Financial services firms seeking to take advantage of the new single market for trading wholesale and retail financial instruments in Europe can start to review their systems now the European Commission has set a date for implementation for the Markets in Financial Instruments Directive ("MiFID"). 

MiFID aims to remove barriers to cross-border trading. It repeals and replaces the Investment Service Directive ("ISD2"). European Union ("EU") member states must convert the directive into national law by October 2006 and firms must comply by 30 April 2007.

The intention of EU legislators is to replace the current patchwork of regulatory regimes with a single market. This will be done through a Europe-wide regulatory framework for investment advice, operation of multilateral trading facilities and commodity derivatives-related services as part of the EU's Financial Services Action Plan.

Who will be affected?

All Financial Service Authority ("FSA") authorised firms currently within the scope of ISD2 - namely securities and futures firms, banks conducting securities business, recognised investment exchanges and alternative trading systems - will be affected.

MiFID will also capture further firms because of the increased scope of the new directive. Such firms will need to apply for FSA authorisation and will be subject to EU capital adequacy requirements. Apart from this broadening of scope, firms in the UK, will need to keep an eye on changes to FSA regulations as outlined before.   

Passport

When MiFID comes into force, firms will be able to take advantage of "passport" provisions for multilateral trading facilities and commodity derivatives trading.  The passport will enable investment firms to conduct cross-border activities across Europe where they have prior domestic regulatory authorisation.

Investment firms dealing in financial instruments in Europe that internalise client orders on an organised, frequent and systematic basis should already be reviewing their IT systems to ensure they are MiFID compliant if they wish to trade in the areas covered by MiFID.  The point of the passport is to enable investors and intermediaries to deal with clients in respect of a wider range of trades in other European countries on the same terms of business as in their home country. This should enable issuers to tap a deeper and more liquid market and make cross-border transactions less complex and expensive.

Reforms

In the UK, the Financial Services and Markets Act 2000 ("FSMA") will be amended to introduce a wider definition of "investment advice" (which now includes commodity derivatives unless an exemption applies) and the new equity transactions reporting requirements. Firms will also have to comply with amendments to the FSA Handbook, particularly the Conduct of Business ("COB") Rules, in the following areas:

  • Permissions;
  • Conflicts of interest;
  • Client classification (particularly in relation to wholesale markets business) and know your customer requirements;
  • Suitability;
  • Best execution and customer order priority;
  • Transaction reporting; and
  • Disclosure by firms operating outside a regulated market (pre and post-trade).

The FSA has stated that: "the new COB standards are likely to involve firms making changes to existing customer documentation. We also anticipate the need for substantial changes to firms' systems."

Timetable

The framework provisions, which are known as "Level 1" measures under the "Lamfalussy process", came into force on 30 April 2004. More detail will be contained in the "Level 2" measures, which are still under review.

The EU Committee of European Securities Regulators ("CESR") has published recommendations on Level 2 measures, which will be published in January 2006, following a second consultation by the European Commission.

The UK Government (the Treasury) will launch a consultation in November 2005 on the necessary changes to UK primary and secondary law.

The FSA is already amending FSA Handbook and Consultation Paper ("CP") text. Its consultation will begin in October 2005.  There may be a second FSA consultation once the "Level 2" changes have been finalised, if there are any fundamental changes. If not, the final rules will be adopted in June 2006.

There has as yet been no cost-benefit analysis of the changes. This will be the responsibility of the FSA, which will publish a cost-benefit analysis together with the consultation paper in October. The cost to UK businesses of updating or introducing new systems, procedures and business or trading models is likely to be significant.

Comment

Increased regulation in this area will impact on the systems of financial services firms and banks conducting securities and futures business as well as exchanges and trading systems. The devil is likely to be in the detail, but it is not too soon to start planning.

Firms and trading platforms that come within ISD2 or are likely to fall within the scope of MiFID should therefore review their IT systems in the light of CESR recommendations to ensure they are in a position to comply with the Level 2 requirements by the implementation date.  They should also consider part in the consultation process if they have concerns about the way the reforms will affect their business.

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