Transforming Trade in the EU Derivatives Market

In MIFID II, OTC Derivatives, Thinking by New Link Editor

MiFID II, and its accompanying regulation MiFIR, comes into force for EU member states on 3 January, 2018.

The scale and cost of the change required to achieve compliance with MiFID II and MiFIR is huge. There are material impacts to the buy-side, the sell-side, market utilities and the end users of derivative products. New Link Consulting’s specialists work with our clients to assess and understand the impact of both MiFID II and MiFIR on their business and determine the resultant effect on their operating model. Our capabilities allow us to plot the course from regulatory interpretation, through to solution design, ultimately delivering compliance. New Link Consulting’s practitioner led service marries unrivalled market expertise with change management skills. This unique approach ensures we assist clients in the development of operating models that achieve compliance in ways accelerate commercial objectives.

Key Dates in the Implementation of MiFID II

The original Markets in Financial Instruments Directive (MiFID) came into force in November 2007, with the ambition to remove cross border barriers in financial services within the European Single Market, and increase protection for consumers and investors.

In 2008, in the wake of the global financial crisis, a review of the existing MiFID legislation was conducted, which identified several key weaknesses in the existing framework, including a lack of transparency, especially in the non-equities market. MiFID II was proposed as a means of addressing these shortcomings by tightening the rules around trading, promoting greater transparency and accountability, and increasing consumer protection. The ultimate objective was to prevent a recurrence of market conditions that allowed the 2008 crash to occur, costing the US alone some $12.8 trillion in losses.

After several rounds of discussion between the European Commission, Parliament and Council, political agreement on MiFID II was reached. The measures were formally published in the Official Journal of the European Union on 12 June 2014. The original targeted implementation date for the legislation was the 3rd January 2017, however the complexities of the legislative task faced by the member state regulatory bodies, as well as the scale of the change required to implement the structural changes, resulted in a 1 year delay being enacted. As a result both MiFID II and MiFIR come into force on 3 January, 2018.

The efforts of regulators to protect investors from market abuse and to standardise complex financial instruments by pushing them onto venue based execution, whilst increasing transparency, do come at a price. Implementing the rules will involve substantial and complex reengineering of market infrastructure for both banks and vendors, entailing additional costs which are likely to be passed on to end users.

The rules do, however, create opportunities for firms wishing to embrace the future state of the trading environment. It is possible that the structural reforms will ultimately yield the opportunity to lower cost base and increase competition in the medium and longer term.

Background: What drove the need for MiFID II?

Key Differences Between Trading Venues

1. Investor Protection:

MiFID required firms to take all ‘reasonable steps’ to ensure the best possible outcome for their clients on certain securities products. MiFID II proposes that firms take all ‘sufficient steps’ to obtain best execution across an extended range of OTC products. A much stricter standard, with a far wider reach. In addition, more stringent and regular disclosure requirements will apply. Firms must inform clients about total aggregated costs and charges, including those for ancillary services, and any costs for providing advice.

To increase certainty, MiFID II requires firms to adhere to organisational standards and requires telephone and electronic communications for transmitting orders, and executing client orders, to be retained for a minimum of five years.

2. Trading Venues:

Under the new legislation, a multilateral system of trading venues will operate, each with the same transparency requirements. Certain products, including OTC products covered by the EMIR clearing requirements, will be mandated to be traded on observable platforms. All trading venues will be required to give open access to their platforms to all CCPs and vice versa. This could create a complex web of venue execution and clearing requiring a wholesale change to both Listed and OTC trade processing. Trading venues are defined as either Regulated Market (RM), a Multilateral Trading Facility (MTF) or an Organised Trading Facility (OTF).

How will MiFID II change the trading landscape?

3. Pre and Post Trade Transparency:

Whilst MiFID applied only to shares admitted to trading on a regulated market, MiFID II increases coverage and applies to non-equities.

Price Transparency – trading venues are required to make information about trading interest publicly available, except where there is a liquid market or when the order is large in scale compared with normal market size.

Systematic Internalisers (SI) – MiFID II extends the existing systematic internaliser regime to apply to a much broader range of asset classes than under MiFID. Including ETFs, depository receipts, derivative, bonds and structured finance products. SIs will be required to make product quotes publicly available and be willing to execute with clients at these prices.

APA Reporting – MiFID II requires publishing data to meet certain organisational requirements and be authorised as an Approved Publication Arrangement (APA).

Transaction Reporting – the reporting regime under MiFID II will be significantly extended
in terms of scope and content. The number of data fields required under MiFID II will rise from 23 (under MiFID) to 65 and include personal information on traders and decision makers
of executed transactions. Bringing together externally and internally sourced employee data presents logistical and quality challenges for buyers and sellers of financial products.

4. Clearing:

MiFIR extends the scope of clearing obligations to all derivative transactions concluded on a trading venue, whether RM, OTF or MTF. Firms trading derivatives must be submitted for clearing acceptance as quickly as technologically practicable. MiFIR states the importance of attaining certainty on clearing as early as possible, preferably before trade execution. This requires Execution platforms to have access to Clearing Broker limits prior to execution.

5. Indirect Clearing:

Clearing members must ensure they offer enhanced levels of protection to margin and positions of indirect clients. This includes clients of their clients, to a similar level as those given by Individually Segregated Accounts under EMIR.

6. Algorithmic Trading:

Is the process of using computers programmed to follow a defined
set of trading rules for placing and executing trades at a speed impossible for a human discretionary trader to achieve. Whilst there are obvious benefits to this methodology, including greater liquidity and lowered costs for investors, regulators also believe this type of trading may cause significant market distortion and impact market confidence. MiFID II introduces closer regulation and monitoring requirements on algorithmic trading. Firms engaging in High Frequency Trading (HFT) must be authorised by the regulator and have special systems and controls in place to risk manage clients’ trading activities. For example, MiFID II stipulates all algorithms must have a ‘kill switch’, enabling a firm to manually cancel all outstanding orders in the event of a disturbance. There’s specific governance, policies and procedures required over algorithms, including named roles and responsibilities. Firms will also be required to flag orders generated algorithmically and to report on algorithmic transactions.

7. Commodity Derivatives:

Contracts traded on trading venues, and economically equivalent contracts, will be subject to position limits set by the local Prudential Regulator. Alongside these limits, positions will need to be reported to trading venues on a daily basis, who will send these on to ESMA – with the latter publishing position held reports. There will however be exemptions for non-financial firms on positions that are objectively measurable as reducing risks directly related to their commercial activity.

8. Clock Synchronisation:

MiFID II introduces a requirement to synchronise the business clocks of trading venues and their clients, thereby standardising the recording time on post trade data, transaction reporting and order event auditing.

How New Link Consulting can Facilitate Engagement with MiFID II

CASE STUDY – MiFID II Impact Assessment – European Investment Bank

Requirement

Client requested a specific 4 month programme to review the MiFIR regulations to determine their regulatory interpretations, impact assessment and key work stream deliverables specifically for their Listed and OTC clearing businesses.

Approach

Working as programme leads and architects, New Link Consulting coordinated a structured review of the regulations with all business, legal, risk and support functions. This was done through a series of general workshops and bilateral meetings in order to capture the full suite of impacts and actions needed to deliver compliance with the new regulations.

Deliverable

Output included an agreed range of regulatory assumptions, a full gap analysis and high-level target requirements for each of the remediation work streams. These deliveries ensured a consistent business response across the work streams. In addition New Link Consultants supported the functional domains in defining their current state model, identifying areas where technology and process changes were necessary to deliver compliance.

Outcome

Client has a robust framework of interpretations coupled with the necessary deliverables, in order to manage the impacts across the firm. These agreed and defined requirements enable the client to commence the mobilisation of their development team.