#9 MiFID II Review - European Commission adopts Delegated Acts on MiFID II

Introduction

The European Commission has adopted a Delegated Regulation with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions; and a Delegated Regulation in relation to the organisational requirements and operating conditions for investment firms (together, the Delegated Acts). ESMA published its report containing final technical advice in this area in December 2014. The Delegated Acts follow the publication of the MiFID Delegated Directive in relation to research and product governance on 7 April 2016, which we covered in series 8 of our MiFID II review.

The Delegated Acts provide detail on areas including, the enlarged regime for systematic internalisers, the delineation of a liquid market for shares the scope and definition of terms such as algorithmic trading and suitability. This briefing looks at some of these issues in further detail.

Scope and Definitions 

Systematic internalisers

An entity is defined as a systematic internaliser where it trades a product on a frequent and systematic and substantial basis. ESMA's technical advice did not provide unique values to define thresholds for "frequent and systematic" and "substantial basis' for non-equity instruments, but only ranges. The Delegated Act specifies when an investment firm will be treated as a systematic internaliser for equity instruments, bonds and structured finance products; derivatives and emission allowances using the mid-point in the ranges provided by ESMA.

For equity instruments, an investment firm internalises on a frequent and systematic basis if the number of OTC transactions executed by the investment firm on own account when executing client orders in liquid instruments was, during the last six months, equal to or larger than 0.4 per cent of the total number of transactions in the relevant financial instrument, in the EU executed on any trading venue or OTC during the same period.

Where there isn't a liquid market for the purposes of MIFIR, the condition is deemed to be met when the investment firm deals on own account OTC in the same financial instrument on average on a daily basis during the last six months. The substantial basis criterion is satisfied if the size of OTC trading carried out on own account is the larger of: (i) 15 per cent of trading in that instrument by the firm; or (ii) 0.4 per cent of the EU-wide turnover in the financial instrument.
See appendix 1 for thresholds for non-equity instruments

For fixed income, the Delegated Act provides that where an investment firm is a systematic internaliser for an instrument relating to an entity, it will be a systematic internaliser for that entity as a whole. This is a change from the instrument by instrument approach that was proposed by ESMA and is not entirely clear as to the consequence. It appears, however, to be an attempt to level the playing field between trading venues and systematic internalisers, in relation to pre-trade transparency requirements.

Algorithmic trading and high frequency trading

Clarification has been provided as to the meaning of limited or no human intervention for the purposes of the definition of algorithmic trading to mean (for any order or quote generation process, or any process to optimise order-execution) any automated system making decisions at any of the stage of transaction process (i.e. initiating, generating, routing or executing orders or quotes) according to predetermined parameters. The recitals provide that algorithmic trading should encompass smart order routers (SORs) where such devices use algorithms for optimisation of order execution processes that determine parameters of the order other than the venue or venues where the order should be submitted. Algorithmic trading does not encompass automated order routers (AORs) where, although using algorithms, such devices only determine the trading venue or venues where the order should be submitted without changing any other parameter of the order.

Clarification has been provided as to the meaning of "high message intraday rate" for the purposes of the definition of high frequency algorithmic trading. A participant or member of a trading venue, who has the qualifying infrastructure, and submits on average at least four messages per second with respect to all instruments across a venue, or trades two messages per second with respect to any single instrument traded on a venue, would be deemed to have a "high message intraday rate". The recitals provide that messages introduced for the purpose of dealing on own account and not for the purpose of receiving or transmitting orders or executing orders for clients should be included in the calculation. Messages introduced through other trading techniques than those relying on dealing on own account will be included in the calculation where the firm's execution technique is structured in such a way as to avoid that the execution takes place on own account. For the calculation of high message intraday rate in relation to DEA providers of direct electronic access, messages submitted by the DEA clients are excluded from the calculations.

Direct electronic access

The criteria for determining direct electronic access is the ability to exercise discretion in relation to the exact fraction of a second of order entry and the lifetime of an order. The recitals provide that arrangements that allow clients to transmit orders to an investment firm in an electronic format, such as online brokerage, should be not be considered direct electronic access, provided that clients do not have the ability to determine the fraction of a second of order entry and the life time of orders within that time frame.

Commodity derivatives

Section C.6 of Annex I of MIFID II expands the list of financial instruments to include commodity derivatives that can be physically settled and traded on an OTF. Wholesale energy products as defined by REMIT that must be physically settled are excluded. A contract must be physically settled if it contains provisions which ensure that parties to the contract have proportionate arrangements in place to be able to make or take delivery of the underlying commodity.

Broadly, MIFID II contains transitional provisions exempting C6 energy derivative contracts of non-financial counterparties from the clearing obligations and risk mitigation under EMIR for three and a half years from its application. Information as to what constitutes an energy derivative contract relating to oil, coal and wholesale energy products has been provided. Contracts related to oil shale are not energy derivative contracts for these purposes.

ESMA's final advice considered whether amendments were necessary to specify derivative contracts in Section C7 of Annex 1 to MIFID II. These are defined as other derivative contracts relating to commodities such as options, futures, swaps, forwards and any other derivative that can be physically settled not otherwise mentioned in Section C6 and not being for commercial purposes. ESMA provided that C7 instruments should be standardised, traded on an EU or third country venue and not be spot contracts. It stated that commodity spot contracts should be understood as for delivery within two trading days or the period generally accepted in the market. ESMA proposed that over-the-counter contracts would be considered C7 financial instruments if they are equivalent to a contract traded on regulated market, MTF or an OTF. The Delegated Act provides that only those over-the-counter contracts which have all the same main features as exchange traded contracts (such as price and delivery and lot) will be considered C7 financial instruments so as to ensure that majority of the contracts used for physical delivery would not be captured by this definition.

Forex and financial instruments

There are differences in the national implementation of MIFID in respect of FX forwards and spots. MIFIR does not provide a definition for a spot FX contract. The Delegated Act defines a spot contract as a contract for exchange of one currency against another where delivery is scheduled to be made within: (i) 2 trading days in respect of any pair of the major currencies, e.g. US dollar, Euro, Sterling, although note this long(ish) list includes currencies such as the Croatian Koruna; (ii) the longer of 2 trading days or the period generally accepted in the market for that currency pair as the standard delivery period for any pair of currencies where at least one currency is not a major currency. Recital 12 provides that non deliverable forwards, options and swaps on currencies are not spot contracts. 

Where the contract for the exchange of those currencies is used for the main purpose of the sale or purchase of a transferable security or a unit in a collective investment undertaking, the period generally accepted in the market for the settlement of that transferable security or a unit in a collective investment undertaking as the standard delivery period or 5 trading days, whichever is shorter.

Organisational Requirements

Complaints handling

Investment firms are required to have in place and maintain a complaints management policy that provides clear, accurate and up-to-date information about the complaint handling process in relation to clients or potential clients. The policy must be endorsed by the management body. Investment firms are also required to publish the details of the process to be followed when handling a complaint and provide it to a client on request. Investment firms should permit complaints to be submitted free of charge and are also required to set up a complaints management function. Firms will be required to communicate to clients in plain language and respond to complaints without undue delay. Firms will need to ensure that the compliance function analyses complaints and complaints handling data, so as to ensure that risks are identified and addressed.

Conflicts of interest policy

Further information is given in relation to the content of a conflicts of interest policy which must include (among other things) the circumstances which constitute or may give rise to a conflict of interest entailing a risk of damage to the interests of one or more clients, as well as the procedures to be followed and measures to be adopted in order to prevent or manage such conflicts. Investment firms will be required to assess and periodically review, on an at least annual basis, the conflicts of interest policy and shall take all appropriate measures to address any deficiencies.

Fair, clear and not misleading

Further information is given in relation to satisfying the requirement that information addressed to retail and professional clients is fair, clear and not misleading. Information to investors should fairly and prominently address risks, using a font size at least equal to the predominant font size used throughout the information provided, as well as layout ensuring such indication is prominent.

Best execution

Further detail is given on the conditions and nature of the procedures and arrangements for best execution and the possible deviations from prompt execution, as well as the different methods through which an investment firm can be deemed to have met its obligations to disclose not immediately executable client limit orders to the market.

When executing orders or taking a decision to deal in OTC products, including bespoke products, investment firms are required to check the fairness of the price proposed to the client, by gathering market data used in the estimation of the price of such product and, where possible, by comparing with similar or comparable products.

The Delegated Act outlines the criteria for determining the importance of the price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to execution. These include: the characteristics of the client; the characteristics of the order; and the characteristics of the execution venues to which that order can be directed.

Firms are required to provide clients details on the execution policy and these details include an account of the relative importance the investment firms assigns to the best execution factors; factors used for selecting an execution venue; and specific execution strategies used.

Provision of information on a reasonable commercial basis

MiFID II and MiFIR contain provisions to ensure that trading data are made available on a reasonable commercial basis. Fees charged by trading data providers would have to be cost-based and transparent. Additional safeguards such as unbundling, non-discrimination and per user charging apply.

Data publication obligations for systematic internalisers

Systematic internalisers are required to make quotes public on a regular and continuous basis during normal trading hours. This is defined as making the quotes available, at all times, during the hours which the systematic internaliser has established and published in advance as its normal trading hours.

The requirements for systematic internalisers to make data machine readable and human-readable are expanded on and defined. Quotes are published in human readable format where:

• the content of the quote is in a format which can be understood by the average reader;
• the quote is published on the systematic internaliser's website and the website's homepage contains clear instructions for accessing the quote.

Portfolio compression

Further information is given in relation to the required documentation of portfolio compression i.e. an agreement with the participants to portfolio compression setting out the portfolio compression process and it the legal effects and method for determining whether the combined notional value following compression is less than the combined notional value before compression. Publication requirements in relation to portfolio compression include:

• a list of derivatives submitted for inclusion in the portfolio compression;
• a list of derivatives replacing the terminated derivatives;
• a list of derivatives changed or terminated as a result of the portfolio compression; and
• the number of derivatives and their value expressed in terms of notional amount.

SME growth markets

MiFID II introduces an "SME growth market" label. It applies where at least 50 per cent of issuers admitted to trading on that market are SMEs. Operators of SME growth markets are given flexibility in terms of evaluating the appropriateness for issuers for admission. The operator of an SME growth market is required to demonstrate to its competent authority that it applies criteria which are effective in ensuring that issuers are "appropriate" for admission to trading on its venue.

Position reporting thresholds in relation to commodity derivatives

A trading venue must make public a weekly position report for a specific commodity derivative or emission allowances or derivative when both of the following thresholds are met:

• 20 open position holders exist in a given contract on a given trading venue; and
• the absolute amount of the gross long or short volume of total open interest, expressed in the number of lots of the relevant commodity derivative, exceeds a level of four times the deliverable supply in the same commodity derivative, expressed in number of lots.

ESMA had recommended that the obligation should apply when there are at least 30 open position holders