Thu, Jun 8, 2017

Hedgeweek MiFID II Blog Series: A Leviathan in Waiting?

Duff & Phelps' Nick Bayley is a managing director in the Compliance and Regulatory Consulting practice has partnered with Hedgeweek to provide a monthly blog series providing insight on this imminent regulatory change.

Prior to this, Nick was a Head of Department in the FCA's Markets Policy and International Division, FCA Senior Markets Advisor and was responsible for the UK regulator’s MiFID II Policy Project.

A few weeks ago, I visited South Africa where I met numerous buy-side firms, some with UK or European subsidiaries and some who operated solely out of that country. Apart from the dreaded Brexit, the other question that in came up in all the conversations was to ask how much the tentacles of MiFID II might extend beyond Europe. In short, what is the reality of its extra-territoriality?

Other related questions the firms raised were: What is likely to happen to current market practice outside the EU after MiFID II? And will the MiFID II model be adopted by regulators in other parts of the world?

To answer the first question, the direct legal effect of MiFID II on institutions outside the EU will actually be quite limited. There are some provisions, such as the commodities derivatives reporting requirements, which do effectively extend globally. This means if you are sitting on a derivative position that relates to a contract in the EU, or an equivalent contract, you must report that down the chain into the EU regardless of where you are in the world.

There are also quite a few new MiFID II requirements, which means firms located outside the EU will have to provide more data to their EU counterparties. If a European broker provides a non-EU firm with DMA to an EU trading platform (‘Direct Electronic Access’ in MiFID parlance), the broker will not only need more information from its non-EU client but also must get some explicit confirmations from the client before allowing it to input orders directly onto a European market.

In addition, if you are a third country firm that is a direct participant of an EU trading venue (perhaps, say, a participant on Bloomberg’s MTF), then the trading venue, Bloomberg, will have an obligation to transaction report to the FCA on your behalf. Don’t underestimate how much additional information the trading venue will need from you to be able to do that!

The message I gave to the firms in South Africa was to be aware of the changes but not to panic about the direct effects of MiFID II. Their European brokers should be in touch imminently, asking for whatever information they require. Compliance with MiFID II is an issue for them, not for you.

The second order effects
More interesting, I think, are the second order effects of MiFID II; those where you are likely to see changes in behavior among European participants as a result of the regulation.

One example of this is product governance.

Under the new MiFID II rules (and the detailed supporting ESMA Guidelines), there are new obligations on both manufacturers and distributors of products, such as more granular identification of target markets and scenario analysis on product.

Where an EU MiFID firm distributes a product manufactured outside the EU it must “…obtain adequate and reliable information from [the] manufacturer…to ensure that products will be distributed in accordance with the characteristics, objectives and needs of the target market.”

In all likelihood, the expectations of EU distributors will be to receive a nice, MiFID II-compliant, package of information from the non-EU manufacturer that mirrors the MiFID II requirement on manufacturing firms. In other words, an EU distributor will probably want their non-EU manufacturers to follow MiFID II rules.

Standardized global research model?
A lot of people I spoke to in South Africa were also worried about research unbundling and whether it could become a de facto global standard.

This is probably one of the most important potential second order effects of MiFID II across the world.

What is it going to mean for non-EU recipients of research when EU sell-side firms have developed new pricing models for their research? Will they start applying the same charging model globally for all recipients? Although non-EU fund managers are certainly not caught by the MiFID II inducement rules - they can receive research for free without it constituting a prohibited inducement – many of the sell-side firms in Europe will probably develop a universal, global model in terms of pricing and distributing their research.

It could turn out to be a false alarm and it might be that some London research desks will be happy to send their research out to global (non-EU) clients without an explicit charge, just as they always have done. But there is going to be such a big reform of the investment research production and distribution process in the EU, because of MiFID II, that many sell-side firms will become much more careful about what research they send where and how they are paid for it.

There are also other challenges for groups that receive research outside the EU and share it group-wide. For example, research that was free in the hands of a Connecticut-based hedge fund manager cannot necessarily be passed to its London office without it potentially being considered an inducement. And the glaring incompatibility between the new MiFID II rules on research and the current US rules is a whole other story…

Speaking to some of the larger buy-side groups in South Africa, many of them are considering adopting the same MiFID II model for research unbundling group-wide, despite having no obligation to do so. Their view was that if they expect their investors to pay for research, this is the right way to manage it and they will voluntarily move to the same structures as their London office.

So, will MiFID II become the new global standard? In some areas, perhaps. I think these and other second order implications for non-EU market participants will become clear quite quickly after January 2018 and, of course, we shouldn’t forget that many other regulators around the world are following the introduction of MiFID II very carefully. Watch this space!

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