MiFID:
Implications for
Sell-Side Firms
By Alan Jenkins
The aim of the Markets in Financial Instruments Directive, as part of the EU’s Financial Services Action Plan,
is to promote a single market in the European Union for wholesale and retail transactions in financial instruments. The directive also aims to improve consumer protection in a number of ways, including increased
transparency and more prescriptive customer classification rules. Already twice delayed, it is now due to
come into effect in November 2007, and will replace the Investment Services Directive, which has governed
the activities of investment firms and markets in the EU since 1995. MiFID is generally broader, and more prescriptive, than the original ISD. For example, its scope has been expanded to include commodity derivatives,
both listed and over-the-counter, and investment advice.
T
he impact of MiFID will be wide-ranging, and will affect all investment firms,
directly and indirectly. But some will be
affected more than others. In particular, broker-dealers and global investment banks on
the sell-side will have to understand and
comply with the directive’s requirements for
“best execution”, which will apply to all
instruments, and for “systematic internalization”, which will apply to liquid shares.
These two requirements are universally
regarded as being the most burdensome and
costly measures that MiFID will impose on
the industry. Together with the other
impacts, such as more prescriptive “know
your customer” rules, they will have serious
implications for investment firms’ corporate
strategies, business processes, technology
architectures and compliance arrangements.
Moreover, the concept of “systematic
internalization” is likely to be extended to
instruments other than shares within the first
few years after MiFID is implemented. To this
extent, MiFID differs from Regulation NMS,
and the November 2007 deadline will be just
the beginning of the European investment
market transformation, rather than the end.
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Futures Industry
The “Implementing Measures”
Are About to Be Finalized
MiFID was adopted by the European
Parliament in April 2004, but it took the
European Commission, assisted by the
Committee of European Securities
Regulators (CESR), until February 2006 to
publish the draft technical implementing
measures, known as “Level 2.” Once
approved by the European Parliament and
the European Securities Committee, these
measures should be adopted by the
Commission in the summer of 2006. The
focus will then shift onto national implementations (Level 3), which are due to be
completed by the end of January 2007, nine
clear months before MiFID comes into force.
MiFID will affect markets and firms operating in all 25 EU countries, plus another five
countries that either are members of the
European Economic Area or are scheduled to
join the EU. The exceptions are Switzerland,
which is not a member of the EU, and several
offshore financial centers, such as the Isle of
Man and the Channel Islands.
The Level 2 measures cover three main
areas. The first two are in the form of a directive (requiring national implementation):
• Organizational requirements: rules on
how investment firms should be organized,
including compliance arrangements, internal systems and controls, outsourcing,
record-keeping and management of conflicts of interest
• Conduct of business: investment firms will
have to follow rules on client classification,
marketing communications, the provision
of information about the firm and its services, client agreements, knowing their customers, execution-only services, best
execution, client order handling, and
reporting information to clients
The third is in the form of a regulation,
which will apply directly in all 30 countries
that will be subject to MiFID:
• Markets and transparency: firms will
have to comply with comprehensive preand post-trade transparency regimes for
trading shares on regulated markets (i.e.
derivatives exchanges), on multi-lateral
trading facilities and through systematic
internalizers and they will have to report
all transactions (including derivatives and
off-exchange transactions) to their local
financial regulator.
Level 2 has also clarified the definition of
instruments impacted by MiFID. Of particular interest to the futures industry, the commodity sector will be partially covered, with
spot and physical forward deliveries excluded
but commodity derivatives such as futures
and options included. (see Commodity
Derivatives sidebar). However, the Level 2
measures have not shed much new light on
cross-border business, branches and passporting, the one major simplification compared
to the ISD. MiFID will extend the range of
activities and instruments covered by the
EU’s current “passporting” arrangements—
the system under which firms authorized in
one member state can provide investment
services in other member states (either crossborder or through a branch) without having
to be authorized separately in each member
state. Clarification on these aspects is
awaited in Level 3.
At a national level, the U.K.’s Financial
Services Authority has already declared that
it will rework “significant sections” of its
overall rulebook, implying that even noninvestment firms will feel the MiFID wind of
change.
In summary, any firm providing “investment services” that is located anywhere in
these 30 countries will be impacted by
MiFID—even if its customers are outside
Europe.
MiFID: The Business
Impact for Sell-Side Firms
The directive’s implications for sell-side
firms are significant, and largely negative.
However, it is possible to make a virtue out
of necessity, and MiFID is no exception.
Firms that quickly adapt their businesses and
supporting functions, most importantly IT,
will gain a competitive advantage over those
that act more slowly. The sooner firms
understand all of the directive’s requirements, how it will affect their business
model, how they will have to change their IT
framework to cope, and how to budget for
that change, the sooner they will gain that
advantage.
The FSA endorses this view, though it is
more positive about the possible outcomes. In
its Planning for MiFID guide, published in
November 2005, it says of the directive:
“Potentially, there will also be new business
opportunities. More services will be passportable. And implementation across the
European Union may bring about significant
changes in market structure. The precise
impact will vary from sector to sector, firm to
firm. Firms that are well-prepared will be positioned to make the most of these changes.”
The impact will be felt in many parts of
sell-side firms. Execution desks will have to
deal with best execution requirements. Back
office and clearing personnel will face new
post-trade reporting requirements. Legal staff
will have to overhaul their customer agreements and suitability determinations. But no
part of the firm will be affected more than IT,
and no part will be more critical than IT to
turning this massive change in the regulatory
environment into a business opportunity.
Best Execution
Best execution is one of the directive’s
conduct of business requirements, set out in
article 21 of MiFID. It requires an invest-
ment firm to take all reasonable steps to
obtain the best possible result for its clients,
which means taking into consideration price,
cost, speed and the likelihood of execution
and settlement of orders. It will necessitate
having an “order execution” policy, disclosing “appropriate information” to clients
about the policy and the execution venues it
uses, obtaining client consent to the policy,
monitoring the policy’s effectiveness and
proving to the client that its orders have
been executed according to the policy. And
despite the equities flavor that permeates
MiFID, best execution applies to all financial
instruments including derivatives.
The best execution requirement has several clear business and IT implications. Firms
will need to have real-time connections with
multiple regulated markets, multilateral
transaction facilities and systematic internal-
Commodity Derivatives
Excerpted from the European Commission’s
Frequently Asked Questions on MiFID—Feb. 6, 2006
What is a commodity?
The concept of a commodity covers goods of a fungible nature, i.e. goods
that are capable of being delivered, including metals and their ores and alloys,
agricultural products and energy (electricity, gas, oil) (Article 2(1) Implementing
Regulation). Goods are fungible, when any unit of a class of those goods is as
acceptable as another unit of that class.
What is a spot contract?
The term spot contract is used in relation to commodities. To put it simply, it
is the contract to purchase or sell a commodity. The MiFID regulates trading in
financial instruments, one category of which is commodity derivatives, but not
the trading of commodities themselves. It is therefore necessary to differentiate
between spot contracts and derivative contracts on commodities. This can be
difficult as the only difference between a spot and a derivative contract can
sometimes be just the time of delivery of the commodity. For example, a contract
to buy a ton of gold that is to be delivered to the buyer the following day should
be treated as a spot contract while a contract to buy a ton of gold in a year’s
time would be treated as a commodity derivative - a financial instrument subject
to MiFID regulation.
Does buying and selling commodity derivatives oblige a firm to be licensed?
Not in all cases. If a firm provides investment services only for its parent or
sister company or if it only deals on its account, it is exempt from the scope of
the MiFID and need not be licensed. There are also other exemptions in Article
2(1) of the MiFID but these two are probably the most important ones.
What about commodities firms? I’ve heard they are exempt.
Article 2(1)(k) of the MiFID exempts persons whose main business consists of
dealing on own account in commodities and/or commodity derivatives from its
scope of application. However, if a “commodity firm” also provides other investment services, such as investment advice and portfolio management, it is not
likely to remain exempt (as its main business would not simply consist of dealing
on own account).
May/June 2006
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Preparing for MiFID:
U.K. Trade Groups Working
on Guidelines to Assist Firms
To assist financial firms prepare for the implementation of the European Union’s
Markets in Financial Instruments Directive over the next two years, 11 financial
trade associations have established a joint initiative to draft guidelines, organize
workshops, draw up sample customer documents, and take other actions to ease
the burden of complying with the new regulations. The Futures and Options
Association, the U.K. trade group for participants in the listed derivatives markets,
is taking a leading role in the initiative, with Anthony Belchambers, the FOA’s chief
executive officer, acting as the project’s chairman.
The project, called MiFID Connect, was launched in November with support
from just four organizations, but another seven joined in the months since then as
the scope and scale of MiFID’s impact on financial markets has become better
understood. All financial firms operating in the U.K., including futures commission
merchants, investment banks and commodity dealers will be affected by MiFID,
even if their headquarters are outside the 30 European countries that will be implementing the directive. The trade associations involved in the MiFID Connect project now represent nearly the full scope of affected market participants, including
asset managers, investment banks, commodity dealers, insurance companies,
brokerage houses, and building societies.
The group is expected to issue a “survival guide” in July recommending a strategy and plan for managing the implementation. At least two educational events are
planned for this fall, with the timing depending in part on the publication of guidance from the U.K.’s Financial Services Authority. Clifford Chance has been
appointed as lawyers to the project, and the British Bankers Association is acting
as the project’s secretariat. The supporting organizations also have established a
subgroup of IT specialists from member firms to consider the consequences of
MiFID for technology and operations.
One of MiFID Connect’s main tasks is to develop guidance in 10 areas where the
MiFID requirements are ambiguous or carry a high degree of legal uncertainty.
Clifford Chance already has produced draft guidance in four areas: best execution,
appropriateness, suitability and conflicts of interest management. These have been
circulated to member firms for review, and MiFID Connect is working with the
Financial Services Authority to make sure that the guidance will be consistent with
regulatory expectations. The law firm is currently working on draft guidance in two
other areas, customer classifications and transaction reporting, and the remainder
will be completed no later than January 31. That is the start of the nine-month period
that the European Commission has set for compliance with the MiFID directive.
“By requiring firms to implement the new MiFID requirements by Nov. 1 2007,
the Commission has set a very ambitious timetable,” Belchambers said. “That,
taken together with the fact that these new requirements will generate significant
changes in firm’s internal procedures, customer documents, and IT systems,
emphasizes the importance for the industry to establish a strong ‘stamp’ on implementation policy and process. Our goal is to ensure that the implementation is practical, market-sensitive and sustainable.”
The members of MiFID Connect include: The Association of British Insurers, the
Association of Foreign Bankers, the Association of Private Client Investment
Managers and Stockbrokers, the Bond Market Association, British Bankers'
Association, the Building Societies Association, the Futures and Options
Association, the International Capital Market Association, the Investment
Management Association, the International Swaps and Derivatives Association and
the London Investment Banking Association.—Will Acworth, editor of Futures
Industry
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Futures Industry
izers to ensure that they have all the necessary
data on prices, costs, speed and other factors.
Firms will also have to use more algorithmic and program trading engines to comply
with best execution and to facilitate quicker
post-trade reporting. Trading engines are
already used to slice and dice orders using a
set of pre-defined algorithms, driven by sellside firms demanding greater efficiency and
buy-side professionals wanting greater control over execution. Best execution will
accelerate this process.
And firms will have to store price and
other data they collect from all venues for
five years.
As firms prepare to implement best execution, they will face a number of questions
about how to interpret the requirements. For
example:
• How should a best execution policy be
drawn up, and what should be in it?
• Should it guarantee the lowest price in the
market, or should it just compare prices
from a set number of venues?
• How should it weigh the importance of
price against other factors?
• How will the attitude of regulators, a firm’s
place in the marketplace and a firm’s strategy, determine policy?
• To what extent should pre-trade costs be
considered?
• Which data vendors should be used, especially for price data from MTFs and systematic internalizers, and how should they be
integrated into a firm’s systems?
No one yet has complete answers to all of
these questions, particularly for derivatives.
But any firm which aggregates its customers’
orders, or opts to act as principal, will have to
make this clear in its best execution policy,
and to prove that it will act predominantly in
the customer’s best interest.
Systematic Internalization
The concept of systematic internalization
is introduced by the directive in its markets
and transparency requirements for trading in
shares, and is set out in article 27 of MiFID.
These requirements are driven by the emphasis on market transparency, and attempt to
balance the views of the continental markets, where concentration rules drive trading
onto exchanges, and the U.K. market, where
internalization is permitted. When MiFID
takes effect, the concentration rules will be
abolished, and internalization will be subject
to new rules.
Article 27 defines three main types of
execution venue for shares: regulated markets, such as stock exchanges; multilateral
trading facilities; and over-the-counter trading by firms, some of which are defined as
“systematic internalizers.” A systematic
internalizer is a firm which, on an organized,
frequent and systematic basis, deals on its
own account by executing client orders outside an RM or MTF.
The directive places pre-trade and posttrade obligations on systematic internalizers.
The pre-trade obligations are that they must
provide firm quotes in liquid shares, and
There are major sell-side implications for
firms defined as systematic internalizers.
Firms currently conducting OTC trading
may decide no longer to do so if being a systematic internalizer carries with it too many
costly and competitive disadvantages. Firms
will have to balance the volume of orders
expected against the cost of continuously
publishing firm quotes during trading hours,
and many will decide it is not worth the
effort or expense.
Firms will also have to use more algorithmic
and program trading engines to comply
with best execution and to facilitate
quicker post-trade reporting.
those quotes, subject to certain waivers, must
be binding for trades up to certain thresholds.
In other words, an investment firm, before
crossing customer orders internally, must
publish the quote to the wider market and
give interested parties an opportunity to
respond. This pre-trade process must operate
continuously throughout the day. The posttrade obligations are that they must meet the
same transparency requirements that regulated markets are subject to, which means
they will have to publish specific information
about completed share transactions in close
to real-time.
Some of the effects are less clear. No one
knows how many systematic internalizers
there will be, where they will publish their
quotes and trades, what their IT costs will be
and whether it will be possible to develop a
joint service utility for reporting, recordkeeping and retrieval.
As an alternative to becoming a systematic internalizer, a firm might consider setting up its own multi-lateral trading facility,
or joining a consortium to set one up. This
would give them many of the benefits of systematic internalization, without the costs
and disadvantages; and they would be follow-
For further reading:
Frequently Asked Questions on MiFID:
Draft Implementing “Level 2” Measures
Published by the European Commission
http://europa.eu.int/comm/internal_market/securities/isd/mifid2_en.htm
Planning for MiFID
Published by the Financial Services Authority
http://www.fsa.gov.uk/pages/Library/Communication/PR/2005/124.shtml
MiFID Joint Working Group
www.mifid.com
MiFID Connect Project Summary
http://www.foa.co.uk/regulation/mifid/index.jsp
BearingPoint White Papers
Preparing for MiFID
The Technical Implications of MiFID
www.bearingpoint.com/mifid
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Futures Industry
ing the example of the electronic communications networks set up in the U.S. to
bypass traditional exchanges and over-thecounter market-makers.
Meeting the MiFID Challenge
There is no denying that MiFID presents
the investment industry with serious challenges, in terms of business impacts, IT
changes, regulatory compliance and costs.
But if those challenges are met head-on,
they can provide a competitive advantage
over firms that take a less robust approach.
To win that advantage, firms need to act
now. The first steps to take are to analyze
the impact in detail, decide on the strategic
response and implement the necessary policies and procedures.
The Financial Services Authority has told
investment firms that in planning for MiFID
they need to understand all of the issues and
organizational challenges that the directive
presents. The FSA lists a dozen organizational
functions that will be affected, including IT
and systems, but gives no advice.
On the technology side, IT vendors
often underplay the complexity of integration and encourage a piecemeal approach to
technology change management. However,
a holistic approach is the best approach.
Technology departments in most investment
firms are already implementing significant
changes in program and algorithmic trading,
as well as getting to grips with the requirements of the Basel II capital accord, the
Sarbanes-Oxley Act and International
Financial Reporting Standards. MiFID is
another IT project, and a large and expensive
one at that, but it is best dealt with by integrating it into a single IT change program.
This article has looked at just two impacts
of MiFID—the effects of best execution and
systematic internalization on sell-side firms.
There will be numerous other effects and they
too can be approached in the same way: they
can be analyzed, appropriate IT change
frameworks created, and the frameworks integrated within an enterprise-wide program of
IT change. Only by taking a comprehensive
approach can firms be sure that their business
practices and IT architectures will remain
compliant, and for a reasonable cost. n
Alan Jenkins, based in London, is BearingPoint’s
European Head of MiFID, and chairs the Cross
Jurisdiction sub group of the MiFID Joint Working
Group.