On 15 December 2015, the FCA published its first consultation paper on the implementation of the Markets in Financial Instruments Directive II (MiFID II) (Consultation Paper 15/43: Markets in Financial Instruments Directive II implementation – Consultation Paper I (CP15/43)).
CP15/43 had been anticipated for quite some time having appeared a number of times in the forthcoming publications section of previous FCA Policy development updates. Like many recent regulatory papers on MiFID II the first thing that strikes readers is its length, being some 297 pages long. Whilst firms are digesting the FCA’s proposals over the Christmas holidays this client briefing picks out 10 key points.
1 | What is in and what is out
In CP15/43 the FCA consults on issues concerning the regulation of secondary trading of financial instruments. It covers:
- trading venues: (i) regulated markets (RMs) – issues around new obligations relating to algorithmic and high frequency trading, direct electronic access, tick sizes, business continuity and systems and controls. The FCA proposes to make changes to the Recognised Investment Exchanges sourcebook (REC); (ii) multilateral trading facilities (MTFs) – changes to the requirements for MTFs. The FCA proposes changes to chapter 5 of the Market Conduct sourcebook (MAR 5); and (iii) organised trading facilities (OTFs) – the FCA is proposing to introduce a new MAR 5A that will cover issues around the requirements for this new category of trading venue;
- systematic internalisers: whilst many of the changes to the systematic internaliser regime are being introduced by Markets in Financial Instruments Regulation (MiFIR) the FCA proposes amendments to MAR 6;
- transparency: the expansion of transparency requirements to equity-like and non-equity markets, including the approach to pre-trade transparency waivers and post-trade transparency deferrals. The FCA is proposing changes to certain sections of the Handbook including REC, MAR 5 and the new MAR 5A;
- market data: the introduction of the new Data Reporting Services Provider (DRSP) category of firms and their responsibilities, and transaction reporting. The FCA is seeking views on proposals within a new chapter of the Handbook, MAR 9 on DRSPs, and whether it should apply MiFID II’s transaction reporting obligations to managers of collective investment undertakings and pension funds;
- algorithmic and high frequency trading requirements: proposals relating to the controls for MTFs and OTFs which can be found in MAR 5 and 5A, and those for trading firms in the new MAR 7A. The FCA’s proposals cover, among other things, business continuity, systems and controls, financial crime and market abuse, direct electronic access and tick sizes;
- passporting and UK branches of non-European Economic Area (EEA) firms: the FCA addresses the technical changes it feels are necessary to make the correct references to the new MiFID II provisions and highlights the harmonised forms required for passporting notifications. The proposed changes predominantly apply to the Supervision manual (SUP). The FCA also wishes to ensure that UK branches of non-EEA firms are subject to the same rules as investment firms when undertaking investment services and activities;
- Principles for Businesses (PRIN): the FCA takes account of the extension in MiFID II of some conduct of business obligations and proposes extending the application of some of the principles, to include firms that conduct business with clients categorised as eligible counterparties (ECPs); and
- the Perimeter Guidance manual (PERG): MiFID II introduces some changes to the scope of investment services and activities and financial instruments, with the FCA proposing to revise parts of PERG 13.
The FCA notes that MiFIR and the regulatory and implementing technical standards (RTS and ITS) apply directly in the UK and generally do not require changes to UK law or rules to have effect. Consequently the FCA is not consulting on the following market issues:
- the double volume cap mechanism to restrict the ‘dark’ trading of equity and equity-like financial instruments (article 5 MiFIR);
- the trading obligation in shares (article 23 MiFIR);
- the obligation of investment firms to maintain records of transactions, and of trading venues to keep data relating to orders (article 25 MiFIR);
- transaction reporting (article 26 MiFIR);
- the obligation to supply instrument reference data (article 27 MiFIR);
- the obligation to trade on an RM, MTF or OTF (article 28 MiFIR);
- the clearing obligation for derivatives traded on an RM and the timing of acceptance for clearing (article 29 MiFIR);
- portfolio compression (article 31 MiFIR); and
- non-discriminatory access to central counterparties and trading venues and non-discriminatory access to, and obligation to, licenced benchmarks (articles 35 to 38 MiFIR).
The FCA states that it will consult on the other MiFID II changes that it needs to make to its Handbook, including the conduct issues covered in its earlier discussion paper, in the first half of 2016. The FCA understands that the PRA will also consult in 2016 on the changes it needs to make to its Rulebook.
2 | Organised trading facilities
The FCA states that it expects instruments not subject to the trading obligation to be traded through OTFs and gives the example via market making schemes. The regulator also adds that the key difference between OTFs and MTFs is the ability of an OTF to use discretion when matching buying and selling interests, provided the use of discretion is in line with fair and orderly trading and with best execution obligations to clients.
The FCA is proposing to insert an additional chapter, MAR 5A, that will contain the rules that apply specifically to OTFs. MAR 5A will contain some of the more general requirements that will also apply to MTFs, thus duplicating some of MAR 5.
The FCA notes that investment firms operating an OTF will be subject to similar financial resources requirements as investment firms operating MTFs, as set out in the Capital Requirements Directive IV and Capital Requirements Regulation (CRR). These rules are implemented in the Prudential sourcebook for Investment Firms (IFPRU) and the CRR (which is directly applicable). As with investment firms currently operating MTFs, the FCA also notes that investment firms operating an OTF will also have to comply with the Bank Recovery and Resolution Directive. This requires such firms to produce recovery plans and also submit data relevant to resolution. These rules are located in IFPRU 11.
3 | Transparency - waivers and deferrals
The FCA continues to believe that pre-trade transparency waivers are important to ensure an appropriate balance between transparency and liquidity in equities markets. Under MiFID II it proposes to grant waivers to RMs and MTFs trading equity and equity-like instruments where the use of the waiver meets the conditions set out in the EU legislation.
The FCA supports greater transparency in non-equity markets but feels that careful calibration is required. The FCA proposes to use its power to grant waivers from pre-trade transparency but within the conditions set by the relevant RTS.
In relation to the waiver application process the FCA states that it will in due course publish a MiFID II Permissions and Notifications Guide, to share more specific step-by-step information about how to apply for waivers.
MiFID II gives Member State competent authorities the power to grant authorisation for post-trade deferrals. The FCA will extend current practice and require market operators and investment firms operating a trading venue to apply for authorisation to defer the publication of details of transactions. In relation to equity deferrals the FCA feels that maintaining consistency with the approach taken under MiFID II is key and that it is inclined to authorise deferrals in large in scale transactions in accordance with the relevant RTS. For non-equity deferrals the FCA is also inclined to follow the conditions set out in MiFID II and the relevant RTS.
4 | Data Reporting Service Providers
The FCA proposes to add a new MAR 9. The chapter will provide entities with directions and guidance about how DRSPs can apply to become authorised or to extend, vary or cancel an authorisation. It will also cover certain other matters such as the FCA’s supervisory approach, and how a DRSP can notify the regulator of important information such as changes to its management body. Frequently Asked Questions will also be inserted into the chapter including those relating to a trading venue operator seeking verification of its rights to provide data reporting services, and to the process for addressing connectivity requirements for Approved Reporting Mechanisms.
MAR 9 will be read in conjunction with the Financial Services and Markets Act 2000 (Data Reporting Services) Regulations 2016 (currently in draft form), Title V of MiFID II as well as the relevant RTS and ITS. In its MiFID II Permissions and Notifications Guide the FCA will provide further information about how to apply to become a DRSP.
It is also worth noting that there will be a one-off and annual fees for becoming authorised and operating a DRSP.
5 | Transaction reporting
Previously the FCA extended MiFID’s transaction reporting obligations to managers of collective investment undertakings and pension funds. These managers were not directly caught by the Directive as they were exempt from it under article 2(1)(h) to the extent they acted in their capacity as a manager. For the purposes of MiFID II the FCA states that it has reviewed the likely costs and benefits of applying the new transaction reporting requirements to these managers, who remain exempt under the recast Directive. As a result it has decided, at this stage, not to apply the article 26 MiFIR transaction reporting obligations to managers of collective investment undertakings and pension funds. The draft SUP 17 instrument contained in Appendix 1 of CP15/43 reflects this decision. However, the FCA states that following the implementation of MiFID II it may review its decision and re-evaluate the position.
Article 17 MiFID II gives Member State competent authorities a choice regarding the frequency of the reporting requirements imposed on a firm regarding engagement in algorithmic strategies and systems and the provision of direct electronic access. The choice is to have either regular or ad-hoc reports. Having considered the other reports that it will receive the FCA has decided to request ad-hoc reports.
6 | Algorithmic and high frequency trading
The FCA is proposing changes to MAR 5 and additional provisions in a new MAR 5A in order to transpose the provisions in Title III of MiFID II that apply high-level systems and controls requirements for algorithmic trading to MTFs and OTFs. Where more detailed requirements are contained in the RTS the FCA proposes to provide references in its Handbook.
In particular in order to prevent market crashes due to a ‘fat finger’ trade entry, or the submission of erroneous trades, MAR 5.3A.2(5) and MAR 5A.5.2(5) require MTFs and OTFs to have mechanisms to manage volatility. These mechanisms include the need to have in place systems and controls to reject orders that exceed predetermined volume and price thresholds, or those that are clearly erroneous.
MAR 5.3A.14 and MAR 5A.5.14 will mandate the MTF or OTF to adopt and enforce the minimum tick sizes that are found in the RTS.
The FCA is also proposing to introduce a new MAR 7A to give effect to article 17 MiFID II which contains systems and controls requirements for investment firms undertaking algorithmic trading. More detailed requirements can be found in certain of the RTS. As some of the proposed content in MAR 7A is closely linked to certain provisions in SYSC the FCA intends to include flags in the relevant parts of SYSC to point the reader to MAR 7A.
Furthermore the FCA notes that in its current Handbook there are references to the European Securities and Markets Authority’s (ESMA) 2012 automated trading guidelines. The references to these guidelines will be removed and replaced with references to the relevant MiFID II text.
7 | Passporting
MiFID II makes certain incremental changes to the passporting regime under MiFID. For example the range of investment services and activities that can be passported has expanded to include the operation of an OTF. The range of instruments has also expanded to include a new category of emission allowances. In addition, there will be harmonised templates for notifications for firms making passporting applications (set out in RTS). These will replace the templates that EU Member State competent authorities agreed on under MiFID in the CESR ‘Protocol on Passporting Notifications’.
Firms will need to assess whether they need to revise their existing passporting notifications because of the change of scope between MiFID and MiFID II. While existing passports will remain valid under MiFID II, firms may wish to revise their passports in order to add new activities or instruments.
8 | Principles for Businesses
PRIN currently applies to MiFID ECP business as follows: (i) Principles 1, 2, 6 and 9 are dis-applied to a firm when carrying on ECP business; (ii) Principle 7 is partially applied for business undertaken with ECPs under MiFID with only the requirement to communicate information to ECPs in a way that is not misleading; and (iii) Principle 8 is dis-applied for ECP business, although the general conflicts rules under SYSC 10 apply to business with ECPs. For non-designated investment business (for example accepting deposits) a firm may choose to comply with Principles 6, 7, 8 and 9 as if all of its clients were customers. Alternatively, it may choose to distinguish between ECPs and customers in complying with those Principles.
The FCA is now proposing to apply Principles 1, 2, 6, 7 and 8 in full to firms when conducting business with ECPs under MiFID II. In addition, PRIN 1 Annex 1 will be updated to remove the possibility of firms categorising local authorities as ECPs for non-designated investment businesses.
The FCA adds that it needs to consider further whether it should re-evaluate the application of PRIN to ECPs for non-designated investment business. However, this would require a more detailed market failure analysis, and a more extensive pre-consultation with the industry, than is possible under the MiFID II implementation timetable. The FCA proposes to give further consideration to the broader policy implementation in the first half of next year.
9 | PERG
The FCA is proposing to make certain changes to PERG. This will include the scope changes in MiFID II and the amendments to the Regulated Activities Order on which HM Treasury consulted in March 2015. In particular the existing flowcharts and tables in the annexes to PERG 13 have been updated and the FCA proposes to update them further when the delegated acts are finalised (see below).
The FCA will issue a later consultation to address the issues relating to scope matters as these will be expanded on in the delegated acts. Therefore, it has generally not covered matters relating to derivatives including foreign exchange and commodity derivatives. Also, questions about exemptions, including those in respect of commodity business, will be addressed at a later stage.
The FCA notes that as the focus of PERG is to describe the circumstances when authorisation is needed it proposes to remove PERG 13.6 (CRD IV and CAD) in due course. However, given that firms have found this material to be useful, the regulator does not propose to delete it but rather move it to another location. So far the FCA has not settled on the timing for doing this.
10 | FCA MiFID II Handbook Guide
Appendix II of CP15/43 contains a draft MiFID II Handbook Guide that will eventually sit alongside the Handbook changes. The guide is intended to clarify how the FCA’s approach to implementing MiFID II is addressed through its sourcebooks. The guide can be expanded to cover other firms and other areas of MiFID II when the FCA issues further consultations if respondents consider it helpful.
For firms wishing to comment on CP15/43 the deadline is 8 March 2016.
Whilst the FCA has now begun its formal consultation process with more papers expected in 2016 firms would be well advised to keep in mind that the European process is not yet complete and may impact the UK materials. ESMA gave the European Commission technical advice on the delegated acts a year ago in December 2014. The delegated acts cover mainly issues around conduct of business and organisational requirements for investment firms. In June and September 2015, ESMA sent most of the draft technical standards to the Commission. These covered mainly issues related to the secondary trading of financial instruments. In CP15/43 the FCA states that it expects to see the delegated acts and technical standards to be completed in the first half of 2016.
The timing of MiFID II is also uppermost in everyone’s mind. At the time of writing there are on-going discussions taking place between the Commission, the European Parliament and the Council of the European Union about whether the date of application of MiFID II should be delayed by a year. Unfortunately, CP15/43 gives no further insight as to whether the delay will happen with the FCA stating that “if there is a change to the legislated timetable, our implementation plans will take that into account.” Even if there is a delay the sheer volume of paper and the breadth of topics that are in and out of CP15/43 reminds firms of the huge task that lies ahead of them and they would be well advised to keep MiFID II on their “to-do” list for 2016.