Brexit simplifies? FCA consultation on changes to UK MiFID's conduct and organisational requirements
By Richard Frase, Partner; Simon Wright, Counsel; Philippa List, Professional Support Lawyer, Dechert LLP
Published: 28 June 2021
On 28 April 2021, the UK’s Financial Conduct Authority (FCA) published a consultation paper (CP21/9) setting out proposals to change certain conduct and “best execution” obligations required under the UK implementation of the second Markets in Financial Instruments Directive (UK MiFID) . In this article we look in detail at the proposals and the impact they would have on market participants.
Why is the FCA proposing changes?
Following the on-shoring of EU legislation post-Brexit, UK MiFID is now spread across primary and secondary legislation, the FCA’s Handbook and regulatory technical standards. The FCA is working with HM Treasury on capital markets reform, which involves looking at the UK’s regulatory regime for capital markets to develop a package of changes. These changes are to ensure the regulation of investment business in the UK is adapted to the specific structures of UK markets.
CP21/9 forms part of the capital markets reform work, and covers changes in two areas to the conduct and organisational rules in UK MiFID.
SME and fixed income, currencies and commodities (FICC) research
Historically, many equity brokerage firms ‘bundled’ research costs with transaction commissions (i.e. the cost charged to clients to trade in shares) so that investment managers buying execution services were paying at the same time for research. MiFID II required executing brokers to charge only for their execution costs, and for any research to be billed separately. This requirement applies not only to commission charges on equity trades, but also to principal dealers such as bond traders who did not charge a commission but instead made a turn on the bid-offer spread they quoted. Investment managers receiving research are currently required either to pay for research themselves from their own resources or agree a separate research charge with their clients. Any other form of inducements linked to an execution service was prohibited (the inducements prohibition), apart from a limited range of low-level inducements known as ‘minor non-monetary benefits’.
The FCA is proposing to broaden the list of permitted minor non-monetary benefits to include research on small and medium-sized enterprise (SMEs) with a market cap below £200 million and FICC research, so that they will no longer be subject to the current prohibition on investment managers receiving ‘free’ research as an inducement to give business to the research provider.
The FCA also plans to make rule changes on how inducement rules apply to openly available research and research provided by independent research providers.
The SME exemption
The FCA proposes creating an exemption from the inducement rules for SME research below a market capitalisation of £200 million. The £200 million threshold would be assessed for the 36 calendar months preceding the provision of the research, provided it is offered on a re-bundled basis or for free. Under the exemption, research on such firms that is provided on a re-bundled basis or for free would constitute an acceptable minor non-monetary benefit and therefore not be an inducement.
The FICC exemption
The FCA proposes to create an exemption from the inducements rules for third party research that is received by a firm providing investment services or ancillary services to clients, where it is received in connection with an investment strategy primarily relating to FICC instruments. The proposal would allow FICC research to be ‘rebundled’.
In fact, the market has been saying for some time that the requirement for investment managers to pay dealers for FICC research is unworkable because there is nothing to unbundle. The FCA for its part insisted that the research cost must somehow be included in the bid-offer spread. It appears that the FCA now accepts that this is not in fact the case, and acknowledges that bid-offer spreads have not narrowed as a result of the unbundling requirement.
Further research exemptions
The FCA proposes to create an exemption for research provided by independent research providers, by including in the list of minor non-monetary benefits research provided by independent research providers, where the independent research provider is not engaged in execution services and is not part of a financial services group that includes an investment firm that offers execution or brokerage services.
The FCA’s final proposal relates to ‘openly available research’. The list of minor non-monetary benefits will be extended to include written material that is made openly available from a third party to any firms wishing to receive it or to the general public.
Best execution reports
MiFID II introduced reporting requirements for execution venues (RTS 27) and for firms executing and transmitting client orders (RTS 28). The aim was to improve investor protection and transparency as to how brokers execute client orders.
RTS 27 requires execution venues to publish quarterly execution quality metrics at the level of individual financial instruments.
RTS 28 requires executing firms to publish an annual report listing the top-five execution venues where they have sent client orders in the preceding year, and a summary of the execution outcomes they have achieved, broken down by venue and class of instrument. Firms who carry out portfolio management or reception and transmission of orders are required by the UK MiFID delegated regulation to produce reports equivalent to RTS 28.
The FCA’s view is that RTS 27 and RTS 28 have not delivered on their objectives in a meaningful or effective way and are not used by market participants, while at the same time being costly for execution venues and firms to produce.
As a result, the FCA is proposing to remove these two sets of reporting obligations from the FCA Handbook. CP21/9 is silent on whether firms can continue to provide the RTS 27 and 28 reports if they wish to do so (as opposed to being obliged to provide the reports).
For portfolio managers and firms who receive and transmit orders, the requirements are not in the FCA Handbook but in secondary legislation in the UK MiFID delegated regulation. HM Treasury is considering the case for amending the delegated regulation in line with the FCA’s proposed changes. The FCA says that its changes to the FCA Handbook are dependent upon whether or not such changes are also made to the secondary legislation.
How will the proposed changes be made?
The FCA proposes to effect the changes by making amendments to the Conduct of Business Sourcebook and the Technical Standards (Markets in Financial Instruments Regulation) (Best Execution) Instrument 2021. Appendix 1 to CP 21/9 sets out the draft text of the amendments.
Are the proposed changes a UK version of the EU's MiFID 'quick fix'?
In 2020 the European Commission consulted on possible changes to MiFID II. That consultation led to a number of changes to MiFID II — referred to as MiFID ‘quick-fix’. The EU enacted these changes in February 2021 as part of its Capital Markets Recovery Package to support post-COVID-19 economic recovery.
The MiFID ‘quick fix’ amendments were published in the Official Journal of the EU on 26 February 2021, and EU Member States are required to transpose them into their national frameworks by 28 November 2021, with amendments due to apply from 28 February 2022. As these changes were agreed and will take effect after the end of the Brexit transition period, they do not apply in the UK.
However, whist the FCA’s proposed changes cover two areas included in the MiFID ‘quick fix’ package, the FCA’s changes as set out in CP 21/9 do not go further and propose that the UK on-shores the remaining parts of the EU’s MiFID ‘quick fix’ package. Several other changes in the EU’s MiFID ‘quick fix’ package would, in the FCA’s view, be best made through changes to the UK MiFID delegated regulation, and it is expected that HM Treasury will propose changes to the delegated regulation in due course.
The FCA is looking for responses to CP 21/9 by 23 June 2021 and will then consider the feedback it receives. If the FCA chooses to proceed, it would publish any rules or guidance in a Policy Statement in the second half of 2021.
Following CP 21/9, HM Treasury will issue a consultation paper looking at the broad themes of capital markets reform and cover a range of high-level and more detailed questions. It will help prepare the ground, in due course, for proposals for changes to primary legislation, as well as helping to establish changes that could be made more quickly through secondary legislation.