It has been ten years since Directive 2004/39/EC on Markets in Financial Instruments (“MiFID I”) has been implemented in Luxembourg and more than 13 years since MiFID I has made its first appearance on regulatory agendas. We certainly live in a different financial world today than we did back then in 2007. Ten years ago, the world faced a financial crisis, followed by an economic crisis, and since then there have been considerable efforts to bring the European economies back on a sustainable growth path. Regulation intended to prevent similar turmoil has since been put in place or is close to implementation.
The MiFID II framework, composed of Directive 2014/65/ EU and Regulation (EU) No 600/2014, completed by a significant pack of Level 2 and 3 documentation (with ESMA having been given the largest mandate ever given by legislation in terms of volume of Level II work), is one of the main pieces of legislation that is part of these efforts. While the objective of MiFID I was to integrate financial markets in the European Union and render them more competitive, MiFID II focuses on making financial markets more stable, more transparent and more diligent in their duty of catering for non-professional investors. The MiFID II framework can certainly be qualified as a game-changer that impacts every part of the securities trading value chain, from trade execution and investor protection to reporting and product distribution.
Together with very challenging implementation deadlines, the breadth and depth of the new measures, which touch upon each and every aspect of the world in which financial instruments operate or are traded, both from a market perspective and an investment firm perspective, make MiFID II one of the key pillars for reforming financial markets after the financial crisis. When considering MiFID II’s impact on credit institutions, investment firms and other in-scope entities, it is equally clear that MiFID II is one of Europe’s biggest bangs of financial market reforms. Additionally, as already highlighted by the ABBL in 2016, MiFID II may become the most expensive measure of the recent reforms in the financial sector (ABBL&EY, Survey on the cost of regulations and its impacts on the Luxembourg financial marketplace – 2016 Edition, pp. 16).
Specific focus has been given in the MiFID II framework to the relationship between investment firms and their clients.
“The entire B2C relationship will be redesigned through the entry into force of MiFID II”.
The entire B2C relationship will be redesigned through the entry into force of MiFID II on 3 January 2018 by the introduction of increased transparency in financial markets and extended protection measures for investors, such as new classifications for both clients and products alike. In-scope entities will further see a significant impact on their operational efficiency in their client communication, as they will have to reach out to their clients to collect the data and documentation required to support the new regulatory obligations. This client outreach effort will drive the final compliance decision and any delays in collecting the required data and documentation will directly impact on compliance ahead of the implementation deadline on 3 January 2018. All things considered, MiFID II has the potential to seriously influence the client experience and the client management of investment firms.
“One of the main impacts MiFID II will have in regard of the B2C relationship is the repapering of the client documentation”.
One of the main impacts MiFID II will have in regard of the B2C relationship, notably when moving into the final stretch for MiFID II implementation efforts, is the repapering of the client documentation. With key challenges such as the impact of MiFID II for existing documents with clients, minimum requirements for legacy documentation, updates for standard documentation and templates, as well as creating opportunities out of the new regulation, firms will need to fully understand the requirements of MiFID2/MiFIR and what agreements they will need to put in place with their clients in order to continue business without breaching regulation. Additionally, firms will also need to identify and understand the indirect impacts, and how their client documents can mitigate and re-direct the risks and costs of business in a post MiFID2 environment. All of this requires firms to sift through, and draw conclusions from, a large volume of legislation and regulation – including not only MiFID2 and the MiFIR itself, but also delegated regulations, directives, technical standards and local implementation rules.
As part of these efforts, the MiFID II client classification regime is increasingly in focus of in-scope entities. While the actual MiFID II client classification regime remains broadly the same as under MiFID I, the identification requirements under MiFID II have been considerably vamped up through the democratisation of the legal entity identifier (LEI).
“The identification requirements under MiFID II have been considerably vamped up through the democratisation of the legal entity identifier (LEI)”.
MiFID II will render compulsory the use of LEIs for firms’ subject to transaction reporting obligations (i.e. for any entity dealing in or trading with securities). This means that firms falling under this remit will not be able to execute a trade on behalf of a client who is eligible for an LEI and does not have one. With national competent authorities announcing the rejection of any trade reports without LEI data, investment firms are facing the dilemma whether or not to accept trades on behalf of eligible clients lacking the required data. Many financial institutions are currently reviewing client data to identify clients without a valid LEI and to encourage these clients to apply for the LEI from the relevant designated local authority. Small and medium entities have proven over the course of the last months to be particularly resistant in applying for an LEI, often citing the significant cost of acquiring the LEI as a barrier for their operations. Given the industry’s anticipation that a significant number of clients are still lacking LEIs, an increased demand on designated local authorities will likely be noticed in the fourth quarter of 2017, in an effort to obtain an LEI before the implementation in January 2018. Firms will need to manage client expectations in this respect and educate their clients about the LEI requirement.
Transaction reporting is another area which is heavily impacted by MiFID II obligations, insofar as reporting obligations have been extended to a wider range of financial instruments and require the disclosure of additional mandatory data. The requirements for transaction reporting are being extended to include Market Rules Platform trading obligation Market Structure Algorithmic trading Data service providers Transaction reporting Pre- and post-trade transparency Investment firm rules Third country regime Commodity derivatives Increased product intervention rules Extended business of conduct rules Governance requirements Overview of MiFID II investor protection measures Impact of MiFID II on the financial industry additional new venues, more financial instruments and a great into scope of the actual report (such as identifiying the client and the individual trader of the transaction). This goes hand in hand with increased transparency requirements of firms vis-à-vis both their clients and their supervisory authorities. To fulfill MiFID II transaction reporting obligations, in-scope entities will have to leverage solutions that can accommodate the capture of client static data and processing additional data and products.
As another relevant transparency element in this context, MiFID II product classification requirements are extended to a much wider range of financial instruments. The definition of “financial instrument” under MiFID II has been extended to include commodities, which cover a wider range of products, including cash-settled commodity derivatives, physically settled commodity derivatives, exotic derivatives and emission allowances. Clients who trade in these newly covered products will be brought into scope under MiFID II and may be required to provide additional data and documentation to support the relevant regulatory obligations. All this client data and new product classifications will need to, in turn, be included in the transaction reporting.
As a consequence, the MiFID II suitability and appropriateness tests have been further refined. As usual under MiFID I, in-scope firms must categorise appropriately their clients either as eligible counterparty, professional client or retail client, depending on their knowledge and experience, including their ability to bear losses and a client’s risk tolerance.
As a result thereof, investment firms will need to ensure that they fulfill their suitability or appropriateness obligations. A core requirement in this respect is to determine and document if investment advice is being given to clients, as this will in fine determine the subsequent suitability and/or apprƒcoopriateness obligations. To this end, firms will need to ensure that their internal solutions for client onboarding or client management are able to manage suitability and/or appropriateness requirements through an embedded analysis of knowledge and experience, financial situations and investment objective. This will enable firms to eliminate regulatory interpretation as much as possible.
A final primer within MiFID II is that Direct Electronic Access (DEA) clients are brought into scope for regulatory compliance, meaning that written agreements must now be put in place between in-scope entities and DEA clients. With an annual due diligence process for DEA clients, in-scope entities will, in a first step, have to identify and classify all DEA clients accordingly. Based thereon, entities will have to assess the suitability of DEA service for specific clients and provide relevant binding written DEA agreements. This article provides merely a short overview of some of the B2C areas banks will need to reassess when analysing their relationship with the client. Overall MiFID II changes a set of other elements relevant in client relationships, all of which include significant procedural, operational and IT-structural re-assessments.
With less than 3 months left before the implementation date of MiFID II, the fall for our members is going to be anything but quiet, especially in light of the outstanding documents and guidance, including the final Luxembourg implementation documentation. The ABBL stresses that the Luxembourg financial market should not understate the impact MiFID II will have. The financial markets landscape is set to change and the Luxembourg financial industry will need to stand ready to adapt.
“Firms who willingly engage and adapt are those who will benefit the most from opportunities arising out of the new regulation”.
As Mr. Michael Hodson, the Irish Central Bank’s Director of the Asset Management Supervision, previously stated: “firms that proactively manage regulatory amendments tend to create opportunities that elude firms who view implementation as merely a compliance task. Firms who willingly engage and adapt are those who will benefit the most from opportunities arising out of the new regulation.”
By Gilles Walers, Legal Adviser – ABBL