Monday, January 20, 2014

E.U. Parliament and Council Agree on Legislation on Derivatives Central Counterparties and Regulating Dark Pools and High Frequency Trading

The European Parliament and the E.U. Council reached an agreement on legislation amending the Markets in Financial Instruments Directive (MiFID) to provide stability and transparency for the financial markets. The new rules will remedy the weaknesses of the financial markets which had become apparent in the worldwide crisis, said European Parliament Rapporteur Markus Ferber MEP-Germany. Commissioner for the Internal Market Michel Barnier said that the legislation is a key step towards establishing a safer, more open and more responsible financial system and restoring investor confidence in the wake of the financial crisis.

The new rules apply to all market operators, such as stock exchanges or other trading platforms, banks, investment companies and funds or other service providers related to financial products. The requirements relate to transparency and investor protection obligations. All market participants get a higher degree of stability and security, from the retail investor to the multinational investment bank, said MEP Ferber.

Excessive downward speculation will be banned under the new MiFID II. The E.U. has ``put the brakes’’ on high-frequency trading , noted MEP Ferber, and unacceptable speculation on food and commodities will also come to an end. The Rapporteur emphasized that it is not in the interest of society as a whole when the price of rice or grain goes up simply because there has been speculation on the markets.

The MiFID is the main piece of E.U. regulation on financial markets. The plenary vote on the MiFID II legislation is expected during the March session of the European Parliament.

U.S. firms. The legislation sets up a harmonized regime for granting access to EU markets for firms from the U.S. and other third countries based on an equivalence assessment of third country jurisdictions by the European Commission. The regime applies only to the cross-border provision of investment services and activities provided to professional and eligible counterparties. For a transitional period of three years, and then pending equivalence decisions by the Commission, national third-country regimes continue to apply.

Dark trading. Dark pools or platforms are where trading interests interact without full pre-trade disclosure to other users or the public. The MiFID II reform means that organized trading of financial instruments must shift to multilateral and well-regulated trading platforms. Strict transparency rules will ensure that dark trading of shares and other equity instruments which undermine efficient and fair price formation will no longer be allowed.

Derivatives. The legislation mandates trading obligations for derivatives that will make trading safer and more efficient and will complement the compulsory clearing requirements under the European Markets Infrastructure Regulation (EMIR). The legislation also sets up a harmonized E.U. system setting limits on the positions held in commodity derivatives, Commissioner Barnier noted, thus MIFID II will contribute to orderly pricing and prevent market abuse, and in turn curb speculation on commodities.

MiFID II provides for enhanced supervisory powers and a harmonized position-limits regime for commodity derivatives to improve transparency, support orderly pricing and prevent market abuse. Under this system competent authorities will impose limits on positions in accordance with a methodology for calculation set by the European Securities and Markets Authority (ESMA).

The legislation also introduces a position-reporting obligation by category of trader. This will help regulators and market participants to have better information on the functioning of these markets.

MiFID II establishes a harmonized E.U. regime for non-discriminatory access to trading venues and central counterparties. Smaller trading venues and newly established central counterparties will benefit from optional transition periods. The non-discriminatory access regime will also apply to benchmarks for trading and clearing purposes. Transitional rules will ensure the smooth application of these provisions.

Investor protection. MiFID II will also strengthen investor protection. Investment firms will have to meet stricter standards to ensure that investors can trust that they are being offered products which are suitable for them and that their assets are well protected. Investors will also be able to rely on independent and neutral advice; and fee and remuneration structures must not conflict with this requirement.

High frequency trading. MiFID II will also ensure that legislation keeps pace with technological developments. The dramatic increase in the speed and volumes of order flows can pose systemic risks. The new rules ensure safe and orderly markets and financial stability through the introduction of trading controls, an appropriate liquidity provision obligation for high-frequency traders pursuing market-making strategies and by regulating the provision of direct electronic market access.

Algorithmic trading is a form of trading where a computer algorithm automatically decides to place an order with minimal or no human intervention. An important form of algorithmic trading is high frequency trading, where a trading system analyzes the market at high speed and then sends large numbers of orders very quickly.

The legislation provides a series of safeguards both on market participants who use algorithms as part of their trading strategies as well as on trading venues where algorithmic and high-frequency trading takes place.

Thus, MiFID II introduces trading controls for algorithmic trading activities which have dramatically increased the speed of trading and can cause systemic risks. These safeguards will include the requirement for all algorithmic traders to be properly regulated and to provide liquidity when pursuing a market-making strategy. In addition, investment firms which provide direct electronic access to a trading venue will be required to have in place systems and risk controls to prevent trading that may contribute to a disorderly market or involve market abuse.

Market structure framework. MiFID II introduces a market structure framework which closes loopholes and ensures that trading, wherever appropriate, takes place on regulated platforms. To this end, it subjects shares to a trading obligation. It further ensures that investment firms operating an internal matching system which executes client orders in shares, depositary receipts, exchange-traded funds, certificates and other similar financial instruments on a multilateral basis have to be authorized as a Multilateral Trading Facility. It also introduces a new multilateral trading venue, the Organized Trading Facility , for non-equity instruments to trade on organized multilateral trading platforms.

These regulations are designed to ensure a level playing field with Regulated Markets and Multilateral Trading Facilities. The neutrality of OTF operators is ensured through restrictions on the use of their own capital, including matched principal trading, and discretion in their execution policy. The legislation introduces a trading obligation for shares as well as a trading obligation for derivatives which are eligible for clearing under the European Markets Infrastructure Regulation (EMIR) and are sufficiently liquid. This will move trading in these instruments onto multilateral and well regulated platforms.

Equity Market Transparency. MIFID II also increases equity market transparency by mandating, for the first time, a principle of transparency for non-equity instruments such as bonds and derivatives. For equities, a double volume cap mechanism limits the use of reference price waivers and negotiated price waivers (4 percent per venue cap and 8 percent global cap) together with a requirement for price improvement at the mid-point for the former.

Large in scale waivers and order management waivers remain the same as under MiFID I. But MiFID II broadens the pre- and post-trade transparency regime to include non-equity instruments, although pre-trade transparency waivers are available for large orders, request for quote and voice trading. Post-trade transparency is provided for all financial instruments with the possibility of deferred publication or volume masking as appropriate.

The legislation also enhances the effective consolidation and disclosure of trading data through the obligation for trading venues to make pre- and post-trade data available on a reasonable commercial basis and through the establishment of a consolidated tape mechanism for post-trade data. These rules are accompanied by the establishment of an approved reporting mechanism and an authorized publication arrangement for trade reporting and publication.

Investor protection. The legislation enhances investor protection by mandating better organizational requirements, such as client asset protection or product governance, which also strengthen the role of management bodies. The new regime also provides for strengthened conduct rules such as an extended scope for the appropriateness tests and reinforced information to clients.

Independent investment advice is clearly distinguished from non-independent advice and limitations are imposed on the receipt of commissions and other inducements. MiFID also introduces harmonized powers and conditions for ESMA to prohibit or restrict the marketing and distribution of certain financial instruments in well-defined circumstances and similar powers for the European Banking Authority in the case of structured deposits. Concerning Packaged Retail Investment Products (PRIPS), the new framework also covers structured deposits and amends the Insurance Mediation Directive to introduce some rules for insurance-based investment products.

Sanctions. The existing regime for effective and harmonized administrative sanctions is also enhanced. The use of criminal sanctions is framed so as to ensure the cooperation between authorities and the transparency of sanctions. A harmonized system of strengthened cooperation will improve the effective detection of breaches of MiFID.