Ashurst London January 2015

#3 MiFID Briefing Series

THE MiFID II REVIEW ESMA's final report and follow-up Consultation Paper Introduction In our MiFID Briefing No. 1 and MiFID Briefing No. 2, we explained the revised MiFID and MiFIR legislation and ESMA's original Discussion and Consultation Papers. In this briefing, we will look in detail at the next stage of ESMA's work, in particular its Final Report to the Commission on the relevant implementing legislation. Between them, the three documents issued on 19 December 2014 run to more than 1600 pages. We have therefore sought to identify and summarise only the key aspects of ESMA's proposals. We have not sought to follow the order of ESMA's documents, but instead to follow topics in a more logical way. In this briefing we cover the following topics: 1.

Research

11.

ALGOS, HFT and DEA

2.

Inducements – quality enhancement test

12.

Pre and post-trade transparency

3.

Independent advice

13.

4.

General investor protection measures

Limits on the use of pre-trade transparency waivers

5.

Transaction reporting

14.

Co-location and fee structures

6.

Product governance

15.

7.

Conflict of interest

Subjecting derivatives to an on-exchange requirement

8.

Underwriting

16.

Tick sizes

9.

Remuneration

17.

Information requirements for MTFs and OTFs

10.

Systematic internalisers

18.

Third country

Contacts Rob Moulton Partner, London T: +44 (0)20 7859 1029 E: [email protected]

James Perry Partner, London T: +44 (0)20 7859 1214 E: [email protected]

Hubert Blanc-Jouvan Partner, Paris T: +33 1 53 53 53 97 E: [email protected]

María José Menéndez Partner, Madrid T: +34 91 364 9867 E: [email protected]

Tobias Krug Partner, Frankfurt T: +49 (0)69 97 11 28 75 E: [email protected]

Anders Malm Senior Legal Consultant, Stockholm T: +46 (0)8 407 24 37 E: [email protected]

Ben Hammond Partner, London T: +44 (0)20 7859 2817 E: [email protected]

AUSTRALIA BELGIUM CHINA FRANCE GERMANY HONG KONG SAR INDONESIA (ASSOCIATED OFFICE) ITALY JAPAN PAPUA NEW GUINEA SAUDI ARABIA (ASSOCIATED OFFICE) SINGAPORE SPAIN SWEDEN UNITED ARAB EMIRATES UNITED KINGDOM UNITED STATES OF AMERICA

1.

Research

To some readers, the most significant development will be the climb down by ESMA (under considerable pressure from the industry, certain member states not, for once, the UK - and its own Securities and Markets Stakeholder Group) on unbundling research. A compromise (of sorts) has now been proposed to the Commission. Originally, ESMA said that all research had to be unbundled and paid for separately because providing it for free amounted to a material inducement. The new proposal is that, as well as permitting managers to pay for research out of their own funds, managers may also use a separate "research payment account". This must be funded in advance by the manager's clients. It must operate based on a research budget set by the manager. The use of the funds in the account must not be linked to the volume of transactions executed. Any surplus must either be rebated to the relevant funds or offset against future research budgets. The administration of this process can be delegated to a third party (so aggregators will still be in business, albeit a slightly different one). Disclosure of the way in which the monies in the account are used must be provided to clients, both in advance (in general terms) and (more specifically) periodically after the event. So aggregators may have a role to play in this regard too. Managers must "regularly assess the quality of the research" that they choose to buy using the account. Brokers must separately charge for execution and research, and the charge for research should not be influenced by or conditional upon execution services. On top of all this, it looks at first glance as though ESMA is proposing that all analysts (no matter what the size of the firm) must be kept behind a Chinese wall. There is then a rather vague statement on flexibility where this is "inappropriate due to the size" of the firm, where a firm can use "appropriate alternative information barriers" (whatever they could be). Whilst segregation is common in larger houses, it is less so in the mid-market and firms are likely to want more clarity from the FCA on these provisions in due course. It is also worth noting that where a firm issues a marketing communication produced by a particular employee, the rules on separation of interests will apply as though the document was a "Research Recommendation" – a proposal which must have unforeseen consequences. For instance, it would mean that the individual involved could not be

remunerated primarily according to the revenues generated from trading flows – which would be an odd situation for a salesman. Again, this proposal is so counter-intuitive that further FCA guidance is likely to be sought on its meaning if the Commission adopts ESMA's proposal.

2.

Inducements – quality enhancement test

ESMA has given further guidance on what "enhancing the quality of service to the client" might mean. Third party payments will need to be justified by reference to additional services, or a higher level of service. Some examples are given: non-independent advice on a "wide range of suitable instruments including an appropriate number from third parties"; the provision of nonindependent advice combined with either an annual review or an on-going service. There is a further reference to the fact that on-going inducements, such as trail commissions, must be justified by the provision of an on-going service. Payments can only be made if they cannot give rise to the potential of bias or distortion in the service provided to clients. Disclosure is required in three ways: in advance (in general terms); immediately after the payment is received (in detail); and annually (in summary).

3.

Independent advice

MiFID has retained its broad proposals relating to the definition of independent advice, and a restriction on product providers making payments to advisors. However, the original proposal, that a firm must advise on a "substantial" number of financial instruments available on the market before they can claim to be independent has been dropped – the new wording is "adequately representative". So the requirement is now (in summary) to offer a diversified selection of adequately representative financial instruments in order to use the label "independent". But a firm specialising only in complex products will not be able to meet this definition.

4.

General investor protection measures

Under MiFID, advice would not amount to regulated advice if it was sent "through distribution channels". So something sent generally to clients could not amount to a Personal Recommendation. ESMA has recommended the deletion of the "through distribution channels" wording, leaving only "made available to public", which would mean that

research might amount to a Personal Recommendation. As a result, a case by case analysis will be needed rather than having the general protection of the "through distribution channels" wording. As well as existing requirements to tape telephone conversations that might lead to transactions, internal calls with the same effect will also have to be recorded (this seems strange unless ESMA one day intends to require the general chat on trading floors also to be recorded – presumably from ceiling microphones!). Any firm that it is caught by the requirement to tape client or internal calls is also caught by new requirement to randomly monitor them. ESMA has, at least, dropped the requirement to get clients to sign the minutes of meetings where any advice was given. The new requirements on information on costs apply to counterparties, professional clients and retail clients. Counterparties can agree to a "limited application" of this requirement unless a derivative is involved, and professional clients can also do so unless they are receiving investment advice or portfolio management or a derivative is involved. This makes the question of whether or not a sales team (for example) is giving advice or not even more important, because full cost disclosure requirements designed primarily for retail clients will then apply. The information requirement is, as a minimum, to provide information about "all costs and charges" and, if a firm is "recommending or marketing financial instruments" or a KID/KIID is required, "full point of sale disclosure" information on costs (which is set out by ESMA in detail) must be given. Third party payments are to be included as part of those costs. Costs must be expressed as both cash and percentage amounts. There will be a new requirement for all "new" professional clients to have a written agreement in place from 3 January 2017 that sets out the "essential rights and obligations" of the parties. But it does not need to be signed. ESMA has confirmed that the requirement to report loss making positions or portfolios will apply to both professional and retail clients. Portfolio managers must report losses of 10 per cent to the overall portfolio (and 10 per cent increments thereafter) whilst firms that hold retail accounts in leveraged financial instruments or contingent liability transactions must do the same.

5.

Transaction reporting

Data Standards and Formats ESMA is currently undertaking a detailed study on the potential reporting standards that might be used to send Transaction Reports to regulators (including: FpML, IFX, FIX). Firms are asked to contribute to the debate on which would be the most straightforward to implement. Obligation to Report Transactions ESMA discusses the definition of "execution" and states that "direct action by the investment firm clearly constitutes execution and this includes where it acts through its branches regardless of whether these are located inside or outside of the EEA" (which will be a significant change in many jurisdictions if implemented in thi s way). In addition, reception and transmission of orders will also be captured for the first time (although this was stated more clearly in the original Discussion Paper than in this Consultation Paper, which merely refers to "an investment firm [which] instructs third parties that results in the transaction". ESMA proposes that no MiFID reporting should be required for stock lending when the Securities Financing Transactions Regulation has been implemented, as reporting is also required under that Regulation. ESMA proposes excluding assignments and novations in derivatives and portfolio compression, in order to focus on decreases and increases in notional as being reportable events. There will then be important changes to the information that actually has to be reported. For example, at the most basic level, the buy/sell indicator fields and counterparty and client fields will be replaced by a buyer field and a seller field. A new "matched principal capacity" field will be required, alongside principal and agent. ESMA has scaled back the amount of information that must be provided when a trader ID is used, although the basic requirement to include one has been retained. Where a particular waiver is being relied upon (for example, reference price), a flag will need to be included on the transaction report (in this case, an "R"). ESMA has stuck by its original proposal that reporting by branches to host authorities should be abolished, and that all reports by an entity should be sent to its home regulator. However, flags will have to be used to identify transactions that involve a branch to indicate if the branch has the primary relationship with the client.

Clock Synchronisation ESMA proposes all venues and firms must use a synchronised time approach consistent to within one millisecond, unless the latency is less than a millisecond, in which case the synchronisation will need to be to the relevant latency time (e.g. measured in microseconds).

6.

Conflict of interest

A number of industry responses noted that ESMA’s original advice (regarding conflicts of interest in underwriting and placements) might result in investment firms refraining from certain legitimate activities. For example, paragraph 14 of the draft technical advice (on one view) implied that a firm should not act as arranger of a securities offering where previous lending or credit provided by a firm was to be repaid out of the issuance proceeds. This (it was thought) did not take into account the robustness of information barriers that investment firms are required to have in place. The result might have been a withdrawal of traditional lending arrangements as investment banks "followed the money" by favouring more profitable mandates (such as M&A advisory) over traditional lending activity. Although ESMA has not pulled its punches with much of the conflicts of interest advice, it does appear to have taken note of this issue and has "removed the implication that refraining from acting was required of firms in all cases".

7.

Product governance

ESMA has confirmed its earlier proposals in this area. The definition of a manufacturer is deliberately broad – simply being the issuer of a product will do. This will mean the end of the lighttouch pure manufacturer definition in the UK. Brokers in the secondary market will be caught by the product governance obligations as though they created the product. All manufacturers will be required to have a distribution agreement, even with a non-EU distributor. Further guidance is given on transparency of charges.

8.

Underwriting

ESMA has proposed that any firm that both advises a company and underwrites an issue by the company must also explain in writing to the company the alternative methods of the company financing itself (i.e. other than issuing shares) and their costs. ESMA has confirmed that the general requirements on underwriting transactions do not apply to blocks.

9.

Remuneration

MiFID proposes new rules that apply to investment firms to ensure that remuneration requirements do not create unnecessary conflict. ESMA proposes that they should apply to "relevant persons who can have a material impact" on the "investment and ancillary services" or "corporate behaviour" of a firm. The resultant remuneration policy must be designed so that clients are treated fairly, and there must be no incentives for staff to favour themselves or the firm over clients (presumably where this would affect the client's interests or there could be a conflict). The design of the policy must be approved by the firm's management after taking advice from the compliance function. There are, in general, quite a lot of requirements in the ESMA proposals that are worded in this way which will introduce additional administrative burdens on compliance functions, or ensure that compliance is properly taken into account by a firm's management (depending on your point of view).

10.

Systematic internalisers

Many of ESMA's original proposals on thresholds have been recommended to the Commission and, where a range was originally suggested, a rough midpoint has been chosen. For example, for equities, the threshold is 0.4 per cent of EU trading in a liquid instrument before it is considered "frequent and systematic" (the consultation had suggested somewhere between 0.25 per cent and 0.5 per cent). To define the word "substantial", ESMA has chosen either of 15 per cent or more of the firm's total trading activity for that instrument, or 0.4 per cent of the total trading activity in the EU. ESMA will calculate the various thresholds on a rolling six month basis. Firms will be given two (not one) months to comply if a threshold is triggered. Intriguingly, ESMA suggests that the Commission should consider the potential link between the systematic internaliser definition and the carve-out from the concentration rule that applies where trading with eligible counterparties or professional clients is non-systematic, ad-hoc, irregular and infrequent. If this led to a binary position (either a firm was a systematic internaliser, or the trading fell outside the concentration rule requirement) then this would be an significant limitation on the impact of the re-introduced concentration rule. Clarity has also been given that a volume or timeweighted average price order is an order which is subject to a condition other than current market

price, and therefore falls outside of the price restrictions that apply to systematic internalisers. There is a potentially important change to the definition of "exceptional market circumstances" (when a systematic internaliser can cease quoting). The option to do so when "the total number and/or volume of orders exceeds the norm" has been removed. ESMA justifies this with reference to the ability of systematic internalisers to limit the total number of orders that they handle, but this is different from ceasing handling orders. In other words, if there is market turbulence, firms can limit the number of orders that they handle, but not cease to quote. Each investment firm will have to develop their own policy for limiting the volume of client orders undertaken. Whilst SI quotes may continue to be made available on a website, they must be published in a machinereadable way.

11.

ALGOS, HFT and DEA

Algorithmic and High Frequency Trading There is a lengthy discussion which includes a great deal of background work undertaken by ESMA, but which culminates in two proposals. First, a reasonably straightforward definition of algorithmic trading (but which may capture smart order routing systems – only automated order routers that cannot change the parameters are excluded). Second, ESMA ducks the most difficult question on what is a high gap volume of messages, and puts three proposals to the European Commission, advising them to choose one: an absolute threshold per instrument of two messages per second; an absolute threshold per trading venue and per instrument of four per venue or two per instrument; a relative threshold of between the 20th and 40th percentiles. Further, ESMA says that only proprietary order flows should be included. There is a clearly a concern that some large investment banks will be captured by the thresholds (aimed at smaller HFT players), so if their flow is not proprietary, they are allowed to "challenge the classification". Trading venues are required to calculate a maximum ratio of unexecuted orders to transactions, and it will be a breach of the trading venue's requirements to exceed it. Whilst ESMA has given some flexibility to trading venues in this regard, it is likely to lead to significant competitive pressure between them from their members.

Direct Electronic Access ESMA finds it difficult clearly to draw a distinction between DEA and Smart Order Routers. ESMA says that the defining element of DEA is the ability of the client to exercise discretion regarding the exact fraction of a second of order entry, merely using the name of the investment firm to enter those orders. However, where a client order is intermediated (by, for example, a Smart Order Router, which splits orders from parent into child orders, and handles their timing) the arrangement does not amount to DEA. Specific requirements relating to notification to clients and regulators apply to those using DEA. ESMA drops two controversial proposals which were contained in the original Discussion Paper. First, firms will no longer need to assess the training given to staff of their DEA clients. Second, firms will no longer need to analyse the client's algorithms – they will need to be aware of the types of strategy pursued instead. Before DEA can be provided, firms will need to gather the (very long) list of information prescribed by ESMA (see page 231 of Annex B to the Consultation Paper for the 37 different items). Compulsory Market Making for Algorithmic Traders ESMA has proposed that the requirement to act as a market maker (and to enter into a written agreement with the relevant exchange) should apply to investment firms who regularly post simultaneous two-way quotes of comparable size (i.e. within 50 per cent above or below each other). Quotes must be provided for more than 50 per cent of trading hours, and can only be withdrawn in exceptional circumstances.

12.

Pre and post-trade transparency

ESMA has largely taken forward the issues raised in its Discussion Paper on (1) the requirement for markets to provide standardised data to investment firms on execution quality and (2) the requirement on investment firms to take that information into account when determining how they execute client orders. A large part of the ESMA Consultation Paper is taken up with pre and post-trade transparency requirements for non-equity instruments. ESMA has undertaken a great deal of work and produced a large number of statistics and tables to show the impact of various policy options. These proposals overall defy summary. There are some important nuggets contained within them, though. For

instance, the post-trade transparency requirement for equities is currently 3 minutes (and, as part of the MiFID II reviews, this will be reduced to 1 minute). For non-equity products, the proposal is that this period be 15 minutes for the first 3 years following the entry into force of MiFID II, and 5 minutes thereafter.

13.

Limits on the use of pre-trade transparency waivers

This is sometimes referred to as the "double volume cap mechanism". The volume cap is calculated on a trading venue by trading venue basis, but is set at a percentage of the overall trading across all venues in the EU. Therefore, no single trading venue using the reference price waiver and the negotiated trade waiver can exceed 4 per cent of the EU wide trading in aggregate. The second cap is calculated across all trading venues, and set at 8 per cent. Again, across all venues, the two waivers (reference price and negotiated trade) are aggregated, so that the use of both waivers combined must stay below 8 per cent. Each trading venue has to submit information about its use of the waivers to its regulator annually.

14.

Subjecting derivatives to an onexchange requirement

Under EMIR, derivatives can be declared subject to mandatory clearing. If they are, ESMA has six months to decide whether also to propose them for mandatory on-exchange trading. It should do so, according to MiFID, if the relevant class of derivatives is admitted to trading and is sufficiently liquid. ESMA has decided to list a set of liquidity criteria, but then assess them on a case by case basis to see if they are truly relevant to a particular class or sub-class of derivatives. So some might be discarded. The criteria include: average frequency of transactions, calculated over a minimum number of trades per day and a minimum number of days on which trading occurs; average size of transactions; average size of weighted spreads over different periods of time; anticipated impact of the trading obligation on liquidity; and whether the trading obligation is suitable only for transactions below a certain size. ESMA is also able to mandate other contracts which have a "direct, substantial and foreseeable effect within the EU", and have said that contracts entered into by third country entities who have guarantees from EU firms, or between two EU branches of non-EU firms, may then be caught.

15.

Co-location and fee structures

The original legislative proposals seemed to ask ESMA to focus on the potential distortion that could be created between those who benefit from colocation services and those who do not. The ESMA Consultation Paper, strangely, seems more concerned with regulating service provision between different parties who benefit from co-location arrangements (not parties who are normally seen as needing protection in this regard!). Trading venues must publish a policy regarding co-location and permit all users of co-location services to have access to its network under equivalent conditions. ESMA seems to tie itself in knots at this point, when it says that trading venues must make sure they reserve sufficient capacity to allow new participants access to co-location services on an equivalent basis, but that this requirement is limited by availability and price (a catch-22 if ever there was one). Trading venues cannot use fee structures whereby they provide discounts upon reaching certain trading volume thresholds. The wording of this is somewhat ambiguous, as it says "including those trades already executed", and it is not clear whether this restriction is in addition to a discount for trades yet to be executed, or a stand-alone issue (i.e. only discounts for trades already executed are affected).

16.

Tick sizes

Perhaps one of the largest jobs delegated to ESMA was to come up with a tick size regime that would work for all of the different instruments governed by MiFID. In the end, ESMA has gone for a largely simplified approach, adopting (and adapting) the second of their two original options, based on the FESE regime. Markets will now have to work from a table that contains 5 different liquidity bands and 17 price ranges to produce a tick size regime which will vary from 0.0001 to 50.

17.

Information requirements for MTFs and OTFs

Both MTFs and OTFs are required to provide a detailed description of their functioning to their regulator. ESMA has set out the minimum required information. These include the description of the steps taken to ensure objective and nondiscriminatory access, identifying potential breaches of trading rules, a detailed description of the functioning of the system, information about outsourcing arrangements and so on.

18.

Third country

Non-EU firms will be able to register with ESMA and provide services into the EU if they are based in an equivalent jurisdiction (as determined by the Commission). ESMA's proposal is that only factual information needs to be provided by the firm, plus a written declaration by its regulator stating that it is subject to supervision and detailing the services and activities for which it is authorised. This will lessen fears that the registration process might be used as a quasi-authorisation process. More generally it is

expected that HMT will release (at the beginning of February, all being well) a consultation that will set out (amongst others things) the UK’s approach to the MiFID II Third Country Regime. It is reasonable to assume that the political climate in the UK will have some bearing on this issue. Given the emergence of UKIP and an imminent election one wonders how much political appetite there will be to opt in to a European third country regime.

This publication is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying the information contained in this publication to specific issues or transactions. For more information please contact us at Broadwalk House, 5 Appold Street, London EC2A 2HA T: +44 (0)20 7638 1111 F: +44 (0)20 7638 1112 www.ashurst.com. Ashurst LLP is a limited liability partnership registered in England and Wales under number OC330252 and is part of the Ashurst Group. It is a law firm authorised and regulated by the Solicitors Regulation Authority of England and Wales under number 468653. The term "partner" is used to refer to a member of Ashurst LLP or to an employee or consultant with equivalent standing and qualifications or to an individual with equivalent status in one of Ashurst LLP's affiliates. Further details about Ashurst can be found at www.ashurst.com. © Ashurst LLP 2015 Ref:39102540 05 January 2015