On January 3, 2018, the EU (European Union) updated its Markets in Financial Instrument Directive (MiFID) to MiFID II. MiFID aims at making the financial markets in Europe more transparent, resilient, and investor-friendly. It’s ideally an attempt by the EU to set up a single rulebook that covers the financial market activities and services while replacing the decade-old MiFID I.

Financial firms are required to deal with approximately 11 areas of change, from reporting transparency to archiving communications and demonstrating best execution, along with the unbundling of research, surveillance, and the trading mandate for derivatives. Since most firms in the financial services industry typically do business with the EU, it’s vital to adhere to the set requirements to ensure that business with their EU clients is not disrupted when the MiFID II is implemented.

Specific Changes from MiFID II

The new legislation affects a number of sections in the financial industry, including broking, dealing, and the various advisory services provided by banks, non-banks, among other financial service providers. As such, all financial services and investment firms will have to comply with the new MiFID II rules. Under the new legislation, firms that offer financial advice of any kind to clients over calls must record these calls, and the face-to-face meetings formalized with taking minutes so that all transactions are recorded.

Impact on Investment Decisions

The new MiFID II legislation also stipulates how asset managers should pay for the research they conduct when making investment decisions. Previously, asset managers could receive research, including documents like written reports or phone calls free of charge. The cost of the service was accounted for in the trading fees, which would normally be paid for by the clients of the manager.

When the MiFID II comes into effect, fund managers will be required to budget for trading costs and research separately. The technical term for this is “unbundling”. For the longer term, institutional investors will have further evidence to prove to their brokers that they are working to the best of their abilities.

Impact on Capital Markets

The MiFID II regulations are strongly aimed at empowering good conduct of business, though the capital markets have come across as an unintended target as well. The MiFID II stipulates that the firms should meet a quality enhancement test, which means that the client is benefiting from your services. The term “client” here can refer to both the investor clients and the issuer.

This raises a few eyebrows, considering that for the capital markets, it could mean the usual daily activities like making the reciprocity agreements in the course of book-running processes. Such an activity is vital in most businesses, implying that some modifications to these agreements might affect the firm’s abilities to trade successfully.

Clampdown on “Dark Pools”

“Dark pools” refer to the private markets that allow the dealers to buy and sell large shares blocks without having to reveal the price paid or order size beforehand. Many traders favor dark pools since whenever a big order is traded on the public stock exchange, those who use algorithms for spotting large block orders and high-frequency traders would probably trade against the orders. One challenge with this is that the stock exchanges are certain that dark pools rob them of business in lost fees and higher prices. MiFID II counteracts this issue by requiring not more than 8% of any stock volume traded this way.

Enhanced Monitoring and Reporting

The new MiFID II legislation requires the financial services community to enhance their reporting and monitoring, to make it easier for the regulator to spot risk, and reconstruct the events whenever necessary. For example, brokers have to record all conversations that relate to a deal and store them for 5 years, bond traders must tell the market of all the deals they have transacted in the first 15 minutes of them taking place, institutions have to report key details about a trade like volumes and price almost instantly, and all trades have to be time-stamped.

The MiFID II essentially integrates the G20 leaders’ commitment to move the trading of derivatives to electronic platforms with more rigorous requirements for investor protection and market probity. Although the EU regulators don’t have a direct impact on the financial firms outside the EU, global financial markets are structured in a way that the new legislation will exert indirect pressure on the non-EU firms, including the U.S. Asset Managers.

It’s quite clear that the revised MiFID II will have a significant impact on the financial services industry, even if the implementation is slow initially. And whatever happens, MiFID II will go down in the financial diary as a landmark legislation and the start of a new chapter for the rules and regulations in the financial sector.