77 The Investment Services Directive a New Basis for Securities Trading in Europe Birgitte Bundgaard and Anne Reinhold Pedersen, Financial Markets INTRODUCTION On 7 October 2003 the Council of Ministers of Economic Affairs and Finance (Ecofin Council) reached political agreement on a new Investment Services Directive (ISD). Final adoption of the directive awaits incorporation of the amendments proposed by the European Parliament. These amendments are still in the negotiation phase. The directive will influence the development of the securities markets in the EU. It is to replace the current Investment Services Directive of 1993, which is out of date in areas such as investor protection, types of investment services on the market and the overall market structure. Furthermore, the current directive has proved to be an insufficient foundation for a single securities market in the EU. The new directive seeks to further harmonise the rules concerning investment firms. In Denmark, this category includes investment companies and credit institutions offering securities trading services. This will be a further contribution to the creation of a single market for financial services in the EU, which is the very objective of the EU's Financial Services Action Plan adopted in 1999. Another aspect of the background to the directive is the increasing use over a number of years of financial products as alternatives to conventional bank financing and placement of funds as bank deposits. Business enterprises can raise capital on the financial markets instead of bank loans, and households can place their savings in securities instead of bank deposits, particularly in the form of units in collective investment undertakings or via pension schemes. The financial markets and their functioning thus play an increased role in financial stability. A solid legal and regulatory framework on the financial markets would very much enhance investor confidence, liquidity and the robustness of the financial markets. It is especially important not to undermine investor confidence, which could happen if the markets function poorly or lack transparency. Investor protection is therefore a key issue in the directive.
78 The directive represents a much-needed regulatory adjustment to the market development. Competition may intensify between the market participants, and the directive will ensure a level playing field between countries. The directive also provides for increased integration of the securities markets for the benefit of the business community and private investors alike. Market transparency is generally expected to be enhanced. Unfortunately, the requirements of increased transparency do not cover bonds. The political agreement reached by the Ecofin Council reflects a compromise to balance the considerations of market function and investor protection. The directive is a framework directive, i.e. several issues must be subsequently specified in a committee procedure with the participation of the member states and the European Commission (the Lamfalussy procedure). The principal elements of the Investment Services Directives are described in the following, where the possible effects of the directive are also reviewed. KEY ELEMENTS OF THE NEW INVESTMENT SERVICES DIRECTIVE The EU securities markets have become more complex as a result of increasing competition concerning securities trading between stock exchanges, other trading systems (multilateral trading facilities, MTFs) and investment firms. Liquidity has become more dispersed and transparency has deteriorated. One of the main objectives of the directive is thus to promote the creation of transparent, efficient and integrated financial markets. This will primarily be achieved by requirements of increased transparency on the markets and harmonisation of the rules concerning the various types of marketplace. The market complexity with many participants and new products has made it difficult for the investors, particularly private investors, to get an overview of the markets. It can therefore be a greater source of concern for the investor whether an investment firm is able to exploit the trading opportunities and achieve the best possible deal for the investor. Another key objective of the new Investment Services Directive is therefore to enhance investor protection in the EU member states. This will be achieved especially by harmonising the conduct of business rules and ensuring the best execution of a securities deal for the client. A number of new services and instruments have gained ground in the financial markets, cf. the Box. These services and instruments need to be regulated, and the Investment Services Directive represents such regulation.
79 FINANCIAL CONCEPTS IN THE INVESTMENT SERVICES DIRECTIVE Box Investment firms are firms that provide investment services in connection with securities trading, such as portfolio management of clients' securities portfolios and purchase and sale of securities. In Denmark, this category includes investment companies and credit institutions. Investment services comprise reception and transmission of orders in relation to one or more financial instruments, dealing on own account, execution of orders on behalf of clients, managing portfolios of clients' securities, investment advice, underwriting and placement of financial instruments and operation of multilateral trading facilities. Ancillary investment services include safekeeping and administration of financial instruments for the account of clients, advice concerning capital structure, etc., foreignexchange services where these are connected to the provision of investment services, investment research and other types of general recommendations. Financial instruments are described in the directive as transferable securities, money-market instruments, units in collective investment undertakings, credit derivatives, contracts for differences, options, futures, swaps, forward-rate agreements (FRAs) and other derivatives. The directive also covers commodity derivatives for cash settlement and commodity derivatives for physical settlement if traded on a regulated market and/or via an MTF. The Danish Securities Trading Act classifies all these instruments as securities. Regulated market is a multilateral system operated by a market operator, which brings together third-party buying and selling interests in a way that results in a contract concerning financial instruments admitted to trading on the regulated market. Multilateral trading facility, MTF, means a multilateral system operated by an investment firm or a market operator, which brings together third-party buying and selling interests in a way that results in a contract concerning securities. Best execution is the requirement for investment firms to take all reasonable precautions to ensure the best possible result for the client of a securities deal. The assessment of the best result must take into account price, costs, speed and likelihood of execution, the size of the trade and other relevant factors. Conduct of business rules stipulate that investment firms must act honestly, fairly and professionally in accordance with the best interest of their clients. The specific requirement is for an investment firm to obtain information from the client so as to enable the investment firm to provide good advice. Furthermore, investment firms are required to inform the client of a number of issues, including fees. Clearing and settlement is the process after conclusion of a securities deal whereby the parties' obligations are settled, finality is ensured and securities and money are exchanged. Systematic internalisation is conducted by an investment firm carrying out the client's trading orders in an organised, regular and systematic manner against the investment firm's proprietary securities trading position. Pre-trade transparency means the publication of prices and volumes applied by the price offerer. Post-trade transparency means the publication of prices in the transaction executed. The volume and timing of execution must also be published.
80 Enhanced transparency The directive introduces rules on increased transparency to enhance the market participants' opportunities to compare prices offered by various marketplaces/players and create a level playing field between the various market players. The requirements concern pre- and post-trade transparency on trading in stock-exchange-listed shares. Pre-trade transparency comprises publication of prices and volumes admitted to trading, while post-trade transparency comprises publication of prices and volumes in the actual trade. The transparency requirements apply to regulated markets, multilateral trading facilities and certain investment firms trading with clients against the firm's proprietary trading position. The investment firms covered by the rules will be those executing clients' trading orders in an organised, regular and systematic manner against their proprietary trading positions (systematic internalisation whereby an investment firm e.g. has established on-line investment access to trade against the firm's proprietary trading position). Illiquid shares and very large share transactions are exempt from the requirement of pretrade transparency. The transparency rules do not apply to bond trading, but two years after adoption of the directive the Commission intends to examine whether the rules can be expanded to include other financial instruments than shares. The exclusion of bonds from the transparency rules implies that the publication of offered prices and the prices of the actual bond trades is not subject to EU requirements. However, according to the directive's preamble the member states may set out national rules concerning pre- and post-trade information for other securities than shares, including bonds. Regulation of multilateral trading facilities Recent years have seen the emergence of a number of trading systems, especially in the USA, in which the members trade stock-exchange-listed securities among themselves, but which are not trading systems on a regulated market 1. So far, these trading facilities have been regulated as investment firms or regulated markets in the various member states. In order to create a level playing field between different marketplaces such trading systems will also be subject to EU regulations under the Investment Services Directive. The rules governing such trading systems or multilateral trading facilities, MTFs, will in several respects correspond to the rules concerning regulated markets, since MTFs and regulated mar- 1 Multilateral trading facilities or alternative trading systems are described in further detail in Birgitte Søgaard Jensen and Lone Natorp, A Change in the Stock-Exchange Environment, Danmarks Nationalbank, Monetary Review, 2nd Quarter 2000.
81 kets have a number of functions in common. An MTF needs to have transparent and objective membership rules and is subject to the same organisational requirements as an investment firm (including requirements of internal control, risk management and trade registration). The group of members of an MTF can be the same as for regulated markets, whereby investment companies and credit institutions may become members. Other persons or firms may become members if they comply with a number of requirements concerning e.g. eligibility and integrity, trading competence and resources, including the ability to guarantee sufficient settlement of transactions. When MTF members execute trades, they will be subject to the investor protection rules solely if they trade on a client's behalf. Only investment firms and markets operators for regulated markets may establish MTFs. A new set of rules for investment firms The new Investment Services Directive further harmonises rights and obligations for investment firms in the EU. The underlying factors include the fact the 1993 Investment Services Directive has proved to be insufficient in the process towards integration. A new feature is an obligation to identify conflicts of interest between the investment firm's range of activities and the client's interests 1. Furthermore, investments firms must seek to manage the conflicts of interest to prevent them from adversely affecting the interests of clients. Where the conflicts of interest cannot be managed with reasonable confidence, this must be disclosed to the clients. In addition, investment firms are granted access to establish a multilateral trading facility. Investment firms are also subject to a number of transparency requirements concerning share trading against their proprietary trading position, conduct of business rules and best execution. These are described in other sections. Investor protection The conduct of business rules are harmonised to enhance the protection of investors in the EU member states. Investment firms must inform the client of a number of issues concerning the firm and the services it offers as well as fees and trading costs. At the same time, the investment firm must be familiar with the client's investment experience, financial situation and investment objectives to be able to find suitable investment products for the client. The client must be advised to this effect. How- 1 Conflicts of interest can arise if investment firms e.g. conduct a financial analysis of a business enterprise with a view to investment recommendations while also handling the sale of the enterprise's new issue of shares.
82 ever, the investment firm may offer the client trading of simple types of securities 1 without the investment firm having to familiarise itself with the client's situation. Such trades are called "execution-only" trades. Prior to execution-only trades the client must be notified of the fact that the investment firm has not assessed the client and not provided advice. The directive introduces a provision for investment firms to take all reasonable precautions to secure "best execution", i.e. the best possible result of a securities trade for the client. The assessment of the best possible result must take into account factors such as price, costs, speed of execution, the size of the trade and other relevant factors 2. Investment firms must implement internal guidelines for how to ensure the best possible result for the client. The client must accept the guidelines and acknowledge that securities trading will take place against the investment firm's proprietary trading position rather than on a regulated market. It will no longer be possible for the member states to require that trading in stock-exchange-listed securities shall be executed via a stock exchange (stock-exchange obligation). New areas This directive implements EU regulation of a number of investment services and financial instruments. Investment advice is classified as an investment service, whereby an investment advisor must be approved as an investment company subject to a number of requirements regarding e.g. conduct of business, management of conflicts of interest and capital adequacy. However, firms providing advice only and/or solely executing orders on behalf of clients will be subject to more lenient capitaladequacy requirements than investment companies and/or subject to a requirement concerning professional indemnity insurance. Financial analysis is included in the list of ancillary investment services. When an investment firm makes general investment recommendations in the form of financial analyses, or provides other types of investment advice, the firm must thus comply with the rules in the directive concerning the avoidance of conflicts of interest, which may be detrimental to the client. Credit and commodity derivatives are included in the list of financial instruments regulated by the directive. As a basic rule, only investment firms may trade in securities. However, firms whose main activity is to trade in commodity derivatives and/or commodities on own account 1 2 Quoted shares and money-market instruments, bonds and other debt instruments (except if they include a derivative), units in collective investment undertakings and other non-complex financial products. In connection with the implementation of the directive, the weighting of the individual factors in the overall determination of "best execution" must be specified.
83 may execute such trading without being subject to the provisions of the directive. A case in point is electricity firms' trading in electricity derivatives. EFFECTS OF THE NEW INVESTMENT SERVICES DIRECTIVE The adoption of the Investment Services Directive is expected to affect market participants, regulated markets, private and institutional investors and financial authorities alike. Competition will intensify in several areas. It will be easier for investment firms to carry out cross-border activities within the EU in increased competition. The member states will no longer be able to require securities trading to take place via a stock exchange. At the same time, the directive will harmonise the rules concerning securities trading on regulated markets, via multilateral trading facilities and against the proprietary trading positions of investment firms. This creates a level playing field for the various market players. In some member states, especially the UK, the regulation of multilateral trading facilities will induce a number of investment firms to set up multilateral trading facilities to continue their current securities trading activity via trading systems outside the regulated market system. In general, the directive will require EU investment firms to comply with more comprehensive rules concerning conduct of business and best execution, and firms facing potential conflicts of interest will have to introduce schemes for identification and management of the conflicts, so as not to adversely affect client interests. The directive does not comprise clearing and settlement of securities transactions. This element of securities trading is regarded by e.g. the authorities as one of the obstacles to efficient cross-border securities trading 1. A proposal from the European Commission to include clearing and settlement is therefore required for the new Investment Services Directive to take full effect. The effects in Denmark The rules of the Investment Services Directive are not expected to impose significant additional burdens on Danish investment firms, since Danish legislation on good conduct in securities trading and good conduct of business already covers a number of the above issues. However, some amendment of the Danish rules will be required. The current Dan- 1 In the Giovannini Group's report, Cross-Border Clearing and Settlement Arrangements in the European Union, November 2001, the direct costs related to clearing and settlement of cross-border transactions in the EU are estimated to be approximately 11 times higher than for domestic transactions.
84 ish rules on disclosure in share transactions will be formally tightened by the directive's publication provisions, since the Danish rules contain no specific transparency provisions. These rules were instead implemented by the Danish regulated markets. In this connection new transparency rules concerning systematic internalisation will be required, cf. the Box. Enhanced transparency in share trading and improved investor protection at European level are expected to contribute to the investors' perception that they achieve the best possible deal. As mentioned, the more comprehensive transparency requirements concerning securities prices exclude bonds. In a European context, the Danish securities market is unique in view of the very large turnover of stock-exchange-listed bonds, especially mortgage-credit bonds. With this directive, transparency on the bond market will no longer be subject to requirements at European level. However, at national level such requirements can still be implemented. In such case, the substantial variation in structure and price formation between the stock market and the bond market and between various bond types should be taken into account. Any national transparency rules should therefore consider the specific functioning of the various markets, so as to not distort competition. CONCLUSION The adoption of the Investment Services Directive will represent a much needed adaptation of EU legislation to the market development. The securities markets are changing rapidly, and have changed considerably since the adoption of the first ISD in 1993. The new directive may intensify competition on the markets and provides for better integration of the securities markets in the EU. Overall, these factors can benefit both the business community and private investors, even though several of the changes implemented by the directive are not substantial.