Since the outcome of the EU referendum was announced in June 2016, MiFID II has been one of the most widely discussed areas of EU regulation. So far the debate has centred on the issues of passporting and regulatory equivalence, which pose a potential licensing gap for UK firms. But a closer examination of MiFID II and MiFIR reveals a myriad of additional issues and complexities that Brexit will give rise to, which we believe policymakers and firms need to consider. Brexit is likely to open up a Pandora’s Box of technical complications due to the way EU and UK regulation has been constructed.

In the case of MiFID II, it’s quite possible that these unintended consequences will require rewriting some of the rules to make them fit for purpose both in the EU and the UK. The MiFID II rules, like all other EU regulations, were written on the basis that the UK is part of the EU. In many cases it is not clear what the appropriate way forward is, given we’re in an unprecedented situation. But policymakers will need to find a way forward on these issues – as well as similar complexities for other pieces of financial services legislation – and quickly.

Avoiding a licensing gap

The media and industry have given lots of attention to the existing MiFID passport, which along with the CRD IV passport, is one of the two most commonly used passports for banks and investment firms. CRD IV doesn’t provide a passport for third country firms, so UK firms without another existing EU banking licence will have to set up and obtain a licence for a subsidiary in another EU country to access passporting under CRD IV. 

In the immediate aftermath of the vote, many commentators pointed to the equivalence mechanism in MiFID II that can allow firms from outside the EEA, ‘third country firms’, to do business in the single market without the need for authorisation in individual Member States. At first glance this was seen by some as a panacea for continued access to the single market.

MiFID firms are concerned there will be a significant licensing gap brought about by a lack of agreement, transitional arrangement or equivalence decision. The current MiFID directive doesn’t provide for third country passporting - a third country passport will be available when MiFID II comes into effect on 3 January 2018. But the UK will not be a third country until it formally exits the EU. A third country passport wouldn’t be available to UK firms until post-exit, which is likely to be in spring 2019. In reality the equivalence mechanism under MiFID II is untested. It is likely to be highly political in the aftermath of the Brexit negotiations, and in any case only applies to business carried out with eligible counterparties and professional clients. So it’s no use to firms wanting to do business with retail clients in the EU.

Only after the UK’s formal exit, would the EC be in a position to make a determination about whether or not the UK has an equivalent supervisory and enforcement regime. If and when the EC reached an equivalence determination, ESMA would then begin accepting individual firms’ passport applications.  It has to approve each individual firm’s application for a third country passport. Together, those two processes could take a number of months. So absent grandfathering of existing passports or transitional provisions being agreed as part of the Brexit negotiations, UK firms would experience a licensing gap, i.e. they could not carry on MiFID business in EU countries until ESMA approved their third country passport application. Waiting out a licensing gap won’t be a viable option for most firms – they will be forced to set up a new MiFID firm in another EU country to keep doing business in the EU (if they don’t already have one).  

Calculating thresholds for pre-trade transparency

Many of the obligations in MiFID II rely on quantitative thresholds that will be skewed if UK data is not included in the calculation. Perhaps the clearest example of this issue is the systematic internaliser determination. Under MiFID II, a firm that executes client orders against its proprietary capital, rather than matching the order with another client or executing on a venue, is considered a systematic internaliser if the volume of this activity that it carries out exceeds a certain quantitative threshold. This situation poses an important strategic issue for firms because systematic internalisers have to comply with additional transparency requirements – they have to show their pre-trade prices to the market. In some instances and for some financial instruments, firms are likely to be reluctant to do this.

The calculation for determining whether or not a firm is a systematic internaliser is complex and varies according to the type of financial instrument and whether there is a liquid market for that particular instrument. But a common component across all financial instruments is that firms should compare the amount of client orders they are internalising against the total trading activity of that financial instrument in the EU.

It’s no secret that a significant proportion of EU trading activity in all financial instruments takes place in the UK, and the thresholds were set taking that activity into account. If the UK data is removed from the total EU activity, the absolute threshold lowers. This reduction is likely to bring far more firms across the EU into the systematic internaliser regime and could inappropriately extend the pre-trade transparency regime to less-liquid parts of the EU market. If the UK data is removed and the UK is forced to continue to use the existing systematic internaliser thresholds to achieve equivalence then it’s likely that lots more UK-based firms would be brought into the regime too. Even if the UK ends up joining the EEA, an outcome that looks increasingly unlikely, this problem will persist; the calculation specifically references total EU trading data rather than total EEA trading data.

Finding a solution

So what might the solution be? It seems unlikely that the EU would rewrite its MiFID II rules to include all EU trading data plus that of the UK, given the UK would be just another third country post-Brexit. Perhaps the UK data could be included in the calculation temporarily as part of a transitional arrangement on MiFID II, but it’s difficult to see the UK being included in the calculation in the long term as this would probably not sit well constitutionally with EU institutions and some Member States.

An alternative approach would be to recalibrate the calculation in MiFID II so that the absolute threshold is more in line with what it would be with UK data included. This alternative would perhaps be the best solution for EU firms but it would require amendments to the MiFID II legislation and potentially create further delays. The date the rules apply has already been pushed back by a year to January 2018, so there is likely to be little patience from the EP and EC for additional postponement.

Should the EU recalibrate the threshold, this change would leave the question of what the UK should do, or will be required to do if it wants to achieve equivalence with MiFID II. It seems unlikely that it would be acceptable for UK firms, some of the largest in the EU with significant trade flow, to simply use the recalibrated thresholds, because that would create an unlevel playing field. UK firms would effectively be given a lower bar than their EU competitors and would be less likely to fall within the systematic internaliser regime. So perhaps the UK would be required to come up with its own thresholds for domestic activity with the aim of producing a similar result to the original calibration. Such a calibration would most likely take some time as it would require significant quantitative analysis of the UK market – and it’s precisely this type of technical issue that has the potential to undermine a swift MiFID II equivalence determination for the UK overall.

The systematic internaliser regime is just one example of a quantitative threshold in MiFID II. There are others where the principle is the same, creating similar problems for regulators. Commodity derivative position limits use the concept of total deliverable supply referencing EU data. The transparency regime for non-equity products relies on liquidity thresholds that have been developed using total EU data that includes a significant portion of activity in the UK. It’s likely that ESMA will have to spend significant time working out the solutions to these very technical issues that threaten the workability of many parts of the MiFID II package, not just for UK firms but across the EU. Whether it has the resources and time to do this before MiFID II has to be implemented is questionable.

Achieving equity trading equivalence

As well as the thorny issues around quantitative thresholds, other fiddly aspects of MiFID II will be affected by the UK not being a part of the EU. The equity and derivative trading obligations require firms to execute certain types of instrument on an EU venue or third country venue which is equivalent. The mechanism for determining equivalence of trading venues is different to the mechanism for determining MiFID II country equivalence for the purpose of allowing third countries to do business in the single market. In fact, there are even different mechanisms for establishing whether a venue is equivalent for the equity trading obligation (this relies on the Prospectus Directive) and whether a venue is equivalent for the derivative trading obligation (a brand new mechanism in MiFIR).

It’s likely that UK venues will be acceptable for execution for some time to come, but it is not out of the question that they could fall victim to a politicised equivalence determination. The net effect is additional complexity and uncertainty for firms.

Complicating transaction reporting

Another area where Brexit could cause operational complexity for firms is transaction reporting. Under MiFIR, firms must report transactions in instruments traded on a trading venue, or where the underlying is an instrument traded on a trading venue (which in this context refers to EEA trading venues). When the UK leaves the EU (and as seems likely the EEA), its trading venues will no longer be EEA trading venues. So in theory, the MiFID II transaction reporting requirement will no longer apply to instruments exclusively admitted to trading on UK venues – but in reality this is not likely to be the case. At the very least, the FCA is extremely likely to still expect UK firms to report transactions in instruments traded on UK venues, despite the potential loss of the explicit MiFID II requirement, for its own supervisory purposes and to achieve equivalence with the MiFID II rules. The FCA required transactions to be reported to it long before MiFID required it.

But the picture is perhaps less clear for EU firms (other than those operating in the UK): will they have to report transactions in instruments admitted to trading on UK venues? Any change in reporting obligations is likely to bring additional operational complexity to an area firms have historically struggled with.

The challenge ahead

All of these issues will need to be addressed ahead of the UK leaving the EU – there are no provisions explaining ‘in case of Brexit do this’ in MiFID II. Even establishing transitional provisions that are fit for purpose and provide clear direction for firms is likely to be extremely challenging in time for the UK leaving the EU, which now seems likely to happen in Q1 2019. The mind boggles when you consider that a similar exercise will have to be undertaken across all areas of EU law and regulation where its construction means that Brexit immediately creates practical and technical complications for regulators and firms.

As part of their Brexit planning, firms need to try to identify the full range of unintended consequences of the UK’s exit from the EU for MiFID II - and for all other laws and regulations they operate under. Firms should also consider working with both regulators and politicians (in the UK and the EU) to ensure policymakers understand all the technical nuances of the impact of Brexit on financial services regulation. While big-ticket issues such as passporting rights have understandably taken centre stage until now, it’s essential that firms and policymakers also consider the more detailed and technical implications if they want to avoid regulatory turmoil when the UK exits the EU. 

To contact the author:

Luke Nelson, Senior Manager, PwC:  [email protected]