Monday 26 February 2007

There is more to achieving MiFID compliance than writing a compliance manual

Achieving MiFID compliance is an interesting process. Contrary to other regulations (e.g. Capital Adequacy - Basel II) the majority of the work is not 'algorithmic' but procedural. Also, every section of MiFID compliance seems to affect operations, systems and internal controls throughout the whole institution.

Here are a two main examples

MiFID introduces some major conceptual changes in operations and these changes will require changes in attitude, behaviour and policies; a change that is far more difficult to implement than new reporting and/or changes in IT.

Client classification.
The criteria are different and the mapping is not 1-1 with the old categories. Some client will change (higher threshold) and the opt out rules are different. What is very different though is that there is a common basic criteria of classification throughout Europe, the client will be classified in the same way by all the operators in the market. Unless they opt to give up some protection with financial institution A but not with financial institution B (highly unlikely). What is more important is the need to involve clients in this process, inform them of their status, disclose best execution policy (see below) and get their proactive approval to those policies. Classification will have an impact on the execution policies and procedures and will ultimately affect the audit trail (which by the way if the institution has links with the USA and therefore is subject to Sarbanes-Oxley will require some fine tuning and checks to make sure that MiFID compliance does not throw SOX compliance out of the proverbial window).
This may also impact reference data and require changes in all the Client related software systems.

Best execution
First of all the seminal change is that best execution will not be just best value, but will be extended to highest likelihood of achieving a positive end of the trade (e.g. settlement, payment, etc.). If the trade is not with a recognised exchange or with a MTF this may require collecting some more information on the counterparty (e.g. if said counterparty fails an AML check there will be no trade), of course reasonability will prevail but you get the idea.
Multeplicity of trading venues (and the possibility of bypassing stock exchanges completely) represent the second big change, best execution policy will have to list the venue(s) normally used to execute an order for that specific financial instrument and the criteria behind the choice within those venues. I somehow assume that the majority of institution will introduce multiple venues slowly but ultimately they will (the FSA clearly mentions reasonable criteria for this). Transparency of trade requires a level of disclosure that will push them in that direction.
Best execution policy and processes must be proactively approved by clients and revised regularly, the clients need to be informed of those revision and approve them. One interpretation of the rule is that OTC instruments need to have their own best execution policy that needs be approved by the client each time, given that OTCs are by their very nature unique and tailor made.
These changes (if any) are primarily procedural, changes in procedures will drive changes in IT, relationship with supplier of market data and changes in the audit trail

These two are probably the most difficult changes to make for those institutions that were not included in the FSD and are now included in MiFID (e.g. commodity traders and a number of hedge funds).

What is even more interesting is the changes required in the Organisation Chart. There is more emphasis on the 'functional independence' of compliance and risk control and outsourcing arrangements will have to be reviewed to make sure that they meet the relevant requirements. Companies will have to make relevant adjustments to business continuity policies; risk assessment, management and mitigation policies; internal audit and administrative and accounting procedures.

All those changes will have an effect on the Operational Risk Profile of the company and therefore may temporarily impact Capital Adequacy (according to Basel II principles)

And yes... there are changes in transaction reporting as well.

All of this has to be achieved by November 1st (less than 180 working days away). Implementing Capital Adequacy criteria was faster, operationally less complex and had more time to achieve full compliance.

Thursday 22 February 2007

Let's be practical - First step towards compliance

Several websites have a sort of MiFID countdown. There are 252 days to November 1st, and that includes weekends, holidays, etc. Not a long time isn't it ?


So what do you do if you have not started yet ?


First of all do not sit hoping to find some pre-packaged, pre-prepared standard implementation solution. You may possibly solve the IT side of MiFID in this way but that would not solve the policies and procedures side and what's more there still be the need to integrate the rest of your IT system. You need to act and act now, so where do you start ?


The first thing to do is assess the impact of MiFID for your organisation.


Look at your organisation chart, look at what you do (traded product, advisory services, research advice, relationship to clients, etc.) and most of all look at what else will be indirectly affected by the changes brought in to become MiFID compliant. Areas likely to be affected are market data, reference data, audit trail, client reporting, financial reporting and you also will need to review all the literature you distribute to clients and the relevant contractual documentation (from standard terms and conditions to clients agreement, etc.). Bear in mind that best execution means more than best value and that you will have the possibility of using more than one trading venue. Last but not least consider your other regulatory requirements, MiFID is not going to exist in isolation. Bear in mind that during the transition to full compliance and for some time after that your Operational Risk will increase and that will affect Basel II, also MiFID will have an impact on your audit trail and therefore if you have to be Sarbanes-Oxley compliant you have to look at that as well. Also MiFID has introduced changes in the Conduct of Business rules, make sure you have considered those changes as wel


Second - Gap Analysis

You have your scope, you have the list of policies and procedures to define or revise, you know what you have to do with IT. You now need to define what you have to do to get there and also what are the dependencies and how many work streams you need to create.

Third - Classify your client, define your best execution policy and make sure you have a proactive agreements from your clients, define your other new policies and procedures

Fourth Run two parallel (but co-ordinated) projects - IT and new policies and procedures. This is really important. If you read this from the UK you need to make sure that your policies and procedures are implemented by everybody in your organisation.


Make sure you have expert advice at hand, you will need legal advice in your communication with clients and supplier and whenever there is the need to interpret vague points in the directive. Your new audit trail also needs to be reviewed by an expert especially if you have to be SOX compliance as well.

This has probably not helped very much, but there are only about 180 working days to go. Do not think that MiFID is just for equity, if you deal in any of the following (and this is a summarised list) you have to be MiFID compliant:

transferable securities, money market instruments, units in collective investment undertakings, options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies interest rates or yields, derivative instruments for the transfer of credit risk, financial contract for differences [N.B. This list is not exhaustive]

Last January 65% of compliance officer questioned in the City thought that MiFID only affected institutions that deal in equity, that is obviously wrong. With about 180 working days to go to November 1st the time for action is now. Unfortunately a lot of smaller companies are in wait and see mode, how do you think we can better educate our peers ?

Wednesday 21 February 2007

MiFID and Passporting: reality, dream or nightmare ?

Charles McCreevy - EU internal market commissioner - has doubts about the implementation of the 'dream' of a single Europe-wide rule book. Are those doubts justified ?


Speaking at a City event organised by UK Treasury, he admitted that translation of 27 regulators with different level of gold plating of the EU rules will not create a single rule book. On the other hand, looking at the content of the directive, does it really matter ?

The concept of a single market for financial services predates MiFID. The idea of being licenced to operate within the EU (actually within the EEA, i.e. EU plus Switzerland, Norway and Iceland) simply by being supervised by one regulator existed already, except the vague definition of the division of competence between the 'home' regulator and the 'host' regulator allowed some countries to make life very difficult for EU based financial institutions that wanted to enter their market.

MiFID was meant to put a stop to that, clarifying the competences between the two regulators. So does it really matter if the gold plating of local bureaucrats (one of their favourite pastime) creates 27 different rule books ?

In principle, a single rule book is very important, but it is less important than a clarity in the division of competence. What stops the single market in financial services is not different rules for different jurisdictions, it is the invisible - and visible - barriers that a regulator can (until Nov. 1st, 2007) put up to make life difficult for a company that wants to open an office in the jurisdiction.

However the blame for this lack of clarity must be shared with all market partecipants, there are (21/02/2007) 8 months and five working days to full implementation and a lot of market participants have failed to wake up to the practical and operational aspects of MiFID. There are a lot of people out there who have not completely grasped the practical consequences of the possibility of using multiple venue to trade financial instruments and there is a generic lack of urgency amongst companies that were outside the rule book and now have to become MiFID compliant. (Astonishingly, 65% of compliance officer questioned in London a month ago still thought that MiFID only affected equity trading)

Level One and Level Two implementation of MiFID are still vague, those affected do not seem to have made enough noise about achieving clarity. Lack of clarity on one side and lack of leadership on the other side are far more dangerous (and therefore a far worse nightmare) than 27 different rule books.


Tuesday 20 February 2007

A few myths about MiFID

MiFID has a way of impacting all side of operations: from changing the meaning of best execution to affecting the way a financial institution sources market data; from the concept that process and procedures behind an execution of an order on every financial product traded has to be shared with clients (and ultimately getting their approval) to transparency of trade reports. Companies will have to create process and procedures, review them on a regular basis and prove to clients and to the regulators that these procedures are followed.

MiFID expands the coverage of the old Financial Service Directive, that means that a whole new group of companies (e.g. commodity traders) that were outside the FSD are now included in MiFID

A lot of experts have discussed MiFID; law firms, experts, professionals have all discussed the big principle behind MiFID. Very few have discussed practicalities and the implication of becoming MiFID compliant; probably because the final Instruments were published by the FSA only a few weeks ago. In the meantime a few myths and a few dangerous claims have appeared in financial markets around Europe.

Myth number 1: Best execution in MiFID only refers to equity. In a survey of compliance officers of London based brokers, hedge funds and commodity traders, over 60% have implied that MiFID does not really affect them because they do not trade in equity. Well, Annex 1, section C of MiFID lists the financial instruments under MiFID[1] and they cover far more than equity. Now, within the boundary of reasonability, each instrument traded needs a best execution policy that has to be regularly updated and shared with clients. It could be argued that there must be policies for retail clients and policies for professional clients. OTC products do not escape that completely, since they are unique and taylor made they may require agreement with the client as far as execution policy is concerned. Now best execution under MiFID means more than just best value, it also means lowest costs, likelihood of execution and settlement, and any other relevant factor that may influence the execution of the order. Financial instrument traded in regulated markets and or in Multi-lateral Trading Facilities (MTF) will require listing venues regularly used and why and that list will have to be regularly updated (and shared with clients).

Myth number 2: Clients will have to be classified in each instrument, this is partly correct but in practical terms it will be far simpler for a company, especially smaller institutions, to reach a common classification for clients.

Myth number 3: bolt-on solutions. A lot of MiFID compliance requirements involve process and procedures. In many ways, these represent some of the features that allow a business to differentiate from the competition. The FSA in his translation of the EU rules has increased the emphasis of process and procedure; unfortunately this negates a standard, good for all solution. Some part of MiFID could be standardised;on the other hand, trade reports are strictly related to processes and procedures that define best execution. MiFID will also have to live side by side with existing regulatory requirement. That will have an impact on reference data, how market data are sourced and used within the companies, all the trading software, and a lot more within a company.

Myth number 4: Client classification is straightforward. On one hand, it is true. On the other hand, MiFID allows trading outside regulated markets, therefore an institution may conceivably find itself executing both sides of the trade. For this reason a conflict of interest policy has to be in place and… of course, shared with the client.




MiFID is not all pain. MiFID will make it easier to operate in other EEA markets, it defines the relationship between the ‘home’ regulator and the ‘host’ regulator. This is a huge contribution to the single market for financial services. MiFID will also allow institution to trade beyond the obvious regulated market in their jurisdiction, it opens up the competition between exchanges, it creates the role of Multi-lateral Trading Facilities (MTF) and ultimately will bring down the cost of trading. Exchanges (from stock exchanges to derivative markets, from commodities exchanges to FX exchanges) will loose the ability to exclusively influence the value of the financial instrument traded.

MiFID has been compared to Big Bang 2. There is too much to gain by London as a financial centre for the FSA to become flexible on November 1st. The time for practical action is now. There is little time to wait. Being compliant with MiFID will not be particularly onerous, becoming compliant will not be cheap, quick or easy.



[1] The products listed include: transferable securities, money market instruments, units in collective investment undertakings, options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies interest rates or yields, derivative instruments for the transfer of credit risk, financial contract for differences, etc. etc. etc.