Heralded as the most significant European Union legislation for the financial services sector since the Investment Services Directive in 1995, the Markets in Financial Instruments Directive (MiFID) will fundamentally change the relationship between investment firms and their clients.

MiFID represents the final stage in creating a single market in financial services. It extends the number of services that can be passported to other EU member states without additional local approval, as originally outlined by the Investment Services Directive (ISD), and brings the governing of regulated markets into greater harmony.
ISD-compliant firms will be affected, along with investment banks, commodities firms, futures and options firms, corporate finance firms, stockbrokers, broker dealers and portfolio managers. Retail banks and building societies will also fall under MiFID’s scope, but to what extent is currently unclear, as it will only affect specific parts of their business, such as the sale of securities.

The directive, which is due to be implemented in November 2007, will also mean that the Financial Services Authority (FSA) will have to review and amend much of its current regime, which could have ramifications for firms not directly affected by MiFID.

New growth model

According to consultants Capgemini, the number of equity trading venues could rise as a result of MiFID. Multilateral trading facilities and systemic internalisers (investment firms that trade off their own account with clients in an “organised, frequent and systemic manner”) will rapidly emerge as the new pan-European trading model.

Other models focusing on specific stock sectors will also experience increased growth and popularity. Although issuance and admission will continue to be carried out by regulated markets, the consulting firms predict that liquidity in top stocks could move elsewhere, encouraging competition between tr ading venues. On the downside, existing exchanges may find their liquidity eroded by new entrants not hampered by legacy business practices.

MiFID also aims to offer increased regulatory protection to clients. Not only will the category of client ­ currently private customer, intermediate customer and market counterparty ­ be re-classified to retail client, professional client and eligible counterparty (ECP), the level of regulatory protection will be different as MiFID imposes more obligations on firms when doing business with those which have chosen professional status. Even business with ECPs will be more controlled.

Additionally, clients will be able to choose overall, or on a deal-by-deal basis, whether to be treated as a professional, retail client, or an ECP. As a result, customers could fall into different categories in respect of different services or products.

Hidden treasury

As long as a treasury department is trading for its own business, it will be excluded from MiFID’s scope. But although the directive’s impact on non-financial sector firms will be minimal, it looks set to alter the relationship between treasury departments and suppliers. According to the Association of Corporate Treasurers (ACT), the new levels of regulatory protection could represent an increased administrative burden for treasurers and a slowing down of standard procedures, such as buying foreign currency, as banks will be obliged to seek an alternative rate associated with “best execution”.

However, the ACT believes that as most large companies in the UK are equipped with professionally staffed treasuries, ECP status still represents the fastest and most cost-effective status and, as such, should be open to as wide a range of companies as possible.

In a response to the directive’s draft proposal, John Grout, ACT’s technical director, said that even smaller firms should be able to opt for ECP if confident, as it will avoid extra costs and delays associated with “best execution” of professional status. He added that although very small companies may opt for higher costs and delays associated with retail status, most should be competent enough to opt for professional status.

Impact on costs

The directive represents a significant compliance challenge for financial services firms. Companies must consider the efficiency and effectiveness of compliance and risk management, robustness of systems and internal controls, record keeping and transaction reporting, together with arrangements for identifying conflicts of interest. There will also be new requirements focusing on the outsourcing of critical and important functions.

The costs of achieving such high level transactional transparency will be significant.

Anastasia Weiner

KEY POINTS

Best execution

Suppliers will need to apply an execution policy that ensures the best result for the customer each time they deal.

Professional clients may wish to negotiate the contents of this policy, in terms of the relative importance it places on various criteria (such as price, costs,
speed, likelihood of execution and settlement) and the range of execution venues where the deal may be done. For retail clients, the most important factor must be cost.

Suitability

Suppliers must understand their client’s knowledge and experience in the investment field relevant to the specific type of product or service, their financial situation and investment objectives, so as to enable the firm to recommend investment services and financial instruments that are most suitable for that particular client. The firm must warn its client if it considers an instrument or service not to be suitable, but the client may still go ahead if they wish.

Reporting and providing information to customers

MiFID sets out detailed rules for the type of information that must be provided and the way it is represented, particularly where retail clients are concerned.

Roger Chidwick, senior consultant, Capgemini