One deal, two jurisdictions – interpreting competing jurisdiction clauses
The Court of Appeal has provided comfort to the derivatives market by giving a wide, commercial interpretation to an exclusive English jurisdiction clause.
The Markets in Financial Instruments Directive (MiFID) is one of the cornerstones of EU financial services law setting out which investment services and activities should be licensed across the EU and the organisational and conduct standards that those providing such services should comply with.
Following technical advice received from the European Securities and Markets Authority (ESMA) and a public consultation, the European Commission (the Commission) published legislative proposals in 2011 to amend MiFID by recasting it as a new Directive (MiFID II1) and a new Regulation (MiFIR2). The legislative proposals were the subject of intense political debate between the European Parliament, the Council of the EU, and the Commission. However, informal agreement between the EU institutions was finally reached in February 2014. The final MiFID II and MiFIR texts were published in the Official Journal of the EU on 12 June 2014 and entered into force 20 days later on 2 July 2014. Entry into application will follow 30 months after entry into force on 3 January 2017.
The implementing measures that will supplement MiFID II and MiFIR will take the form of delegated acts and technical standards. On 22 May 2014, ESMA released a consultation paper (the CP) setting out ESMA’s proposed advice to the Commission regarding delegated acts and a discussion paper (the DP) setting out ESMA’s proposals for technical standards. The deadline for responses to the CP and DP has now closed. ESMA is expected to provide advice on the delegated acts to the Commission by the end of 2014 and drafts of the technical standards by the middle of 2015.
MiFID II and MiFIR introduce a new category of trading venue, the organised trading facility (OTF). Alongside regulated markets (RMs) and multilateral trading facilities (MTFs), this will be a third type of multilateral system in which multiple buying and selling interests can interact in a way that results in contracts. However, unlike RMs and MTFs, an OTF will only relate to bonds, structured finance products, emission allowances or derivatives. Operating an OTF will be an investment service so a person wishing to do so will need to be licensed as an investment firm. The operator of a RM will also be able to operate an OTF.
The main distinction between RMs and MTFs on the one hand and OTFs on the other is that the execution of orders on an OTF is carried out on a discretionary basis. There are two different levels of discretion for the operator of an OTF: (i) when deciding to place or retract an order on the OTF, and (ii) when deciding not to match a specific client order with another order available in the system at a given time, provided it is in compliance with specific instructions received from a client and best execution obligations. The operator of an OTF that crosses clients’ orders may decide if, when and how much of two or more orders it wants to match within its system. The operator of an OTF that arranges transactions in non-equities may facilitate negotiation between clients so as to bring together two or more potentially compatible trading interests. As a result of this discretion, the operator of an OTF will owe certain conduct of business duties to its clients including acting in accordance with their best interests, appropriateness, best execution and order handling. Please see our briefing on conduct of business requirements for more information on these subjects.
The concept of an OTF does not include facilities where there is no genuine trade execution or arranging taking place in the system, such as bulletin boards, aggregation engines, electronic post-trade confirmation or portfolio compression arrangements.
As with RMs and MTFs, the operator of an OTF will not be permitted to trade against its proprietary capital and this ban also applies to the capital of any entity that is part of the OTF operator’s corporate group. However, there is an exception with regard to sovereign debt instruments for which there is no liquid market. Unlike the operator of a RM or MTF, an OTF operator is also permitted to engage in matched principal trading in bonds, structured finance products, emission allowances and derivatives that are not subject to the clearing obligation pursuant to EMIR provided the client consents to the process.
An operator of an OTF will not be permitted to be a systematic internaliser (SI), nor to connect with an SI in a way which enables orders in the OTF and orders or quotes in the SI to interact. An OTF will also not be permitted to connect with another OTF to enable interaction of orders between the two systems. It will be permissible for an OTF to engage market makers but any such investment firms must not have close links with the OTF operator.
One of the aims of MiFID II and MiFIR is to ensure that functionally similar activities are subject to a level playing field of regulation. The requirements that apply to the operators of RMs, MTFs and OTFs (trading venues) are therefore quite similar. Most of the organisational requirements that already apply to RMs and MTFs have been extended to OTFs. For example, they must all have transparent rules and procedures for fair and orderly trading and objective criteria for the efficient execution of orders, as well as transparent rules for determining which instruments can be traded and transparent, non-discriminatory and objective membership criteria. There are also new requirements relating to fee structures, which must be transparent, fair and non-discriminatory, and not create incentives that contribute to disorderly trading or market abuse.
All types of trading venue will be subject to enhanced and identical surveillance requirements with monitoring for compliance with their rules and monitoring of orders, cancellations and transactions undertaken in order to identify breaches, disorderly trading and market abuse. They will have to inform their home Member State competent authority of any such concerns. If a trading venue suspends or removes an instrument and any related derivatives from trading due to suspected market abuse or on the request of a Member State competent authority, other trading venues will be required to do the same, except where this could cause significant damage to investors’ interests or the orderly functioning of the market.
MiFID II and MiFIR aim to catch up with certain technological developments that outpaced MiFID. All trading venues will be required to have in place effective systems, procedures and arrangements to ensure their systems are resilient and have sufficient capacity to ensure orderly trading under severe stress, and have effective business continuity arrangements. There are also numerous requirements as to functionality, many of which will be further detailed in regulatory technical standards, including the ability to reject orders that exceed thresholds or are erroneous, halt or constrain orders and cancel, vary and correct transactions. There are also requirements as to tick sizes for certain instruments and synchronisation of business clocks.
Both trading platforms and investment firms face greater regulation in relation to algorithmic trading, market making and direct electronic access, with a number of new requirements relating to both functionality of systems used and formalising the relationship between trading venues and users. For more information, please see our briefing note on high frequency and algorithmic trading.
The new transparency and transaction reporting obligations in MiFIR apply to all three types of trading venue, albeit calibrated for different types of instrument and different types of trading, and to investment firms when trading financial instruments admitted to trading on a RM or traded on a MTF or OTF. The transaction reporting requirements will also be extended to financial instruments traded on an OTF or whose value depends on such an instrument. For more information, please see our briefing note on these subjects.
MiFIR will implement the G20 commitment that was not included in EMIR, to mandate the trading of standardised derivatives on exchanges and electronic platforms by requiring certain derivatives to be traded on a RM, MTF or OTF or certain trading venues in third countries that have been considered equivalent for that purpose and reciprocate by recognising EU trading venues. The obligation departs from the normal scope of MiFID II and MiFIR and applies to financial and non-financial counterparties that are subject to the clearing obligation in EMIR, as well as third country entities that would be subject to it if they were established in the EU and either trade with in-scope EU entities or other third country entities where their transactions could have a direct, substantial and foreseeable effect within the EU or it is appropriate to prevent evasion of MiFIR.
Regulatory technical standards will be developed to determine which derivatives will be subject to this trading obligation. It appears that the starting point will be those derivatives that are mandated for clearing under EMIR, however, ESMA may specify additional characteristics to create more granular categories than those subject to the clearing requirement under EMIR.
However, to be mandated for trading, the derivatives must also be traded on at least one trading venue and be considered to be sufficiently liquid, taking into account the average frequency and size of trades over a range of market conditions, the number and type of active market participants and the average size of spreads. ESMA must also consider the likely impact of listing a derivative on its liquidity and the commercial activity of end users, and may determine that a particular derivative is only sufficiently liquid in transactions below a certain size. However, ESMA also has an own initiative power to identify classes of derivatives that should be subject to the trading obligation but which no central counterparty (CCP) has been authorised to clear or which are not admitted to trading on a trading venue.
Investment firms will be required to trade shares that are admitted to trading on a RM or traded on a trading venue on a RM, MTF or SI or a third country trading venue that has been assessed as equivalent for these purposes. The obligation does not apply to trades that are non-systematic, ad hoc, irregular and infrequent, or are carried out between eligible and/or professional counterparties and do not contribute to the price discovery process (a test which will be fleshed out in regulatory technical standards). Whilst ESMA is mandated to specify the characteristics of transactions that “do not contribute to the price discovery process” in draft regulatory technical standards, ESMA is not required to include definitions of what is “non-systemic, ad hoc, irregular and infrequent”. However, ESMA has suggested that “infrequent” would be considered to be an activity which does not meet the frequency and systematic thresholds set out below for SIs and therefore the regulatory interpretation of “non-systemic, ad hoc, irregular and infrequent” would be even narrower than this.
An investment firm that operates an internal matching system which executes client orders in shares, depositary receipts, exchange traded funds, certificates and other similar financial instruments on a multilateral basis must be licensed to operate an MTF.
An SI is a firm which deals on own account when executing client orders outside a trading venue. The definition of an SI has been updated to reflect the introduction of OTFs, as well as to provide that a SI must deal on a substantial, as well as an organised, frequent and systematic basis.
The term “frequent and systemic” has been defined as the number of OTC trades in the financial instrument executed by the SI. In the CP, ESMA proposes that the frequency criteria is met if the number of OTC transactions executed by the SI in liquid instruments is, during the most recent calendar quarter, greater than a particular percentage of the total number of transactions in the relevant financial instrument in the EU in the same period. ESMA considers that for illiquid instruments, where it is not feasible to apply thresholds, an absolute number of transactions should be used, which will be set at different levels depending on the liquidity of the instrument.
The term “substantial basis” has been defined as being measured either by the amount of a specific financial instrument traded by the SI outside of trading venues in relation to the total trading of the SI in that financial instrument; or by the amount of OTC trading in a specific financial instrument carried out by the SI in relation to the total trading in the EU of that specific instrument.
ESMA’s suggestions from the CP are set out below.
|Frequent and Systemic basis (liquid instruments)||0.25% - 0.5%||2 - 3%||3 - 5%||2 - 4%||TBD|
|Frequent and Systemic basis|
|Absolute number of transactions TBD||At least once a week||At least once a week||At least once a week||TBD|
|Substantial basis (criteria 1)||15% - 25%||25%||30%||25%||TBD|
|Substantial basis (criteria 2)||0.25% - 0.5%||0.1% - 1.5%||1.5% - 3%||1.5% - 3%||TBD|
MiFIR also permits investment firms to opt into the SI regime where the quantitative thresholds are not met, provided it complies in full with all the requirements. Information on the pre-trade transparency requirements applicable to SIs is set out in our briefing note on transparency and transaction reporting.
CCPs are required to clear financial instruments on a non-discriminatory and transparent basis regardless of the trading venue on which a transaction is executed, although the CCP may require the trading venue to meet operational and technical requirements. The CCP may only grant access if a relevant Member State competent authority considers that this would not threaten the smooth and orderly functioning of the markets or, in certain cases relating to derivatives, where it would not require an interoperability arrangement. The CCP can only deny access under certain conditions to be defined in regulatory technical standards, but which will include the anticipated volume of transactions, the number and type of users, arrangements for managing operational risk and complexity and other factors creating significant risk. ESMA considered that access should be given wherever it does not give rise to risks that cannot be effectively managed or adequately mitigated and therefore access denial should be considered with the aim of achieving this objective. However, ESMA does recognise that differences in asset classes may need to be taken into account when considering access.
On a similar basis, a trading venue must, on request, provide trade feeds on a non-discriminatory and transparent basis to a CCP that wishes to clear transactions that are concluded on that trading venue.
There are also requirements on persons with proprietary rights in benchmarks to ensure that CCPs and trading venues are permitted access to relevant price and data feeds and information on composition, methodology and pricing for the purposes of clearing and trading and licences on a fair, reasonable and non-discriminatory basis. Access must be given on a reasonable commercial basis and taking into account the price at which access is granted on equivalent terms to other CCPs and trading venues. Different prices can only be charged where objectively justifiable.
Non-EU trading venues that are recognised for the purposes of the derivatives trading obligation and non-EU CCPs that are recognised as such under EMIR are permitted to make use of these access rights if the Commission has concluded that the relevant third country provides reciprocal access to its trading and clearing infrastructure to foreign trading venues and CCPs. There is a similar reciprocity requirement for third country trading venues and CCPs wishing to request a licence and access rights to a benchmark on the same terms as EU infrastructure.
MiFID II and MiFIR will introduce new requirements for firms wishing to carry on investment activities with and provide investment services to clients in the EU. In most cases, these will require third country entities to establish a branch and become licensed in the relevant Member States for business with retail and elective professional clients or to register with ESMA for business with per se professional clients and eligible counterparties. This regime is discussed in more detail in our briefing on the subject.
Directive on Markets in Financial Instruments repealing Directive 2004/39/EC and amending Directive 2011/61/EU and Directive 2002/92/EC.
Regulation on Markets in Financial Instruments and amending Regulation 648/2012.
The Court of Appeal has provided comfort to the derivatives market by giving a wide, commercial interpretation to an exclusive English jurisdiction clause.