Peeling Back European Regulations in 2018: What to Expect Next Year

Its path from formation to completion has not been an easy one, however, with delays, bickering between lawmakers and regulators, and stiff opposition from the industry hindering its process through the EU’s complicated Lamfalussy process of rulemaking.

Despite its problems, however, the revised Markets in Financial Instruments Directive (Mifid II) will go live on January 3, 2018, and will affect nearly all asset classes through the trade lifecycle. While all eyes are focused on Mifid, this sea change is not limited to the second iteration of this massive directive. This feature covers some of the key features of these soon-to-be-enforced laws.

Mifid II

The revised Markets in Financial Instruments Directive and Regulation, or Mifid II, touches nearly all aspects of the trade lifecycle across asset classes. Here are a few of the key areas:

Reporting

Mifid II has significant implications for both trade and transaction reporting. It will expand the number of fields that firms are expected to submit with each report, and forms dedicated reporting entities to handle the information.

Trading Obligations

Implementing post-crisis reforms ordered by the Group-of-20 in derivatives markets, standardized non-equity instruments—including some derivatives—will be mandated to trade through electronic platforms created by Mifid II. The revamp will also effectively prohibit broker crossing networks, forcing firms that trade client orders against their own capital to register as systematic internalizers (SIs).

Investor Protection

A range of investor-protection measures are included in Mifid II, governing disclosure requirements around costs and charges that go beyond what was in the original Mifid. There are also enhanced requirements around the recording of telephone and email communications.

Research Unbundling

One of the most controversial provisions in Mifid II has been the “unbundling” of research payments from execution commissions. Firms must now delineate the costs of research provision—and set up research payment accounts to cover this—from the fees charged by brokers to execute trades.

Best Execution

Firms will be required to step up their efforts with regards to ensuring clients receive the best possible execution of their orders. Mifid II seeks to accomplish this in a number of ways, but chief among them are provisions to rank their top five execution venues on an annual basis, and review client orders to ensure they received best execution.

Dark Pools

Mifid II will have a range of impacts on dark trading, not just through the establishment of SIs, which do not have to disclose details in the same way as other venues, but also through caps on how much volume in European stocks can take place on dark venues. Certain waivers exist for block orders, but it is uncertain whether these will be fully available come January 3.

Algorithmic and High-Frequency Trading

One of the primary reasons for revising the original Mifid has been the growth of algorithmic and high-frequency trading (HFT). While Mifid II does not prohibit these practices, it does place a number of requirements on firms operating systems that trade in this fashion, including obligations to monitor trading systems, to test algorithms and to continuously provide two-sided quotes if these firms act as market-makers.

Transparency

In addition to upgraded reporting requirements, other transparency initiatives feature strongly in the revised rules. These include pre-trade and post-trade disclosures of orders transacted through a trading venue, along with the publication of certain data on a consolidated tape. Controversially, bids and offers are also published after varying time delays, which participants have warned could damage liquidity in bond markets.

For everything written about Mifid II on WatersTechnology.com, click here.

Brexit

Britain upsets the applecart. 

When the United Kingdom triggered Article 50 of the European Union’s constitution, which governs the right of a member state to leave the federation of state, on March 29, 2017, it kick-started a two-year process of divorce between the two powers. Increasingly, that timeframe looks impossible to achieve, leaving great uncertainty as to what—if any—agreements or formal relationships will exist between the UK and the EU come April 2019.

The battle lines are already being drawn, however, and the financial sector has emerged as one of the bloodiest battlegrounds to date, in areas that may not have been obvious points of conflict at the outset.

Clearing

The European Commission fired one of the first broadsides over Brexit in June 2017, when it announced proposals for enhancing the oversight of central counterparty (CCP) clearinghouses. In extreme circumstances, the Commission said, it may require CCPs handling euro-denominated business to relocate to the Eurozone, in order for Esma to more efficiently supervise them. While this was widely seen as an attempt to force LCH, which handles 90 percent of interest-rate swaps clearing in euros, to relocate from London, the proposals have also had an unintended effect of drawing the US into confrontation with the EU. Christopher Giancarlo, the chairman of the Commodity Futures Trading Commission (CFTC), has made it clear that he will not accept Esma oversight of US CCPs, which conflicts with the CFTC’s sovereignty. The proposals are still under discussion in European lawmaking circles.

Passporting

One of the more immediate effects of Brexit will be a change in the UK’s status from member state to a foreign one—what is known as a third country in European legalese. This means that firms based solely in the UK will no longer be able to export their services and financial offerings throughout the EU by means of a “passport,” which previously allowed companies resident in one member state to operate in another freely. This could have far-reaching implications for the UK’s financial sector, if an alternative is not agreed between negotiators. However, the EU has so far proved unwilling to allow the UK access to the single market once it leaves the EU, without the UK accepting the free movement and immigration of European citizens.

Human Resources

The fate of EU citizens resident in the UK has emerged as one of the three key topics that must be resolved in early negotiations, before any treaties or arrangements can be entered into, along with the border between Northern Ireland and the Republic of Ireland, and the settlement of the UK’s financial obligations to the EU. The UK has a large immigrant European population, many of which staff the front, middle and back offices of financial institutions. While UK leaders have promised that anyone lawfully resident in the UK on departure from the EU will be entitled to stay, there have been reports of job offers rescinded for European nationals in UK banks, and vice versa, following the referendum on EU membership in 2016.

London’s Loss?

The numbers vary but the sentiment remains the same across all Brexit prognosticators—Brexit will be a net loss for the City of London, which has long been regarded as the financial capital of Europe. While it’s unlikely that Leadenhall Street will go silent overnight, banks and asset managers are already preparing alternate locations within the diminished EU, with Paris, Frankfurt, Dublin and Luxembourg emerging as popular locations depending on the specific industry subsector. Job losses in the City could reach tens of thousands in number, and the UK is certain to lose at least one institution—the European Banking Authority, which is headquartered in London.

Regulatory Affairs

It is likely that the UK’s regulatory regime will be deemed “equivalent” under European law once it leaves the EU, given that its statute books will exactly mirror the Union’s. However, divergence over time is a factor that will potentially have severe ramifications in the future—and the European Commission has hardly been shy in using equivalence as a political tool in the past. More concerning to some market participants Waters spoke to for this article, however, is the loss of UK expertise at the European table. British regulators such as the Financial Conduct Authority (FCA) have been responsible for writing large sections of European legislation in key texts such as the revised Markets in Financial Instruments Directive (Mifid II), and UK citizens comprise significant parts of European advisory bodies in Esma and other agencies. That loss, some argue, could lead to weaker, less cohesive European regulation in the future.

Click here to read more about how Brexit looms over the industry in 2018.
 

Benchmarks Regulation

Key facts to be aware of.

The European Commission’s Benchmarks Regulation (BMR) technically goes into effect on January 1, 2018, though there is a transition period that ends January 1, 2020. Here are a few key points to keep in mind:

• BMR was created to improve the process for setting a benchmark after a string of scandals brought some doubt as to how these standards are created.
• The rule dramatically changes the way sell-side firms will calculate the value of their indices and structured products.
• Buy-side participants have said that complexities have been created because there are so many categories, which creates problems categorizing these benchmarks and finding the appropriate limits.
• Some benchmarks serve to eliminate conflicts of interests and, thus, industry participants believe they should not be regulated at all.
• One key challenge: Article 28, which requires firms to have their own continuity plans for benchmark withdrawal.

For more on how BMR is affecting buy-side firms, click here.