Dangerous Border Crossings Under MiFID II

By George Bollenbacher, Capital Markets Advisors

Originally published on TABB Forum

There are three parameters that govern the applicability – and thus the requirements – of various parts of MiFID II to market participants. But complicated criteria means crossing E.U. borders can be a dangerous process. George Bollenbacher provides some guidance on when and to whom MiFID II rules apply and highlights three trends that are likely to emerge as a result.

In a previous article, I addressed some of MiFID’s regulations on the provision of investment services to E.U. customers by firms outside the E.U., called “third-country firms” (“MiFID: Is ‘Third Country’ Synonymous With ‘Third World’?”). While that issue is complicated enough in itself, it actually represents a small fraction of the cross-border concerns that are surfacing as people dig into the MiFID II requirements. So, unfortunately, we have to spend some more time in this area.

Understanding the Parameters and Combinations

There are actually three parameters that govern the applicability of various parts of MiFID II. The first is the regulatory venue of the investment firm providing the services. Second is the regulatory venue and status of the customer for the services. And finally there is the regulatory venue of the instrument(s) involved. When we start combining those parameters, we get a pretty wide variety of possibilities.

These parameters in turn affect the requirements contained in both MiFID and MiFIR, and, for good measure, MAR (the market abuse regulation). Among the more important requirements are: the trading obligation, the pre-trade transparency obligation, the post-trade transparency (or transaction reporting) obligation, the best execution obligation, and the obligation to monitor customer activity for market abuse. Some of these obligations appear to be triggered by where the customer is located, some by where the firm is based, some by the venue of the instrument, and some are just too confusing to call right now.

The Simple Combinations

Let’s look at the simplest of the combinations first. We will assume here that any non-E.U. firm has attained the appropriate third-country status, so that it can deal with EU customers. The first combination is a non-E.U. firm dealing with a non-E.U. customer in non-E.U. instruments. It seems pretty clear that none of the MiFID rules apply, except that we need to be careful with customers that are non-E.U. subsidiaries of E.U. entities, where the trade might have a significant impact on the parent or the E.U. itself.

The other simple combination is an E.U. firm, an E.U. customer, and an E.U. instrument, where all the E.U. provisions seem to apply. I think we can handle that one.

Some Complications

But things immediately start to get more complicated. For example, let’s look at an E.U. firm dealing with and E.U. customer in a non-E.U. instrument. Barclays executing a trade for Scottish Widows in U.S. Treasuries, for example. Simple enough, right? One would think that there’s no MiFID trading obligation, since the security doesn’t trade in the E.U. … unless somebody in the E.U starts an MTF for Treasuries. And, we hope, no reporting obligation.

But what about best execution? Since the customer is an E.U. person, albeit a professional, what best ex obligation does Barclays have? If Barclays is acting as a principal in this trade, which is highly likely, does the MiFID best ex requirement apply at all? And, while we might not think that market abuse would be applicable in Treasuries, our friends at Goldman would probably tell us otherwise, based on some recent revelations. So whose market abuse regulations apply: the E.U.’s or the US’s – or maybe both? Oh, I almost forgot, what is Barclays’ obligation regarding pre-trade transparency? If it did this trade as principal, must it expose the quote it showed the customer to the rest of the E.U. market, even though the trade was done in its New York office?

Just for fun, let’s reverse the parameters. A non-E.U. firm executing for a non-E.U. customer, in an E.U. instrument. UBS Securities LLC (with no presence in the E.U.) selling a German Bund for a U.S. hedge fund. If the bund is listed in the E.U., we assume that the trading obligation applies, as long as UBS can trade on that venue. Except, it isn’t UBS the Swiss bank we’re talking about, it’s UBS Securities LLC, the U.S. securities firm. Let’s assume that LLC isn’t a member of any of the E.U. venues where the bond trades, so it would have to use a broker such as its Swiss affiliate to execute. Now we need to know whether the trade with the hedge fund was done as principal, with LLC doing a matching trade with its Swiss affiliate. Or was it done as agent, with LLC passing the order through to the E.U. broker? If so, was it done omnibus, where the executing broker (the Swiss bank) only knows LLC as the selling party, even though the actual seller was the hedge fund? Or was it done on a disclosed basis?

Let’s say it was done as agent, under the omnibus arrangement. Clearly the trading obligation applies ... or does it? The selling party, the hedge fund, isn’t bound by any MiFID rules, and its agent, LLC, isn’t either, since it isn’t an “investment firm” as defined by MiFID. Never mind, we’ll do the trade on a venue. But the executing broker, which must then file the report, doesn’t know who the actual seller is, so part of its reporting requirement can’t be satisfied. And do any of the parties owe the hedge fund a best ex report? Oh, and the monitoring for market abuse – who does that? If the original seller is a U.S. person, and the broker that knows its identity isn’t subject to MiFID, can anyone be held to the monitoring obligation?

But wait, it turns out that LLC bought the bonds from the hedge fund as principal, so it is the one selling them on the venue. The trade with the hedge fund is totally outside of MiFID and MAR, and totally within the purview of the SEC, except the SEC doesn’t regulate trades in E.U. securities. LLC’s trade on the venue is the one now under MiFID. So it doesn’t take much imagination to see non-E.U. customers gravitating to principal trades with U.S. broker-dealers in E.U. instruments – let somebody else worry about MiFID.

And just to complicate it a bit more, let’s say that LLC sold the bunds as principal to its E.U. affiliate, raising the question of whether inter-affiliate trades are covered. I’ve asked ESMA about this, but haven’t heard back yet.

Sorting It All Out

So now, I don’t know about you, but I’m pretty confused. With all these moving parts we need some organized way of looking at this. Let’s try the matrix below, where the columns labeled Trading, Reporting, Best Ex, Pre Trade and Market abuse indicate whether the MiFID requirements apply. Hopefully, the domicile columns are self-explanatory.

There are a few “?”s in the matrix, and I’m perfectly prepared to admit that I’m not 100% sure about some of the other answers, so if any of you have something to add on this, please chime in.

Some Possible Developments

Meanwhile, what can we predict about how this will all shake out?

1. The best execution requirement, which has everybody up in arms, will probably lead to a rise in limit orders, as long as everyone agrees that this part of Article 27 of MiFID II means what it says: “Where there is a specific instruction from the client the investment firm shall execute the order following the specific instruction.” The open question is whether a limit order in a principal trade that is away from the market (too high on the bid or too low on the offered) is still exempt from the best ex obligation.
2. For non-E.U. customers that want to avoid some of the MiFID requirements, such as intrusive trade reporting, and for non-E.U. dealers that serve them, there will probably develop a “grey market” of principal trades in E.U. instruments by two non-E.U. parties, where MiFID doesn’t apply, and where the non-E.U. dealer then lays off the position with an E.U. affiliate. The desire of some E.U. customers to avoid some E.U. regulations may also lead to a raft of customer requests for service under Article 42 of MiFIR. In any event, one of the major impacts will be to drive some trades in E.U. instruments outside of the E.U.
3. As with every other part of MiFID, technology will be the key. OMSs will have to store domicile information about both the customer and the instrument, and will have to apply the appropriate rules, since traders and/or salespeople won’t be able to make those determinations on the fly. Who’s working on that – are you?

The hordes of migrants moving across the European continent have reminded us recently that crossing E.U. borders can be a dangerous process. By the middle of next year the world’s financial markets may be proving the very same thing.