This is the first in a series of articles from Harneys on MiFID II. Here we focus on scoping issues and changes to the perimeter of the local investment services regime.
Cyprus has given full effect to Directive 2014/65/EU, (MiFID II), through the enactment of the Investment Services and Investment Activities and Regulated Markets Law 2017 (New IS Law). We outline below the key changes expected for the Cypriot financial services industry once the new MiFID II regime comes into force from 3 January 2018.
The new local legislation repeals and recasts the vast majority of rules contained in the Investment Services and Investment Activities and Regulated Markets Law 2007 (Old IS Law) which implemented Directive 2004/39/EC, (MiFID I).
The macro perspective
MiFID II represents a vast panoply of EU regulations, rules and processes designed to harmonise and set a benchmark for European financial markets in investment services and activities. Together with Regulation (EU) No. 600/2014, known as MiFIR, these two legislative acts constitute the core of the new regime. MiFIR, as a European regulation, will be directly applicable from the same date as MiFID II and as such is not further implemented under the New IS Law. In addition to the provisions of the New IS Law and MiFIR, financial and credit institutions in Cyprus will need to have regard to numerous and growing subsidiary legislation issued at European level, “Level 2”, and comprising (as at the date of going to press):
- 4 delegated acts, comprising one directive and three regulations
- 31 regulatory technical standards (RTS) all enacted as regulations
- 9 implementing technical standards (ITS) again solely comprising regulations.
At “Level 3” a range of guidance has been issued by the European Securities and Markets Authority (ESMA) as well as Q&A documents and opinions. Furthermore, the above framework continues to be refined through amendments being formed in consultation papers currently in circulation. The range and depth of such detailed rules and guidance lives up to the stated intention of using the MiFID II regime to impose a minimum standard of regulation on firms, and to achieve a greater level of convergence in such regulation across EU member states.
Implementation of MiFID II under the New IS Law: Scoping issues
New financial instruments
MiFID II, and consequently the New IS Law, has introduced the following additional new classes of financial instruments:
- Physically settled derivatives relating to emission allowances
- Emission allowances, consisting of any units recognised for compliance with the requirements of the EU Emissions Trading Scheme Directive 2003/87.
Regulation of data reporting service providers
The New IS Law also introduces the requirement for persons who wish to provide data reporting services to become authorised by CySEC. The requirements of the New IS Law distinguish between the various types of data reporting service provides, these being:
- ‘Approved publication arrangements’ (APAs), which provide the services of publishing trades on behalf of investment firms
- ‘Consolidated tape providers’ (CTPs), which provide the service of collecting trade reports on financial instruments from both trading platforms and investment firms, and consolidating this into a continuous electronic data stream made available to the market
- ‘Approved reporting mechanisms’ (ARMs), which provide the service of enabling investment firms to report transaction details to the relevant competent authorities.
The different requirements between the types of providers reflect tailored requirements which apply to each type of data reporting service, although all categories are subject to tight deadlines and relatively strict obligations. As compared to APAs, ARMs would seem to be subject to a relatively lighter regime, particularly as the responsibility or trade reporting remains with the investment firm, whereas APAs are instead subject to an obligation to improve the quality of data on OTC contracts.
Changes to territorial scope
Significant changes have been made to the territorial scope provisions of the New IS Law. We explore the impact of these changes in a separate article.
Revised exemptions regime
As with MiFID I, MiFID II comprises ‘mandatory’ as well as ‘optional’ exemptions. Cyprus has chosen not to exercise its discretion to implement any of the optional exemptions available – as such the exemptions contained in the New IS Law represent the revised exemptions regime contained in Article 2 of MiFID II.
As regards those mandatory Article 2 exemptions, MiFID II makes a number of changes compared to MiFID I; both in introducing certain new exemptions, but also in modifying existing exemptions. These changes are largely as a consequence of the widened scope of application of MiFID II, and do not ultimately represent a material expansion of the available exemptions. In terms of the existing exemptions which have been revised under MiFID II, these effectively result in narrowing the available exemptions.
Dealing on own account expanded, highly relevant to the Cypriot FX industry
The key exemption for own account dealers under the Old IS Law (MiFID I) has been significantly narrowed. Under the current regime persons who do not provide any investment services or activities other than dealing on own account will not be subject to licensing or regulation unless they, in summary, act as market makers or deal on own account on an organised, frequent and systematic basis by providing a system accessible to third parties in order to engage in dealings with them.
Under the New IS Law (MiFID II) the revised exemption will no longer apply to dealers in commodity derivatives, emissions allowances or emissions allowance derivatives. As such the dealing activities of the following types of persons may be subject to licensing under the New IS Law:
- Persons who are members or participants of a regulated market or a multilateral trading facility, or who have direct electronic access to a trading venue, except for non-financial entities carrying out hedging activities for themselves or their group
- Persons who apply a high frequency algorithmic trading technique
- Persons who deal on own account when executing client orders
Commodities trading now caught, highly relevant to the Cypriot FX industry
Under the Old IS Law (MiFID I) commodity dealers not part of a wider financial or credit institution fell almost entirely outside of scope of the regime (under section 3(2)(k) of the Old IS Law equivalent to Article 2(1)(k) of MiFID I). That blanket exemption has gone under the New IS Law and in its place commodity dealers seeking to avoid regulation must now rely on a far more curtailed safe-harbour under section 4(1)(j) of the New IS Law equivalent to Article 2(1)(j) of MiFID II.
This provides an exemption only in respect of persons dealing or providing investment services in commodity derivatives to the clients of their main business, where this is an ancillary activity to their main business and where the main business does not consist of the provision of investment or banking services. In addition, persons looking to benefit from the exemption:
- Must not apply a high-frequency algorithmic trading techniques
- Must notify annually the relevant competent authority (the Cyprus Securities and Exchange Commission – CySEC) that they make use of this exemption and upon request report to the competent authority the basis on which they consider that their activity is ancillary to their main business.
Matched principal trading: reclassified and consequential
This last provision gives effect to the intention to include ‘matched principal trading’ within scope of the dealing on own account activity. Historically this has been considered to constitute ‘execution of orders’ under the Old IS Law (MiFID I). Matched principal trading would cover a transaction where the facilitator interposes itself between the buyer and the seller to the transaction in such a way that it is never exposed to market risk throughout the execution of the transaction, with both sides executed simultaneously, and where the transaction is concluded at a price where the facilitator makes no profit or loss, other than a previously disclosed commission, fee or charge for the transaction.
With matched principal trading now being considered part of the investment activity of dealing on own account, rather than the investment service of execution of orders a number of consequences occur – perhaps the most significant being that the group company exclusion will no longer apply to it. This is because the group company exclusion applies exclusively to the provision of investment services – but not investment activities.
As such it will be imperative that EU entities providing broker-like services on an unregulated basis to group affiliates now reconsider whether such services will continue to be viable.
The organised trading facility
The New IS Law (MiFID II) introduces regulation covering the operation of a new type of trading venue, the ‘organised trading facility’ or OTF. As an investment service, operating an OTF will be subject to licensing by CySEC. OTFs will operate alongside the existing concepts of the regulated markets and the multilateral trading facility (MTF). An OTF is a multilateral system, other than a regulated market or a MTF, in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives (i.e. non-equity instruments) are able to interact in the system in a way that results in a contract. The key distinguishing feature of an OTF is that in an OTF the execution of orders is carried out on a discretionary basis, where such discretion may be exercised by the operator of the OTF:
- When deciding to place or retract an order on the OTF
- When deciding not to match a specific client order with another order available in the system at a given time, provided it is in compliance with specific instructions received from a client and best execution obligations.
Regulation of algorithmic trading
The New IS Law (MiFID II) introduces a significant shift in relation to the regulation of algorithmic trading. Dealers engaging in high frequency algorithmic trading (HFAT), categorised as a sub-set to algorithmic trading, will no longer be able to benefit from the exemptions under the Old IS Law (MiFID I) and, as discussed above, will now need to become authorised by CySEC. Persons dealing in algorithmic trading other than HFAT will not be required to become authorised by CySEC, however they will be subject to some obligations newly introduced by the New IS Law.
More specifically, all persons dealing in algorithmic trading will now be required to have in place effective systems and risk controls to ensure their trading systems are resilient and have enough capacity, are subject to appropriate thresholds and limits which prevent sending erroneous orders, do not function in a way that contributes to a disorderly market and cannot be used for any purpose that is contrary to the rules of a trading venue to which it is connected. They will also need to have effective business continuity arrangements to deal with trading system failures and to ensure their systems are tested and monitored. A firm engaging in algorithmic trading or providing direct electronic access is required to notify accordingly CySEC and the competent authority of the trading venue of which it is a member, and must further maintain records to enable CySEC to monitor the firm’s compliance with these requirements.
MiFID II has been years in the making. The ten years following the original MiFID have contributed to a fair amount of emotional ‘baggage’ for the industry to contend with: the 2008 Lehman Brothers crash, the 2009 Madoff scandal, LIBOR rigging in 2013. The list goes on. The new rules in many ways follow the classic adage on financial regulation – that it tends to be reactive rather than proactive. Indeed many of the changes to scoping and perimeter provisions in MiFID II look backwards over the experience of the last ten years. The absence of any significant regulation over, for example, the rapidly expanding financial technology sector is intriguing. It therefore remains to be seen whether the MiFID II regime will be able to achieve its aspirations to protect investors and empower competitiveness in this respect.
From a Cypriot perspective however the net outcome of MiFID II results, in practice, in the transfer of much discretion from the local legislature and regulator under MiFID I to the EU competent authorities, namely the Commission and ESMA. Whilst excessive EU harmonisation and power transfer is often criticised, bearing in mind the strength in depth that the European institutions offer to smaller member states such transfers are in many ways and in practice to be welcomed as they level the playing fields throughout the Union.