reporting: MiFID II aims to harmonize reporting requirements across its Member States and provides extensive pre-trade, trade and transaction reporting requirements across additional asset classes for the purpose of market supervision. MiFID II will therefore mirror the scope of MAD, which due to the ongoing review of MAD will require further adjustments. These will require major changes in both operational and reference data unique trade identifiers, counterparty and legal entity identifiers and product identifiers. Those firms that have, in recent years, invested in enhancing their data architecture across multiple asset classes will be best placed others will need to investigate such initiatives as a priority. Near real time reporting: the near real-time post-trade reporting requirements will drive system, process and cultural changes to enhance timing of trade capture down to 15 minutes after trade execution. To improve the quality and consistency, the amendment is requiring firms to publish their trade reports through APAs for all asset classes of MiFID II with harmonized reporting standards across all Member States. Record keeping: most firms have already implemented their transaction reporting capabilities to comply with MiFID I and have robust arrangements to store their records for five years. However, there were several high profile fines over the last two years with more competent authorities inclined to fine firms for misdemeanors. Audit trails will need to be more robust to evidence best execution with regard to the broader market for OTC-traded markets. In addition, some Member States such as the UK will remove the exemption for mobile phone conversations for reasons of market abuse prevention. MiFID II will also strengthen the treatment of client assets and client money, which will necessitate further investments in record-keeping.

MiFID review

Data and reporting (continued)

Block trades: the requirements on block trade reporting are not clear yet. Dealers have voiced concerns over adverse market price impact should information be publicized too soon after execution. The European Commission has indicated that for certain trade types waivers could be given. Whatever the final regulation will stipulate, a back door is being left open, allowing the Commission to adjust reporting requirements two years after its entry into force. Outsourcing: the move to execution on trading venues is likely to result in higher volumes of smaller value transactions, just as occurred with equity trades across Europe from 200711. Enhancing the scalability of OTC derivative trading, trade confirmation and novation and netting systems will be imperative. There will be a need to manage operational complexities in the front-, middle- and back-offices too. Many asset managers and potentially other intermediaries without the scale to invest in the systems may look toward new outsourcing service providers, located both on EU/EEA territory as well as offshore in order to provide support services and facilitation at the appropriate price points. Parties who outsource will still need to perform the necessary regulatory due diligence. Nevertheless, MiFID II could presage a shift in the industry toward more outsourcing providers in the front- and middle-offices ( complementing those who service back offices). Adequate capitalization will be a feature, not just under EMIR but given CRD III/IV as well.

What next?
Regulatory developments
At present, not all regulatory components are fully specified. It is anticipated that the next MiFID review draft scheduled for mid 2012, followed by ESMA regulations in 2013, will contain further details on: Position limits Reporting thresholds Trading restrictions Eligible list of complex vs. non-complex products Clarification on suitability and appropriateness testing Exemptions and waivers

Priority actions
For those with Dodd-Frank programs: establish cross regulation dependencies specifically covering the different regulatory timelines Initiate MiFID II business model impact assessment Conduct asset class specific MiFID II front-to-back impact analysis Review whether the classification as SI for specific asset classes should be pursued Assess MiFID II impact on fees and commissions For players with single dealer platforms: assess MiFID II impact and identify business risk and opportunities Review MiFID II impact specifically from a risk management point of view for times of prohibited or restricted trading

Incremental change or fundamental reform?

Firms currently preparing for Dodd-Frank and EMIR will be frustrated

For those firms currently implementing Dodd-Frank or EMIR, which is due to take effect from the end of 2012, the comparative differences in approaches to market infrastructure combined with the lack of clarity on implementing details and precise timescales may be frustrating. They will need to build excess flexibility into their Dodd-Frank models to save them from undergoing this type of large-scale organizational change twice in quick succession. Application of the Dodd-Frank measures beyond the US will remain a concern for firms headquartered in the US and/or acting on behalf of US clients.
Dai Bedford Ernst & Young

MiFID review

How Ernst & Young can help

Ernst & Young has extensive experience in helping organizations navigate through regulatory initiatives. Our global regulatory reform team is a dedicated, cross-functional team with years of relevant industry experience advising clients in derivatives risk management, regulatory matters and process or systems changes. The team is composed of core members, as well as those drawn from across the broader global regulatory team, with significant experience in the following competencies: Working with global regulators Conducting a number of EMIR/MiFID impact assessments including assisting in execution and transaction reporting evaluation, and assisting with subsequent implementation Designing and developing global OTC derivatives operations, valuations and risk management approaches Assisting in implementing practical options for compliance functions at numerous large financial institutions Working with trade execution and market connectivity solutions, reconciliation tools, business process management and workflow programs Translating target models into enterprise, application and data architecture Supporting enhanced regulatory and legal entity reporting through information management and data governance or quality capabilities Assisting and enhancing product control functions, including P&L attribution, reconciliations and reporting Reviewing MiFID requirements across clients jurisdictions Conducting gap assessment to identify required enhancements to help ensure MiFID compliancy Reviewing front-to-back regulatory reporting Project and program management of implementing MiFID I release Analyzes of MiFID impact on business and client activities. Managing and coordinating workshops to compile regulatory requirements

Incremental change or fundamental reform?


United States
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Fabio Gasperini
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MiFID review

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