European regulation hits US investment firms
It is now common knowledge that investment firms have been granted a one year reprieve in terms of compliance with the Markets in Financial Instruments Directive (MiFID) II, as rule changes won’t come into force until 3 January 2018. While firms have plenty of time to comply, they should be thinking now about how to leverage reporting practices they have in place under regulations such as the European Markets Infrastructure Regulation (EMIR), and look for synergies across these regulatory regimes to simplify their overall reporting processes.
Whilst MiFID II is a Directive imposed by the European Commission, in a global marketplace, it holds implications for US investment firms outside of Europe who buy and sell securities on European trading venues. However, a transaction does not need to have been executed on an EU trading venue to be subject to the reporting requirement. For example, derivatives traded outside of the EU where the underlying asset is traded on an EU trading venue will have to be reported. The regulation will also capture branches of European investment firms located in the US when they make a transaction in a reportable instrument.
MiFID II implementation is dependent on a large amount of EU-level two legislation. It is expected that drafts of this are expected to be finalised in the coming months and will present significant strategic challenges and operational issues for both EU and many non-EU investment firms, such as US buy-side firms trading European securities. Despite the fact that firms are awaiting clarification on the technical details, it is recommended that they begin to familiarise themselves now with the requirements of the Directive and the expanded scope of asset classes that will have to be reported. In doing so, many buy-side firms will find that their current reporting capabilities are not robust or flexible enough to support the increase in volume of reportable data and that they may need to make upgrades and changes to their systems to ensure they are able to cope with the new rules.
Not only will MiFID II extend the scope of reporting beyond equities to other asset classes, it will mandate two types of reporting. The first will be the requirement to report the trade which must be submitted in near real time with information on the price and size of the trade. The purpose of these reports is to provide investors with indicative prices when they buy and sell securities. The second is transaction reporting, which will extend the current 25 reportable fields to 65, and which must be provided to regulators via an Approved Reporting Mechanism (ARM) on a T+1 basis. The transaction reporting requirements under MiFID II are integral to regulatory efforts to detect potential market abuse and are considered one of the most onerous components of the Directive.
Under the first iteration of MiFID, applicable to equities only, and trade reporting under EMIR, buy-side firms have been able to delegate reporting to their brokers. However, given that the amount of data that must be reported is going to increase significantly, buy-side firms may be better off reporting themselves. Choosing to delegate reporting to a broker could be made all the more burdensome for fund managers who have relationships with multiple brokers, which would mean establishing separate agreements with each of them and building individual mechanisms to send and receive the data, which could potentially lead to reporting errors such as data being dropped or corrupted in movement. And there will be no leniency on the part of regulators. For evidence of this, one needs only look to the number of large, well known brokers that have faced multimillion dollar fines recently for reporting errors under MiFID, dating back to 2008. What is more, falling foul of regulations through inadequate reporting practices would do no good for buy-side firms when it comes to marketing and selling their funds to investors.
Furthermore, with the emergence of cyber attacks threats and security breaches fund managers may be inclined to report directly. By doing so, they are not at risk of disclosing personal data, such as the identifier for the person that made the decision to deal, and identifier for the individual executing the trade, that could be compromised in the reporting process.
So, the message is clear, the additional levels of granularity required in MiFID II reporting will represent major operational challenges to buy-side firms. As such they need to be preparing now for the new reporting obligations. They should start by looking at what reporting systems they currently have in place for compliance with existing regulations such as MiFID and EMIR and establish whether they can be developed to support the more onerous reporting requirements of MiFID II. These systems should be able to understand the transaction lifecycle, be designed to support the data, enrich and reconcile it before reporting it to trade repositories and ARMs. Regulators and policy makers have made it clear, there will be no grace period for firms who have not implemented the appropriate systems and processes by 3 January 2018 – the time to prepare is now.