08/02/2012 Author: Tony Griffiths

Return of the Mifid

Somewhat overlooked due to the more pressing AIFM Directive, the release of draft proposals for Mifid II legislation has been attracting an increasing amount of concern. HFMWeek spoke to those in the know to identify the main areas that impact hedge funds 

Those expecting the draft proposal of the Markets in Financial Instruments Directive (Mifid) II – an update, as the name suggests, of the EU’s 2004 Mifid legislation, in the form of both a regulation and a directive – to be a mere tweaking of the original, may have had a nasty surprise following its debut last October.

The sequel to, until recently, Europe’s most famous fund regulation (a somewhat dubious honour), has new concepts and definitions, and a wider scope. The result is something with potentially far-reaching implications.

Speaking at a regulatory conference last month, Sidley Austin partner Leonard Ng described elements of the draft proposal as “scary”. The response elsewhere has been similar, with several provisions described as “surprising” and “bizarre” by HFMWeek interviewees.

This week, it was revealed that Mifid II’s legislative representative in the EU Parliament, Germany’s Markus Ferber, had received 193 responses to a 15-point questionnaire about Mifid II sent out into the public domain in mid-December. With what is believed to equate to 4,000 pages of input to wade through, the provisional date of 23 March for his first report might prove optimistic. 

For many hedge fund managers, the likes of Dodd-Frank registration and/or the Alternative Investment Fund Managers Directive (AIFMD) Level 2 will be at the top of their regulatory in-tray; and not without good reason. Mifid II’s implementation isn’t expected until 2015, and, in contrast to the AIFMD, whose controversial first draft debuted in April 2009 to a mixture of shock and disbelief, it has arrived with little publicity or fanfare.

This is not to say the relevant industry trade bodies are not concerned. The Alternative Investment Management Association (Aima) and the Managed Funds Association (MFA) are already feeding into the consultation process, demanding improvement. The reduced hype – neither entity has trumpeted its worries in the manner done during the AIFMD process – is a marked departure from previous lobbying efforts. Commentators have suggested this could reflect a more refined approach to lobbying on behalf of the industry as a whole, following almost three years of mixed success. The sheer amount of new regulation means that the risk of diluting existing messages is also greater.     

In an interview this week, Aima’s director of government and regulatory affairs, Jiri Krol, has given a flavour of the trade body’s stance regarding Mifid II – with the third-country provisions coming in for particular scrutiny. “There have been a number of divergent treatments in the various third-country regimes as regards clearing, short-selling, fund management and depositary services. We are piling up a very unwieldy selection of rules that have the potential to isolate Europe at a time when it needs investment from the rest of the world,” he says. “Mifid is the latest example of that.”

A sobering sense of de ja vu could be forgiven then. Although perhaps not as quite as alarming as the AIFMD’s first draft, there is plenty in Mifid II worth keeping an eye on. 

THIRD COUNTRIES
The ‘big one,’ according to those HFMWeek spoke to. Why? Because Mifid – previously without provisions relating to non-EU services – will, under Mifid II, have concepts similar to the controversial third-country rules in the AIFMD. The legislation’s “most worrying proposals are around third- countries, particularly the need to register with Esma if you wish to trade with European eligible counterparties,” says Aima’s Jiri Krol.

A US broker, for example, keen to provide a service to a UK entity presently benefits from an ‘overseas persons exemption’, allowing firms without a UK base dealing with institutional entities to provide a service without being regulated in the UK. France, meanwhile, generally requires a reverse enquiry. Every EU member state has its provisions. Mifid II tries to harmonise the EU regime.

Does the AIFMD supersede Mifid II?
To a certain extent. If you are an AIFM you’re subject to the AIFMD rather than Mifid. However, fund managers do different things. Non-EU firms with subsidiaries inside the EU – for example, US hedge fund managers with sub-advisors in the UK – could be caught by Mifid II through the services provided by their subsidiaries in the EU. It will depend how individual member state regulators interpret the AIFMD, but, an EU entity delegated authority of some kind by a non-EU parent could be classed as a Mifid portfolio management firm, rather than an AIFM, depending on the the relationship.

How do the Mifid third-country provisions compare to AIFMD?
They’re potentially worse, Sidley Austin’s Leonard Ng tells HFMWeek. A UK investment manager interested in Brazil-based investments may wish to use a Brazilian investment firm  for investment advice. As it stands, the Brazilian firm can offer such a service from outside the EU due to the UK’s overseas persons exemption. However, as Mifid II is drafted, that entity would effectively need to set up a branch in the UK in order to provide that service to the UK investment manager. An exemption is available for certain services to ‘eligible counterparties’ but that exemption does not include investment advice or investment management services to ‘professional clients’ and so is not available to the asset management sector, according to Ng.    
  
“The third country provisions are pretty controversial,” he says. “They appear to make it impossible in the asset management industry, in particular for a third-country investment manager or advisor, to provide a service even to a bank inside the EU.”

HIGH-FREQUENCY TRADING
Considered a subset of Mifid II’s broad Algorithmic Trading definition, high frequency trading (HFT) comes under some serious scrutiny in the draft proposals. Under Mifid II, any situation where an algorithm is used which has an effect on the execution of the purchase or sale order is considered HFT. As such, even an asset manager trading five times a day will be caught if a trade is executed on the say so of an algorithm. This isn’t just about the growingly popular quant space – algorithms, in their broadest sense, are used by a plethora of fund managers.

What happens if you are considered a high frequency trader?
Apart from strict systems requirements, the impact is two-fold. Firstly, you need to provide continuous liquidity to your market – to post ‘firm quotes at competitive prices with the result of providing liquidity on a regular and ongoing basis... regardless of prevailing market conditions.’ This, effectively, would turn asset managers using algorithms into market makers.

Secondly, and potentially more significantly, you need to provide regulators with information on your algorithmic trading strategies on an annual basis. In short, fund managers will have to divulge their competitive edge. Regulator confidentiality applies of course, but the concern is that, with disclosure requirements increasing dramatically as a result of the change, the chance of leakage will also grow.  

Mifid’s algorithmic trading provisions are “another concern”, admits Krol. “The vast majority of the provisions are acceptable, with tweaks of course. For example, introducing appropriate risk management techniques and strengthening dialogue with the regulators around algorithmic trading sounds sensible.”

“The issue we find surprising is the proposed requirement for all algorithmic traders to post firm and competitive quotes in all market circumstances. There needs to be a narrowing of the definition of algorithmic trading so as to not to capture all computer-assisted trading such as execution algorithms.”  

PRE- AND POST-TRADE TRANSPARENCY
Increased transparency is one of Mifid II’s defining characteristics. Currently, Mifid requires disclosure within the equity markets. Mifid II wants to extend the transparency regime to bonds and derivatives.

Why is that a problem?
Liquidity. Few argue with the sentiment for increased transparency in Mifid II. The issue is that, under the current drafting, the text doesn’t appear to appreciate the differences between the equity, bonds and derivatives markets in regards to how trades take place.

Bonds don’t have the same level of market depth as the equity market, meaning that, if a broker always has to give its trading details, it may not be able to make money on those trades, Sidley Austin’s Ng explains. “Pre-trade transparency could have the effect of reducing brokers’ incentives to be market makers and provide liquidity to the bond markets, if those brokers believe they will not earn a return that covers the cost of the capital they bring to the market,” he says.        

The current ‘dark pools’ regime allows fund managers to avoid revealing transparency to the market during certain types of trades – such as the large-in-scale exemption for big orders. The status of such waivers, even for the more liquid equity markets, will need to be clarified, given Mifid II’s ambiguous wording, Ng adds.   

ORGANISED TRADING FACILITIES
Mifid II introduces the new concept of the Organised Trading Facility (OTF) – adding to the two categories of trading venue in Mifid I – as part of its new focus on the bonds and derivatives markets. A sweeping definition, an OTF is designed to cover broker-crossing systems, inter-dealer broker systems, dark pools and other currently unregulated organised trading systems.

Among the rules applying only to OTFs, such a venue will be banned from using propriety capital when executing client orders, a stipulation highlighted by Kay Swinburne, a UK member of the European Parliament and a shadow rapporteur for Mifid II.

“In terms of the hedge fund industry I am worried about the prohibition on the use of proprietary capital for OTFs – including broker crossing networks,” she tells HFMWeek. “I think this needs some serious time and attention to ensure that investors are able to have the maximum amount of choice available to them when choosing where to execute orders, while still maintaining a level playing field.”