FSA faces challenge with level two of MiFID, says industry

Feb 07 2006 Alex Davidson

The draft of the Markets in Financial Instruments Directive's level two measures has belied commissioner Charlie McCreevy's suggestions that there would be "more regulation than directive", according to sources. The draft, which the European Commission published yesterday, has given the Financial Services Authority the unenviable task of revisiting its regulations to see how much it could override the fairly prescriptive emphasis of level two where a conflict existed. PricewaterhouseCoopers, among others, has argued that the FSA's softing and unbundling rules would be a probable casualty.

The FSA delivered a prepared statement via its press office that it welcomed the EC's document as a reference point for consultation but its lawyers can hardly have been so sanguine. Compliance consultants said that firms had cause for relief because they could budget more precisely for MiFID, although there was still some room for interpretation and the document was not final.

Level two has turned out closer than it might have been in the direction of maximum regulation and minimum directive - but hardly as McCreevy had hinted just before Christmas. "We had already known on the grapevine that there were problems making it mostly regulation and it has turned out impossible," a compliance officer said. He was amused that McCreevy had taken off to the US to speak to captive audiences on regulation at a time when every self-respecting financial journalist in London required a quote from him.

Mathew Rutter, associate at Norton Rose, said legal problems had long been identified - in particular how firms could ring-fence client and company assets. "This varies according to solvency laws in member states and you cannot be too precise."

McCreevy got as much as he could, however, according to lawyers. "They made this directive a maximum harmonisation directive, which is as close as you get to it being regulation without it actually being it," Rutter said. Recital seven says that you cannot add supplementary rules in areas covered by the directive, but recital eight says that you can add rules in specific circumstances of investor protection and market integrity, and they must be proportionate. "It gives a little wriggle room," Rutter said.

The overall outcome was slightly odd, however, he said. "Principles are supposed to be flexible. Here we have uniform principles. They are trying to give flexibility to investment firms but not to regulators."

Thwarting gold platers

The intention of the European Commission is clear, Rutter said. "It has tried to be as clever as it can in stopping regulators from gold-plating. It doesn't stop regulators from interpreting the regulations in different ways but levels three and four - covering implementation procedures - will address this."

Lawyers for regulators across Europe may be examining how far they may go beyond what MiFID requires. Rutter said: "If you say retail client protection should go beyond MiFID, you'd have to show it was not addressed by the legislation. It would be hard to do, but some regulators might try."

In areas other than those covered by MiFID, firms can do what they want, Rutter noted. "But I cannot immediately see a gaping hole waiting for regulators to fill."

PwC has been saying for some weeks that MiFID could undermine FSA rules. The highly harmonised legal regime that level two has become only confirms this, according to John Tattersall, head of the financial services regulatory practice.

Tattersall said: "This result must have made it more difficult for the FSA to retain some elements of its existing regime that are more popular with the industry, including bundling and soft commission."

Areas such as information provided to client classification, suitability and appropriateness, and reporting and best execution are now explicit in the directive, and regulators will need to note this, Tattersall said. "All this is not particularly good news for the FSA. But firms now know the scope of what they must cover and the FSA has only limited ability to change what there is."

The parts of level two that relate to markets, such as pre-trade and post-trade transparency, disclosure and systematic internalisers, are subject to regulation, Tattersall noted. The parts that involve firms and customers are subject to directive - no doubt because they had already been in civil law - which delayed the issue of level two. The tightly worded principles implemented in the directive section are "not as bad as they could be", Tattersall added.

The balance is 60 per cent directive, 40 per cent regulation, Rutter noted. "They made this a maximum harmonisation directive, which is as close as you can get to regulation without being it. We'll have to see how the FSA interprets level two and how much flexibility it tries to retain, but it is more prescriptive than UK firms are used to. They won't see it as principles-based."

Domestic practices

Rutter said that some overseas regulators might see level two as more principles-based than they would have wanted but Tattersall took a more ambivalent view: "There was a desire in some states such as Belgium and France to create greater transparency where equities are traded, and this has probably been achieved. Level two is prescriptive enough for this purpose. But they may not be so pleased to find level two has an impact on their domestic business practices and they have to change them."

How far MiFID has moved on is debatable, according to sources. In some areas, there is no difference from six months ago. There has not yet been much time to read the document in detail, but areas seen as uncontroversial so far include reporting obligations, cooperation and enforcement procedures, exchange of information between competent authorities, and some organisational issues.

Some areas have been more fluid, lawyers said. The area of information to clients has been changed and amended significantly. So have some transparency obligations. Outsourcing has been retained within the scope of level two, which had not previously been certain. Certainty has been needed for the scoping of systematic internalisers - not just for the comparatively few and large firms still deciding whether to become one, but for the mass of brokers that need to know how many systematic internalisers there would be so they may provide best execution requirements, Rutter said.

The significant steer that firms have on how to approach MiFID could be subject to further modification because parliament has got to approve the level two draft in the next four months and has the right to query it and raise issues. Tattersall said: "It must be understood, there is no real finality. This is an ongoing process."

Parliament has the right to question the content and to reopen issues, Rutter said. "The commission would encourage parliament not to take this route as it would undermine the consultation process. Firms have a greater element of certainty but need to monitor parliament and factor in some variation."

Compliance officers should be reading level two and identifying significant changes, Rutter concluded.

The views and the opinions expressed in 'hot topics' are that of the individual authors and not necessarily those of the Securities & Investment Institute.