On 28 September 2015, ESMA published its final draft regulatory technical standards (RTS) on the Markets in Financial Instruments Directive (MiFID II), the Market Abuse Regulation (MAR) and the Central Securities Depositories Regulation (CSDR). These regulations are amongst the most important in the post-crisis reform agenda and will significantly alter how European financial markets operate by increasing their transparency, safety and resilience as well as investor protection. The magnitude of these changes should not be ‘underestimated’, ESMA warns, and will require firms to carefully consider how it will impact their implementation programmes.
This post covers the final draft RTS on MiFID II and summaries the main provisions across the following areas: transparency, market microstructure, data publication and access, requirements applying on and to trading venues, commodity derivatives, market data reporting, post-trading and investor protection. I also highlight what has changed from the December 2014 consultation paper (CP) in our high-level summary.
Pre-trade transparency for trading venues and investment firms
- Pre-trading information (No Change): ESMA proposes the same pre-trade transparency requirements should apply equally to all trading venues to mitigate arbitrage opportunities for some market participants (namely operators of systematic internalisers (SIs)).
- Most relevant market (No Change): ESMA proposes that the most relevant market in terms of liquidity for equity/equity-like instruments should be the trading venue with the highest turnover for that instrument under which the trading venue operates.
- SSTI Indicative Prices (No Change): The final draft RTS details the valid methodologies to be used when publishing indicative prices while allowing trading venues to choose the methodology that they consider most appropriate.
- Negotiated transactions waive (Change): The scope of the waiver has been widened by a loosening of the definition. Participants dealing on own account (so essentially market makers) are now able to trade ‘on behalf of clients’, which could give more importance to the role of SIs in the future.
- Order management facility waiver (No Change): ESMA proposes to retain the proposed definition (and related thresholds) of the relevant characteristics of orders held in an order management facility and has decided not to restrict it to reserve and stop orders.
- Large in scale (LIS) waiver (Change): ESMA reiterates its proposal to use the average daily turnover as the relevant metric to establish orders that are large in scale (LIS) for shares. The LIS waiver has also been broadened and loosened to give market participants an extra opportunity to use it with a final lower threshold of €15,000 for shares and Depository receipts and a flat-lined threshold for exchange traded funds (ETFs) of €1,000,000.
Pre-trade transparency for equity and equity-like instruments
- SI reporting of firm quotes (No Change). SIs are required to ‘adopt arrangements’ to ensure that the publication of firm quotes in equity and equity-like instruments are ‘sufficiently reliable and free of errors, capable of being consolidated with other similar data from other sources and is made available to market participants on a nondiscriminatory basis’.
- Prevailing market conditions (Minor Change): ESMA has slightly amended the definition in the CP. Under the new definition, ‘a price reflects prevailing market conditions if it is close in price to quotes of equivalent sizes for the same financial instrument on the most relevant market in terms of liquidity for that financial instrument at the time of publication’.
- Standard market size (SMS) (No Change): ESMA has decided to group the two smallest classes into a single class for shares with an average value of orders between zero and €20,000 and set an SMS of €10,000.
Trading obligation for shares
- Price discovery process (Minor Change): ESMA remains in favour of providing an exhaustive list of transactions in shares that do not contribute to the price discovery process, as this ‘will deliver a clearer and more harmonised regulatory framework across the EU’. ESMA maintains the current proposal with some amendments aiming at mitigating cost and operational concerns and providing additional clarity.
- Content of public reporting (No Change): ESMA, in line with the CP, proposes to require investment firms and trading venues to publish information in respect of transactions executed by them or under their rules, in fields such as trading date, unit price, venue, transaction identification code.
- Identifiers (Change): ESMA has reviewed the list of identifiers following responses to the CP and is proposing to require five additional flags to be included in post-trade reports:
- transaction not contributing to the price discovery process
- transactions above the SMS
- transactions in illiquid instrument
- transactions which have received price improvement
- duplicative trade reports.
- Timing (No Change): ESMA has decided to keep its proposed definition of normal trading hours and maintain its proposal to shorten to one minute the maximum permissible delay to publish transaction details.
- Reportable trades (Change): ESMA agrees with respondents that certain OTC non price forming transactions should not be considered as reportable trades for the purpose of the post-trade transparency regime. It has provided a list of types of transactions that fall-in this category.
- Large in scale thresholds – Shares and certificates (Minor Change): The regime for shares has remained the same, a part from the introduction of a new class of highly illiquid stocks and depositary receipt (below €50,000) with a lower LIS threshold and a delay of publication of EOD + 1 for the largest transactions in the new liquidity band. The regime for certificates has remained the same.
- Large in scale thresholds – ETFs (Change): ESMA has adopted the proposed system backed by many respondents where all transactions up to a size of €10,000,000 would be made transparent in real-time, transactions of a size between €10,000,000 and €50,000,000 would benefit from a deferred publication of 60 minutes while transactions in a size exceeding €50,000,000 would be published at the end of the trading day.
- Large in scale thresholds – definition of EOD (Change): ESMA decided to amend its proposal with regard to the meaning of end of day (EOD) allowing reporting entities to publish transactions at noon local time on the following trading day at the latest. While EOD + 1 means that the transactions have to be published after the end of the closing auction of the following trading day.
- Content and timing of post-trade transparency requirements (No Change): ESMA is proposing to set the maximum time limit for publishing post-trade information from as close to ‘real time’ as possible to a maximum delay of five minutes. To allow market participants to adapt to the new regime, ESMA provided for a less strict requirement of 15 minutes for the first three years of application (i.e. until 2020).
- Liquidity assessment (Change): ESMA proposes to use a revised and more granular classes of financial instruments approach as the basis for determining the liquidity of all classes of non-equity financial instruments. In particular, ESMA decided to adopt a Classes of financial instrument approach (COFIA) for all asset classes of non-equity financial instruments except for bonds for which the instrument by instrument approach (IBIA) will be used. The COFIA methodology has been made more dynamic, and will be reviewed on a yearly basis, and more granular by taking into account asset classes, sub-asset classes and sub-class
- Deferral period to publish post-trade transparency report (Change): ESMA revised its proposal and amended the deferral period to two trading days after the transaction has taken place (T + 2) for all different types of transactions that are LIS, above the size specific to the instrument (SSTI) and for transactions in illiquid instruments.
- Threshold (Change): The thresholds of LIS and SSTI set in the RTS will be applied for only the year 2017, while from 2018 onwards the thresholds would have been recalculated on a yearly basis according to specific methodology illustrated in the RTS related to:
- Derivatives (excluding equity derivatives) and emission allowances: threshold calculated as percentiles of trade count and volume (for liquid markets), or fixed (for illiquid markets).
- Bond and SFPs: thresholds calculated in terms of percentiles of trade count.
- Securitised derivatives: static thresholds.
- Equity derivatives: thresholds calibrated in relation to the average daily notional amount.
- Scope (Change): ESMA has clarified that references in the governance process refer to those elements that are specific to the investment firm’s algorithmic trading system. This is significant in terms of carving out investment decision algorithmic trades.
- Scope of testing (Change): ESMA has clarified that pure investment decision algorithms that are executed by non-automated means are out of scope of the algorithm testing requirements.
- Direct Electronic Access (DEA) (Change): ESMA has clarified that organisational requirements apply to all DEA providers whether their clients are using algorithmic or non-algorithmic trading strategies.
- Training (Change): ESMA has removed references to the specific types of training needed to gain the relevant competencies and knowledge regarding algorithmic trading, and instead focused on the necessary competences and knowledge required.
- Outsourcing (No Change): ESMA decided not to differentiate between material and nonmaterial outsourcing or procurement since minor components of an IT system may have an important impact on the entire system. ESMA clarified that requirements regarding outsourcing are general requirements and don’t require specific commercial agreements.
- Sign-off (No Change): ESMA has clarified in the Regulation that the record keeping requirements regarding the sign-off process for making changes to proprietary software is limited to material changes only.
- Disruptive scenarios (Change): ESMA has decided not to include a list of disruptive scenarios that were viewed as being too prescriptive, but instead to require firms to have business continuity arrangements that are appropriate to the nature, scale and complexity of their business.
- Pre-trade and post-trade controls (Change): ESMA has reduced the number of mandatory pre-trade controls from six to four. In particular, it has removed the market impact assessment control given its limited added value and large operational and cost concerns.
- Stamp (Change): ESMA has removed the need for nano-second time-stamping (in conjunction with clock synchronisation in Art 49.)
Data Publication and Access
- Periodic reconciliations (No Change): ESMA maintains its proposal that an approved reporting mechanisms would have to perform periodic reconciliations not only at the request of the supervisor of the home Member State but also at the request of any other supervisor to whom the approved reporting mechanisms (ARMs) submitted reports.
- Maximum recovery times (Change): ESMA has decided not to be overly prescriptive in setting a deadline for the resumption of business, although it still expects the data reporting services providers (DRSP) to be operational as soon as possible after a disruptive incident.
- Operational hours (No Change): No change to the approach outlined in the CP. DRSPs will be permitted to establish their own operational hours provided that the hours are pre-established and made public.
- Technical arrangements facilitating the consolidation of information – Machine readability (Minor Change): ESMA proposes to retain the principle of a free and nonproprietary format and protocol but has slightly amended the definition to take feedback of stakeholders into account.
- Content of the information published by the consolidated tape provider (CTP) and the approved publication arrangement (APA) (Change): In light of the strong support for a trade ID assigned by APAs and trading venues rather than by CTPs, ESMA has amended its approach and proposes to require APAs and trading venues to assign a transaction identification code.
- Data disaggregation (Change): In the light of the comments on relying on the criterion ‘insufficient demand’, ESMA has decided to dispense with it and to make all disaggregation mandatory. Pre-trade and post-trade data relating to all instruments will have to be disaggregated by the following criteria: asset class (separating equity from equity-like, and distinguishing fixed income, emission allowances and different types of derivatives), currency, scheduled daily auctions as opposed to continuous trading. In addition, shares and sovereign bonds will also be disaggregated by country of issue.
- Conditions under which granting access will threaten the smooth and orderly functioning of the markets or would otherwise adversely affect systemic risk (Change): ESMA reformulated its approach to identifying when granting access would threaten the smooth and orderly functioning of the markets or would adversely affect systemic risk. The revised approach is more focused on risk considerations.
- Conditions for non-discriminatory treatment of contracts (Minor Change): ESMA confirms the approach proposed in the CP, subject to some fine-tuning of the language in the draft RTS, that there must be non-discriminatory access to central counterparties (CCPs) and trading venues. The final draft RTS provides the basis:
- on which a CCP can deny access to a trading venue (volume of transactions, operational risk and complexity, factors creating significant undue risks)
- on which a trading venue can deny access to a CCP (operational risk and complexity, factors creating significant undue risks)
- on which the competent authority can assess that the access will threaten the smooth and orderly functioning of markets or adversely affect systemic risk
- Benchmark information (Minor Change): ESMA maintains the main principles of the draft RTS on the benchmark information to be made available. CCP and trading venues now are allowed to request access to information required for clearing or trading purposes. There is now an obligation to licence benchmark. Requirement is particularly stringent as the obligation includes the need to disclose the benchmark composition, methodology and pricing.
Requirements applying on and to trading venues
- Admission of financial instruments (No Change): No change to the approach outlined in the CP, however, ESMA has provided further clarity on arrangements for verifying compliance with disclosure obligations and arrangements for facilitating access to information.
- Suspension and removal of financial instruments (No Change):ESMA maintains in the draft RTS its proposal with respect to the connection between a derivative and the underlying financial instrument as outlined in the CP.
- Commodity ancillary exemption (No Change): A firm must be below thresholds for both the trading activity threshold and the main business threshold to use the commodity exemption.
- Trading Activity Thresholds (Change): ESMA has set the following thresholds across the eight different asset classes:
- 4 % derivatives on metals
- 3 % derivatives on oil and oil products
- 10 % derivatives on coal
- 3 % derivatives on gas
- 6 % derivatives on power
- 4 % derivatives on agricultural products
- 15 % derivatives on other commodities (including freight)
- 20 % emission allowances or derivatives
- Main Business Thresholds (Change): If the main business threshold is less than or equal to 10% then the trading activity thresholds above apply. If the business threshold is greater than 10% but less than 50% the trading activity is reduced by 50%. If the business threshold is equal or greater than 50% the trading activity threshold is 20% of the thresholds above.
- “De minimis” exemption (No Change): Given limited scope in Level 1 text, ESMA is not in a position to offer a de minimis exemption threshold under which smaller firms would not be required to undertake further calculations and report to the regulatory.
- Privileged transactions (Change): ESMA clarifies the activities that will be exempt from threshold calculations (intra-group transactions, hedging and liquidity obligation).
- Measure of size (Change): For both the trading activity threshold and main threshold size of position is measured through the gross notional value of derivative contracts measured in euros.
Market Data Reporting
- Data standards and Formats for reporting (Change): ESMA has decided that transactions and instrument reference data should be reported under MiFIR in a common XML format and in accordance with ISO 20022 methodology.
- Transaction and execution (Minor Change): ESMA has decided to maintain the general approach to transaction and execution outlined in the CP but has made some minor changes and clarifications taking into account feedback from respondents.
- Definition of execution (Minor Change): ESMA appreciates that the proposed definition for execution could be overly broad and foresees difficulties in retaining such a broad definition while carving out activity that should be excluded with sufficient certainty. Therefore it has amended the RTS to limit it to an exhaustive list of services or activities that result in a transaction being concluded.
- Transmission of orders (No Change): ESMA has adopted the general approach to transmission of orders as outlined in the CP and has made a number of clarifications in response to feedback.
- General approach to reporting (No Change): Given that most concerns raised are going to be addressed in future guidelines ESMA has decided to replace the existing transaction reporting framework (buy/sell indicator, counterparty and client fields) with buyer and seller fields.
- Designation of natural persons (Change): ESMA has assessed the industry’s concerns and proposals and therefore has modified the existing approach. However, the proposal on introducing a phase in approach has not been adopted
- Reporting transactions executed by branches (Minor Change):Following concerns raised during the consultation, ESMA has now introduced new rules to govern how EEA branches of non-EEA firms should transaction report.
- Fields to be reported in transaction reports and as instrument reference data (Minor Change): ESMA acknowledged the concerns raised during the CP and has made a number of clarifications in response to feedback and also incorporated some changes in the RTS text to address the raised issues
- Clock synchronisation (Minor Change): ESMA has amended the definition in response to feedback.
- Other (No Change): In areas such as identification of persons responsible for investment decision/execution, conditions for the use of Legal Entity identifiers etc. there seemed to be no fundamental concerns expressed by respondents, therefore ESMA has decided to follow the approach as proposed in the CP.
Post trading issues
- Clearing certainty (Change): ESMA have included an exception to carrying out clearing pre-checks where the rulebooks or contractual arrangements ensure the same objective of clearing certainty.
- Communication models (Change): ESMA will give firms flexibility in what communication models they use (ping, push, hub) to communicate applicable limits for the pre-trade checks.
- Mandatorily versus voluntarily cleared OTC derivatives (Change):ESMA has amended the draft RTS so as not to distinguish between mandatorily cleared and voluntarily cleared OTC derivatives in line with feedback.
- Timeframes to send trades to the CCP (No Change): The majority of respondents agreed with the timeframes provided in the draft RTS and ESMA has kept the timeframes unchanged.
- Scope (Change): ESMA amended the RTS to ensure that only trading venues and SIs (and not market makers and other liquidity providers) will be subject to publishing data for financial instruments subject to the trading obligation.
- Quantity of data (Change): ESMA has sought to address the concern about overly burdensome reporting obligations by re-assessing its initial proposals and reducing the number of metrics required in the RTS and the quantity of data sought by some of those metrics. For example, ESMA has also clarified that where no transactions occurred in a particular financial instrument on a particular day, execution venues are not required to publish the reports dealing with price information.
- Publication of sensitive information (Change): In order to protect sensitive information ESMA proposes that the number and volume of client orders executed on each of the top five venues can be provided as percentage of the firm’s total for that class of financial instruments.
- Calibration of execution quality data publication (Change): SIs and venues are required to publish execution quality data within three months of quarter end rather than the one month proposed in the CP.
- Scope of point-in-time transaction reporting (Change): SIs and market makers are exempt from reporting point-in-time transaction reporting above Standard Market Size or Size Specific to the financial instrument.
- Calibrating reporting obligations (Change): ESMA has adopted a post-trade taxonomy to better calibrate reporting obligations across different types of venues, such as continuous auction order book trading systems, quote driven trading system or RFQ trading systems.
- Market segment reporting (Change): Venues are required to provide data for each market segment that they operate.
- Treatment of securities financing transaction (SFT) (Change): SFT captured and reported separately from client order data.
The final report was submitted to the European Commission on 28 September 2015. The Commission has three months to decide whether to endorse the technical standards. We are also waiting on the Commission to publish its final delegated acts associated with MiFID II (which now expected in November).
Full links to the texts are provided below: