MiFID II implications for US financial firms
30 August 2017
Key provisions of MiFID II will have a direct or indirect impact on US investment managers and brokerage firms depending on a firm’s business model and extent of their connection to Europe. Any US investment manager or broker/dealer that deals with EU counterparties, trades through EU execution venues, provides investment research to EU firms, or seeks access to EU investors is likely affected in some way.
MiFID II is a term widely used to describe the far-reaching set of revisions to the current EU Markets in Financial Instruments Directive (MiFID I) which governs EU discretionary portfolio managers that manage separate accounts. MiFID II is intended to create harmonization and transparency and a more equal playing field across the EU. The trade-off is increased regulation, cost and complexity of trading or distributing product in Europe.
US investment management firms with a subsidiary that performs investment services to separate accounts in Europe are directly affected and need to meet all the new MiFID II requirements. And while investment managers that are only authorized as Alternative Investment Fund Managers (AIFMs) under the EU Alternative Investment Managers Directive (AIFMD) or as UCITS management companies are not squarely in scope, and US investment managers are not subject to MiFID II simply by having investors in their European sponsored funds, they are likely to be indirectly impacted by certain MiFID II requirements.
US investment management and brokerage firms are indirectly affected by MiFID II if they:
- Trade with an EU counterparty, venue or exchange
- Provide investment research to EU firms
- Provide investment services or market products to European investors
Trading Related Implications
US investment managers trading securities, commodities or derivatives on European trading venues or with regulated EU investment firms, brokers or banks will be indirectly affected by MiFID II. The range of asset classes and products within the legislation’s scope is broad and includes fixed income, equities and commodities and their derivatives as well as money market instruments. While foreign exchange spot transactions are out of scope, FX derivatives are in scope.
European regulators conduct market abuse surveillance on all in scope financial instruments that are traded on a EU-regulated exchange or alternative trading venue, regardless of whether the trading takes place inside or outside the EU. MiFID II requires that that every trade in a covered financial instrument traded in the EU be reported to a European regulator. To meet these EU reporting obligations, EU buy-side and sell-side firms will at a minimum need non-EU clients to establish a Legal Entity Identifier (LEI) so that trades executed with the non-EU firms can be disclosed in these regulatory filings. An LEI is a reference code to uniquely identify a legally distinct firm that engages in a financial transaction.
Under MiFID II, the pre- and post-trade transparency requirements are being expanded, both in terms of scope of instruments and firms that are impacted. While these requirements do not directly affect US firms, given that EU fixed income markets will become transparent and dark liquidity pools will be less able to remain unlit, there is likely to be a substantial impact on the way in which these instruments trade in practice. US investment managers will need to analyze the likely impact on their trading strategies. Trading in EU instruments in scope of the expanded transparency regime will also be reported to the market by the EU counterparty. US firms that trade in commodity derivatives through an EU trading venue will also be directly impacted by position limits and will need to comply with EU position limit reporting.
MiFID II introduces new trading obligations for EU listed equities and certain derivatives1 by EU firms. Trades in these instruments can no longer be traded Over-the-Counter (OTC) and must only be traded on an EU regulated market, Multilateral Trading Facility (MTF), Organised Trading Facility (OFT2), EU systematic internaliser (SI3) , or through an ‘equivalent’ non-EU trading venue. It should be noted that no third country trading venue has been currently assessed as equivalent. This means that a US firm trading in scope EU instruments with an EU counterparty will be indirectly impacted due to the obligations on its EU counterparty. Where the trade is between two non-EU counterparties, the trading obligation does not apply, even if the instruments are in scope.
Unbundling Investment Research
MiFID II is already having global implications on the consumption, use and value of investment research. Perhaps more than any other MiFID II requirement, the requirement in the EU to unbundle research from commissions and pay hard dollars for the research has attracted the most attention.
Firms have historically used trading commissions with a brokerage firm to pay for investment research, and this practice of ‘soft dollars’ is generally allowed, subject to certain restrictions. Regulators in the EU believed this system is conflicted, creates unnecessary costs and potential ‘inducements’ and are requiring research and execution costs on both equity and fixed income transactions to be unbundled.
Under MiFID II, EU investment managers will be required to select one of the two options to pay for investment research:
- Pay for research out of their own P&L, or
- Establish a client research payment account (RPA).
Under the RPA model, managers are required to set and disclose to clients a research budget on a periodic basis, track the cost of any research received and pay for that research out of clients’ RPA. This also requires EU-licensed sell-side firms to identify separate charges for research and execution, which prohibits these firms from allowing the supply of, and charges for, research to be “influenced or conditioned by levels of payment for execution services.”
In the US, firms that charge money for analysis and research are deemed to be investment advisers and generally must register with the SEC. US brokers are currently prohibited from accepting actual hard dollars for investment research, which is exactly what MiFID II requires. In addition to the enhanced regulatory burdens if firms decide to register as both a US broker/dealer and investment adviser in order to continue to provide investment research to European clients, US firms are precluded under Section 206(3) of the Investment Advisers Act from trading as principal with an advisory client without disclosing its capacity in writing and receiving client consent to the transaction.
The SEC has had requests from US brokers that distribute research to European firms asking permission to receive hard dollar payments for research from clients that are subject to MiFID II. There is also some question whether funds swept from an RPA will still be considered commissions and not compensation for US purposes. There are ongoing discussions with the SEC staff about these issues and while it is expected that the SEC will grant some sort of relief in the form of an exemptive order or no-action letter, this is not guaranteed and it remains unknown what position the SEC will take on these matters.
Investment managers that share research across all accounts may need to consider ‘ring-fencing’ trading activities for accounts subject to MiFID II. This would include deciding whether to accept certain research for the benefit of the MiFID II accounts and then make an appropriate internal payment for the research. This in turn may implicate regulations outside the EU and impact the ability for US managers to rely on the soft dollar safe harbor provisions of Section 28(e) of the U.S. Securities Exchange Act of 1934. There also will be US disclosure and other obligations if accounts are subsidizing research that is indirectly being used to manage accounts subject to MiFID II that may not be paying their pro rata share for the research.
Firms such JP Morgan Asset Management, Pimco, T Rowe Price, Vanguard and Russell Investments are some of the first US asset managers to confirm they plan to absorb the cost of external research under the new rules to eradicate the need to set out a clear budget for research to clients, and address the ambiguities over whether research can be shared freely across a global organization. Vanguard expects to spend over $5 million annually out of their own P&L to cover the cost of research under the new regime.
There is also a recent trend of top ranked analysts on Wall Street leaving to start boutiques on the premise US firms will adapt to EU standards. The current research model involves brokers ‘pushing’ as much research as they can to a client. If a portfolio manager or analyst receives research in their inbox that they did not ask or budget for, they could be in violation of MiFID II. The buy-side will need to control what research they are consuming and receiving, and brokers will have to more tightly control access to their research portals. JP Morgan has been one of the first to announce they plan to charge as much as $10,000 per month for access to their research portal, and Deutsche Bank is analyzing how much time is spent by the buy-side on their portal to come up with a pricing structure. There is likely to also be a decline in stock coverage from the sell-side.
MiFID II will also have an impact on US investment managers who do block trades and then allocate to client accounts alongside a MiFID II covered account. Traditional trade aggregation and trade order procedures will need to be revised, and consideration given to creating two trading blocks – one for MiFID II accounts and then all other accounts, which creates significant compliance and operational complexities.
Providing Investment Services and Marketing Products in Europe
A US investment manager that is a sub-advisor to an EU MiFID licensed firm may indirectly get caught up in certain MiFID II requirements as the EU firm cannot delegate away their own obligations under MiFID II. The UK’s Financial Conduct Authority (FCA) recently stated that any delegation arrangement must “achieve the same investor protections for….underlying clients” as portfolio management would under the MiFID II regime, and that a MiFID firm must make sure that any outsourcing arrangements provide an equivalent level of protection and do not place it in breach of its MiFID obligations.
Some EU firms are looking to amend sub-advisory agreements to contractually pass through many of the MiFID II requirements to their US sub-advisors. At a minimum, non-EU sub-advisors will need to provide assurances that investment research does not impact order routing or affect best execution decisions. The FCA has stated that non-EU sub-advisors should:
- Set a budget for the maximum research costs it will incur on behalf of the delegated funds, and provide a policy for how that budget will be used
- Fully account for the research inputs it receives in relation to managing the delegated funds, the value of the research inputs used (using objective benchmarks or metrics to make this value-assessment), and control payments made to research providers in line with the valuation of services, and
- Have systems and controls to ensure the receipt of research does not influence order routing and best execution decisions, or give rise to any other conflicts of interest that risks material detriment to the delegated clients’ funds.
US sub-advisors may also be asked to contractually agree to other MiFID II requirements, such as the recordkeeping and taping requirements, to keep their European mandates.
MiFID II has new product governance requirements for firms that manufacture or distribute investment products in Europe to help ensure that products are appropriate and fit the needs of those clients. US firms that use European distributors to offer products and services to EU investors may need to provide detailed product information to the distributor. Some distributors are requiring distribution agreements be updated to contractually obligate the US firm to provide all the necessary information in an agreed format.
In this increasingly global environment, the EU’s MiFID II legislation will directly or indirectly affect many US financial services firms. With only a few months before the MiFID II rules go into effect, US asset manager and broker/dealers need to take the time to understand the implications on the industry and their specific business.
 Generally, these are liquid derivatives that are required to be centrally cleared.
 OTF’s are a new type of trading venue intended to capture a range of currently unregulated trading platforms, including broker crossing networks. Equity instruments cannot be traded on OTF’s; OTF’s will act as a marketplace for derivatives and debt instruments.
 SI’s, traditionally called market makers, are investment firms who match buy and sell orders in house. Instead of sending orders to a central exchange, an SI matches them with other orders on its own book. SI’s compete directly with stock exchanges and automated dealing systems.