Thursday, February 03, 2011

US Hedge Fund Industry Comments on European Commission Proposed Changes to MiFID

While generally supporting the increased transparency embodied in the European Commission’s proposed reform of the Markets in Financial Instruments Directive (MiFID), the US hedge fund industry is concerned that proprietary or confidential information of individual investors may be disclosed to the public. In a letter to the Commission, the MFA, chaired by former US Rep. Richard Baker, also voiced concern that the idea of introducing a third country regime in MiFID based on the principle of equivalence could be viewed as protectionist. Further, while noting that automated trading and high frequency trading can be beneficial to financial markets, MFA is concerned that the proposed definition of automated trading could capture certain types of trading which rely on execution strategy algorithms, but which do not necessarily relate to the execution of orders. The MFA supports the development of exchange-traded products as a complement to OTC derivatives but notes the advice from CESR that this should be encouraged rather than mandated at this point in time.

In announcing the proposed revisions, Commissioner for the Internal Market Michel Barnier said that the original aim of this key piece of European legislation, MiFID, was to create a robust common regulatory framework for EU securities markets. In many ways, it has been a success. The goal of the proposed revision is to adapt the MiFID regulatory framework to the new trends and players on financial markets to provide greater market transparency and more investor protection.

MFA concerns over the disclosure of hedge funds’ proprietary or confidential information relating to their investment strategies, portfolio holdings and investors, is based on the fact that such information is highly sensitive from a competitive standpoint and thus funds employ substantial safeguards to protect this information. Moreover, an investment manager’s strategies typically include multiple components and the disclosure of pieces of data would be incomplete and inherently difficult to understand. As a result, reasoned MFA, such information in isolation would be misleading to investors, which could have negative consequences should they misguidedly try to act on it. Given the sensitive nature of such information, MFA believes that it is critical to have strong confidentiality safeguards in place to protect the proprietary interests of individual investors and the welfare of the financial markets.

MFA is also concerned by the Commission’s statement that third country financial firms (read non-EU firms) must be subject to a regulatory regime which is at least equivalent to that offered by MiFID. The association urged the Commission to reconsider applying, on a pan-EU basis, access based on what is essentially a strict equivalence standard. The concern is that such a standard implies that no aspect of a regulatory regime imposed by the US or other third country could be different from that of the standard set in MiFID, which may give the impression that the EU is taking a protectionist stance. In addition, setting such a high standard would prevent EU investors from seeking investment opportunities in US and other non-EU economies which may have comparable regulatory standards, but do not meet the strict equivalence standard.

Since the Commission should focus on conduct and not the proprietary analytical processes of investment decision making, the MFA suggested that the proposed definition of automated trading be changed to clarify that it relates only to the execution aspects of the order rather than to the investment strategy employed in the selection of investments. Algorithmic trading is often used by asset managers as a proprietary tool in selection of investments based on pre-determined parameters. It would neither be appropriate nor practical, said MFA, to apply the organizational requirements proposed by the Commission to investors employing algorithms in their investment selection and, in particular, require them to notify and explain the design and functioning of proprietary algorithms to a regulator.

In MFA’s view, the activity of investment selection by the use of algorithms does not carry the same risk of impacting the market. How an investor reaches a decision to buy or sell a security should be inconsequential, the group reasoned, on the other hand, trading practices, or how investors operate in the markets can impact market functioning.

Similarly, MFA asked the Commission to clarify the proposed definition of high frequency trading to indicate that the focus is on firms which trade on their own capital in exchange-traded markets, rather than on asset managers which act as agents for investment funds they may manage.

Regarding the issue of whether all high frequency traders over a set minimum would have to be authorized, MFA does not believe that there is any reason that the underlying investment funds or managed accounts should themselves have to be authorized. The investment managers would already be regulated either as portfolio managers under MiFID, alternative investment fund managers under the AIFM Directive or as managers of UCITS under the UCITS Directive.

If the Commission believes there are unregulated principal trading firms that need to be similarly authorized, the MFA would support a level playing field where all market participants are subject to oversight. Separately, MFA would be concerned about any extraterritorial requirements such that non-EU asset managers would not be able to use high frequency trading techniques in relation to shares admitted to trading on EU markets unless regulated by an EU regulator.

Given clarification of the definitions, MFA supports the Commission proposals to require firms engaging in automated trading to have risk controls, including pre-trade checks and risk management controls, particularly where these can be standardized on a global basis. In this context, MFA noted that similar steps have been taken in the United States, in particular SEC Rule 15c3-5 prohibiting naked access. Broker-dealers that provide direct access to trading securities to persons other than broker-dealers must maintain a system of risk management and supervisory controls relating to the provision of such access. Those controls must be reasonably designed to limit the financial exposure of the broker-dealer providing access, and ensure compliance with regulatory requirements applicable to providing access.

The MFA also supports risk controls such as market-wide single stock circuit breakers or limit up/limit down systems since they will help curtail disruptions during times of market stress. However, the group cautioned that such risk controls must be of short duration and triggered only in limited instances, so as to provide a cooling-off period and add to investor confidence by removing a potential panic scenario, and not triggered by erroneously-reported prices.
The MFA does not support risk controls such as speed bumps, trading delays or specified maximum execution speeds because they would likely harm investors by increasing trading and transaction costs.

The MFA cautioned the Commission against hard position limits in favor of a position management approach. The mechanical imposition of position limits for commodity derivatives would have the effect of reducing liquidity and the ability of commercial participants to hedge against future changes in price by limiting the ability of market participants to diversify and reduce risk. It is also likely to reduce the competitiveness of European markets, said MFA, and indeed may distort global commodity derivatives markets. Thus, MFA urged the Commission to consider alternatives to position limits, such as enhanced post-trade transparency obligations and reporting of derivatives position

While supporting the concept that position information should be made available to the public only on an aggregated basis, MFA is concerned about the disclosure of position-level data that includes the identities of the counterparties and other sensitive details. Trading strategies are often complex with various pieces combining to express a single view, the group noted, and a narrow perspective could lead to misunderstanding and potentially misuse.

Also, given the multitude of national regulators involved, unfettered access without precondition could have harmful side effects on the markets. Thus the Commission was urged to establish a reasonable threshold or nexus requirement for a regulator in one member state to gain access to data from an organized trading venue in another member state. Without constraining legitimate interests, such a requirement would appropriately balance the proprietary nature of market transactions with the overall goals of the regulation.

The MFA supports the proposal to give national regulators the power to temporarily ban or restrict the trading or the distribution of a product by investment firms so long as this power is, as the Commission proposes, exercised on pre-notified and coordinated basis through the new European Securities and Markets Authority. However, MFA asked the Commission to consider a mechanism under which such coordination with ESMA would involve having ESMA consider the proposed action by the national regulator within a certain time, issue advice to the national regulator as to whether the action is appropriate, and give the market sufficient notice of the proposed action so that its effect can be properly absorbed without causing market instability.

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