The new requirements of the MiFID II Directive, which enters into force on January 3rd, 2018, will significantly change trade of shares, bonds and derivatives in the European Union.
MiFID (Markets in Financial Instruments Directive) is a directive concerning financial instruments market, which has been in effect in the European Union since November 2007. It is the basis of the EU legislation aimed at improving the competitiveness of EU financial markets and protecting investors by creating a single market for investment services and activities, and ensuring a high degree of their harmonization.
A second attempt at regulation
After the implementation of the legislation, and as a result of changes in the market, it turned out that MiFID had significant loopholes and defects in certain areas. For this reason in April 2014 the European Parliament introduced amendments to the legislation concerning trade of financial instruments – MiFID II (Markets in Financial Instruments Directive) and MiFIR (Markets in Financial Instruments Regulation). From January 3rd, 2018 these two pieces of legislation will become the applicable law in the European Union.
MiFID mainly applied to shares and caused the popularization of new trading platforms – both electronic platforms and so-called dark pools operated by investment banks. This led to increased competition in the market, which was previously mainly dominated by national stock exchanges. As of now the new requirements will apply to a broader set of assets, i.e. bonds and derivatives.
MiFID II, along with the supporting MiFIR and implementing acts, is intended to provide greater protection to investors in the capital markets. This is because additional reporting obligations have been imposed on investment companies – both at the pre-trade and post-trade stages.
The effects of legislative changes
MiFID II will have the greatest effect on the market of derivatives and bonds. Currently these instruments are mainly traded on unregulated platforms (over the counter. OTC, trade). After the new legislation enters into force, derivatives and bonds trading is supposed to become more accessible for market participants, which means that the role of electronic platforms will increase at the expense of banks. Additionally, in the case of the most liquid derivative instruments, i.e. interest rate swaps, it will become mandatory to trade them on public platforms.
The main objective of the new legislation is to provide greater price transparency on the markets. The prices of instruments that the ESMA (European Securities and Markets Authority) determines as liquid must be published both in advance and directly after the completion of the transaction (the principle of the so-called pre- and post-trade transparency). The prices of less liquid instruments also have to be published, but with some delay. However, the threshold indicating the liquidity of an instrument is based on transaction volumes including the United Kingdom. In the case of a so-called “hard” Brexit most bonds and derivative instruments might not exceed the threshold, and therefore will not be subjected to the transparency requirements set out in the new legislation.
The regulatory bodies will also require full reports on each transaction in order to prevent market abuse. Asset managers will have to provide so-called best execution policies, in order to prove that they trade assets at the best possible prices. An important aspect of the new legislation is also the necessity of including very detailed client data, which – in the opinion of the financial community – could deter clients from outside of Europe.
There is still no clarity with regard to, among others, the incompatibility between investor protection legislation in the US and in the EU. Additionally, we do not know the extent to which companies using derivatives (e.g. manufacturers of cocoa butter) should be subjected to the regulations as financial companies.
The MiFID II/MiFIR legislation will change the structure of the financial market and the model of distribution of investment funds. This is because the directive limits the possibility of accepting inducements from third parties (including investment funds), and introduces new requirements concerning the remuneration of dealers and advisors. The new requirements will also lead to the introduction of a new model of investment advice services, requiring the use of additional solutions concerning, among others, preventing conflicts of interest and offering a wide range of products tailored to the investment needs of the client. Investment firms will have to prepare for the new requirements, including the implementation of appropriate procedures, policies and the introduction of changes in their IT systems.
MiFID II will therefore have a significant impact on the functioning of the financial institutions in the European Union, and especially on bank capital groups offering financial products and instruments, such as investment funds participation units, derivatives, structured products or investment advice.
One of the changes the most widely discussed by the financial community concerns the conduct of research. Thus far, the costs associated with the development of analyses (e.g. analyses of individual companies and sectors, recommendations) incurred by investment banks were included in the brokerage fees and commissions. According to the new rules the fees for these analyses have to be charged separately. This could mean that large investment banks will reduce their market research departments, and that companies specializing solely in conducting market research will emerge on the market. At the same time, this could lead to the development of a market mechanism allowing for the valuation of analytical reports, and asset managers could obtain the ability to better spend the funds on research and analyses, buying reports of the highest quality and ones that are better suited to their needs.
The group that could be most exposed to the potential adverse consequences resulting from the introduction of the MiFID II/MIFIR package are independent investment companies that are not affiliated with a capital group (e.g. a bank). Such institutions do not have their own distribution network and use the services of banks, insurance companies and brokerage offices. From 2018 such institutions will have to find a different distribution model, because otherwise they will be in danger of disappearing from the market.
The new legislation may contribute to an increased role of internet platforms as a channel for the sales of investment products. The development of online investment platforms – which will take over the role of the existing sales networks and will offer various investment products and instruments to retail clients – can also lead to a reduction of costs for customers. In this context, MiFID II provides an opportunity for the development of enterprises in the fin-tech sector.
From the point of view of customers, the new MiFID II/MiFIR legislation and the associated market transformation concerning greater transparency, changes in the model of distributors’ remuneration, and additional restrictions on investment advice, are rather favorable. They may ensure that clients will receive a clearer offer of investment products tailored to their investment objectives and risk appetite. In the longer term the management fees borne by customers might also fall.
However, given the scale and complexity of the MiFID II/MiFIR legislation, facing up to all the expected and positive effects of these laws will be a challenge.