In January 2018, MiFID II (Markets in Financial Instruments Directive) will be introduced across the EU financial arena. Its impact will be significant and far-reaching, affecting the activities of investment banks, broker dealers, various asset managers, private wealth managers, and financial advisors on a broad range of fronts.
In with the new
MiFID II has been drafted to address the weaknesses inherent in the original directive, which was introduced prior to the financial crisis. Designed to enhance protection for consumers of financial products, the directive is also a response to recent technological advances in trading – particularly algorithmic trading and direct market access systems – and the need for greater transparency in investments other than shares.
The directive, which will also introduce the new Markets in Financial Instruments Regulation (MiFIR), will bring about a raft of changes to the regime established under MiFID. These core amendments include:
- Greater transparency both in terms of trading in equity markets that are not exchange traded, as well as in non-equity markets such as structured finance products, emissions trading allowances and certain derivatives and bonds
- New regulations to regularise Organised Trading Facilities (OTFs) and increased regulatory focus on commodity derivative markets
- Enhanced criteria for professional investor and eligible counterparty classification
- Increased investor protection measures
Given the extensive nature of the legislation, the impacts of the directive will be felt across most investment-related activities and functions.
MiFID II will extend the directive’s reach to encompass assets such as over-the-counter (OTC) derivatives trading, classifying funds using these instruments as ‘complex’. UCITS funds that are structured/capital protected will also be labelled complex. This classification means both retail and professional investors will need professional advice if they wish to invest, incurring an additional cost. Those products deemed non-complex will, however, still be eligible for investment on an execution-only basis.
Another significant change will be the requirement that both retail and professional investment advice must be categorised as independent or non-independent. This will affect financial incentives as MiFID II will limit incentive bonuses only to advisors categorised as non-independent.
In addition, the directive will see clients undergo more stringent appropriateness tests assessing their product knowledge, financial stability, investment objectives and risk tolerance levels. Only those products classified as non-complex will be excluded from the tests.
MiFID II will also look to tackle the issue of derivative and fixed-income trading outside of organised venues through OTC, which regulators view as a non-transparent risk to the financial system. The directive aims to push much of the trading in these instruments to one of the regulated trading venues for financial assets and instruments: Regulated Markets (RM), Multilateral Trading Facilities (MTF), and the new Organised Trading Facilities (OTF).
Derivative contracts eligible for clearing under EMIR (European Markets Infrastructure Regulation) will now be required to trade through RMs, MTFs, and OTFs. MIFID II will also require that each facility continuously publish bid and offer prices for equities and other instruments.
Reporting requirements for commodity derivative trading will also change. Under the directive, venues will be required to send out weekly reports on their aggregate positions, while trading organisations will need to provide daily position reports to their national regulator.
A limiting factor
Under Article 57 of MiFID II regulators will be required to apply strict quantitative limits on positions taken by any entity in relation to any commodity derivative traded via an EU trading venue, plus any OTC contracts of economic equivalence. The limits will be applied at investment fund level rather than manager level and therefore may impact both complex UCITS and AIF funds.
These new rules will have significant implications for the liquidity of the fixed income market, driving increased costs for this type of asset trading. In addition, the commodity derivative limits may affect the fund’s portfolio construction as fund managers may look to reduce or eliminate such holdings.
The wider implications
Given the fact that MiFID II will not come into effect until January 2018, it is still very much a case of maintaining a watching brief. However, at this stage, it is fair to surmise that the new directive will most likely increase costs for those companies it encompasses. It is therefore expected that such increases will in turn result in increased costs for trading in financial instruments.
A further possible knock-on effect will be a potential increase in independent advisors seeking non-independent status. This may reduce the numbers willing to promote smaller funds through advisors, as non-independent practitioners will focus more on larger funds which generate greater media exposure.
Whatever the final outcomes, it is clear that MiFID II will introduce fundamental changes into the trading environment. It is therefore a strategic imperative that all steps are taken now to ensure that the transition to this new environment is as seamless as possible.
This article was first published by Finance Malta in their January 2017 newsletter.