As ever there is a lot going on in the regulatory sphere – although perhaps as much is emanating from politicians as from official regulatory authorities. Here is a brief overview of a few areas that are impacting capital markets.

MiFID IIMost firms will by now be very aware of the challenges they face in implementing the updated Markets in Financial Instruments Directive (MiFID II) and Markets in Financial Instruments Regulation (MiFIR) by 3 January 2018 – in fact some of the challenges may well now be becoming far too clear! There is some clarity provided by the huge number of regulatory technical standards (RTS) and delegated acts but questions still remain, especially with the added complexities arising from Brexit.

Transaction reporting – focus on LEIs

The FCA has set up a new section on its website for firms subject to the MiFID II transaction reporting – highlighting their expectations that all transaction reports from 3 January 2018 (no earlier and no later) must include a Legal Entity Identification (LEI) number for clients who are legal entities. If there is no LEI the transaction report will be rejected, so in effect if firms do not have an LEI by 3 January 2018 for all relevant clients, they will not be able to trade. If firms have not done so already, they will need to give thought to how they will obtain LEIs for all clients, how this data will be stored and interfaced with their transaction reporting systems. The Global Legal Entity Identifier Foundation (GLEIF) has a repository of LEI numbers for those countries which have implemented requirements for firms to obtain an LEI. However, the challenge will be for firms with clients in jurisdictions that do not as yet require it, and how they will obtain an LEI for the legal entities they transact with. Firms can apply for an LEI on behalf of their clients, but this will be a significant administrative and logistical burden, and some clients may not be happy with an unrelated firm going ahead and getting them a number they will need to manage and look after going forwards (albeit firms making transaction reports will not have to check the LEI has been kept up to date on an ongoing basis).

A welcome extension to the SI regime

MiFIR introduces new types of trading venue and will significantly alter market structures, particularly for business currently undertaken over-the-counter (OTC). This includes the extended coverage of the Systematic Internaliser (SI) regime. For firms trying to decide if they will be an SI or not, one of the deciding factors is whether the products in which they transact fall within the definitions of being liquid or illiquid. This cannot be determined without extensive market data, which is currently unavailable – as such the implementation date for the SI regime has been pushed out to Sept 2018 to allow time for the European Securities and Markets Authority (ESMA) to gather transaction reporting data and to be able to calibrate what constitutes liquid and illiquid instruments, and for firms to determine the securities for which they will be an SI. However, firms can still opt into the SI regime from 3 Jan 2018. Although this postponement will give those firms that will be SIs slightly longer to plan, it is crucial for firms to be absolutely clear which category they fall into sooner rather than later.

Untangling unbundling

MiFID II also seeks to address potential conflicts of interest, including requiring firms to separate out the fees they pay for research from execution fees – so-called unbundling. The requirements (which include mandatory payments made from a dedicated Research Payment Account; research budgets having to be set by the investment management firm, with research pricing determined independently of the volume or value of transactions, and regular assessments of the quality of research being received to be performed by the investment management firm) on the face of it sound positive for underlying investors who may be unwittingly paying for reams of poor quality research. But there is a risk that the new rules could see a significant drop in the provision of research and a concentration of production at larger firms (who are able to offer wide and deep research coverage) something which certain larger investment managers have already said they will do. There is also a risk that larger firms may not offer coverage of small and perhaps also certain medium sized issuers.

The alternative to using a Research Payment Account is for the investment management firm to pay for research out of its own profit and loss account and then charge their clients directly. This may well reduce the demand for research.

The unbundling requirements will have differing impacts on different products, eg, in fixed income markets (where payment of fees and commissions is less usual than in equity markets) research is supplied usually without recompense, and as such clients may not be willing to pay directly for research which they would previously have viewed as ‘free’.

There is also an interplay with the changes around investment research that arose from the recent Market Abuse Regulations (MAR), where the distinction between ‘investment recommendations’, and ‘personal recommendations’ means firms are polarising in their approaches to the dissemination of bespoke client specific advice, and more substantial investment research requiring significant administrative controls around it. Under the unbundling rules, a distinction is made between short-term market commentary – including information on upcoming corporate events – which will not be caught by the new requirements and more substantive research which will.

For firms that receive research, decisions will need to be made and policies put in place for how this will be paid for and reviewed under the new rules, including disclosures to, and agreement of, underlying clients. Firms will not be allowed to receive research for free. For firms producing research, the value of this research to those receiving it will be of paramount importance – and firms that are not in the top tier may well find themselves being sidelined. Another potential impact is whether investment managers will look to bring research in-house – will we see a move of analysts away from the investment banks to the asset management side?

When is a client not a client? Categorisation changes

As well as the headline requirements in MiFID II there are lots of trip-wires hidden away in the detail. In particular the new client categorisation definitions contain a few surprises. Eligible Counterparties are now clients (ECPs are still excluded from the best execution requirements, but a careful review of the other rules will be needed to check how they will apply to ECPs who currently fall outside ‘client’ requirements). Then there are changes to who can be categorised as a per se ‘professional client’ – check this out if you have local or municipal authorities as clients (firms will need to follow the legislation of the jurisdiction in which the relevant local authority is based to determine which type of entity is caught by this – and how that country (not the UK) categorises them from a size perspective as to whether they can be deemed an elective professional or not – this will be a challenge if checking for multiple countries).

A little something to note as well – hidden away in the detail – if you deal with ECPs you will need to obtain their express consent to their categorisation – probably an idea to start early on this to ensure firms can continue to deal with their counterparties – especially those outside the EU who may wonder why they need to sign up to this.

CSDR – the ‘poor relative’ regulation?With all the focus on the ‘big’ headline regulations, in the background is a rather less well known set of new requirements with the potential to have a big impact – the Central Securities Depository Regulation (CDSR) – which initially sounds like something only central securities depositories (CSDs) will need to worry about. However, the objectives of the CSDR are not only to harmonise rules for CSDs, but to improve settlement performance overall – this is where other types of financial institutions are caught.

The FCA gave an industry talk on the impact of CSDR for market participants and what firms should be doing to prepare. The CSDR itself has taken effect, but the level 2 RTS is still pending. However, there are aspects of the CSDR due to come into effect in late 2018, including Article 7 which covers cash penalties for trades settling beyond intended settlement date; the mandatory buy-in process (for failed trades, includes those where there is only partial settlement), and cash settlement if that fails. Investment firms must take measures to limit the number of settlement fails – at a minimum arrangements with professional clients to ensure prompt communication.

For liquid securities buy-in is triggered four days after the intended settlement date, with a four-day buy-in period (then cash settlement/deferral) and for less liquid securities, seven days after the intended settlement date and a seven-day buy-in period. Industry bodies have voiced concerns around these durations, given differences in market practices for different products. However, as the timescales are in the level 1 Regulation, it is unlikely these will change. There are also challenges around who will manage and oversee the buy in process – it will be done by the central counterparty (CCP) for transactions they settle, but for OTC trades it is less clear cut, with the onus being on the participants to the trade – which could get interesting if the other party is in a third country.

Penalties per day for failing trades are likely to be 1.0bp for equities, 0.25bp for government bonds, 0.5bp for corporate bonds, and cash trades will be based on a discount rate per currency – it is anticipated that the CSD will pass on the penalties between the impacted parties.

There are also quarterly reporting requirements to the Bank of England for CSDs and settlement internalisers (who execute transfer orders on behalf of clients or on their own account other than through a securities settlement system) – firms should check whether any transactions they undertake fall within this definition, and if so how they are going to comply with the reporting requirements.

Firms should be looking to liaise with their CSD to clarify the steps they are taking and how they themselves may be impacted.

What will the new US presidency mean for regulation?Given all the uncertainty around the future of regulation in the EU following the UK’s Brexit vote, a bit of stability elsewhere in the world would be rather welcome, unfortunately this doesn’t seem to be happening. Trump has set out his take on regulation – with a ‘one in two out’ approach to the current rule book – but it isn’t clear which rules he will prioritise for removal and which will be keepers. One area where the media expect him to continue focusing is on anti-money laundering (AML). In an article dated 1 February, the Financial Times says that the big US banks are expecting Trump to maintain strict AML regulations, particularly where they relate to sanctions against those countries he views as problematic, such as Iran. However, in terms of appointments to key positions in the US Treasury, Federal Reserve System and the Securities and Exchange Commission (SEC), these will show the likely direction of travel, in particular the nomination of industry insiders (Steven Mnuchin, 17 years at Goldman Sachs, appointed as US Treasury Secretary) and Jay Clayton (also with connections to Goldman Sachs and Barclays, as Chairman of the SEC) suggests a move away from a focus on enforcement towards lighter, more industry friendly regulation. Whether this will see a dismantling of Dodd-Frank, and in particular the Volcker Rule remains to be seen, and whether this would be viewed as positive by the industry is also questionable, particularly given the workload and cost involved in removing a raft of recently implemented policies and procedures. It is, however, possible that given the complexities of the Volcker Rule, and the difficulty in determining whether trading is proprietary or falls within one of the exceptions, such as market making, that there could be an appetite to let Volcker go, while retaining some of the post crisis regulation introduced to avoid ‘too big to fail’.

The general tone we can expect will be towards less regulation of financial services overall, and perhaps we can get a better steer from Trump’s Executive Order setting out his seven core principles for US financial services regulation – empowering Americans to make independent and informed financial decisions, prevent taxpayer bailouts, with economic growth and rigorous impact analysis for regulations – to address systemic risk, market failure, moral hazard and information asymmetry. All this while advancing American interests in international regulatory negotiations and competitiveness in foreign markets. Regulation is to be efficient, effective and appropriately tailored, with a publicly accountable regulatory agencies (rationalised of course).

Usually we would expect this to then have a follow-on effect in overseas regulation. However, in this case my feeling is we are likely to see the EU differentiating and distancing itself from the US, with articles reporting that Valis Dombrovskis, EU financial services commissioner, has stated that any repeal of global regulations introduced after the financial crisis could undermine financial stability and introduce regulatory arbitrage, potentially resulting in non-EU financial firms being frozen out if they are no longer viewed as equivalent. Who might he be addressing? US, UK – take your pick!

A couple of other areas to keep an eye on

New prudential regime for investment firms

The European Banking Authority (EBA) is considering a simplified Capital Requirements Directive (CRD) regime for investment firms which currently follow the same requirements as credit institutions. This is positive for smaller investment firms, but any changes to CRD, even simplifications, will cause a lot of work.

The EBA on remuneration

Following consultations around how national regulators are implementing the proportionality aspects of CRD on remuneration, the EBA has undertaken a review of how different countries have implemented this – which makes for interesting reading – particularly because it appears that the EBA is now making a distinction between the EU 27 (ie without the UK). The rationale for this is that the UK remuneration figures distort those of the rest of the EU, as FCA-reported figures included non-UK branches and subsidiaries, potentially leading to double counting. Or was this a subtle way of the EU starting to plan for an EU without the UK?

The FCA consults on primary market effectiveness

While the EU moves forwards with the Capital Markets Union, the FCA is consulting on how UK primary capital markets can better meet issuer and investor needs. It is interested in whether the differences between standard and premium listings for exchange-traded funds (ETFs) and overseas issuers are appropriate; whether the UK primary equity market provides sufficient capital growth; also whether there is a role for a UK primary debt multilateral trading facility (MTF) – and if so how it should be structured. It is also looking into encouraging greater retail involvement in debt markets. As part of this, a review of the listing rules will also be undertaken. For firms involved with primary markets these papers will be of considerable interest.

Views expressed in this article are those of the author alone and do not necessarily represent the views of the CISI.