MiFID II: US asset managers prepare for impact
August 2017 | FEATURE | FINANCE & INVESTMENT
Financier Worldwide Magazine
August 2017 Issue
The original Markets in Financial Instruments Directive (MiFID) impacted UK and European firms, primarily on the sell side, though it also regulates portfolio managers, investment advisers with rules applicable to those sectors on best execution, client categorisation, outsourcing, suitability and appropriateness, commissions and conflicts. However, its replacement, MiFID II, not only impacts the buy side, but also has implications for any firm servicing clients in the eurozone or those that market products there. Therefore, with regulations becoming final as of 3 July 2017, and with all impacted firms needing to comply by 3 January 2018, an understanding of the changes is key.
MiFID II will create a more equal regulatory playing field across the EU for investment firms by harmonising several areas that were previously regulated by individual EU Member States. It will also implement a handful of post-crisis G20 initiatives in Europe, such as mandatory platform trading of liquid instruments, among others.
All told, MiFID II will impact seven key areas: investor protection; transparency; data publication; micro-structural issues; requirements applying to and on trading revenues; commodity derivatives; and portfolio compression. According to EY, rather than impacting asset and wealth managers directly, these key impacts will instead affect the environment in which they operate. Regardless, non-compliance could be a disaster for firms in the EU and beyond. Indeed, asset management is a global business, and as such regulatory creep, particularly since the 2008 financial crisis, is becoming widespread. The main difference between MiFID I and MiFID II is the level of prescription of rules, which was previously largely left to Member States, but is now enshrined in EU legislation and EU technical standards. However, much like MiFID I, MiFID II regulates portfolio management, though it does not regulate fund management.
For those firms affected by MiFID II, there is no time to waste. The final countdown to implementation is on, and parties must ensure that their preparations are well under way. The vast majority of asset managers, in the EU at least, are unlikely to be fully compliant before Q4, according to a new survey conducted by Rsrchxchange. Approximately 85 percent of the fund groups surveyed admitted that they would not be compliant despite the fact that the directive will come into effect in early January 2018. However, preparing for MiFID II will be a difficult process for many, given that the directive brings some of the most wide-reaching changes to financial market regulation that the industry has ever seen. Indeed, MiFID II governs everything from where and how derivatives can be traded, to policing potential conflicts of interest among financial advisers.
The directive will finally move toward consolidating the regulatory approach across the 27 EU Member States. To date, there has been no harmonised regime in the EU for the regulation of non-EU investment managers, and so managers have been required to carry out a Member State by Member State assessment wherever they wish to do business. For retail business and business for clients that ‘opt up’ on an elective basis to the professional category (which will include local authorities), Member States will be able to choose whether or not to apply a new framework in MiFID II that would require them to set up an EU branch. Member States can also choose not to apply that framework and instead continue with their national, non-harmonised regimes.
However, achieving compliance with the new directive will likely be expensive. According to the Boston Consulting Group, preparing for implementation could cost firms $2bn during 2017 alone. For many asset managers, the key challenge will be ensuring that they have the right infrastructure in place to achieve compliance. For example, MiFID II requires telephone calls to be recorded and archived.
Since its implementation in 2007, the original MiFID has formed a crucial part of European securities law. It regulates trading venues and intermediaries that provide services to clients around shares, bonds, units in collective investment schemes and derivatives. MiFID II is much bolder in scope. It boosts transparency standards for venue-traded instruments in the EU (including bonds and swaps), increases investor protection standards, implements the G20 mandate on venue trading of swaps, introduces position limits for commodity futures, and broadens the scope of what has to be reported to regulators.
While MiFID II has been welcomed by many, for financial institutions on both sides of the Atlantic, it may lead to many sleepless nights. Institutions face a mountain of paperwork in order to get to grips with the incoming technical standards it mandates. However, the scale of complex technical challenges has meant that many firms are still unprepared for the full impact. They will need to get up to speed quickly.
For US asset managers, the impact of the directive may seem negligible. In reality, however, it will affect a number of firms, particularly US managers with an EU sub-adviser. Given the increasingly global nature of capital markets, non-European asset managers that do business with European customers will be required to interact with European regulators and counterparties.
US managers must pay attention to MiFID II if they have clients in the EU, if they have manager or distributor affiliates in the EU and to the extent they trade on EU markets. Under MiFID II, EU sub-advisers will be regulated as MiFID ‘investment firms’ and, as such, the EU entity will need to redesign its systems and processes to achieve compliance with the new regime. The Directive will even impact US asset managers which do not have a European entity if they trade on European markets or with European brokers. These managers will be subject to EU commodities position limits, which apply extraterritorially. Their brokers will need to perform additional due diligence on them, to be able to provide them with market access.
Additionally, they will have to consider changes being made to the European trading landscape, which mean a shift of OTC trading and a big increase in the data disclosed to the market – including for bonds and swaps. Indeed, post-implementation, US asset managers could see higher costs and reduced liquidity when trading European securities, especially in the fixed-income and OTC derivatives markets.
For US asset managers, transitioning to MiFID II could be a complex process with a number of challenges. “One obvious question for US managers with EU fund or segregated mandate clients is whether they can continue to provide services to them, cross-border, on the same basis under the new regime,” says Imogen Garner, a partner at Norton Rose Fulbright. “Those with retail or ‘elective’ professional clients, which will include local authorities, might be required, in some Member States, to establish an authorised branch, while other Member States may retain the status quo. For those in the institutional space, the status quo will again prevail in the immediate term – but in due course there should be an option for US managers to obtain a registration with ESMA which would allow them to provide services across the EU.”
According to Thomas Donegan, a partner at Shearman & Sterling LLP, trading with European counterparties is the biggest challenge. “The main impacts on US investment managers will be for those that use an EU broker or have an EU regulated sub-manager. Such firms will likely find that research costs need to become unbundled from execution fees, for example. Other non-execution services will require separate pricing. Some EU Member States, notably the UK, are intending to apply the MiFID II unbundling requirements to all locally regulated fund managers, whether they manage UCITS, alternative funds or portfolios. Any existing Commission Sharing Arrangements with EU brokers will need to be revised. A new ‘research payments account’ regime under MiFID II replaces usage of CSAs with stricter requirements. We also expect to see a market-wide repapering exercise, for US managers that deal with EU brokers, and changes to the ways in which firms with algorithmic strategies can access EU markets,” he adds.
According to Ms Garner, some broader questions arise where EU managers, which are directly subject to MiFID, are delegating portfolio management to affiliates or third-party sub-managers in the US. “The industry is currently grappling with the question of how an EU manager can properly ensure its own compliance, when delegated to sub-managers that are not themselves subject to the same rules. This question comes up quite frequently in relation to MiFID requirements for EU managers to obtain best execution for their clients as well as requirements on how managers are permitted to purchase investment research. Other aspects of MiFID II will indirectly impact fund managers distributing products through an EU distributor. For instance, MiFID II introduces a new EU-wide product governance regime. The rules will apply to the distributor, rather than the US manager, but will be relevant to the relationship between the two entities and the information flows between them. Another key part of MiFID is market structural reform. There is still, even with only six months to go, some lack of clarity about the extraterritorial application of some of these requirements and this will be a real challenge for US managers trading on EU markets.”
Non-compliance could have serious consequences for asset managers, even compromising their ability to work with EU-based sub-advisers. There are a number of steps which asset managers should take in order to avoid being caught out. “US asset managers should, first and foremost, consider how they might be impacted by the MiFID II unbundling rules and how to address any resulting issues,” says Mr Donegan. “US asset managers that are unable to comply may need to cease using EU-regulated sub-managers or brokers. The scope and applicability of other MiFID II rules, such as those on algorithmic trading, direct electronic access to markets and best execution should also be analysed. Trading strategies may need to be tweaked to take into account new transparency and disclosure rules, given all the additional transaction information that will be made publicly available under MiFID II. The consequences of non-compliance for US managers facing EU brokers will be that EU brokers are unlikely to be able to continue providing services, unless they comply with the new inducements rules. Where US managers are indirectly in-scope as a result of an EU sub-manager, the EU sub-manager would face the possibility of regulatory fines or other sanctions for non-compliance, rather than the US entity.”
US asset managers will also need to submit trade reports on the same day as the trade. Failure to report could result in fines. Equally, firms that report something which they are not supposed to may also be fined.
On the whole, for many US asset managers, many of the tools they will require to carry out research valuations, set budgets and assess research quality are already in place. As such, achieving full compliance should not be too arduous. Even firms that may not need to achieve compliance could benefit from bringing their practice in line with MiFID II’s requirements.
Undoubtedly, US asset managers will have a lot to grapple with over MiFID II’s implementation. While domestic US investment firms may disregard the requirements, they may find themselves behind the times compared to European rivals. However, for all firms which fall under the auspices of MiFID II, time to prepare is running out.
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