1 MIFID MATTERS - ASSESSING THE WIDER AGENDA MiFID - what is it, and what does it mean? February 2012 kpmg.com
2 2 MiFID - what is it, and what does it mean? In October 2011, the European Commission published its much anticipated proposal for the Markets in Financial Instruments Directive 2 (MiFID 2).The legislation is the hub of a series of new regulations that will come into force over the next few years and will dramatically reshape the way firms operating in the financial services sector conduct their business. Responding to the regulatory changes that MiFID will bring requires firms to fundamentally review their business operations and processes, while simultaneously posing questions about which markets to continue operating in, and how to position themselves. Early analysis will be essential to ensure continued success and profitability in the years to come and therefore presents an opportunity for firms that take action now to ensure competitive advantage. Whilst the intent of MiFID is clear, the text is likely to undergo a number of amendments and changes before it is adopted. Parliamentary process will be long, controversial and inevitably lead to lots of changes to the Commission s proposal. As such, the full details are yet to emerge we will continue to monitor developments in the negotiation process and share our perspective on the potential impacts for firms KPMG International Cooperative ( KPMG International ), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. All rights reserved.
3 MiFID - what is it, and what does it mean? 3 Background MiFID 2 comes at a time of fundamental change sweeping the financial services industry. The failure of Lehman Brothers in 2008, and the financial crisis that ensued, highlighted shortcomings in financial markets that needed to be addressed. The aim of MiFID 2 is clear to reduce systemic risk, strengthen financial stability by ensuring maximum transparency in markets and ensure robust levels of investor protection. In order to achieve this, the Commission has focused on opaque over-thecounter (OTC) markets, and extended pre- and post-trade transparency requirements currently applicable to equity markets to non-equity and equity-like products. The impact on these markets will be substantial and some industry participants fear higher costs, greater complexity and reduced flexibility in managing risk. Investor protections are strengthened through more robust due diligence and disclosures, as well as changes to third country access to EU markets. MiFID is already a cornerstone of Europe s financial regulatory regime, and the proposed changes must be considered in tandem with other regulatory developments that are proposed or ongoing. Linkages between MiFID, European Market Infrastructure Regulation (EMIR - central clearing of OTC derivatives), Capital Requirements Directive 4 (CRD 4) (Europe s interpretation of Basel 3), Dodd-Frank, the revised Market Abuse Directive and Regulation (MAD/MAR) 1 Why US Banks need a new business model McKinsey and Company, January 2012 and Regulation on Energy Market Integrity and Transparency (REMIT) need to be identified, their impact to business models determined, and a way forward mapped. The costs of not doing so are clear it was recently estimated that if US banks retain their current business models, their return on equity will drop to 7 per cent, against a cost of equity of 9 per cent 1, as a result of Basel and other regulatory reform. These numbers are clearly not sustainable for business. Firms cannot consider each regulation in isolation. There are a number of common themes that run across all of them by taking a holistic approach to the changes, firms should ensure that they save time and money and achieve better outcomes by aligning objectives and avoiding multiple overlapping or conflicting change initiatives.
4 4 MiFID - what is it, and what does it mean? Seismic shifts in wholesale markets Standardisation and exchange trading of OTC derivatives MiFID Theme OTFs Topic Automated Trading OTC Derivatives MiFID I -Three trading platforms: Multilateral Trading Facilities (MTFs), Regulated Markets (RMs) and Systematic Internalisers (SIs). Threshold test in order to register as a Systematic Internaliser No specific requirements No specific requirements The OTC derivative market will feel particular heat from the Commission s proposals under MiFID and EMIR. Eligible OTC derivative contracts will need to be traded through an electronic trading venue, cleared through a CCP, and be subject to transaction reporting requirements. This will bring about greater standardisation and higher aggregate collaterisation and risk management requirements. The results: higher costs for participants, tighter margins and reduced flexibility when hedging. Market Structure Commodity derivatives Central Clearing Data Consolidation Investment Advice Inducements No specific requirements - Investment firms have the right of access to CCPs - MTFs and RMs may enter into appropriate arrangements with CCPs and Settlement Systems in other territories No specific requirements NA NA The overhaul of OTC derivative trading is done under the context of wider global reforms mandated by the G20. In the US, Dodd-Frank requires that eligible Swaps be traded through either a Swap Execution Facility (SEF), or another eligible venue, and be centrally cleared. The reporting requirements, together with the clearing requirements in Dodd-Frank are mirrored in EMIR. Taken together with the proposed changes brought about by the Volcker rule in the US to ban proprietary trading, and capital requirement changes to the counter party risk regime in CRD 4, it is very likely that the OTC derivative space will undergo substantial changes over the next four years. The changes will impact across all industries, and businesses that use such financial instruments to hedge underlying business operations should carefully consider how the changes will affect their ability to manage risk. Investor Protection Transparency Governance Execution Only Best Execution Appropriateness Pre- and post-trade transparency Transaction reporting Position reporting Organisation Requirements Authorisation/ Registration Managing bodies - Execution only services can be offered for non-complex products traded on a Regulated Market or where they are UCITS compliant - Firms required to achieve best execution for their clients - Firms assess whether financial instruments are appropriate for clients based on information received from them on their financial situation and investment objectives - Pre-trade requirements apply to shares traded on an SI, RM or MTF - Relevant details of executions in financial instruments to be reported to the competent authority No specific requirements - General requirements for Investment Firm and Market Operators, ensuring that adequate policies and controls are in place to ensure compliance - Exemptions currently exist for non market-making proprietary traders who are not Sis, and also for those trading on own account in commodities or commodity derivatives No specific requirements Equivalence No specific requirements Third Country Establishing a branch No specific requirements
5 Summary of key changes and impacts of MiFID 2 MiFID 2 - New category of trading venue designed to capture organised trading outside of RMs, MTFs and Sis Impacts - Impacts internal crossing systems operated by sell side brokers - Pre-trade requirements applied to OTC volumes - Ban on proprietary capital may impact the way in which sell side brokers achieve best execution - Continuous liquidity during the trading period - Annual description of trading strategies to competent authorities - New registration system and control requirements - Eligible OTC derivative contracts to be traded on-exchange - Clearing obligation in EMIR - Position reporting for all commodity positions - Position limits to be enforced by trading venues - Non-discriminatory access to index and benchmark data - Non-discriminatory access to CCPs - Impacts execution strategies for sell side brokers - Significant impact to High Frequency Trading (HFT) risk management - Added costs arising from execution on trading platforms and central clearing - Potential reduction in flexibility when hedging positions - Added cost for trading venues and participants to enact - Restrictions in the positions that participants may take could inhibit firms executing, inter alia, client orders -Threat to those Exchanges operating vertical operating models - Competition in clearing and derivatives should reduce costs, but potential for increased complexity - Additional risk management challenges if dealing with multiple CCPs - New regime for data consolidation and reporting, including Consolidated Tape, APAs and ARMs - Should improve data quality, consistency and granularity - but, greater complexity and risk of double reporting - Advisers have to state whether their advice is independent or not. - Where advice is independent, firms will need to consider a wide range of products and offerings available, at a potential cost to its own products/ offerings - Ban on independent advisers receiving/giving third party fees, commissions or other monetary benefits. - Firms will need to carefully evaluate their remuneration and commission policies. Some face significant changes to business models - Meaning of complex has been redefined to include all products with embedded derivatives, and some Structured UCITS -This may reduce the liquidity of some financial instruments - Firms will need to update their appropriateness tests - Firms to publish top five trading venues for executing orders - More granular reporting requirements to clients -Trading venues to publish data relating to the quality of executions - Need to account for the type and complexity of financial instruments involved, and, in the case of advice, report how that advice meets the personal characteristics of the client - Greater costs for trading venues and investment firms in achieving best execution, and reporting against it - Impacts to policies and procedures - Pre- and post-trade requirements extended to non-equity instruments, and applies to OTFs - Details of persons responsible for the execution, including executing algorithms, to be submitted - Details of end clients on whose behalf orders are executed - Reports can be made by the Investment Firm, the Trading Platform, or an ARM - Extending pre-trade requirements to volumes that are currently OTC, and to non-equity, will require firms to adjust their risk management systems, as quotes extended to a client could be filled by others - Complexity in determining who reports the transactions - may require individual agreements if double reporting is to be avoided - Added costs of updating systems to comply with added data fields - See commodity derivatives above - Overly prescriptive requirements that may run counter to Comply or Explain - More specific requirements for Investment Firms, RMs, SIs, Data Providers and Algorithmic Trading - Greater systems and controls and record keeping requirements will add cost and complexity to Firms - Requirements for all members of RMs and MTFs to be authorised -Tightening of the exemptions regarding commodity traders - A larger universe of market participants will be captured by MiFID, and will therefore need to ensure that they are authorised and compliant - New requirements for Managing Bodies of Firms and Market Operators, including quantitative requirements for the number of positions that a Board member may hold -The Commission will rule whether the regulatory regime of a third country is equivalent to the EU s -This will be required before -Third country firms who wish to provide investment services to Retail Clients will be required to establish an authorised branch in the Member State - May impose high barriers of entry into the EU for third country firms - Underestimating the scale of achieving equivalence arrangements uncertainty remains on practical implementation
6 6 MiFID - what is it, and what does it mean? 2012 KPMG International Cooperative ( KPMG International ), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. All rights reserved.
7 MiFID - what is it, and what does it mean? 7 Organised Trading Facilities (OTFs) A new classification of trading venue is introduced - the OTF - which is designed to act as a regulatory catch all for all organised trading that occurs away from Regulated Markets (RMs) and Multilateral Trading Facilities (MTFs) and that is not genuinely OTC. Currently, internal broker systems that cross client order flows - often with proprietary capital - are reported as OTC, and therefore avoid pre-trade transparency requirements. Investment firms operating broker crossing networks will either need to set up an OTF, or register their operations as a Systematic Internaliser (SI). The new venue will have a significant impact on the way in which firms conduct their business; they will not be able to cross their proprietary capital with client order flow on the same platform, and all flows within an OTF will be subject to pre- and post-trade transparency (as indeed will those on an SI). Aside from the well-documented impact that this will have on OTC derivative and bond markets, it raises interesting questions as to how brokers will go about achieving best execution - as brokers currently may reduce execution costs by netting off order flows internally. This initiative is proving to be particularly contentious, and we will continue to closely monitor developments in this area, and share our views on the potential impacts to firms. Algorithmic Trading Automated trading comes under increased scrutiny. Concerns over the impact to markets from rogue algorithms and the potential for a European flash crash have driven algorithmic trading activities to the forefront of the regulator s attention. Automated traders will be required to continuously post executable quotes during the trading day, feedback to regulators on at least an annual basis about how their strategies work, and those who are not already will need to become authorised - at least where they are members of a Regulated Market or a Multilateral Trading Facility (MTF). Together with these requirements, algorithmic traders and trading venues alike will have tightened organisational requirements to ensure that excessive orders cannot seize up markets or increase volatility. The implications of these requirements are wide-ranging. By making specific requirements around posting liquidity and providing details of trading strategies, the Commission has not distinguished between varied proprietary trading strategies executed by HFTs, and execution algorithms operated by sell side brokers. HFT firms will need to consider authorisation to undertake their activities where they are not already, and fundamentally rethink their risk management policies to account for the new liquidity requirements. Sell side brokers may need to reconsider how they work large orders through order books now subject to pre and post trade transparency requirements, unless they meet the (much narrower) criteria for an exemption. Commodity derivatives under the spotlight Political concern over the effects of speculation in commodity markets has led to a raft of new regulatory initiatives for commodity and energy products. Previous MiFID exemptions which benefitted non-financial market participants are significantly scaled back. Participants who are currently exempted from MiFID by virtue of Article 2 (1) (k) (where the main business of the entity consists of trading on own account in commodities and/or commodity derivatives) will now need to prove that their trading activities are ancillary operations to their main business and that they are dealing on their own account. There will be two tests for determining what is ancillary: 1) whether the activity demonstrably reduces the risks attached to commercial activity or treasury financing activity; and 2) the capital employed for carrying out the activity. Those who pass these tests, but still trade wholesale electricity and gas products, will still need to comply with REMIT. Those who do not will need to become MiFID compliant.
8 8 MiFID - what is it, and what does it mean? Commodity derivative traders will need to comply with new requirements on position reporting and limits. Traders will need to make available position reports to trading venues (on an on-going basis), and trading venues will need to monitor this and enforce position limits where necessary. Transaction reporting requirements under EMIR and MiFIR will also cover exchange traded and eligible OTC derivative contracts, setting up a web of reporting requirements that traders will need to comply with. However, the Commission has recognised the overlap between REMIT and MiFIR any transaction reports made under MiFIR will see any equivalent obligations under REMIT fulfilled. The changes in this space will have a number of potential impacts. Though Article 2 (1) (k) in MiFID 1 has been deleted, commodity traders may still be able to make use of other exemptions. Firms will need to closely analyse this in consideration of their business operations. Those who are caught will need to consider whether they continue these operations and become MiFID compliant - with the costs that this will entail - or restructure their organisations. Increased reporting requirements Reporting requirements under MiFID 2 will be dramatically widened in scope, and necessitate significant changes to business processes and technology systems, and many core data sets are still being defined by industry working groups. Pre- and post-trade requirements will apply to equity-like and non-equity products. Transaction reports will be required for these products (including emission allowances), and more details will need to be provided, including the identity of the trader or the algorithm responsible for the execution decision, and any client details on whose behalf the trade was made. The changes to reporting under MiFID will require a series of substantial system overhauls for investment firms and trading platforms alike. However, opportunities exist: by driving synergies in reporting requirements under EMIR, MiFID, REMIT and MAD, firms will be able to drive down costs and reduce complexity KPMG International Cooperative ( KPMG International ), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. All rights reserved.
9 MiFID - what is it, and what does it mean? 9
10 10 MiFID - what is it, and what does it mean? More protection for investors Changes to the investor protection regime will require investment firms to consider how their current policies fit with the proposed requirements. In particular, changes to the way in which firms may provide investment advice, receive fees, achieve and report against best execution, and treat eligible counterparties will require wholesale changes to their approach. Firms will also need to consider the interplay between evolving national requirements, such as the UK s Retail Distribution Review (RDR), multiple European initiatives including Packaged Retail Investment Products (PRIPs), and also the changes that are occurring in the US with the introduction of the Consumer Financial Protection Bureau (CFPB). The impacts of these changes are numerous. Changes to the way in which firms must treat eligible counterparties will result in a more onerous burden, and may require changes to existing policies and contracts. The ways in which firms have to treat client money, report to clients, and act in an independent way will require full scale changes to the way in which asset managers and retail banks interact with their clients.
11 MiFID - what is it, and what does it mean? 11 Third country firms New requirements for third country firms Changes to the third country regime will impose significant barriers to entry for firms outside the European Union, and run the risk of reducing the liquidity of Europe s markets. The Commission is proposing to introduce a form of exemptive relief for those firms operating in third countries whose regulatory regime is considered equivalent to the EU s. The Commission will set the parameters and requirements for a third country to be considered equivalent. Third countries regulatory regimes will need to be deemed equivalent to the European Union s by the European Commission before a third country firm can apply to undertake investment services within the EU. This will need to be done before a third country firm can establish a branch in the EU, for the purpose of providing services to retail clients, or can provide services from off-shore to eligible counterparties. The third country requirements under EMIR proved highly controversial during negotiations between the Parliament and the Council in their trialogue discussions. It will therefore be interesting to see how these negotiations progress for MiFID. It is likely that third country firms will, in the future, face significantly higher hurdles when seeking to conduct business in the EU. For example, they will have to comply with higher levels of market abuse rules and a more stringent supervisory regime than may currently exist in their country. Recognition of equivalence by the Commission of a third country s regulatory regime may be extended particularly where the supervisory regime, and regulation of market abuse, is significantly different to that of the EU. Agreeing Memorandums of Understanding (MoUs) between ESMA and the supervisory authorities in the third countries once this is done could also be another significant hurdle and prove time consuming. It is likely that these negotiations will take significantly longer to conclude than the transitory period of four years currently written into the Commission s proposal.
12 12 MiFID - what is it, and what does it mean? Trade lifecycle Where regulation will impact Trade strategy Trade initiation Trade execution Settlement and clearing Ongoing management Close out Financial counterparty non-financial counterparty Exchange Bilateral Other regulated trading platform P re and post trade reporting CCP Bilateral Margin and collateral Risk management Asset servicing and custody Accounting Transactions reporting 1. European Market Infrastructure Regulation (EMIR) Standardise OTC and require central clearing for standardised trades Higher margin and collateral Improved risk management Reporting to trade repositories 2. Markets in Financial Instruments Directive (MiFID 2) Moves trading of standardised derivatives on to exchanges or other organised trading venues Creates a new organised trading facility to capture smaller broker to broker networks Proposes major extensions to pre and post trade transparency and transaction reporting Specific reviews of commodity and high frequency trading, with both subject to heightened scrutiny, including potential position limits or forced reduction of positions Enhanced conduct rules with significant increases in investor protection 3. BASEL 2.5/3 Increases capital for trading book positions Additional capital for bilateral derivatives trades New liquidity rules require larger holdings of a limited pool of assets which must also be used to satisfy likely collateral rules 4. Fundamental review of trading book Expected to reduce or remove capital and financial accounting distinctions between trading and banking book, eliminating existing arbitrage opportunities 5. Activities specific Commodities/High Frequency Trading/Exchange Traded Funds Potential for further reporting, additional supervision, position limits or outright bans New European rules allow temporary bans on short selling, and require increased reporting 6 Market Abuse Directive (MAD) Currently covers disclosure of interests, reporting of suspicious transactions, maintenance of insiders lists and accepted markets practices New rules extend to derivatives and commodities, including data sanctions and HFT Scope across financial instruments on MTFs and OFTs as well as OTC Issuers to disclose company specific inside information 7. Dodd-Frank OTC trades standardised and traded on exchange or newly formed swaps execution facilities (SEFs) Derivatives trades should be cleared through CCPs Additional margin and collateral will apply to cleared and uncleared trades, subject to segregation All trades reported to trade repositories following confirmation and short time frames look likely Non-financials may be deemed major swap participants and subject to clearing, but can opt out if genuine commercial hedge Many classes of swaps must be pushed out of banks into separately capitalised entities 8. Financial Market Infrastructures (FMIs)/CSDs New global proposals to enhance risk management and stability of key market infrastructures, including Central Securities Depositories, Central Counterparties, and payment systems Rules proposed/expected in US and EU Autumn 2012 Designate FMI as systemic and subject to heightened supervision, risk management requirements, and systemic protections, e.g. living wills and enhanced capital standards Emphasis on improved client asset protection
13 MiFID - what is it, and what does it mean? 13 What can you do now? Though the implementation of MiFID seems like a long way off 2015 is the expected due date firms should act now to ensure that they are ready for the changes, and in a position to drive competitive advantage by being first movers. 1 Conduct a strategic assessment. This should include a high level business assessment. KPMG firms can help you determine the effects of the changes on your business operations, the effects on your counterparty relationships and how your competitors and operating environment will be affected. 2 Do I stay, or do I go? Firms will be faced with a stark choice - to exit markets in which they operate, or to adapt. KPMG can help firms with their strategic decisions and advise on market positioning. 3 Conduct deep business impact assessments. In order to help with the first two points, a deep business impact assessment can help highlight the processes and systems most likely to be affected, where you are currently compliant, and where there are gaps. This will help you determine the scale of the changes required. 4 Don t focus on just one regulation at a time.there are interdependent themes that should be considered across related regulations. Take a wide view of the changes, consider everything, and react decisively. 5 Don t wait! System and process changes take time to design and implement lead times must be considered to ensure that any changes can be implemented successfully before you need to become compliant with MiFID and the other regulations. KPMG firms can advise on the set up of your programmes, technology solutions and system changes. 6 Engage with the legislative process now to understand the proposals, determine the impacts, and enable industry dialogue. How are you affected? Do you: Trade commodity derivatives? If you are not already, you may need to become MiFID compliant, with the additional reporting and capital requirements that this will entail. Engage in algorithmic trading? It doesn t matter whether you are trading your proprietary capital (in which case you will probably need to become authorised), or a sell-side broker. If you engage in algorithmic trading, you will need to post continuous quotes and provide descriptions of your algorithms, whilst beefing up your systems and controls. Trade OTC? Expect higher costs as eligible OTC contracts move to become exchange traded and are centrally cleared. Provide investment advice? You will need to consider whether the advice is independent or not, not cross-sell, and think about how you charge for your services. Cross internal order flows? If you operate a broker crossing network, or other equivalent models, you will almost certainly have to register as an OTF (and therefore not cross your client flow with your proprietary capital), or become a systematic internaliser. Execute client orders?you will need to think about how you achieve and report against best execution. Provide investment services from outside the EU? You will be faced with significantly higher hurdles than is currently the case, and will need to re-evaluate the way in which you will do this in the future.
14 14 MiFID - what is it, and what does it mean? Taking a thematic approach to MiFID and regulatory change MiFID provides the context for a number of new regulations that will impact firms differently according to their business model. To drive an efficient regulatory change agenda, it is important that firms identify at an early stage which regulations they will need to comply with, determine how their business will be impacted, and effectively map a regulatory change pathway through the Governance, Operations and Technology requirements. It is vital to understand the resulting threats and opportunities for your business strategy and structure. A thematic approach will ensure firms are able to adapt their business models in a way that drives value across the regulatory change horizon - while ensuring full compliance with the spirit and intent of the rules. Using this approach, a number of consistent themes that run across the regulations can be identified, together with a much better understanding of their impacts on different parts of a firm s business model. KPMG firms can help you apply these themes to your business, identify impacts, prioritise actions and structure an integrated change management approach delivering change that is effective, efficient and compliant. Our experienced professionals: Work through a decision tree to determine which regulations are applicable to you. Understand your business to determine how each theme may affect you. Determine the impacts on your current change programme(s). Help you prioritise your new regulatory change activities according to the impacts on key business lines. Help you budget, plan and implement an effective, risk-based change management programme. The regulatory change agenda applying it throughout the organisation Remuneration Liquidity Customer base Core business processes Governance Capital Funding and Financial performance Governance Control & Reporting Supervision and Regulatory reporting Regulatory Agenda Structural change Business Products & Model Infrastructur e, Data & Markets Technology Customer treatment Market Infrastructure Financial Crime Incentives & Compensation Leadership & Corporate Culture Staffing, Training & Development
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16 For further information please contact Giles Williams Partner, Financial Services Regulatory Centre of Excellence, EMA region KPMG in the UK T: E: Kara Cauter Director, Financial Services Regulatory Centre of Excellence, EMA region KPMG in the UK T: E: Chris Collins Director, Risk Consulting Financial Risk Management KPMG in the UK T: E: Marius Floca Principal Advisor, Financial Services Management Consulting KPMG in the UK T: E: Sophie Sotil Senior Manager Financial Sevices KPMG in France T: E: Marcel Aellen Dr.iur.Attorney at Law Senior Manager Audit Financial Services KPMG in Switzerland T: (Office Zurich) T: (Office Berne) E: Chris Leonard-Appleton Regulatory Advisor, Risk Consulting Financial Risk Management KPMG in the UK T: E: Dr. Markus Lange Partner, Head of Financial Services Legal KPMG in Germany T: +49 (0) E: Charles Muller Partner, Financial Services Regulatory Centre of Excellence, EMA region KPMG in Luxembourg T: E: Pietro Stovigliano Associate Partner, Financial Services KPMG in Italy T: E: Rob Voster Senior Manager, Financial Services KPMG in the Netherlands T: +31 (0) E: The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. Printed in United Kingdom. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.. RR Donnelley RRD February 2012