CONTEXT

MIFID 2 (Markets in Financial Instruments Directive) joined its younger brother MIFID 1, set up in 2007, which already had the following goals:

  • Improve investor protection through a series of measures which focus on the implementation of rules within the organization, good management and strengthening of customer classification;
  • Repeal the ‘centralization of orders’ rule on regulated markets ending the monopoly of historical stock exchanges.
    Unfortunately, the first version of MIFID did not live up to its expectations.

The crisis of 2008 has highlighted:

  • the lack of liquidity,
  • the flaws found in regulations / deliveries,
  • the principle of transparency circumvention via dark pools.

Because of the shortcomings in the first directive, a new regulation was established ten years later.

APPLICATION SCOPE

MIFID 2 is considered as one of the major European regulations in terms of investor protection. It concerns financial products such as equities, bonds, derivatives, structured … but also investment services (consulting, research, stock market orders…) for an implementation that started in January 2018. (Initially planned for January 2017).

MORE SPECIFICALLY, WHAT IMPOSITIONS WILL FINANCIAL INSTITUTIONS BE FACING WITH MIFID 2?

MIFID 2 imposes a series of measures whose aim is to clarify as well as making products and financial transactions more transparent. The key measures being:

  • A suitable investor profile;
  • Adapted investor costs;
  • Greater transaction transparency.

Lets take a closer look at these 3 key measures in order to understand the impacts.

A SUITABLE INVESTOR PROFILE

Profil investisseur adapté

In order to improve targeting of products and customer advising, the product designer must clearly explain the product characteristics by detailing:

  • the type of investment,
  • the type of targeted customer,
  • the risks,
  • the investment horizon,
  • the costs.

MIFID 2 considers these elements as essential to the customer’s general understanding of the product. The distributor of the product also has an obligation towards the customer and therefore commits to:

  • making the information produced by the designer available,
  • offering products in line with the profile and the customer’s needs.

Regulation therefore pressures the distributor into having a deeper knowledge of his client.

CLEAR COSTS AND REMUNERATION

MIFID 2 - visuel 3

MIFID 2 requires clarifications and ensures a good understanding of products. This is why costs and remuneration of the various stakeholders and services are to be clarified.

This part of the regulation takes the measures existing in MIFID 1. Compared to the first version, it goes further in the detail of the costs attributed to a customer by detailing the remuneration (nature, costs …) of the various actors (analyst, designer, distributor, etc …) in justification of the service or services offered.

Here is a concrete example to illustrate it:

To avoid conflicts of interests and ensure a better transparency regarding costs detail, MIFID 2 requires financial players to sell their research.

Beforehand, this type of information was usually free, but indirectly funded by the orders it raised. The client would receive on a regular basis written reports on Stock Exchange listed companies. This gave him the opportunity to contact financial analysts directly.

With MIFID 2, the research is invoiced to the customer and requires him to choose between different services: from simple writing to personalized advice.

An illustration of the application of this measure is for example the display of research in trading tools, which will no longer appear systematically but accordingly to the service requested by the customer as it can be found in Invivoo Electryon order passage platform.

GREATER TRANSACTION TRANSPARENCY

A revolution is also taking place regarding negotiation and transaction transparency, which can be exposed in 3 major levels:

A first level of transparency occurs when made mandatory, for a broad spectrum of products, to go through trading platforms;

A second level of transparency occurs when negotiated prices with a customer for products deemed liquid are made public (in real time);

A last level of transparency occurs when a carried out transaction, with mentioned volumes, prices and the time of the transaction is made public.

AN EXAMPLE OF MIFID 2’s IMPACT

There is nothing better than a clear example to understand and assimilate the impact of this regulation. Therefore lets focus on the impacts of regulation on the negotiation of an OTC product all the way up to its execution.

impact mifid 2

As you have noticed, the goal here is not to present a trading workflow in its completeness. It is to understand the impact of MIFID for a seller. For each negotiation phase, the regulation imposes customer knowledge and thorough product:

  • Trading obligation answers the following question: « Is the financial institution allowed to deal this product directly with the client or does the customer have to go through a « Trading Venue » (for instance a regulated market)? « . This step is a blocking point during negotiations and forces the financial institution to stop the trade and to steer its client towards a trading venue.
  • Suitability answers the following question: « Is the customer’s profile compatible with the type of product offered? More precisely, does the customer have the knowledge and skills to buy this type of product?” This step can also be blocking and forces the financial institution to either stop the negotiation or to refer another type of product to its client.
  • Product Documentation: the financial institution must provide indicators of risks, costs, and horizon… on the product being sold to the client in the form of documentation. This documentation is mandatory and blocks the negotiation if it is not transmitted at the latest during the price transmission.
  • Pre trade transparency: Each set price communicated to a customer is made public (if the product and price communicated to the customer follow the MIFID context). This publication allows other customers to run at the same price (within a given time and similar conditions).
  • Post trade transparency: Each execution with a customer is made public (if the product and the execution price follow the MIFID context) in order to inform market players.
  • Reporting: « Transaction Reporting », « FIRDS », « Quality of Execution » and « Best Execution » are intended to give a clearer understanding of what has been negotiated and / or processed (with different granularity and different reporting indicators). One can find the negotiated/treated volume through types of products, and a classification of the actors by volume/type of products treated.

This example illustrates the obligations imposed by this new regulation. Before communicating a price to a customer, the seller must follow no less than 5 measures. This, regardless of the new regulations like PRiiPS, will further increase the workflow. In a context of digitalization where speed is a real challenge, we perceive MIFID 2 as real technical challenge for financial institutions.

TO CONCLUDE

We have overlooked MIFID 2’s main rules, but to give a better idea of the extent of this regulation, MIFID 2 also covers (without giving an exhaustive list because the regulation text is over 7000 pages):

  • Product descriptions standardization;
  • Strengthening of the rules of sale and distribution for complex products;
  • Training of market players;
  • Better identification of stakeholders during an exchange transaction;
  • Greater regulation on high frequency trading and algo trading;
  • Stricter market commodities;
  • A tightening of the rules regarding means of communication (telephone and electronics);
  • Strengthened reporting on transactions and their content.

If we were to summarize MIFID 2 in one sentence, just keep in mind that « MIFID 2’s primary goal is to protect the investor and ensure that financial institutions play their roles by offering products that are right for their clients, in an interest of transparency and risks.”

Useful links:

The AMF (Autorité des Marchés Financiers) website: http://www.amf-france.org/Acteurs-et-produits/Marches-financiers-et-infrastructures/De-MIF-1-a-MIF-2/Les-principaux-apports-de-MIF-2
The ESMA (European Securities and Markets Authority) website: https://www.esma.europa.eu/policy-rule