UK: MiFID - Analysis of FSA´s July consultation paper: Markets

FSA's latest consultation paper (CP06/14 - Implementing MiFID for Firms and Markets) was published on 31 July 2006. Here we look at the Markets section of the consultation paper which covers:

• Regulated markets: expansion of the regime for MiFID and the impact of the new transparency rules

• Multilateral trading facilities: the new regime and the impact of the new transparency rules

• The new pre-and post-trade transparency rules for investment firms trading equities OTC

• The changes to FSA's rules on transaction reporting

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FSA’s latest consultation paper (CP06/14 - Implementing MiFID for Firms and Markets) was published on 31 July 2006. Here we look at the Markets section of the consultation paper which covers:

MiFID introduces pre- and post-trade obligations to report information to the market concerning equities that are admitted to trading on a regulated market. Pre-trade transparency obligations are applied to regulated markets and multilateral trading facilities, as well as certain investment firms, called systematic internalisers, that deal on their own account on an organised, frequent and systematic basis. Post-trade transparency obligations apply to regulated markets, multilateral trading facilities and all investment firms.

Many firms will be required to look at pre-trade transparency requirements from a wider perspective than merely compliance – in many cases the new regime is likely to lead to a fundamental change in the business model, a development that is acknowledged by the FSA. Another related driver behind changes to the way in which firms will operate in the post-MiFID landscape are the new best execution requirements (see FSA’s discussion paper DP 06/3). If you are interested in our analysis of these requirements then please contact Nick Paul.

The RM regime under MiFID expands on the corresponding regime under the Investment Services Directive (‘ISD’), and covers the broader range of MiFID financial instruments including markets for commodity derivatives. Under MiFID market operators will be required to seek authorisation to operate an RM. As a result of the widening of scope, some market operators whose exchanges are currently recognised under the UK regime for Recognised Investment Exchanges, such as the London Metal Exchange and ICE, will be able to apply for RM status for their exchanges under MiFID.

The MiFID requirements for RMs will be mainly implemented by amendments to UK legislation, in particular FSMA and the Recognition Requirements Regulations (‘RRRs’). HM Treasury has already proposed these changes in their consultation document on UK implementation of MiFID of 15 December 2005. Building on this, FSA has proposed some changes to rules and guidance already given in its sourcebook on Recognised Investment Exchanges (REC).

The most significant changes for RMs are the requirements for trading transparency, and the FSA’s powers to suspend or remove financial instruments from trading.

MiFID introduces a new "core" investment service/activity of operating an MTF. An MTF is described as a multilateral system that brings together multiple third party buying and selling interests in financial instruments, on a non-discretionary basis, in a way that results in a contract, in accordance with MiFID’s rules on conduct of business. As with RMs, the MTF definition extends to all classes of MiFID financial instruments, including commodity derivatives and other non-equities.

Both market operators (who may also operate RMs) and investment firms will be able to operate MTFs. Potential examples of MTFs in the UK include AIM, operated by a market operator (the London Stock Exchange) and Instinet, operated by an investment firm (Instinet). Investment firms wishing to conduct the activity of operating an MTF will therefore be faced with the dual burden of complying with both the MTF regime, and the rules applying to investment firms, including the new conduct of business and capital adequacy requirements of MiFID and the Capital Requirements Directive / recast Capital Adequacy Directive (to be implemented on 1 January 2007).

Operators of RMs who wish to also operate an MTF will be required, under the RRRs to comply with the MiFID requirements (under Title III of the MiFID framework directive), rather than any FSA-level regulation. For investment firms, the concept of operating an MTF will replace the existing FSA Handbook regime for operators of Alternative Trading Systems (found in MAR 5).

In addition to the transparency issues discussed below, MiFID will require operators of MTFs to have transparent rules concerning the instruments admitted to trading on their systems and the entities that may participate in their markets. Not all MTFs have such rules currently in place, and where they do, they may not be robust enough to satisfy MiFID’s requirements.

The transparency rules throughout MiFID, only apply in respect of equities that are admitted to trading on an RM (although they apply irrespective of whether the trade takes place on a trading platform or "over the counter" (‘OTC’)).

Although the concept of pre-trade transparency at the EU-level is new to RMs and MTFs, the LSE, for example, already fulfils many of the requirements. MiFID is however more prescriptive in terms of the exact information that RMs must make public concerning bid and offer prices and the depth of trading interest for each share.

MiFID allows FSA to waive the pre-trade publication obligations of RMs and MTFs in respect of certain market maker models, types of orders or sizes of orders. With respect to RMs, FSA intends to use its powers to waive the following from general pre-trade transparency: crossing systems (where the price is determined by reference to a price generated by another system), systems that formalise negotiated transactions in shares, orders held in an order management facility (pending those orders being disclosed to the market) and transactions that are larger than normal market size (as defined under MiFID, with reference to the liquidity of the share as measured by its average daily volume of trading). FSA is seeking feedback on whether it should use its powers to apply the same waivers to MTFs.

In practice there will be few high-impact changes to the pre-trade transparency already provided by RMs and MTFs, and, according to FSA, no change in relation to order-driven, quote-driven or hybrid models (e.g. markets combining order-books with orders placed by liquidity providers). The obligations will however be applied for the first time for request for quote services in order-book equities – firms that engage in this activity will be required to make public quotes.

Most trades in shares to which MiFID applies post-transparency obligations are already subject to post-trade transparency requirements, however MiFID extends to many trades executed in the UK in shares admitted to trading on non-UK (but EEA) RMs. MiFID also requires RMs and MTFs to publish more detailed information than they do under the present regime.

In terms of timing of publication, the general requirement is to publish information as close to real time as possible, within three minutes of the transaction being executed. Although the FSA intends to use its powers to allow RMs and MTFs to provide for deferred publication of the details of certain large transactions (to enable firms to protect risk positions), as permitted under MiFID, it encourages RMs providing block trading facilities to provide investment firms with the option for immediate publication where the shares traded are more liquid. Although the LSE already has a deferred publication regime, it anticipates the cost of implementing the changes to its block trade regime required by MiFID to be significant.

FSA intents to maintain transparency requirements for non-equity instruments traded on MTFs.

All investment firms that execute OTC trades in equities admitted to trading on an RM are subject to post-trade publication requirements under MiFID. However pre-trade requirements, which involve publishing and honouring firm pre-trade bid/offer quotes, are only applicable to some firms. These firms are referred to as systematic internalisers (‘SIs’) in respect of certain equities. Under MiFID, an investment firm, may be operating as an SI for a particular class of equities where it is trading against proprietary capital outside an RM / MTF (i.e. OTC) on an organised, frequent and systematic basis.

FSA distinguishes between fully matched back-to-back trading which does not fall within the definition of SI, and position taking which does. In the former situation the investment firm executes a client order as principal but the position it takes is fully matched by the client order at the time that it takes the position – the only risk exposure is to creditor risk that the counterparty will default. In the latter, the investment firm enters into a position (trading on its own capital) to execute an order on behalf of a client, although it may subsequently hedge its exposure, partially or completely, by taking a corresponding position on the market – it therefore has exposure to both market and creditor risk.

FSA has proposed two new chapters of their Market Conduct Sourcebook (‘MAR’) that will implement the MiFID pre-and post-trade transparency requirements: MAR 6 addresses pre-trade quoting obligations for SIs, and MAR 7 addresses post-trade publication requirements for all firms. The new rules will apply to all UK investment firms and UK branches of EEA firms, and the FSA is considering applying the requirements to UK branches of non-EEA firms.

Although various internal changes will be required under these provisions, firms will not require a variation of permission to continue acting as a SI, provided that their Part IV Permission includes dealing on own account and executing client orders. FSA expects firms to assess and determine, with reference to the MiFID provisions, whether they are an SI, and firms will be required to inform FSA in writing when they become, or cease to be an SI.

Whilst the OTC transparency requirements only relate to equities, the Commission is required under MiFID to report, by April 2007, on whether they should be extended to other financial instruments (such as bonds), and on shares not admitted to trading on an RM (such as AIM-listed shares). FSA has already consulted on transparency in the secondary bond market (in its discussion paper DP 05/5) and concluded that this asset class would not benefit from being subject to transparency obligations (see FSA’s feedback statement FS 06/4).

As with RMs and MTFs, trade transparency for investment firms only applies in respect of equities that are admitted to trading on an RM.

MiFID requires an SI executing transactions in equities admitted to trading on an RM, up to a standard market size, to publish firm quotes in respect of liquid shares for which it is an SI.

The liquidity qualification acknowledges the risk involved in issuing a firm quote in respect of an illiquid share, where the transaction may be costly to execute. FSA has discretion to apply either one, or both, of two tests for liquidity, and it intends to apply both. The first test concerns the volume of daily transactions (to be not less than 500) and the second concerns the daily turnover (to be not less than EUR 2m). Using these criteria jointly, FSA have determined 141 UK shares that would currently be "liquid" for the purpose of transparency obligations.

The obligation to provide a firm quote does not exist in respect of shares for which an investment firm makes OTC trades above standard market size. Shares will be allocated to a class depending on the average value of market transactions in them, and each class will be assigned a specific standard market size. For UK shares that meet the liquidity criteria, it is expected that the standard market size will range from EUR 7,000 to EUR 80,000.

The responsibility for classifying shares and assigning a standard market size will lie with the "relevant competent authority", which will be the regulator of the member state where the share was first admitted to trading on a regulated market.

Whilst the quotes must be visible to the public, SIs may have standards setting out the basis on which they will decide exactly which market participants they will give access to their quotes, provided that those standards are objective and non-discriminatory.

SIs are obliged under MiFID to execute a client order in a size up to standard market size at the price it is quoting when it receives the order. For non-retail clients, it may offer price improvement under certain circumstances.

In practice, FSA recognises that there are several ways in which investment firms may respond to pre-transparency requirements, and indeed they may choose to alter their business model to accommodate more than one of the following options:

• They may cease to be SIs and become a registered market-maker on an RM or MTF and execute the trades on-exchange.

• They may continue to execute OTC trades as SIs and arrange to make use of a compliant publication facility provided by an RM, MTF or 3rd party.

• They may continue to execute OTC trades as SIs and offer compliant pre-trade transparency themselves.

• They may choose to act solely in an agency capacity for the affected trades, referring orders to an execution venue that offers transparency itself.

• They may cease to provide execution services altogether for some or all of the trades affected.

8. Investment firms trading equities OTC: Post-trade transparency for systematic internalisers

Under MiFID, all investment firms undertaking OTC trades in equities admitted to trading on an RM will be obliged to make public the same information that would be available if they had concluded the transaction on an RM / MTF. They are offered a choice of publication venue (see below).

As with RMs and MTFs, post-trade transparency obligations must be fulfilled as close to real-time as possible (within 3 minutes), except where the transaction takes place outside of the normal hours of the investment firm – here the publication must be made before the opening of the next business day. As with RMs and MTFs, FSA proposes to allow investment firms to defer publication for certain large transactions.

The two key issues surrounding post-trade transparency for OTC equity trading are the party responsible for making the publication, and the means by which a firm publishes the information.

Investment firms must take all reasonable steps to ensure a transaction is published as a single transaction (a matched principal transaction is to be regarded as a single transaction). MiFID allows for parties to a transaction to agree which party must arrange for the information to be made public, however in the absence of such an agreement, the party responsible will be either the seller, the seller’s agent/arranger, the buyer’s agent/arranger or the buyer, depending on which party comes first in the above sequence. Therefore in most cases where there is no agreement, the obligation will fall on the seller.

RMs, MTFs and investment firms trading OTC are all required to make pre- and post-trade information available in a manner that is easily accessible to other market participants. Furthermore there are requirements to ensure that information is reliable and monitored continuously for errors (and corrected), is consolidated with data from other sources, and is made available on a reasonable and non-discriminatory commercial basis. FSA is recommending that pre-and post-trade publication arrangements should conform to a set of minimum standards, such that they:

• include a verification mechanism that is independent from the trading process - this process should be systematic and conducted in real-time;

• publish the information in a way that conforms to a consistent and structured format based on industry standards;

• make the information accessible by automated electronic means and in a machine-readable format; and

• be accompanied by instructions outlining how users can access the information.

FSA will consider guidance that will be issued by CESR in this area, before finalising its own Handbook guidance.

In addition to the above, FSA has expressed concern about the possibility of data fragmentation during post-trade publication. MiFID gives firms trading OTC a choice of facilities that it may use to publish post-trade information: they may either use the facilities of an RM, MTF, a 3rd party, or proprietary arrangements. FSA has anticipated an increase in the number of providers of trade processing services for OTC trades, which whilst bringing benefits in terms of competition, may reduce the overall quality of market data. Lower standards in the monitoring of data may reduce incentives for accurate publication, and could increase the incidence of market abuse, undermining MiFID’s overreaching transparency objective. FSA does not consider that market forces are sufficiently unhindered and incentivised to avoid this situation, and it considers that addressing any impact on price-formation, market efficiency, and market confidence retrospectively after fragmentation has occurred would be costly.

FSA has considered the possibility of itself being a provider of an information publication service, but it feels that this would involve it becoming a significant part of the market fabric, and that this would be too much of a departure from its current role.

Therefore it has proposed a "Trade Data Monitor" (TDM) framework under which firms could use a choice of FSA-approved TDM to meet their post-trade publication obligations. Using a TDM would not absolve a firm of its post-trade publication obligations, however, it would reduce the amount of due diligence required on the part of a firm, and provide a firm with a degree of certainty and comfort that it has complied with their obligations. As under MiFID, firms would still have the choice of trade publication facilitator (RM, MTF, 3rd party), and TDMs would come under the heading of third party providers.

FSA will impose minimum standards on TDMs relating to security of information, data integrity, timeliness and systems and resources. TDMs would be responsible for the real-time monitoring of the trades reported to them, and would arrange for the reporting firm to correct any incorrect information. TDMs may offer additional services for commercial reasons, and would be entitled to charge for the monitoring service they provide, whilst adopting a transparent, non-discriminatory pricing policy.

FSA has published draft Handbook text for SUP 17 to address the impact of MiFID on the existing transaction reporting regime. As well as amending the existing provisions (and deleting some where necessary) to bring the Handbook up to date, FSA have also proposed certain "gold-plating" measures where it feels that additional obligations are required to enable it to effectively monitor market activity.

In addition to its CP, FSA also plans to issue:

• a paper on our proposals in relation to Approved Reporting Mechanisms (ARMs). This paper has already been sent to the current permitted reporting systems and selected trade bodies; and

• a technically focused Transaction Reporting Users Pack, which FSA will publish by the end of 2006.

Under MiFID EEA-passported branches will be required to report the host state authorities, whereas under ISD firms are obliged to report to their own (home state) regulator. FSA’s transaction reporting rules will apply to these passported branches accordingly.

The MiFID transaction reporting regime does not apply to investment managers of pooled or collective investment funds, although they are currently subject to similar obligations under SUP 17. Furthermore, under the present regime, investment management firms are permitted to rely on the reports made by their brokers to satisfy their transaction reporting requirements. FSA recognises the concerns of investment managers and has indicated that some guidance may be helpful in situations where such firms do not themselves execute transactions. FSA will address these points in its CP on conduct of business due in October 2006, and intends to continue to apply the SUP regime to these entities.

MiFID requires a firm to make a transaction report when it executes transactions in financial instruments. This therefore extends the scope of transaction reporting to cover all MiFID instruments, including commodity, interest rate and foreign exchange derivatives that are admitted to trading on RMs (irrespective of where the trade takes place). This is reflected in the Handbook amendments. Similarly, obligations to report transactions in non-EU securities that are not admitted to trading on an RM have been removed. The rules under MiFID do however apply to non-EU securities that are listed on RMs, even where the transaction takes place on a non-EU execution venue.

In the interests of meeting its statutory requirement to maintain market confidence and reduce financial crime, FSA is proposing to exercise its discretion to widen the scope of the obligations. It proposes including all transactions carried out on prescribed markets (e.g. AIM and OFEX), and, in addition, transactions in OTC derivatives that are priced or valued by reference to either debt /equity instruments admitted to trading on a prescribed market, or indices constituted by instruments admitted to trading on a prescribed market.

MiFID has prescribed reporting fields that will increase current obligations on investment management firms and personal investment firms, who currently enjoy narrower reporting obligations than securities and futures firms. FSA propose to gold-plate some of the finer details of the transaction reports, such as adding additional instrument and client classifications.

Firms that are currently exempt from reporting to the FSA on the grounds that they transact on and report to one of the non-UK exchanges listed in Annex 1 to SUP 17 will, under MiFID, be required to report to the FSA instead.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 04/08/2006.