MiFID3 View - August 2022

Whilst many have been basking in the European heat, the regulators have been hard at work this last month pushing forward their MiFID reforms. There are a number of notable developments which have required some heavy reading so, without further delay, let’s get down to it.

A landmark piece of legislation

Let’s start with what the Chancellor of the Exchequer hailed as a ‘landmark piece of legislation’ in his speech at Mansion House where he introduced the long awaited Financial Services Markets Bill. The Bill provides us with a first glimpse of the Government’s post-Brexit vision for the future of the UK’s financial markets. With the aim of unravelling the UK from EU retained law and improving competition and investor protection, there are provisions in the Bill which implement the outcomes of the Future Regulatory Framework and Wholesale Markets Review.

Whilst the Bill is over 300 pages (500 if you include the explanatory memorandum) - so too long to summarise here- there are a number of key changes being proposed to the MiFID framework. These include:

• a change to the definition of systematic internalisers (“SIs”) to allow the FCA to decide how to determine whether the dealing on own account for clients take place on an “organised, frequent, systematic and substantial” basis so as to make the firm an SI;
• removing restrictions on SIs for midpoint crossing for trades;
• removing the share trading obligation;
• aligning the trading and clearing obligations with EMIR;
• exempting post-trade risk reduction services from the derivative trading obligation (“DTO”) and giving the FCA a power to modify or suspend the DTO;
• replacing the pre-trade transparency waiver and removing the double volume cap;
• simplifying the position limits regime; and
• simplifying the transparency regime for fixed income and derivatives.

While none of these proposals come as a surprise, what is clear is that the UK is embracing the opportunity to create UK market specific financial services regulation. Inevitably, this regulation will be influenced by EU law, but it will also be influenced by other international developments. More fragmentation and divergence from the EU seem on the cards. What remains to be seen is whether the UK developments might influence the EU direction of travel. As the Bill was introduced just before Parliament broke for its summer recess, it won’t be until early September before we see any further movement.

We will be running a briefing series in the coming weeks covering key themes and topics found in the Bill, including the reforms to MiFID.

FCA reforms to equity secondary markets

As part of its work on implementing the Wholesale Markets Review, the FCA published a consultation paper setting out proposals to improve the UK’s equity secondary markets. As we reported in our previous MiFID3 View, the FCA is taking a staggered approach to its implementation of the Wholesale Markets Review. It will initially consult on reforms that are currently within its authority to change and will then proceed with reforms that need to follow the legislative changes under the Financial Services and Markets Bill. So, as part of its first wave of reforms the FCA has proposed changes to: (a) improve the content and consistency of post-trade transparency reports; (b) establish a new designated reporter status for OTC trades; (c) allow UK trading venues to use reference prices from overseas markets where those prices are robust, reliable and transparent; (d) permit the use of the tick size regime from overseas primary markets; and (e) simplify the SI regime.

These reforms will be of particular interest to trading venues, investment firms and UK branches of overseas firms. The deadline for responding to the consultation is 16 September 2022. Once the FCA has reviewed the responses, it will submit updated technical standards to HM Treasury for approval. The FCA has also indicated that it intends, in due course, to consider whether a broader review of equity markets is necessary in other areas covered by its existing powers or for which it will receive new powers, as part of the outcomes of the Future Regulatory Framework Review.

New UK Consumer Duty has arrived

We cannot overlook the other mammoth publication at the end of last month with the FCA’s Final Policy Statement on the Consumer Duty. The new Consumer Duty will be of particular importance to firms that manufacture and distribute products where there is an underlying retail customer (note the definition of retail customer is wider than current market understanding). A first point to the note, is that the FCA has confirmed the implementation timeline as being phased with a deadline of 31 July 2023 for all in scope new and existing products and services that are open to sale or renewal and 31 July 2024 for closed products and services. A new and challenging deadline has, however, been introduced: by the end of October 2022 boards or other governing bodies will need to sign off Consumer Duty implementation plans and subsequently maintain oversight of their delivery to ensure the implementation work is sufficient to meet the Duty standards.

Over 300 pages long, there is a lot in the policy statement to work through, particularly as the FCA has made a number of updates to the finalised guidance from its December feedback statement. To help firms navigate these reforms we have produced a client briefing setting out the key changes and how we can support. We have a dedicated team of specialists already working with many firms on their compliance arrangements and a consumer toolkit so please reach out if we can help. Immediate focus needs to be on the October 2022 requirement.

EU Sustainability and MiFID – how are you tracking?

As the deadline of 2 August for the integration of sustainability factors, risks and preferences into organisational requirements passes, another one approaches. The sustainability changes to MiFID product governance arrangements will apply 22 November - see our summary. To assist with implementing these changes ESMA has published its consultation paper on changes to the product governance guidelines. Further detail on the paper can be found here. ESMA has indicated it intends to publish its final report only in Q1 2023, so after the November deadline. Firms needing to comply with these requirements should look to ESMA’s paper to guide their compliance arrangements in the absence of the final guidance. We have been helping a number of firms and assisting with updating terms of business, internal processes etc., so please get in touch if we can assist.

ESMA updates its Q&A on algo-trading - the devil’s in the detail

One which may have slipped through the net, is ESMA’s updated Q&As on MiFID2 and MiFIR market structures topics. In the update, ESMA has added two new questions.

First, ESMA considers whether orders executed through automated order managing systems qualify as algorithmic trading. ESMA answers this in the affirmative. Systems that do more than merely route orders to trading venues, for example by automatically redirecting unexecuted portions to other venues or slicing orders, should be considered “algorithmic trading.” By contrast, an automated order routing (“AOR”) system which merely determines the trading venue(s) to which the order has to be sent whilst leaving the order otherwise undisturbed, is not algorithmic trading. This narrow view of AOR could have knock on implications for firms’ relationships with clients and trading venues and systems:

• For instance, it is possible to be a direct electronic access (“DEA”) client and still use the firm’s AOR. But if the firm’s system provides something more than AOR, e.g. by generating child orders, then the client cannot be a DEA client. To put it another way, that additional order management functionality must be embedded in the client’s systems for the client to be considered a DEA client.
• Some leading exchanges impose different obligations on firms providing AOR and those providing DEA: our Trading Venue Reviewer has more details.
• Orders subject to such management would need to be flagged as algorithmic trading.

In a second question, ESMA considers how firms should ensure compliance with the system and risk control requirements (for which they are ultimately responsible) when using third party algo trading providers. ESMA takes a robust view, suggesting firms can ensure compliance by including a commitment to comply with legal requirements in their contracts with third party system providers. Where firms are looking to purchase algorithmic trading systems, or renew contractual arrangements, this should be part of the negotiation to the extent not already covered.

Is the EU set to ban inducements?

European consumer groups are increasingly calling for a ban on payments for order flow (“PFOF”) and possibly all inducements - arguing they create a fundamental conflict of interest and poor and costly advice for investors. Claiming, that the current disclosure regime has been ineffective at stemming these concerns, EU regulators are being asked to take a strong stance in their MiFID reforms and retail investor strategy. In the lead up to the publication of its final report, a number of groups wrote directly to the European Commission asking for prompt action.

The issue has divided Europe, with regulators in Spain and the Netherlands supporting a hard ban, whilst Germany remains opposed to any such proposal. The European Commission published a final report last week on disclosure, inducements and suitability rules following its commissioned retail investors study. This is ahead of the final publication of its retail investment strategy expected Q1 2023. The European Parliament’s rapporteur, Professor Hubner, has also published a draft report, which links the debate on PFOF to divergent interpretations of best execution rules and supports a ban on PFOF, the removal of RTS 27 and 28, plus the removal of any best execution provisions deemed redundant in light of the proposed PFOF ban. The report suggests that ESMA draft RTS specifying the criteria to be taken into account for defining and assessing order execution policy, differentiating between professional and retail clients.

We are sure this will continue to be a lively debate and we will see more lobbying from industry bodies and consumer groups in efforts to sway the regulators’ final decision.

As always, we appreciate your feedback on all our publications and should you need to discuss any of the developments above then please reach out to our MiFID3 Team.