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.

Who is sorting out MiFID for financial institutions in London ?

I have been looking through roles posted by contract agencies in the two main job boards, jobserve (mostly IT role) and efinancialcareers.com . The picture they paint is interesting and worrying at the same time.

Some recent posting are looking for roles of Business Analyst or Project Manager for best execution and transaction reporting and conclude with variations on the theme of ‘knowledge of MiFID advantageous but not essential’.

MiFID is 60% process and procedures and 40% IT implementation. Unless all the process and procedures have been sorted (and if that is the case why looking for an interim Business Analyst) you actually need to know about MiFID to understand what is important or not in a best execution policy

MiFID changes the emphasis of best execution and the essentials ‘bookends’ for best execution are the preliminary guidelines, the choice of trading venue and the relevant provision of market data at one end and the trading reports on the other. Anything else is just… execution. You need to know the impact on the front office system of the new reality for market data (and therefore have an appreciation of the changes brought in by MiFID and therefore know MiFID), how to present information on quotes, liquidity and costs in an environment where there could be more than one trading venue for any given security and you need to know the impact of suitability and appropriateness, conflict of interest and client classification on the relationship between a trader and his/her clients. On the other side you need to know the fields in the transaction reports and the rules for the latency between execution and reporting. You need to make an assessment on reference data, etc. all things tied to MiFID.

Implementation of MiFID is full of things that are not completely clarified, others have been clarified in a way that cannot be immediately processed by the City. Recruiting professionals that are expected to learn MiFID on the job contributes to the confusion.

Isn't it a bit late to threaten legal action ? (sequel to MiFID.... and sex )

Charlie McCreevy is now threatening legal action if countries do not ratify the MiFID rulebook in time. (See the article on the Finextra website ) . The strong statement quoted in the article comes about six months before November 1st. The deadline for institutions not countries. As the FSA keeps telling us the UK was the only countru to ratify MiFID on time.

So, is there a mad rush out there ? Actually not, and it is not surprising. There are a few things tied to transposition (and ratification), the easier to discuss is transaction reports. Until a regulator has fully transposed, the information required may actually change and with that reference data, etc. etc. Therefore, until transposition an institution can only go by the EU directive and be prepared to implement changes. No wonder that there is not a mad rush.

A transaction report is one of the things a host regulator will require from investment businesses passported into their jurisdiction, if France has not fully transposed the delay in formalising a definitive requirement for transaction reporting does not just affect French companies, it will also affect any other institution with a presence in France.

Guidelines on transition become more and more important, the balancing act for regulators is to be pragmatic and assertive at the same time. This cannot be left to a case by case policy.

MiFID changes the way people involved in investment businesses will work, these changes will go beyond compliance with new regulation. There is a strategic element to MiFID that has to be considered when planning compliance.

All of this takes time, UK based institutions are still behind (the smaller they are the further behind they are) and they had about three months advantage on any jurisdiction that will ratify by the end of April. Institution based in other countries can learn from the British experience but however wonderful they are they will not be able to become compliant instantly.

It is time to define a 'core MiFID' where regulators will be strict for a period of say six months provided there is a plan in place to achieve full compliance (The FSA has already esplicitely stated that they will tolerate delays provided there is evidence of a plan to achieve compliant and a progress report to prove that the plan is being executed) without it threatening legal actions on countries will have no practical consequences for institutions doing business in those countries.

Why the lack of rush to be internalisers ?

Systematic Internalisers ? Who are they and why very few large players have declared their intention to become systematic internalisers ?

The MiFID directive defines a systematic internaliser as “an investment firm which on an organised, frequent and systematic basis, deals on own account by executing client orders outside a regulated market or an MTF” [ Directive 2004/39/|EC of European Parliament of 21 April 2004 Article 4 (7) ]

A lot of people think of a SI (common acronym for systematic internaliser) as a Market Maker, but MiFID defines a market maker as “a person who holds himself out on the financial markets on a continuous basis as being willing to deal on own account by buying and selling financial instruments against his proprietary capital ay prices defined by him” [Directive 2004/39/|EC of European Parliament of 21 April 2004 Article 4 (8) ]

The differences between the two should explain why there has not been a rush to declare intentions to become systematic internaliser even in markets like London where market making is common.

What are exactly the obligation of a systematic internaliser ?

1) Publish Quotes

2) Pre-trade transparency reports for liquid shares (and although liquidity is centrally defined, single regulator can act on that definition in two ways, (a) when they transpose or (b) by specifically designating an otherwise illiquid share as a liquid share in accordance with Article 22(3)

3) Make trades public within three minutes of execution (this includes both liquid and illiquid shares) as part of the reporting obligations of a trading venue. They also need to make their market data available to the public at reasonable costs on a commercial and non discriminatory basis.

4) They also have to state their intention of being systematic internalisers and the specific security (or other financial instrument) they want to be systematic internaliser for. The relevant home regulator will keep a list of all systematic internalisers and that list will be made public by CESR (one of the first instances of an operational role as a coordinator of all the regulators). This list will have to be updated regularly and it will include the average daily turnover, average daily number of transactions and free float.

Limiting the disclosure to liquid shares is already a step forward towards transparency given that currently there is no such an obligation for large trades that happen outside markets (and they do happen). Information on illiquid shares can be inferred from post trade reporting.

So… a lot of reporting headaches, what are the strategic advantages in being SI ?

Let’s see what restriction do market makers have :

1) they still fall under MiFID (the exemption for persons who do not provide any investment services or activities other than dealing on own account specifically states “unless they are market maker or deal on own account outside a regulated market or an MTF [Directive 2004/39/|EC of European Parliament of 21 April 2004 Article 2 (1) (d)]

2) When the authorisation to operate a regulated market is mentioned in Art 1 (49) there is a specific reference to “the medium of designated market maker appointed by the regulated market” , therefore it could be inferred that a market maker is tied to a specific regulated market and therefore the interesting legal questions lies in “What happens if an institutions wants to market make securities listed in different regulated market ? Will they have to seek authorisation from all the regulated markets ? (If that is the case we have the first strategic advantage of being a SI, you only deal with your home regulator). There are several references in the text of MiFID to ‘registered market maker’

3) One of the other interesting issues is that the pre-transparency rules for a venue mean that they have to include the “best bid and offer by price of each market maker”, so indirectly a market maker is not exempt from transparency rules completely.

4) Even more interesting is Article 44 of Best Execution Rules (Best Execution Criteria) that states “for the purpose of this Article and Article 46, ‘execution venue’ means a regulated market, an MTF, a systematic internaliser, or a market maker, or other liquidity provider or an entity that performs a similar function in a third country to the functions performed by and any of the foregoing”. Yet again not much difference there.

The only conclusion to draw so far is that a market maker has to be designated by a regulated market and act in according to the practice of that market. A systematic internaliser does not have to be designated and can create its own trading rules – within the limits stated by MiFID - therefore an institution can be a systematic internaliser for shares listed on different stock exchanges and that may open opportunities for companies who have market making capabilities in several countries in Europe to be internalisers across jurisdictions.

So there does not seem to be much difference from an operational point of view, any legal mind that would like to join the debate will be mostly welcome.

After all, this is maybe one of the several instances of MiFID where an operation expert and a legal professional should work together to the best advantage of their client.