The past year has witnessed a flurry of activity as regulators have been finalizing the Markets in Financial Instruments Directive (MiFID II) Regulatory Technical Standards (RTS), which were published on September 28. While consensus exists that there were few surprises, MiFID II has deservedly been labeled a game changer. This article explores several components of the Directive that are set to fundamentally change the way investment managers run their businesses and the preparations firms should be making ahead of the deadline, currently Jan. 3, 2017, though that appears likely to be pushed back at least a year.
The state of MiFID II readiness varies across the spectrum of buy-side firms. While it may be expected that the largest investment managers have the capacity to prepare well, there are undoubtedly many smaller firms that could struggle. Furthermore, the impact will be felt by both European and non-European businesses, as MiFID II has implications for non-EU firms if they buy and sell securities on European venues. While an investment manager may not trade any MiFID II-affected asset classes in Europe, it will be affected if the regulatory framework applies to its sell-side broker-dealers.
Compared to the current MiFID, MiFID II notably extends the scope of the existing reporting regime to all financial instruments traded on Multilateral Trading Facilities (MTF) or Organized Trading Facilities (OTF) and will apply to a greater number of asset classes. It will also triple the number of reportable data fields, from 26 presently to 65. For buy-side firms this means making decisions now about which electronic, MiFID II-compliant platforms they wish to use and making the necessary operational changes to their current processes in order to connect to them. For firms with less trade process automation that still trade routinely by phone, the impact will be considerable.
MiFID II will also subject buy-side firms to new requirements for best execution. Traditionally, firms would be required to produce a report of aggregated costs for the end investor that would be distributed on a pro-rata basis. However, MiFID II will require them to record the costs associated with executing each trade and report this back to the client. For some, this will mean major reconfiguring of their operating models, to ensure that broker fees and commissions are recorded within the reports to be sent to clients. Defining and implementing the systems and processes needed to meet these requirements will be complex, with the need for multiple suppliers of data sources to collaborate.
Buy-side firms will also be subject to transaction reporting requirements to an Approved Reporting Mechanism (ARM) but, similar to reporting of derivatives under EMIR, they will be able to delegate or outsource this process to a third party. This can be done by their sell-side brokers or via a Trade Repository such as DTCC GTR or REGIS-TR. Whichever option they chose, an automated interface will be required in order to transmit the required data for reporting. Firms that choose to outsource the reporting to their sell-side counterparty will need to consider whether they are comfortable sharing detailed information about their own clients and the investors whose funds they manage. They will be required to identify and capture the details of client, investment decision maker, algorithm used for investment decision, execution decision maker, algorithm used for execution and short selling indicator. The sheer volume of transactions and data points that will need to be reported will create a need for implementing best practices for automated data management across the entire business.
Currently, many buy-side firms still depend heavily on manual processes in the back office. For such businesses, the new requirements will introduce new scalability issues and may lead to an increased risk of human error. For those firms that are not yet using automated processes to manage the requisite data, they should start thinking now about building the appropriate interfaces necessary for transaction reporting under MiFID II.
It is clear that with the advent of MiFID II and the consequent changes to operational infrastructures from pre-trade to post-trade, buy-side firms are going to be faced with an unprecedented level of complexity and indeed choice regarding the sourcing of liquidity, execution, and transaction reporting. Equally, there will be greater scrutiny on execution performance placed upon firms by their clients and indeed regulators. They will need to explain and to demonstrate the measurement of this performance, incorporating transaction cost analysis tools for both pre- and post-trade processes.
Recent comments from the European Commission suggested that a delay to the implementation of MiFID II is desirable given the vast changes that firms need to make to their IT systems and operational infrastructures. This is particularly the case for buy-side firms, especially that large proportion of which still rely on legacy systems and manual processes – for these the challenge is significant. At present, this is simply a proposal and as such firms would be wise to continue making preparations to comply with the pre-agreed implementation date of Jan. 3, 2017. These preparations should begin now, with an in-depth analysis of exactly what data, both pre- and post-trade, will need to be reported, followed by an assessment of current reporting practices, to allow sufficient time for changes to be made. Any delay, if there is one, should be considered a lifeline rather than an opportunity to put the issue on the back burner – authorities are unlikely to forgive laxity on the part of any firm squandering the opportunity to get it right.
Carsten Kunkel leads SimCorp’s Regulatory Centre of Excellence.
This post was originally published on TABB FORUM.