The EU Markets in Financial Instruments Directive (MiFID1) established a pan-European framework for the provision of investment services and the operation of markets. It has been in force since November 2007.
The existing MiFID1 framework is being substantially amended by new legislation (MiFID2) which comes into force in the EU with effect from 03 January 2018. In the UK, MiFID2 will still come into full force and effect, notwithstanding the Brexit vote to leave the EU.
Much attention has been given to the impact of the forthcoming MIFID2 regime on investment managers established in the EU. What is perhaps less appreciated, however, is that MiFID2 will also indirectly impact investment managers which are established outside of the EU (including APAC asset managers), if they fall within one or more of the four key trigger points for MiFID2 becoming relevant to a non-EU entity. In summary, MiFID2 will be indirectly applicable to APAC asset managers which:
- trade on European trading venues
- trade with (or are clients of) European counterparties
- market their funds and other products through European distributors, or
- provide investment management services directly to clients in the EU.
This note sets out a very high level summary of the key issues arising from MiFID2 which have a potential impact on the business of APAC asset managers.
2. Trading on EU trading venues
The first set of indirect MiFID2 issues arise as a result of an APAC asset manager trading in financial instruments which are admitted to trading on an EU trading venue (a regulated market, a multilateral trading facility or an organised trading facility).
2.1 Increased transparency on non-equity markets
MiFID1 already contains a requirement for EU trading venues to disclose pre-trade and post-trade information on prices for equities trading, along with a parallel obligation on EU investment firms to immediately print to the market details of off-exchange or over-the-counter (OTC) trading in listed equities. The obligation does not (under MiFID1) extend to equity-like instruments, nor to non-equities. Such markets are therefore relatively opaque at present, as compared to equities markets.
Under MiFID2, the pre-trade and post-trade transparency requirements are being significantly expanded:
- Wider range of instruments in scope: a wider range of equity-like instruments will be within scope of the price transparency regime, and non-equity instruments are also brought within scope of the regime, including bonds, derivatives, and structured finance products, where they are admitted to trading on an EU trading venue (and therefore currently opaque markets will become transparent).
- Wider range of trading venues in scope: MiFID2 newly regulates a wider range of trading venues, known as organised trading facilities (OTFs). OTFs include trading platforms such as broker-crossing networks and swap execution facilities.
An APAC asset manager will not be directly subject to any pre-trade or post-trade reporting obligations under MiFID2. The changes set out above could have an impact on price discovery and trading patterns on those markets, and market participates should also be aware many more of their trade details will be printed to the market.
2.2 Dark pools–double volume cap restrictions
MiFID1 contains a regime to allow dark pools to operate outside of the pre-trade price transparency rules for equities by means of a waiver from the pre-trade transparency rules. MiFID2 contains a regime which limits the ability of dark pools to make use of a waiver from the pre-trade price transparency rules, if two new volume cap restrictions are breached (the double volume cap):
- If the EU trading volumes in a particular equity instrument that are transacted on a particular dark pool during any rolling 12 month period exceed 4% of overall trading volumes in that instrument during that period, the dark pool in question will immediately lose the benefit of its pre-trade transparency waiver in relation to that specific equity for a six month period.
- If the EU trading volumes in a particular equity instrument that are transacted in aggregate across all EU dark pools during any rolling 12 month period exceed 8% of overall trading volumes in that instrument during that period, all EU dark pools will immediately lose the benefit of their pre-trade transparency waivers in relation to that specific equity, again for a six month period.
There are certain exemptions for large-in-scale orders.
The possibility of dark pool waivers being suspended for six months is likely to have a profound impact on the manner in which EU equities markets function and the way that asset managers execute their equities trades. As the relevant change affects the functioning of equity dark pools generally, APAC asset managers which currently trade via EU dark pools will be impacted if a particular dark pool loses the benefit of a transparency waiver.
2.3 Commodity derivatives – position limits and reporting
MiFID2 introduces two parallel regimes relating to commodity derivatives trading: position limits, and a position reporting regime. Unlike the majority of the provisions in MiFID2, these new regimes apply to all persons globally (in other words, they are directly applicable to APAC asset managers).
In respect of position limits, each EU regulator must impose limits on the size of a net position which a person can hold in commodity derivatives trading on a trading venue (or in economically equivalent OTC contracts). The baseline figure for calculating the position limits is 25% of the deliverable supply (although national regulators may amend this to a maximum of 35% or a minimum of 5%). In addition, trading venue operators will be empowered with position management controls which will enable them to monitor and manage positions, for example by requiring a person to terminate or reduce their positions. As noted, an APAC asset manager will be directly subject to these position limits, and so – if an APAC asset manager trades in EU commodity derivatives – it should consider how the position limits will impact on its business and update trading systems accordingly.
In addition, MiFID2 also introduces a new reporting regime for commodity derivatives requiring members or participants of EU trading venues to report their own commodity derivatives positions to the trading venue at least daily. An APAC asset manager that is a direct member of or participant in an EU trading venue will be directly subject to this position reporting regime.
3. Trading with EU counterparties
The second set of indirect MiFID2 issues arise as a result of an APAC asset manager having a trading relationship with, or being the client of, an EU broker, bank or trading counterparty. These issues arise principally as a result of the regulated status of that EU counterparty.
3.1 Equities – mandatory on-exchange trading
MiFID2 introduces a new requirement that an EU regulated firm may execute an equity trade only if it is on an EU trading venue (or with a firm which is a systematic internaliser or an equivalent venue in a third country). The instruments in scope for this requirement are any equities admitted to trading on any EU trading venue, including those with only a secondary listing in the EU (as is the case for a large proportion of the most liquid internationally traded stocks).
APAC asset managers will not be directly subject to this requirement. However, whenever an APAC asset manager trades with an EU bank or broker, that trading counterparty will be subject to the rule, and so there will be an indirect impact on APAC asset managers (due to the constraints on its counterparty). The effect of this rule is to introduce a substantial limit on the possibility of trading off-exchange or OTC in EU listed equities with EU counterparties.
3.2 Repapering and new terms of business, including conflicts rules
All EU regulated banks and brokers will (once MiFID2 comes into force) be subject to a range of revised and updated conduct of business and organisational requirements. This includes revised rules relating to best execution, conflicts of interest and disclosures of costs and charges. Certain of these organisational and conduct rules will require the relevant bank or broker to make new disclosures to its clients and obtain new consents from clients. We have seen EU banks and brokers documenting this by repapering clients, for example by issuing updated Terms of Business (TOBs) and Prime Brokerage Agreement and/or new client agreements.
There is the ability to negotiate the details of these changes. Impacted APAC asset managers may also wish to consider preparing and issuing a standard “MiFID2 side letter”, similar to that implemented in 2007 for MiFID1. Such a side letter may include the APAC asset manager’s baseline requirements or requests to EU counterparties, in areas where MiFID2 affords the EU firm a degree of discretion or choice in its conduct (including for example as to client classification).
One of the key changes to the conduct rules, to which an EU broker is subject, relates to conflicts of interest. MiFID2 clarifies what is expected of sell side firms–from a conflicts perspective–when underwriting or placing Initial Public Offerings (IPO) or secondary issuances. MiFID2 prohibits sell side firms from allocating issuances to clients either (a) to incentivise the payment of a large amount of fees for unrelated services provided by the EU firm or (b) which is conditional on the receipt of future orders or the purchase of any other service from the investment firm by a client. APAC asset managers may find that the manner in which IPOs and secondary issuances are allocated to them by their sell side service providers changes significantly, once MiFID2 has come into force.
3.3 Use of direct market access provided by EU broker
MiFID2 introduces new requirements on an EU bank or broker which offers direct market access (DMA) software, to allow its clients to trade on EU trading venues via its trading systems. APAC asset managers will be indirectly impacted by these requirements to the extent that they make use of DMA software offered by EU brokers.
EU DMA providers will be required to impose trading and credit thresholds on their clients, to have the benefit of monitoring rights and impose a set of appropriate standards as to the suitability of DMA traders. It will also be necessary for the broker to enter into a binding written agreement with the client, which deals with compliance with MiFID2, market abuse rules, and the trading venue rules. APAC asset managers should therefore anticipate their EU brokers seeking to enter into DMA agreements.
3.4 Transaction reporting by EU firms
MiFID1 contains an obligation on EU firms to report transactions in EU listed instruments to the local regulator (reporting privately to the national regulator on a T+1 basis). MiFID2 is extending the transaction reporting requirement to capture a wider range of instruments and trading venues, and also to increase the number of reporting fields, and the level of detail to be reported in a transaction report.
While APAC asset managers are not currently subject to the transaction reporting requirement, and will continue not to be subject to the requirement once MiFID2 comes into force, their EU counterparty need to obtain certain information from APAC asset managers in order to complete transaction report. APAC asset managers may also be required to have legal entity identifiers (LEI) in place for their trading entities. There are fears of a last minute rush for LEIs which may lead to a backlog in applications. Those without LEIs will be locked out of the EU’s markets.
4. Use of EU distributors
The third set of indirect MiFID2 issues arise as a result of an APAC asset manager appointing an EU distributor to market units or shares in its funds.
4.1 Product governance – use of EU distributor
MiFID2 introduces a new product governance regime which impacts EU “distributors” of investment products, such as third party introducers, selling agents, private banks, wealth managers, or financial advisers. The distributor rules apply to such EU firms which offer and/or recommend investment products and services to clients, including offering and selling fund units in alternative funds.
The relevant EU distributor firms will need to have in place explicit product governance arrangements. Where investment products are “manufactured” by non-MiFID firms such as APAC asset managers, such distributors must take all reasonable steps to ensure that the level of product information from the non-MiFID firm is of a reliable and adequate standard to be distributed in accordance with the distributor’s target market. While not being directly subject to the product governance rules as a manufacturer, an APAC Asset Manager will be indirectly impacted as a result of its relationship with EU distributors. This will require additional information to be provided to distributors and may also require certain contractual agreement to be renegotiated.
4.2 Inducements rules – payments of commission
MiFID1 already contains a set of rules, known as the “inducements” rules, which limit the situations in which an EU firm can receive payments and non-monetary benefits from third parties other than its client. MiFID2 significantly enhances the inducements rules, particularly in respect of independent financial advisers and portfolio managers.
APAC asset managers will not be directly subject to these rules, but will be indirectly impacted if and to the extent that it wishes to make payments to third parties which are EU MiFID firms. This may impact on an APAC asset manager if an EU distributor is required to re-negotiate distribution agreements in respect of commission payments, trail payments, retrocession payments, or similar.
Additionally, EU research providers that are MiFID firms will be obliged to price their research services separately from their execution services. It remains to be seen whether some of those research providers might seek to impose that pricing model on their investment manager clients globally, rather than just applying it to their clients in the EU.
5. Providing services to clients in the EU
The fourth and final set of indirect MiFID2 issues arise as a result of an APAC asset manager providing investment services to clients located in the EU, which could include clients within the same corporate group.
5.1 Providing services to EU firms – outsourcing and third country rules
Certain APAC asset managers may provide services to an EU firm under a delegation / outsourcing agreement (for example, where an EU firm is the primary investment manager on a client mandate, and then delegates sub-investment management functions to a non-EU affiliate). MiFID1 already contains outsourcing rules which govern this type of arrangement, and MiFID2 is updating those rules. As such, the relevant EU firm will likely need to revise its contractual relationship with its APAC asset managers to ensure compliance with the MiFID2 outsourcing rules.
Additionally, in order to provide investment management services to an EU based MiFID firm on an outsourced basis, the EU based investment management firm will need to satisfy itself that there is a co-operation agreement in place between its EU regulator and the non-EU regulator that regulates the activities of the APAC asset manager to which portfolio management activities have been delegated.
As per the existing rules under MiFID1, APAC asset managers may not conduct regulated business with retail and elective professional clients, unless such APAC asset managers have a permeant establishment in the EU (through a subsidiary or branch). In contrast, for services provided to per se professional clients and eligible counterparties, MiFID2 creates and new ‘third country regime’ whereby the third country firm may provide services if (a) they register with the ESMA, and (b) a positive equivalence decision has been made by the European Commission in relation to that third country firm’s home jurisdiction. No equivalence decisions have yet been made in respect of the APAC region, but regulators in Australia, Japan, Singapore and Hong Kong have expressed confidence they will be fast tracked, and they hope such determinations are in place before the 03 January 2018.
In each case, there is a “reverse enquiry” exemption (though this is different from that under AIFMD with which some APAC asset managers may be familiar).
6. Next steps
APAC asset managers that trade with EU counterparties should consider the following points well before 03 January 2018:
- If your trading entity does not have an LEI and it trades with EU counterparties, apply for an LEI as soon as possible.
- Are your investment and trading strategies prepared for your trading information (including pricing) to be printed to the market, and are these strategies ready to capitalise on the increased amount of data being made available to the market?
- Have you explored potential local law data protection issues arising out of the requirements to provide additional information to EU counterparties?
- We also suggest you speak to your EU counterparties to establish what, if anything, they require from you to continue trading after 03 January 2018. You may wish to ask:
- Will there be any changes to their services?
- Does any contractual documentation need amending (e.g. prime brokerage agreements, agreements governing direct electronic access and terms of business)?
- Do any systems and/or process need to be amended or established?
- In respect of research, will this still be bundled or is a formal budget now required?
Simmons & Simmons MiFID2 Manager is an online service which provides key information on how MiFID2 applies to particular firm types, the services and activities it provides/performs and to what sort of clients, analysing the requirements and producing a list of action points which may form the basis of an implementation project plan.