News review : The impact of regulation : PJ Di Giammarino

THE NEED TO ENGAGE.

PJ Di Giammarino, founder and CEO of JWG-IT Group assesses MiFID II’s new conduct requirements.

PJ DiGiammarino

The new conduct requirements that MiFID II is set to bring into the European market often get overlooked. On the face of it, the high profile issues such as transparency, transaction reporting, HFT and derivatives obligations appear more challenging. But make no mistake; the way business is conducted with clients will be radically reshaped. In fact 18% of the 860 questions in ESMA’s MiFID II recent consultation and discussion papers focus on investor protection. The requirements laid out by the politicians are set to have a substantial impact on the order and execution process. The biggest deltas will be in client handling, pre-trade and execution. Now that the process of defining the letter of the law has kicked off in anger, it’s time to get your views in.

Client handling

The way a firm exchanges information with a customer is set to become more complicated – in other words more time-consuming and expensive. The provisions regarding client disclosures and classification are set to become more substantial. These changes are in line with an ongoing trend; before MiFID I, firms’ relationships with their clients could be characterised by the phrase ‘my word is my bond’, but then firms were compelled to implement rigid suitability checks, and then they were compelled not only to do the suitability checks, but also to prove that they did them – not, in many cases, as easy as it sounds. With MiFID II, the suitability checks will have to become more arduous and the proof more detailed. MiFID I established the need to classify all clients in standard categories, with the objective of levelling the playing field. MiFID II maintains the same objective in this respect, but moves to achieve it more comprehensively by tightening the pre-existing rules. This means that the process of classifying clients and assessing their knowledge is going to get more complicated and difficult. This will be expensive in terms of the systems and workflow updates that will certainly be necessary, not to mention how time-consuming the process of fully understanding, identifying and then implementing these changes will be. For example, municipalities will no longer be able to be classified as eligible counterparties or professional clients. This has the potential to cause problems for firms due to the difficulty, in certain cases, of identifying regional governments and getting them to sign bits of paper. MiFID I also brought in rules around reporting to clients, designed to make the firms’ activities more transparent. Again MiFID II maintains these original aims while attempting to strengthen the regime. This means that firms will have to disclose more information to their clients regarding suitability decisions and execution. Key deltas include firms’ new requirements for monetary and non-monetary payments for services, and the disclosure of the costs and risks of instrument bundling is now mandatory.

Pre-trade controls

MiFID II takes the pre-trade controls, established in the original directive, which were designed to improve the tracking of market abuse, and expands them, both in terms of breadth and depth. MiFID II insists on much wider market transparency, and more detailed pricing and order controls will apply to a wider range of instruments for both investment firms and trading venues. This has the potential to be very disruptive to the current operating model. It will likely mean production system changes, new market data sets, reference data revamping and a large programme management effort. There are now much stricter rules on algo testing, broader market making obligations and a new circuit breaker risk regime for HFT trading. Investment firms may find the new rules on algo testing particularly troubling as they have the potential to seriously increase the cost/income ratio. Just as importantly, MiFID II discussions are calling upon operational risk managers to play a much more active role in controls.

Best execution market monitoring

MiFID I introduced a best execution regime designed to get firms to trade in the interest of their clients. This was part of the grand objective to make the EU the most competitive market in the world. The regime consisted of making it compulsory for firms to have an execution policy, and to be transparent with its details. Firms were asked to monitor their own compliance and review arrangements at least annually. MiFID II gets much more specific about the nature of the execution policies and how they are disclosed. To this end a new concept is introduced; total consideration. Firms must ensure they apply this new concept to their execution policy; however, ESMA are yet to make clear exactly what is meant by total consideration. What is clear is that the more specific best execution policies will result in a more complex, expensive and time consuming agreement and reporting processes. An example of a new disclosure requirement is the obligation for firms to publish their top five trading venues by instrument class and to show the quality of execution. Trading venues must also publish data pertaining to the quality of executions.

Your input

This may all sound like a lot of deltas for the industry to get their heads around, but the areas that we have gone into here are just a start. Client handling, pre-trade controls and best execution – together – only make up a small part of the investor protection section of the discussion and consultation papers. There is plenty more to think about. Given both the sheer scale of MiFID II and the fact that its objectives range from fairly broad to downright unclear, the need for all market participants to engage in the ongoing consultation process is high, not least because we are talking about highly complex issues. Those discussed here are linked to several other areas of MiFID II, most notably market data and transparency issues, which form a substantial part of the new regime. Furthermore, the industry is not likely to have a unified voice throughout the consultation process, since what a market data vendor thinks on a lot of these issues is likely to be very different from what those in procurement departments believe. This makes it even more vital for each separate party to get their voice heard. The first, and most important, round of this process is underway now and responses are due 1 August. We look forward to Q&As, guidelines, opinions and reviews of supervisory practices at national level throughout 2015. 2017 is closer than it feels.

© BestExecution 2014

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