MiFID II Series #7 – FCA's Consultation Paper I

On 14 December 2015, the FCA published the first of a series of MiFID II Consultation Papers, this one covering the markets elements of MiFIR.

Given that most of the requirements are contained in the Regulation, there is relatively little for the FCA to consult on. And the CP makes clear that the FCA is not intending to consult at all on some

MTFs

MTFs will be required to have at least three active members. New guidance, to be contained in MAR, will contain the restriction on the operator engaging in proprietary trading in the MTF. The FCA has put forward the view that this does not prevent the operator of an MTF from proprietary trading or matched principal trading outside the MTF. In other words, a single firm can be both a normal broker and provide MTF functionality. It is likely that other regulators in the EU will take a different view.

OTFs

MiFID II introduces this new category of trading venue. It is aimed at broker crossing networks and dark pools, although how many businesses will remain sufficiently static to be captured by this measure is not clear.

Firms that are caught as OTFs are not allowed to execute client orders against their own capital (or that of any entity in their group). But they can engage in matched principal trading where the clients have agreed.

An entity operating an OTF cannot allow it to interact with an SI (nor also to operate an SI), nor can liquidity on one OTF interact with that of another.

Systematic internalisers

The SI provisions are contained in MiFIR, and are therefore directly applicable. FCA proposes to delete most of its existing handbook provisions dealing with SIs, and merely cross-refer to the relevant parts of MiFIR.

Trading Venues & Contract Formation

In relation to the definitions of MTF/OTF, the FCA has noted that the combined effect of Articles 4(19) and 1(7) in MiFID II, is that the MiFID requirement that a contract is executed under the system's rules by means of the system's protocols is now a sufficient, but not necessary, condition to be a multilateral system and hence to be regulated as a trading venue. Instead, the FCA notes, it is required that an order is able to interact in the system. The FCA states that the MiFID II definition of a multilateral system is broader than the existing MiFID I definition (i.e. it captures more within it) and that the condition for orders to interact in the system does not require that a contract is executed under the system's rules.

So what does all this mean for the market?

The first point is that it could include a lot of systems and practices that are currently performed under the umbrella of brokerage activity. However, we do not think that the FCA is trying to target agency voice brokers here, although the FCA's comments on Articles 1(7) and 4(19) could be construed in this manner. Instead we consider that the FCA is aiming its crosshairs at unregulated platforms/systems which have previously argued that they are not trading venues because contracts do not form directly under their systems.

Clearly more detail is needed in this area and guidance is required (perhaps from ESMA level 3?).

Transparency waivers

The FCA proposes to take the option (a rare event in MiFID II, national discretion!) to grant waivers to RMs and MTFs trading equity and equity like instruments where the following waivers are to be utilised:

• Reference price;
• Negotiated transactions;
• Large in scale;
• Order management facilities.

However, the FCA is not yet convinced that it should use its option to permit a further group of exemptions, and intends to consult further on whether or not to do so. Key exemptions falling into this category include:

• Permitting a number of transactions to be aggregated over the course of a day and disclosed before 9.00 am on the following trading day.
• For non-equity instruments other than sovereign debt, publishing information on transactions aggregated over the course of a week by 9.00 am on the Tuesday of the following week.

Transaction reporting

Under MiFID, FCA extended transaction reporting obligations to fund managers who were exempt from MiFID (under article 2(1)(h)). The FCA has changed its mind – presumably because it knows that the brokers are currently largely transaction reporting on behalf of the managers. So it seems as though, in the UK, there will be no transaction reporting obligation on MiFID-exempt UK-based asset managers. This is a welcome development, and should reduce some of the tension between the buy and sell side when it comes to whose transaction reporting obligation it may be. 

Structured deposits

The FCA has pointed out that a firm cannot get a passport to sell structured deposits because they are not a financial instrument under MiFID. The PRA/CRD route needs to be used instead in order to provide EUwide access for such products. This may help the banks issuing the product, but not intermediaries selling it.

FCA's general principles

MiFID II increases the level of investor protection afforded to both Professional Clients and Eligible Counterparties. In particular, several of the principles for business do not apply to business with Eligible Counterparties. FCA intends to change that by extending the following principles to business undertaken with ECs.

• 1 – to act with integrity.
• 2 – to act with due skill, care and diligence.
• 6 – to pay due regards to the interest of customers and treat them fairly (a fair treatment principle applying between counterparties is a novel concept).
• 7 – communications must be clear, fair and not misleading (again, an unusual concept between counterparties who ought to be eye-to-eye with each other).
• 8 – a firm must manage conflicts of interest fairly (with, again, fair treatment on a conflict between counterparties being a somewhat novel position).

Next steps

With the EU process only partly complete, and a delay for MiFID II looming, the FCA has gone ahead and consulted on a limited number of areas where it has sufficient confidence that the position at an EU level is final. This does mean that many of the key conduct controversies remain outstanding to be covered in further FCA consultations, promised in the first half of 2016.