With three weeks to go until MiFID II takes effect, this special edition of Uncorrelated shines a light on 4 of the issues our hedge fund clients tell us are exercising them most:
References in this article to “MiFID II” include the MiFID II Directive (2014/65/EU), the Markets in Financial Instruments Regulation (MiFIR) and the various pieces of subordinate legislation and regulatory standards which accompany them.
MiFID II’s rules on research unbundling – the decoupling of payments for investment research from dealing commissions – are among its most disruptive.
Unhelpfully for hedge fund managers, the FCA has chosen to extend the unbundling rules to AIFMs.
Hedge fund managers have traditionally received their research from banks and brokers in return for routing trades through their systems.
These so-called “softing” arrangements are relics of the bygone days of fixed commission when, unable to compete on cost, brokerages had to offer more than trade execution to win buy-side business.
Bundled brokerage has been on the regulatory radar for some time. European lawmakers – the UK FCA (and its predecessors, the FSA and the SIB) in particular – have long been concerned that it is the provision of “inducements” such as investment research and corporate access which dictate through whom managers execute trades, rather than what is necessarily in their client’s (i.e. the fund’s) best interests.
MiFID II seeks to address this perceived conflict by banning the acceptance of inducements, save for certain “minor non-monetary benefits”.
These minor non-monetary benefits must be capable of enhancing the quality of service provided to the fund, they must not impair the manager’s duty to act in the best interests of the fund, and they must be clearly disclosed.
In general, the receipt of investment research will not amount to a minor non-monetary benefit.
However, research will not fall foul of the new rules if it is paid for:
With recent reports suggesting that the cost of equity research may be around 10 bps of AUM, the P&L method will likely only be an option for those managers with the deepest pockets.
The RPA Method
The rest will have to grapple with the complexities of the RPA method, including agreeing a capped research budget with clients from time to time, regularly assessing the quality of research received to ensure its usefulness and complying with certain disclosure and transparency obligations.
Commission Sharing Agreements (CSAs)
The new rules contemplate that there may be “operational agreements” under which the research charge can be collected “not separately, but alongside a transaction commission”.
This appears to open the door to the continued usage of CSAs.
However, the rules go on to say that any such “operational agreements” must “indicate a separately identifiable research charge” and must otherwise comply with the burdensome conditions relating to RPAs (including those mentioned above).
Existing CSAs are unlikely to meet those requirements.
It remains to be seen whether CSAs will survive. Initial signs are not promising: an increasing number of sell-side firms are abandoning their CSA arrangements in favour of AFME’s standard form Research Charge Collection Agreement (RCCA), which has been designed specifically to cater to the requirements of the new rules.
Conflict of laws?
US rules require broker-dealers which sell research for “hard dollars” to be registered as investment advisers, subjecting them to onerous regulatory and other obligations.
As, such, the MiFID unbundling requirements – which insist that managers pay for research with hard dollars (whether out of P&L or through the RPA) – put the European rules in direct conflict with their US equivalents.
Helpfully, the Securities and Exchange Commission (SEC) has recently announced that it will grant “no action relief” for broker-dealers – allowing them to receive research payments from managers in hard dollars or from advisory clients’ RPAs without sanction.
However, the relief is temporary – lasting 30 months from MiFID II’s implementation on 3 January 2018.
During this time, the SEC will consider whether new rules may be necessary or appropriate.
MiFID II’s telephone taping rules have also left COOs scratching their heads.
From a UK perspective, a significant development is the removal of the exemption from taping requirements for discretionary investment managers.
The new regime – which aims, amongst other things, to prevent market abuse – requires MiFID firms to record telephone conversations (including mobile conversations) which relate to the ‘reception, transmission and execution of client orders’. Internal calls – between sales and trading desks, for example – will be subject to the taping obligation where they relate to the handling of orders and transactions.
Whilst many managers already record fixed lines, capturing mobile conversations presents particular challenges – solutions are expensive to implement and monitor. So much so, in fact, that many managers are simply banning the use of mobiles for trading-related calls.
Mangers will also be obliged to keep a copy of trading-related “electronic communications”, which might include Bloomberg mail, SMS, WhatsApp messages, instant messaging and communications via certain other mobile apps.
All of this goes significantly beyond the FCA’s current COBS 11.8 taping regime. COBS 11.8 will be deleted and replaced by a new chapter 10A in the Senior Management Systems and Controls sourcebook (SYSC).
Again, the FCA has chosen to extend the rules to cover both MiFID firms and AIFMs when carrying on the activities of arranging (bringing about), dealing as agent or principal, managing investments, the portfolio management function in respect of AIFs and operating CISs. However, the FCA has – bowing, to pressure from the PE industry – included an exclusion from the taping obligations under SYSC 10A for discretionary portfolio management activities in relation to unlisted securities.
In addition to taking reasonable steps to record telephone conversations and keeping a copy of electronic communications, in-scope managers must take steps to prevent employees from making, sending, or receiving relevant telephone conversations and electronic communications on their own devices which the firm is unable to record or copy.
Records must be kept for at least 5 years and must be provided to clients on request.
MiFID II’s enhanced transaction reporting obligations may also present significant challenges for the hedge fund community.
Whist a volte face from the FCA means that the new rules do not apply to AIFMs – whether in respect of their fund management or managed account activities – they will impact managers which are MiFID investment firms.
MiFID II expands the scope of reporting obligation in the current rules to apply to a broader spectrum of trades and financial instruments. These can be broadly categorised as equity and non-equity transactions. They include shares, ETFs, bonds, emission allowances and derivatives.
The expanded scope includes financial instruments which may be admitted to trading or are being traded on a trading venue including on a Multilateral Trading Facility (MTF) and on an Organised Trading Facility (OTF).
OTF is a new concept introduced by MiFID II. It is a multilateral system which is not a regulated market or MTF and in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives takes place resulting in such financial instruments.
Reporting must be made within a T+1 period. The obligation under MiFID II is expanded to apply to a financial instrument which references another financial instrument which is traded on a trading venue or references a basket or an index of such financial instruments which are referenced on a trading venue.
The information to be reported under the new rules is extensive and detailed guidance has been produced to assist managers in meeting their obligations.
Additionally, the report will need to include an identification of the counterparties to the transaction using their LEIs (see below).
Under current UK rules, managers may (and many do) rely on their brokers to transaction report on their behalf.
Whilst MiFID II admits of the possibility that this may continue, the new conditions imposed in respect of such arrangements going forward (including the requirement to enter into a “transmission agreement” and to provide detailed information with the order) will make it more likely that managers will report transactions themselves through an Approved Reporting Mechanism (ARM).
An ARM provides the service of reporting details of transactions to EU member state national competent authorities or to ESMA on behalf of investment firms. The obligation to make the reported information public is done by entering into Approved Publication Arrangements (APAs). APAs are responsible for publishing details of executed trades to the market on behalf of firms as close to real time as possible.
There are a number of ARMs who provide an APA service. Hedge fund managers who rely on a third party such as an ARM for transaction reporting, must take reasonable steps to ensure that the report is timely, accurate and complete. Hedge fund managers who are in scope of the obligation and have not done so already, should make urgent arrangements, given the proximity to the go live date of MiFID II, to facilitate their reporting obligations and testing any processes they have put in place prior to implementation date.
Legal Entity Identifiers – “LEIs”
Firms which are subject to the transaction reporting obligation must obtain an LEI. Such firms will therefore not be able to enter into transactions with counterparties who are eligible for but do not have a LEI.
LEIs are 20 digit alphanumeric code generated to identify parties to a transaction. Counterparties have already been using LEIs as part of the reporting obligation of derivative to Trade Repositories under European Market Infrastructure Regulation (EMIR).
MiFID II expands the requirement for an LEI to a “decision maker” in relation to a transaction. ESMA’s guidance note sets out examples of entities which now need to acquire an LEI under MiFID II. They include investment firms that execute financial instruments on behalf of their client and investment managers acting under a discretionary mandate on behalf of their underlying clients.
An LEI can be acquired from a Local Operating Unit who issues the LEI or from a Registration Agent. A Registration Agent helps legal entities to access the network of LEI issuers and can partner with one or more LEI issuers.
The costs of obtaining an LEI vary. There is typically an initial registration charge. LEIs need to be maintained annually so to ensure that their data is accurate. There is therefore also an annual maintenance fee that will be due.
Since there is no requirement to obtain an LEI from an operator within a legal entity’s own country, there is opportunity for market participants to shop around according to their requirements and pricing preference.
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