The sheer breadth and complexity of MiFID II is astounding and that is why many investment firms throughout the EU are finding navigating through the MiFID II maze a significant challenge. For instance, MiFID II not only covers more widely applicable areas such as trade reporting and transaction reporting, but it also covers more complex areas such as regulating commodity and over-the-counter derivative markets through the imposition of position limits and position reporting, algorithmic trading and high frequency trading (HFT), and direct electronic access (DEA). This whitepaper will seek to summarise certain areas under MiFID II which form core functions for investment firms, namely investor protection, product governance, best execution, and will then review trade reporting and transaction reporting issues in greater depth.
In light of the complex packaged risks such as residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDO) that lay at the heart of the sub-prime crisis, MiFID II seeks to ensure that investors are better protected through increased information disclosure and specific tailoring of the financial instrument (FI) to the specific needs of the client. Under MiFID II investment firms have a core duty to act honestly, fairly and professionally in accordance with the best interests of its clients when providing investment services or ancillary services to clients. Firms that provide advice must inform clients whether such advice is provided on an independent basis or not, and all information provided to clients (or potential clients) must be fair, clear and not misleading. Investment firms are also required to provide appropriate information in good time to clients (or potential clients) about the investment firm and its services, the FIs and proposed investment strategies, execution venues and all costs and related charges.
In essence, MiFID II seeks to ensure that investment firms are not manufacturing ‘ticking time bombs’ that have packaged risk in a way that is not discernible by the investor, and that they are not selling unsuitable FIs to clients simply to meet remuneration and sales targets.
Under MiFID II investment firms that are manufacturing FIs must now ensure that they are designed to meet the needs of an identified target market of end clients within the relevant category of clients. Investment firms must also ensure that the strategy for distributing FIs is compatible with the identified target market, and that it takes reasonable steps to ensure that the FI is distributed to the identified target market. If investment firms are offering or recommending FIs which they have not manufactured, they must ensure that they understand the FIs, and that they have assessed the compatibility of the FIs with the needs of the clients as well as taking account of the identified target market of end clients. Investment firms must only offer or recommend FIs when this is in the ultimate interest of the client.
Under MiFID II, when executing orders investment firms are obliged to take all sufficient steps to obtain the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature, or any other consideration relevant to the execution of the order. When executing orders on behalf of retail clients, investment firms must determine the best possible result in terms of the total consideration, representing the FI’s price and execution costs, and including all expenses incurred by the client directly relating to the execution of the order (including execution venue fees, clearing and settlement fees and any other fees paid to third parties involved in the execution of the order). Investment firms are also required to publish the top five execution venues in terms of all trading volumes for all executed clients orders for retail clients and professional clients. In addition to this, investment firms must make an annual public statement summarising an analysis and conclusions drawn from the firms’ detailed monitoring of the quality of execution obtained on the execution venues where it executed all client orders in the previous year. The new MiFID II best execution requirements mean that firms must adjust internal systems and controls to be able to provide more refined execution reporting and data evidencing compliance with the new MiFID II objective sufficiency standard.
For smaller and medium sized investment firms a mix of internal MiFID II operational revisions combined with MiFID II third party outsourcing arrangements may prove to be the optimal balance between operational efficiency and regulatory compliance cost-savings. Third party trade reporting via an APA and transaction reporting via an ARM may also allow investment firms to concentrate on implementing core MiFID II functions whilst at the same time leveraging the expertise of third party data reporting firms. MiFID II requires firms to undertake strategic decision-making in order for them to be able to put in place a MiFID II regulatory compliance framework that allows them to carry out more efficient operational practices whilst at the same time providing them with increased opportunities to develop new firm offerings or services.