by John Morton
The Markets in Financial Instruments Directive II (MiFID II) represents the European Union’s ambitious attempt to create a single rule book for the region’s financial markets whilst also governing third country access to its investors. A vast, sprawling piece of legislation that seeks to build on the existing requirements, adding in electronic execution elements of the Pittsburgh G20 Trading Commitment, to tackle an interconnected group of issues and ultimately:
Extend the transparency of exchange-traded instruments to virtually all OTC markets.
Strengthen investor protection.
Increase market probity through stronger regulatory oversight.
Arguably the most significant change from the existing regulatory regime is the application of pre- and post-trade transparency to all OTC markets, similar to that experienced by practitioners in equity markets. From the expected start date of January 2018, firm quotes in liquid instruments below a certain trade size (Size Specific to the Instrument, or SSTI) will have to be made public prior to execution. Additionally, almost all trades will have to be made public on a post trade basis similar to the TRACE provisions in the USA.
Even though post-trade transparency is relatively uncontroversial, pre-trade transparency represents a significant experiment and proved to be the most argued-over element of MiFID II during initial negotiations. The intensity of the negotiations carried over to the creation of the delegated instruments and technical standards by the European Securities and Markets Authority (ESMA) which underwent significant modification following further negotiations among national regulators.
MiFID II’s provisions that are designed to strengthen investor protection will ensure investors receive far more information regarding the costs of investment and the effects of such costs upon potential returns. Such illustrations of likely returns will also have to include the results of potentially negative scenarios as well as positive ones in an attempt to ensure investors are fully informed of the possible risks of their investments. Additionally fund managers and firms executing client orders will have a strengthened duty of best execution with “…take all reasonable steps…” being replaced by “…take all sufficient steps…” applied to the provision of best execution.
Where many feel that MiFID II has become over-bearing is in the level of regulatory oversight brought in by the legislation. Regulators will receive details of all transactions including national ID codes and dates of birth of the principals involved. Investment firms will have to keep all records, including phone, email, chat, social media and minutes of meetings in an immutable format for up to seven years to be made available to regulators upon request. Compliance officers will have to monitor all records for potential instances of market abuse and store any investigations prompted by such monitoring. Lastly, regulators can demand the reconstruction of the major steps in any trade process, similar to the provisions in Dodd-Frank.
So even though MiFID II doesn’t apply to everyone involved in financial markets, given managers of collective investment schemes are amongst those excluded, it is still fundamental for most participants operating in the European Union. Looking ahead however, two questions come to mind regarding MiFID II; will pre-trade transparency for cash bonds fatally damage capital provision for the real economy and, following Brexit, what will MiFID III look like?