Ella van Kranenburg provides this excellent description on MiFID et al (MAR, MAD, EMIR). Thanks Ella for sharing.
The ever increasing call to (further) regulate the financial industry has resulted in European rules either becoming stricter or completely new rules are drawn up for previously unregulated markets. The Basel III is an example of the first and the AIFM Directive, regulating the fund industry, including hedge funds and private equity, being an example of the latter. The set up of this Dummy is different from the Basel III and Solvency II Dummies. The reason being that the proposed change to Markets in Financial Instruments Directive (MiFID), ancillary and related regulations cover a wide range of topics. This Dummy is in the form of a phantom interview where the expert is being interviewed by a corporate treasurer. The purport of the interview format is to provide more insight in what the changes to MiFID II et al could mean to you and your company. Some of these proposed regulations bear relevance on your activities as a corporate treasurer.
This Dummy is not aimed to be complete or conclusive. Many of the underlying technical details remain subject to interpretation or further clarification from the European Securities Markets Authority (ESMA) which are yet to be published (May 2012).
Question: I understand that MiFID II will include new transparency requirements for issuers. Why is this so and assuming I have a portfolio management relationship with an investment firm, what would this mean to my company?
Answer: Where MiFID currently only imposes harmonized pre- and post-trade transparency requirements to shares admitted to trading on regulated markets, MiFID II indeed introduces additional pre- and post-trade transparency requirements for other financial instruments. The transparency requirements may differ depending of the nature of the product, which would include all bonds, structured finance products with a prospectus as well as all derivatives eligible for central clearing and those submitted to trade repositories. The pre- and post-trade transparency requirements should, in the view of the European Commission, result in higher market efficiency and lower risks in the non-equity markets.
Though increased transparency may result in better efficiency, investment firms may be facing additional costs in order to ensure that they can adequately meet the new reporting requirements. Such costs could in part be passed on to customers. Hopefully the benefits of market efficiency outweigh the potential costs that investment firms may pass on to their clients. The result of the new rules should be that you as a client of an investment firm receive better service from your investment firm based on proper and harmonized information. However, as said such better service may come at a cost. In the long run the better service should, theoretically, bring better results in terms of what the clients of investment firms have anticipated on. In other words, in the example of portfolio management, the performance of the portfolio managed would be more aligned with the expected results and risk appetite of your company.
Question: Is it true that the new rules will give investors more protection? How would this additional or increased protection work?
Answer: True, MiFID II will strengthen investor protection. For one, MiFID has the concept of so-called ‘financial instruments’. Investment services and investment activities relating to these financial instruments are regulated services under MiFID. The definition of products qualifying as ‘financial instruments’ as well as the definition of investment service shall expand under MiFID II.
Two important examples that can illustrate this are for one the fact that financial instruments will include emission allowances and secondly that investment services will include custody services (regarding financial instruments). Widening the scope of MiFID in terms of investor protection also means that companies dealing with investment firms shall benefit from such expansion when receiving these newly regulated investment service. The same applies to investors when dealing with investment firms in relation to the newly regulated financial instruments.
Where MiFID allows for third party inducements under certain conditions, MiFID II will further restrict third party inducements for portfolio managers and independent investment advisers. At this stage it is unclear whether there will be a complete ban on third party inducements, or whether inducements may only consist of non-monetary benefits or could only be allowed when fully disclosed to the client or a combination of the aforesaid. With inducements one should think of payments or other (non monetary) benefits that investment firms receive or make with respect to investment services or ancillary services provided to professional or retail clients. The prohibition of third party inducements on the one hand serves clients in that the operations of their investment advisor / portfolio manager are more aligned with their interests. However, where currently investment managers or portfolio managers (partially) rely on information given by third parties against a fee, under MiFID they will be prohibited to do so. This means that investment firms will have to put in more effort themselves to understand and explain the product to be acquired and/or service to be provided to the client. The down side of the prohibition of inducements may be that investment firms will, particularly from a cost perspective, be forced to narrow down the scope of products or services offered to their clients.
Certain derivatives contracts, to be determined by ESMA, will need to be traded on a regulated market, Multilateral Trading Facility (MTF), or on an Organised Trading Facility (OTF). The introduction of OTF’s as a separate venue is newly proposed under MiFID II. Financial instruments traded on an OTF shall, similarly to instruments traded on a regulated market or an MTF, be subjected to pre and post transparency requirements which are currently lacking. The derivates mentioned, will also become subject to a clearing obligation. The market expects that as a result of the clearing obligation derivative contracts will become more expensive. The same effect is expected as a result of the new transparency requirements (see the response to your first question).
Question: Why does the Commission want to have OFT’s covered by MiFID, where it is understood that MiFID currently only covers MTFs and regulated markets? Also, how could this affect our treasury activities?
Answer: Effectively having the OTF’s as a third category of trading venue introduced mainly purports to increase the transparency of transactions in financial instruments. It is believed that the current system allows for market inefficiencies or even market distortion. By regulating OTF’s, it is believed that dark liquidity pools – trading systems which are not subject to pre-trade transparency requirements – are caught, hence allowing for a better understanding of the market as a whole. Investment firms operating OTFs will need to be authorized under MiFID II and MiFIR (Markets in Financial Instruments Regulation).
The definition of an OTF is very broad. It is designed to cover broker-crossing systems, inter-dealer broker systems which bring together third party interests, dark pools and other currently unregulated organised trading systems. Trading facilities that are bilateral or multilateral, discretionary or non-discretionary are captured, however pure OTC trading and order routing systems are probably excluded. Although the proposals aim to create a level playing field for the regulation of all organised trading, there will be some differences in the treatment of OTFs compared to other kinds of trading venue. Whereas regulated markets and MTFs are characterised by the non-discretionary execution of transactions and are therefore subject to pre-determined rules, operators of OTFs will have a degree of discretion how transactions will be executed. However, OTFs will be subject to investor protection, conduct of business and best execution requirements.
By introducing the OTF as a separate venue, corporate treasurers will have to bear in mind that when currently operating transactions in financial instruments through, for example, a bilateral trading system, such trading system in the future will become subject to supervision (and as a result transparency requirements). Again clients can expect that further regulation will also imply bearing additional costs when dealing through such systems. The upside and benefits of the new transparency requirements and executions requirements shall hopefully arise with respect to pricing. In order words the new transparency requirements should in fact result in better pricing of financial instruments traded on OTFs.
Question: So, apart from the fact that it is believed that MiFID II could make investment services more expensive to the clients, it seems that MiFID II would in all other respect be fairly good news to the end users, including corporate clients. Can MiFID II or perhaps other regulations which we understand will be changed in tandem with MiFID II have other (side) effects that could affect us as well?
Answer: Indeed the changes by the introduction of MiFID II will not come in isolation. The Market Abuse Directive (MAD) will be amended in the Market Abuse Regulation (MAR) and a Directive will be put in place setting out rules on sanctioning. Furthermore an OTC Derivatives Directive (also known as the European Market Infrastructure Regulation (EMIR)) will be introduced.
Without being complete, there are several reasons why the proposed changes in MAD will have a significant effect on corporates who have their bonds, equities and other financial instruments traded through an MTF and OFT. The changes are significant in that all market participants should bear in mind that insider information will not only relate to bond/equities dealing on the traditional stock exchanges, but shall also apply to such instruments which are traded on MTF’s and OTF’s. This increases the scope of MAD in an unprecedented way. One can question whether market participant fully understand what this will mean to them. Not only is MAD expanded by way of including the new trading venues, additionally the scope of insider information will expand. Where inside information currently needs to be precise to qualify as ‘inside information’ under the wider definition this is not necessarily required. ‘Inside information’ will also include any information which would be regarded by a reasonable investor ‘relevant information’ so as to determine the terms on which to effect the transaction in the particular financial instrument. Though the obligation to disclose inside information to the public as soon as possible shall not apply to this type of information, indeed insider trading based on ‘relevant information’ would (also) be prohibited.
MAD has no clear and binding definition of inside information in relation to commodity derivative markets. It has been recognized that as a result information asymmetries may occur in connection with spot markets. Investors in commodity derivatives have less protection than investors in derivatives of financial markets under MAD because a person could benefit from inside information in a spot market by trading on a related derivative market. MAR shall align the definition of inside information in relation to commodity derivatives by extending it to price sensitive information which is relevant to the related spot commodity contract as well as to the derivative itself. Furthermore, MAD only prohibits any manipulation which distorts the price of financial instruments, e.g. excluding spot markets. Since transactions in the derivatives markets could also be used to manipulate the price of the related spot markets, and vice versa, the definition of market manipulation shall be extended in the MAR to also capture such cross-market manipulation.
Though the prohibition on market manipulation in MAD is included in MAR as well, MAR will extend the scope of market manipulation. Under MAR market manipulation covers not only orders and transactions, but will include “any other behavior” that could give false or misleading signals or secure prices at artificial levels or which employs a fictitious device or other form of deception. Also, where MAD did not explicitly include banning attempts on market manipulation (though it does contain elements thereof), MAR will include such attempts on market manipulation to enhance market integrity. Attempts in itself will become a separate offence under MAR.
The new rules can also have unpredicted effects in terms of extraterritoriality. To illustrate; say that you are trading in a non-EU listed share through your EU broker, e.g. an EU OTF. It appears that due to the trading of the share on an OTF it will fall within the scope of MAR. This implies that the trading in such shares outside the EU could be caught by the prohibitions of MAR.
All of the above could have relevance to your company as well as you as a corporate treasurer. The chance that financial instruments of your company fall within the scope of MAR will increase (if not already the case), hence making your company and its employees more susceptible to the risk of, even unknowingly, breaching the provisions of the MAR. The draft rules also seem to provide issuers less certainty as to the moment in time where they need to disclose inside information. All in all we would suggest that in due course it would be advisable for your company to analyse the effect of the changes to MAD. The analyses should take place both with regard to the fact that financial instruments of your company itself may caught by the widening of trading venues, as well as the fact that your company, when trading in financial instruments of third parties, needs to bear in mind that such instruments could be captured in the MAR framework where they were previously out of scope. The latter will make your company vulnerable to (unintentionally) breaching the insider trading rules or market manipulation rules. Hence all individuals in your organization dealing with trades in financial instruments should be very cautious of the effects of MAR once it comes into play.
As MAR will in principle require member states to include criminal sanctions for insider dealing and market abuse, the expansion of the MAD is not to be taken lightly.
Question: You mentioned EMIR as a relevant development as well. Could you shed some light on this? We are of course mostly interested in understanding how such changes would affect our business and operations?
Answer: The European Commission has recognized that derivatives are a very important tool in hedging risks, including risks which derive from normal business operations. Derivatives however were also regarded as one of the key features in the economic turmoil by allowing leverage to increase and by interconnecting parties unnoticed due to a lack of transparency. The majority of hedging takes place by way of standardized contracts (estimated at 95%), however the Commission understands that tailor-made contracts have been and will remain necessary as well. EMIR purports to strengthen the market infrastructure for derivative contracts by (i) increasing transparency, (ii) reducing counterparty risk, and (iii) reducing operational risk.
The above objectives shall result in a set of rules which requires all standardized OTC derivatives contracts to be cleared via so called ‘central counterparties’. The central counterparty would be subject to strict requirements and would operate between the purchaser and seller of a contract, hence mitigating counterparty risk. The central counterparty must calculate the margin which is to be posted to hedge the risk on the contract. When entering into an OTC derivative contract all parties involved, including the banks as well as the OTC counterparts must report the entering into an OTC derivative contract to a trade repository. The information to be provided would in any event include the identity of the counterparty and the underlying of the contract (face value included).
EMIR would provide for some exceptions on the clearing obligation, for one on contracts between affiliates. To ensure that these contracts do not increase systemic risk EMIR will require that such transactions will, in principle, be subject to bilateral collateralization. Collateralization can be avoided if (i) there is no practical or legal impediment to prompt the transfer of own funds and repayment of liabilities between counterparties and (ii) the risk management procedures of the counterparties are sound, robust and consistent with the level of complexity of the derivative transactions.
Non-financial institutions may benefit of a threshold exception (to be defined over a certain period of time). Furthermore, if non-financial institutions use OTC derivative contracts to reduce risk on commercial or treasury activities, these contracts do not need to be calculated in the threshold amount. The threshold amounts are one of the matters on which ESMA still needs to provide clarification by way of technical standards. In doing so ESMA will take into account systemic relevant of the sum of net position and exposures by counterparty per class of derivatives.
Given that the Commission recognizes that not all contracts are suitable for central clearing, bespoke derivative contracts should be allowed, whilst counterparties will have to exchange collateral over their exposure. As financial institutions will be facing higher capital charges when using derivatives which are not cleared centrally, this would be an incentive for financial institutions to decrease the use of non-centrally cleared derivatives and probably would result in customized contracts becoming more expensive to their contract counterparties.
For corporate treasurers the introduction of EMIR means that one will have to make sure that internal procedures are put in place to ensure that your companies are in keep with the future reporting and central clearing obligations. Obviously when entering into derivative contracts which require central clearing, the company would also have to get connected to a central counterparty.
It is believed that on the long run standardization and transparency will provide an economic benefit. However, setting up the right infrastructure by all parties involved will result in additional costs which, one way or the other, will have to be born by such parties.
Question: Apart from the above, how could the implementation affect our relationship with investment firms or other parties which whom our companies currently hold out a relationship (as client)?
Answer: Investment firms will be making impact analyses on how the new rules affect their business. In anticipation of the new rules they could already be making changes earlier on, so as to ensure that their systems (including with respect to conduct of business) are aligned with the new rules in a timely manner. It is expected that these changes will affect existing client relationships. Where clients refuse to agree to the new changes or do not respond to certain requests made (for example this could be the case with respect to new client categorization requirements) investment firms may be forced to terminate their relationship with such clients.
As reflected in responses above, the expectations of MiFID et al are that the new rules will enhance the quality of the service that you receive from your investment firm. The same however is likely to apply to the costs that will be brought upon your company when taking in such improved services.
Since the scope of MAD will change significantly, not only investment firms but you and your company should make an impact analyses in due course to ensure full compliance in the future. It’s just not good enough to remain operating in a ‘business as usual’ manner. Particularly so since individuals in your organization may be breaching MAR unintentionally if they do not understand the impact of the proposed changes.
EMIR will not only require companies to ensure that they have adequate internal procedures in place to meet the future reporting and central clearing obligations, but also will require companies to enter into contracts with central counterparty with regard to their OTC derivatives. Furthermore, when using a threshold exception which prevents the obligation to use central counterparty clearing, it will be very important to monitor the positions of the derivatives falling within such threshold. The threshold exception will also require risk management procedures to be in place, including having a system in place to exchange collateral if a clearing threshold is breached. When using the intra group exception (without the need for bilateral collateralization) the risk management procedures within the companies must be sound, robust and consistent with the level of complexity of the derivative transactions.
Finally, in general the question of territoriality is an important one. Certain aspects of your company and/or treasury business may at first seem out of scope with regard to MiFID et. all, though could still be captured because of the product, a counterparty or trading venue or a combination of any of the aforesaid.
Question: Within what time frame will the markets be facing the new rules?
Answer: It is unclear what the time frame will be for the implementation of the MiFID, MAD and EMIR reforms. The current MiFID proposals will have to pass through the Commission and European Parliament, making them subject to negotiation and further amendment. It is expected that they would not apply until two years after their adoption and publication in the Official Journal. The Directive will then need to be transposed in the national laws of Member States which probably delays full implementation of the reforms further. Regulations such as MAR, MiFIR and EMIR take immediate effect and do not require local implementation. Though it remains estimation it is believed that 2015 is the envisaged time frame to have the MiFID II rules implemented (as well as having MiFIR and MAR finalized). For EMIR the timing depends on technical standards which are to be developed before 30 September 2012 by the European Supervisory Authorities (ESA). The date of application of the reporting requirements and clearing obligations will be set out therein. Before the end of 2012 the standards have to be adopted by the European Commission.
Thanks Ella for your kind efforts! Published May 8, 2012