0. MiFID 2 – investor protection
Andrew Hart, Mark Kalderon, Raffaele Lener and Romin Dabir
28 April 2014

1. Agenda Eligible counterparties Suitability and appropriateness
Inducements
Best execution
Bundled services
Product governance
Algorithmic trading and high frequency trading
Direct electronic access
Product intervention
Enforcement

2. Eligible counterparties
Municipalities and local authorities  
i). Professional clients
In accordance with the finalised version of Annex II, part I, of MiFID 2 listing the type of clients who are automatically considered to be professionals, the category of “public bodies that manage public debt” has been narrowed to those who operate on a national or regional basis only. Such restriction is in line with the already existing limitation to national and regional governments.
Accordingly the new wording “National and regional governments, including public bodies that manage public debt at national or regional level [..].” list public bodies managing public debt as a sub-category of national and regional governments.
In light of the above, it will no longer be possible for investment firms to automatically treat public sector bodies, local public authorities and municipalities as professional clients.

3. Eligible counterparties (cont.)
ii). Professional clients on request
Public sector bodies, local public authorities and municipalities may opt to be treated as professional clients. Member States will be given the option of adopting specific criteria for the assessment of the expertise and knowledge of these bodies when they ask to be treated as professional clients (which can be alternative or additional to the criteria specified in MiFID 2)
The difficulty in distinguishing, in certain cases, between “regional governments” (which can be automatically treated as professional clients) and public sector bodies, local public authorities and municipalities (which must be opted up), will be increased

4. Eligible counterparties (cont.)
Annex II of the finalised Directive shows a stricter approach when providing that professional clients on request shall not be presumed to possess market knowledge and experience comparable to that of the per se professional clients and in the assessment of the expertise and knowledge of the clients. This can be read in the finalised text of Annex II of MiFID 2, where the word “should” is replaced by the word “shall”:
“Those clients shall not, however, be presumed to possess market knowledge and experience comparable to that of the categories listed in Section I”
“In the course of the assessment, as a minimum, two of the following criteria shall be satisfied”
What to do:
Firms will need to decide whether they are willing to bear the costs of “opting up” these (historically litigious) clients or whether to treat them as retail clients.

5. Eligible counterparties – under MiFID 1
Eligible counterparties are any of the following entities to which an investment firm provides the services of reception and transmission of orders and/or execution of orders on behalf of clients and/or dealing on own account:
investment firms;
credit institutions;
insurance companies;
UCITS and their management companies;
pension funds and their management companies;
other financial institutions authorized or regulated under Community legislation or the national law of a Member State;
undertakings exempted from the application of MiFID 1 in terms of Article 2, paragraph 1, letters (k) and (l):

6. Eligible counterparties – under MiFID 1 (cont.)
article 2, paragraph 1, letter (k) - persons whose main business consists of dealing on own account in commodities and/or commodity derivatives (and that are not part of a group the main business of which is the provision of other investment services within the meaning of directive 2004/39/EC or banking services under directive 2000/12/EC)
article 2, paragraph 1, letter (l) - firms which provide investment services and/or perform investment activities consisting exclusively in dealing on own account on markets in financial futures or options or other derivatives and on cash markets for the sole purpose of hedging positions on derivatives markets or which deal for the accounts of other members of those markets or make prices for them and which are guaranteed by clearing members of the same markets, where responsibility for ensuring the performance of contracts entered into by such firm is assumed by clearing members of the same markets
national governments and their corresponding offices, including public bodies that deal with public debt; and
central banks and supranational institutions.

7. Eligible counterparties – MiFID 2 changes
According to Article 30, paragraph 2, of the finalised text of MiFID 2, the following entities will no longer be considered as eligible counterparties:
persons whose main business consists of dealing on own account in commodities and/or commodity derivatives (and are not part of a group the main business of which is the provision of other investment services within the meaning of directive 2004/39 or banking services under directive 2000/12);
firms which provide investment services and/or perform investment activities consisting exclusively in dealing on own account on markets in financial futures or options or other derivatives and on cash markets for the sole purpose of hedging positions on derivatives markets or which deal for the accounts of other members of those markets or make prices for them and which are guaranteed by clearing members of the same markets, where responsibility for ensuring the performance of contracts entered into by such firm is assumed by clearing members of the same markets;
public bodies that do not deal at a national level with public debt.

8. Eligible counterparties - obligations
Obligation to act honestly, fairly and professionally
The obligation for investment firms to act honestly, fairly and professionally and to communicate in a way that is fair, clear and not misleading has been extended also to eligible counterparties (taking into account the nature of such client and its business) but, the obligation to act in accordance with the client’s best interests has not been extended to eligible counterparties.
Information requirements (art. 24, paragraphs 4 and 5)
provision of appropriate information when providing investment services;
provision of the information in a comprehensible form, in such a manner that clients or potential clients are reasonably able to understand the nature and risks of the investment service and of the specific type of financial instrument that is being offered and consequently to take investment decisions on an informed basis.

9. Eligible counterparties - obligations (cont.)
Periodic reporting requirements (art. 25, paragraph 6)
Provision of adequate reports on the service provided, which shall include periodic communications to clients taking into account the type and complexity of financial instruments involved and the nature of the service provided to the client and, where applicable, shall include the costs associated with the transactions and services undertaken on behalf of the client.
The provisions (included in article 24, paragraphs 4 and 5 and article 25, paragraph 6 of the finalized version of MiFID 2) are currently set out in article 19, paragraphs 3 and 8 of MiFID 1 which do not apply to eligible counterparties.
What to do:
Amend policies and procedures in order to extend their scope of application to eligible counterparties and consider providing eligible counterparties with terms of business. 

10. Suitability and appropriateness
Suitability (for advised services and portfolio management)
firms giving investment advice are required to disclose whether the advice is provided on an independent basis and whether it is based on broad / restricted analysis of the market (similar to RDR)
firms giving investment advice are required to disclose whether they will provide client with on-going assessment of suitability
Appropriateness (for non-advised services)
Narrows the categories of “non-complex” products, to exclude:
shares traded on a regulated market (or third country equivalent) or MTF where they are shares in a non-UCITS collective investment undertaking or embed a derivative;
bonds and other forms of securitised debt unless they are traded on a regulated market (or third country equivalent) or MTF;
all debt instruments that “incorporate a structure which makes it difficult for the client to understand the risk involved” (ESMA to issue guidelines);
structured UCITS; and
where a firm is lending money or granting credit to an investor for the purposes of a transaction in which the firm is involved.
Suitability/advice
Independence will be determined on the basis of criteria including a firm’s assessment of a sufficiently diverse range of financial instruments (not limited to those provided by the firm or entities having close links with it) and on its not having taken third party inducements.
Firms will be required on request to demonstrate to competent authorities that individuals providing investment advice to clients possess the necessary knowledge and competence to do so.
Appropriateness
At present the appropriateness requirement is effectively disapplied by the Level 2 measures when dealing with professional clients and it remains to be seen whether this will continue to be the case.
These changes will significantly affect the way in which certain products, such as structured UCITS, are sold to retail clients. 10 10

11. Inducements
Review of the inducements regime – inducements regime under MiFID 1 has led to significant uncertainty across jurisdictions
MiFID 2 introduces two new key requirements:
no monetary or non-monetary benefits permitted when providing independent advice or portfolio management
minor non-monetary benefits designed to enhance quality of the service are permitted e.g. training on features of product
UK already has a regime that is broadly equivalent to these requirements:
FCA consultation on use of dealing commission closed 25 February 2014 with Policy Statement due Spring 2014
FCA likely to proceed with its “clarification” regardless of MiFID 2
Similarity of MiFID 2 and UK rules currently but scope for divergence in national implementation and level 2 and 3.
UK already has:
an inducements rule similar to fees/commission/non-monetary benefits section; and
a rule on restricting use of dealing commission for investment managers unless:
related to execution of client trades or comprise provision of research; and
assists client service without impairing best interests duty
Firms must not remunerate or assess the performance of their own staff in a way that conflicts with the firms’ duty to act in the best interests of their clients
However MiFID proposal both narrower (only apply to independent advice) and broader (apply also to portfolio management) 11 11

12. Best execution
Rules around best execution policies and information disclosure have been tightened
The execution policy must be provided in simple, easy to understand language
Clients must be notified by firms of material changes to their order execution arrangements or policy
Firms must summarise and make public, for each class of financial instrument, the top five execution venues where they executed client orders in the preceding year, on an annual basis
Firms must not receive any remuneration for routing client orders to a particular trading or execution venue
Each execution venue must make available to the public at no extra charge data relating to the quality of execution of transactions executed on the venue on an annual basis
should include information on price, speed of execution and likelihood of execution
Firms will need to review and make more explicit the information about their order execution policies 12

13. Bundled services
New requirements for firms offering an investment service together with another service or product as part of a package
Such firms will be required to inform clients:
whether it is possible to buy the different components separately; and
to provide evidence on the costs and charges associated with each component.
Where the sum of the risk is greater for the bundled service is different from the risks of its component parts firms will need to provide a breakdown of such risks.
ESMA is expected to develop and maintain further guidelines for the assessment and supervision of cross-selling practices.
These requirements could have far reaching effects, applying to matters such as the provision of execution and investment research as part of a single service. 13

14. Product governance
Both manufacturers and distributors of products will be required to comply with new requirements
Product manufacturers:
Products will need to be approved, both before they are marketed and then periodically on an on-going basis
Must consider target market and distribution strategy
Must provide appropriate information to clients (including costs and charges)
Product distributors:
Must obtain the above information from product manufacturers 14

15. Algorithmic trading and high frequency trading - scope
High frequency trading is essentially an evolution of algorithmic trading
Algorithmic trading
High frequency trading
Computer automatically determines whether to initiate order, timing, price or quantity
Algorithmic trading plus infrastructure to minimise latencies by one of following:
Co-location, proximity hosting, high speed direct electronic access
Limited or no human intervention
No human intervention
Does not include routing/processing/confirmation
High message intraday rates of orders/quotes/cancellations 15

16. Algorithmic trading and high frequency trading - requirements
Systems and controls to ensure trading systems:
(i) are resilient and have sufficient capacity;
(ii) have appropriate trading thresholds and limits;
(iii) prevent erroneous orders;
(iv) do not contribute to disorderly markets; and
(v) cannot be used for market abuse or breach trading venue’s rules.
Firm to store all orders, cancellations and quotations to be made available to competent authority on request
Regulated markets may be able to charge a higher fee for high frequency trading to reflect additional burden on system capacity
Effective business continuity plans
No human intervention
Liquidity provision obligation where pursuing market-making strategies
High message intraday rates of orders/quotes/cancellations
Similar to ESMA guidelines published in May 2012 16

17. Direct electronic access - scope and requirements
Direct electronic access will also be regulated more tightly in future
Scope
Requirements
Use of trading member’s trading code to transmit orders directly to trading venue
Includes:
“Direct Market Access” (i.e. use of trading venue member’s infrastructure)
“Sponsored Access” (i.e. where the infrastructure is not used)
Suitability of clients must be assessed, trading monitored and clients must not exceed trading and credit thresholds
Controls to prevent disorderly market or market abuse
Ensure clients comply with MiFID and trading venue’s rules 17

18. Product intervention Product intervention
ESMA and competent regulatory authorities will have powers to temporarily prohibit or restrict the marketing, distribution, or sale of financial instruments; and restrict types of financial activity or practices.
Action may be taken if:
there are significant investor protection concerns
there is a serious threat to the orderly functioning and integrity of financial markets
there is a serious threat to the stability of the financial system
ESMA has power to impose a restriction on a temporary basis. When taking action, ESMA must ensure that its actions do not create a regulatory arbitrage, and do not have a detrimental effect on the efficiency of financial markets, or on investors, that is disproportionate to the benefits of the action
Competent regulators acting in conjunction with ESMA can impose a permanent restriction
Level 2 measures will specify criteria and factors to be taken into account by ESMA and competent authorities in determining when there is a threat to the orderly functioning and integrity of financial markets or commodity markets
Product intervention
ESMA will have powers under MiFIR to temporarily prohibit or restrict (i) the marketing,
distribution or sale of certain financial instruments or financial instruments with certain
specified features or (ii) a type of financial activity or practice where there is a threat to the
orderly functioning and integrity of financial markets or commodity markets and if other
conditions specified in MiFIR are met.
Competent authorities will have similar product intervention powers.
‘The orderly functioning and integrity of commodity markets should be included as a
criterion for intervention by competent authorities in order to enable action to be taken
to counteract possible negative externalities on commodities markets from activities on
financial markets. This is true, in particular, for agricultural commodity markets... In these
cases, the measures should also be co-ordinated with the authorities competent for the
commodity markets concerned.’ (Recital 24, MiFIR)
Level 2 measures will specify criteria and factors to be taken into account by ESMA and
competent authorities in determining when there is a threat to the orderly functioning
and integrity of financial markets or commodity markets. 18 18 18

19. Enforcement – greater co-operation
MiFID 2 will encourage greater co-operation between regulators across Europe and introduce a more level regulatory playing field
The new rules include changes that aim to standardise regulatory powers, sanctions and approaches, including:
ability to require compensation or other remedial action for financial loss by investors
ability to bring administrative action against firms or individuals
requirement to publish enforcement decisions and report all sanctions to ESMA for publication of member state comparisons
requirement to take into account all relevant circumstances when imposing sanctions, including co-operation
maximum administrative fines of at least EUR5m or 10% of the total annual turnover of legal persons or twice profit made
ESMA will draft and standardise co-operation agreements between regulators in different member states
MiFID 2 will require co-operation by exchanging information and providing assistance in investigations and supervisory actions
Co-operation can involve the domestic regulator carrying out the investigation or allowing the overseas regulator to do so
Disputes over information requests, assistance and/or inaction of another competent authority can be referred to ESMA 19 19 19

20. Enforcement – regulatory focus
Areas that regulators across Europe may focus on could include:
Product approval / governance
potential new area for regulatory action
‘mis-marketing’ of products, or their sale to the wrong target audience, has been seen as a significant source of customer detriment (for example, interest rate swaps, PPI)
an issue that encourages co-ordinated action where the same product is sold across several jurisdictions
the new regulations provide a more concrete and rigorous framework for regulators to act within
Suitability and appropriateness
has been an area of regulatory focus in the UK
subject to a new, stricter regime
an area where consumers would benefit from a consistent approach, especially with greater passporting of services throughout Europe
Firms which manufacture financial instruments for sale to clients will be required to
maintain a product approval process. This must identify the target market for each product
and ensure that all relevant risks to that target market are assessed, and that the intended
distribution strategy is consistent with the identified target market. The target market and
performance of products should be subject to periodic review.
Suitability requirements apply to advised services and portfolio management. There will be
more onerous obligations on investment firms to determine suitability (including of bundled
packages of products).
Firms giving investment advice will be required to disclose whether
they will provide the client with an ongoing assessment of suitability of the product.
Periodic reports must be provided to clients, including an assessment of the suitability of the portfolio
(unless, in the case of investment advisers, the firm is not carrying out a periodic assessment
of suitability).
Firms providing investment advice must provide clients with a statement specifying the basis on which the investment recommended is suitable for the client.
Appropriateness requirements apply to non-advised services. The categories of ‘non-complex’ products will be narrowed, so that the ‘appropriateness’ test will apply:
• to shares unless they are traded on a regulated market (or third country equivalent)
or MTF and to shares in a non-UCITS collective investment undertaking or that embed
a derivative;
• to bonds and other forms of securitised debt unless they are traded on a regulated market
(or third country equivalent) or MTF;
• to all debt instruments that embed a derivative or ‘incorporate a structure which makes
it difficult for the client to understand the risk involved’;
• to structured UCITS; and
• to structured deposits that ‘incorporate a structure which makes it difficult for the client to understand the risk of return or the cost of exiting the product before term’.
At present the appropriateness requirement is effectively disapplied by the level 2 measures when dealing with professional clients and it remains to be seen whether this will continue to be the case.
These changes will significantly affect the way in which certain products, such as structured
UCITS, are sold to retail clients. 20 20 20

21. Enforcement – regulatory focus (cont.)
Best execution and information requirements
would be consistent with MiFID 2 focus on transparency
subject to substantial rule changes, and regulators will want to ensure compliance from an early stage
High frequency trading (algorithmic trading)
high profile area
significant potential to cause disruption to markets (flash crash of 2010)
regulators have stated a desire to regulate wholesale markets
nature of the trading means it may operate across jurisdictions and this is an area where consistent systems and controls will be important in creating a level playing field across Europe
Best Execution
MiFID 2 will introduce the following changes for investment firms executing client orders:
• the execution policy must be provided in sufficient detail and in clear, easy to understand
language; and
• firms must summarise and make public, for each class of financial instrument, the top
five execution venues where they executed client orders in the preceding year, on an
annual basis.
Firms should not receive any remuneration for routing clients’ orders to a particular trading
or execution venue. Trading venues and systematic internalisers will be required to publish annual data relating
to the quality of execution of transactions, which must be available publicly and at no extra
charge. This should include information on price, costs, speed and likelihood of execution for
individual financial instruments. The Commission is empowered to adopt level 2 measures in relation to the nature and extent of information to be provided by firms in relation to their execution policies.
Firms will need to review and make more explicit the information about their order execution policies provided to clients.
Aim is to ensure that firms provide appropriate information to clients on their order execution policy, including explaining clearly, in sufficient detail and in a way that can be understood by clients, how orders will be executed by the firm for the client.
Investment firms will be required to provide appropriate information to clients in relation
to a number of matters, including proposed investment strategies and risks, whether the
financial instrument is intended for retail or professional clients, execution venues, costs
and associated charges, including cost of advice, cost of financial instruments recommended
to the client, and third party payments. Costs and charges should be shown on an aggregated
basis but an itemised breakdown must be provided if requested by the client. The
Commission may adopt level 2 measures specifying the content of such disclosures,
which are likely to be more extensive than those currently required and required to
be provided on a regular basis. 21 21 21

22. Disclaimer Template tip
A disclaimer should always be included at the end of the presentation
[LON ]
This material is for general information only and is not intended to provide legal advice.
© Freshfields Bruckhaus Deringer LLP 2014