Is MiFID Necessary in the UK?

By Trevor Barritt, Head of Compliance at Actimize Europe

May 4, 2007

'When Wellington thrashed Bonaparte,
As every child can tell,
The House of Peers throughout the war
Did nothing in particular,
And did it very well.
Yet Britain set the world ablaze
In good King George's glorious days!

And when the House of Peers withholds
Its legislative hand
And noble statesmen do not itch
To interfere in matters which
They do not understand,
As bright will shine Great Britain's rays
As in King George's glorious days!'

Thus wrote W S Gilbert in Iolanthe some 125 years ago. When asked to write an article on MiFID, I was reminded of these lines. It is not my intention to imply that that the European Commission or the FSA seeks to interfere in matters which they do not understand. Far from it, particularly as I worked for the FSA for four years, and have many dealings with both bodies today, and I find them invariably helpful, pragmatic and well informed. But, at the risk of a charge of heresy, the questions need to be asked - is MiFID necessary in the UK, and is it helpful?

At one level, of course, the answer has to be yes. The UK is a member of the European Union. The EU Commission published the Markets in Financial Instruments Directive ('MiFID') as Directive 2004/39/EU on 21 April 2004 and, by European Law, its provisions must be incorporated into the laws of the UK and of every other EU member state by November 2007. However, this will be at least the fourth major overhaul of regulations in the UK Financial Services Industry in 20 years. I am not aware of any other industry whose regulations have been changed so fundamentally and radically so often.

First came the Financial Services Act 1986, requiring those undertaking 'Investment Business' to be regulated for the first time, and the five 'Self-Regulating Organisations' together with a number of 'Recognised Professional Bodies' and such like, all supervised by the SIB. Thereafter in 1993 we had the Investment Services Directive, allowing 'passports' for the first time for the provision across the EU of investment services. Thereafter, of course, came N2, and the advent of FSMA and the FSA. Now finally (?) MiFID.

MiFID seeks to harmonise the way in which Financial Services business involving the trading of securities and derivatives is undertaken across the EU. This is no small undertaking given the different cultures and legal systems across the increasingly expanding community. It replaces the ISD, and extends the scope of cross-border passporting to areas such as commodity derivatives, and investment advice. MiFID covers many different areas, including new passporting rights, client order handling, Best Execution, pre and post trade transparency, treatment of employees and agents, conflicts of interest, safekeeping, suitability and appropriateness, powers and duties of regulators, management responsibility, outsourcing, and record keeping. To cover all these points would require a regular column in this journal over several months- so I will therefore visit a few of these areas briefly:

1. Transparency

MiFID has much to say on this subject. The most innovative development in this area is the concept of the Systematic Internaliser, defined as 'an investment firm which, on an organised, frequent and systematic basis, deals on own account by executing client orders outside a regulated market or an MTF'

Such animals must provide firm quotes in shares admitted to trading on a regulated market. Where the market concerned is 'liquid' these quotes must be published 'on a regular and continuous basis' during normal trading hours. Where the market is not liquid, quotes must be published on request.

This, of course, begs two questions - what constitutes a 'liquid' market, and what does 'organised, frequent and systematic' mean? Many more questions follow from this: Can I suddenly wake up and find myself to have evolved into a Systematic Internaliser? If I regularly and systematically trade with clients prop but my trading floor is a disorganised rabble of prima donnas only interested in making profits for themselves, do I pass the test or not? If I fail to trade much in the way of prop business with clients for a day, do I slide backwards down the evolutionary slope? What if it is a week, a month or a year?

The Directive itself keeps its counsel on these matters, and to date CESR and the FSA have not published any hard and fast thresholds as to the percentage of market volume or absolute volume of transactions that a firm must undertake off market before the firm becomes a Systematic Internaliser.

2. Exchanges and MTFs

MiFID's terminology is wonderful. They say that the camel was invented by a committee. Surely it must have taken the combined efforts of many draftsmen to come up with the term 'Systematic Internaliser'. This must be even more the case with our next exhibit: the Multilateral Trading Facility (or, as its friends call it for short, the 'MTF').

Before MiFID, a number of EU member states already had rules relating to entities similar to MTFs. FSA, for example, has rules relating to Alternative Trading Systems, or ATSs which are basically MTFs by another TLA (Three Letter Acronym). However, the requirements for an MTF will be substantially greater and more qualified than the existing requirements as to ATSs. It is also interesting to note that the requirements of RIEs and DIEs are similarly becoming more codified. Many of the new requirements on RIEs under MiFID (particularly in the area of pre and post-trade transparency (PTT)) are actually not prescribed by the current rules (TCR) of FSA, HMT, HMG, or EEA (even in the ISD).

3. Best Execution

The rules on Best Execution after MiFID will change substantially. At present, under FSA Rules, all one really needs to worry about is the price at which one deals (subject, of course, to the rules on reasonable charges for Private Customers). Post MiFID, one has to formulate a Best Execution Policy, setting out the pools of liquidity in which one will fish (be they systematic internalisers, MTFs or exchanges) and ensuring that the net consideration given to the client is the best available considering all charges, taxes etc and also taking into account the speed of execution. The contents of this policy must be communicated in writing to clients.

Such a policy must be regularly reviewed to ensure that the execution venues which are considered by the policy remain the most appropriate, so that if it is discovered that a particular market systematically gives the best net consideration to the client, but is not included in the firm's Best Execution Policy, such a market must be added to the policy.

Firms must also be able to prove on enquiry by a regulator or client that Best Execution has taken place. Firms are required to 'capture the market' in that they must keep a 'snapshot' of all quotes, orders etc at all times on all markets which form part of their policy, in order to be able to discharge this duty. This requirement to prove that Best Execution has taken place was described by a Head of Equities Compliance at a major European Investment Bank recently at an Actimize conference as a reversal of the presumption of innocence, such that one is assumed not to have given Best Execution until one can prove that one has!

Akin to this is the new post MiFID need for portfolio managers to inform Retail Clients when losses in open uncovered options positions reach a predetermined level.

Firms must also have a charging policy, setting out in writing what they will charge which client types for which forms of business. Firms will be expected to monitor compliance with this policy.

4. Conflicts of Interest & Management Responsibility

Incredible as it may seem, no current FSA Rule requires a firm to identify its conflicts of interest. MiFID does require this, and imposes very substantial additional monitoring and supervision requirements on senior management, over and above those already required under current FSA rules. Firms are required to have adequate procedures to ensure that conflicts within the firm and between the firm and its clients (and between clients) are managed such that 'risks of damage to client interests' are eliminated. Where this is not possible, there is a requirement to notify clients of these conflicts.

5. Suitability and Appropriateness

The suitability rules of FSA are largely similar to those of MiFID. However, the number of clients to which they apply will be substantially greater as more clients will fall into the 'Retail Client' definition (see below). In addition, MiFID introduces a new concept of 'appropriateness', whereby the firm must warn the client, even in the case of execution - only business, where it believes that orders given are not appropriate for the client, taking into account the KYC information which must be obtained and held on file.

6. Reclassification of Clients

All of the above are sensible developments in the area of Financial Services regulation. What at first sight is more difficult to accept is the necessity, for at least the fourth time since 1988, for all UK firms to conduct a root and branch reclassification of all their clients.

In the beginning were the Market Professional, the Business Customer and the Private Client. The Securities Association saw that this was good.

Then came the SFA, who changed the Market Professional to the Market Counterparty (a term which had previously been adopted by TSA's little brother, the AFBD).

Thereafter, the FSA gave us the Market Counterparty, the Intermediate Customer and the Private Client.

In the above regime, the Market Counterparty was not a customer (except in odd circumstances when it was).

Now MiFID gives us the Eligible Counterparty, the Professional Investor and the Retail Client. The categories of client under MiFID are similar, but not identical, to those under current FSA rules. It would appear that quite a few clients will be reclassified post MiFID in a more junior capacity than they are now categorised (e.g. some current Market Counterparties will become Professional Investors, and some current Intermediate Customers will become Retail Clients).

This is, of course, a real pain for firms in the UK, who will have to reassess their client base one more time. Having said this, it is no bad thing to require firms to look through their customer databases from time to time. An awful lot of out of date, inaccurate and incomplete information usually lurks in such databases, and is usually discovered only after a thorough spring clean. There are many uncertainties under MiFID, and many rules are yet to be clarified. The definitions of client types, however, are known, and firms would do well to conduct their spring cleaning at this seasonable time of year, to get at least one lengthy aspect of MiFID compliance under their belts and so free up more time later in the year.

The other thing to be said about this aspect of MiFID is that while the UK has client types, many other countries do not, and a harmonisation of the rules in this area across Europe must be a welcome development.

So, was MiFID necessary and helpful in the UK? After all, the FSA has done a pretty good job over the years with the legislation available to it. Gone are the Wild West days of my youth, when unscrupulous cowboys preyed on the elderly, sick and unwary, cold calling the unsuspecting public, making ridiculous promises of fantastic returns, dispatching motorcycle riders to pick up cheques before the victims could change their minds, and then 'churning' portfolios to nothing in order to make a quick buck. Is there really now a need for overhaul?

I believe the answer to these two questions must be 'yes'. MiFID makes a number of bold moves in areas such as client protection, transparency, and the management of conflicts of interest. The developments in making management more accountable and the duty for increased monitoring are also welcome. The burden on firms will substantially increase post MiFID, and the complexities of MiFID will mean that larger firms at least will find it very difficult to comply without some form of electronic surveillance and reporting system. Actimize offers such a system designed specifically to address MiFID issues.

There is much speculation at present that many EU states will not be ready to implement MiFID by November 2007. This is unfortunate, and an open question exists as to how the passporting arrangements will work if this is the case. FSA has stated quite categorically that the UK will be ready, and substantial new regulations and guidance have already been published. More is to follow shortly. It is also rumoured that many firms will also not be ready, both in the UK and overseas. This is also unfortunate, as the embracing of MiFID gives many opportunities for legitimate, clean and appropriate Financial Services business to flourish across the EU.