Frances Faulds
Frances Faulds

Countdown to MiFID II. FX gears up for impending new regulation

Whether or not MiFID II/MIFIR is delayed remains to be seen, but as Frances Faulds reports, the industry is still grappling with a January 2017 deadline to get the systems in place for the biggest regulatory shake-up of the FX, derivatives and commodities markets.

MiFID II/MIFIR introduces changes that will have a huge impact on the EU’s financial markets. These include transparency requirements for a broader range of asset classes; the obligation to trade derivatives on-exchange; requirements on algorithmic and high-frequency-trading and new supervisory tools for commodity derivatives.

It will also strengthen protection for retail investors through limits on the use of commissions; conditions for the provision of independent investment advice; stricter organisational requirements for product design and distribution; product intervention powers; and the disclosure of costs and charges.

However, on 2 October 2015, the European Securities and Markets Authority (ESMA) wrote to the European Commission advising that it would not be feasible to have some IT systems necessary to implement certain MiFID II provisions ready for 3 January 2017, which has given rise to the discussions of a delay by the European Commission and Parliament.

The key technical challenges are those described by ESMA in its letter to the Commission in relation to designing resource-intensive IT systems in a very short time frame. A spokesman for ESMA says that position reporting systems for commodity derivatives have to be built from scratch by national competent authorities, and market participants have to build their own systems to be able to comply with the requirements established. ESMA has started a massive project to establish a centralised solution for reference data and transparency calculations, which will be of real benefit to investors in Europe, but it will require an appropriate amount of time to be implemented.

Addressing MEPs in November, ESMA chairman Steven Maijoor said that the Regulatory Technical Standards (RTS) would not be finalised until 2016. He said: “The building of some complex IT systems can only really take off when the final details are firmly set in the RTS and some of the most complex IT systems would need at least a year to be built.”  For this reason, ESMA has raised the possibility of a legislative response with delaying certain parts of MiFID II, mainly related to transparency, transaction and position reporting.

John Kernan“OTFs will capture multilateral trading in non-equity instruments, which have not been covered before, increase investor protection and break up monopolistic positions of regulated markets.”

John Kernan

“OTFs will capture multilateral trading in non-equity instruments, which have not been covered before, increase investor protection and break up monopolistic positions of regulated markets.”

Additional reporting

MiFIR will expand firms’ transaction reporting obligations by increasing the scope of products - now almost all financial instruments have to be reported, whereas, only equities and bonds had to be reported under MiFID I. In general, MiFIR requires that all instruments traded, admitted to trading or requested to be admitted on a trading venue; all instruments with underlying traded on a trading venue and all instruments with underlying index or basket composed of instruments traded on a trading venue are reported.

But John Kernan, SVP, Head of Product Management at trade repository REGIS-TR, says that some of the newly added reportable data represent new challenges for market participants as difficulties exist in gathering/identifying that information, especially the new requirement to report information (ID, date of birth etc.) on natural persons (e.g. broker, and even end-client). 

Investment firms must undertake all trades including trades dealt on own account and trades dealt when executing client orders on a regulated market, an MTF, a systemic internaliser (SI) or an equivalent third-country trading venue. An investment firm may execute a trade elsewhere but only if the trade is non-systematic, ad hoc, irregular and infrequent, or if it is carried out between eligible and/or professional counterparties and does not contribute to the price discovery process. A similar obligation now also applies to the trading of standardised derivatives mandated to clearing under EMIR and which are sufficiently liquid, to be traded exclusively on RMs, MTFs, OTFs or non-EU trading venues deemed equivalent by the European Commission.

Kernan says: “By comparing MiFID I and MIFIR, we can see a trend towards harmonisation of transaction reporting requirements across the Member States as currently there is a considerable amount of divergence between how Member States implemented the transaction reporting obligations under MiFID I. In relation to other reporting regimes, for example EMIR, certain realignment works have been made by regulators and as we can notify a convergence in terms of reporting formats, technical processes and required data fields as many pieces of information are the same across different regulations (e.g. client data, instrument data, broker data, UTI, LEI etc.).”

However, Kernan believes it is impossible to completely harmonise the requirements given that the different reporting regimes exist for different purposes. For instance, given different nature of EMIR and MIFIR reporting, the fields are quite different and he says it would be hard to effectuate a joint reporting as it was initially planned because not all information required under EMIR can be reported under MIFIR, as there are not enough relevant fields. 

“Firms will need to navigate their way through the various reporting obligations and their technical differences which will be complex task for many. Choosing an ARM who is already a licensed trade repository will help negate the need to double report some of the data under MIFIR article 26.7. Market participants should consider a single reporting solution which covers this, and other, data requirements.”

New trading facility

One of the most important changes that MiFID II will bring is the introduction of a new type of trading facility – the Organised Trading Facility (OTF), which will exist alongside regulated markets and multilateral trading facilities (MTFs). Kernan says: “OTFs will capture multilateral trading in non-equity instruments, which have not been covered before, increase investor protection and break up monopolistic positions of regulated markets. Beside the increase of the number of types of trading venues, existing infrastructure will also be applied more broadly as for instance, MTFs can accept with the entry of MiFID II more instrument types.”

MiFID II extends the SI regime so that it applies not just to equities but also equity-like instruments and non-equity instruments, such as derivatives, bonds, structured finance products and emission allowances. MiFID II also introduces a new definition for an SI, which is based on quantitative criteria, requiring investment firms to undertake complex assessments in order to calculate if they are below/or above certain thresholds.

Furthermore, Kernan adds, the new legislation imposes an entirely new transparency regime, which has led to the introduction of new data reporting service providers, APA and CTP, an expansion of transaction reporting obligations to equity-like and non-equity instruments and the enhancement of pre and post trade transparency requirements, introducing also the need to undertake complex assessments of whether an instrument is below certain thresholds in order to check if a  pre-trade transparency waiver could be granted and/or deferred publication of post trade might be possible. MiFID II also adds extensive requirements for firms engaging in algorithmic trading to ensure they have effective systems and risk controls in place. 

Kernan believes that there is an overarching need for more information and stricter governance. He says: “IT and organisations need to cater for the collection and storage of that data ensure governance and compliance teams are equipped to meet their new responsibilities. Furthermore, firms will encounter a lot of additional reporting types: transaction reporting, client reporting (i.e. costs and charges) and post-trade transparency requirements.”

Transparency and ReportingSource: BNY Mellon

Transparency and Reporting

Source: BNY Mellon

Identifying reportable trades

For Kernan, the major challenges ahead in complying with the transaction data reportable under MiFIR, include the identification of all instruments that need to be reported, as there is no golden source of all reportable instruments and each firm needs to ensure that it reports all relevant instruments. Then there is the need to identify all situations when reportable instruments need to be reported, for example, for transmitted orders, executed transactions, aggregated transactions, etc, as well as the need to either identify IT systems that record the information to be reported, as often there is a very dispersed IT landscape, or modify systems to capture certain information, for example, the new requirement to capture the investment decision maker.

He adds that additional challenges might include the fact a LEI must be used instead of BIC for legal entities, as well as the need to capture the full identification of buyer and seller. This will mean collecting the LEI for firms and passport / personal data for natural persons. There is also the new requirement that firms must indicate whether the transaction is a short sale and whether it falls under an exemption as well as the need to link the transaction with the pre-trade transparency waivers and strict formatting rules regarding price, quantity, currency, instrument identification and dates.

Kernan also adds that formalisation, regular review and monitoring of quality of execution will play a much greater role compared to today. He says: “Under MiFID I, firms were obliged to take ‘all reasonable steps’ to achieve the best possible results for their clients.  Under MiFID II, firms will instead be required to take ‘all sufficient steps’. This slight change in the wording implies that firms may have to make changes to current practices and policies.”

MiFIR will expand firms’ transaction reporting obligations by increasing the scope of products

MiFIR will expand firms’ transaction reporting obligations by increasing the scope of products

One-stop shop

Acting as an Approved Reporting Mechanism (ARM) under MIFIR, REGIS-TR in collaboration with Deutsche Börse’s Market Data + Services will address all major customer challenges by offering a strategic solution and top-edge technology hub setup. By offering a one-stop shop to meet trade reporting requirements for all relevant regulations and deliver solutions for data, interface and system mutualisation, Kernan says REGIS-TR can offer a flexible, modular offering geared towards specific customer requirements, efficient implementation, with self-servicing and tools, in order to reduce cost and complexity. He says: “In order support customers in their compliance obligations, our solution will offer full transparency and control over reporting process, alert/notification services, various quality assurance features, such as validation, enrichment, etc.”

Customers can use REGIS-TR products and services – like EMIR TR, Phase 1 or Phase 2 of REMIT or MiFID II ARM services on a modular basis – either the core regulatory interface and reporting mechanism for any/each of these on a standalone basis, or through the one-stop-shop hub, which can include additional data management services, bespoke compliance reporting etc provided by Deutsche Börse Group. “It is intended to be a flexible offering to suit the needs of different clients,” he adds. In addition to the group’s MiFID II Transaction Reporting Service, Deutsche Börse supports clients with its MiFID II OTC Trade Reporting Service, an efficient and straightforward option to meet the transparency requirements for OTC transactions under the new directive. 

Throughout 2015, REGIS-TR has already been participating in a number of client working groups in major European locations led by Deutsche Börse Market Data + Services and attended by the corresponding National Competent Authorities. Says Kernan: “These have been very well received and give market participants the opportunity to ask specific questions to both our team of experts and also the expert from the National regulator. These working groups will continue and market participants also have the opportunity to discuss their requirements in more detail on a bilateral basis. Indeed, we have also conducted many of these discussions with tier 1 clients who are well advanced in their analysis and selection of a preferred provider.”

David Nowell“Assigning ISINs to OTC instruments will be a bit of a game changer. Although we at the London Stock Exchange already assign ISINs to some OTC derivatives, it is currently more of an exception rather than the rule.”

David Nowell

“Assigning ISINs to OTC instruments will be a bit of a game changer. Although we at the London Stock Exchange already assign ISINs to some OTC derivatives, it is currently more of an exception rather than the rule.”

Data protection issues

David Nowell, head of regulatory compliance and industry relations, at UnaVista, London Stock Exchange Group’s EMIR trade repository and MiFID Approved Reporting Mechanism, says that as transaction reporting for firms is set to become significantly more onerous for firms with the implementation of MiFID II. As the new reporting requirements come under the regulation, MiFIR, at least there is one set of harmonised reporting requirements across the whole of the EEA countries. 

For Nowell, MiFID II brings a number of key changes, starting with the number of instruments that are now covered by the directive – extending from the current securities-related instruments (equity and debt) of MiFID I to the range of FX, interest-rate and commodity related instruments now included. Also, the legislation not only covers EEA-regulated markets but now all financial instruments, traded on any “Trading Venue”, will become reportable. He says: “This captures all the EEA-regulated markets but in addition, the Multi-lateral Trading Facilities (MTFs) and the newly established Organised Trading Facilities (OTFs) now come into scope.  We expect that a lot of what we now consider to be OTC derivatives will migrate onto OTFs for trading.”

But the regulation will go much further than simply including all the asset classes when MiFID II replaces MiFID I, it is also dramatically expanding the amount of information that needs to be reported, drilling down to a much deeper level.  A Market Data Reporting Working Group has been set up by ESMA and the National Competent Authorities to examine all the new trading scenarios that will be covered, and to write guidance documents, based on the scenarios identified. 

At the end of September, ESMA published what it hopes will be the final draft of its regulatory technical standards (RTS) for MiFID II and it is hoped that these will be finalised in early January 2016. 

Pre/post Trade Potential FlowSource: BNY Mellon

Pre/post Trade Potential Flow

Source: BNY Mellon

The RTS for MiFIR transaction reporting sets out a total of 65 fields for information across all the asset classes covered – a significant increase from the 23/24 fields that were required by MiFID I. This is expected to require a major rewrite of the systems used to populate transactional reports and ESMA is understood to be looking at trying to converge the standards between the two reporting regimes. Nowell says there is also a demand for much more information on the individuals, either those who are clients or the individual traders executing the transaction, as well as the individual responsible for the decision for the transaction. 

Individuals will now have to be identified by a meaningful national identifier, rather than an internal identifier within the company as used under EMIR. In the UK, this will be the individual’s national insurance number. Furthermore, it does not stop with the identifier; the new regulations will require the names and dates of birth of the individuals involved.

Says Nowell: “This is going to present huge data protection issues for the entire industry so the Commission is trying to reassure firms that the confidentiality of the data will be assured. However, disclosing this kind of information about non-EEA individuals can lead to a breach of local laws. This presents a major concern for the industry, but one where UnaVista may be able to help ameliorate.”

Mandatory LEIs

Already, differences between MiFID II transaction reporting and EMIR trade reporting, which will run alongside MiFID II, are apparent. Apart from the different product identification methods, EMIR has 85 fields so there is going to a mismatch of the field between EMIR and the 65 field required by MiFID II/MiFIR.  There are some consistencies, which Nowell says could be built upon, for example the legal entity identifiers (LEIs) will be the same for both regimes, but thousands more new LEIs will be required as it will not just be for the reporting firm but also for the counterparty where there is a legal entity under MiFID II. “ESMA has taken a very strong position on this, saying firms should not be dealing with legal entity counterparties that do not have LEIs. While many organisations needed LEIs for EMIR reporting, it is new to MiFIR reporting, so some FX firms will be impacted by this. It may have a greater impact on the equities market, moving from MiFID I to MiFID II, as many firms aren’t caught by EMIR reporting as they only trade cash instruments.”

But global developments in product identification mean that there is further complication ahead. Under MiFIR, the regulators insist that the only identifier to be used will be the International Securities Identification Number (ISIN). While the ISIN is well-known and well-liked in the securities industry it is less commonly used for derivatives. This is another inconsistency with EMIR, which uses the ISIN but also uses the Alternative Instrument Identifier (Aii) for certain exchange traded derivatives and ESMA’s own interim identifier for OTC derivatives.

Trading venues, including the MTFs, OTFs and systematic internalisers will have to adopt the ISIN. A lot of the current OTC derivatives will migrate onto OTFs and into systematic internalisers so these trading venues will have to supply reference data to their local national competent authority on a daily basis, which will be a huge task, and one Nowell believes will impact FX derivatives in particular, if they are brought onto OTFs as expected. “Assigning ISINs to OTC instruments will be a bit of a game changer. Although we at the London Stock Exchange, as the UK national numbering agency, already assign ISINs to some OTC derivatives, it is currently more of an exception rather than the rule. However, we already have the experience and this is a challenge we will look to embrace” Nowell adds.

There is no golden source of all reportable instruments

There is no golden source of all reportable instruments

‘Golden’ source

There are concerns about getting a ‘golden’ source of all this reference data. To facilitate transaction reporting, firms need to know what instruments are reportable because going forward, not only will it be a breach to under- report, it also looks as though it is going to be a breach to over-report. Firms need to know what is reportable – which trades to send to the trade repository for EMIR and which trades to report through the approved reporting mechanism for MiFIR. Nowell says that UnaVista currently provides this golden source of data for MiFID and will look to do so for MiFIR. 

He adds: “MiFIR will bring in the new asset classes of FX, commodities and interest-rates but it actually goes further than this as well; it also captures financial instruments where the underlying is a financial instrument traded on a trading venue.  So if there were OTC instruments that didn’t migrate onto a trading venue, or derivatives on third country exchanges, then firms still need to look at the underlying instrument and determine whether it is a financial instrument traded on a trading venue. It really is incredibly difficult for firms to work this out unless they have got this ‘golden’ source of data.”

The only area where the reportable instrument set for MiFIR and EMIR overlaps is on the derivatives that are admitted for trading on trading venues, or where the underlying is a financial instrument, traded on a trading venue. This means MiFIR will include instruments that are not in EMIR, including all the cash instruments, and EMIR will continue to capture derivatives that are not traded on a trading venues or where the underlying is not traded on a trading venue. 

Organizational RequirementsSource: BNY Mellon

Organizational Requirements

Source: BNY Mellon

Using its experience as an EMIR trade repository UnaVista has predicted what validations will be required and UnaVista’s MiFIR Accelerator Programme now provides firms with the tools needed to get data and personnel ready in time for MiFIR reporting. The 65 fields for MiFIR have been built-in, along with all the LEIs needed, allowing participants to upload different sources of data and turn and off certain fields to check whether that data source has the correct information and whether it passes validation. “Step-by-step, market participants can check each data source that will need to feed into the different reports, and test its readiness well before the go live date. As we learn more about the regulation, the validation will be updated and firms can adapt their processes accordingly,” Nowell says. UnaVista will also be reaching out to firms to explain the reporting requirements as well as offering new MiFIR training next year.

Final details needed

Harry Eddis, Partner in the Financial Regulatory Group at Linklaters, says that while the regulation will be directly implemented into all Member States, the directive needs to be formally implemented by all the countries, which can lead to differential implementation as some countries will simply rewrite the text of directive into their own law; others will do what they call an ‘intelligent copy-out’; while others seek effectively to rewrite the directive to try and make the same points. 

He says: “MiFID I was a directive but in recasting MiFID they have actually split it into a directive and a regulation so there certain obligations which come under the directive and others are in the regulation, and therefore directly implemented.” In the past, this has also meant there could be a gradual roll-out, across the different countries although nowadays Eddis expects that all countries will be aiming for the date MiFID II will come into force, originally January 2017, but possibly now a year later.

Harry Eddis“They are giving the industry very little time to make changes, given that a lot of this will require new systems to be built and this takes time.”

Harry Eddis

“They are giving the industry very little time to make changes, given that a lot of this will require new systems to be built and this takes time.”

With regards to trading FX instruments going forward, Eddis says there is a mandatory trading obligation in Article 28 of MiFIR that is cast in very similar terms to the mandatory clearing obligation, and affects the same class of financial counterparties. “Financial instruments have to be subject to a mandatory clearing obligation before they can be subject to a mandatory trading obligation; ESMA will go through all those instruments subject to mandatory clearing and then decide whether they will be subject to a mandatory trading obligation as well,” Eddis adds.

The main impact of MiFID II will be in the changes that will be introduced to market infrastructure, particularly in the obligations that will apply to systematic internalisers, MTFs and OTFs. For example, pre-and post-trade transparency requirements in conjunction with restrictions in how systematic internalisers and MTFs/OTFs may interact are likely to lead to a dramatic change to the way in which investment firms conduct their businesses - equities trading in dark pools will likely be problematic and trading in the fixed income market will be radically different. While FX spot trading is unaffected, FX derivatives will be subject to the same pre-trade transparency and market infrastructure changes.

Additionally, Eddis says that more entities will come within the scope of regulation, as MiFID II takes away many of the exemptions that applied in MiFID I – for example, commodities traders trading on their own account, as well as algo and high frequency traders may need to become authorised and will likely now be subject to much greater amounts of regulation.

Delay of up to a year

In terms of implementation, Eddis says one of the key difficulties is that industry is still waiting for finalisation of the level two texts – the delegated acts and regulatory technical standards are still in draft-form and it is not clear when and in what form they will be adopted. In addition, a lot of the rules are difficult to interpret and it is proving difficult to get certainty and clarity from the regulators. Eddis says: “They are giving the industry very little time to make changes, given that a lot of this will require new systems to be built and this takes time. The industry is struggling with how much needs to be done.”

That is the reason, Eddis says, for recent calls for a delay in implementation; the latest appears to suggest there is a one year delay to MiFID II coming into force. If so, Eddis says that he hopes the regulators make use of the time productively and finalise the detail quickly to enable the industry to implement the requirements more easily.