1. Dodd Frank / MiFID II: Where the US leads, will Europe follow?
A US / Europe comparison
MIG Seminar
Financial Services Team
Norton Rose LLP
April 2013

2. What this session covers
The new marketplace: MTFs/OTFs v SEFs and mandatory trading
The impact on equities and derivatives
Access to Europe and trading cross-border
Some key themes tie together the EU and US legislative agenda
The trust problem: Fundamentally there is a perception that the contract between the City/Wall Street and the Public/Main Street has been breached: This has led to calls for tough new intervention powers and more regulation – good example is commodity derivatives
The end of the free market world? Suspicion of free market liberal economics: When are barriers legitimate with the outside world and when should regulators decide on structures?
The pace of change: Technology has outpaced regulation: The catch up game
Sorting out co-ordination problems: The internal EU problems of co-ordination and the global issues: Does this create significant arbitrage?

3. MiFID II

4. Developments in European legislation: Where the trade side fits in
30 January 2013: Draft statutory instruments published
19 December: Bill receives Royal Assent
19 February 2013: Provisions relating to appointing senior members of FPC, FCA and PRA come into force
UK Government
15 March 2015 most RTS enter into force and CCPs can seek reauthorisation
16 August 2012: EMIR came into force
Mid 2014: First clearing obligations expected to apply
EMIR
15 June and 15 July 2013: Equivalence decisions for first and second phase third country CCPs
2011
2012
2013
2014
2015
25-26 October 2012: EU Parliament votes on amendments to draft legislation but then refers matters back to ECON for further consideration
MiFID II
13 December 2012: Council progress report of MiFID II
8 October 2013: EU Parliament to vote on MiFID II legislative proposals
Implementation of MiFID II legislative proposals (at the earliest
UK FSA
2 April 2012: FSA moves to ‘twin peaks’ operating model reflecting how PRA and FCA will operate
1 April 2013: Cutover to FCA and PRA

5. The Timeline
The main point is the differential timing between EU post trade and trade implementation
The trade side contrasts with the US “single framework” under Dodd Frank
A number of questions about unintended arbitrage opportunities, eg lighter platform requirements in the absence of SEF regime in Europe until MiFID changes are implemented
Significant time difference in this context

6. Issue 1: Trading venues - New concepts and boundaries
Regulated
Markets (RMs)
Non-discretionary
execution of transactions
Managed by market operator
Operating is not an investment activity or service
Council proposal that a firm that operates an internal automatic electronic matching system is an MTF or OTF
Multilateral Trading Facilities (MTFs)
Non-discretionary execution of transactions
Operating as an investment service but can be operated by market operators
Few conduct of business rules apply
Organised
Trading Facilities (OTFs) (Commission proposal)
Discretion over execution of transactions
Investor protection, conduct of business and best execution requirements
Cannot trade against proprietary capital
Operating as an investment service but can be operated by market operator
Systems that bring together third party
trading interests and result in
contracts

7. Issue 1: Trading venues – OTFs
Political background is the broker crossing system debate: View against unregulated trading venues and close link to the SI debate
Broadly defined: All types of organised execution and arranging of trading which does not correspond to RM or MTF
Includes:
Broker crossing systems which execute client orders against other client orders
Systems eligible for trading clearing-eligible and sufficiently liquid derivatives
Does not include:
Facilities where there is no genuine trade execution or arranging taking place in the system, such as bulletin boards, entities aggregating or pooling potential interests or electronic post-trade confirmation
Bilateral systems
There are two different levels of discretion:
When deciding to place an order on the OTF or to retract it again
When deciding if, when and how much of two or more client orders it wants to match within the OTF

8. Issue 1: Trading venues – OTFs
Clarification that simultaneous matched principal trading is permitted subject to strong conflicts management – UK Government agrees
Boundaries of “discretion” for purposes of the definition not entirely clear

9. Issue 1: Trading venues - The SI debate
Concern on the equities side at only 10 registered SIs:
Commission given powers to clarify criteria for when a firm is an SI: Complementing material commercial relevance test with quantitative thresholds
Broader range of equity like instruments, e.g. exchange traded funds and DRs
SIs to maintain minimum quote size – 10% of SMS
Extension of SI regime to bonds and derivatives which are clearing eligible or admitted to trading on a RM, MTF or OTF
Recognition that the equities and derivatives worlds are different: See slide on transparency: Headlines are:
Liberalisation on price improvement in relation to equities: Now price improvement permitted for retail investors and in justified cases where price falls within public range close to market conditions and removal of current ban on price improvement where below retail size transactions
On derivatives Commission to set size limits about when obligations apply
Controversial approach under which pre-trade obligations will only not apply to “ad-hoc and irregular” dealings

10. Issue 1: Trading venues - The SI debate
What the whole SI and OTF discussion illustrates is a deep suspicion of the “open architecture” approach to regulation: Lack of trust and pace of technological change have come together

11. Issue 2: Mandatory on-platform trading
Mandatory on-platform trading for derivatives under MiFIR: Reflects G20 commitment
Derivatives that are subject to clearing obligation in EMIR which:
are traded on at least one RM, MTF or OTF
are considered sufficiently liquid to only trade on these venues
the Commission and ESMA will define eligible derivatives through technical standards
ESMA also has an own initiative power to identify derivatives for this purpose. Unclear whether this allows ESMA to include instruments which are not CCP cleared but this appears so
Must be traded on a RM, MTF, OTF or certain third country trading venues which the Commission deems to be equivalent and where third country provides equivalent recognition for EU trading platforms
Same scope as EMIR in relation to counterparties:
trades between financial counterparties and in-scope non-financial counterparties
trades between an EU captured entity and third country entities that would be subject to EMIR
trades between third country entities that would be subject to EMIR if they were established in the EU where their transactions could have a direct, substantial and foreseeable effect within EU and this is necessary to avoid evasion
excludes certain intra-group transactions and large in scale trades
The only derivatives contracts that will in future continue to trade OTC are those that do not meet the test of being ‘clearing eligible and sufficiently liquid’
Council proposes obligation that investment firms trade liquid shares on a RM, MTF, OTF or SI save in certain circumstances

12. Issue 3: Active intervention in markets
The four layer sandwich on position limits for commodity derivatives:
Participants on RMs and MTFs must report to market their own positions and those of their clients and underlying clients
Layer 1
Competent authority shall impose position limits to prevent market abuse or support orderly pricing and settlement conditions
Layer 2
Commission will adopt technical standards to determine criteria regulators should factor in when setting position limits
Layer 3
Regulators can set more restrictive limits than those of the Commission where objectively justified and proportionate taking account of liquidity and orderly market for 6 monthly renewable periods or when necessary to ensure integrity and orderly markets
Layer 4
ESMA must opine on whether this is necessary and plays coordination role

13. Issue 3: Active intervention in markets
Trading venues must have position management powers for commodity derivatives:
Monitoring open positions
Access to information about positions
Require a person to terminate or reduce a position
Require a person to provide liquidity back into the market
Competent authorities can request a person to reduce positions and exposures in any derivative
ESMA can:
Request information about size and position of any derivative and require a person to reduce it
Limit ability of a person to enter into a commodity derivative
Position reporting by trading venues for commodity derivatives, emission allowances and derivatives on them:
By category of trader, commercial undertaking, investment firm etc
Information available to regulators in detail and public in aggregate

14. Issue 3: Active intervention in markets cont’d
Note considerable toughening of commodities exemptions to parallel this: Ancillary activities (Article 2(1)(i)):
First part of the exemption (persons dealing on own account in financial instruments) now excludes persons who deal on own account by executing client orders
Both this and the provision of services limb of exemption are as currently subject to ancillary activity to main business on group basis test plus main business must not be financial services plus link back to high frequency trading
BUT important to note that there is now Commission Level 2 power to clarify ancillary and specific reference to just being for hedging
Article 2(1)(k) deleted and Article 2(1)(d) no longer applicable to commodity derivatives although cumulative with Article 2(1)(i)

15. Issue 4: The tough new approach to new technology
Providing electronic access to clients
Systems and controls, including suitability of clients, pre-set trading and credit thresholds, monitoring clients
Responsible for ensuring clients comply with rules, monitoring and report breaches, disorderly trading and market abuse
Written agreement
Notify competent authority which trading venues it provides access to
Algorithmic trading
Systems and controls to avoid disorderly markets and market abuse
Notify competent authority of trading venues if they may require strategy
Algorithmic trading pursuing market making strategy
Must market make continuously during specified proportion of trading hours
Take into account risk management, liquidity, scale and nature of market and characteristics of instruments
Systems and controls
Only acts for persons that meet clear criteria and are suitable in order to reduce risks to firm and market
Investment firms – systems and controls to be further defined in technical standards
General clearing member
Only act for persons that meet criteria to reduce risks to firm and market
Written agreement
N.B. There are Level II powers in this area

16. Issue 4: Themes in the technology debate
Generally the Council has been more pragmatic on these issues for example rejecting an outright ban on direct market access called for by the Parliament draft
The compromise on direct and sponsored market access has been to go with the ESMA guidelines approach:
Politically, this still reflects considerable intervention in the shape of the market and an example of the trust problem
Algo and high frequency trading have been the focus of a lot of attention and reflect a combination of a lack of trust in the impact of trading on market price formation and grappling with the changes to technology
A lot of detail to be worked through in Level 2: In some ways, ESMA is being left with some of the hard political choices
Examples of some of the detail: Algo systems must have:
Resilient trading systems with sufficient capacity
Appropriate thresholds and limits to prevent erroneous orders, disorderly trading and market abuse
Effective business continuity and testing arrangements

17. Issue 4: Themes in the technology debate
Much will depend on the detail at Level 2 and also how these tests are applied
Other example is suitability test for clients whom firms providing direct electronic access allow to use their facilities

18. Issue 4: Themes in the technology debate
Draft report by the European Parliament rapporteur calls for a more differentiated approach on algorithmic trading:
Proposes definitions for HFT and HFT strategy to identify a particular subset of algorithmic trading
Ban of direct electronic access
Adds proposals to strengthen circuit breakers include trading venues to ensure that their fee structures contain higher fees for placing an order which is cancelled than for an order which is executed
European Parliament:
Prohibits firms from providing sponsored and naked market access to a trading venue
Requires investment firms engaging in HFT to store in an approved form the raw audit trail of any quotation and trading activities performed on any trading venue
Requires investment firms and market operators operating an MTF or an OTF to have arrangements in place to identify any conflicts of interest between the interest of the MTF or OTF, its owners or its operator and the sound operation of the MTF or OTF
Inserts new provisions on systems resilience, circuit breakers and electronic trading concerning tick sizes and synchronisation of business clocks

19. Issue 4: The tough new approach to new technology
Systems to:
reject orders that exceed thresholds or are erroneous
temporarily halt or constrain trading if there is a significant price movement
cancel, vary or correct transactions
Relevant trading systems
Give competent authority access to order book on request
Capacity for peak order and message volumes
Systems to prevent algorithmic trading contributing to disorderly trading
limit ratio of unexecuted orders to transactions
slow down flow of orders if close to capacity
limit net size
Ensure orderly trading in times of stress
Trading venues -
details to be included in technical standards
Effective business continuity
Must have schemes to incentivise market makers to post firm quotes and provide liquidity
written agreement between venue and MM
If allowing direct electronic access:
to be provided by banks and investment firms only
risk controls and thresholds
need ability to stop such orders separately from other orders
Rules on co-location services and fee structures
Identify orders generated by algorithmic trading, different algorithms and persons using them

20. Issue 5: Extension of transparency regime – Trading platforms
Shares and equity-like instruments
Other instruments
Pre-trade
Extended to equity-like instruments such as depositary receipts, exchange traded funds and certificates
Make public bid and offer prices and depth of trading interest
Extended to actionable indications of interest
Commission sets framework for waivers
ESMA will opine on use of waivers before their use and has powers to oppose their use: 8% overall trading limit proposed for price taking waiver
Extended to bonds, structured finance products, emission allowances and derivatives
Same as for equity-like instruments
Competent authority can temporarily suspend disclosure where liquidity drops
Post-trade
Extended to equity like products
As close to real time as possible
Deferred publication for large in scale where authorised by competent authority within framework set by Commission
Make public price, volume and time of trades
Deferred publication for large in scale and illiquid where authorised by competent authority within framework set by Commission
Info must be available on reasonable commercial basis as soon as possible and free of charge within 15 minutes
Must offer pre and post-trade information separately
Commission to clarify details

21. Issue 5: Extension of transparency regime – Investment firms
Shares and equity-like instruments
Other instruments
Pre-trade
Applies to SIs: Extended to equity-like instruments such as depositary receipts, exchange traded funds and certificates traded on a trading venue
Some amendments including minimum quote size, two way quotes and price improvement for retail as well as professional clients
New SI regime extended to bonds, structured finance products, emissions allowances and derivatives
Must provide quotes where liquid market and asked by clients
Must make available to other clients and trade if up to certain size
Price improvement permitted in justified cases
Post-trade
Investment firms must make public trades through an Approved Publication Arrangement
Applies to instruments traded on a trading venue but if venue can defer, this should also apply to OTC trades
Make public volume, price and time of transaction
Unclear how this will work in buy/sell side chains of firms
Detailed information requirements to be set by Level 2
Competent authority can permit deferral, or restricted disclosure and can suspend and this also applies to OTC trades
Unclear how it applies to lookalikes

22. Issue 6: Access of third country firms to EU
Council has pulled back from Commission’s proposal:
No restrictions on third country firms trading with or providing services to eligible counterparties and per se professional clients in EU: This would be left to a Member State decision
A third country firm wishing to provide services to retail clients (including opt ups) in EU must establish a branch – the major change is the deletion of an equivalence test but various indirect tests including:
Branch must be properly authorised in its third country
Branch must have sufficient initial capital
Third country must not be on FATF non-compliant list
Third country must have entered into cooperation arrangement with EU regulator
Third country must have signed OECD model tax convention

23. Issue 6: Access of third country firms to EU
Exception where the service is provided at “the exclusive initiative” of the client and no advertising or promotion in the EU by the firm
Numerous problems with the exclusive initiative test: For example, does it allow another group entity to advertise and does it mean that any generic or internet advertising puts the firm offside?
Complex example of the tensions between liberal and statist instincts in Europe

24. Issue 6: Access of third country firms to the EU
The contrasting approach – the European Parliament pushes for a common EU
A third country firm wishing to provide services to retail clients (including opt ups) in the EU must establish a branch:
Important to note that the equivalence test remains
Note additional requirement that Member State must be satisfied that third country firm intends to provide a significant proportion of investment services or perform significant quantity of its investment activities within the Member State where the branch is established: Unclear what “significant proportion” means
The carrot remains: The EU passport in article 44 of the recast Directive
Subject to the exclusive initiative of the client
A third country firm wishing to provide services to eligible counterparties and per se professionals:
Per Commission’s original proposals that the firm must be subject to registration by ESMA and to the supervision in the third country
Member States may not impose additional requirements on the third country firm in respect of matters covered by MiFID or MiFIR

25. Dodd-Frank

26. Issue 1: Swap Execution Facilities (SEFs) and Security-Based SEFs (SB-SEFs)
Dodd-Frank Definition: The term “SEF” means a “trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids or offers made by multiple participants in the facility or system, through any means of interstate commerce…”. The term SB-SEF is defined similarly
The statutory goal is to promote the trading of swaps on swap execution facilities and promote pre-trade price transparency in the swaps market (but this language was not included with respect to SB-swaps)
CFTC: Order execution is divided into two types of transactions: Required Transactions and Permitted Transactions:

27. Issue 1: Swap Execution Facilities (SEFs) and Security-Based SEFs (SB-SEFs) Cont’d….
a Required Transaction is subject to the execution requirements and is made available for trading pursuant to Section of the SEF rules, and is not a block trade
a Permitted Transaction is one that meets any of the following criteria: is not subject to mandatory trading or clearing, is a block trade, or is an illiquid or bespoke swap. CFTC proposes to require SEFs to provide for execution of Required Transactions on an order book or an RFQ system (to no less than 5 participants). Permitted Transactions could be executed via an order book, RFQ or a voice-broker SEC: Has proposed a different approach, an order book or an RFQ to as few as one other participant
Registration: SEFs must register with the CFTC, and SB-SEFs with the SEC
Foreign Boards of Trade (FBOTs) that register with the CFTC may offer swaps to U.S. persons

28. RMs, MTFs, OTFs and SEFs: How do they compare
MiFID rules will not come into effect until Q3/Q4 2015
No Swap Execution Facility (SEF) detail equivalent for EU venues, but MiFID Level 2 rules will provide more specifics
MiFID obligations more or less the same across venues (see table), but more cost effective for MTFs and OTFs
Scope of financial products available for trading significantly differs: SEFs cover only swaps; whereas, RMs, MTFs and OTFs cover swaps, equities, commodities and other derivative contracts
OTFs not only have discretion over who they accept to trade but also, crucially, over how those trades are executed
SEF is a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce

29. RMs, MTFs, OTFs and SEFs: How do they compare
Voice brokerage excluded under SEFs: probably for OTFs
SEFs have real-time data reporting requirements that create significant additional costs for operators, but result in additional commercial opportunities
SEFs/OTFs have the potential to make the swaps market more electronic, transparent, and competitive, but not all transparency is equal; venues must be able to attract liquidity
Price discovery could be hindered unless careful consideration is taken to make the rules adaptable and to reflect the fact that the swaps market is less liquid than some people imagine

30. RMs, MTFs, OTFs and SEFs: What is the difference?
Regulated Market
Multilateral Trading Facility
Organised Trading Facility
Swap Execution Facilities
Pre and post-trade transparency
Yes – however, pre-trade transparency provisions are calibrated towards different models. Post-trade transparency is subject to authorisation of deferred publication and applies to firms concluding transactions across trading venues.
Same as for RM
Yes – includes posting both firm and indicative quotes on a centralised electronic screen accessible to all market participants (excludes block trades)
Transaction reporting to competent authority
Yes, where a firm trading on the venue is not subject to reporting obligation
Yes
Organisational requirements
Organisational requirements specific to operators of RMs
Organisational requirements applicable to all investment firms
Same as for MTFs. Not allowed to operate an OTF and SI within the same legal entity; OTFs can engage another investment firm to carry out market making on an OTF on an independent basis (Parliament)
Organisational requirements specific to operators of SEFs; limit on dealer ownership of SEFs and a minimum proportion of public directors on their boards
Monitoring
Requirement to monitor compliance with rules and transactions for breach, disorderly trading and abuse
Same as for RM (more detail provided in Dodd-Frank)
Client protections
Investor protection rules in MiFID do not apply
Investor protection rules in MiFID do not apply; however, MTFs must ensure that members/participants do comply with these requirements
Investor protection, conduct of business, order handling and best execution rules apply

31. Issue 2: Dodd-Frank Act Trading Requirement for Cleared Swaps “Made Available to Trade”
DFA imposes a new mandatory “trading requirement” for certain swaps and security-based swaps
CFTC Swap Trading Requirement: A swap that is required to be cleared and is “made available for trading” is also required to be executed on a designated contract market (“DCM”) or a swap execution facility (“SEF”)
SEC SB-Swap Trading Requirement: An SB-swap that is required to be cleared and is “made available for trading” is also required to be executed on a registered securities exchange or a SB-swap execution facility (“SB-SEF”)
Exemptions from Trading Requirement:
Trading requirement does not apply to an end-user eligible for the end-user exemption from the clearing requirement, or
If no exchange or SEF or SB-SEF “makes the swap available for trading”

32. Issue 2: Dodd-Frank Act Trading Requirement for Cleared Swaps “Made Available to Trade”
“Made Available for Trading” determination still not resolved
CFTC Proposal: SEF/DCM make the determination subject to CFTC oversight based on a multi-factor test, including: (1) number of ready and willing buyers and sellers, (2) frequency or size of transactions, (3) trading volume, (4) number and types of market participants, (5) bid/ask spread, (6) number of resting bids/offers, or (7) will the platform support trading in the swap. If one SEF or DCM make a swap available for trading this would require all other SEFs/DCMs to treat the contract (and economically related contracts) as subject to mandatory trading
SEC Proposal: SEC will determine whether an SB-swap is made available to trade based on objective measures after it has sufficient data. SEC is considering such measures such as overall volume in the SB-swap, minimum number of transactions or notional value during a given time period

33. Issue 3: Futurisation? Movement away from OTC swaps to futures
Oct. 15, 2012 – ICE converted energy swaps to futures & CME allowed cleared energy swaps to be executed as futures block trades
Jan. 31, 2013, the CFTC held a public roundtable to discuss the “futurisation” of swaps. The roundtable addressed:
Concerns regarding the futurisation of swaps in different asset classes; clearing and different margin requirements for swaps and futures; block rules for swaps and futures; and effect of the conversion of swaps to futures on end-users
Movement away from OTC swaps driven by risks and uncertainty from Dodd-Frank swaps regulation
Will the CFTC “level the playing field” between the swaps and futures markets by requiring consistent block sizes and margin requirements for cleared products

34. Pegasus: our online technical resource for MiFID

35. Disclaimer
The purpose of this presentation is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Norton Rose LLP on the points of law discussed.
No individual who is a member, partner, shareholder, director, employee or consultant of, in or to any constituent part of Norton Rose Group (whether or not such individual is described as a “partner”) accepts or assumes responsibility, or has any liability, to any person in respect of this presentation. Any reference to a partner or director is to a member, employee or consultant with equivalent standing and qualifications of, as the case may be, Norton Rose LLP or Norton Rose Australia or Norton Rose Canada LLP or Norton Rose South Africa (incorporated as Deneys Reitz Inc) or of one of their respective affiliates.