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Banking

Roundtable: The controversy and confusion over Mifid

Banks, exchanges, associations and lawyers consider the problems and debates surrounding Mifid implementation

(This article appears courtesy of International Financial Law Review,  sign up for a free trial here)


Cliff Dammers, IFLR

Welcome everyone. We have a little bit of a problem here because the Markets in Financial Instruments Directive (Mifid) is a moving target. By August, when this roundtable hits people's desks, some of the consultation papers will have closed – we just got a new paper today. Maybe we could start by talking about key dates and instruments. Michael, could you to tell us about the implementation dates in the Directive for the level two measures.

Michael Raffan, Freshfields

The Directive was adopted in April 2004. Since then there have been various iterations of the level two measures, one a Directive and one a Regulation. The European Commission published its final draft Regulation and Directive on June 30 2006. They are being reviewed by the European Securities Committee, who can only make changes if they think the regulations exceed the powers of the level two measures. We expect those to be adopted in September this year. Mifid including the level two measures has to be transposed by the end of January 2007, which means final regulations and rules in each of the member states need to be in place by then. The rules must come into effect by November 1 2007, which is when firms start having to comply with them.

Cliff Dammers

Are member states, starting with the UK, going to meet that timetable? With other Directives in the Financial Services Action Plan, we've had a certain amount of slippage. What do you hear from your members, Mike?

Michael McKee, BBA

The view is that many member states are unlikely to meet the deadline. Some of them have been open about that. The Dutch, for example, have said they cannot do it before early 2008. But we are hearing that a number of other jurisdictions also have problems, including most of Scandinavia, probably Spain, and Poland. The UK is adamant that it will meet the deadline unless something happens at the wider EU level, in a political sense, that moves the goalposts.

Cliff Dammers

Are firms in the UK prepared for the new business rules? Are they going to be ready on November 1?

Peter Snowdon, Norton Rose

A lot of our clients are nervous, particularly on the retail side. Some of them are holding off implementation.

Anthony Belchambers, FOA

They can and should be setting up their project teams. They have level one and level two finalized, so they can advance to this point. The difficulty is the wall of regulatory uncertainty after that point.

Patrick Buckingham, Lehman

I'm heavily involved in our internal Mifid implementation project and regulatory uncertainty is undoubtedly the biggest problem we are currently facing. We face additional uncertainty in relation to our branches in the EU because so many member states appear to be well behind the UK when it comes to implementing Mifid. The recent UK Financial Services Authority (FSA) discussion paper on best execution has contributed to the overall level of regulatory uncertainty. This paper wasn't what anyone in the industry expected and has raised a number of unexpected issues. As a result we, and I understand many other institutions, have downed tools on our best execution work until such time as the regulatory position becomes clearer.

Cliff Dammers

Maybe this is a good chance for Mifid Connect to get an advertisement.

Anthony Belchambers

Mifid Connect is a group of 11 trade bodies that represent about 80% of the UK financial services community. It represents wholesale, retail, buy and sell side, small and large. It includes the whole range of the financial services' trading chain across a spectrum of markets and products, which I think is a first. Its purpose is to do two things. The first is to try to put a practical industry stamp on implementation. We recognise the FSA's authority, but feel it is critically important that implementation marries up commercial needs with regulatory responsibilities. The second thing it is intended to do, through the issuance of guidance and survival guides, is to make sure that we reduce legal risk as much as possible. We want to make sure that the process of implementation is cost-efficient. In a sense we are lucky because this member state mirrors the Mifid implementations more than any other member state.

Cliff Dammers

The British Bankers' Association is providing the secretariat?

Michael McKee

Yes, that's right. We have asked the FSA to give us some indication of its regulatory views on a few particular areas. For example, we targeted customer classification early, even though it is seen as one of the less exciting elements of Mifid. When you are running one of these projects, so many of your obligations hang off the way you classify your customer.

Chris Bates, Clifford Chance

The thing many people didn't get with Mifid as compared with FSMA implementation, which was widely billed as old wine in new bottles, is that Mifid is new wine in new bottles. You are not just trying to deliver the same result by a different means. Mifid has limited transitional and grandfathering arrangements. There are some, but they're not very extensive. You will need new documentation. The other curious thing about the timetable is that we are already beginning to talk about the commodities review, the extension of transparency in other markets and the other reviews, before appreciating the full implications of Mifid. The next 12 months will be a very demanding period for firms.

Adam Kinsley, LSE

The technology challenges are large, and they don't just affect firms. It affects exchanges and regulators. Transaction reporting requirements mean that the regulators are going to have to start communicating with each other; they do not do that at the moment. As far as I'm aware, there isn't a central plan or IT project to build that. Actually, you could find that while the firms can get ready in 12 months (we are three-quarters of the way through a technology programme which will finish in May, giving us good time for testing) the systems aren't there so it is impossible for firms to meet the requirements in the way envisaged by the Directive, with information flowing not from firm to regulator, but between regulators.

Cliff Dammers

I want to emphasise the point made by Anthony, that while big changes are required in the UK they are much bigger on the continent. Many concepts in Mifid are new to the continent. We have more experience with more sophisticated and varied markets. Doing away with the concentration rule in those countries is a major change – something we went through in the 1980s.

What statutory instruments are we going to get in the UK? We have the Mifid Directive and a level two Directive and Regulation. In the UK, we're going to get statutory instruments from the Treasury and FSA rules. Can we outline those so people know what to expect?

Chris Bates

Hopefully, the Treasury will have relatively little to do. This is a test of the FSMA statutory framework that was designed to be very flexible. It should be possible to do most of what is required without primary legislation or much in the way of statutory instruments. There will be changes to the regulated activities order, particularly to address the scope of the regulatory regime and to deal with the regime for regulated markets and investment exchanges. Alongside that, one thing we haven't mentioned is the parallel implementation of the Capital Requirements Directive, which takes effect from January 1 2007 and overlaps with Mifid. There is a complex set of rules in the FSA's recent consultation paper, trying to align the two regimes and to allow firms to manage the transition.

Michael McKee

Our initial reaction was that it is a pretty good attempt to marry two rather large, complex and different sets of requirements.

Cliff Dammers

We have mentioned various discussion and consultation papers. What will still be outstanding when people read this in the IFLR August issue? The Treasury's consultation paper has been closed.

Michael McKee

Yes, but feedback will be due in the autumn. The consultation papers likely to be current in August will be on the market-facing side of Mifid, on the systematic internaliser obligations. Also, in October, there will be an important paper on the conduct of business side.

Peter Snowdon

Picking up on the point about one of these instruments being a Regulation, regardless of whether member states implement in time, that Regulation will come into effect on November 1 2007.

Cliff Dammers

Will that work if the Regulation is directly applicable and the Directive is not? If it hasn't been transposed? How connected are the two?

Peter Snowdon

In principle, the Regulation is directly applicable and quite clear. Whether it can stand alone without the Directive is another matter.

Cliff Dammers

The Market Abuse Directive (MAD) was implemented with the Regulation, even though no members states had transposed the Directive.

Patrick Buckingham

This is different though. In MAD, the Regulation was just a safe harbour, so you either got yourself in it or you didn't. It did not mandate you to do or not do various things. The Regulation for Mifid is different, it does require you to take action.

Michael McKee

The issue with the Regulation is not so much its interdependence with the Directive, because generally speaking they deal with different issues, but the fact that there will be no market structure on that date. That will partly be the fault of the regulators, who will not have got their act together to make Mifid a living piece of legislation.

Chris Bates

We would be concerned where the regulation creates free-standing obligations, rather than defining elements of obligations yet to be created. There are some exceptions, the record-keeping provision for example, but for the most part it defines terms that only come to life once they have a wrapper delivered by the national regulatory framework.

Patrick Buckingham

It gives you a commodity derivatives definition that is clearly very important to anyone doing commodities business.

Cliff Dammers

That brings us nicely into scope. One big change with Mifid is that commodities are now covered.

Anthony Belchambers

The background to this is that the Investment Services Directive (ISD) did not include commodities derivatives because at that time there were a lot of small, specialist dealers that could conduct business around Europe quite comfortably. As far as they were concerned, inclusion of commodities derivatives in the ISD would have brought no benefits. That all changed. Banks bought up a lot of these specialist dealers and member states began to look at that space and consider authorisation and licensing requirements. A review was conducted by the Commission at the behest of the member states, and as a result it decided to include commodity derivatives. The only question was whether this heavy, prudential burden of banking-type regulation, largely built around big bank business – deposit taking, securities dealings and an underlying financial business – was too much for the commodities dealers. The underlying business of most specialist commodities dealers is trade and commerce, not investment. We're talking about BP, Shell, even those regulated by the FSA, such as Amalgamated Metal Trading. There is a curious approach within the FSA rules that says if you are a metal trader, you get near full-on rules, but if you are an oil trader, or in the oil and energy space, you get a much lighter code.

The bottom line is that if this prudential regulation makes dealers seriously uncompetitive in the world outside the EU, we all have a very serious problem. Geneva is looking with great interest at what is happening here and a number of energy joint ventures are already setting up there. The Commission could score a real own goal here, particularly as the US doesn't have anything like this regulation of the commodities business.

Chris Bates

In the short term, it's a problem for the non-bank, non-securities firm people who want to participate in this market. You can argue that for the banks and securities firms, the Directive will do what it says on the tin – it will give them a broader passport to tackle the licensing rules that have grown up around Europe. There will still be gaps; they will probably still need top-up licenses, but on the whole it should be easier.

The problem is for those outside that group: oil companies and energy traders. Those firms will find that the rising tide of authorization requirements in Mifid means they will not get an effective passport. They will fall within exemptions that are designed to protect them from these prudential requirements in the short term, but do not give them the benefit of a passport. It will affect non-EU entities trying to be used as booking vehicles for business with EU counterparts.

Cliff Dammers

Focusing on the over-the-counter derivatives (OTCs) business, this is going to require change in regulated activities orders. What will that look like?

Patrick Buckingham

It was drafted at the end of last year, so it was done within a slightly unclear legislative landscape. It's going to need some more work so that it reflects the final form of the level two Regulation.

Anthony Belchambers

The regulators are going to have to make some amendments to bring it in line with level two, which defines commodity derivatives. For example, the spot definition from the current draft sets a maximum seven-day delivery period. Level two talks about two days or longer, whatever the market traditionally regards as spot contracts.

Michael Raffan

The approach HM Treasury took in the consultation paper at the end of last year was to retain the existing definition. Now there is the Mifid definition as well, so you have double-tier definition that is horrendously complicated. The question is, does the Mifid element apply just to Mifid investment firms, and the pre-existing definition apply to non-Mifid firms?

Chris Bates

The mess is less problematic than it could be because the UK has a liberal approach to the treatment of cross-border business, which we hope will not be interfered with by Mifid, although some question marks are being raised. The impact in other countries, where some have regulated commodity derivatives and some do not, is very unpredictable. Will they take the extended scope, but not the exemptions? Will they invent their own exemptions? How will they apply that to cross-border activity? All of these questions are open, and this is where we could see difficult issues for firms that don't benefit from the passport.

Anthony Belchambers

The big problem for commodity derivatives is that the underlying product is not financially regulated. If you look at derivatives in every other space, the underlying product is regulated, so it is easy for the regulators because they know that both aspects of the derivative are regulated. The problem with commodities is that you then have to draw a line between what is a derivative and what is a forward, and make sure that you cut out forwards.

Michael McKee

That, of course, is the same issue that arose with foreign exchange (FX).

Cliff Dammers

That's the next thing we're going to talk about. There's a question mark in the FX world, where the underlying is not a physical commodity and not regulated. Are FX forwards and swaps going to be covered by Mifid?

Michael McKee

There is good news in the UK about that. We worked with the joint-FX Standing Committee run by the Bank of England and argued that the position under FSMA could be retained under Mifid, that FX and forwards would be outside of Mifid as they are outside of FSMA. The Treasury has indicated to the joint-FX standing committee that that is now its view as well.

Cliff Dammers

What happens if you're an FX trader in London with a European client in a country that takes a different interpretation?

Michael Raffan

Home state regulation applies, if the bank in London is dealing with a client in France or Germany.

Cliff Dammers

What about a London branch of a German bank?

Chris Bates

That is really a securities firm problem, not a banking problem. Banks get a broad passport regardless of whether foreign exchange is in Mifid or out of it. The problem has been that there was a reluctance to give an equivalent passport to securities and non-bank investment firms. They can only get the passport for connected FX, or FX connected to other activities. There are some countries that regulate free-standing FX. Italy is probably the best-known example. That question won't go away, home state control or no home state control. The Italian advice you'll get will still say something like 'we have a licensing regime, do you have a passport? If not, how are you going to address that?'

Cliff Dammers

Let's move on to the effect on overseas exchanges and firms. What will be the competitive impact, leaving aside any questions of mergers?

Adam Kinsley

For us, the ISD has proved quite adequate in attracting remote members. Because the UK has always been open and accepted a passport, it hasn't caused us problems. I think there were issues going the other way, when UK-based firms wanted to operate in some of the Mediterranean countries. That was and is more difficult. Mifid will certainly make it easier for firms to become direct members of the Spanish or Italian exchange by virtue of their passport.

Cliff Dammers

What about non-EU exchanges who are trying to attract business? They're presumably left out of this scheme?

Adam Kinsley

Yes, they're left out of this. It doesn't change anything.

Chris Bates

That was what everybody believed to be the case, that the existing arrangements for dealing with non-EU firms or exchanges would continue. Most member states have come to some sort of accommodation with cross-border business – whether it is the German one, with an exemption regime for some foreign firms, or the UK approach, with its broad overseas person exclusion. It has been suggested that there is a large change under Mifid, that it applies not only to firms with their head office in the EU, but also to firms that provide investment services there, whether through a branch or on a cross-border basis. That would be very counter-productive for the EU because there has to be a way for non-EU companies to operate through branches or on a cross-border basis into the EU for institutional business and for them to offer the services of exchanges and other types of intermediaries.

Anthony Belchambers

As the EU becomes more of a single market, those independent member state arrangements will be challenged. If an individual member state gives a third country rights of access that are not available to other member states, the Commission may decide to stop them. That creates a real problem for the City as a global centre. There is a real risk that we might be creating barriers to our trans-Atlantic and third country business. This could go badly wrong.

Chris Bates

This is why it is essential we put forward the argument to third countries in the current trade round aimed at removing barriers to cross-border institutional business. The industry cannot advocate that and then find that those barriers are being raised within Europe. It just does not make any sense.

Peter Snowdon

There is a tension between the wider concept of EU law and this idea of a single market, and the ability of people outside the single market to access it. All EU citizens have a right to travel to other member states and to work. That does not extend to US citizens who live in London. I think that is the way the Commission tends to see these things. Gradually these loopholes will be closed down.

Anthony Belchambers

That principle works in reverse. A third country cannot give a right of access to a particular member state that is greater than the right afforded to all other member states. Several agreements already do this, such as the CFTC part 30 rules, which cherry pick a number of member states. There are some real nasty political issues sitting outside there.

Cliff Dammers

Let us turn to some of the substantive provisions of Mifid, such as conflicts of interest. Obviously, in many regulatory systems there are already rules covering this, and firms have their own internal regulations, but Mifid will require firms to structure themselves in a certain way and to inform clients of this. It has already raised questions. Patrick, how do you see this?

Patrick Buckingham

I have reviewed the FSA's consultation paper and it has stuck to intelligent copy out. We did not get any surprises. By and large, I am not particularly perturbed by what I have seen so far; it should sit fairly comfortably with our existing arrangements. We will have to provide information to clients on our conflict arrangements, but it is not as bad as it looked like being six months ago. I still have some concerns about the status of disclosure, but I am hoping that the way we currently manage conflicts will be broadly consistent with what is required under Mifid.

Cliff Dammers

Mike, is that what you have heard from your clients?

Michael Raffan

Yes. With the heavy emphasis on conflicts in the last few years most of the bigger firms have already reviewed their procedures. A lot of that work will not need to be repeated under Mifid. There will be some additional obligations, particularly in relation to record keeping. In level one disclosure is a last resort when conflicts cannot be managed otherwise, whereas in the UK, certainly from a legal perspective, disclosure has been one of the front line weapons in managing conflicts. There was originally some concern about the tension between these two approaches and that firms would not be able to rely so much on disclosure. However disclosure will remain an important element of conflict management procedures and firms can use it in conjunction with other mechanisms.

Peter Snowdon

The FSA has been quite sensible on disclosure. I think that level two was quite tight on the extent to which you can use disclosure – some of the comments suggest it is absolutely a last resort, and if you use it once you should add it to your conflicts policy next time. There is still a degree of discussion here, but you will certainly be able to use disclosure less in the future.

Michael McKee

One thing we have got to remember is that the concept of conflicts is built on fiduciary relationships, and so is not recognised in much of Europe. It is an English law concept, and therefore lawyers, regulators and lawmakers in Europe often analyse conflicts in a different way. It is frankly much more sceptical.

Cliff Dammers

Turning to the next subject, let's talk about the new concept of best execution. I say new because it is new for most of our continental friends, though it is not in the UK. The FSA published a discussion paper on implementing the best execution rules in May that has stirred up quite a reaction here in London.

Adam Kinsley

Before we get to the discussion paper, it is interesting to think of the genesis of the best execution rules in Mifid, because you are right, we have them in the UK. Best execution was the subject of consultation here a few years ago, and the industry told the regulators to wait because Mifid was coming and might change everything. In the end Mifid did not do anything that different, because it borrowed from the consultation paper the FSA put forward. So these changes to best execution have probably been around for years, and they have only just been picked up and dusted down.

Anthony Belchambers

I have a real problem with the idea of best execution. The financial services community is the only economic sector where the regulator imposes a best execution obligation. Most price regulators in the other important economic sectors talk about fair price, genuine price and fair execution. But the concept of best, as far as I am aware, is unique to financial services. It has become such an icon of investor protection that nobody has the courage to ask whether the idea of best is actually something a regulator should consider. I know that is an impossible question.

So, moving on to the paper, the problem is that this was not something that came out of any formal consultation with the industry. It was a home-grown idea, for which the FSA went out to tender and retained IBM. And let us not fool ourselves; it forms a major plank of the FSA's discussion paper.

The problem with the IBM report is that nobody has seen the mandate. Until you see the question IBM was asked, you cannot define what the FSA's policy was in putting the idea of benchmarking forward. But it does suggest that there is a deeper commitment to benchmarking than many thought. Is this just an option? Can firms actually reject it? I do not read that into the use of the of the word option in the paper. It is clearly a preferred option on the part of the FSA, and therefore behind that stands a certain weight of policy.

Michael McKee

The FSA has had a best execution rule in place for some time. It focuses on the concept of an order, and the best execution of that order. There are a number of aspects of both Mifid and the FSA paper that begin to depart from those basic concepts. One key problem with the paper is it does not articulate any view on the scope of the best execution obligation. There are various statements that indicate that it is broader than just the equities market, and of course the dealer markets. There is a recital in the implementing Directive, Recital 69, which says that it applies when dealing on own account, and makes certain statements about that. But actually the degree to which the market is uncomfortable or comfortable with what the FSA puts forward could depend on their articulation of the scope of the obligation.

Chris Bates

Clearly the scope issue is critical to dealer markets. When people first looked at Mifid, best execution was not seen as a big problem. The level one text and indeed the draft level two pieces had that core concept of executing an order and therefore appeared to align with the existing UK arrangements. It seemed to be in line with the common sense idea that if you are in a service role, as opposed to an arm's length role, there should be higher duties.

The Directive also had some helpful provisions about client instructions, which many people drew comfort from in advance. Although scope wasn't entirely clear, they thought the client instruction concept would help, because we are doing what the client wants and so have less responsibility. But the discussion papers suggest that that assumption was wrong; that no comfort can be drawn from the client instructions provision.

The other troubling feature is the suggested alternatives. The paper suggests that firms can cut down their client list so they just deal with eligible counterparties, as though that was likely to be practical. Many member states are going to limit who can be an eligible counterparty, despite the Commission's rather generous approach. The paper suggests that the business can go on to MTFs or exchanges, or that firms can set up agency desks to deal with this business. Those aren't minor changes to the business; this is restructuring markets. If Mifid was about restructuring economically significant markets, you would think we would have known it by now. I trust and I hope that this is just an unintended consequence of Mifid.

Cliff Dammers

Let's be concrete. In today's world, if you have a client order to buy or sell a share on the London Stock Exchange, you have best execution if you send it to the stock exchange. And if you execute off the stock exchange, if your price is as good as or better, then you have met the price requirement for best execution. Does that safe harbour disappear now?

Adam Kinsley

I think the current rule is actually quite principle-based. It says that you should get best execution when you are trading – an agency obligation. There is a piece of guidance, I wouldn't say it is a safe harbour, that says if you match the best bid you have probably got best execution.

Arguably, best execution is not taking a price that is available but creating the price, putting liquidity into the order and trading patiently. Market convention has led to people becoming comfortable that best execution is giving prices that are acceptable. Mifid throws everything up in the air. For example, how do you define what a dealer market is?

Michael Raffan

The current rule does refer to price, and that is what best execution means for agency orders. The regulators were moving away from that to a broader concept of best execution, and that is what Mifid refers to with "best possible results".

Cliff Dammers

The industry fought for a broader definition.

Michael Raffan

And that is what has come through, which makes it even more bizarre that the discussion paper seems to focus purely on price, as if that is the only thing that matters. In the dealer market it ignores all the other factors.

Anthony Belchambers

In dealer markets one has to appreciate that the factors firms take into account will be personalised to their own cost base. So to try and standardise across the dealer markets is impossible because such individual assessments go into the business of making price.

Patrick Buckingham

I wonder if price benchmarking has its origin in the fact that the FSA realised it had a problem to solve for some dealer markets, specifically the markets for contracts for differences (CFDs) and spread betting, where retail participation means price is going to be the most important factor for a firm providing best execution.

Coming back to Chris's point, it is important that the FSA is open sooner rather than later about what is covered under order execution. There are respectable arguments based on the level one text that would limit the scope of the best execution obligation in dealer markets. Recital 69 of level two isn't very helpful, but arguably you need to read that recital in conjunction with level one (particularly Recital 33) to say that you will owe best execution when you have an agency or some other fiduciary-type responsibility to the client. Firms acting for their own account in dealer markets don't usually have this sort of responsibility when they deal with their clients.

On a separate point, I am not sure how one can realistically think of, for example, a structured OTC derivative as involving a client order. It is a bilateral contract negotiated between the two parties.

Chris Bates

If benchmarking is a solution, it is a solution for a very limited class of products. There are over 100,000 corporate bonds issued. Most bonds only trade a couple of times a day. Effective benchmarks for a large portion of bonds would be very hard. If we move into the other OTC markets you can see this is a solution which is really only capable of being applied to a small segment of the market. That then leaves the question, is there any alternative? The best execution paper seems to suggest that there isn't.

Anthony Belchambers

To be positive for a minute and defend the FSA to some extent, this is only a discussion paper. The FSA does see this best execution as an option. But if there is a consensus across the industry that this is not the appropriate way to go (benchmarking may have a place but it is a means of measuring one factor amongst many) and they are prepared to accept that position, we may not have too much to worry about.

Chris Bates

And then the FSA comes out with its long-awaited paper on the transparency of the bond market. In which it says that the market has no signs of market failure and shows highly efficient pricing. If this is a market which works, why the extra requirements?

Michael McKee

Yes, there is a huge disconnect between the discussion paper on bond market transparency and the most recent one on Mifid. There is going to be feedback from the BBA relatively soon.

Patrick Buckingham

There is also a disconnect with the systems and controls consultation paper, in the conflicts section. The argument in the best execution discussion paper is that there must be an inherent conflict of interest by virtue of a dealer's incentive to make profits. Yet if you look at the conflicts section of the systems and controls paper, it very clearly and correctly states that the mere fact that a firm stands to gain is not sufficient to give you a conflict. It also makes the point that a firm only needs to worry about conflicts of interest when its own interests conflict with a duty it owes to its client.

Cliff Dammers

Another area where there is major change in the way we do business is the new client-facing requirements. These include both client documentation and information and client classification and suitability tests. Patrick, are we going to have to repaper?

Patrick Buckingham

Our view is yes, we will have to reclassify and repaper the existing client base. That will be a large exercise. Perhaps the area where we have more concerns is the criteria used to classify clients under Mifid. We are a wholesale investment bank and a lot of our businesses operate at the moment on the basis that the top two customer categories – market counterparties and intermediate customers – are the ones we do business with. Our key concern, having done some preliminary mapping work internally, is that a segment of our intermediate customer base may not map across to the professional client category; specifically, some of the unregulated corporates. The principal reason is that the FSA has rather helpfully included listed corporate categories as intermediate customers under current rules. There is no equivalent of that listed corporate category within the Mifid professional client categories. There is a large undertakings test that sets out some quantitative financial criteria to qualify a client as professional. Those financial criteria are on the large side. What do firms do with those clients that don't fall neatly into the professional client category? It raises some significant strategic issues for wholesale firms. Do they accept retail clients for businesses for which previously there were no clients from the bottom client category? Or do these firms stick to the top two client categories under Mifid, albeit with the consequence that this may shrink the overall client base?

Cliff Dammers

One of the problems with a large undertaking definition in the Directive is of course SPVs. An SPV is a professional, eligible counterparty, but it fails the test. What do you do? Do you restructure derivative products? They are typically issued by and purchased by an SPV.

Patrick Buckingham

There is a separate category of professional client designed for SPVs. They are classified as other institutional investors whose main activity is to invest in financial instruments. It says explicitly, including entities dedicated to the securitisation of assets or other financing transactions. That is separate from the large undertakings test and is quite helpful.

Chris Bates

The other problem about the large undertakings definition is that it doesn't apply on a group basis. You could be dealing with the biggest group in the world and find that the subsidiary you are dealing with doesn't qualify as professional under the financial criteria. This means that a number of counterparties will fall into the retail category who had previously been classified as intermediates. The classification issue is exacerbated by the fact that under the current regime it matters less which side of the intermediate customer/market counterparty boundary a client is on, but in the new regime it matters a lot because of the best execution requirements and order handling requirements.

Patrick Buckingham

Clients can ask to be classified in more than one way, so that a client could ask to be professional for some things, retail for others, and an eligible counterparty for yet more things. The way the legislation is framed allows firms to decide whether or not they are willing to accept that request. There is an issue for firms as to whether or not they are going to agree to these requests from clients. Will firms be willing to allow an order by order, transaction by transaction approach to classification? Pressure for multiple client classifications is likely to come on sell side firms from portfolio managers. This pressure will reflect the nature of a portfolio manager's underlying client base.

The other thing is, with the opting up of professional clients to eligible counterparties, we are left in the rather difficult position of having to look to the home state of the client to work out which set of rules apply. Because member states have some discretion here, I am concerned that we could end up with a multiplicity of rules. I do think this is an area where CESR (the Committee of European Securities Regulators) could usefully seek harmonization.

Peter Snowdon

The eligible counterpart point is a real problem because it is a home state categorization. It is going to be very difficult for firms. This was quite a tough point when the draft was being negotiated. The Italians particularly had a thing about this.

Michael McKee

The French were also concerned. Indeed the original negotiation of Annex 2 of Mifid effectively puts in legislative form the results of a mediated dialogue between the FSA and the AMF in France over where the boundaries should be.

Michael Raffan

France has a very different view on investor protection than we do here in the UK. Hedge funds are an interesting category. They can count as professional clients, but a lot of offshore funds who are not regulated can only be professional clients by being classed as an institutional investor. For some reason that is excluded from the category of professional clients that can be opted up to eligible counterparty. A lot of hedge fund clients will not be able to be treated as eligible counterparties.

Patrick Buckingham

Some people think that may have been an oversight.

Chris Bates

The question is, who is the client? Can the manager be the client? That indirect customer issue is going to be significant. I know that many funds treat the underlying fund as the direct client for the account opening but there may be some scope to use the indirect client customer rule for regulatory purposes.

Cliff Dammers

Related to the client classification issue is the suitability test, because it is different for different categories. What are people expecting in this area?

Chris Bates

In wholesale, if you can get everyone into the professional category or above, the suitability test is much reduced. There is effectively no appropriateness tests so the only question is, are you giving advice? It is only going to be advice that triggers the application of suitability. Even for a professional or eligible counterparty, if you give them advice you have got to get prior information about at least their investment objectives, and record it. Firms will be much more conscious of trying to ensure that they're not giving advice. That's going to be important because a whole range of things, particularly in marketing, border on advice. Pitch documents contain information for prospective clients that is based on the client's potential circumstances, and the key question is whether they contain some form of recommendation to the client.

Michael Raffan

The other area where that applies is general sales and trading banter with customers. Salesmen will throw around ideas and suggestions, and it can be quite a fine line between that and a recommendation.

Patrick Buckingham

Some firms are going to find it hard to square this with their sales and trading materials, because there is an interplay with the MAD. Firms like us who produce sales and trading notes that are not branded as research proceed on the basis that they are personal recommendations carved out from the research recommendation definition under MAD. Of course, a personal recommendation is the hallmark of investment advice under Mifid. We may have to live with the Mifid suitability requirements as the lesser of two evils. With other materials, I wonder whether it will be enough to put in a disclaimer to the effect that investment advice is not being provided.

Chris Bates

If that's right, this would involve gathering at least some information from those counterparties doing the same. We need to reach some agreement about how much information you need in order to send something which might be construed as a personal recommendation to a client. One would hope that because of the nature of the materials and the client, one didn't have to have a great deal of information about their investment objectives.

Peter Snowdon

It also underlines the importance of the FSA text, because if they go too far it can cause all sorts of problems.

Patrick Buckingham

In this area, there is definitional overload. It is difficult to escape the fact that there is an interplay here between a number of concepts. You have the MAD research recommendation, Mifid investment advice, Mifid marketing communications, Mifid investment research, and then all the domestic FSA research definitions. I am slightly concerned about understanding the boundaries of these concepts and the extent of any overlap. I also hope the FSA seriously thinks about rationalising some of the definitional overload, because it is becoming complicated.


Cliff Dammers
IFLR consulting editor

Cliff is the ex-secretary general of the International Primary Markets Association, now part of ICMA, and IFLR's consulting editor

Patrick Buckingham
Lehman Brothers

Patrick practised as a solicitor at both Slaughter and May and Clifford Chance before joining Lehman Brothers in 2004 as European Regulatory Counsel

Adam Kinsley
London Stock Exchange

Adam was made the director of regulation at the LSE in June 2006, bringing together the exchange's regulatory strategy and trading services functions

Chris Bates
Clifford Chance

Chris is a partner at Clifford Chance in London and a member of the Financial Services Authority's practitioner group on the market abuse regime

Michael McKee
British Bankers' Assciation

Michael is the executive director of wholesale and regulation at the British Bankers' Association, which represents 218 organizations in 60 different countries

Anthony Belchambers
The Futures and Options Association

Anthony is the chairman of the Futures and Options Association, as well as being involved with the joint venture Mifid Connect

Peter Snowdon
Norton Rose

Peter is a partner in the London office of Norton Rose and used to work in the general counsel's division of the Financial Services Authority

Michael Raffan
Freshfields Bruckhaus Deringer

Michael is the head of the financial services group at Freshfields Bruckhaus Deringer in London

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