MiFID II Series #15 - UK regulator publishes MiFID II papers (CP17/8 and PS17/5) 

On 31 March 2017, the FCA published its first policy statement PS 17/5 (First PS) and a fifth (unexpected) consultation paper CP17/8 (Fifth CP) on MiFID II. Together, these documents focus on markets issues, conflicts and some of the consequential changes that are needed to the FCA Handbook as a result (including for occupational pension scheme firms and commodity derivative trading). The first PS will be followed by a second policy statement  which will be the most eagerly awaited with some crucial confirmations on some of the key conduct of business changes under MiFID II.

The first policy statement

The FCA's First PS sets out the final rules that the FCA consulted on in CP15/43 (which we covered in our briefing here) and CP16/19 (which we covered in our briefing here), as well as some discrete parts of 16/29 (which we covered in our briefing here). The following is a brief summary of the key provisions.

Regulated Markets

The FCA is going ahead with its proposal to signpost the directly applicable EU regulations in REC rather than copying out. The draft handbook text in REC has also been amended to reflect revised implementing legislation from the Treasury which will affect direct electronic access (DEA) to align these provisions with those for MTFs and OTFs. The FCA has adopted a flexible transposition of the restriction on third country members of trading venues providing DEA access, which will permit some brokers based outside the EU to offer DEA access to their clients on UK venues. We understand that other continental regulators are likely to take a different view, applying more restrictive DEA access requirements to third countries.

MTFs

The key question on the perimeter guidance surrounding MTFs has been postponed until the FCA's next policy statement in June. The FCA has also parked the issue of what constitutes a multilateral system (although ESMA's Q&A on market structures which was published on 5 April after the FCA's PS was released, touches on what multilateral means).. The FCA is expected to publish its own interpretive guidance later.

On the restrictions on the use of proprietary capital including matched principal, the FCA will adopt the guidance it proposed in CP15/43 i.e. the operator cannot engage in proprietary trading in the MTF. The FCA is of the view this still allows the operator of an MTF to proprietary trade or engage in matched principal trading outside the MTF.

OTFs

The FCA has parked the issue of use of discretion by an OTF and whether this should be at a system level or on a trade-by-trade basis. The FCA has said that it will await Level 3 guidance from ESMA (which has now been published in the form of a Q&A on market structures) and has pointed to article 20(6) of MiFID II, which requires that OTF operators carry out the execution of orders on a discretionary basis and that an OTF operator may facilitate negotiations between clients so as to bring together two or more potentially compatible trading interest in a transaction. But that the use of discretion should not undermine non-discriminatory access. The FCA has gone on to say that the key difference between an MTF and a OTF is that an OTF 'can use discretion' and that indeed 'discretion must be a key and essential component of the operating of an OTF'. ESMA.

The FCA has also said that non-MiFID II instruments can be traded on an OTF but that participants would expect to receive a similar level of service with equivalent outcomes. The FCA has retained its position that OTFs can engage in matched principal trading so long as consent from the clients has been obtained and the OTF makes this clear in its rule book.

SIs

The FCA had little to do on SIs as the SI provisions are contained in MiFIR which is therefore directly applicable. One point, however, is that in its CP15/43 the FCA proposed that a notification requirement was turned off when a SI dealt above standard market size or the size specific to the instrument. The FCA has removed this provision and noted that, regardless of the size in which the firm trades, if a firm exceeds the relevant trading thresholds it is still an SI. The notification requirement applies when the firm becomes or ceases to be an SI regardless of the size they are trading or intend to trade.

Transparency waivers

In CP15/43 the FCA proposed taking the option to grant waivers to RMs and MTFs trading equity and equity like instruments in relation to: systems matching orders on the basis of a reference price; systems that formalise negotiated transactions; orders that are large in scale; and orders held in an order management facility. Respondents agreed with this proposal.

The FCA also consulted on whether it should authorise operators of trading venues and firms to defer the publication of post trade information in relation to large in scale transactions in shares, ETFs and DRs by investment firms acting as principal, to which respondents supported the proposal (more so than the FCA in CP15/43). The FCA will authorise deferrals of transactions in shares, ETFs and DRs as well as bonds, structured finance products, derivatives and emission allowances, provided conditions are met.

Transaction reporting

The FCA maintains its position that UK based asset managers and managers of pension funds will not need to transaction report. The FCA acknowledges, however, that this means that as a result these managers will potentially be brought into the group of members of trading venues that trading venues will have to report on behalf of under Article 26(5) MiFIR.

FCA's principles for business

As suggested in CP15/43, the FCA's Principles for Business 1 (act with integrity), 2 (act with due skill, care and diligence), 6 (pay due regards to the interests of customers and treat them fairly), 7 (clear, fair and not misleading communications) and 8 (manage conflicts of interest fairly) will be extended to apply to business with Eligible Counterparties for MiFID business.

(As a side note, the client categorisation of local authorities has been parked until the FCA's second policy statement in June.)

Commodity derivatives

In its CP15/43, the FCA proposed a new section of MAR to set out guidance and directions on MiFID II's regime of position limits, position management and position reporting for commodity derivatives (with position limits to be set in due course). The proposals were made before much of the Level 2 text on commodity derivatives had been published, however, the FCA does not agree that the Level 2 text makes a difference. MAR10 remains unchanged from the consultation paper.

Conflicts of interest

Conflicts has been a key issue for the FCA during MiFID II implementation. MiFID II requires firms to change from taking 'reasonable' steps to manage or prevent conflicts to taking 'appropriate' steps which requires much more active identification of conflicts. The FCA is clear that its view of the new disclosure requirements under MiFID II is that firms 'should only use disclosure as a measure of last resort'. This is the same message that it gave in CP16/19 and the FCA has gone on to reiterate that disclosure is not a form of management of conflicts. The FCA says that 'over reliance on disclosure without adequate consideration as to how conflicts may be appropriately managed is not permitted'. The FCA goes on to say that, when dealing with a self-created conflict of interest (such as payment for order flow), 'the most straightforward method of complying is to prevent the conflict from arising in the first place'. The FCA has not softened its approach in relation to these rules and notes that, despite a proportional approach, the FCA expects the industry to enhance conduct standards and ensure effective management of conflicts.

Taping

The regulator's response on some of the taping requirement proposals (which included extended the existing regime) has been postponed to the June policy statement (including for portfolio managers and corporate finance firms).

The FCA has communicated however that, for Article 3 retail financial advisers (but not MiFID RFAs), additional flexibility on taping requirements is appropriate and the FCA has allowed these firms to comply with 'at least analogous' requirement by either taping all relevant conversations or taking a written note. The note/taping decision should be a firmwide decision, rather than a decision dependent on the conversation. The FCA has also said that firms will not be able to rely on existing record keeping requirements (currently six months in the UK) as the outcomes should be analogous (and MiFID II has a five year record keeping requirement). Full rules will be published on this in the June policy statement.

The fifth consultation paper

The FCA's Fifth CP on MiFID II was a round-up of some of the leftover issues that remained to be dealt with.
In it, most importantly the FCA is consulting on changes required under MiFID II which will impact occupational pension scheme firms. OPS firms undertake investment management for a group occupational pension scheme or trust and . OPS firms are not caught by MiFID and this is not changing under MiFID II. However, OPS firms were already subject to COBS rules under MiFID and some MiFID II provisions affects key aspects of existing COBS rules such as best execution. The FCA previously asked (in its third MiFID II consultation paper) whether it should extend revised requirements on record keeping of client orders, decisions to deal and transactions to OPS firms. In this Fifth CP, it is now proposing to apply the MiFID II requirements to inducements and research, best execution and taping to OPS firms. The FCA is also proposing that two other sections of COBS will apply to OPS firms, COBS 11.3 on client order handling and COBS 11.7 on PA dealing. All other COBS provisions will be turned off for OPS firms. The FCA's proposals will mean that there is effectively a ban on OPS firms receiving inducements from third parties (except in the case of minor non-monetary benefits) and the MiFID II provisions on research will apply to OPS firms (i.e the OPS firm will need to pay for research itself or establish a research payment account). Best execution rules will become burdensome for OPS firms and they will be subject to the requirement to collate data and publish top five execution venues by instrument. Taping requirements will apply too when the OPS firm is carrying out certain activities (this is as a result of the discretionary investment management exemption being deleted), again this could be onerous for OPS firms who may not have any taping capability.

The FCA's Fifth CP also proposes changes to the FCA's decision procedure and penalties manual and its enforcement guide as a result of MiFID II. First, the FCA is amending DEPP and EG to reflect the obligation under MiFID II for it to establish and enforce net positions which persons may hold in commodity derivatives and economically equivalent OTCs. As these requirements apply to all firms (authorised and unauthorised) the FCA is proposing a standalone position limits regime which will apply to both. The FCA will therefore be able to limit the ability of a person to enter into a commodity derivative, restrict the size of the position a person may hold in such a contract, and to require a person to reduce the size of their holding (all of which will require notice to be given). The FCA is also amending DEPP and EG to reflect that it has a new power as set out under MiFID II to require a firm to remove people from their management board.

MiFID II requires member states to authorise data reporting service providers. In the UK, a data reporting service is not a regulated activity and the DRS Regulations create a regime outside the RAO. The DRS Regulations give the FCA regulatory power over DRSPs (including the ability to appoint investigators, impose public censures, limitations or other restrictions). The FCA is adding a new section to its EG to set out how it will apply its powers in relation to DRSPs.

Next steps

The deadline for responding to the Fifth CP is 23 June 2017 for the occupational pensions scheme firm issues and 12 May 2017 (a substantially shorter period) for the proposed changes to DEPP and financial instrument data reporting and commodity derivative positions. This latter deadline will allow the FCA to publish its rules in its second policy statement with a separate publication for the rules for OPS firms.

Otherwise, firms will be on tenterhooks for the publication of the policy statement which looks likely to contain some important information.