MiFID II has been a long time in the making, and the repeated delays may have led some to think that 12 months is plenty of time to get ready. However, this is a far-reaching directive with implications across trading, transaction reporting and client services, encompassing IT and HR systems. Firms need to get on the front foot now to ensure they can meet the requirements of the directive this time next year.
Fail to plan, plan to fail
Anyone relying on Brexit to create further delay, or to be repealed, should think again. While the Brexit timelines are not yet confirmed, MiFID II will pass into UK law this summer and will come into effect in January 2018. Even after it formally withdraws from the European Union, the UK is expected to follow the MiFID II regime.
So now is crunch time. There are a number of obvious challenges, as well as some that may have slipped under the radar. Some business changes may prove relatively straightforward, such as creating formal documentation for existing processes, but others could well involve sweeping changes to how managers run their business, interact with counterparties and even how the industry itself is structured.
In line with the overall goal of increasing transparency and improving market abuse detection, MiFID II will usher in sweeping changes around transaction reporting. Hedge fund managers have typically relied on the sell-side to fulfil both sides of the transaction reporting obligation on their behalf.
From January 2018 onwards, the picture will become more complex. Current FCA consultation suggests that hedge fund managers operating as Collective Portfolio Management Investment firms (Alternative Investment Fund Managers with a top-up MiFID-style investment manager licence) will not be required to submit transaction reports. The FCA says it can get the information it needs from brokers and exchanges. However, firms managing hedge funds under a segregated investment mandate will need to choose between submitting T+1 transaction reports or formally delegating the responsibility to a third party. This could require firms to not only connect to one of the Approved Reporting Mechanisms (ARMs) authorised to provide this function, but also to understand what data is needed – a requirement which has itself increased from 23 data points to 65 – or how much of this data it will pass to a third party to be reported on the manager’s behalf.
With uncertainty over whether third parties will commit to providing transaction reporting services, a small number of ARMs in operation and a significant proportion of the market needing their services, it is important to assess how a manager will be affected by these rules and what the preferred solution should be.
Changes to dealing commissions will be highly contentious. As regulators have identified an inherent conflict of interest in the current use of commission sharing agreement (CSA) models, their use will need to be justified from 2018.
This will prompt some difficult conversations. Managers may need to pay for research themselves and/or agree with the client in advance to a budget, which must be tracked, monitored and reported on. Managers may face the conundrum of paying for unbudgeted research costs themselves rather than trying to pass them on to their clients. While quality of research and transparency of pricing are expected to improve, such a departure from current practices will take time to explain, agree and implement. The discussion should start soon so that terms of business can be agreed with counterparties, and research budgets set with clients.
Under MiFID II, a much larger range of instruments will be included in trade reporting. Over-the-counter (OTC) trades and third-country brokers in particular will be required to report for the first time.
The sell-side has typically handled this, but the obligation now rests with the seller, unless the firm trades with a registered systematic internaliser for the instrument being traded. Counterparty agreements need to be reviewed to ensure they meet obligations and can cover all relevant asset classes going forward.
In addition to these issues, which have been covered quite widely, there are some equally challenging aspects that have received less attention.
The changes around product governance are a case in point. The language being used may feel quite alien, particularly to those unfamiliar with the concepts of ‘manufacturer’, ‘distributor’ or ‘product approvals’. But these rules will now apply across ‘products’ and services provided to professional clients. Hedge fund managers will need to have conversations with their intermediaries and, if they use them, their host managers, to understand where they stand in the ‘supply chain’, whether they are classed as a ‘manufacturer’ or a ‘distributor’ and what exchange of information is needed to demonstrate effective product governance.
This may be a simple case of benchmarking procedures to the new standards for managers with less complex strategies or it may involve a more radical rethink of how a fund is designed, its target market defined, its performance monitored and its distribution arrangements structured and assessed.
An equally challenging concept around best execution monitoring may also have been largely overlooked. On the surface, hedge fund managers are accepting the requirement that they will need to summarise and make public, on an annual basis, the top five trading counterparties by volume in the preceding year. But because the disclosure is by each class of financial instrument, detailed reports will need to be prepared for upto 36 asset classes and subsets, explaining which were the top five counterparties and the quality of execution achieved. This public disclosure will likely prove to be an intensive annual process for firms who need to plan how this can be achieved.
One final area that may not have been explored in much detail yet is the new reach of telephone taping requirements, in line with the prevention and detection of market abuse. The requirement is now extended to apply to a much wider range of conversations, including internal ones which involve a transaction, and will apply to everyone – including investment managers. As a result, much of the market will likely need to source a taping solution over the coming year.
In fact, this is reflective of the overall MiFID II challenge for hedge funds. This far-reaching regulation will affect nearly every type of market participant, with many of these changes likely to have a profound impact on the way the industry is structured and functions on a daily basis. Many of the issues it raises, or seeks to address, are varied and complex. They range from smaller but still mandatory changes all the way through to a full-scale disruption of operating orthodoxies. While we cannot fully predict what the impact of these changes will be after January 2018, hedge funds can be certain that MiFID II will be in place and need to ensure their house is in order well in advance.