The European financial services industry arguably stands at the threshold of a new era of regulation.
To date, the basic model has been for high-level European law (such as the current Investment Services Directive) to be set in stone, underpinned by an evolving mass of detailed regulation at national level. Two key factors lie behind the likely demise of this world: first, technology and market structures are changing constantly and the EU has recognised that it needs to create a legislative structure which permits a rapid response to these changes; second, and more controversially, there has been a feeling at EU level that the current single market directives have not delivered a genuine single market at all – too many barriers have prevented the carrying on of cross-border business.
To solve these problems, the European Commission (the Commission) has been pushing ahead with the Financial Services Action Plan. The Markets in Financial Instruments Directive (MIFI) and the Market Abuse Directive (MAD) are two of its flagship measures.
MIFI: what stage is it at?
MIFI will replace the existing Investment Services Directive, which was implemented in 1995. There are a number of outstanding controversial areas since the Council of EU Economic and Finance Ministers (Ecofin) did not accept certain key parliamentary amendments favoured by the UK. To some extent, there is now a ‘Mexican standoff’ between Ecofin and the EU Parliament, with all to play for in the forthcoming negotiations. The Parliament’s second reading will take place over the next few weeks. In order to achieve political agreement before the European parliamentary elections and the subsequent accession of additional states to the EU, some compromise between the current positions of Ecofin and the Parliament will be required.
Certain outstanding issues remain of concern to the UK financial services industry. First, ‘know-your-customer’ checks may be required for execution-only business in certain circumstances. Depending on how the drafting turns out, this may have a key impact on the cost model for fund supermarkets and online execution-only brokerages. Second, the current flexibility of the UK market structure, in which firms execute trades on exchange, on electronic ‘multilateral trading facilities’ or off exchange (through ‘crossing’ the order with other client orders or as a matched principal), is under threat. Firms will be required to obtain the prior express consent of their customers both to their best execution policies and before executing orders outside a regulated market or multilateral trading facility. Firms that execute client orders against their own book on an organised, regular and systematic basis (in the technical jargon, ‘systematic internalisers’) will be required to publish and adhere to firm bid/offer quotes in relation to most transactions.
This pre-trade disclosure requirement is the key area in relation to which the UK still wishes to see significant changes. The optimal position would have been to remove the provision entirely, but this is no longer realistic given the current state of the negotiations. Therefore, the UK is lobbying to reduce the maximum transaction size to which the obligation applies; to impose fewer constraints on price improvements for wholesale clients; and to limit the extent to which further requirements can be imposed on systematic internalisers by delegated European legislation. It is likely that the final version of MIFI, approved by both Ecofin and the Parliament, will include a compromise on this issue.
A single set of European regulations?
Amid these controversial issues, it is important not to lose sight of the bigger picture. MIFI marks a sea change away from the world in which a ‘host state’ (ie the state of the consumer) may impose conduct of business rules when services are provided into its territory from another member state. Host states will be stripped of the majority of these powers in a move towards the ‘Holy Grail’ of a single set of compliance and operational procedures for pan-European business. Instead, the power to impose conduct of business regulation will lie with either the home state of the firm (usually the member state in which it has its registered office) or, where this is different, the member state in which a branch is located and from which the service is provided.
The other key point to note is that MIFI is likely to usher in a new era in which much, if not most, of the detailed prudential and conduct of business rules applicable to day-to-day business will be set at a European level. MIFI contains powers for the creation of level two delegated legislation under the ‘Lamfalussy’ process. This will allow the Commission to expand on a number of key areas, creating a much thicker layer of EU legislation, such as through rules on systems and controls, conflicts, conduct of business and best execution. The reverse side of the coin is that there will be less room for putting matters right at national level. This requires a major cultural change for the financial services industry, with much more focus on the consultations by the Commission and the Committee of European Securities Regulators (CESR), rather than exclusive concentration on domestic consultation from the Financial Services Authority (FSA) or equivalent regulators.
MAD: what stage is it at?
MAD is more advanced than MIFI. It was adopted at EU level on 28 January 2003 and is due to be implemented by 12 October 2004. For the first time at European level, it establishes a formal legal framework in relation to not just insider dealing, but market manipulation as well. The text of the first set of level two delegated legislation has also been agreed, and the CESR has consulted on further legislation. There is a tight timetable for the directive, and HM Treasury and FSA consultations on implementation are due to be published in the next few months. The most important practical question in the UK context is what impact the directive will have on the market abuse regime under the Financial Services and Markets Act.
Impact on the UK
Unlike the current UK regime, MAD does not contain a ‘regular user’ test. In relation to market manipulation, there is a partial equivalent by reference to a dual test based on a person’s ‘legitimate’ reasons for entering into a transaction and the transaction’s compliance with “accepted market practice”. However, “accepted market practice” for these purposes is determined by reference to its acceptability to the competent authority rather than to the market as under the current UK regime. One way around this problem might be for the competent authority to align its standard to that of the market. This could be done by the issue of guidance on “accepted practices” in accordance with an express power in the directive. However, it is not clear whether the evidential status of such guidance will be the same as that of the Code of Market Conduct. Currently, the FSA is able to give guidance in the code that certain behaviour does not constitute market abuse. This guidance has the status of a safe harbour and is not merely indicative that abuse is not being committed.
Second, there is the key question of territoriality. Both the member state in which the abuse takes place and the state in which the relevant instrument is admitted to trading have power to take action under MAD.
The UK favoured this approach as it wished to maintain the current scope of the UK market abuse regime. However, the effectiveness of this dual territoriality will depend in large part on effective practical cooperation between competent authorities in different member states. The key issue will be whether different member states take similar approaches to particular market practices in the context of cross-border deals. The theory of the level two delegated legislation process and the level three underlying common standards being developed by the CESR is that such differential regulatory arbitrage should not occur. It remains to be seen how this will work in practice in relation to cross-border transactions.
MIFI and MAD are topical examples of a more general shift in the financial services arena towards European-level regulations and away from differing national standards. While a single European standard should prove beneficial to firms operating in the EU, it may create different problems if it is more onerous than the particular national regimes currently in operation. There is all to play for in the months to come.
Jonathan Herbst is a partner in Norton Rose’s financial services group and was assisted in this article by assistant Rosamund Brown