On Monday, ESMA published its final draft technical standards detailing the MiFID II / MiFIR rules for firms caught by the Directive and Regulation. The technical standards (28 in total) were consulted on in three papers (in May 2014, December 2014 and February 2015), and since then have been widely debated and long-awaited by the industry. In the revised standards, ESMA has made a number of substantial changes, particularly regarding the liquidity assessment for non-equity instruments, best execution and algorithmic trading. However, further clarification is still pending across a number of areas, such as the use of dealing commissions, costs and charges, and thresholds for defining systematic internalisers (SIs), which will be set out in the Delegated Acts to be released later this year.
Key areas of interest
Transparency regime for non-equities
The main concerns in relation to the transparency requirements for non-equity instruments in the earlier consultations were around the definition of a liquid market for fixed income instruments and calibration of thresholds for granting pre-trade waivers and post-trade deferrals of disclosure.
The biggest change introduced in the final draft regulatory technical standard (RTS) is a move to a more dynamic approach in assessing the liquidity of fixed income instruments. The liquidity test will now rely on a bond-by-bond assessment that will be performed at the end of every quarter based on a set of quantitative criteria. The liquidity of newly issued bonds will be determined based on their issue size and the time passed since the issuance. The bond-by-bond approach will help to address issues around potential misclassification of bonds, particularly given market views that most bonds tend to be relatively liquid straight after issuance, but less so thereafter.
ESMA has also introduced a more granular and dynamic liquidity test for derivatives. The initial approach proposed to determine a liquid market was based on classes of financial instruments (COFIA). This has now been detailed to the level of sub-classes, providing more specifications within each sub-asset class of derivatives. ESMA has also proposed to deem the FX derivatives as illiquid due to the lack of accurate data to allow for an appropriate analysis of the market. The recalibrated COFIA approach now also entails a yearly reassessment of liquidity.
However, while the more regular liquidity reassessments should help to ensure that non-equity instruments are classified appropriately throughout their life cycle, firms face a practical challenge in implementing these requirements and may still require significant operational and system changes to ensure that the transparency requirements are complied with on a trade by trade basis.
The thresholds for pre-trade waivers and post-trade deferrals for large transactions were also recalibrated by ESMA. The pre-trade thresholds are now set at a lower level than the post-trade ones for all non-equity instruments.
Key issues raised by firms as part of ESMA’s consultation on the RTS were on the number of data fields and lack of clarity on the scope of the rules.
There are some changes to the reportable fields, which have shrunk from 81 data fields in ESMA’s December consultation to 65 now. Whilst some of this can be attributed to the data format proposed by ESMA (e.g. some fields have been merged), a number of fields, including the post code fields, have been removed. There are also some additional fields that have been introduced to cater for information required by the Transparency Directive.
ESMA has also provided further clarifications on definitions. It has expanded the list of specific exclusions from the definition of “transaction” and confirmed that Securities Financing Transactions (SFT) reportable under the SFT Regulation (SFTR) will not be required to be reported under MiFID II, even ahead of the SFTR application date. ESMA has also amended the definition of “execution” to limit it to a list of services or activities that result in a transaction being concluded. ESMA plans to publish further guidelines for the industry on transaction reporting.
There were a number of issues arising from the initial draft RTS around data sensitivity and the volume of reporting required on best execution by both investment firms and execution venues. ESMA has revised some of the disclosure requirements relating to best execution to address some of these concerns.
Regarding the information to be published by investment firms, ESMA has responded to certain industry concerns regarding the publication of sensitive information and now requires firms to publish the number of client orders executed on each of the top five venues as a percentage of the firm’s total for that class of financial instruments (rather than including the number itself as well).
ESMA has also made changes to how classes of financial instruments are aggregated for reporting by firms on the top five execution venues (e.g. bonds and money market instruments are now classified under debt instruments).
The amount of data that execution venues will need to publish has also been reduced. In a bid by ESMA to provide sufficient protection for SIs and mitigate the risk of commercially sensitive information being made public, the timeframe for publishing information by execution venues has been extended to three months after the end of each quarter.
There were concerns around the level of activities that could be caught in scope given the broad definition of algorithms, as well as the onerous governance and monitoring requirements set out in the consultation.
The final draft RTS sets out that business continuity arrangements are required to be appropriate to the nature, scale and complexity of the business, which is a significant change in stance to previous “one size fits all” requirements. There are many ways this proportional approach has been reflected.
ESMA has also provided clarity that pure investment decision algorithms, which do not make execution decisions, are out of scope for the algorithmic testing requirements which will come as some relief to certain market participants. It is also interesting to note that the industry request to clarify “request for quote” trading systems as out of scope was not met by ESMA.
The final draft technical standards have been sent for approval to the European Commission. The Commission now has three months to approve these. Once endorsed, both the European Parliament and the Council have an objection period. If passed, the standards will apply from 2017. In the meantime, the Commission has delayed the adoption of the Delegated Acts to at least November 2015 amid concerns expressed by several EU Member States, particularly around the investment research rules.