By Molly Preleski, financial services expert
On 3 January 2017 the Markets in Financial Instruments Directive (MiFID II) comes into effect across the European Union. The new rules, in particular those aimed at strengthening conduct of business, will have several unintended impacts for capital markets businesses. MiFID II is primarily aimed at regulating secondary market transactions, but the rules will also capture primary market transactions. In some cases, the European Securities and Market Authority (ESMA) has specified how the rules should apply to primary markets, but in many areas, such as inducements and product governance, it has not.
Where it has specifically addressed primary markets, the rules have often been predicated on a poor understanding of primary market businesses (for example, the rules against under/over pricing have been described as “fanciful” by trade bodies who note that no market would exist if such activity was undertaken since issuances are priced based on issuer need and investor demand).
Given that ESMA’s final advice has been issued, it cannot be guaranteed that firms will get answers to some of the key remaining issues and certainly unlikely before the already delayed Technical Standard are released. Therefore, firms must begin work now to resolve key strategic, operational and regulatory issues resulting from MiFID II, working together to determine an industry interpretation wherever possible.
ESMA has not always been fully clear in their clarification of how the rules apply to the primary markets, with more often than not the interpretation left open. This poses many strategic issues as a result.
For example, capital markets businesses are unlikely to be providing independent advice and, as such, inducements will be allowed. However ESMA has emphasised that firms must be able to demonstrate that the inducements meet a ‘quality enhancement test’ - that is, that they provide some benefit to the client. But ESMA has also indicated that ‘client’ refers to both the issuer and investor clients, which in this case, poses additional questions. Unpicking whether arrangements will meet this test in capital markets businesses is likely to be difficult as benefits from each inducement will not necessarily benefit both equally - even if it can be reasoned that the sum of all across the issuance process may.
For capital market desks, this could mean typical activity such as making reciprocity agreements during book running may be classed as benefits which do not enhance a service to the investor client - even though it could be argued that they enhance the service to the issuer client. These types of agreements form a fundamental part of how business is done at most firms, and changes to these arrangements could have a significant impact on some firms’ ability to win businesses, potentially resulting in firms exiting the market.
ESMA has also specified that certain practices such as laddering and spinning are banned, despite the fact that they have been banned within the industry for years.
In its drive to ensure firms capture essential information related to transactions, ESMA has determined that firms must record the justification behind all investor allocations made during the syndication process. The operational challenges this presents for firms were probably not considered by ESMA when this rule was defined. Nevertheless, firms must now assess how they will operationalise the capturing and recording of the justification for all allocations in specific detail since ESMA has stated that general commentary will not be acceptable.
A particular challenge to this is presented in joint book running situations, where firms will need to have either the same system, or systems, consistent to ensure that each firms’ records specify the same rationale for each allocation.
To achieve this, it seems most logical for the industry to work together to define a common approach and potentially create a shared technology solution, perhaps leveraging some of the existing book running platforms such as Ipreo’s IssueBook and IssueNet.
Finally, there are some key areas where firms must continue to press regulators for clarity - a key example being about how product governance rules apply. ESMA has given confusing advice in relation to the application of product governance rules and when a firm is a manufacturer versus a distributor for primary markets issuances.
ESMA has stated that the manufacturing rules apply to investment firms “advising corporate issuers on the launch of new securities”, and have also explicitly stated that shares and bonds should be included in scope (in response to industry feedback that they be excluded.) This undoubtedly feels like a stretch of the manufacturing definition of ‘create, develop, issue and/or design’ and would create a confusing requirement for firms to undertake significant product governance work for bog standard shares and bonds.
ESMA goes on to state that a firm which sells investment products issued by entities outside of MiFID scope (for example, a car company issuing bonds) then the governance rules for distributors apply to them. The logical conclusion of these two statements seems to be that where a firm advises a corporate or supports the structuring, then they are a manufacturer. However, where they only sell, they are a distributor. In practice, capital markets businesses will therefore be both, and will also need to have a clear business processes for identifying when they act as what.
There are many more areas where the impacts on capital markets firms are unclear and firms should pick these up with their regulators or through their industry bodies urgently in the lead up to implementation.
For capital markets businesses, it is clear that MiFID II brings in many new requirements for them to assess and implement changes for, which is compounded by the fact that the rules apply to primary markets but weren’t expressly written for them. This means the impact of the rules is often non-trivial. Some of the required changes will be strategic, while some operational, and firms will need to ensure they understand how the rules impact their particular business to enable them to overcome these.
To find out how PA can help you understand how MiFID II's rules will impact your business, contact us today.