MiFID 2—The Level 2 Legislation Is Starting: Part 2

World Securities Law Report informs you of developments in the regulation of transactions involving securities around the world. It provides expert analysis and practical guidance, with...

By Emma Radmore

This is Part 2 of a two-part article written by Emma Radmore, of Dentons UKMEA LLP, discussing the revised Markets in Financial Instruments Directive (MiFID 2) and Regulation (MiFIR) package and the European Commission's two pieces of finalized legislation—a Directive and a Regulation. This article discusses the Regulation.

The Delegated Regulation

The Commission finalised the Delegated Regulation on 25 April. The Commission explains it used 19 of its “empowerments” in MiFID 2 when making it. The Regulation is lengthy, and covers several discrete areas.

Scope and Definitions

The Commission generally had power to embellish on several definitions and the Delegated Regulation sets the parameters for:

  • durable medium: and when it may be appropriate to provide information on a website, or otherwise than on paper;
  • in an incidental manner for the purposes of the exemption for those providing investment services in an incidental manner in the course of another professional activity. The Commission mandates a close and factual connection between the investment activity and the main activity, that the ancillary activity should not be a systematic source of income and that the activity should not be promoted or marketed;
  • commodity derivatives: the Regulation sets out:
  •  situations when wholesale energy products must be physically settled for the purposes of section C(6) of Annex 1 to MiFID 2—and the attendant meanings of operational netting, force majeure and bona fide inability to settle as well as what physically settled could comprise;
  •  the scope of the meaning of energy derivative contracts relating to oil, energy derivative products relating to coal and derivative contracts that have the characteristics of wholesale energy products —also for the purpose of section C(6);
  •  other derivative financial instruments—specifically looking at when contracts that are not spot contracts (as defined in the Regulation) and are not for commercial purposes (also as defined in the Regulation) will be considered to have the characteristics of other derivative financial instruments for the purposes of section C(7); and
  •  contracts that will be covered by section C(10) apart from those already referred to in the Level 1 legislation. These are defined as contracts relating to any one of eight underlyings that meet the criteria set out in the Level 1 legislation and in the Regulation's guidance on other derivative financial instruments.
  •  when derivatives contracts relating to currencies will not be financial instruments under section C(4)—specifically addressing what will be considered a spot contract;
  • personal recommendation for the purposes of the investment advice definition;
  •  money market instruments and systematic internalisers for the purposes of trade transparency and market structure rules. Key criteria include that a characteristic of a money market instrument is that it has a maturity at issuance of 397 days or less. The Regulation considers the scope of the systematic internaliser status separately for each of equities and similar products, bonds, structured finance products, derivatives and emission allowances;
  •  algorithmic trading, high frequency algorithmic trading technique and direct electronic access for the purpose of trading controls. The provisions include a view on what will be considered as no or limited human intervention, what is a high message intraday rate and when a person will be considered not capable of electronic order transmission.

 

Organisational Requirements

The Delegated Regulation further specifies procedures for organisational requirements generally in terms of firms' processes, resources and monitoring. This includes the specification that performance of multiple functions by relevant persons (a term the Regulation defines) does not and is not likely to prevent those persons from discharging any particular function soundly, honestly and professionally. The requirements include that firms put in place systems to safeguard information, have adequate business continuity planning and accounting policies, all of which are regularly reviewed. The Regulation then addresses particular requirements in more detail, specifically:

  •  the compliance function, including the need for a risk-based monitoring programme and requirements around appointment and remuneration of compliance staff. Certain requirements are, however, subject to a proportionality test for smaller firms;
  •  risk management, including the need for some firms to establish and maintain a risk management function and the duty for any that do not establish a function to be able to show it has satisfied the relevant requirements;
  •  internal audit;
  •  responsibility of senior management, including the possibility of having a supervisory function;
  •  complaints handling, including a specification that the complaints management function may, but need not, be carried out by the compliance function, and the need for the compliance function in any event to analyse complaints and related data to ensure they identify and address any risks and issues;
  •  remuneration policies and practices, specifically the need to design policies that do not create any conflict between clients' interests and those of the firm and to ensure their policies apply to all relevant persons whose have an impact, directly or indirectly, on investment and ancillary services provided by the firm or on its corporate behaviour, to the extent that their remuneration may encourage them to act against the interests of any of the firm's clients. It also addresses the need for balance between quantitative and qualitative criteria and between fixed and variable remuneration;
  •  personal transactions, looking at the scope of these and what controls firms should put in place over relevant persons;
  •  outsourcing, specifically the scope of critical or important operational functions and conditions firms must comply with when outsourcing them;
  •  conflicts of interest, addressing what firms should consider when assessing whether there may be a conflict of interest that may be detrimental to clients, what a conflicts of interest policy should address and what conflicts prevention and management procedures should cover. It also imposes the need to keep records of conflicts which senior management should review at least annually;
  •  underwriting and placing services. The Regulation mandates information that firms must provide to issuer clients before managing offerings, specific conflicts management requirements relating to pricings of offerings and procedures to prevent recommendations on placing being inappropriately influenced by existing or future relationships. Firms must also have in place systems, controls and procedures to identify and manage conflicts that arise when they provide an investment services to a client to participate in a new issue where the firm is receiving any fees, commissions or other benefits for arranging the issue. The Regulation also sets additional requirement in relation to lending or provision of credit in the context of underwriting and placement, and record keeping in relation to underwriting or placement; and
  •  investment research, defining the term and requiring firms to have in place arrangements around the activities of financial analysts.

 

Operating Conditions for Investment Firms

The detail of the Regulation specifies:

  •  information to clients on categorisation, costs and changes, investment services and financial instruments and risks of financial instruments. The Regulation sets ways in which information should be presented and communicated, conditions around the use of comparative or past or future performance information and timing of information to be provided to clients generally and specifically on particular aspects of a client relationship;
  •  new requirements on investment advice and the suitability and appropriateness assessment, including an explanation of whether and why advice is independent and any restrictions that apply, with a description of what firms will consider as part of the service. Where advice is independent, the Regulation requires firms to define and implement a selection process to assess and compare a sufficient range of instruments, and imposes additional conditions where comparisons are not possible or the firm focuses on a limited range of instruments, and further disclosure requirements where a firm offers both independent and non-independent advice. The Regulation also provides criteria against which firms must make suitability assessments and what each element of the criteria comprises. It also sets out how firms should take reasonable steps to ensure the information is reliable. Further provisions include:
  •  that the firm should have in place procedures to show it understands the services and products they offer and whether there would be a suitable equivalent;
  •  that where the firm owes a suitability obligation but nothing is suitable, it shall not recommend anything;
  •  that firms providing a periodic suitability assessment should review recommendations at least annually; o minimum requirements for information held for clients;
  •  assumptions firms are entitled to make in respect of professional clients;
  •  additional instruments which are “non-complex” for the purpose of the exemption from the appropriateness test;
  •  the obligation to have written agreements with clients and what the agreement should include;
  •  reporting to clients—in respect of execution of orders within and outside a portfolio management relationship, and clarification that the obligations will apply in respect of eligible counterparties unless the firm and the counterparty agree otherwise. This section also includes details on reporting of client assets held;
  •  best execution and client order handling: this part sets out the criteria firms should take into account when determining the relative importance of factors to establish best execution and embellishes on the expectations on firms carrying out portfolio management and reception and transmission of orders to act in the best interests of the client. It also sets the requirements for review of execution policy and what firms must provide to clients on the policy. In relation to client order handling, the Regulation sets out general principles, dictates when firms may aggregate orders and how then they allocate trades, including for own account and publication of unexecuted client limit orders;
  •  criteria for being treated as an eligible counterparty: this allows Member States to permit firms to treat certain professional clients as eligible counterparties, and also addresses the procedure firms must follow when opting clients up and down from eligible counterparty status;
  •  record-keeping, setting requirements on record retention, including medium and duration and on recording of telephone conversations and electronic communications; and
  •  conditions under which multilateral trading facilities (MTFs) can be registered as SME growth markets.

 

Operating Obligations for Trading Venues

The Regulation specifies:

  •  when removal or suspension of a financial instrument from trading would cause significant damage to an investor's interest. It sets minimum criteria that should lead to this conclusion and factors firms and operators should consider when making their assessments;
  •  where significant infringement of the rules of a trading system or system disruptions in relation to a financial instrument and circumstances indicating market abuse can be assumed. The Regulation notes the need to apply a proportionate approach to assessing potentially abusive behaviour.

 

Commodity Derivative Position Reporting

The Regulation sets out:

  •  when there should be an aggregate commitment of traders report on a specific commodity derivative or emission allowance or a relevant related derivative; and
  •  the thresholds in respect of number of persons and their open positions which, if exceeded, should be published.

 

Data Provision Obligations for Reporting Service Providers

This part of the Regulation clarifies the obligations for approved publication arrangements and consolidated tape providers to provide market data on a reasonable commercial basis. The rules also apply to firms and market operators operating a trading venue and to systematic internalisers.

Competent Authorities

Finally, the Regulation set out the criteria for determining when the operations of a regulated market or trading facility are of “substantial importance” in a host state and the consequences of this.

What next?

For some elements of MiFID 2, the EU-level requirements are now final. But for many more, we still await the final technical standards. Then, of course, national implementing measures. There is still some way to go, but firms should study these new Delegated Acts carefully and assess what changes the requirements may require them to make to their current policies and procedures.

Emma Radmore is a Managing Associate and Rosali Pretorius is a Partner at Dentons UKMEA LLP, London. She is also a member of the World Securities Law Report Advisory Board. She may be contacted at emma.radmore@dentons.com.