In the early 2000s, the EU sought to break down cross-border trading barriers by introducing the Markets in Financial Instruments Directive (MiFID). The Directive, which took effect in 2007, swept away monopolies enjoyed by traditional national exchanges and facilitated the development of alternative trading platforms with a primary focus to equity markets. Following the proposal by the EU Commission in 2011, the second version of the Directive was agreed upon by the EU Parliament and thus the most anticipated MiFID II.
The ultimate aim of the MiFID II is the reduction of systematic risk and the strengthening of financial stability by ensuring maximum transparency in markets. All of this is intended to achieve a broader investor protection. In achieving this goal, the Directive focuses on over-the-counter markets and extending the pre and post trading requirements also in respect of non-equity markets and equity-like products (MiFID I targets equity markets).
Investor classification under MiFID
MiFID distinguishes between two client categorisation, namely retail and professional. For each category, MiFID applies different regulatory implications with a main direction: investor protection.
MiFID: Professional Investors
The Professional Client category accounts for investors who possess the right knowledge, experience and expertise to make investment decisions and, subsequently, assess the applicable risk. The MiFID Directive defines a professional client as per below:
- A large undertaking meeting two of the following size requirements on a company basis: (i) Balance Sheet total €20,000,000 and over, (ii) Net turnover of €40,000,000, (iii) Own funds of €2,000,000 and over;
- An institutional investor whose main activity is to invest in financial instruments, including entities dedicated to the securitisation of assets or other financing transactions;
- An individual, or in the case of a body corporate, that fulfills at least two of the following:
- Has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous calendar year;
- Has a financial instrument portfolio exceeding €500,000;
- Works for, or has worked, in the financial services sector for at least one year in a professional position which requires knowledge of the transactions envisaged by the Fund
- Entities which are required to be authorised or regulated to operate in the financial markets. The list below should be understood as including all authorised entities carrying out the characteristic activities of the entities mentioned – entities authorised by a member state under a European Community Directive, entities authorised or regulated by a member state without reference to such Directive, and entities authorised or regulated by a non-Member State:
- Credit Institutions
- Investment Firms
- Other authorised or regulated financial institutions
- Insurance undertakings
- Collective Investment Schemes and Management Companies of such schemes
- Pension Funds and Management Companies of such Funds
- Commodity and Commodity Derivatives dealers
- Other institutional investors
MiFID: Retail Investors
Investors not falling within the definition of a Professional Client are, by default, classified as Retail Clients. Such category of investors would, thus, entail a higher level of protection since most Retail investors would not possess the same knowledge, experience, and expertise as brought about by Professional investors.
The Directive lays down the opportunity for Retail Clients to be classified as Professional Clients. Such re-classification is subject to a formal request by the end investor and also subject to an assessment by the MiFID licence holder. Such assessment would need to satisfy, at least, two of the below criteria:
- The Client has carried transactions of significant size on the relevant market at an average frequency of 10 per quarter over the previous four quarters;
- The size of the Client’s financial instrument portfolio, including cash deposits and financial instruments, exceeds €500,000;
- The Client possess working experience in the financial sector for, at least, one year holding a professional position requiring knowledge of the transactions and/or services envisaged.
To whom does MiFID apply?
Certain types of asset management companies conducting certain types of activity fall outside of the scope of EU’s Markets in Financial Instruments Directive II (MiFID II). In context, Management Companies that have been authorised as Alternative Investment Fund Managers (AIFMs) under the Alternative Investment Fund Managers Directive (AIFMD) and UCITS management companies under the UCITS Directive fall outside the scope of the directive. However, this is applicable when both the AIFM and the UCITS management company fall within the scope of managing / marketing of the AIF or UCITS Fund for which they act as AIFM / UCITS management company.
Both the AIFM Directive and the UCITS Directive highlight that such management companies, besides acting as AIFMs and UCITS managers to AIFs and UCITS Funds respectively, may provide ancillary activities as defined by Article 6(4) of the AIFMD and Article 6(3) of the UCITS Directive. Typical examples include:
- AIFMs and UCITS management companies acting as portfolio manager to individual managed accounts;
- AIFMs and UCITS management companies providing investment advisory services; and/or
- AIFMs and UCITS management companies performing the management of a Fund’s portfolio for which they do not act as the AIFM / UCITS manager.
Implications of the MiFID II
The markets carrying the most pressure will be the OTC derivative markets. In fact, such products will need to be traded through an electronic trading venue, cleared through a Central Counterparty (CCP) and be subject to transaction reporting requirements. Such standardization may bring about higher costs, tighter margins and less hedging flexibility.
Considerations for EU-based Discretionary Portfolio Managers under MiFID
EU-based discretionary portfolio managers involved in the management of managed accounts should take into consideration the below main factors once the MiFID II is introduced:
- Best Execution – Although the first version of the MiFID already requires MiFID investment firms to seek best execution for customer and portfolio orders, MiFID II continue to add value when it comes to execution. In fact, order execution policies will need to be amended to ensure that the factors used to choose trading venues are applied to more subcategories of financial instrument than the five used currently. Transparency would be key in such instances and therefore the said portfolio managers would need to report, annually, the top five execution venues for each subclass of each financial instrument for each traded managed portfolio. Such report would be required to include information in the likes of commercial relationships with execution brokers, a breakdown between passive and aggressive orders, conflicts of interest and execution venue fee arrangements. When combined with an expanded obligation to monitor execution quality, these new requirements will significantly increase compliance burdens.
- Pre-Trade and Post-Trade Transparency – the introduction of the MiFID II would increase the compliance burden for the applicable managers. In fact, the revised directive extends the pre and post trade transparency requirements in cases of non-equity assets and over-the-counter transactions whilst restricting trading venues.
- Transaction Recording – the directive outlines the importance of scheduling and recording every type of correspondence with it comes to portfolio transactions. This would, together with the pre and post trading reporting as mentioned above, increase reporting requirements.
As a side note, MiFID II will introduce new “third country” requirements for non-EU managers who wish to provide portfolio management investment services to EU investors. Under the revised directive, there is the proposal for an exemptive relief for those firms operating in third countries whose regulatory regime is considered to be parallel to other EU countries.
MiFID Firms in Malta
The Maltese investment services rules are governed by the Investment Services Act, 1994 of the Laws of Malta. The Act have seen transposition of directives in the likes of the UCITS Directive and AIFM Directive. The application of MiFID, and eventually MiFID II, within the Investment Services Rules is no exception.
Applying for a MiFID licence would require an application pack including, but not limited to, the relevant licence application, business plan, future projections, and Memorandum and Articles of Association.
The Maltese sole regulator, the Malta Financial Services Authority (MFSA) makes it a point that a licence would be granted to any promoters who will be providing the provision of the licensable activity from Malta. Therefore, the MFSA would require detailed information on substance.
Additionally, as minimum requirements, the Malta-licensed MiFID firm would require a minimum of three directors (of which one is executive), a compliance officer and a money laundering reporting officer.
With offices in Malta, Switzerland and the UK, CSB Group has been into the financial services industry for over 30 years with investment services professionals available to assist in any enquiries. Kindly contact us on [email protected].