Written by Matt Raver
The Second Markets in Financial Instruments Directive (‘MiFID II’) has had an interesting journey. Originating in 2010, it sought to update the European regulatory framework for investment firms, reflecting the 2008 financial crisis and industry developments, including technological advances and commercial trends. The requirements eventually took effect in 2018 – 1 year behind schedule.
The legislative package is significantly larger than its predecessor and covers a sizeable number of topics. Given the sheer number of market participants impacted by MiFID II, it is perhaps inevitable that when put into practice, for any given firm certain elements would be more effective than others.
Brexit has further complicated matters. There are now two versions of MiFID II – the original European Union version and the UK version which as at 1 January 2021 was an almost carbon copy. For some time now, commentators have opined on the extent to which the respective frameworks will diverge in 2021 and beyond.
Although representing a small part of the framework, the FCA is proposing some changes related to research and best execution. If adopted, the changes will take effect during the second half of 2021.
Research – exemption for SME and FICC research proposed
Since 2018, under the MiFID II inducements framework, subject to certain exemptions, research services are either paid for by the firm itself or by agreeing a separate research charge with its clients. ‘Bundling’ of research and execution services – which was hitherto convention for certain asset classes – is not permitted.
This significant change arose out of a policy objective to improve accountability over costs passed onto clients and to improve price transparency vis-à-vis both research and execution.
However, the FCA has concluded that these benefits are outweighed by costs regarding small-cap firms. In particular, the changes have caused research coverage of such firms to decline and become lower in quality.
The proposal is to categorise research with respect to firms with a market capitalisation of less than £200 million as a ‘minor non-monetary benefit’. In other words, it will be possible to either receive research for free, or to bundle (or, re-bundle) the research and execution costs.
The FCA also proposed creating an exemption where the research relates to fixed income, currencies and commodities (‘FICC’). Such transactions are not typically paid for via commission payments but on the basis of a bid-offer spread. Therefore, re-bundling research and execution does not carry the same opacity risks as – for example – is the case for equities.
Finally, the FCA is creating exemptions regarding research provided by independent providers (i.e. where the provider does not also provide execution services) and where the research is openly available.
Best Execution – proposal to remove publicly available annual reports
MiFID II aspired to improve investor protection and transparency in how firms execute client orders. The solution was to introduce publicly available reports focussing on the quality of execution. For execution venues the reports are known as ‘RTS27’ reports. For investment firms, the ‘RTS28’ reports have been an annual requirement for each calendar year from 2017 onwards.
The FCA has found that the policy goal has not been achieved. In particular, the report are viewed by a very small number of market participants.
The FCA therefore proposed to remove the requirement to produce these reports.
In proposing these changes, the FCA notes the so-called ‘quick fix’ amendments that have been made to the EU’s version of MiFID II. These are intended to support economic recovery from the Covid-19 pandemic. Among other aspects, the changes relate to a number of topics including client reporting and disclosure, product governance and commodity derivatives.
Regarding research and best execution, the EU has enacted changes along similar philosophies to the FCA’s proposed edits. However the FCA has arguably gone further, for example by explicitly removing the RTS28 reports. The FCA also states that certain aspects of the EU amendments aside from research and execution disclosure matters might be dealt with via legislative changes in due course.
It would thus appear that – regarding MiFID II at least – the regulatory divergence between the EU and the UK is evolutionary and not revolutionary. Furthermore, from a thematic perspective there will be some alignment between the UK and the EU regarding regulatory change – albeit there might be some differences at a more granular level. The UK’s ‘Investment Firms Prudential Regime’ which takes effect in January 2022 is substantially similar to the EU’s equivalent regime, to be introduced in June 2021, but with some differences.
Notwithstanding this, many UK market participants will argue that there are certain components of the wider regulatory framework (for example, also including the investment funds frameworks AIFMD and UCITS) that should also be reviewed and amended as applicable. Within the fund management sector, there remains fundamental differences in regulatory approach dependent upon whether the firm is authorised under AIFMD or MiFID and/or whether the mandate is an AIF or a segregated account. There is also the argument that there are certain requirements that relate to firms not dealing with retail clients that are disproportionate to the risks, in particular regarding client disclosure requirements.
The impetus to make changes where regulation is not working is there – the nature and scale of the remedial work remains to be seen.
Ultimately, the UK legislators and regulators will face a historical trade-off – offering the protection afforded by effective regulation whilst ensuring that the regulatory environment does not stifle the effectiveness and competitiveness of the UK financial services industry. But now the goal posts have changed – the UK has the autonomy to manage this trade-off on its own whilst seeking to manage its future relationship with the EU including how best to deal with the thorny issue of reciprocal market access. Many pairs of eyes will be on the rule makers as they walk this tightrope.