Cicero Policy Briefer

Issue 4, September 2006

Everything you ever wanted to know about MiFID

By Ben Gil

There are certain EU initiatives, especially in the area of financial services, which the people and institutions most affected do not fully understand until late in the day. MiFID, the Markets in Financial Instruments Directive, is potentially an example of this; yet it is of profound importance for the whole European financial services industry, and it is essential for stakeholders to realise its implications.

MiFID is the last major element of the EU’s Financial Services Action Plan. It is designed to lower barriers to cross-border share trading, facilitate investment and give a boost to the EU economy. However, the financial institutions are worried about the timetable and the anticipated heavy costs of the required systems and IT changes.

MiFID was proposed in 2002 to update the existing ISD (Investment Services Directive) of 1993 in order to regulate the increased level of cross-border investment transactions, which were increasing at a rate of 20-25 per cent in the years from 1996. The old ISD only applied to a specified number of financial instruments and investment services and did not cover commodities derivatives. As a result, some member states had imposed licensing for a wider range of activities, causing uncertainty and expense for companies operating across borders.

The 42 measures of the new MiFID create a comprehensive regulatory regime, impose higher standards and include commodities derivatives, leading to greater European harmonisation and integration of the EU capital markets. With implementation, securities trading throughout the EU will become more efficient, quicker, cheaper and will afford greater protection for investors. MiFID covers almost all tradable financial products, including commodity and freight derivatives which were not covered by ISD. The main exception is foreign exchange trades.

Most importantly, MiFID will incorporate the ‘passport principle’, whereby an investment firm authorised by the competent authority in its home member state (for example, the FSA in the UK) can operate throughout the EU under the continuing supervision of the home authority. This reverses the old ‘host state’ rule, which required compliance with rules of the member state in which business was being done.

MiFID also introduces the concept of 'maximum harmonisation', which places more emphasis on home state supervision, rather than the 'minimum harmonisation or mutual recognition' principle seen in previous financial services legislation. In this respect, the directive sets minimum standards for the powers of national regulatory authorities and establishes procedures for cooperation amongst authorities in the investigation of breaches of the rules.

A further new feature introduced by MiFID is the multilateral trading facility (MTF), a new core investment service covered by the passport and which extends its scope to commodity derivatives, credit derivatives and financial contracts for differences for the first time.

The common conduct of business standards established in MiFID is extensive, and it will require significant changes to the FSA Handbook. The starting point for many of these changes is the introduction of a new client categorisation regime – which differs in several important aspects from the current FSA regime.

For starters, MiFID requires firms to classify clients as eligible counter parties, professional clients and retail clients, with increasing levels of protection. Clear procedures must be introduced to classify clients and assess their suitability for each type of investment product.

The directive sets out requirements for accepting client orders, ensuring that a firm is acting in a client's best interests and as to how orders from different clients may be aggregated. It will require operators of continuous order-matching systems to make aggregated order information available at the five best price levels on the buy and sell side. For quote-driven markets, the best bids and offers of market makers must be made available. These requirements currently only apply to equities but it is expected that they will also apply to other products in the future.

Firms will need to publish the price and volume of all trades, even if executed outside of a regulated market. MiFID requires firms to take all reasonable steps to obtain the best possible result in the execution of an order for a client and this also includes cost, speed, likelihood of execution and settlement.

While current reporting requirements extend to debt and equity related products, MiFID will require transaction reports for any instrument admitted to trading on a regulated market, including commodity instruments admitted to trading on exchange. For example, systematic internalisers, houses that execute orders from clients against their own books or against orders from other clients, will be treated as mini-exchanges and will be subject to pre-trade and post-trade transparency requirements.

To determine which firms are affected by MiFID, the directive distinguishes between investment services and activities (core services) and ancillary services (non-core services). If a firm performs investment services and activities, it is subject to MiFID rules both for these and also of ancillary services. It can use the MiFID passport to provide these services in other member states. However if a firm only performs ancillary services, it is not subject to MiFID rules – but, by the same token, cannot benefit from the MiFID passport.

Most firms that fall within the scope of MiFID will also have to comply with the new Capital Requirements Directive (CRD) which will set requirements for the regulatory capital which a firm must hold. Firms newly covered by MiFID will be subject to directive based capital requirements for the first time.

The scale of the changes involved, both for member states and for industry, led the MiFID Joint Working Group to convince the Commission in June 2005 to modify the original timetables. The deadline for transposition of the MiFID provisions by member states has now been postponed to January 2007, while firms and markets have until November 2007 to ensure full compliance.

MiFID will require major changes to the way investments firms, banks, regulated markets and clearing and settlement intermediaries conduct their business, including all their IT and records systems. They will have to keep records for five years and will also have to publish much more information than before, which will require new communications and business processes to deal with all this additional work. Many houses that currently trade off-book do not have the systems to record and store this information and prove that they are providing best execution. Analysts have predicted costs of £10m for IT and £12m for new processes—potentially costing the industry around £1bn in total.

Many players – including the FSA – are warning that the costs of compliance may be even higher than estimated, particularly given the number of IT projects, and may even outweigh the benefits in the first stage. The FSA will be incorporating MiFID into the FSA Handbook and to date has published four consultation papers about it to stakeholders; all eyes will be on the conclusions it draws.

Ben Gil can be contacted on +44 (0)20 7665 9530 or click here to email.