Firms in the region either embrace, endure or avoid MiFID II’s LEI requirement, but must accept that it’s not just regulations from the US which now have a profound extraterritorial impact.
In 1972, during President Nixon’s visit to Beijing, the Chinese Premier Zhou Enlai was asked about his viewpoint on the French Revolution – an event almost 200 years prior. His now infamous answer was that it was “too early” to tell.
It certainly won’t take two centuries to assess the impact of Europe’s MiFID II (2nd Markets in Financial Instruments Directive) on Asia-Pacific markets, though it may take a few years. There’s been lots of early impressions and analysis, but for some pockets of the market, implementation has only just begun.
MiFID II is one of the broadest and most complex pieces of securities legislation ever launched. Its scope and reach are significant, and it has the potential for many unintended consequences. But many market participants across Asia-Pacific are still trying to gain a deeper understanding of the extra-territorial impacts of the legislation.
While trading and market access issues have tended to dominate the agenda, two post-trade issues have achieved similar prominence in the region: the mandatory use of LEIs (legal entity identifiers) to identify a trading counterparty and the rules on unbundled commissions.
Mandating the LEI
At the G20 Summit in Pittsburgh in 2009, it was agreed that, in the wake of the near meltdown of the global financial system and the glaring gaps that limited the ability of regulators and firms to monitor and respond to systemic risk, that a globally standardised numbering system was needed to accurately identify every entity that trades in financial markets. Nine years later – with almost one million LEIs now issued – the LEI remains an incomplete effort. In Asia-Pacific, some financial firms misunderstand the global nature of new regulations and continue to try and circumvent adoption.
In Europe, the requirement to obtain LEIs was included in MiFID II and the mantra “No LEI, No Trade” neatly encapsulates the regulation. The EU, and its regulator ESMA (the European Securities and Markets Authority), have fully embraced the concept. Other regulators globally, and especially those in G20 countries, are also adopting the policy. Although regulators across jurisdictions are aligned, industry attitudes vary, from supporting to enduring to avoiding the requirement.
Most firms are in the first two groups, but a noticeable minority are not registering for or renewing their LEIs. These buy-side firms are regulated companies that have nothing to hide, but they do have an aversion to their trading activity being visible to European regulators to whom they have no reporting obligation. The tactic they have adopted instead is to trade European stocks with non-MiFID II firms. Although this provides a quick-fix solution to the reporting issue, it does raise several questions.
First, if the broker/dealer does not insist on having an LEI, will the exchange permit a trade without one? Second, how can these firms ensure best execution? And third, when the trade is processed by a CSD (central securities depository) or a CCP (central counterparty clearinghouse) in Europe, will it be accepted with a missing LEI? These issues are unclear, and must be resolved.
Plus, in addition to the embrace, endure and avoid contingents, we need to add those that are “unaware”. In the days since MiFID II became reality, it’s become clear some firms in Asia-Pacific have only just become aware of the regulation and its extra-territorial impact.
The financial sector has long been accustomed to US legislation having a global impact. Regulators, policymakers and industry trade associations outside Europe now need to start treating EU regulations the same way.
In addition to the LEI requirement, the longer-term post-trade issue impacting the market participants is the requirement to unbundle research fees and execution commissions. Because of this rule, buy-side firms based in Europe can no longer receive so-called “free” research, which is classified as an “inducement” to trade. Moving forward, all research must be requested and paid for.
Buy-side firms must now adopt this new requirement in one of two possible ways: the “P+L model,” where the firm buys and pays for research from its own funds, or the “RPA (research payment account) model”, where client funds continue to be used to buy research. The P+L model is certainly the most popular, however some firms will adopt the RPA model. Complex global asset managers can use both.
Irrespective of the model, the broker/dealers that they use – wherever they are in the world – must be able to facilitate the new commission payment model adopted by the buy-side. As a result, broker/dealers globally must comply so their client can demonstrate compliance to their local regulator. The brokers must also analyse the commercial factors, including whether clients trading with them are effectively “paying” for research, if they’re getting best execution, whether they’re paying for their research with their own money, how they should price the research and how billing will work.
The immediate impact on a broker in Asia-Pacific with clients in the EU is that the broker needs to be ready – and there is evidence many just aren’t. Those are ready now have an immediate commercial advantage.
The unbundling of research and execution commissions isn’t a purely technical issue. Longer-term, it’s a cost issue for the buy-side and a revenue issue for the sell-side – and cannot be ignored. Now is the time for market leaders to analyse how to avoid future implementation issues and accept that new regulation will often have a global impact.
Tony Freeman is Executive Director, Industry Relations at DTCC