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Much-needed reform of financial regulation is presenting investment banks, private equity and hedge funds across Europe with major challenges. MiFID II – a radical attempt to introduce greater transparency across equities, bonds and derivatives markets – came into force across the European Union on 3 January.
According to the European Commission this revised version of the EU Markets in Financial Instruments Directive aims to reinforce the rules on securities markets and to strengthen protection for investors by introducing new requirements relating to the conduct of organisations and actors involved in these markets.
The related Markets in Financial Instruments Regulation (MiFIR), which focuses on the rules and reporting requirements for executing trades, came into force on the same day.
‘The new rules will make European equities, bonds and derivatives markets much more transparent,’ claimed European Commissioner Valdis Dombrovskis at a recent conference. ‘They will also increase investor protection and introduce better safeguards against misselling of financial products.’
Josh Hogan, McCann Fitzgerald; Young Lawyers Liaison Officer, IBA Banking Law Committee
MiFID II is enormous in terms of its scope and coverage. ‘It impacts all investment firms around Europe’, says Michelle Kirschner, a partner in the Financial Services Regulation practice at Macfarlanes, ‘from the big investment banks, investment managers, hedge fund managers and private equity fund managers right through to the independent financial advisers on the high street'.
While some firms have been immersed in huge MiFID II implementation projects over many years, others have been slower or less proactive. One recent poll suggested that only six per cent of asset managers were ready to meet the new best execution analysis standards under MiFID II, for example, while 61 per cent still need to add more detail to their policies.
‘MiFID II is nothing less than a revolution in the regulatory framework governing investment firms and the fact that some firms are still unprepared is not particularly surprising,’ says Josh Hogan (pictured), Head of the Financial Services Regulatory Group at McCann Fitzgerald and Young Lawyers Liaison Officer for the IBA Banking Law Committee.
‘The new authorisation and reporting requirements are also challenging for regulators, who do not necessarily have the resources to cope with their new MiFID II roles.’
Some regulators have responded to the challenge by pledging to be flexible in their enforcement of the rules. ‘We will not take a strict liability approach, especially given the size, complexity and magnitude of the changes that are required to be in place,’ says Mark Steward, Director of Enforcement and Market Oversight at UK regulator the Financial Conduct Authority. ‘We have no intention of taking enforcement action against firms for not meeting all requirements straight away where there is evidence they have taken sufficient steps to meet the new obligations by the start date.’
Imelda Higgins, a senior associate at McCann Fitzgerald, thinks this is a sensible approach. ‘While MiFID II and MiFIR are relatively short, the associated delegated acts run to hundreds of pages and over a million paragraphs of text,’ she says. ‘Many of these delegated acts have only been finalised relatively recently, meaning that firms have had little time to introduce the significant changes that [they] require. Moreover, the costs of complying with MiFID II/MiFIR have been substantial, running into the billions according to some estimates.’
MiFID is not the only administrative headache for the finance sector in 2018. ‘When we were implementing MiFID I in 2006/7, that was the only regulatory change that firms were grappling with,’ says Kirschner. ‘In the post-financial crisis regulatory world, that is absolutely not the case. The resource within firms to achieve what they need to achieve is under challenge.’
In addition, a significant number of EU Member States haven’t yet brought forward legislation to implement MiFID II, which makes it difficult for financial institutions in those jurisdictions to know what they need to prepare for.
The legislation will affect each segment of the market in different ways. ‘For the asset management community, for example, one of the big issues is the additional transparency burden that has been placed upon them,’ Kirschner says. ‘Under MiFID I, transparency to regulators and transparency to the market was very much an issue for the brokerage and investment banking community, whereas MiFID II made that a joint obligation between the buy side and the sell side. That’s been a massive operational and IT issue for asset managers, who are incurring lots of additional expense.’
The reform that has probably attracted the most attention is the requirement to ‘unbundle' research. Until now, asset managers received research, including written reports and phone calls with analysts, for free, although the cost of this service was built into trading fees – usually paid by managers’ clients. Under the terms of MiFID II, managers will have to budget separately for research and trading costs.
This led to serious concerns in the US when financial institutions realised they would not be able to provide research to European clients unless they registered as investment advisers with the US regulator, the Securities and Exchange Commission (SEC). Doing so would increase their compliance burden. ‘Where you have a US asset manager who is managing all or part of a portfolio under delegation from a European manager, there is the issue of the extent to which the MiFID II obligations apply to that US manager,’ says Kirschner. ‘There has been a great deal of debate and uncertainty about this.’
In October 2017, the SEC responded by granting temporary relief to US banks and brokers. The so-called ‘no action relief’ means US banks can accept direct payments for research, as mandated by MiFID II, without it being considered investment advice. The relief lasts for 30 months, starting from the Directive’s enforcement date. However, it is unclear what will happen once this period expires.
Similarly, in January, the European Securities and Markets Authority said it had delayed publication of those equities that would be excluded from being transacted via dark pools under MiFID II because a large proportion of trading venues had yet to provide complete data. ‘The delay is hardly surprising [because] it was inherently unlikely that initial reports would contain sufficiently complete data for publication purposes,’ says Hogan. ‘In all likelihood, the MiFID II/MiFIR reforms will take a number of years to bed down and more unexpected and unintended consequences will appear over time.’
The need to reform the financial services industry is not in doubt, but as has so often been the case since the financial crisis, the issue of whether the reforms being implemented are the right ones remains open to question.
Jonathan Watson is a freelance journalist and can be contacted on firstname.lastname@example.org