MiFID 2 Cheatsheet

What are the main differences between MiFID 1/2?

Extended scope of product & activities

Additional instruments brought into scope:

• Structured deposits issued or sold by credit institution
• Certain packaged retail investment products (PRIPs)
• All emissions allowances (such as carbon
• The sale of financial instruments issued by the investment firm.

Insurance-based Investment products are also included with respect to conflicts of interest.

Prohibited payments and inducements (MiFID article 24)

Article 24 prohibits the common practice of retrocessions (inducements) for discretionary  asset management and ‘independent’ advice.

Enhanced investor protection

A series of measures will reinforce investor protection, including the following:

• Advice from investment firms must meet two criteria in order to be 'independent': assess a sufficient range of financial instruments and refrain from accepting or retaining inducements from third parties)
• Discretionary portfolio management will also refrain from accepting or retaining inducements from third parties.
• Advisory and portfolio management clients will receive a detailed suitability assessment in a periodic performance report.
• Pre and post trade information to clients will be enhanced, in particular detailed information on fees and commissions paid and received by the investment firm
•  Definition of non complex instruments will be amended and exclude structured UCITS. This implies that an assessment of appropriateness will be required before selling any  structured UCITS. In other words, ‘execution only’ will not be possible anymore for structured UCITS, regardless of the product risk profile

Creation of new Execution Venue - the OTF 

• To capture ‘dark pool’ operators and other alike trading systems (e.g. interbroker dealing systems), a new category of trading venue called Organised Trading Facility (OTF) will be introduced for non equity instruments (e.g. bonds, derivatives, structured products).
• Derivatives, which are sufficiently liquid and eligible for clear
  ing, will need to be traded on eligible platforms: OTFs, MTFs (Multilateral trading facilities) or RMs (Regulated Markets) instead of OTC trading.
• Requirements will be imposed on operators of OTFs (e.g. clients orders on an OTF cannot be executed against proprietary capital) and transactions concluded on an OTF will be submitted to pre & post trade transparency provisions similar to RM and MTF, creating a level paying field.
• The scope and obligations of systematic internalisers will be amended

Stricter governance - greater accountability

Some of these provisions have parallels with some work I did recently for the FCA to implement the PCBS 2013 Senior Manager's regime.

• New requirements for corporate governance and (non executive directors, in addition to other texts (e.g. CRD IV or CSSF circular 12/552).
• Introduction of the new concept of “management body”: governing body of an investment firm or a data services provider, including the supervisory and the
  managerial functions (i.e. all persons who effectively direct the business).
• Strengthened criteria for qualified senior management, the role of directors and supervisors who must commit sufficient time to perform their function and take into account diversity in their composition.
• Stricter control of remuneration of staff (e.g. bonus criteria) advising
  or selling to clients, which cannot prevent staff from complying with obligations to act in the best interest of clients. 
• Strengthened role of the compliance office

 Product intervention - greater supervision, stricter sanctions

• In coordination with ESMA, national regulators (i.e. CSSF in Luxembourg) will have powers to permanently ban financial products, activities or practices.
• Administrative sanctions, fines and penalties will be made public, sufficiently high to offset any benefit and to be dissuasive also for larger institutions.
• Position limits for products, such as commodity derivatives, will be introduced. This will include powers for regulators to require existing positions to be reduced or to limit the ability of any person from entering into commodity derivatives

Harmonised regime for third country firms - passporting

• When serving retail or professional clients on request in the EU, third country firms will have to establish a branch in each EU country where they operate. Branches will be subject to authorisation and supervision in the member state.
• When serving eligible counterparties or per se professional clients in the EU, investment firms will directly register with ESMA. This registration will be first subject to the third country receiving a positive equivalence assessment from the European Commission. No EU branch is required. The EU passport will be available

Extended market transparency & transaction reporting

• Transparency requirements will be extended to additional instruments, such as bonds and derivatives.
• Trade reports will need to be published through Approved Publication Arrangement (APA) firms, which will also be subject to authorisation and certain organisational requirements.
• Transaction reports will need to capture additional information (including identification of individuals or computer algorithms where relevant responsible for the investment decision).Key system changes will be required to capture additional reporting requirements
• (including new instruments). Static data may require cleansing in order to ensure additional information is reported correctly.
• As such, reporting will be impacted in 4 dimensions: the format (aligned with EMIR, frequency (near real time), the content and audit trail

Market Model Typology (MMT)

In the post-MiFID environment, several aspects have contributed to reducing the quality of data and hindering its consolidation. The MiFID review should look at the standardisation of both data formats (code identifiers, etc.) and flags to solve issues in some specific areas (e.g. OTC trades). The
relevance of trade flags stems from the support they offer to liquidity discovery mechanisms across trading venues. Market initiatives should reduce the number of trade flags, currently around 50, to fewer than 10 across Europe.

MMT

The Market Model Typology (MMT) initiative is a collaborative effort established by industry participants to improve the quality of post-trade data through the use of standards for post-trade transparency. The work conducted has built on some earlier advice from ESMA’s predecessor CESR.


MiFID II proposes regulatory intervention to improve post-trade information and reduce costs and EU regulation aims to:

• Improve the quality of raw data and ensure it is provided in a consistent format through more standardised trade reports and by mandating OTC trade publication via an APA (Approved Publication Arrangement)
• Reduce the cost of post-trade data for investors through unbundling of pre- and post-trade data
• Introduce a European Consolidated Tape

Trade data standardisation for MiFID 2

MMT introduces a standard set of codes for equities post-trade data, making it easier for market data to be compared and consolidated by investors.

MiFID II proposals call for provision of consolidated post-trade data to be available for an instrument from all the EU venues where it is traded, on- or off-exchange. So, rather than participants having to consolidate this data from numerous sources themselves, data would be available as a consolidated tape. Standardisation of trade data is a pre-requisite for effective data consolidation and the MMT industry standard maps legacy trade flags to a common code.

MMT takes the form of a data model and cross reference table which maps trade flags across securities exchanges, MTFs and OTC reporting destinations to a set of standard single character enumerations (the native code includes 10 characters) and is currently endorsed by trading platforms and reporting venues, as well as the major market data vendors.

Summary

Whilst MMT is gaining industry support and its broad implementation is envisaged under  FIX governance, whether this will lead to regulatory endorsement of the MMT under MiFID II is yet to be seen.

Exchange-traded vs Over-the-counter (OTC) Derivatives

The most common types of derivative products are interest rate swaps, caps and their offshoots. Over 90% of commercial bank derivative trading is interest rate related due to the natural ebb and flow of their corporate finance and hedging activity.

An exchange traded product is a standardized financial instrument that is traded on an organized exchange.

An over the counter (OTC) product or derivative product is a financial instrument traded off an exchange, the price of which is directly dependent upon the value of one or more underlying securities, equity indices, debt instruments, commodities or any agreed upon pricing index or arrangement.

Why would you want to trade OTC?

The reason derivative products exist is that users often need customized products as the standardization of exchange products can lead to hedging mismatches and gap exposures.

The main differences between exchange and OTC products can be viewed as follows:

Exchange Traded	OTC Traded
Pricing	Standardized	Customized
Maturity	Standardized	Customized
Quantity	Standardized	Customized
Frequency	Standardized	Customized
Quality	Standardized	Customized
Documentation	Standardized	Customized
Regulatory Body	One entity	Various

Standardization versus customization

Hence the primary difference is standardization versus customization. This leads to a crucial distinction. This standardization is fundamental to risk management and trade plans.

When dealing in exchange traded products terms are standardized and the clearinghouse guarantees that the other side of any transaction performs to its obligations. That is, it assumes all contingent default risk so both sides do not need to know about each other’s credit quality. This differs from customized OTC products where there is no clearinghouse to guarantee performance.

The need to know the counterparty’s credit standing is an essential distinction. The exposure difference is quite significant.

In summary:

Exchange Traded = Standardizes = Market Risk

OTC Traded = Customized = Market Risk + Counterparty Risk

MiFID II - a quick overview

The regulatory ship that once seemed distant on the horizon is drawing nearer...

The vessel is named Markets in Financial Instruments Directive II, and when it reaches port, its regulatory cargo will hold implications for institutional market participants and market operators who buy or sell securities in Europe. In an increasingly global marketplace, that universe is of significant size.

In simple terms MiFID II focuses on four key areas: trade execution, capital requirements, regulatory reporting, and risk management. The European Union’s overarching goal in implementing MiFID II and its corollary Markets in Financial Instruments Regulation is to increase transparency, and by extension, investor protection.

In order to comply with MiFID/MiFIR, market participants are faced with having to digest a vast array of information and to then assess the impact on their activities depending on whether they are operating as an investment firm or venue,

Meant to go into effect on January 3, 2017, MiFID II is a comprehensive, multi-asset-class revision to the original equity-centric MiFID, which commenced in 2007. Specific areas covered include microstructural Issues, data publication and access, venues, commodity derivatives, market data and reporting, and post-trade. MiFID I is substantially expanded as these subjects are now interlinked to ensure that information pertaining to clients, venues and instruments is disclosed so that both pre- and post-trade activities are fully transparent.

The  upshot is that as with any regulation, the end-result benefit will not be cost-free. Additional operational costs due to the introduction of new regulatory oversight on existing pre-trade, trade and post-trade processes results in additional IT and operational process controls. These are likely to be recurring too.

Rising to the challenge

MiFID II is clearly more complex than its predecessor given that reporting requirements pull in more complex and less standardized financial instruments, across asset classes which historically have traded in a dealer-driven over the counter framework, i.e. via privately negotiated telephone transactions.

The fixed income markets and derivatives markets are being pushed to have a coherent pre-trade and post-trade transparency framework around trade execution. By imposing new transparency rules around the publication of bids and offers, as well as the details of executed trades, is likely to have quite a big negative impact in terms of trade life-cycle efficiency.  

Going forward

MiFID II milestones include the start of the formal approval process this summer, an FCA MiFID II conference in October, and a formal consultation addressing implementation in December.

The end of systematic risk?

It will be more than a half decade between the initial proposal and full implementation, but given the stakes are so high, a long lead time is necessary. Key is to get the calibration right in advance so as not to disrupt the provision of liquidity too significantly. That’s a particular concern at the moment, given some of the issues we’re seeing around liquidity in bond markets generally as a source of potential systemic risk.

According to a previous client, the U.K.’s Financial Conduct Authority, MiFID II is “designed to take into account developments in the trading environment since the implementation of MiFID in 2007, including advances in technology and gaps in transparency to investors and regulators. It is also a response to the financial crisis.”