slaughter and may
Two contrasting aspects of the possible future financial direction of the European Union are on view this Autumn.
The more familiar one is of the Eurozone in crisis, with the partial dismantling of monetary union an outcome
which has moved from the category of “fanciful” to that of at least “mentionable”. In some respects it is therefore
slightly incongruous to be reviewing the Commission’s proposals for more integrated and better regulated single
EU financial markets embodied in the draft re-castings of MiFID (the Markets in Financial Instruments Directive)
and MAD (the Market Abuse Directive) published on 20 October 2011.
The more pessimistic commentators might question whether the outcome of the Eurozone crisis could leave
little in the way of a harmonious single market to nurture: as the EU cruises perilously close to an iceberg, the
crew consults on next week’s destinations. However, this briefing paper proceeds on the assumption that the ship
remains afloat and retains sufficient power to move forward.
Although this paper is not an exhaustive guide to every detail of the proposals, in the following sections we
consider and comment on the main themes of the proposals, namely:
•
a redrawing of the boundary between “organised” and OTC trading, with the clear aim of greater regulatory
oversight of financial market activity in Europe;
•
a complementary extension of the market abuse regime;
•
an increase in transparency rules, including in non-equity markets;
•
new rules which bear directly on the conduct, trading practices, organisation and management of investment
firms, including a narrowing of the more liberal regimes for professional clients and eligible counterparties, and
the introduction of product intervention powers for regulators;
•
a much broader and less precise definition of “inside information” for the purposes of the market abuse regime;
•
a radical and probably highly restrictive new regime for permitting firms established outside Europe to do
business within Europe;
•
g reater regulation of commodity derivatives markets and their participants, particularly in the area of market
abuse.
Running as a theme throughout the proposals is a drive for enhanced “harmonisation” – i.e. the levelling of
differences in national regulation. The Commission has proposed two principal measures for achieving this
objective: first, the proposal to use EU Regulations (contrasted with Directives) to create directly enforceable
BRIEFING
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The European Commission’s proposals for
the revision of MiFID and MAD
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The European Commission’s proposals for the revision of MiFID and MAD
and uniform legal requirements throughout the EEA (in the case of the market abuse regime, a regulation is to
replace MAD in its entirety); and second, the grant of material delegated authorities and continuing roles and
responsibilities to the European Securities and Markets Authority (ESMA).
As we noted in our assessment of the initial policy proposals for MiFID reform published in December 20101, the
EU agenda in this context, although driven in part by a worthy desire to reform regulatory structures to better
fit changing market developments, also appears to be informed by a suspicion, even fear, of certain market
developments and practices. The trend, therefore, seems to be towards more encompassing and prescriptive
regulation backed with threats of prohibition and more severe consequences for infringement.
In the following sections we group the key themes under three broad headings looking at how the proposed
reforms, referred to below as the MiFID package and the MAD package2, will affect financial markets, investment
firms and commodity markets.
PART I: FINANCIAL MARKETS
1. Supervised vs. OTC trading
Commissioner Barnier, in his formal presentation of the MiFID package on 20 October 2011, said that “one of the
major objectives which I want to achieve is to put an end to the reign of the OTC and the reign of opacity”. This has
been a core theme of the MiFID reform project. The original MiFID project sought to remove venue concentration
requirements for financial trading activity and to encourage the development of more efficient and accessible
structures for trading. In this respect, MiFID was a great success – new models and markets for trading in financial
instruments in Europe have proliferated.
But one consequence of this liberalisation is that markets have been able to develop far more rapidly than
regulation and so a great deal of financial trading now takes place away from regulated markets and supervised
multi-lateral trading facilities (MTF). This sort of trading has been categorised by policy-makers under the general
heading of over-the-counter, or OTC, trading. In essence, this is trading which at present is not subject to marketlike rules (especially rules as to transparency) notwithstanding that it is often conducted on a highly organised
basis, for example through so-called broker-crossing systems operated by the largest and most sophisticated
financial intermediaries.
The proliferation of “private” markets is regarded by the Commission, probably with the support of at least some
Member States, as being detrimental to the development of a liquid and fair single European financial market. This
latest package of reforms is thus the Commission’s first major move to regulate new activities since MiFID was
originally enacted.
1.1 Organised trading facilities
In order to confine OTC trading to its true area of ad hoc bilateral dealings, the draft legislation contains a new
investment service (first mooted in the December 2010 consultation) of operating an “organised trading facility”, or
1
2
02
See our briefing of January 2011: The MIFID Review: tough but necessary changes or death by a thousand rules?, searchable at www.slaughterandmay.com
The MiFID package consists of a draft EU Regulation and a draft EU Directive, which would supplement but not replace the existing MiFID; the MAD
package similarly consists of a draft Regulation (which is intended to replace the existing MAD in its entirety) and a supplementing EU Directive.
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OTF. An OTF is defined as “any system or facility, which is not a regulated market or MTF, operated by an investment
firm or market operator, in which multiple third-party buying and selling interests in financial instruments are able to
interact in the system in a way that results in a contract…”.
Thus defined, an OTF appears to possess much of the DNA of an MTF, in that it must bring together third-party
buy and sell interests. The critical difference between the two, however, is that an MTF does so on the basis
of mandatory non-discriminatory rules (the implication being that an OTF may therefore operate on a nonmandatory, or discretionary, basis).
The principal features of the new OTF regime as proposed are as follows:
•
Any person applying for authorisation to operate an OTF will have to show why the system cannot be operated
as a regulated market or by a supervised MTF or systematic internaliser (the latter being investment firms
operating organised bilateral trading facilities with their clients).
•
In order to ensure the “neutrality” of the OTF operator, no orders placed through an OTF may be executed
against the proprietary capital of the operator: in other words an OTF operator must act only as a broker or
arranger and cannot combine OTF operation with systematic internalising.
•
OTFs will be subject to the same new transparency requirements as will apply to regulated markets and MTFs
(see below).
The creation of a new (and broad) OTF category of trading venue will, if implemented in its present form, constitute
the most ambitious attempt yet to bring trading activity “on market”. It is not yet clear from the Commission’s
proposals how formal an OTF structure must be. For example, there are questions as to whether informal ordermatching facilities – for example the telephone-based crossing services offered by many brokers which bring
together buy and sell client interests on a discretionary ad hoc basis – would constitute OTFs. Such arrangements
may not be regarded by brokers as being formally “organised” trading facilities, but interestingly the OTF definition
as drafted does not expressly contemplate that an OTF must deal on an organised or systematic basis (a departure
from the Commission’s initial proposals).
Importantly, from a group structure perspective, investment banks and brokers would be made to separate out
the operation of an OTF from the activity of trading of their own balance sheets to fill client orders as systematic
internalisers: single dealer platforms which combine brokerage and principal trading would not be permitted.
The forced dismantling of these platforms could lead to the subsidiarisation of OTF facilities (i.e. operating an OTF
in a specially-formed subsidiary, leaving the group’s main operating balance sheet free to continue bilateral client
order execution); such structural separation may of course be complementary to other reform initiatives3. But
structural separation of substantially similar trading activity (similar at least from the client-side’s perspective)
will inevitably also have negative consequences, including a reduction in the synergies, efficiencies and possibly
therefore liquidity of trading activity, and presumably an associated increase in trading costs. However, given the
level of fragmentation of trading activity, such arguments alone are unlikely to go far with the Commission.
3
03
See for example our briefing paper on the final report and recommendations of the UK’s Independent Commission on Banking, and our separate briefing
on the FSA’s proposals for recovery and resolution planning, both searchable at www.slaughterandmay.com
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2. Transparency
The draft new EU Regulation in the MiFID package (MiFIR) contains a comprehensive and in some respects highly
contentious set of transparency requirements applying to both equity and non-equity markets (including debt
markets and derivatives markets).
By “transparency” is meant, firstly, publication of “prices and the depth of trading interests at those prices for orders
or quotes… this requirement shall also apply to actionable indications of interest” (pre-trade transparency); and
secondly, publication of the “price, volume and time of transactions executed…” (post-trade transparency).
2.1 Extension of the equity transparency regime
The headline proposal in this area is that existing pre- and post-trade equity transparency requirements will
be extended both to include equity-like instruments, and at the same time to include equities and equity-like
instruments which are traded on an MTF or an OTF.
The extension of the regime to include instruments traded only on an MTF within scope for pre-trade transparency
is by itself notable; going a step further to include instruments which are traded only through an OTF is a
proportionately much greater step and not without complication. To give just one example of the difficulties
presented by this element of the proposal, one must question how an investment firm operating an ad hoc
telephone-based order-matching facility of the sort described above could present reliably “current” bid and offer
prices.
Firms operating as systematic internalisers will be required to publish firm quotes when dealing in financial
instruments which are traded on any of those venues (not just those traded on regulated markets, as at present).
The existing MiFID proviso that there must be a liquid market in the instrument in question and that the systematic
internaliser is not dealing in sizes above “standard market size” will, however, continue to apply.
In another well-trailed move, the Commission has confirmed that waivers from pre-trade transparency and
deferred publication for post-trade transparency will be tightly controlled. This is a reaction to the emergence of
substantial yet opaque “dark pool” trading venues, which some constituencies within Europe have come to fear
may be a hiding place for dubious or even malevolent trading strategies. Waivers will be granted in future only for
“specific sets of products based on the market model, the specific characteristics of trading activity in a product and the
liquidity….”; or in respect of “orders that are large in scale compared with normal market size”, and the Commission
will be empowered to adopt more detailed rules in this area through subsidiary measures, after taking advice from
ESMA.
2.2 Transparency rules to apply beyond equity markets
Comments on the Commission’s original proposal to extend transparency requirements to non-equity markets
suggested that it would be disproportionate, inflexible and likely to impose higher costs, thus damaging liquidity at
a time when corporates (among others) are already finding it challenging to raise debt funding.
In our briefing on the original MiFID review proposals, we commented that:
“[t]he Commission believes that greater transparency in non-equity markets should increase liquidity, improve price
formation and thereby reduce trading costs, but acknowledges the arguments advanced by many brokers in those
markets that greater transparency could in fact adversely affect their liquidity. Greater transparency in pricing narrows
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the role for brokers to play. It is argued that if, as many believe, brokers have the ability to make higher profits in a less
transparent market environment, the number of brokers prepared to provide liquidity in these markets will fall with the
advent of greater transparency.”
“It appears, therefore, that the Commission accepts that a simple transplant of the equity transparency regime into nonequity markets would be a step too far; those with strong views in this area may therefore wish to focus on identifying
(or in many cases re-identifying) for the Commission those areas where a much lighter-touch and/or less prescriptive
transparency regime, if any, would be appropriate and most effective/least detrimental.”
Notwithstanding extensive representations having been made on this point, the Commission appears determined
to push ahead with its proposals, though again deferring to subsequent subsidiary measures the explanation of a
limited regime of exemptions for both pre- and post-trade obligations.
3. Market Abuse Regulation
The draft MAD package aims to provide a common and enhanced market abuse regime across the EU. In addition
to a draft EU Regulation, there is also a draft EU Directive requiring Member States to introduce criminal sanctions
for serious forms of market abuse. The UK has long had such a criminal regime, although in legislative terms it has
sat separately from the market abuse regime implementing the original MAD.
The Commission’s proposal for a criminal penalties regime suffers from uncertainty as to both detail and scope. It
is not yet clear what the final impact on the existing UK criminal regime for regulating market abuse will be. The UK
is not in fact obliged to implement this particular EU Directive so there is a question as to whether the UK Treasury
will choose to criminalise market abuse under the Financial Services and Markets Act 2000 (FSMA) and then repeal
the existing criminal offences for insider dealing (under the Criminal Justice Act 1993) and misleading statements
and practices (under section 397 of FSMA); in theory all three regimes could provide for criminal penalties.
The draft Market Abuse Regulation (referred to in this paper as the MAReg) will have direct effect and will therefore
replace national regimes in the area it covers. This means that the current UK market abuse provisions in FSMA
will be replaced and it will presumably be necessary to amend FSMA to remove the existing civil market abuse
provisions.
MAReg, if adopted in its current form, would extend the scope of the existing MAD regime in a number of material
respects:
•
Instruments traded on MTFs and OTFs as well as on regulated markets will be covered, and MAReg will
controversially have the effect of regulating trading activity extra-territorially, i.e. activity which takes
place entirely outside Europe between non-European counterparties in relation to instruments whose only
connection with Europe may be that they are traded on a European MTF or OTF.
•
Also within scope will be instruments which are traded OTC but which can have an effect on instruments which
are traded on any such trading venue, including derivatives and credit default swaps.
•
The definition of inside information will be modified; unfortunately certain aspects of the modified definition as
drafted could have many legally- and commercially-adverse consequences (on which see further our comments
below).
•
Cancelling or amending an order on the basis of inside information will be prohibited.
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•
Commodities markets, both derivative and spot, will be the subject of much closer attention (on which see
further our comments in Part III below).
•
Manipulation through algorithmic and high frequency trading (such as quote stuffing, layering and spoofing) is
singled out for special attention, notwithstanding the Commission’s admission that such activities are already
prohibited by MAD.
•
Attempts to manipulate markets will be prohibited whether or not they are successful.
3.1 The definition of inside information
MAReg would materially alter the definition of “inside information” in MAD in three significant ways (leaving aside
the general extension of the market abuse regime to MTFs and OTFs):
•
The definition as it applies to commodity derivatives will be aligned to the definition applicable to securities
generally. We comment on this point in Part III of this paper.
•
The primary piece of market abuse legislation will specify that information is likely to have “a significant
effect” on price if it is information that a reasonable investor would be likely to use as part of the basis of his
investment decisions, suggesting that the reasonable investor test would supplant rather than supplement the
current price-sensitivity test.
•
There will be a new category of inside information: information which is not generally available but, if it were,
would be likely to be considered “relevant” to a reasonable investor’s decisions. This information need be
neither “precise” nor (apparently) price-sensitive. Although issuers are not required to disclose this information
(as they are all other categories of inside information subject to limited exceptions), trading with this
information will be prohibited.
These last two points bear examination in greater detail:
•
First, the move away from referring expressly to price sensitivity and towards the reference to matters that a
“reasonable investor would be likely to use as part of the basis of investment decisions” appears, at first glance not
to be a particularly material change from the original MAD regime, where an equivalent provision is provided
for in the subsidiary legislation (Level 2).
•
As a matter of EU law, Level 2 measures cannot enlarge the scope or effect of a Level 1 Directive. As MAD, read
on its own, merely refers to inside information as information which would have a “significant effect on price”,
there is a strong argument that the effect of the phrase appearing at Level 2 means only that “significance” is
to be judged through the eyes of a reasonable investor making a considered investment decision – but that
there must nevertheless be some price effect.
•
The opposite, broader interpretation – that the reasonable investor test in fact supplants the price-sensitivity
test – has been advanced by the FSA and accepted in a decision of the UK’s financial services tribunal4 though
practitioners doubt its legal force; but the apparent elevation of the reasonable investor test to the Level 1
MAReg lends some support for that broader interpretation.
4
06
See our briefing of February 2011: Market Abuse and the Definition of Inside Information, searchable at www.slaughterandmay.com
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•
The inclusion within the definition of a new category of information which is “not generally available” but which
would be “relevant” to a “reasonable investor” is a direct copy out from the UK’s pre-MAD market abuse regime
(such information is known by the acronym RINGA: relevant information not generally available).
However, there are significant differences which the Commission may not have appreciated: in particular, FSMA
only prohibits the use of RINGA if its use would be considered as falling below the standards expected of the
person using it “in relation to the market” in question. Moreover, the FSA’s market abuse guidance5 provides a
further gloss to the effect that information should only be considered “relevant” to a reasonable investor if it
would ordinarily be the subject of an announcement required by law or made by convention.
Both new elements of the definition appear to remove price sensitivity from the concept of inside information; and
the new RINGA provision appears to create an open-ended category of “imprecise” information. Some helpful
pointers may nevertheless be noted:
•
The recitals to MAReg clearly stress that price sensitivity is a paramount feature of inside information,
suggesting that the Commission may not have intended to effect quite such a material change to the
definition.
•
The recitals also indicate that the RINGA definition is aimed at information concerning developments that
will in time qualify for announcement as inside information in the normal sense but which are at a stage of
development where the necessary “precision” is lacking.
•
The general principles laid out by the European Court of Justice in the Spector Photo judgment would remain
relevant – only truly abusive behaviour is within the scope of the market abuse regime.
These considerations certainly do not dispose of the problems identified in this first draft of MAReg, but do at
least support a powerful prima facie case for clarification and the drawing of more workable boundaries. It is to be
hoped that the Commission can be persuaded to acknowledge the flaw in this element of the MAD package and to
entertain sensible alternative formulations.
3.2 Scoping the regime and extra-territoriality
Many of the changes proposed in the MAD package, as they stand, will be controversial and the debates that must
now take place are therefore likely to heat up quickly. In particular, the extension of the market abuse regime to all
instruments traded on all regulated markets, MTFs and OTFs will in practice create a hugely expanded universe of
instruments for which the regime will be engaged.
This by itself is likely to present material practical issues for firms seeking to avoid inadvertently committing a
market abuse offence: the Commission has not made provision for the maintenance of a central list of MTFs and
OTFs, or of financial instruments traded on those facilities, such that one could determine definitively whether an
instrument is in fact subject to the MAReg regime.
Moreover, the apparent extra-territorial extension of the MAReg regime to abusive activity taking place outside
Europe introduces the possibility of bizarre practical outcomes; for example, abusive trading by a New York-based
5
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The FSA’s Code of Market Conduct, or “MAR”; see in particular Chapter 1.5 of MAR.
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hedge fund with a US bank as counterparty in a US-listed security would apparently be subject to the MAReg
regime if that US security were traded on a single European OTF.
3.3 Other concerns
A range of other initial concerns have been identified, including the following:
•
Many instruments will not be issued by an issuer which is subject to disclosure requirements, or will be issued
by issuers not subject to disclosure requirements; consequently once in possession of material non-public
information in relation to such instruments it is not clear how a person could ever expect to be cleansed of that
information.
•
Many defences and safe harbours appearing in the Recitals to the existing MAD have disappeared in MAReg
including, for example, Recital 29 which provided a basis (at least in the UK market abuse regime) for
exempting certain trading in connection with takeover activity – does the Commission mean to imply that
such trading should be prohibited under MAReg? This could have very serious dampening effects for European
corporate activity.
•
MAReg seeks to provide a safe harbour for dealings by a “legal person” where inside information is held behind
a Chinese wall and the decision to deal is taken by individuals outside the wall. However, the effectiveness of
the provision is substantially weakened (if not in fact rendered futile) by two factors:
–– First, if the definition of inside information is to include relevant information not generally available
(RINGA) but without reference to information which the market would expect to be disclosed, the breadth
of information which would need to be subjected to effective Chinese wall treatment is likely to become so
extensive in some cases as to mean that traditional Chinese wall operational arrangements are likely to be
insufficient.
–– Second, there is a condition attached to the safe harbour that there be “no contact” between those on
either side of the wall “whereby the information could have been transmitted or its existence could have been
indicated”. This condition is likely to be very difficult to police – in practice, it would mean a complete ban
on business and social contact and the effective monitoring of that ban.
•
The MAReg regime appears to be couched in wholly objective terms, in that there is no requirement for
regulatory authorities to discern an intention to commit market abuse, or even recklessness. This becomes
more alarming when one considers that it would be sufficient to attempt market abuse in order to commit an
offence, and that serious market abuse will be subject to criminal penalties.
4. Other developments for financial markets
Among other matters, the draft MiFID package also makes provision for:
•
regulated markets, MTFs and OTFs to make post-trade data publicly available free of charge within 15 minutes
of trade execution, and to require firms executing trades on an OTC basis to disclose those trades;
•
transaction reporting to regulators in relation to the full range of financial instruments traded on a regulated
market, MTF or OTF; transaction archive obligations will also apply to organised trading venues, with a
minimum 5 year look-back;
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•
certain categories of derivatives which ESMA determines to be capable of mandatory trading and clearing to
be traded on a regulated market, MTF or OTF. That determination is to be made in accordance with technical
standards to be proposed in due course by ESMA and adopted by the Commission. Arrangements will also be
made for the Commission to be able to recognise particular non-EEA trading venues as being equivalent to an
EEA regulated market, MTF or OTF for this purpose. Regulated markets (but not MTFs or OTFs) will be required
to ensure that such trades are then cleared through a central counterparty (CCP). This measure is clearly
complementary to the proposals for mandatory central clearing in the draft European Market Infrastructure
Regulation (EMIR), which remains under consideration;
•
firms which compile proprietary benchmarks and indices for use in the financial and commodity markets
(such as stock market indices and commodity price assessments) to grant non-discriminatory licences on a
mandatory basis to all trading and clearing venues wishing to make use of such benchmarks and indices. The
price at which such licences could be granted would in effect be capped. This provision did not feature in the
original MiFID review proposals and although there is little by way of explanation, the Commission appears to
regard this as a necessary extension to facilitate the transfer of OTC derivative trading activity onto regulated
trading venues and through CCPs. As currently drafted, the proposal involves a potentially material incursion
into private intellectual property rights which will surely draw fierce resistance;
•
spot contracts for EU emission allowances to become financial instruments and therefore subject to, among
other things, the transparency, reporting and market abuse regimes.
PART II: INVESTMENT FIRMS
5. Increased requirements and restrictions
It has for some time been a truism in EU policy-making that the financial crisis of 2008/9 “exposed” failings in the
governance and conduct of firms. To remedy these deficiencies the MiFID package proposes a number of reforms
covering areas such as management and internal organisation, conduct of business and product regulation.
From a UK perspective, much of what is proposed has a familiar look – it appears that the Commission has
borrowed widely from existing UK Government and FSA initiatives.
Matters covered include:
•
requirements relating to the quality of a firm’s management, both individually and collectively;
•
enhanced requirements for the provision of investment advice, including the banning of commission for
independent advisers (following the FSA’s lead in its Retail Distribution Review);
•
restrictions on the ability of firms to provide execution only services;
•
enhancements to existing best execution requirements;
•
adjustments to the category of professional clients to reflect the fact that some organisations, such as local
authorities, may not in reality be sufficiently professional in investment matters to be treated as such;
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The European Commission’s proposals for the revision of MiFID and MAD
the imposition of fair treatment and fair communication principles in relation to dealings with eligible
counterparties.
Two other initiatives should be highlighted: special attention has been given to high frequency and algorithmic
trading; and proposals have been made for new supervisory intervention powers. These initiatives are discussed
below.
5.1 High frequency and algorithmic trading
Although the Commission has not been able to find convincing reasons to ban or limit high frequency trading
(HFT) or algorithmic trading, it remains suspicious of these practices and is proposing to subject them to special
measures including:
•
specific mention of such trading in the MAReg proposals noted above, suggesting (although not quite
articulating) that the starting point for regulators should be to consider such strategies as being “at risk” for
market abuse purposes;
•
a specific authorisation requirement for traders employing such methods and who meet certain qualitative and
cumulative thresholds;
•
a requirement for traders to divulge details of their programming and strategies to competent authorities, for
“monitoring purposes” (a proposal that is likely to prove particularly contentious);
•
a quasi-market making obligation for firms employing HFT techniques to support liquidity (i.e. an obligation
not to withdraw from the market at times of market stress);
•
a requirement that regulated markets, MTFs and OTFs develop and maintain special risk-mitigating
arrangements for such trading.
It is not yet clear whether the definitions used to capture these forms of trading will themselves be impervious
to arbitrage and manipulation, or indeed whether they will be shown to capture technology-driven trading of an
altogether more pedestrian nature. This will surely be an area where trading and asset management firms will want
to make the case for limiting the possibility of supervisory intervention in proprietary commercial technologies.
5.2 Intervention against products or services
Following the UK Government’s example, the Commission has proposed to grant powers to national regulatory
authorities (in the first place) or ESMA (in the second place, where a national regulatory authority is deemed to
have failed to act) to take action either:
•
to prevent or restrict the “marketing, distribution or sale” of a financial instrument, or of an instrument with
certain features; or
•
to prevent or restrict a “type of financial activity or practice”.
Safeguards would be provided for, such that intervention may only take place if there are:
•
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a serious threat to market integrity or systemic stability,
and existing regulatory requirements or powers cannot adequately cope with the development.
In addition to back-up powers of intervention, ESMA is to have a co-ordinating role when national regulatory
authorities use these powers.
6. Third country firms
In one of its most controversial moves among these two packages, the Commission has proposed a radical
transformation of the relationship between the European single market and firms established outside the EEA
(third country firms). The present situation is that third country firms may establish branches or provide crossborder services subject to the various national laws of Member States (there being only a requirement under MiFID
that such firms are not treated more favourably than equivalent European firms). Third country firms which obtain
national authorisation cannot benefit from the MiFID passports, but there is otherwise broadly a level regulatory
playing field as regards the provision of investment services within Europe.
Under the new proposals, national regimes for third country firms will be abolished, including the relatively relaxed
“overseas persons” exemption in the UK which has functioned fairly efficiently and effectively for more than 20
years. Instead, two new MiFID passports will be offered to third country firms, but under conditions which at best
will impose costs, restrictions and legal uncertainties and at worst may effectively frustrate their availability and
utility altogether.
The two new passports are for branches and cross-border services respectively. The proposed conditions are
summarised below.
6.1 Third country branches
A third country firm wishing to provide services to retail clients anywhere in the EU would be required to establish a
branch somewhere in the EU. As drafted, this establishment would be permitted only if certain conditions could be
satisfied:
•
only third country firms from countries whose supervisory regimes are determined by the Commission to be
“equivalent” (on which see below) may establish a branch;
•
the home state of the third country firm must have in place reciprocal recognition arrangements for the EU’s
prudential framework for investment firms;
•
there must be co-operation arrangements for sharing information on supervisory and taxation matters
between the relevant third country and the proposed host state of the branch;
•
the branch must meet certain requirements as to initial capital and management resources;
•
the branch must meet the conduct and organisational requirements applicable to branches (the original MiFID
requirements as supplemented by the new MiFID package).
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Once established and authorised in Europe on a branch basis, a third country firm will be able to provide services to
retail and professional investors elsewhere in the EEA under a passport regime similar to the current MiFID crossborder passport for EEA firms.
6.2Equivalence of third country supervisory regimes
The “equivalence” assessment by the Commission of third country regimes will cover:
•
authorisation and ongoing “effective” supervision of third country firms;
•
“sufficiency” of capital requirements;
•
“appropriate” requirements as to fitness of management and shareholders;
•
“adequacy” of internal organisational requirements;
•
an effective market abuse regime.
Although the regime in a third country need not amount to an “identical twin” of the European regime (MiFID/
MiFIR, the Capital Adequacy Directive and MAD), there is clear scope for discretion in the Commission’s
determination and this discretion could narrow or broaden the category of equivalent third countries according
to the political climate. Indeed, the present politics of international co-operation on regulatory matters suggests
there is a logical possibility of the discretion scarcely ever being exercised in favour of third country regimes.
6.3Services passport
In principle the new branch passport arrangements described above, and the derivative services passport for
established branches, are a welcome development. By contrast, the Commission’s proposal on the passport
arrangements for third country firms to provide investment services into Europe without establishing a branch
(involving a registration process to be administered by ESMA) appears to be severely restrictive.
As with branches, only third country firms from countries judged by the Commission to meet requirements of
equivalence, reciprocity and co-operation with respect to supervisory information will be eligible for a services
passport. If a passport is granted, services may be provided only to eligible counterparties. Where third country
firms do not hold a services passport, EU persons may receive investment services from such firms “only at their
own exclusive initiative”. A recital to MiFIR indicates that the concept of “exclusive initiative” is to be interpreted
narrowly, by stating that services provided as a result of solicitation, promotion or advertisement in the EU by a
third country firm are deemed not to be provided at the initiative of the client.
Many questions are raised by this controversial stance:
•
12
Does the proposal take away with one hand what it gives with the other? The equivalence and reciprocity
conditions are drafted in terms which are sufficiently general, and flexible, to allow for a number of jurisdictions
to qualify if the Commission uses its discretion liberally. However, there is a danger that determination of
these matters will be subject to political pressure at Commission level. Perhaps most critically in the present
economic and political environment, the conditions would seem effectively to close the European single market
to firms providing services from developing countries (and in turn could be expected to restrict European
persons from gaining investment exposure to those same countries).
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•
In earlier leaked drafts of the MiFID package, the services passport was to be available for the provision of
services to professional investors. It is now confined to eligible counterparties, yet no reason is given for this in
the Commission’s draft explanatory memorandum. At present it appears that third country firms could only
service their solicited professional clients by establishing an EU branch. Eligible counterparty is not a universal
client type, i.e. it applies only for the provision of certain investment services; given this, is the passport regime
in fact restricted even further to those eligible counterparty services, or is the intention that services may be
provided to any EU person who is capable of being categorised as an eligible counterparty? And what is the
justification for concluding that professional clients are not sufficiently professional to judge whether they wish
to deal with third country firms?
•
Will the non-solicitation test need to be satisfied only once (i.e. when a relationship is first established between
EU person and third country firm) or is it intended to be applied on a transaction-by-transaction basis? If the
latter, does this mean that a third country firm will be prohibited from offering new services to its existing EU
clients or else risk breaching the non-solicitation condition?
•
The restrictions on dealing with a third country firm across borders raises many technical questions which have
not yet been addressed at all by the Commission:
–– What relationship can a client of a European branch have with the overseas (third country) head office or
other non-EEA branches of a third country firm?
–– What steps can a European firm take to introduce its clients to the services of its non-EU affiliates? (A
question especially pertinent for groups which locate different aspects of an integrated client service in
different jurisdictions, e.g. advising, custody and dealing.)
–– How, if at all, will the exemptions in MiFID apply to third country firms? If they do apply, does account
have to be taken of their activities worldwide or just in the EU? (For example, will the servicing by a third
country firm of group companies in Europe be within scope of the MiFID group exemption if the third
country firm also provides services to clients exclusively outside Europe?)
–– How is the internet to be treated in applying the non-solicitation test?
–– Is there any appetite to provide safe harbours for certain cross-border client relationships, given the
uncertainties identified above?
The Commission’s apparent willingness to create a so-called “fortress Europe” single market has been played out
to some degree already in the debate over the third country firms regime for the Alternative Investment Fund
Managers Directive. The debate in that context has been partially deferred by means of transitional provisions, and
a similar approach is proposed for the MiFID package (the draft proposal suggests a four year transitional period
during which “existing” third country firms may continue to provide services within Europe under existing national
regimes).
Perhaps for now the Commission believes it is beneficial to hold open the threat of effective closure of European
markets to third country firms. The question remains, however, as to whether the threat is hollow or remotely in
the short or long term interests of European corporates and (to a lesser extent) consumers who make extensive use
of the global reach of services provided by third country firms.
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PART III: COMMODITY MARKETS
7. Commodities regulation
The Commission has identified commodity markets and their related derivative markets as an area of concern,
lacking in measures to ensure integrity and transparency and therefore open to abusive behaviour. There has been
extensive debate as to the relationship between spot and derivative commodity markets, and the extent to which
greater regulation is required to protect each from the other, and ultimately to protect the interests of end user
consumers.
It has been argued that the spot markets have hitherto been subject to little or no regulation as regards insider
trading and manipulative behaviour and that, because of the inter-connectedness of spot markets and derivatives
markets, the latter suffer “contagion” from market abuse that may take place in the former. It has equally been
argued that recent volatility in physical commodity markets, and particularly in those markets for oil-based and
agricultural products, has been caused (on one view) or aggravated (on another) by speculative behaviour in the
derivatives market.
Whether either or both arguments are in fact borne out, the Commission, in support of IOSCO and with the
support of France in particular, has been looking at ways in which it might address volatility in commodity markets.
The most concrete product of that process to date has been the new disclosure and anti-abuse regime for the
physical electricity and natural gas markets6.
Spot commodities markets are not within the scope of MAD or MiFID at present and proposals to reform those two
directives cannot directly extend their scope in this regard. However, the Commission has identified a number of
ways in which the regulation of derivatives markets can be directly enhanced and some ways (via the regulation of
the derivatives markets) in which the regulation of spot markets can be indirectly enhanced.
In brief, the proposals for commodity markets include:
•
extending the scope of the market abuse regime to behaviour on spot markets which has an abusive effect on
derivatives markets and behaviour on derivatives markets which has an abusive effect on spot markets;
•
abandoning the somewhat weak definition of inside information which has until now applied to commodity
derivatives markets and replacing it with essentially the same definition as will apply to other securities
markets;
•
bringing more derivative trading firms within the scope of MiFID regulation by narrowing certain exemptions
which have until now applied to certain specialist commodity derivative market participants;
•
compelling more trading of commodity derivatives to be conducted on regulated trading venues;
•
providing that such trading venues monitor and publish positions taken by market participants.
We address each of these key features below.
6
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The Regulation on Energy Market Integrity and Transparency (REMIT) was adopted on 10 October 2011: see http://www.consilium.europa.eu/uedocs/
cms_data/docs/pressdata/en/trans/124995.pdf
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7.1 Extending the scope of market abuse
As discussed in section 3 above, the existing market abuse regime will be extended beyond instruments traded
only on regulated markets to include instruments traded on MTFs and the new category of OTFs. This extension,
coupled with proposals to make it mandatory to trade many more derivatives contracts on those trading venues
(see below) will of itself mean that some trading in commodity derivatives which is currently considered to be
purely OTC, and therefore outside the MAD regime, will be captured under MAReg.
The second extension of scope is for MAReg to apply explicitly to behaviour and dealings which cross the
boundaries between derivatives and spot commodity markets. Although it is arguable that behaviour in spot
markets which has an abusive effect on commodity derivatives markets is already within the scope of MAD, MAReg
makes this explicit and will further prohibit:
•
the use of inside information (as newly defined) relating to spot markets (i.e. physical commodity
fundamentals) to trade abusively in derivatives markets; and
•
trading on derivatives markets in such a way as to manipulate either (or both) the derivative markets or the
spot markets (even if the trading of derivatives is not in this case of itself manipulative of the derivatives market
in question).
MAReg is not intended to address behaviour occurring on and affecting only a spot commodity market which, at
least as regards the electricity and natural gas markets, is the subject of a separate initiative at Commission level as
noted above.
But the extension of the market manipulation regime to include behaviour which could have an impact on spot
markets is nevertheless a considerable and potentially contentious extension of scope which some may regard as
leading to the quasi-regulation of spot commodity markets ‘by the back door’. The question arises as to where
responsibility will lie for monitoring for and detecting manipulative behaviour which is capable of having an abusive
impact on spot commodity markets – it is not clear whether European financial regulators (in most cases already
strained for resources) will be equipped to perform that function effectively.
7.2 Definition of inside information
The proposed new definition of inside information is discussed in section 3.1 above. There are two key questions
of relevance (unanswered for now) to how that definition could work in commodity and commodity derivatives
markets:
•
what underlying disclosure requirements should be taken to apply? in securities markets, price sensitivity is to
a large extent directly related to an issuer’s obligation to disclose price sensitive information to the market, and
•
how will the new RINGA test be applied (i.e. how sensitive is the term “relevant” in a commodity markets
context), especially given the open-endedness of the current draft definition?
7.3 Narrowing of MiFID own account exemption for commodities dealers
The existing MiFID exemption for persons trading on their own account in commodity derivatives will be eliminated
under MiFIR, thus bringing all specialist commodity derivative dealers within the scope of regulation.
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Because the MiFID package will then apply to such dealers, it seems that the existing light-touch UK regimes for “oil
market participants” and “energy market participants” will have to disappear.
7.4 Trading of derivatives on exchange
Another potentially contentious proposal is for much more commodity derivatives trading to be forced onto
regulated markets, MTFs or OTFs. This obligation would apply to:
•
financial counterparties;
•
certain active non-financial counterparties; and
•
classes of derivatives determined according to criteria developed by ESMA.
The Commission will have the power to recognise third country markets as permitted trading venues.
To the extent that this results in the mandatory use of more standard form derivatives, the scope for customisation
and flexibility that currently exists in the OTC markets may well diminish. This is likely to exacerbate the trend
– also encouraged and to a degree mandated by EMIR - towards derivative product terms over which significant
market users will have diminished influence notwithstanding their market strength.
7.5 Position monitoring and position limits
To complete the proposals for the enhanced regulation of the commodity derivatives markets, EU Member States
will be required under MiFID as recast to ensure that trading venues:
•
have the power to impose position limits on their participants, in the interests of liquidity, preventing market
abuse and orderly pricing and settlement;
•
report publicly aggregate positions held in the form of different categories of trades;
•
supply on demand to regulators a “complete breakdown” of market participants’ positions, including client
positions.
These powers will be co-ordinated and reinforced by back-up powers conferred on ESMA, including powers to
intervene directly where a national regulatory authority is judged to be tardy or unwilling.
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CONCLUDING THOUGHTS
EU policy on financial services, as evidenced by the proposals in both the MiFID and MAD packages, can be
viewed as being concerned with outliers (or perhaps outlaws) in the financial markets, which include both national
regulatory authorities and market participants.
On the one hand, there are jurisdictions where single market directives have been poorly implemented to
minimum standards, poorly supervised and poorly enforced. On the other hand, there are jurisdictions, among
them the UK, which have tended towards trail-blazing in terms of regulatory ambition and effort (if not always
regulatory success).
Harmonisation is a primary objective for the Commission – but how much of this harmonisation is “upwards” and
how much is “downwards”?
“Upward harmonisation”
The policy of raising standards among firms and national regulators, ensuring consistent enforcement and thus
improving confidence in the single market and reducing regulatory arbitrage, is reflected in many of the proposals
in these two packages:
•
the use of the directly effective EU Regulations to by-pass national implementing measures;
•
taking every opportunity to give ESMA centralised roles in:
–– determining standards (such as for on-market derivatives trading);
–– acting as EU gatekeeper (such as in relation to third country firms);
–– co-ordinating the actions of national regulatory authorities and admonishing and intervening over the
heads of those authorities which fail to implement or enforce rules effectively (such as in relation to
product regulation);
•
adopting some originally ‘super-equivalent’ regulatory initiatives, such as those already taken in the UK in the
market abuse regime, for the whole of the EU.
“Downward harmonisation”
By contrast, other proposals in these packages appear to reflect the fears and suspicions of European policy-makers,
particularly as regards those firms pushing the boundaries in developing new trading strategies and techniques, and
so look to harmonise away any scope for options and discretions that might otherwise give rise to arbitrage and
manipulation.
That some of these more technologically-based strategies and techniques may in part have contributed to, or at
least aggravated the effects of, the financial crisis is no longer debated; and that high standards of market conduct
have not always been universally upheld is also accepted. But these facts alone have not yet been shown sufficient
to justify material restrictions on financial activity of the nature proposed, which fail to discriminate fairly between
the dubious and the legitimate, for example by:
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•
forcing the larger part of OTC trading, especially in non-equity instruments, onto trading venues subject to
disproportionate transparency requirements;
•
singling out high frequency and algorithmic trading for special attention;
•
limiting the circumstances in which firms will be able to execute client orders against proprietary capital;
•
extending the scope of the market abuse regime so that it applies to a potentially open-ended and unverifiable
universe of instruments;
•
destroying workable and flexible national regimes for third country firms in favour of a retail branch passport
which probably offers too much and a services passport which offers far too little.
As we said at the outset of this paper, the clear trend evident from these two complementary packages of reform is
towards a much greater use of prescription, prohibition and limitation. That is perhaps not surprising when viewed
against the backdrop of the financial crisis. It is to be hoped, however, that in its attempt to navigate away from
stormy waters, the Commission’s single market enterprise does not find itself stranded in a stagnant lagoon.
If you would like to discuss the issues raised in this briefing paper, or any other financial regulatory matter,
please contact one of the following or your usual Slaughter and May contact:
Ruth Fox: [email protected]
Jan Putnis: [email protected]
Ben Kingsley: [email protected]
Slaughter and May
One Bunhill Row
London EC1Y 8YY
United Kingdom
T +44 (0)20 7600 1200
www.slaughterandmay.com
© Slaughter and May 2011
This material is for general information only and is not intended to provide legal advice.
For further information, please speak to your usual Slaughter and May contact.
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