MiFID II: How Did We Get Here and What Does It Mean?
As the industry has been preparing for the implementation of MiFID II (Markets in Financial Instruments Directive II) in 2018, so too has Trading Technologies been working closely with our clients on planning and executing compliance solutions. Over the next few months, I will be sharing my thoughts and TT’s point of view on MiFID II and industry implications. We begin the first in a series of blog posts with what is MiFID, how did we get here and what does it all mean?
MiFID II is a consequential and reactionary financial regulation born from MiFID I and the same G20 Pittsburgh meeting in 2009 that instigated the blueprints of its older siblings, Dodd-Frank, EMIR, REITS and, recently, the seemingly stalled Regulation Automated Trading (Reg AT), post the 2008 financial crash.
Dodd-Frank accompanied with the Commodity Futures Trading Commission (CFTC) regulations and the European Market Infrastructure Regulation (EMIR) are derivatives reporting transparency requirements pursuing similar purposes, yet they have differing approaches in the U.S. and EU respectively. Sounding first on July 21, 2010, the U.S. regulatory starting pistol fired into staggered effect the requirement that historical interest and index credit default swaps transactions be reported by Direct Clearing Organisations (DCOs) to a trade repository. Incrementally, further types of contributors transaction reported additional asset classes over a successive period of time in stark contrast to EMIR.
By comparison, EMIR’s ambitions sounded via regulatory multi asset class blunderbuss, commencing with equity, foreign exchange, credit, commodities and interest rate swaps from the outset on August 16 2012. Contrary to the U.S., where only one counterparty can be deemed responsible for transaction reporting, EMIR requires that both counterparties report or permit third-party reporting delegation to a clearing broker et al. Dodd-Frank stipulates reporting obligations for swaps, EMIR captures both exchange traded derivatives and over-the-counter (OTC) transactions respectively. The use of collateral is weighted more significantly to form part of the extensive reporting information captured by EMIR. Both transatlantic regulatory initiatives target similar high-level outcomes, but each was arguably fed by differing market compositions, abilities to normalize existing transactional data and respective legislative oversights.
CONTINUING FROM EMIR’S GRANULARITY: MIFID II
The European Securities and Markets Authority (ESMA), adhering to political pressure, drew up an extensive family tree of proposed regulatory recitals and articles in its efforts to protect the investor and, arguably, the markets from themselves against systemic risk and algorithmically caused disorder. The modi operandi comprises two legal conduits, MiFID II and MiFIR (Markets in Financial Instruments Regulation).
MiFID II and MiFIR come into effect January 3, 2018 across the EU.
Since the publication of ESMA’s Technical Advice to the European Commission on December 19, 2014, this regulatory framework has undergone a tri-tiered equivalence to fractional distillation, exposing articles to the heat of marketplace scrutiny during rounds of consultation papers and subsequent questions and answers into a more universally and palatably accepted tonic.
Tactically, ESMA’s new-build regulation diverges from its equities-centric MiFID I foundations. Implementation is focused squarely and equally by all EU Members States’ National Competent Authorities across almost all financial instruments traded in European markets, OTC or listed, cash or derivatives.
The core principles of MiFID II regulation are to:
- Improve investor protection
- Reduce the risks of a disorderly market
- Reduce systemic risks
- Increase the efficiency of financial markets and reduce unnecessary costs for participants
Investor protection is brought into effect by a swath of measures to ensure investment firms treat their customers fairly, adhere to improved transparency, and implement these changes at the center of their business and corporate models. The legislation seeks to improve clarity of product design and investment information to customers, apply best execution monitoring and reporting across asset classes, and bolster protection against investment research (RDR-style) rules on inducements to portfolio managers, to name a few.
REDUCTION OF DISORDERLY MARKETS AND REDUCTION IN SYSTEMIC RISKS
MiFID II and MiFIR transparency requirements significantly enhance EMIR’s transactional reporting foundations. This framework targets listed and OTC markets in financial instruments, including economically equivalent contracts (EEOTC) for pre-trade and post-trade order and execution disclosures respectively submitted on trading venues. MiFIR extends MiFID I’s equity-centric pre-trade transparency product requirements to include:
- Emission allowances
- Exchange traded funds (ETFs)
- Depository receipts
- Structured products on a regulated market
Microstructural changes introduce and expand trading venues to include regulated markets (RM), multilateral trading facilities (MTFs) and organized trading facilities (OTFs) to cater for these newly included asset classes. Transparency requirements pertaining to MiFID II instruments comprise two key components:
- Pre- and post-trade order disclosure on trading venues
- Transaction reporting to National Competent Authorities
In the former case, transactional disclosure will vary across differing instruments and trading types (e.g., central listed order book, quote-driven, hybrid and auction trading systems) to provide greater depth of market clarity and support monitoring systemic risks, respectively. Pre-trade and post-trade public disclosure of orders, quotes, indications of interest (IOIs) and executions on trading venues will be subject to NCA waive discretion dependent on normal market size and instrument liquidity. Post-trade execution data outside of fair commercial arrangements is to be made publically available after 15 minutes without charge.
Investment firms will be subject to transactional reporting obligations on a T+1 basis to the relevant NCA. In addition, position reports in commodity derivatives, emission allowances and their EEOTCs are to be disclosed in aggregation by trade businesses conforming to pre-defined ancillary tests to determine and segregate genuine market hedgers from speculators.
MiFID II requires 65 transactional reporting fields with respective tags to be implemented where applicable in order and execution API and FIX protocol messaging. Identification of the client, investment decision maker and trader (human or algorithm) are amongst the Legal Identifier tags including Direct Electronic Access (DEA), waivers and their abbreviated short codes that are included for reconciliation between investment firms, trading venues and CCPs. HFT authorized businesses will require relevant order and transactional reporting to be measured in one microsecond, UTC GPS precision.
The above is simply a snapshot as to MiFID II’s origins and some of the issues investment firms and market participants will face come next January.
In my next blog post, I will dive deeper into implications and effects of MiFID II on algos.