Including updates on MiFID II, short selling and advice on payment services


EC publish final MiFID II proposals

On 20 October, the European Commission published its long-awaited formal legislative proposals to amend the Markets in Financial Instruments Directive (MiFID II). MiFID II consisting of two parallel pieces of legislation: a Directive repealing Directive 2004/39/EC, and a Regulation focusing primarily on all requirements relating to market and supervisory disclosure. The Commission, at the same time, issued its proposals for amending the EU’s market abuse regime.

The original MiFID framework was geared towards improving market efficiency by breaking the dominance of national stock exchanges and enabling the development of new trading platforms. However, these changes coupled with technology advances, resulted in the fragmentation of market structures and data and the financial crisis also surfaced other weaknesses in the regime.

Therefore, MiFID II goes much further then the originally planned 3-year refresh and, if enacted, will result in a ‘complete overhaul’ in the way in which financial markets operate, according to EU Internal Market and Services Commissioner Michel Barnier. It will bring light to many dark pools of liquidity and dark orders, regulation to high frequency trading, and an end to the ‘reign’ of OTC transactions. In addition to upgrading the current regime for equities markets, MiFID II proposes to extend this revised regime to a far wider range of product classes, including fixed income products and derivatives, including commodities derivatives. It will pare down the existing exemptions from the regime so more financial market players will find themselves subject to the full regime. It will have significant strategic repercussions for firms undertaking investment business in all securities markets. The key proposals include:
  • Organised trading facility: Definition of a new type of trading venue within the regulatory framework – an organised trading facility (OTF) – designed to capture all forms of organised trading platform not included in the current regulated market and MTF categories. All OTFs will be subjected to the same transparency requirements as other trading venues and be prohibited from trading against proprietary capital.
  • The Systematic Internaliser regime will be reinforced: any trading against proprietary capital will flag SI activity unless clearly dealing on own account.
  • New disclosure requirements for trading venues: Trading venues will be required to publish annual data on execution quality.
  • High frequency trading: New safeguards for algorithmic and high frequency trading activities, including a requirement for all algorithmic trading systems to become properly regulated and to provide liquidity and introduce measures to reduce market volatility.
  • Extension of scope: The enhanced transparency regime for equities markets will be extended to ‘equity like’ products, such as structured deposits, exchange traded funds, and certificates: a similar regime will be introduced for non-equities, tailored by asset class. Emission allowances and spot commodity markets are also in scope. Pre-trade reporting requirements will apply to indications of interest in both equity and non-equity markets.
  • Transaction reporting requirements will be revisited: fields for a client and ‘trader’ identifier will be included: there may also be moves to rationalise disparate TR requirements across Member States.
  • Banning products: Under certain conditions, national regulators will be able to permanently ban specific products, services or practices if these jeopardise market stability or customer protection. The European Securities and Markets Authority (ESMA) will be able to introduce similar measures on a temporary basis.
  • Commodity derivative markets: Commodity derivative traders may not longer be exempt. There will be new position reporting obligations by category of trader in commodity derivative markets. National regulators will also have additional powers to monitor and intervene at any stage in trading activity in all commodity derivatives, including in the shape of position limits if there are concerns about disorderly markets.
  • Corporate governance: Increased focus on the responsibilities of the ‘management bodies’, particularly those responsible for ‘supervisory functions’, which involves amongst other things increased diversity in the boardroom.
  • Conduct of business requirements: A repositioning on conduct of business requirements and client information for all categories of clients, including eligible counterparties. Revisiting the concept of ‘independent’ investment advice and banning independent advisors and portfolio managers from making or receiving fees, commissions or other monetary benefits to/from their parties.
Looking at the market abuse regime, apart from ensuring that the regime is aligned to the broader scope of MiFID in relation to trading platforms, financial instruments covered, and regulated entities, the regime will explicitly target attempted market abuse as well as actual market abuse. The existing Directive (2003/6/EC) will be repealed and replaced by a Regulation. However, a new accompanying Directive aims to ensure that criminal sanctions are applied to all forms of actual and attempted market abuse are applied across the European Union.

Both the new MiFID and MAD proposals now pass to European Parliament and the Council for negotiation and adoption of the level 1 text: it is anticipated that these negotiations will take about a year. Work will probably commence in parallel on the implementing measures, but these will only be finalised once the Level 1 text is adopted. The Regulation and Directive in each case, together with the necessary technical rules for implementation, will come into force on the same date.

You can find more perspective on the final MiFID II proposals in our press release. We have also a dedicated website on MiFID II where you can subscribe to future alerts, find some of our thought leadership publications and take part in a special MiFID poll.


EU lawmakers agree permanent ban on naked short selling of CDS

According to the EC, following a year of lively debates, the European Parliament and the Council of the EU have reached agreement on imposing a permanent EU-wide ban on naked credit default swaps (CDS) trading. The agreed curbs and limits in relation to the European Commission’s proposed Regulation on short selling and certain aspects of credit default swaps will increase transparency and will also introduce restrictive rules on traders’ short-selling of bonds and shares which are admitted to trading on EU markets and in terms of buying credit insurance relating to EU sovereign debt.

National regulators have the option to lift the ban temporarily in cases where its sovereign debt market ‘is no longer functioning properly’. While the suspensions are finite, the bans can be rolled-over indefinitely and existing CDS positions can be grandfathered until they expire. For national regulators to invoke this ‘opt-out’ clause, they must submit a case to ESMA citing evidence of widening bond yield spreads, poor liquidity or exceptional market volatility. ESMA’s decision, though, will be non-binding, a clause which disappointed Parliament.

However, ESMA, under the proposals, will be given additional powers to act as an arbiter in instances where governments are seeking to introduce a short selling ban and even require other authorities to introduce short selling bans in stressed market conditions. This should allow for better coordination at the EU level in times of crisis which was lacking following the collapse of Lehman Brothers in 2008.

Moreover, the European Parliament and Council agreed to further strengthened requirements related to reporting and transparency in the draft Regulation. A lack of information was one of the main problems for supervisors before the crisis. The extra information to be provided to national and European supervisors will allow them to carry out ‘their preventive work better by alerting them earlier to potential risks’. For example, supervisors would be informed of large short positions already when this position accounts for 0.2% of the issued capital.

The deal arrived at by EU lawmakers followed a series of measures adopted by various EU members states such as Italy, Spain, Belgium and France which on 25 August 2011 extended their bans or put in place an indefinite prohibition on short-selling, which ESMA reviewed and coordinated.

Although the merits and effectiveness of banning CDS in preventing contagion remains controversial, EU lawmakers view the deal as fortifying ESMA’s arsenal in cracking down on short selling and sovereign debt speculation. According to Michel Barnier, EU Financial Services Commissioner, ‘these balanced measures will ensure that sovereign CDS are used for the purpose for which they were designed, hedging against risk of sovereign default, without putting at risk the proper functioning of sovereign-debt markets.’ However, critics argued that prohibiting traders from buying sovereign CDS as a ‘straight bet’ rather than a means of insuring against risk exposure will further increase sovereign borrowing costs.

Notably, the agreement does not impose the ban on non-EU based firms. Notification and disclosure requirements will apply, and EU supervisors are tasked with establishing cooperation agreements with third country supervisors to encourage adherence to the rules, but the Regulation does not extend to a full ‘third country regime’ which would impose the ban outside of the EU.

The next step is for the Council and the European Parliament to ratify the agreement. A plenary vote in Parliament is expected by the third week of November with subsequent adoption by the Council. The Regulation will come into force in November 2012.


Accessing the impact of extra capital buffers on G-SIBs

The impact of additional capital buffers for global systemically important banks (G-SIBs) will be marginal in terms of economic growth and lending activity, according to new research by the Bank for International Settlements (BIS). The BIS estimates that requiring the largest 30 banks to hold an additional 2% of capital over an eight year period will result in a 0.04% fall in gross domestic product (GDP), and a 31 basis points increase in lending spreads. Any fall-off in economic activity will be more than off-set in terms of reducing the probability of systemic crisis and subsequent costly bank bail-out which can have long-lasting effects on the economy, according to the Basel-based institution. Notwithstanding the current deep crisis, historical experience seems to support this conclusion. Rogoff and Reinhart estimate that, following a major financial crisis, GDP declines by an average 9% over a six year cycle with public debt increasing by an average 86% based on data from over 200 major financial crises in the last two centuries.

The additional loss absorbency requirements of G-SIBs will range from 1% to 2.5% of Common Equity Tier 1, depending on the bank‘s importance, according to proposals published in June by the BIS. For banks facing the highest G-SIB surcharge, an additional loss absorbency buffer of 1% could be applied as a disincentive to increase materially their global systemic importance in the future. The higher capital requirements will be introduced in parallel with Basel III capital conservation and countercyclical buffers and will be fully effective on 1 January 2019. The BIS, in consultation with the Financial Stability Board and national authorities, is expected to determine which institutions these additional requirements will apply by the end of this year.

The results from the assessment will be used to try and convince countries to push ahead with proposals to improve the loss absorbency of G-SIBs when heads of State meet at next month’s G20 summit in Cannes. Since Basel III regime was agreed, there has been much debate over its impact on banks’ balance sheets and on the financial system’s ability to support broader economic growth. On one side, there are those who argue that there are significant macroeconomic benefits from raising bank equity: higher capital requirements, lower leverage and a reduced risk of bank bankruptcies. A contrary argument notes that Basel III will result in higher cost of equity financing relative to debt financing, which would lead banks to raise the price of their lending and could depress loan growth and stunt the already fragile global recovery.

However, the pendulum appears to be turning to those who argue that the benefits which accrue from higher capital requirements will exceed its costs in the long-run. Notwithstanding the BIS’s own research, an IMF working paper this summer demonstrated that the potential reduction in lending and investment following the implementation of Basel III ‘is not predicted to be substantial’. The IMF’s current models on loan rate and loan demand predict that a 130 basis points increase in the equity-to-asset ratio required by Basel III would increase large banks lending rates by 16 basis points, causing loan growth to decline by 1.3 percent in the long run. While the impact on lending will be small, the IMF notes that Basel III could result in incentives for regulatory arbitrage.

Other impact assessments (e.g. European Parliament) have reached similar conclusions (which is not surprising as they typically use the same data and underlying assumptions). However, more analysis is needed to understand these effects fully. For instance, if large complex financial institutions cannot mitigate the effect of higher capital costs, they may lose competitiveness and business to smaller institutions. This may result in the fragmentation of the global financial system as shareholders push for large institutions to be broken-up or downsized. Also, the role of large financial institutions may be underestimated by looking at raw data alone, given the range of services they provide to the entire financial system.


EC issues guidance on payment services

The European Commission has published some guidance on the supervision of payment institutions under the Payment Service Directive (PSD) and their reporting obligations under the anti-money laundering Directive (AMLD) in various cross-border situations.

Under the PSD, the authorisation of a payment institution is the responsibility of the home supervisor, who is called upon to work closely with host authorities. Once authorised, a payment institution is able to provide services in any other Member State under the freedom of establishment but is required to ‘respect’ various national rules and codes related to payment transactions, as well as national rules implementing the AMLD. So, it is possible for the host supervisors to express ‘serious concerns’ to the home supervisors about an agent of a payment institutions’ respect of the host country’s AML obligation. The home authorities, once alerted, may withdraw the agent’s registration.

Under the PSD, the host Member State is responsible for the prudential supervision of both branches and agents of payment institutions (unlike MiFID, for example, where responsibility for branches and tied agents rests with home supervisors). The guidance also tries to provide some clarity around how branches and agents of payment institutions are treated under the AMLD. Firstly, branches are individually subject to the AMLD obligations as if they were separate financial institutions. Agents of payment institutions are not considered as separate financial institutions under AMLD nor do they explicitly fall within any of the categories of entities covered under the directive. However, the EC explains that the territorial nature of the AMLD implies that agents themselves, acting on behalf of the payment institution, have to comply with AMLD requirements of the host country.

To ensure compliance with AMLD for retail agents not directly covered by the Directive, the EC recommends payment institutions either mandate their agents to perform AMLD obligations on their behalf or to restrict their activities to book entry and execution. The former scenario implies that the payment institution has supplied adequate resources (training etc.) to ensure the retail agents understand their obligations. However, even with appropriate training and adequate internal control mechanisms, retail agents such as grocery shops and petrol stations may still be inadequately suited to perform efficient due diligence (required for payments in excess of 15,000 euros), to identify possible suspicious activities or to prepare meaningful transaction reports to the host country’s financial intelligence unit. In fact, the growth of agents, which has mushroomed recently, is a point for concern for the Commission which sees it as posing a risk to terrorist financing and money laundering. Payment institutions may need to temper any future growth strategies until many of these issues are dealt with adequately by their compliance teams.