The level of attention in what MiFID II means for the future of the region has undoubtedly increased from the ambivalence evident in 2016. Outside of the global houses, clearly it would take more than press articles and conferences to shine the light on a changing European regulatory frame work.
Under its complex implementation, MiFID II is the European response to the 2008 Global Financial Crisis that aims to improve transparency and investor protection with more market participant accountability, harmonised across all EU member states.
The Legal Entity Identifier - what is it and who needs it? The LEI was actually not created for MiFID and is already in use in a number of different jurisdictions (including Australia, the USA and India). After January 3rd 2018, an LEI will be mandatory if you trade any European instrument directly with a European broker, including baskets or structured products where at least one component is a European security. It will also be required if you trade directly against a European counterparty. Somewhat alarmingly, earlier this year, media coverage suggested that only 3% of LEI applications were originating from APAC. It is imperative that you have (or have renewed) an LEI if you are trading directly with a European counterparty. It’s likely that the approval queue will get longer as January 2018 approaches and there are no guarantees that late applications will make the end of year cut.
Regulatory Vs Commercial Obligations
One of the first (un)intended consequences is the apparent transformation of what are essentially European-based regulations to a set of de facto global best practice. Noticeably, this process began when American and Asia-Pacific investment managers started feeling pressure from their own clients to align with MiFID II expectations.
Regardless of where a pension fund is based, the key drivers behind their ‘MiFID II World’ service needs won’t change – getting cost transparency (on both research and execution); reassurance that portfolio managers and traders are working in the best interest of their underlying clients; and receiving best execution that the buy-side is directly responsible for. This was re-emphasised in the European Securities and Markets Authority (ESMA) Q&A on Investor Protection - Question 4 “EU/EEA firms subject to MiFID II inducements rules must comply … irrespective of the status of geographical location of the research provider”. This was also subsequently followed up in the UK’s Financial Conduct Authority (FCA) “Pushdown” letter of July 19th, where Stephen Hanks reiterated that firms must remain “fully responsible for discharging all of their obligations” and “the relationship and obligations of the investment firm towards its clients under the terms of Directive 2014/65 is not altered”. Any delegation arrangement will require MiFID II firms to take steps to secure an equivalent level of protection for clients.
Here is the key point: Even if out of regulatory scope, the commercial obligations are helping MiFID II obligations to spread globally.
So, if an APAC entity sub-manages funds for an EU entity, that APAC entity will face very little pressure from European regulators, given the European regulator (ESMA) has no jurisdiction over them. However, the EU entity is obliged to provide MiFID II compliant services to its own clients. It is still under discussion exactly how ESMA and national regulators will push such EU entities to require MiFID compliant services from their sub-managers. Those firms offering their full service within Europe may reasonably view themselves at a financial disadvantage due to the cost of implementing the new regulations.
Others could consider this option as regulatory arbitrage and be tempted to open or work more outside of the EU.
Equivalence and Trading On a Trading Venue (TOTV)
European and US firms should probably care more than APAC based institution. So what is it all about?
Under MiFID II, if a security is available to trade on a (EU) trading venue or a non-EU trading venue which has an “equivalent status”, then European firms must trade there. “Equivalence” essentially means these non-EU trading venues are regarded as having a comparable regulatory framework and therefore considered “safe” (approved) for European investors to trade in. Whilst this shouldn’t have been much of an issue, the Brexit era after the 2016 vote saw continental Europeans pushing to exclude automatic equivalence to the UK once Brexit is formalised. This would prevent trading volumes from crossing the Channel or be used as part of the negotiation – who said regulatory change wasn’t political....
European Trading Venues will be split between Regulated Markets (lit exchanges) and MTFs (multilateral trading facilities) which are regulated alternative exchanges, potentially without pretrade transparency (dark pools). Systematic Internalisers (SIs), which are “execution venues”, will be permissible. Broker Crossing Networks will not be allowed anymore and will have to become either MTFs or SIs or otherwise simply shut down.
For a jurisdiction not achieving equivalent status, European firms will be prevented from trading in that market and must trade on a European trading venue if the stock is listed there. For example, AIA (1299 HK), BHP Billiton (BHP AU), Amazon (AMZN US), Apple (AAPL US), would have to be traded in Frankfurt or Dusseldorf if Hong Kong, Australian or US trading venues are not granted equivalence.
Will there be sufficient liquidity for Europeans to trade? Will sufficient liquidity exist to provide best execution? What would be the impact on the stock’s liquidity on its primary market and its price formation? Indications suggest that main markets in APAC will be granted equivalence before the end of 2017.
In Hong Kong, MTF-like platforms are regulated by the SFC and report trades on the local exchange. Provided the HKEX gets Equivalence, we don’t anticipate problems for these platforms. In Australia, trading on alternative platforms are also regulated and trades are reported to a regulated exchange and we expect equivalence for the local exchanges should provide the necessary regulatory assurance.
In the US, alternative platforms are called ATSs (Alternative Trading Systems). They do not report to an exchange but on a consolidated tape. They form their own ecosystem and we would expect ESMA to give them equivalence together with the granting of equivalence to Regulated Markets NYSE, NASDAQ…). MiFID II is fast approaching yet some of the key implementation elements remain to be clarified. The extra-territorial reach, especially for sub-management and the conflict between best execution and potential lack of equivalence are two key issues we will keep monitoring.
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