(see IP/06/121)
This document has been prepared by the Commission services (DG Internal Market and Services).
It is split into two parts: the first covers questions of a general nature; the second answers specific questions about how the ("level 2") implementing measures will work in practice, and how they interact with the relevant provisions of the framework ("level 1") legislation.
Since the implementing measures are still at draft stage (i.e. they are formal draft measures which have been presented by the Commission), the answers to these questions cannot be regarded as definitive.
Furthermore, the information which is provided here is:
- of a general nature only and is not intended to address the specific circumstances of any particular individual or entity;
- is not necessarily complete and does not systematically cover all the aspects;
- is made available for general information only and does not constitute professional or legal advice;
- in no way constitutes an interpretative document.
It does not prejudge the position that the Commission might decide to take on the same matters if developments, including Court rulings, were to lead it to revise some of the views expressed here.
Nor does it prejudge the interpretation that the Court of Justice of the European Communities might place on the matters at issue.
PART I: GENERAL QUESTIONS
1. What is the "MiFID"?
The MiFID is the Markets in Financial Instruments Directive – or Directive 2004/39/EC. It replaces the Investment Services Directive (ISD) which was adopted in 1993. It was agreed unanimously by the Member States and by a strong Parliamentary majority. It is a central element of the Commission's Financial Services Action Plan (FSAP). It is a very far-reaching piece of legislation. It sets out a comprehensive regulatory regime covering investment services and financial markets in Europe. It contains measures which will change and improve the organisation and functioning of investment firms, facilitate cross border trading and thereby encourage the integration of EU capital markets. Economists agree that this will strengthen the EU economy significantly. At the same time, it will ensure strong investor protection, inter alia with a comprehensive set of rules governing the relationship which investment firms have with their clients.
2. MiFID is a so-called "Lamfalussy" Directive. What does this mean?
It means that the MiFID is being adopted using a legislative approach known as the "Lamfalussy Process." This approach was devised by a Committee of Wise Men (chaired by Baron Alexander Lamfalussy, former Head of the European Monetary Institute) which was set up at the request of the European Council. "Lamfalussy" Directives are split into two levels – the "level 1" Directive which establishes the guiding principles of the legislation agreed in co-decision by EP/Council and the "level 2" implementing measures (see question 3). The advantage of this "split-level" approach is that it allows the Council and Parliament to focus on the key political decisions, while technical implementing details are worked through afterwards. This flexibility allows for more rapid and frequent adaptation of the legislation so that it can keep pace with market and technological developments.
3. How does the "Lamfalussy process" work?
- The "Lamfalussy process" centres around a "4 level" legislative approach:
- Level 1: Level 1 is traditional EU decision making, i.e. Directives or Regulations proposed by the Commission and then co-decided by the European Parliament (EP) and the Council. These Directives or Regulations contain framework principles.
- Level 2: Technical implementing measures to render the level 1 principles operational, can be adopted, adapted and updated by the Commission after having been submitted to the European Securities Committee (ESC) – a committee composed mainly of members of Ministries of Finance - and the European Parliament for their opinion. The Committee of European Securities Regulators (CESR), an independent advisory body made up of securities regulators, can advise the Commission on the technical implementing details to be included in level 2 legislation. This advice is provided in response to specific "mandates" from the Commission asking for help in particular areas. Level 2 implementing measures do not in any way alter the principles agreed at Level 1; they simply provide the technical details which are necessary to make these principles operational.
- Level 3: In order to facilitate coherent implementation and uniform application of EU legislation by the Member States, CESR may adopt non-binding guidelines. CESR can also adopt common standards regarding matters not covered by EU legislation (but these standards have to be compatible with level 1 and 2 legislation).
- Level 4: Enforcement: This refers to monitoring correctness of implementation of EU legislation into national legislation by the Commission and, in case of non-conformity, launching of infringement proceedings which can end before the European Court of Justice.
4. What stage has the MiFID reached?
The "level 1" Directive was adopted in April 2004. The current drafts are for the "level 2" implementing measures. The Commission granted a formal mandate to CESR in June 2004 for the provision of technical advice on the level 2 measures. CESR provided this advice in February and April 2005. The substantive part of it is reflected in the Commission's draft measures.
5. What exactly are the provisions of the Level 1 Directive?
The Level 1 Directive abolishes the so called ‘concentration rule’ (in other words, Member States can no longer require investment firms to route orders only to stock exchanges). This means that, in many Member States, exchanges will be exposed to competition from multilateral trading facilities (MTFs), i.e. broadly non-exchange trading platforms and ‘systematic internalisers’, i.e. banks or investment firms who systematically execute client orders internally on own account (rather than sending them to exchanges).
MTFs and 'systematic internalisers' will be subject to similar pre- and post-trade transparency requirements as the exchanges. This will ensure a level playing field between the exchanges and their new competitors – and full information on trading activity to the market.
The Level 1 Directive also updates the ‘single passport’ for investment firms, which was first introduced in the ISD. It extends the list of services and financial instruments covered to bring it into line with the new market realities. For example, investment advice is covered for the first time. This reflects modern trends since more and more retail customers are investing in securities and seeking advice from their bank or their broker. This will allow investment firms to provide services across the EU on the basis of a single authorisation from their "home" Member State. At the same time, investor protection rules are strengthened and harmonised at a high level so that investors can feel confident in using the services of investment firms, wherever those firms originate from in the EU. Ensuring investor confidence is critical for pan-European trading to deepen.
6. What is in the Level 2 measures?
The Commission can only propose "level 2" measures in those areas where the "level 1" Directive specifically gives it the power to do so – i.e. those areas where it is granted "delegated powers." This applies to just 18 out of 73 provisions in the level 1 Directive. The main areas covered are:
- conduct of business requirements for firms, e.g. their obligation to divide their clients into different categories ("eligible counterparties", "professional" and "retail"), their obligations towards each category of client, their obligation to assess whether the products and services which they provide are "suitable" or "appropriate" for their client and their obligation to secure "best execution" for their clients (i.e. the best possible result with the emphasis on best price for retail investors).
- organisational requirements for firms and markets, e.g. compliance, risk management and internal audit functions that operate independently, identification and management of conflicts of interest and limitations on out-sourcing, especially to third countries;
- transaction reporting to relevant competent authorities of buy and sell transactions in all financial instruments;
- transparency requirements for the trading of shares (i.e. pre- and post trade transparency for regulated markets, MTFs and 'systematic internalisers') to ensure a level playing field between exchanges, MTFs and systematic internalisers for the trading of the most liquid shares in Europe.
More detail on each of these areas (together with other areas covered by the "level 2" measures) is provided in Part II.
7. What is the procedure from now on? How will the level 2 measures be adopted?
The draft measures have been sent to the European Parliament and members of the European Securities Committee (ESC). The Parliament now has three months to examine them and formulate observations on them. The ESC is due to deliver its opinion on them at the beginning of June. The Parliament will then have a further one month period in which to check that the measures are not ultra vires, i.e. that the Commission has not overstepped its "delegated powers." The draft measures will then be formally adopted by the Commission – probably in Summer 2006.
8. Why do we need the MiFID?
We need MIFID because the old Investment Services Directive is out of date, doesn't work well in many areas and needs replacing. The ‘passport’ system is not working well enough. It has to be updated so as to eliminate barriers to cross-border trading and thus inject fresh competition into the European investment services industry which is so vital to the European economy, e.g. in dealing with the financial implications of the pensions time-bomb. And investor protection needs to be enhanced to attract new investors to EU capital markets. The "concentration rule" represented a barrier to the emergence of an integrated and competitive trading infrastructure and so needs to be amended. Finally, modernisation was necessary; new services, such as investment advice, and new financial instruments, such as derivatives, need to be brought within the scope of European legislation in order for these products to circulate freely.
9. What will MiFID mean for consumers and small investors?
MiFID is good news for consumers. They will have a bigger choice of investment service providers – who will be required, all of them, to conform to high standards of behaviour to their clients. This should allow them to seek out services of the best quality at the cheapest price. Firms will be subject to greater competition forcing them to be more responsible vis-à-vis their clients and to offer a better level of service. More generally, small-scale and retail investors will have a bigger choice of products and services to choose from and equities, bonds etc to invest in, thus allowing them to maximise the returns on their savings. This will help to guarantee a higher standard of living for millions of people – e.g. during retirement.
Consumers will enjoy the same level of protection whether they choose a domestic service provider or a foreign one. And the level of protection they will have will be high. The draft measures build in a range of tough safeguards for consumers. For example, there will be strict limits on the inducements which banks or financial advisers can receive in respect of the services which they provide to their clients. When executing client orders, firms will have to take all reasonable steps to deliver the best possible result ("best execution"). For retail clients, the emphasis will be on ensuring that they get the best price for the instrument and the costs associated with the execution.
The approach is not to flood consumers with reams of information which may not be relevant to them and which they may have difficulty in understanding. Instead, the emphasis will be on the fiduciary duties of firms towards their clients (i.e. their duty to always put their client's interests first). This will include a range of measures including a modern and thorough approach to the identification and management of conflicts of interest. Firms are also required, when providing investment services, to collect sufficient information to ensure that the products and services which they provide are "suitable" or "appropriate" for their clients.
Clearly, this new investor protection regime will apply to the full extended list of products and services which are now covered by the MiFID thus ensuring even greater protection for consumers.
10. Will MiFID cost firms a lot of money? What cost estimates are available?
There are a number of studies estimating the impact on banks, exchanges etc. However, these must be treated with some caution. Clearly, they are not based on the level 2 draft measures (which have only just appeared). Many of them are based on early working documents, now out of date.
In reality, it is very difficult to predict what the impact will be on individual firms, banks etc since it depends to a large extent on the commercial decisions which they will take. For example, an investment firm may decide that it wants to become a systematic internaliser or to run a Multi-lateral Trading Facility (MTF). In such a case, investments will have to be made in order to acquire the appropriate technology and/or hire new staff.
It is true that there will be some up front implementation costs due to the need to comply with some of the rules that may not already be in place in a particular Member State.
This is inevitable in the process to build an integrated EU financial market with market opening measures which involve breaking down barriers and levelling the playing field between operators across 25 Member States. Furthermore, investment in IT systems may well take up a bigger part of firms' budgets as they seek to deliver best execution.
However, it is important not to over-estimate these costs. This issue must be considered in terms of the global legislative environment in the securities field. A number of changes have already been introduced by securities Directives which have been or are about to be implemented in the Member States. Firms have already made some of the adaptations necessary for MiFID in response to these Directives and, wherever possible, existing structures and arrangements will serve the purposes of both these existing Directives and MiFID and its implementing measures.
Moreover, the Commission services believe that making the technology investment to become compliant with MiFID need not be a compliance burden but, if managed strategically, should help firms to gain competitive advantage – including trading a much wider range of products. Securities markets in the EU are expanding, not declining – and this trend is expected to continue.
Finally, there will be benefits as well as costs. The Commission is convinced that overall these benefits will outweigh the costs - although this may not be immediately apparent, since the costs will be front-loaded, while the benefits will take time to accrue. The Commission's economic work has shown strong macroeconomic gains to be expected from an integrated EU market – results confirmed by peer review. The Commission's exhaustive consultative process has also ensured the most thorough preparation possible.
11. Which firms will benefit most from the MiFID?
The first movers and the better prepared will be the winners. For those firms prepared to adapt expeditiously and make the necessary preparations, the opportunities will be considerable, and not just limited to equities. Experts predict that firms who choose to become "systematic internalisers" may use their upgraded electronic equipment to internalise other financial products as well across a range of European markets. On the other hand, those investment firms that ignore MiFID may well find themselves behind the curve.
12. What will be the overall effects of the MiFID?
It will significantly reduce the barriers to cross-border trading of shares and cross-border provision of investment services. It will end the monopoly which certain stock exchanges have had on the trading of securities. As a result, it will create new opportunities for firms, markets and indeed consumers. However, its precise effects will depend on the extent to which the various players are prepared to seize the opportunities on offer. If they are prepared to do so, there could be a significant increase in competition among exchanges and between exchanges and other trading platforms. And there could a big increase in stronger cross border trading, and a significant decrease in the cost of capital – benefiting the overall economy - large and small firms alike - and investors.
Levels of competition between investment firms will force them to become more efficient and productive, leaving them better able to withstand increasingly tough global competition. It will lower costs for issuers and investors of accessing capital markets and give investors a far greater choice of equities, bonds etc to invest in – allowing them to maximise their returns. This would enable businesses to invest more so that they can grow and create more wealth and jobs.
13. How have the MiFID and its implementing measures been developed? Has the Commission talked to the relevant stakeholders?
Yes. The Commission has adopted an open and comprehensive approach in order to build the widest possible consensus. The level 1 Directive was debated from 2000 to 2004. It was an exhaustive and inclusive debate.
The draft level 2 measures are the result of an unprecedented and intense round of consultations with all stakeholders – including Member States, regulators, firms and consumers. They are based largely on the advice provided by CESR which itself is the product of long, in depth technical discussions among experts in the securities regulators, as well as extensive consultation with the public. There have been repeated and lengthy discussions in the ESC based on discussion and feedback documents prepared by the Commission services. These documents have also been made available to the public.
The process has been iterative and transparent. Indeed, there have been no fewer than 11 public consultations in the last two years (organised either by the Commission or CESR). The Commission has generally maintained an "open door" policy. There have been innumerable meetings at all levels with industry and consumer representatives and other interested parties.
14. Why has the Commission not carried out a cost benefit analysis (impact assessment) of either the Level 1 Directive or the Level 2 measures?
It is true that the Commission has not carried out a formal and exhaustive economic cost benefit analysis (CBA). It was not a requirement 5 years ago when work on the level 1 Directive was started.
Moreover, costing the potential benefits of individual items of FSAP legislation is hazardous; establishing economic cause and effect in such complex, interwoven markets very difficult.
However, there has been a major study quantifying the potential macro benefits of integrating capital markets as a whole (London Economics, November 2002) – a study that was appraised by peer review. The study's results, although positive, were felt, if anything, to under-estimate the overall benefits of European integration to the EU economy.
The extensive, transparent and open stakeholder consultation – plus the information gathering and analysis which the Commission carried out during the preparation of both the level 1 and the level 2 measures – has produced a very sound economic and technical basis for decision taking, including a thorough assessment of the legal measures' impact on firms, markets and consumers.
Furthermore the MiFID draft measures have been drawn up in accordance with "better regulation" principles. The Commission has adopted a "principles-based" approach. The aim is not to tell firms how to run their businesses. Instead, the measures set out the principles which they must adhere to. The Commission has also rejected the "one size fits all" approach. The proposed measures have been drafted with an awareness of the diversity of market structures and service providers. Rules should be applied in an appropriate and proportionate manner. This is explicitly recognised in numerous provisions in the draft measures where the requirements vary according to the nature, scale and complexity of the particular investment firm and its business.
15. In which form will the draft "level 2" measures be presented? Which legal instruments has the Commission chosen to use and why?
The first question which the Commission considers in relation to the choice of legal instrument is whether or not it is necessary to legislate at all. Could a non-legislative response prove more effective? Would it be possible to rely on self-regulation?
The answer in this case is clear. The level 1 Directive obliges the Commission to adopt level 2 measures in order to ensure uniform application of the level 1 provisions. In almost all the areas dealt with by the level 1 Directive, the body of national law is highly diverse. Only through European legislation can national legal systems be sufficiently aligned and uniform application of the level 1 provisions achieved. Otherwise, the 'passport' will not work; cross-border trading will be sub-optimal; and the wider economic benefits will be weaker.
As far as the choice of legal instruments is concerned, some of the draft measures are suitable for presentation in a Regulation which has direct effect and does not need to be transposed into national law. Others need to be presented in a Directive to enable Member States, when transposing its provisions, to adjust its requirements to the specificities of their markets and ensure coherence with other areas of their national law. The Commission has therefore chosen to use a combination of a Regulation and a Directive (the "Implementing Regulation" and the "Implementing Directive").
The Regulation covers the core issues relating to the transparency and the functioning of the markets; the Directive covers those areas where there is a relationship between the firm and the client – i.e. it covers those issues which impinge on national private law.
The Commission's overriding objective is to provide a single, predictable set of rules for firms operating throughout the EU and greater security for consumers buying investment services abroad. The legislative architecture described above will achieve this objective. The Implementing Directive establishes a highly harmonised regime. It should not therefore be necessary for Member States to add supplementary rules over and above what is in the Directive. Indeed, they are only allowed to do so in exceptional and strictly defined circumstances to address national or emerging issues which affect investor protection or the stability of their markets.
16. When will the MiFID come into force?
The initial application date for the level 1 Directive was the end of April 2006. However, it was decided that more time was needed to enable firms to adapt their systems to the new rules. A Directive extending the deadline has been approved by the Council and the European Parliament (formal adoption is still pending but will be completed in the first quarter of 2006). It will push forward the application date to November 2007 - with Member States due to publish final rules 9 months ahead of that, by the end of January 2007. Firms should use this extra time now to plan ahead, and not as an excuse to slow down their preparations for MiFID.
17. What happens next (after the level 2 measures are adopted)?
The focus will be on ensuring that the level 1 Directive (and the level 2 Directive) are transposed into national law fully and on time (level 4 of the Lamfalussy process). The Commission will launch infringement procedures against Member States who fail to do this. It will continue to publish its "Lamfalussy Scoreboard" which tracks the progress of the different Member States in transposing all the Lamfalussy Directives.
It is also important to ensure that the MiFID is consistently applied and enforced. This will require much closer co-operation between Europe's supervisors. That is the aim of ‘Level 3’ of the ‘Lamfalussy’ process. It will promote convergence of supervisory practices in Europe. CESR is now gearing up to the challenges ahead.
Finally, the Commission will continually evaluate the MiFID. It will ask whether or not it has got it right. Is it working in practice? Has it delivered the intended results? When carrying out this evaluation, the Commission will talk to practitioners, market participants and investors/consumers – i.e. those who are directly affected by the MiFID and who are therefore best placed to identify any problems.
In addition, the MiFID specifically requires the Commission to draw up reports on the implementation of particular provisions (e.g. professional indemnity insurance, pre-trade transparency of systematic internalisers, pre- and post-trade transparency of financial instruments other than shares). The majority of these reports are due to appear during 2007 and 2008.
If any changes to the MIFID implementing rules are necessary then the mechanisms in place can allow for relatively speedy adjustment.
PART II: SPECIFIC QUESTIONS
NB: throughout this
section, the "level 1" framework Directive is referred to as "MiFID" and the
draft "level 2" implementing Regulation and Directive are referred to as the
"Implementing Regulation" and the "Implementing Directive."
1. Conduct of business requirements for firms
1.1 General approach
1.1.1 What is the general approach to client protection?
Essentially, MiFID envisages two types of investor protection mechanisms. On the one hand, firms will have to provide their clients (and potential clients) with information (about the investment firm, the services it provides and the financial instruments that are the object of these services). This is important. If clients receive sufficient information, they should be able to detect (and reject) inefficiency and unprincipled conduct by firms. However, this mechanism cannot be relied on entirely. It is no good swamping clients with large amounts of complex information and hoping that they will be able to analyse and evaluate it all and then draw the appropriate conclusions. MiFID therefore also places considerable emphasis on the fiduciary duties of firms towards their clients – i.e. their obligation to put their clients' interests first. It imposes a number of specific obligations on firms, including execution of client orders on the best possible terms ("best execution"), the obligation, when providing investment services, to collect sufficient information to ensure that the products and services which they provide are "suitable" or "appropriate" for their client and the proper handling of client orders. It also imposes strict limits on the inducements which banks or financial advisers can receive in respect of the services which they provide to their clients.
1.1.2 Will all clients be treated in the same way?
The regulatory response to the challenge of investor protection should be proportionate and appropriate. It should centre on the demonstrable risks which different types of investors are likely to incur. These risks will vary according to the level of knowledge and sophistication which a particular investor has. MiFID therefore distinguishes between three different types of client, each with a different level of knowledge and sophistication: retail investors, professional investors and "eligible counterparties." The obligations which firms will have towards these different categories of client will vary – with the least sophisticated investors receiving the most information and protection and the most sophisticated receiving the least, because they are professional experts.
1.2 Client classification – eligible counterparties
1.2.1 How will the system of client classification work?
The system has been designed to be as simple and as flexible as possible. Annex II to MiFID establishes which clients are considered as professional. These clients – who are known as per se professionals – include investment firms, credit institutions, other institutional investors, large undertakings etc. Retail clients form a residual – but large and diversified - category. They are defined as clients who are not professionals. In other words, any person not listed in Annex II, MiFID will be considered as a retail client. It is therefore fairly easy for an investor to know what kind of client they are.
However, for the sake of clarity, Article 28 of the Implementing Directive states that clients should be told which category they have been classified in. They should also be made aware of the legal consequences of such classification (i.e. that they will have higher or lower levels of protection). Once classified in one category, a client is allowed to change this classification, if they meet certain criteria and comply with a particular procedure. So, for example, a retail investor who feels that he has a high level of knowledge and experience and so can manage with a lower level of protection might decide to become a professional investor. Equally, a professional investor who feels that he needs a higher level of protection might ask to become a retail investor. Clients must also be made aware of the option to change their classification.
MiFID clarifies (in recital 31) that a distinction should be made between the way that the rules are applied to retail clients and the way they are applied to professional clients. Most of the specific rules established in Chapter III of the Implementing Directive only apply to retail clients, since, unlike retail investors, professionals should have the expertise and resources necessary to protect their own interests in the market. However, the fact that they are not covered by most of the implementing measures does not reduce or in any way modify the protection afforded to professional investors by the principles set out in the MiFID.
The situation is slightly complicated by the existence of the third category – "eligible counterparties". This is in fact a sub-category of the professional client category. In other words, eligible counterparties are all professional investors but not all professional investors are automatically eligible counterparties. Article 24 (2) of the MiFID sets out a list of per se eligible counterparties – i.e. those entities which are automatically recognised as eligible counterparties. The MiFID also gives Member States the option to recognise as eligible counterparties entities other than the per se eligible counterparties defined in Article 24 (2) if those entities so request. The Implementing Directive (in its Article 50) specifies the requirements that such entities need to meet in order to request treatment as an eligible counterparty. Since eligible counterparties are considered to be the most sophisticated class of investors, they are afforded the lowest level of protection. When they receive certain types of services (execution of orders, dealing on own account and reception and transmission of orders), they do not benefit from the protections afforded by the conduct of business rules.
1.3 Information to clients
1.3.1 I am a retail client. Will I be entitled to receive precise information about financial products and services? Will I be entitled to know in advance how much I will have to pay for the services provided by the firm?
Before taking an investment decision, clients must receive adequate information so that they can make their choice on an informed basis. That is why the Implementing Directive specifies the exact type of information that needs to be provided to retail clients.
For example, retail clients have to receive: general information about the investment firm and its service (Article 30 Implementing Directive); sufficiently detailed information about the specific type of financial instrument (Article 31 Implementing Directive); information about the costs and charges that the client has to pay (Article 32 Implementing Directive).
Additionally, the Implementing Directive determines when the client has to receive this information. The paramount principle is that the client has to have sufficient time to read and understand the specific information provided before taking an investment decision.
1.3.2 How will this information be given to me? Will it be delivered in a format which is clear and easy to understand?
All information to clients has to be fair, clear and not-misleading. The Implementing Directive introduces (in Article 27) the specific objective standards that specify how information provided to clients shall meet these three criteria. The information, required by Article 19 (3) MiFID must be provided to clients in a "durable medium".
The requirement for the information given to clients to be fair, clear and not misleading also applies to marketing communications. However, there are many ways in which a marketing communication can reach a client or a potential client. This is why firms and regulators need to take proper account of the means of communication, as well as the information contained in marketing communications, when applying the regulatory requirements. Given the large number and diverse range of communications that are covered by these requirements, the Implementing Directive clarifies (in Recital 41) that it would not be appropriate and proportionate to apply such requirements to marketing communications that contain only a very limited amount of information (such as the logo or image of the firms, contact point, etc).
1.3.3 MiFID obliges firms to provide their clients with certain information in a "durable medium". Will it be sufficient to provide this information on a web page?
The Implementing Directive (in Article 3) specifies that firms may provide the information to their clients on a web site only if certain conditions are satisfied. The client must have chosen expressly to receive the information on the web. Additionally the firm has to notify the client of the relevant web-address. And finally, the information has to be is published continuously on the web to ensure that the person, to whom the information must be provided, is able to look over it and reproduce it.
1.3.4 I am a professional client. Will I be entitled to receive any information about the investment services I receive and the financial instruments that are the object of these services?
The general approach is that professional clients have a sufficient level of knowledge to enable them to identify themselves the information which is necessary for them to take an investment decision. Investment firms are therefore only obliged to provide professional clients with information if they request it (Article 29(8) Implementing Directive) unless the provision is explicitly directed to all types of clients – for example Article 32 (5) and (6) Implementing Directive.
1.4 "Suitability" and "Appropriateness"
1.4.1What is the purpose of the "suitability" and "appropriateness" tests?
As explained above (in section 1.3.), in order to take informed investment decisions, clients have to receive sufficient information about the services that they receive. However, MiFID does not only rely on this means of investor protection (see section 1.1). It also establishes a general obligation for firms to act in clients' best interest (Article 19(1) MiFID). This obligation finds expression in different specific obligations, including the "suitability" and "appropriateness" tests. Accordingly, firms are required to asses whether the service they provide to a client is "suitable" or "appropriate" for the client's needs and personal circumstances on the basis of information about the client that they have to collect.
1.4.2 When does the "suitability" test apply?
Firms are required to assess the "suitability" of a service or transaction when providing services that entail an element of recommendation on the part of the firm - investment advice and portfolio management (Article 19 (4) MiFID).
1.4.3 When are firms required to assess "appropriateness"?
Article 19(5) MiFID requires firms to apply the “appropriateness" test for other services, where clients do not rely on firms' recommendations (for example execution of orders, reception and transmission of orders, etc.).
1.4.4 What is the difference between the two tests?
Firstly, the two tests are different in the degree of information gathering and the rigour of the assessment which is necessary. The "appropriateness" test is less wide-ranging than the suitability test. Firms are only required to assess whether the client has the knowledge and experience necessary to understand the risks in relation to the specific type of product or service in question (Article 37 1st sub-paragraph Implementing Directive). For the purposes of the "suitability" test, the firm also has to collect additional information about the client's financial situation and investment objectives.
Secondly, the regulatory consequences of the two tests are different: while an investment firm is not allowed to provide an "unsuitable" recommendation, it may provide a service which it considers as not "appropriate", as long as the client is given the adequate warning required by Article 19 (5) MiFID.
1.4.5 Can firms provide investment advice or portfolio management without obtaining any information from clients?
No, investment firms are not allowed to provide investment advice or portfolio management without first carrying out the "suitability" test. They cannot carry out this test if they do not have the necessary information. They are therefore obliged to "obtain" this information before performing the service (Article 19 (4) MiFID).
1.4.6 When can firms provide "execution-only" services?
An "execution-only" service is an investment service that consists only of execution or the reception and transmission of client orders. When carrying out "execution only" services, firms are not obliged to assess "appropriateness". This has some advantages; it allows clients to receive faster and cheaper services. However, it is important that it does not result in unjustifiable increased risks for the client. That is why MiFID makes the provision of "execution only" services subject to several conditions (Article 19(6) MiFID) which must all be satisfied:
(i) First of all, "execution only" services are possible only in transactions related to instruments that are considered as "non–complex" (see question 1.4.7). The presumption is that the structure of "non-complex" instruments is so simple that clients can be expected to easily understand the characteristics and risks associated with them. The "appropriateness" test should not therefore be necessary;
(ii) Secondly, the provision of "execution-only" services is only allowed if the client has requested it;
(iii) Finally, the firm must warn the client that it is not going to assess the appropriateness of the transaction and it must comply with the requirements relating to conflicts of interest (see section 2.3).
1.4.7 What is a "non-complex" financial instrument? Are all derivatives complex financial instruments?
MiFID explicitly mentions (in Article 19(6)) some financial instruments in which "execution-only" services are possible - for example shares, that are admitted to trading on a regulated market[1], UCITS, money market instruments, etc. In addition, the Implementing Directive defines the concept of "non-complex" financial instruments (Articel 39).
Complexity for the purposes of the Implementing Directive is determined by the way that an instrument is structured. The level of complexity of a financial instrument's structure will affect the ease with which the risk attached to the product may be understood. Thus, all derivatives are assumed to be complex because their value is derived from another financial instrument or asset, adding a level of complexity to the understanding of the characteristics and valuation of those instruments.
1.4.8 Will firms be allowed to provide investment services in "complex" instruments to retail clients?
Yes, but if the service relates to an instrument not covered by the definition of "non-complex" instruments - i.e. it relates to a "complex" instrument - the firm will not be allowed to provide an "execution only" service. This means that the firm is obliged to assess the "appropriateness" of the service – i.e. whether or not the client understands the risks involved in it.
1.5 Best execution
1.5.1 What is meant by "best execution"?
"Best execution" means that, when firms execute client orders, they must take all reasonable steps to deliver the best possible result for their clients, taking into account a variety of factors, such as the price of the financial instrument, speed of execution of the order and cost. For retail clients, "best possible" means the most favourable result in terms of the price of the instrument and the costs associated with the execution.
This means that if, all else being equal, venue A offers an instrument for 100 euros and the costs of executing on that venue (e.g. exchange fees, settlement fees, etc.) amount to 5 euros (making the total consideration equal to 105 euros), while another venue B offers the same instrument for 102 euros with costs of execution equal to 2 euros, the investment firm should execute a client order to buy this financial instrument on venue B, since the total consideration of 104 euros delivers a better result for the retail client.
1.5.2 Why is it necessary to legislate in order to force firms to seek to secure the best possible results for their clients? Surely, in a competitive market place, they will want to do this anyway?
First, best execution is fundamental for investor protection. When providing investment services to their clients, investment firms are obliged to act honestly, fairly and professionally in accordance with the best interests of their clients (Article 19(1) MiFID). This fiduciary duty an investment firm owes its client is further developed in the best execution obligations (Article 21 MiFID) by focusing on one particular area - the way client orders should be executed by an investment firm. This area is singled out because of the information asymmetry arising between the service provider and the client. Under normal circumstances, clients have very little opportunity to monitor whether the investment firm that executes orders on their behalf has indeed acted in their best interest since they are unlikely to have the access to the relevant information that would help them assess the quality of the service. But even if such information were freely available, clients would probably not have the time or specialist knowledge to understand or evaluate detailed disclosures related to the execution of their orders, nor the resources to make an effective comparative evaluation of the execution policy of the firm. There is therefore a danger that some investment firms could take advantage of this information asymmetry by giving unfair treatment to their clients without necessarily suffering the usual reputation consequences in a competitive market. This is why it is necessary that a clear obligation is established for the execution of client orders.
But there are other regulatory aspects to best execution that are relevant in the MiFID context. MiFID establishes a regime where multiple trading venues will be able to compete for client order-flow. Competition between trading venues should lower the cost of transacting financial instruments and thus contribute to the greater efficiency of European capital markets. However, it is well-known that liquidity pools are extremely sticky, i.e. it is extremely hard for new trading centres to attract new business, even if they can provide better services than their competitors.
As trade should be driven to those venues that can consistently provide the highest quality results, the best execution obligation will help ensure that firms are not able to ignore such venues. Apart from promoting competition, best execution obligations should thus also contribute to greater market integration.
1.5.3 Which financial instruments are subject to best execution?
Best execution is not limited to shares but applies to all financial instruments. However, investment firms, though always subject to best execution obligations, are not expected to meet these obligations in the same way for each type of instrument.
1.5.4 How will it work in practice?
Investment firms must establish and implement effective arrangements for complying with the requirement to deliver best execution as it is defined in Article 21(1) MiFID. In particular, investment firms must establish and implement an order execution policy to allow them to obtain, for their client orders, the best possible result (Article 21(2) MiFID). This execution policy is therefore the firm's key instrument in achieving best execution. It must at least include, in respect of each class of instruments, information on the different venues (e.g. traditional venues, such as stock exchanges, but also multilateral trading facilities[2] or systematic internalisers) where the investment firm executes its client orders and the factors affecting the choice of execution venue. Furthermore, it must include those venues that enable the investment firm to obtain, on a consistent basis, the best possible result for the execution of client orders (the policy should of course differentiate between different types of client) (Article 21(3) MiFID).
When assessing a particular firm's compliance with MiFID, supervisors will have to decide (a) whether the firm's policy is adequate and (b) whether the firm adheres to its policy in practice. The policy will also have to be dynamic. Investment firms must monitor its effectiveness in order to identify and, where appropriate, correct any deficiencies. In particular, firms must assess, on a regular basis, whether the execution venues included in the policy are actually delivering best execution and make appropriate changes when necessary (Article 46 Implementing Directive). For example, the policy may have to be amended to take account of the emergence of new venues.
1.5.5 Is it possible to comply with the best execution obligation while executing at only one venue?
In most cases, to have a reasonable chance of securing the best possible result for their clients, firms should assess a choice of venues. This will allow them to determine which venue is offering the best conditions and to route the order to that venue.
1.5.6 How will an investment firm know which venues offer the best results?
MiFID obliges execution venues to make available to the public, on a reasonable commercial basis, pre- and post-trade information (this means that execution venues may charge fees for making the data available to third parties).
It is conceivable that investment firms obtain this information directly from the execution venues but it is more likely that data vendors will consolidate this information to allow firms to evaluate the venues' execution quality.
1.5.7 Will firms usually have to gain access to a number of venues?
A firm must, of course, have access to at least the venues cited in its execution policy, i.e. venues that enable it to obtain best execution on a consistent basis. This can be achieved by gaining access to these venues directly (e.g. becoming a member of an exchange) or via an intermediary (or intermediaries). Clearly, the cost of direct access to a multitude of venues may be high. In many cases, therefore, an indirect access through an intermediary may be the best solution.
However, the commissions paid to intermediaries providing access to execution venues can mount up over time and it may become clear that gaining direct access is more economical and efficient than going through intermediaries. As explained earlier, firms will have to monitor and regularly review their execution policy and decide which option (direct access vs. intermediated access) is likely to secure the lowest execution costs for their clients. Supervisors will have to decide whether the decisions taken by firms are reasonable. In doing so, they will take account of a number of factors (including the size and cost structure of the firm concerned).
1.5.8 Who are these intermediaries providing access to execution venues and why would an investment firm want to use their services?
These intermediaries may be numerous, ranging from classical brokers to what one could call 'best execution package providers' – service providers specialising in delivering off-the-shelf solutions to best execution. As best execution is composed of many elements – data gathering and analysis, connectivity or access to execution venues, order routing, etc. - it is likely that products that integrate all the different steps of order execution in such a way as to ensure compliance with the Directive will become quite popular. Depending on the investment firm, the type of business it undertakes and the type of clients it serves, investing in such packaged solutions may be one simple way of ensuring best execution.
1.5.9 Are investment firms responsible for best execution if they do not execute their client orders directly but rather transmit them to other intermediaries who then execute them?
Yes. In this case, both the investment firm itself and the other intermediaries who actually execute the client orders will be subject to the best execution obligations. The important point is that the firm that is in contact with the client will always be directly responsible to him.
1.5.10 What about firms who initiate trades as portfolio managers?
The best execution obligation will apply to them too (Article 45 Implementing Directive). This is because there is no real difference in the duty a firm owes to a client who initiates orders himself and the client who delegates the decision to initiate orders to the investment firm.
1.5.11 I am a client. Can I define the factors that are important to me for the execution of my orders or tell my broker to execute only at a venue of my choice?
Yes. Firms have to obtain prior consent from their clients as regards their execution policy (Article 21(3) MiFID). An individual client may agree to the policy or he may decide to issue his own specific instructions (e.g. to execute only at a single venue of his choice). These instructions always prevail over what is in the policy. Where a client gives an instruction relating to just one area (e.g. price limits), the firm is still bound by its best execution obligations in other areas (i.e. in relation to the part of the order where no client instructions have been given).
1.5.12 How can I know how and where my broker is executing my orders?
Firms have to report to their clients the details of the transactions they have executed on their behalf (Article 19(8) MiFID). This includes the price at which a particular instrument was bought or sold, the venue where the transaction was carried out and the time of the trade. Moreover, clients can demand that a firm shows them how it has complied with its best execution policy.
1.6 Order handling
1.6.1 Can a broker benefit from the information he gets from his client's order flow? Can he trade ahead of them?
No. This is prohibited. Specifically, brokers must prevent the misuse of all information relating to pending client orders (Article 47(3) Implementing Directive).
1.6.2 How can a broker ensure sequential treatment of orders received by the client desk through different channels?
According to the MiFID, investment firms must establish such procedures or arrangements that allow for the execution of otherwise comparable client orders (e.g. orders that are received through the same channel) in accordance with the time of their reception by the investment firm (Article 22(1) MiFID). The Implementing Directive provides more detail in relation to sequential order execution in situations where orders come into the firm through a variety of different media, such as telephone or internet. It is stated (in Recital 66 of the Implementing Directive) that client orders should not be treated as otherwise comparable if they are received by different media and it would not be practicable for them to be treated sequentially. This means that it may not be possible to ensure an 'absolute' sequential treatment of orders and, in such circumstances, it may be accepted that some of the client orders are not executed in perfect accordance or sequence with the time of their reception by the investment firm.
1.7 Inducements
1.7.1 I am a client of a bank. Can my bank get paid by third parties in respect of the services that it is providing to me? How can I be sure that it is then going to act only in my interests?
In general, the bank may not receive payments from third parties, unless those payments (i) are consistent with the bank's duties towards the client (such as its duty to act in the client's best interests); (ii) improve the quality of the service provided; and (iii) are fully disclosed to the client (Article 26 Implementing Directive).
1.7.2 I am an independent financial adviser. I've heard you are cracking down on inducements. Will I still be able to accept trailing commissions?
If you are an investment firm covered by MiFID, then the rules on inducements in the MiFID implementing Directive will cover you. Those rules require that any inducement received by you or on your behalf from third parties be properly disclosed to the client, not conflict with your duties towards your client (including your duties to act in his best interests), and improve the quality of the service to your client. The text also states that the receipt by an investment firm of a commission in connection with investment advice or general recommendations, in circumstances where the client does not pay the investment firm for the advice or recommendations, and where the advice or recommendations are not biased as a result of the receipt of commission, is likely to enhance the quality of the investment advice to the client (Recital 36 Implementing Directive).
2. Organisational requirements for firms and markets
2.1 Compliance and risk management and internal audit functions
2.1.1 Must firms always have a compliance officer, a risk manager and an internal auditor? Can these tasks be fulfilled by the same person?
Firms will always have to have a compliance function and a compliance officer responsible for overseeing it ("function" denotes an investment firm's employee or employees responsible for carrying out compliance activities and is not intended to prejudge any particular organisational arrangements) (Article 6 Implementing Directive).
Sometimes it is possible not to have a specific risk management function or an internal audit function (Articles 6(2) and 8 Implementing Directive). This will depend on the size and complexity of the business. Nevertheless, firms will always have to put in place proper risk management strategies and have good internal control mechanisms.
2.1.2 Do all investment firms need to have separate and independent compliance, risk management and internal audit functions and can any of these functions be outsourced?
Not necessarily. As explained above, the requirements are graduated in such a way as to be adaptable to all sorts of businesses ranging from large global institutions to one-person investment firms.
It is expected that the former are very likely to have separate and independent compliance, risk management and internal audit functions, while the latter can benefit from the flexibility clauses and are not obliged to maintain such a high degree of organisational segregation.
It is possible to outsource some of the activities associated with the performance of the compliance, risk management and internal audit functions. However, an investment firm may not outsource the responsibility for those functions and it should always retain the necessary expertise to effectively supervise the outsourced activities.
2.1.3 Do firms have to produce a formal annual report commenting on their compliance activities?
Yes. This should be the bare minimum. A firm's management should receive frequent reports on these matters because it is responsible for the overall sound management of the investment firm, its compliance with all relevant laws and regulation and, in particular, for the proper and effective operation of the compliance function (Article 9(2) Implementing Directive).
2.1.4 As an employee of a bank, what type of transactions can I do for my own account? Do I have to communicate them to my bank?
An employee may not enter into personal transactions in instruments in relation to which he possesses inside information (e.g. information in relation to a financial instrument which has not been made public and which, if it were made public, would have a significant effect on the price of the financial instrument) or is in a situation of conflict of interest (Article 12(1) Implementing Directive). This means that he may not even advise or procure other people to enter into such transactions. In any case, his firm should be aware of all personal transactions he carries out. The restrictions on personal transactions do not apply to transactions that are effected by an employee's discretionary portfolio manager or to transactions in units in collective investment undertakings that meet strict diversification criteria (e.g. UCITS) (Article 12(3) Implementing Directive).
2.2 Out-sourcing
2.2.1 Can firms outsource particular functions?
Yes, but outsourcing is a serious matter and it is carefully regulated. Outsourcing may never result in the delegation of the investment firm's responsibility, alter the relationship and obligations of the investment firm towards its clients or undermine the conditions with which an investment firm must comply in order to remain authorised (Article 13(3) Implementing Directive). Furthermore, when entering into, managing or terminating any arrangement for outsourcing a particular function to a service provider, investment firms must comply with many other requirements (Article 14 Implementing Directive). For example, an investment firm must ensure that the service provider has the ability, capacity and any authorisation required by law to perform the outsourced function.
Special conditions apply when an investment firm outsources the investment service of portfolio management provided to retail clients to a service provider located in a third country (Article 15 Implementing Directive).
In such cases, apart from complying with all the other conditions, an investment firm must ensure that the service provider is authorised or registered in its home country to provide such a service and that there are appropriate cooperation agreements between the competent authority of the investment firm and the supervisory authority of the service provider. When one or both of these conditions are not satisfied, an investment firm may still outsource the management of retail client portfolios to a third country service provider but only if it gives prior notification to its competent authority about the outsourcing arrangement and the competent authority does not object to that arrangement within a reasonable time of receiving that notification.
2.3 Identification and management of conflicts of interests
2.3.1 How can a client of an investment firm or bank know whether the firm or bank is acting for one of the client’s competitors?
In many cases, acting for two competitors presents a conflict of interests which at least potentially risks damage to the interests of one or both clients. This will be so where the firm or bank has an advisory or strategic relationship with one or both clients, and the clients’ activities can come into conflict (where, for example, both clients are large investors).
Investment firms, and banks that provide investment and ancillary services, must draw up a comprehensive policy identifying the steps that will be taken for identifying and managing conflicts of interests that present the risk of damage to client interests (Article 22 Implementing Directive). Where the steps taken are insufficient to ensure, with reasonable confidence, that risks of damage to client interests will be prevented, the source of conflicts must be disclosed to the client. For example, an investment firm that underwrites a particular financial instrument may need to disclose a conflict of interests when providing investment advice to its clients in relation to this financial instrument. Sufficient detail must be provided to enable the client to take an informed decision with respect to the relevant investment or ancillary service.
2.3.2 Is it possible to manage conflicts of interests only through disclosure of these conflicts to clients?
Investment firms and banks providing investment and ancillary services should aim to identify and manage the conflicts of interests arising in relation to their various business lines under a comprehensive conflicts of interests policy. While disclosure of specific conflicts of interests is required by the MiFID (Article 18(2) MiFID), an over-reliance on disclosure, without adequate consideration as to how conflicts may appropriately be managed, is undesirable.
2.3.3 What investment research is affected by the MiFID?
The Market Abuse Directive and its rules on disclosure of conflicts and the fair presentation of research recommendations apply to all ‘recommendations’ as defined in that Directive. The MiFID contains specific rules on conflicts management for investment research (Article 25 Implementing Directive). These rules apply to firms that produce or disseminate ‘investment research’, i.e. recommendations which are labelled as investment research or otherwise held out as objective, and which are not tailored to particular services (Article 24 Implementing Directive).
2.3.4 The rules on investment research seem quite complicated. What is permitted and what isn’t?
Where a firm produces or disseminates investment research, it will be required to implement a number of specific steps. These are spelt out in detail in the Implementing Directive (Article 25 Implementing Directive), but in general terms all the steps are designed to preserve the objectivity of the analysts concerned by according them an appropriate degree of independence from other parts of the firm whose business interests may conflict with the interests of the recipients of the research. The rules largely reflect the 2003 IOSCO standards for analysts' conflicts.
More specifically, analysts should be isolated from improper influences from at least corporate finance personnel and persons involved in sales and trading on behalf of clients or the firm. The flow of information between analysts and such people should be controlled, and remuneration, supervision and joint activities must be controlled to ensure analysts’ independence is preserved. Analysts and others must be prevented from dealing ahead of investment research, and other personal account transactions restrictions must be implemented. There are also restrictions on inducements, promising favourable coverage and the review of draft recommendations.
2.3.5 What about pitches and roadshows?
Analysts may not attend or participate in such events if doing so would be inconsistent with the analyst’s objectivity, or could reasonably be considered to be so (Recital 33 Implementing Directive). Normally, active participation would be unacceptable, while mere passive attendance would be acceptable.
3. Transaction reporting and co-operation among competent authorities
3.1 General approach
3.1.1 What is the general idea behind these provisions?
The main purpose of transaction reporting and cooperation among competent authorities is to enable the regulators to properly monitor the activities of their firms in order to uphold the integrity of the markets. This should be done in a way which is effective but which makes it as easy as possible for firms to buy and sell financial instruments across borders. Under MiFID, firms will only have to report transactions once – to their home supervisor. There is no obligation to report transactions to the supervisor of the market where they have been executed. The competent authorities in the different Member States will have to exchange information concerning transactions in order to ensure that the activities of investment firms are properly monitored.
3.2 Co-operation among competent authorities
3.2.1 Which information will competent authorities need to have access to in other Member States?
Competent authorities must automatically receive information concerning transactions in financial instruments for which they are the competent authority of the most relevant market in terms of liquidity (Article 25(3) MiFID). For example, a German investment firm will report trading in Vodafone shares to its regulator and that regulator will then pass on this information to its UK counterpart as it is the competent authority of the most relevance to Vodafone. Competent authorities may also request additional information. For example, the UK authorities could ask the German authorities to provide them with information concerning transactions in Vodafone derivatives or other financial instruments which involve Vodafone shares.
3.3 Transaction reporting
3.3.1 Are transaction reports going to be essentially the same in all Member States?
Yes. The Implementing Regulation aims at harmonising the content of the reports (Article 12 Implementing Regulation). However, Member States are given a possibility, in very restricted circumstances, to add extra reporting obligations.
3.3.2 Who is going to set up the standards for reporting transactions to competent authorities? Are there going to be any European standards?
The Implementing Regulation sets out what information concerning the transactions carried out by an investment firm needs to be reported (Article 12 Implementing Regulation). The Regulation specifies and describes particular data fields that need to be reported but it does not prescribe the particular technical standards which should be used (Annex I Implementing Regulation). For example, it is not prescribed whether firms should use a particular code identifying a financial instrument or the trading venue where the transaction took place as long as those codes are unique and enable the competent authority to ascertain what instrument was traded and on which venue.
3.4 Determination of "substantial importance"
3.4.1 Will regulated markets be subject to supervision by more than one competent authority?
Not in principle. Normally, a regulated market will be under the supervision of its home competent authority – the regulator which has authorised its operations. Exceptionally, however, the MiFID (Article 56(4)) and the Implementing Regulation (Article 15) provide for a reinforced cooperation of competent authorities when a regulated market becomes of "substantial importance" in another Member State. This possibility to establish appropriate cooperation arrangements is triggered when, for example, a regulated market merges with another regulated market or when there is another change of ownership of regulated markets. The legal texts do not specify what this reinforced cooperation entails. This is left up to the competent authorities to determine.
4. Transparency
4.1 General approach
4.1.1 What is transparency?
Transparency is allowing investors and market participants to know at what prices they can buy or sell a share (pre-trade transparency) and at what prices shares have been sold and bought (post-trade transparency).
4.1.2 Are there exemptions for large trades?
Large trades are subject to limited transparency. In the case of pre-trade transparency, orders bigger than certain thresholds need not be displayed to the public (Article 19 Implementing Regulation). In the case of post-trade transparency, large trades are made public but only after a certain period of time has elapsed (Article 27). These exceptions to the transparency rules have been introduced in order to take into account the trade-off between transparency and liquidity provision, i.e. sometimes too much transparency may reduce the willingness of actors to place their own capital at risk and thus facilitate trading because exposing their positions to the whole market could make them vulnerable to those who would wish to trade against them.
4.1.3 Will bonds be made transparent?
The MiFID establishes a comprehensive pre- and post-trade transparency regime for equities only. This means that regulated markets, MTFs and systematic internalisers are not bound by such transparency requirements in relation to their bond trading by virtue of the MiFID. However, in accordance with Recital 46 of the MiFID, Member States may decide to apply pre- and post-trade transparency requirements to financial instruments other than shares. Article 65 of the MiFID requests the Commission to report on whether the pre- and post-trade transparency regime should be extended to other financial instruments. The Commission will be considering this issue later this year and is due to report by November 2007.
4.1.4 How will shares traded on stock exchanges be affected?
Shares traded on exchanges and trading platforms are subject to the pre- transparency requirements set out in the MiFID (Articles 29 and 44 MiFID) and the Implementing Regulation. However, fulfilling the pre-trade transparency obligations will depend on the type of trading system that a stock exchange operates. For example, if an exchange operates an order-book system that matches the incoming buy and sell orders, it will have to disclose the five best buy and sell orders in the order book. There is a different requirement for trading systems that are quote-driven, i.e. systems where different market makers display bid and offer prices at which they are ready to trade a particular share. In such a quote-driven market, each registered market maker has to make public and continuously update their quotes.
4.1.5 Will regulated markets or MTFs be obliged to run a continuous trading order book?
No. Regulated markets are not forced to run particular trading systems as a result of the MiFID and its implementing measures.
Regulated markets should be free to operate whatever trading systems or algorithms they choose as long as these comply with the obligations to provide for fair and orderly trading and other regulatory obligations, notably the transparency ones. The Implementing Regulation thus remains open to innovation in this area.
4.2 "Sytematic internalisers" – liquid shares
4.2.1 Does every internaliser of share trading have to publish quotes?
No. Internalisers (i.e., firms which execute customer trades internally on own account) only have to publish quotes when three conditions are met: (i) they are considered as "systematic internalisers"; (ii) the shares are "liquid"; and (iii) the transaction is not above standard market size (Article 27 MiFID).
4.2.2 What is a systematic internaliser (SI)?
An SI is a firm or a bank that executes client orders internally on own account. It does so frequently, systematically and in an organised fashion. In other words, internalisation is not something that the firm or bank does from time to time; it is a fully-fledged business activity with a proper business structure supporting it (Article 20 Implementing Regulation). An SI internalises its client orders in a way that makes it look like a market. It shares some of the most common features of markets.
4.2.3 How will a firm or a bank know if it is going to be counted as an SI?
As stated above, internalisation, for a "systematic internaliser", is not an occasional activity but rather a fully-fledged business activity. The decision to enter into this business is taken on commercial grounds. In principle, therefore, becoming a "systematic internaliser" is not something which "happens" to a firm; it is the result of a conscious, deliberate decision.
4.2.4 Will a firm which internalises client orders from time to time be counted as an SI?
A firm which only internalises client orders occasionally is unlikely to be considered as systematic.
4.2.5 What are liquid shares?
Member States must define as "liquid" any shares with a free float of more than €500 million, and an average daily turnover higher than €2 million and/or an average daily number of transactions higher than 500.
If, according to these criteria, a Member State has less than 5 liquid shares (0, 1, 2, 3 or 4), it can choose to define as liquid a sufficient number of other shares (i.e. shares which do not meet these criteria) to take its total number of liquid shares up to 5. So, for example, if according to the criteria, a Member State only has 2 liquid shares, it can define as liquid the next 3 liquid shares in order of size (or 2 or 1 or none).
On the other hand, Member States with less than 5 liquid shares are not obliged to define additional shares as liquid. For example, a Member State with 0 liquid shares can perfectly well remain at 0 (Article 21 Implementing Regulation).
4.2.6 Are SIs obliged to trade at their quoted prices with non-clients?
No. SIs are only obliged to trade at their quoted prices with their clients. However, they cannot have a discriminatory access policy for becoming a client (Article 27(5) MiFID).
4.2.7 Can SIs publish the details of their transactions themselves or will they have to continue to send them to a regulated market?
SIs can publish the details of their transactions themselves as long as they ensure that they are available to the market (Articles 29-31 Implementing Regulation). Not only do they not have to send their OTC transactions to the regulated market, but any attempt to make this obligatory (for example through the rules of the exchange) will be considered as contrary to MiFID and the Implementing Regulation.
4.3 Data consolidation
4.3.1 Will market users be able to see the details of all transactions executed in respect of a particular share? Will summaries of this information be available?
MiFID does not oblige anyone to produce summaries of this kind. However, it is expected that they will be produced as a result of market forces. Since they will clearly have a commercial value, it is very likely that they will be produced on a commercial basis (see question 1.5.5).
5. Record keeping, transaction and client reporting and post-trade transparency
5.1 Record keeping
5.1.1 What records do firms need to keep? Will there be a minimum list of records?
Article 13(6) of the MiFID contains a general record keeping requirement that obliges investment firms to keep the records necessary to enable competent authorities to monitor compliance with the MiFID. This general provision is sometimes supplemented with explicit record keeping requirements (e.g. record keeping with regard to client order handling (Article 6 Implementing Regulation) or transactions (Article 7 Implementing Regulation) and record keeping obligations relating to SIs (Article 23 Implementing Regulation)). In order to provide investment firms with greater legal certainty, the competent authorities should draw up an indicative list of records in order to help firms assess what records they need to keep (Article 51(3) Implementing Directive).
5.1.2 For how long do firms have to keep their records?
Generally, firms are required to retain the records required for a period of five years (Article 51(1) Implementing Directive). However, competent authorities can require firms to keep their records for a longer period of time if such a requirement is necessary to enable effective supervision and if the longer period is justified by the type of instrument or transaction. Additionally, records related to the client agreement and the documents that set the rights and obligations of the firm and the client have to be retained for at least the duration of the relationship with the client.
5.1.3 Do firms have to record the orders they receive by telephone?
Yes, firms are required to record all orders, irrespective of whether they have received an order on the phone or through other means. However, the Implementing Regulation does not require voice recording of telephone orders. It only establishes the general conditions with which the records have to comply (Article 51 (4) Implementing Directive). Nevertheless, Member States can still impose obligations relating to the recording of telephone conversations or electronic communications involving client orders.
5.2 Reporting to clients
5.2.1 I am a client. How can I ensure that the order I have given to my broker corresponds to what he has finally executed?
Every time a firm receives a client order, it has to record this order. After executing the order, the firm has to report to the client that it has done so (Article 19(8) MiFID). The notification has to be prompt and, in case of a retail client, the Implementing Regulation requires the firm to send the notification on the following business day at latest (Article 40(1) Implementing Directive). In this way, the client has the opportunity to verify whether the firm has executed the order in accordance with his instructions and/or (in cases where the client has not given any specific instructions) with the obligation to act in the client's best interest.
5.2.2 What kind of reporting obligations do firms have towards their clients?
Clients have to be informed on a regular basis and in sufficient detail of the type of service that has been provided to them (Article 19 (8) MiFID). In this respect, the Implementing Directive sets out three groups of reporting requirements: reporting in the case of portfolio management (Articles 41 and 43 Implementing Directive), reporting obligations in respect of the carrying out of orders other than for portfolio management (Article 40 Implementing Directive) and reporting related to the safeguarding of client instruments and funds (Article 43 Implementing Directive).
5.3 Common components for records/reports
5.3.1 Can firms use basically the same template for all their record keeping and reporting obligations under MiFID?
No, but the Implementing Regulation establishes a set of components (or data fields) which will be common to all the records or reports required by MiFID (with regard to record keeping of orders, post-trade transparency, record keeping of transactions, and transaction reporting to clients and the authorities) (Annex I Implementing Regulation). Firms will therefore be able to use these common data fields for the purposes of the different recording and reporting obligations.
6. Other issues covered by the implementing measures
6.1 Admission to trading
6.1.1. Is a regulated market required to have an official segment?
No. An official segment can only be established on a stock exchange. It is not mandatory for a stock exchange to establish an official segment. If a stock exchange decides to create an official segment, securities and issuers that want their securities to be admitted to this official segment must meet the criteria established in accordance with the Directive 2001/34/EC on the admission of securities to official stock exchange listing. A regulated market must always ensure that the financial instruments admitted to trading comply with the requirements of MiFID and its implementing measures.
6.2. Commodity Derivatives
6.2.1 What is a commodity?
The concept of a commodity covers goods of a fungible nature, i.e. goods that are capable of being delivered, including metals and their ores and alloys, agricultural products and energy (electricity, gas, oil) (Article 2(1) Implementing Regulation). Goods are fungible, when any unit of a class of those goods is as acceptable as another unit of that class.
6.2.2 What is a spot contact?
The term spot contract is used in relation to commodities. To put it simply, it is the contract to purchase or sell a commodity. The MiFID regulates trading in financial instruments, one category of which is commodity derivatives, but not the trading of commodities themselves. It is therefore necessary to differentiate between spot contracts and derivative contracts on commodities. This can be difficult as the only difference between a spot and a derivative contract can sometimes be just the time of delivery of the commodity. For example, a contract to buy a ton of gold that is to be delivered to the buyer the following day should be treated as a spot contract while a contract to buy a ton of gold in a year's time would be treated as a commodity derivative – a financial instrument subject to MiFID regulation.
6.2.3 Does buying and selling commodity derivatives oblige a firm to be licensed?
Not in all cases. If a firm provides investment services only for its parent or sister company or if it only deals on its account, it is exempt from the scope of the MiFID and need not be licensed. There are also other exemptions in Article 2(1) of the MiFID but these two are probably the most important ones.
6.2.4 What about commodities firms? I've heard they are exempt?
Article 2(1)(k) of the MiFID exempts persons whose main business consists of dealing on own account in commodities and/or commodity derivatives from its scope of application. However, if a 'commodity firm' also provides other investment services, such as investment advice and portfolio management, it is not likely to remain exempt (as its main business would not simply consist of dealing on own account).
6.3. Investment Advice
6.3.1 If a firm provides generic advice, does it have to be licensed?
Firms that provide only generic advice (i.e., advice on types of financial instruments only that is not specific to particular investments) do not have to be licensed under the MiFID. The definition of investment advice, as detailed in Article 52 of the Implementing Directive, does not cover this type of advice; consequently, the authorisation requirements under the MiFID (Chapter 1 of Title II MiFID) do not apply.
However, investment firms that provide this type of service may be subject to national legislative requirements, including the need to have a licence, and the rules governing these kinds of firms are not standardised.
6.3.2 Can a client nevertheless rely on generic advice it receives from an investment firm?
Yes. Under the MiFID, an investment firm is under an obligation to act in the
best interests of its clients (Article 19(1) MiFID) and any communication it
provides to clients must also be fair, clear and not misleading (Article 19(2)
MiFID). This means that the provision of generic advice by investment firms will
be subject to compliance with these provisions of the MiFID, even though it is
not an investment or ancillary service within the terms of MiFID. In particular
this means that, the provision of generic advice which is not in fact suitable
for the client will be contrary to the firm’s duty to act in the best
interests of the client. Moreover, where generic advice is not based on a
consideration of the client’s circumstances, presenting it as suited to
such circumstances will be misleading, and thus, a breach of the requirement of
Article 19(2) MiFID.
[1] A regulated market is an exchange – whether stocks, bonds or derivatives – that is authorised as a regulated market by a competent authority. Most main-board stock exchanges are, and can be expected to remain, regulated markets. In addition, derivatives exchanges and (for the first time) commodities exchanges are eligible to be regulated markets.
[2] Multilateral trading facilities (MTFs) form a new category. This category covers, broadly speaking, all trading platforms that permit trading between participants and which are not regulated markets. They can be operated by investment firms – which will require authorisation to carry on this activity – or by regulated markets. Secondary boards, and electronic trading platforms that are not associated with exchanges, can be expected to become MTFs.
