MiFID II: The rise and rise of regulation

So did the final roll out of the new rules on 3^rd January this year have the huge impact that the industry and speculators had anticipated?

The start seems to have been relatively smooth. The Chairman of the European Securities and Markets Authority (“ESMA”) reported no teething problems and, while trading volumes dropped off after Day One, they recovered relatively quickly and prime brokers reported no real change in liquidity.

As a hedge fund allocator, Aurum Fund Management Ltd. (“Aurum”) wanted to know how its in-scope hedge fund managers (EU fund managers and managers with an EU place of business) had coped with the implementation, what challenges they faced and what their takeaways from the process have been so far.

The results of Aurum’s post go-live due diligence indicate that, in the short term, it seems that all of its in-scope managers have seen increased organisational compliance costs, heavier operational workload and increased process complexity. However, nearly all of them admit that the initial go-live process has gone smoothly.

Despite the short term costs, managers are expecting some long-term benefits, including: increased transparency into the value and cost of the research consumed internally, more uniform transaction reporting and decreased transaction and research costs.

In the short term, investors should benefit from the ability of most managers to negotiate lower fees and the fact that any organisational and third party costs have been absorbed by the managers and not charged to the funds. Investors could see transaction and research costs decrease further in the longer term as managers continue to assess the quality of current research providers and negotiate further cost reductions.

The Markets in Financial Instruments Directive (MiFID) is the EU legislation that regulates firms which provide services to clients linked to “financial instruments” (shares, bonds, units in collective investment schemes and derivatives), and the venues where those instruments are traded. MiFID applied in the UK from November 2007, and was revised by MiFID II, which took effect in January 2018, in order to improve the functioning of financial markets in light of the financial crisis and to strengthen investor protection. MiFID II extended the MiFID requirements in the following areas: new market structure requirements, new requirements in relation to transparency, new rules on research and inducements, and new product governance.

What measures have hedge funds put in place?

In 2017 Aurum’s MiFID II in-scope hedge fund managers were busy working on:

• building out their Order Management Systems (“OMS”) to cater for the additional information required for transaction reporting;
• revising their existing compliance policies and legal documents to capture the requirements of MiFID II;
• setting up research expense budgets;
• renegotiating terms with research providers;
• implementing solutions for recording video conferences and skype calls – and voice calls for the few that did not already have this in place;
• and setting up monitoring mechanisms and committees to ensure ongoing compliance.

Many managers opted to engage third parties to assist with compliance. These included independent consultants to help in the overall compliance effort, independent platforms to track research consumption and data providers to compile the data and report in a MiFID II compliant format. The engagement of third parties and the increased workload led to an increase in the managers’ overall business costs.

Taking stock of the work that has been done, Aurum’s in-scope managers believe that the worst part of the implementation is now over and they have the resources and ability to implement the rules.

The three key areas of MiFID II that have directly affected the managers the most are transaction reporting, research unbundling and best execution. Other areas, like the fate of services such as cap intro and prime brokerage consultancy as minor non-monetary benefits, still remain uncertain, with managers having to make their own judgement. In the absence of clear ESMA guidance, most of them have chosen not to take action as yet.

Transaction reporting

In-scope hedge fund managers are required to report on all instruments traded on European venues, including non-EU derivative instruments that relate to an EU security or index. Reports can contain as many as 65 data fields, compared to 24 fields required previously under MiFID. Transaction reporting has created the biggest headache for the hedge fund managers Aurum spoke to. The cause of the headache seems to be the general underpreparedness of third parties to fulfil the reporting obligation combined with the lack of clarity given by the regulator around the reporting of esoteric and bespoke instruments.

The goal of the regulation is to achieve greater transparency on both a pre- and post-trade basis, in respect of EU trading venues and EU counterparties. So, will this transparency benefit all managers? The increased transparency arising as a result of restrictions on the use of “dark pools” and other unregulated trading venues could potentially lead to price discovery. This could disadvantage some hedge fund managers, particularly in the fixed income market, who previously benefitted from the lack of transparency in the space.

Despite these issues, hedge fund managers see transaction reporting as a positive exercise, which will bring more discipline and uniformity in the way trades are reported. In general, increased transparency should benefit the wider market. There remains, however, some scepticism as to the actual value regulators will be able to extract from the data.

Research unbundling

This is the MiFID II requirement that has generated perhaps the largest amount of media attention. The requirement is for managers to either pay for research expenses themselves through their P&L or to establish a Research Payment Account (“RPA”), funded by the funds (i.e. investors). Some of the media attention has arisen as a result of several large and high profile asset managers making an about-turn on their plans to charge investors and opting to meet research costs themselves, in response to pressure from clients and consultants.

Pressure from clients and consultants is not the only reason that managers are opting for the P&L approach. There is also an increased workload associated with RPAs. Where an RPA exists, managers are required to constantly assess and report on the quality of the research provided under the RPA. While this undoubtedly will lead to overall improvements in the quality of research, in the short term it is another administrative and reporting burden for managers.  Also, ESMA requires RPA users to report the amount budgeted for research each year and have a mechanism for rebating surplus and justifying any increases.

In order to ease the regulatory burden across the pond, at the end of October 2017, the US regulator, the SEC issued three no-action letters confirming that no enforcement action would be recommended against investment advisors which, in compliance with the new MiFID II rules, contravened the Investment Advisers Act of 1940 or the Securities Exchange Act of 1934. The Division of Investment Management provided temporary relief for thirty months from MiFID II’s implementation date to permit a broker-dealer to receive payments in hard dollars or through MiFID-governed RPAs from MiFID-affected clients without being considered an investment adviser. This was seen as good news by US advisors and broker-dealers, but it disadvantaged some European managers who were not able to renegotiate research fees with US brokers on time.

As a result of the SEC no-action letter, managers with US operations have had to set up additional levels of monitoring to ensure that research from the US is only passed to the EU jurisdiction they operate from if it is on the MiFID II approved list, as they have ring-fenced the research unbundling requirement of MiFID II to the EU operations.

In order to meet the research unbundling requirement of MiFID II, Aurum’s managers utilised significant amounts of time, money and resources assessing research providers, negotiating fees, selecting third party providers, setting up research budgets and conducting staff training. The implementation of the rules had its challenges. Some managers were not able to renegotiate competitive rates with US brokers and others were forced to reduce use of external research significantly in order to cut down on costs.

Despite the challenges, however, most firms consider the exercise to be positive, increasing transparency of the fees charged by the prime brokers for research and execution. Some reported being able to negotiate fees on the equity side, but paying for research on the fixed income side for the first time, making the overall costs relatively unchanged. Others reported a slight decrease in costs. The overall sentiment is that research fees will continue to be compressed in the long run and that the quality of research will improve.

Best execution

MiFID II’s best execution rules require firms to take all sufficient steps to obtain, when executing orders, the best possible result for their clients, taking into account price, costs, speed, likelihood of execution and settlement, size and any other consideration relevant to the execution of the order.

Firms are required to publish an annual report detailing their top five execution venues for the previous year along with data relating to the quality of execution of transactions on that venue. The report is very comprehensive and includes information on the type of execution venue, the price of orders executed (including a variety of intraday and end-of-day information), the costs applied by the execution venue, the likelihood of execution, best bid and offer price and corresponding volumes, average volume and spread at best bid and offer, etc.

One issue that AIMA reported as part of its February 2018 MiFID II Compliance Stocktake webinar with regard to best execution is that some prime brokers may be bypassing the requirements of best execution by categorising managers as eligible counterparties (ECPs). ECPs are entities that are authorised or regulated to operate in the financial markets, but are not given investment advice and remain outside the MiFID II best execution rules. Managers should push back on categorisation as ECPs to ensure that they receive best execution.

The first report must be published by 30th April 2018 and annually thereafter. Most of Aurum’s managers are still compiling the data for reporting, with some considering engaging third parties to assist with the granular reporting. A key issue highlighted by the managers was, again, the low levels of preparedness of third party providers, with many managers resorting to the use of internal resources to build a solution. Many managers also still appear to be working on finalising the updates of their best execution policies.

The best execution requirement aims to achieve greater transparency into the trade execution process. It is generally expected that hedge fund managers will adopt a pragmatic approach to best execution, in line with the investment objectives of their funds.

Conclusion

As a result of the MiFID II regulation, in the short term, all of Aurum’s managers have seen organisational compliance costs, heavier operational workload and increased process complexity. However, nearly all of them admit that the initial go-live process has gone smoothly. Despite the short term costs, managers are expecting some long term benefits, including:

• increased transparency into the value and cost of research consumed internally;
• more uniform transaction reporting;
• decrease in transaction costs;
• decrease in research costs;
• increased transparency into the trade execution process.

The FCA is expected to start reviewing some of the first transaction reports in less than six months. In the long run, it will be interesting to see if some of the hedge fund managers Aurum spoke to were right to be sceptical about the value this reporting will provide to regulators.

At this point in time, only a few months after the go-live date, it is hard to conclude whether the benefits outweigh the costs of yet another piece of legislation, but 2018 will be an important year for MiFID II. As volatility is starting to creep its way back into the markets, will the increased burden of regulation enhance or hinder managers’ strategies? Will the reduction of external research result in better or worse strategy implementation? Will the regulators actually benefit from the increased transparency and will they use all the data reported in a constructive way? And, in the end, will MiFID II really prove to be the crucial piece of legislation it was intended to be?