MiFID - Time to stop talking and start acting

The MiFID Permissions and Notifications guide recently published by the FSA gives a few indications as to how the FSA intends to manage the transition. So, what could be the potential issues behind a set of very tight deadlines ?

Client categories and mapping of permission. The FSA will map permission in a very clear cut basis, i.e. intermediate = professional, etc. Unfortunately the criteria to place clients in one category or another under MiFID do not exactly match the criteria currently being used under the ISD and BCD rules. Corporate clients usually were classified as intermediate, MiFID sets clear guidelines to decide when a corporate client is a professional client and when it is a retail client. So what happens if some of your client have ‘gone retail' and you cannot justify moving them to professional status? You should submit a VOP (Variation of Permission) application by August 1st, unfortunately the paper also says "If you apply for permission to deal with clients requiring higher level of protection, for example where a firm is dealing with retail clients for the first time, you will need to demonstrate to us that you have the necessary systems and controls in place to do so". Therefore your deadline of August 1st is not just for an application, but it is also for the "necessary systems and controls" that must be in place, or at least on their way to be "in place" by November 1st. The same chapter clearly states that even if you do not do MiFID business you will have to change your classification criteria eventually, with the deadline being July 1st, 2008 and the deadline for VOP applications being January 1st, 2007.

Passporting. If you do not do MiFID business and wish to ‘opt-in' to benefit from the advantage of passporting rules under MiFID or decide to opt-out of the exemptions you have an interesting situation if you want to have your non-UK operations up and running by November 1st. You should send your application immediately (MiFID sets out a maximum time period of five month for both home and host regulator to process a branch passporting notification). If you are already passported and you do not wish to extend your passporting to other financial instrument beyond the FSA mapping, you are fine. Otherwise act now. If you plan to work with tied agent outside the UK, a tied agent is considered a branch and will require passporting (and therefore following the five months maximum processing period, act now). If you are one of the "new" investment business (Commodity broker, spread betting, etc.) and need to passport - even if it is a passport for services, not a passport to open a branch - you should start working at it.

This two examples give you an overall idea of the change of attitude. The ‘transition guidelines' have arrived and it is now time to stop thinking and start talking. Each possible variation of permission application will require policies and procedures to be in place or at least will imply strategic and operational decisions which deserve to be taken with the relevant care and attention.

If the FSA is any indication of what will happen in the rest of Europe we shall probably see a ‘rush to transpose' over the summer and by October 1st a majority of EU countries will be "MiFID compliant". Leaving financial institutions to scramble to meet the November 1st deadline. Since the first tier institutions started earlier, they will be ready (or on their way to be ready). All those that are still ‘talking' rather than acting may have interesting surprises on November 2nd. I sincerely hope I am wrong, but... you read it here first

MiFID - it is really happening (aka the FSA changes tone)

Recently, the FSA has published a "MiFID Presentations and Notifications Guide" where they discuss in some detail what is changing with MiFID and what regulated firm need to do to be up and running by November 1st.

It is a complete change of tone from earlier publication, there is a sense of urgency (as in there is not an unlimited amount of time) and also a clear indication of deadlines for applications and notifications to make sure that business can be conducted under MiFID right from the start. Some of the deadlines to present such notifications or applications are dangerously close. Let's see :

Client Classification 1 - If your firm has a limited permission for Intermediate Customers Only you may need to apply for permission for Retail and Professional Clients since some corporate clients may 'downgrade' to retail following the MiFID rules. If this is the case, the deadline to submit a VOP application is August 1st

Client Classification 2 - Not really included in the guide but to be able to make a judgement call whether you need to apply for a different permission you need to have completed your client classification process (and all the other things that go with it, from conflict of interest to best execution policy).

MiFID exemptions - If you are marginally affected by MiFID or "you do not have a requirement not to hold client money on your permission" (I am quoting the FSA publication !) and wish to rely on article 3 MiFID exemption to fall outside MiFID, you should apply for appropriate standard requirement (by August 1st, 2007)

Passporting and Tied Agents - there are several deadlines around September 30th; however if you want to open a new branch or you want to operate in another territory throgh a tied agent (and be in business on November 1st), your application deadline for passporting is... May 31st !!! (This is because home and host regulators have up to five months to process an application to open a branch)

Systematic Internalisers and MTFs - Should we call this "Anyone for a trading venue ?" . If you want to be a SI you have to apply by August 1st, if you already are an ATS and would like to apply to be an MTF you do not have to do anything, if you are not an ATS you need to apply by... August 1st. On the other hand, if you are an ATS and you DO NOT WISH to be an MTF post November 1st you need to submit a VOP application not later than October 1st, 2007

And there is more.

By now you have noticed a pattern emerging, there is a new deadline August 1st. Two months away !

This is an interesting change of tone, until now the message was a bit bland. Now they clearly state that if you want to be able to do one thing or another on November 1st you need to apply by August 1st.

I am not sure about the practical consequences of this, deadlines for applications are somehow different from deadline for compliance. However it is quite clear that some decisions have to be made by August 1st and it is also quite clear that the FSA clearly indicates that it means business as far as non compliance goes.

I would not be surprised if we see a 'rush to transpose' during the summer and by end of September 2007 the majority of the main markets will have transposed.

What is now clear that the time to sit on the fence is running ou

MiFID expands the concept of ‘investment business’ – Part 2

This is the second of three parts that look into specific issues of trading in instruments that are in the list of MiFID and were not in the list of the ISD. Institutions dealing in those financial instruments face the need to implement MiFID and CRD (Basel 2) at the same time and therefore becoming compliant means a lot of work, with issues related to the specific nature of some of the businesses involved. This article looks at spread betting companies.

Annex I of the level 1 Directive published in 2004 lists contract for differences as one of the financial instruments within the scope of MiFID. Therefore dealing in contract for differences is an activity deemed to be an investment business.

This provision brings all the spread betting companies under the MiFID umbrellas. This presents a few challenges and several advantages. For once lets start with the positives.

A spread betting company is an online business 99% of the time. Once they are passported under MiFID they will be able to operate all over the EU (plus Norway, Iceland and Liechtenstein). Being an online business they do not really need branches, all they need is a telephone number for customer service in the relevant language and nowadays this can physically be arranged from their home country. Without a branch in a territory they can operate into that territory with the home Conduct of Business, therefore they will be able to advertise for the first time throughout the EU, proactively seeking clients in other European countries (rather than passively waiting for the clients to find them) and still work under UK conduct of business rules. Isn’t that great ?

The flip side of the coin is having to be MiFID compliant and CRD compliant. This present some interesting issues, first of all what are they ? Most of them write their own contract for differences (the spread bet) and have their own policy for margin calls, etc. They also tend to hedge their exposures but the two sides are completely independent from one another. So, you have an online platform for retail trader that trades only contract they have prepared. Are they a trading venue (e.g. a systematic internaliser) or are they an investment business engaged in proprietary trading? I leave it to the legal eagle to answer that.

Being on line they need to have a client execution policy that includes notices as to suitability and appropriateness of investing in contract for differences (most of their clients will be classified as retail clients anyway) and it could be argued that most of their transaction are on an execution only basis (nobody advises ‘me’ to bet one way or another, my own ‘bet’ defines the contract for difference that will be written and therefore there is no specific advice given). The relationship with their client is mostly online, therefore they need to post their policies on line and have to find a way to make sure that the client ‘pro-actively’ acknowledges them and agrees with them (this could be part of the registration process for new clients). Interestingly enough these issues are shared with any on line trading platform available to the general public irrespective of the financial instrument traded.

Their capital adequacy also presents interesting issues especially in the criteria used to mark to market their exposures. Another interesting side that covers both MiFID and CRD is Risk Mitigation and I wonder how they can relate their hedging policies to mitigation of financial risk and their business continuity solution to mitigation of operational risk.

Overall, this is a business sector that will have a lot to gain from MiFID (mostly thanks to passporting) and that explains why a number of industry professional I spoke to had an interesting upbeat attitude towards the whole thing (attitude that may not necessarily be shared by their compliance manager)

Anybody interested in being a trading venue ?

The FSA has a new list for Approved Reporting Mechanism (and why would you get there unless you were - or plan to become - a trading venue ?), there is a new interesting entrant: Credit Suisse.

Five months before November 1st, Project Turquoise is still a project, Chi-x of Instinet is being tested and some other things are appearing in other markets.

Credit Suisse being on the FSA ARMs list is the first example of a big bank 'declaring its hands', will they be SI or will they start their own MTFs. There is no rush to internalise and I suspect a lot of Market Makers still think they can go on market making as they do now post Nov.1st - at least in London. This could be another example of the 'to-morrow' effect on MiFID.

But why internalise ? or creating an MTF ? Well, two things come to mind. One is the intention to create a market in a specific financial instrument, create your own business hours and trading rules (market makers will have to operate through a regulated market and only during the market business hours. So, technically speaking, large transactions out of trading hours are out). The other is to stimulate a market in instruments not listed in the 'local' market (for instance Euronext shares in London or German Shares in Milan).

But also, what about instruments not currently traded in a regulated market in a specific jurisdiction ? (After all most commodities are traded in a couple of places around the world for historic or business reasons); and what about some of the instruments included in MiFID that were not included in the ISD ? Spread betting sites trade contracts for differences, but what is a spread betting site ? A broker, a market, or what ? (See the forthcoming MiFID expands the concept of investment business. Part 2)

So far most analysts have discussed the issues of competing with the local market (what Project Turquoise will do once it happens) but I think that the most likely scenario will be local access to instruments listed in foreign markets. Hard to say what will happen to non EU instruments but within the EU that may really increase the weight of London as a 'trading market' compared to the rest of Europe.

Of course, there is a lot of time to sort this, after all, it is just May and November 1st is about five and a half months away (please put a hint of sarcasm in here when you read this); this is probably the reason why only Credit Suisse so far has declared its hand. All the other market makers out there have a lot of time to think !

MiFID expands the concept of ‘investment business’ – Part I

This is the first of three parts that look into specific issues of trading in instruments that are in the list of MiFID and were not in the list of the ISD. Institutions dealing in those financial instruments face the need to implement MiFID and Basel 2 at the same time and therefore becoming compliant means a lot of work, with a lot of issues due to the specific nature of some of the businesses involved.

Annex I of the level 1 Directive published in 2004 lists all the ‘services and activities and financial instruments’ covered by MiFID. Underwriting or placing a financial instruments is clearly defined as one of the investment services and activities that defines an ‘investment business’. The list of financial instruments includes : (a) “Options, futures, swaps and any other derivative contracts relating to commodities that can be physically settled…” and (b) “Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climate variables, freight rate, emission allowances or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties…. , as well as any other derivative contracts relating to assets rights, obligations, indices and measures not otherwise mentioned in this Section that have the characteristics of other derivative financial instruments, having regard to whether… they are traded on a regular market or an MTF, are cleared and settled through recognised clearing houses or are subject to regular margin calls.”. Therefore underwriting or placing a commodity future became an investment activity.

So, if you are reading this from your desk in a financial institution spare a thought for commodity dealers and brokers. Their headache is slightly bigger than yours.

The FSA currently does not have dedicated rules for commodities and commodity derivatives markets. Its regulation is derived from several different regimes and its overall approach combines these. The implementation of MiFID and of the re-case Capital Adequacy Directive (i.e. the Capital Requirements Directive otherwise known as Basel 2) will significantly affect how the FSA regulates commodity markets.

The European Commission will report in 2008 to the European Parliament on a range of issues associated with commodity and other non-financial derivatives business. The Commission must decide which relevant firms, activities and instruments should be covered by the scope of EU financial markets regulation in this areas and if the current regulations need to be adapted to take into account the specificities of the commodity and commodity derivatives markets.

This will happen in 2008, MiFID will be effective from November 1^st , 2007 and the CRD from January 1^st 2008. So what is going to happen in the meantime ?

The questions behind an implementation of MiFID and CRD before the review varies depending on the nature of the firm and the business transacted. Also, CRD creates many more issues (and headaches) than MiFID.

A broker in commodity based derivatives working mainly with financial counterparty (i.e. clients that use the instruments clearly as an investment) will have less issues implementing the directive. Their business is basically a financial investment business and some of the principles behind the details of MiFID and CRD clearly apply to them.

CRD becomes very difficult to implement when we move to large commodity house that trade in their own account (say an oil company), there are several issues mostly due to the fact that CRD was that for a financial company, not for commodities. The two markets have clear differences. For instance :

In some commodities buying forward is the norm, for instance a coffee company would arrange a delivery plan with future contracts both as a way to cover against the risk of price fluctuation and to arrange a supply plan. Marking to market becomes a problem when you compare futures quotes with spot prices. Also, payment thirty days post delivery is the norm, that would be considered as a long term settlement. The other question is how far a Letter of Credit can be considered ‘risk mitigation’ rather than presenting a different risk in itself.

Operational Risk Requirements could be particularly onerous for those ‘producing’ companies (e.g. an oil company) that do not have a separate legal entity for trading. The Basic Indicator Approach requires a contribution to the reserve capital of 15% of income (a lot of money for the likes of BP, Shell, Centrica, etc.) and some Standardised Approach presents difficulties, mostly due to the different nature of the business (in other words, there is an obvious difference between trading commodities and trading money).

MiFID and CRD start have a fundamentally valid set of principles behind them. This is the case where there is a herd of devils in the detail (not just one). So what will happen ?

This is hard to say. The FSA helpline mentions a review and the deadline for comments was 30 April 2007, but still November 1^st and January 1^st are only a few months away.

If no special provision are made, a large commodity group could be in the same position as a financial house with a very large proprietary trading unit. Although the two business model could not be further apart, at the moment the range of possibilities between the worst case and best case scenario (in terms of time and efforts to become complaints) is very wide and, as yet, there is no real indication where the pendulum will stop. So, please spare a thought for the poor oil traders and commodity brokers who have a bigger headache than yours.

These are the headaches, would MiFID present any advantages to them? Clarity in the regulation may lead to a larger markets for commodity based investment products which could be marketed throughout the whole MiFID area (the EU plus Iceland, Norway and Liechtenstein). A level playing field across Europe comes to mind, MiFID will regulate activities across jurisdiction. It will be easier to operate from one territory to another, but does it really matter ? Stay tuned for Part II where I will discuss a business sector where it does (spread betting).

Once again, there is the need for a strong statement from the FSA over the transition period. Hopefully this will come once the Commission and CESR have examined the evidence gathered and everything will happen early enough to allow the affected business to have a realistic plan to become compliant in time.