The implementation of MiFID II in January 2018 is being predicted by many market participants as a Big Bang moment for Europe's financial markets. This is because the scope of MiFID II/MiFIR is so wide-ranging and covers a much broader range of financial instruments and activities than its predecessor, MiFID I. It includes new rules on investor protection, trading platform classifications and associated rules, more stringency on best execution requirements and greater transparency around trade execution.
Further, MiFID II is extra-territorial - many firms outside of the EU are beginning to realise that they will be captured in the new rules when trading in European securities or with EU regulated firms. For example, this applies to the MiFID II rule on the unbundling and transparency of payment for sell-side research.
While there has been much discussion around how MiFID II will impact the trading landscape of Europe, thus far little has been written about the effect of the forthcoming regulation on the post-trade space. In reality, MiFID II will dramatically alter the post-trade landscape and will require affected firms to make significant changes to their middle and back office activities in order to comply with the new requirements.
The most significant post-trade changes which will be wrought by MiFID II are:
- Derivatives trading: greater transparency in derivatives markets through the migration of more over-the-counter (OTC) derivatives trading on to trading venues.
- Greater engagement of the buy-side in transaction reporting: this is likely as a result of the more onerous requirements of MiFID II transaction reporting, including the need to report additional data fields such as the identity of the decision maker in trading decisions. The requirements for timeliness of reporting will also mandate both the sell-side and buy-side to submit transaction reports no later than T+1.
- Unbundling of research costs: MiFID II will require the unbundling and transparency of payment for sell-side research and will therefore enforce strict separation between payment for research and payment for execution commission.
- Adoption of LEIs: from the start of MiFID II implementation, investment firms which are subject to its transaction reporting rules should not execute a trade for a client without that client having a valid and verified LEI.
From recent conversations held with industry participants it is apparent there is a lack of clarity about how the new LEI system will work. For example, some brokers believe that trades can continue to be reported at the investment manager level. Other firms have said that in addition to the trades at the investment manager level, they will also be obliged to report who the investment manager's underlying clients are. In the case of the latter scenario, there is little agreement on how and when brokers will receive LEIs for both the investment manager and its underlying clients when accepting orders.
Many firms wish to continue a two-stage process, where the block-trade contains the investment manager LEI, and allocations, which are delivered later, contain the underlying clients’ LEIs. However, even this approach is problematic as a two-stage process could lead to brokers executing trades and subsequently discovering that an underlying client has a lapsed LEI or even no LEI at all. With much of the MiFID II focus on the adoption of LEIs, some firms are not enforcing or monitoring whether LEIs are current and have been through the annual review process. Lapsed LEIs currently may be accepted by regulators, but it is not safe to assume they will tolerate this approach in the longer term.
The collaboration between market participants in order to reach an agreement on how MiFID II should be implemented in the post-trade space, particularly in areas such as the adoption of LEIs, is encouraging. There also appears to be a desire for consensus on an international level with regulators trying to reconcile differing interpretations of the new rules. For example, there are cases of French and UK regulators having interpreted certain aspects of MiFID II compliance quite differently such as the commission unbundling rules where the proposed models differ greatly.
The complexity and scope of MiFIR/MiFID II was acknowledged by regulators when its implementation date was delayed by a year to January 2018, and industry collaboration to prepare for the changes is a positive trend. But with less than eight months to go before MiFID II comes into force, the clock is ticking and the industry needs to start implementing alterations to their post-trade processes now in order to ensure they are ready for European financial market infrastructure's Big Bang.