On July 3rd this year MAD II comes into force in the EU, to be following by MiFID II, planned for January 2018; two regulations that aim to continue the fight against market abuse. One of the main consequences of these regulations is that buy-side firms are going to face significantly larger compliance challenges than at any time in their past; one that will demand wholesale change to the way in which such firms currently monitor and report on their orders and transactions.
MAD II will demand that firms not only monitor trades, but orders too. This innovation will exponentially increase the monitoring responsibilities of compliance teams. Significantly, the range of instruments requiring monitoring will increase. MAD II applies to financial instruments traded on all regulated markets (as did the 2003 Directive) but it extends the surveillance obligations to cover instruments traded on multilateral trading facilities (MTFs) and organised trading facilities (OTFs). MAD II also covers trading in other financial instruments outside of those markets, which are themselves dependent on the price of a financial instrument traded on one of the prescribed markets, for example: contracts for differences or credit default swaps. MAD II applies wherever the activity is taking place. On top of this, and following LIBOR and other rate-setting scandals, the manipulation of benchmarks falls within the scope of MAD II.
Crucially, buy-side firms will no longer have the option of outsourcing market monitoring to brokers. Firms will be required to monitor their order books and report insider dealing or market manipulation, including the names of the employees connected to the potential offense, to the regulator. Additionally, post July 2016, the offences of market manipulation under MAD I will be extended to cover attempts of manipulation.
Attempts may include situations where the activity is commenced, but not completed. This could happen, for example, as a result of technology failure, data errors or an instruction to trade that is not actually executed. This is a level of information that buy-side firms will want to share directly with the regulator rather than going through their brokers. The impact of this change on the buy-side cannot be overstated, as it demands an entirely new approach to compliance monitoring and reporting.
In addition to prescribing market abuse offences, MAD II requires the management and disclosure of inside information and the maintenance of insider lists. Buy-side firms should also be aware that from July 3rd they will also have new responsibilities with regards to monitoring for insider-trading. As recent events have shown, insider trading remains a challenge in the financial markets and one that MAD II is intended to clamp down on.
The Financial Conduct Authority has produced a paper detailing best practice for insider trading monitoring. The document makes it clear that buy-side companies will be expected to maintain up-to-date trader lists and use these to ensure against conflicts of interest for new and existing employees. These requirements demand new tools and processes and will add further to the burdens faced by already strained compliance teams.
Similar large-scale changes will be driven by MiFID II, which will require all firms to report all trades, transactions and orders in a vast variety of instruments. The complexity of these reporting has forced the regulators to increase the reporting format from 25 fields to more than 60. One key change in this respect is that under MiFID II buy-side firms will need to make their order books more transparent in order to help enforce laws against manipulation.
MiFID II will also add several complexities to the Best Execution regime. Firms have the obligation to annually publish the top five execution venues for each class of financial instruments. Buy-side firms will also be prohibited from receiving any remuneration, discount or non-monetary benefits from routing orders to a particular venue or broker.
ESMA is clear in its finding that: “In order to detect market abuse and attempted market abuse, entities will need to have in place a system which is capable of the analysis of every transaction and order, individually and comparatively, and which produces alerts for further analysis. ESMA is of the view that in the large majority of cases this will necessitate an automated surveillance system.”
The effect of MAD II and MiFID II on the buy-side will be huge. These regulations demand nothing less than a complete change to the way in which market trades and transactions are monitored and reported and will involve a level of complexity that some firms might struggle to meet. There is no time to wait. With the implementation of MAD II just weeks away firms need to start planning now or risk falling foul of the regulator.
These topics, and particularly the incoming EU Benchmark Regulation, will be discussed at RIMES’ regulatory seminar in London on June 9th. Please click here to view the agenda and to register.