MiFID - How Should Firms Prepare in 2006?

During the second part of 2005, the amount of comment, publicity and discussion around the MiFID (Markets in Financial Instruments) regulatory framework increased dramatically. Both the specialist trade press and national titles began to take an interest, industry associations began to seek advice and the industry joint working group was formed to actively examine the detailed implications.

At the end of 2005, there was a loss of momentum as the industry switched attention to end of year activities, while at the same time the pressure was reduced with the announcement that the implementation deadline would shift from April to November 2007.

At the start of 2006, MiFID remains an issue that should be firmly on the agenda of all financial services companies. With the publication in early February of the level 2 text, investment firms should once again turn their attention to the topic and proactive firms should begin to announce their plans for implementation.

Main Elements of MiFID

The major impact on each firm will depend upon the role that it plays within the financial services landscape. In addition, the nature of the client base, in particular the retail versus professional split of the client population, will affect the extent that MiFID will impact a firm. In broad terms, however, the key elements of the regulations to consider are:

Regulatory scope

The scope of products brought under a common regulatory umbrella will increase, incorporating all transferable securities, UCITS (undertakings for the collective investment of transferable securities), money market instruments and a wide variety of derivatives relating to securities and commodities. Financial services firms transacting client business in these products will need to do so via an entity authorised in Europe.

The range of investment services covered by common European legislation will also be broader. In some cases, this may generate the need for firms to seek new authorisation. Other firms may have the opportunity to offer more services cross-border and to establish European branches based upon their home country regulated entity (without the need to satisfy additional host country requirements).

Conflicts of interest

While there is nothing inherently new in MiFID’s principles around conflicts of interest the emphasis is placed on firms to demonstrate that they avoid conflicts. Rather than being ‘innocent until proven guilty’ firms must show that their policies and their compliance with those policies will ‘keep them innocent’.

Firms must ensure that they have clearly documented principles on managing conflicts of interest and may need to consider segregating some areas of the business. If not already the case then MiFID requires that firms have an independent compliance function that is not remunerated in a manner that undermines its independence.

Investor classification

MiFID aims to establish a common EU classification for trading partners and investors. Different rules apply for business conducted with non-professional investors and within the ranks of the professional the ‘eligible counterpart’ is defined for which specific exemptions exist.

Firms will need to ensure that their client classification is correct, that the information upon which they base their categorisation is complete and that, where necessary, clients have been informed of how they are categorised and how this impacts their rights. For many firms that have already undertaken client repapering exercises as part of anti-money laundering and KYC initiatives, the issue of client data could begin to feel like a never ending drain on investment spend.

Record keeping

MiFID sets a common framework for record keeping and reporting. The customers of investment firms must receive adequate information and reporting on transactions in a clearly comprehensible form, including details of costs. In addition, the legislation defines quantified minimum standards around the timeliness of reporting and retention of data. Investment firms must review their reporting and retention systems and ensure that they at least meet the minimum standard.

MTF regulation

MiFID creates both a common regulatory framework and the potential for greater competition between trading venues. Multilateral trading facilities (MTFs) will be included in the scope of EU regulation, while at the same time concentration rules practiced in France, Spain, Italy and Germany will be swept away.

For existing national exchanges, there is both opportunity and threat as both the chance to compete with each other and the number of potential competitors increases. Given that MiFID’s data transparency rules also threaten the revenue that national exchanges have enjoyed from their data publication monopolies, we should expect to see significant change in this part of the market.

Best execution and client order handling

MiFID has a clear objective to establish a regulatory framework that protects the retail investor. The rules around order handling and best execution reflect this. Firms are required to maintain a formal order/execution policy and be able to demonstrate that this policy is followed and achieves best execution for clients, taking into account multiple factors including price, cost, speed and likelihood of execution and settlement.

With respect to order handling, firms need to prioritise ‘comparable’ orders on the basis of the time that the order was received. There are specific rules regarding the aggregation of client orders to ensure that no individual investor is unfairly treated and to avoid the investment firm benefiting at the expense of their client.

Firms will need to amend their policies and systems associated with order handling and continue to monitor them to ensure that they remain compliant. This is likely to become more complicated, if as we expect, the elimination of concentration rules and greater competition between trading venues, results, at least initially, in more pools of liquidity.

Pre-and post-trade transparency

MiFID tries to ensure a level playing field for all participants when understanding the liquidity of the market and to ensure that firms have the best opportunity to fulfil a trade.

For pre-trade transparency, MiFID creates the new definition of ‘systematic internalisers’. These are firms which cross orders against proprietary positions internally. These firms will be required to publish a firm quote, accessible to the market on a reasonable commercial basis, on those publicly traded shares that they internalise. Firms that decide that they will be systematic internalisers will need to work out how to meet this obligation.

An additional transparency requirement will force firms to make unfulfilled limit orders public. Placing the order in a regulated market that reports the order in an order book system may fulfil this obligation. For some firms, however, in markets that are driven by quotes from market makers this will be a new requirement.

Post-trade reporting obligations will change with the potential for additional complexity (multiple new venues associated with a single security), specific common European requirements and the potential opportunity to consolidate reporting across multiple entities within a firm.

Responding to MiFID Now

Most firms will by now have started their response to MiFID. The following is intended as a high level ‘health-check’ on your MiFID plans.

• Broad representation. It is a mistake to see MiFID as a narrow regulatory or IT issue. Formulating the optimum response to the initiative requires representation from the business, operations, technology and legal/compliance. For example, a firm may need to decide whether it wishes to continue to operate as a systematic internaliser based on the cost benefits case of doing so. This decision needs to be taken by the business before operations and technology can start on the detailed work of how to meet publication requirements.
• Big picture first. The review of MiFID’s impact must be comprehensive and review all potential impacts across the breadth of the firm. In order to do this quickly, the first review should remain at a high level and focus on determining whether the impact to a particular area of the firm is high, medium, low or zero. This ensures that the detailed plans are based on a solid foundation.
• Proactive approach to suppliers. How MiFID compliance is achieved could be significantly impacted by new services available from other market players. A firm should identify the critical issues that it faces and determine those suppliers that would appear to offer the best potential to assist. Examples of suppliers that have the potential to develop new services are exchanges, MTFs and data vendors. Firms should both monitor announcements from such organisations and pro-actively approach them about their plans.
• Proactive approach to regulators. In order to finalise detailed implementation, investment firms need to understand the plans of local regulators. A pro-active approach to working with the local regulator will benefit the MiFID program. This part of the program should try to address any remaining concerns about the level of local interpretation that we will begin to see as national regulators transform the European directive into market practice.
• Clearly identified champion. Given the far reaching impact and the need to monitor developments from both regulators and suppliers, investment firms need a clearly identified MiFID champion who will ensure the firm keeps up to date with developments in terms of national rulebooks, new announcements and timing of new regulations. This person should be the focus of the proactive response to suppliers and regulators and should be able to participate in, or even lead, the market consultation and debate.
• Alignment with other programs. Firms need to find ways to minimise the need for duplicate ‘regret spend’ and maximise the effective use of scant skilled resource. In order to do this, a firm’s MiFID plans should determine how to best align to existing strategic programs. This will allow the leverage of existing or planned and funded initiatives. Examples of where such existing initiatives could exist include reference data initiatives, workflow implementation and, for US-based firms, potential synergies with Reg NMS (national market system) programs.

Conclusion

As MiFID once again attracts attention at the start of 2006, it is important that firms ensure that they not only understand the latest developments but also check that their planned response will ensure that compliance is achieved in the optimal manner. A short but timely check now will save unnecessary pain later.