Markets in Financial Instruments Direction II, or MiFID II, is an expansive set of regulations governing EU investment firms that goes into effect on 3 January 2018. It has been under development for nine years, being formally approved in 2014, and replaces the original MiFID enacted in 2007. The original law sought to harmonize financial intermediaries and thereby shield investors from unscrupulous or unbeneficial trading while at the same time increasing transparent, efficient, and client-focused markets
As a follow-up, MiFID II aims to “course correct” by addressing and remedying various weaknesses and oversights consequent to the original directive. In fact, it revises existing regulations to such a broad degree as to impact all EU investment firms, from insurers and mutual funds to banks, brokerages, and so on.
The changes arising from this course correction are vast, with most of the new regulations involving revisions to the original MiFID’s existing regulatory framework. One of the biggest course corrections involves expanded regulations regarding over-the-counter (OTC) transactions. Regulators are using MiFID II to migrate the last remaining unregulated over-the-counter trading onto a shared, uniformly regulated venue known as Organized Trading Facilities (OTFs). This will ensure that all trades are conducted fairly and with an open process that protects the investor.
Why MiFID II, and Why Now?
Of the motivating factors behind the MiFID II legislation, one of the biggest was the 2008 global financial crisis. This event exposed some of the weaknesses and inefficiencies of the MiFID regime, particularly as applied to investor protections and innovation within trading platforms. EU regulators hope to mitigate the potential aftershocks of another such worldwide crisis by shoring up any holes within their own systems, in effect making the EU regulatory framework stronger and more impervious to financial trauma originating outside its borders.
Stated in its simplest terms, MiFID II is concerned with making the investment process significantly more transparent for the individual investor. It is essentially a consumer protection package, albeit issued across multiple countries and with extremely far-ranging implications. The regulations themselves total over 1.5 million paragraphs of text and, as such, are nowhere near completely understood even in its broadest sense, let alone its many implications and minutiae.
To accomplish this investor-friendly atmosphere, the MiFID II directive seeks to harmonize the markets and all products traded therein by bringing everything together under the same regulatory umbrella. The reach of MiFID II now extends even to third-party countries, also known as third-country firms (TCFs), a facet of EU investment processes that were previously given much more freedom.
More specifically, the new legislation cracks down on how third countries operate with EU firms. Under the first MiFID, regulators afforded third country firms the freedom to set their own levels of regulatory oversight on a national basis. Because TCFs were not adhering to the same directives as EU firms, legislators eventually realized that this gave third country firms a unique advantage over their EU counterparts. Competitively, third country firms stood to outperform EU firms because their standards were less stringent. In a clear quest to make the investment process both transparent and harmonious across all levels, EU regulators revised MiFID to demand that third country firms abide by the same best practices when engaging with EU firms.
To this end, the directive is almost guaranteed to challenge the majority of a firm’s operations. As a result, there is also a lot of concern over the technological ramifications of the new legislation. Because the directive is so broad, so complex, and because it pulls into its orbit so many contingencies that could arise from within the vast network of EU partners–including third country firms–the current technological infrastructure of most investment firms has been found lacking. The shift for many firms, will be such a huge undertaking that some are only now getting themselves up to speed on the requirements posed by the new directive; in fact, many estimate they will not be fully compliant for another three to four years before they even manage to upgrade their tech. It has been estimated that by the time the January 3 deadline rolls around, over 90% of investment firms will be non-compliant. As a sign of just how layered, nuanced, and involved the entire compliance process will be for years to come, the last facet of the new directive will not be rolled out until the year 2020. Pricing and commission systems will need to be upgraded in order to clearly report itemized, unbundled expenses, again with the goal of proving that inducements have not been factored into the exchange.
When it comes to pushing for greater transparency within the EU markets, another key driving motivation has been to reduce the prevalence of inducements. Inducements are defined as perks or benefits given to asset managers by sell side parties with the goal of persuading managers to employ the sell side’s services. Trades within the EU markets and the decision-making that informs them are often supported with reams of analytics and research. Many times, this data is sold from research firms (“sell side”) to investments firms (“buy side”) with the stipulation that those on the buy side half of the transaction will be “induced” to either work with the sell side firm or guide its clients toward a particular investment.
MiFID regulators found this problematic as the sell side research has not always proven beneficial to respective investors. Indeed, banks and brokers will sometimes go so far as to persuade asset managers with inducements that are completely unrelated to what is best for their clients or their portfolios. Rather than allowing sell side to promote its own services or products first and foremost, the directive’s updated regulations require both sell side and buy side to be forthcoming about every step in their transaction process. This way, consumers are put at the fore of business decision-making and are protected from errant advice and investments that may harm them in the future.
Another byproduct of greater transparency as engendered by the directive is that of increased competition within the markets. If every firm must lay bare its processes and the rationale for reaching its decisions, then it behooves asset managers and their firms to select only the very best and most relevant analytics in their clients’ favor. The directive removes from the transaction any shroud of mystery, allowing clients to “peek behind the curtain”, so to speak, in order to help them better understand the quality and accuracy of the advice they receive. Aside from potentially losing clients, firms that continue operating with less than maximum transparency in their reporting under MiFID II risk doing so at potentially sizeable expense to their business.
One of the other reasons for the amendment to the MiFID regime has to do with anticipating innovation and technological advancements, particularly as it concerns technology-oriented markets and how these innovations might impact investments as a whole. This includes overseeing the algorithms within automated trading as well as the impacts of high-frequency trading and its associated technology. Neither of these innovations were present for regulators to consider while drafting the original MiFID.
Sell side is now required to “unbundle” its analytics and research from the expenses involved in trading. Banks likewise will be required to itemize commissions specifically for their clients’ viewing, all as part of an effort to transparently inform investors on every step that their banks or brokers take on their behalf. Based on this information, clients have the freedom to proceed or amend their approach. From the buy side angle, a new standard will have to be met wherein research, analytics, and other associated trading data is justified directly to the client to ensure investor confidence. By standardizing regulations across the board, parity within the market is increased, thereby allowing both EU and third country firms to not only access more investors but to compete against one another for each trader’s business.
Based on research provided by the Electronic Research Interchange, or ERIC, over 75% of fund managers have indicated that they were much more likely to cut down on the research they currently receive as a direct response to MiFID II. BCA Research estimates asset managers receive approximately 500 research reports on a daily basis. They go on to state, in their professional opinion, that this figure will drop by 20% after the new regime is implemented.
Similarly, ERIC surveyed these fund managers and found the same percentage that planned on cutting the research they currently receive will also begin to more closely review their research and analytics sources. ERIC also predicts a shift from outside researchers to in-house teams, both for quality assurance and to manage overall costs.
One of the most concerning ramifications of the new regime is the unintended effect on mid- and small-sized firms. There is great uncertainty across the industry as to how these firms will fare after January 2018, mostly because they do not possess the resources of larger firms that can more efficiently adapt to and implement changes required by the law. It is increasingly likely that mid- to small-sized firms will fall quickly behind, thus hampering their ability to attract new clientele while sustaining their existing customer bases.
Among the biggest factors playing into this post-MiFID II uncertainty is the EU’s strict prohibition against buy side receiving research for free. This is at the heart of the new directive’s framework because it embodies the purest form of inducement, i.e. the seductive nature of free analytics to push-pull buy side into commissions or other benefits. But this also goes beyond the hard data itself to the very means of how it is communicated. Phone calls, face-to-face meetings, travel, and the like fall under the new law, too, and must be justified as much as the research itself.
It’s the loss of free research in particular that is poised to much more acutely impair mid- and small-sized firms compared to their larger, established counterparts. Without the means to gather no-cost research on a consistent basis, firms of all stripes must drum up the money for quality analytics. Naturally, without the budget to do so, smaller buy side firms will feel the pinch, with some of them very well being pinched out of the market.
However, there is relief—albeit temporary—on the horizon. The Financial Conduct Authority (FCA) ruled in July 2017 that “a limited trial period for a research service subject to other strict conditions could constitute an acceptable minor non-monetary benefit for firms.” This decision came after investment firms lobbied for more wiggle room on the inducements measure to “test drive” research before committing. Trial periods would help them determine whether research providers are of enough quality to be in the client’s best interests.
Welcome news for investment firms, to be sure, but the FCA hemmed in such samplings with strict guidelines. These include:
- Trial periods may last no longer than three months
- Research should not be paid for
- Firms may not take up another trial with the same provider for a minimum of 12 months after the completion of the previous trial
Many other regulations are to be placed on investment firms’ day-to-day functions and workflows. Included among these is the requirement that conflicts of interest are to be disclosed as part of the effort to increase transparency throughout the transaction process. Piggybacking off that, firms are now required to assign an officer whose responsibility involves managing and safeguarding client interests. Audit trails will be mandatory in order to guarantee that research, both in content and funding, is being conducted with the best interests of the individual client in mind. Research and analytics must also be properly classified, whether sell side or buy side. A guiding principle in these new rules and regulations, beyond ensuring client confidence in the investment process, is that research provided from sell side is not done so as an inducement to engage in trading. Due to the sheer breadth of strictures that will be placed on research, firms will be tasked with somehow ensuring compliance with the high volume of regulatory considerations. One such task that might be taken up is to reallocate personnel into new departments whose primary focus is the critique of research with the aim of eliminating conflicts of interest as much as possible.
Similarly, sell side firms will be forced to overhaul their infrastructure to remain transparent in how they process payments and manage budgets. Other systems will need to be improved that help firms more efficiently and quickly detail every cost involved in transactions, again with an eye on steering the firm clear of inducements.
Independent research firms could flourish in the wake of what might prove to be a drastic reduction in sell side research and analytics reporting. Sell side firms that have either previously peddled redundant, overpriced, or low-quality reports will be pressed into upping their game, or risk being phased out of the industry entirely. Those firms that do not improve the quality and relevance of their analytics will likely either be replaced by independent researchers or, as noted earlier, subbed with research departments developed in-house of buy side firms.
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