MiFID 2/MiFIR: An overview

Here is a brief overview of MiFID 1 and 2 with a focus on MiFID 2.

MiFID 1

Markets in Financial Instruments Directive (MiFID) came into effect in November 2007 and is applicable for firms in the European Economic Area (EEA). MiFID by itself replaced Investment Services Directive (ISD) which came into effect in 1995.

The objective of MiFID is to increase harmonisation of services by trading venues and investment firms in the EEA, prevent market abuse and improve protection for the investors. It retained the concept of EU passport for firms to trade in other EEA countries.

Products in scope of MiFID are Equities, Bonds, Credit derivatives and Interest Rate derivatives (with underlying as an Equity or Bond, eg: Bond Option).

Since the implementation of MiFID Level 1, there have been various changes in the Financial Markets due to 2 key reasons.

1. technological advancements like algorithmic trading
2. 2008 Global Recession.

Due to these changes, a revision to MiFID has been proposed this is the MiFID 2.

MiFID 2

There are 2 levels in MiFID 2 level 1 and level 2. Level 1 includes a revision of MiFID and a new regulation MiFIR (Markets in Financial Instruments Regulation). Level 2 includes implementing measures for the directive and the new regulation in the form of delegated acts and technical standards (RTS).

The updated effective date for MiFID 2 is 3rd January 2018 (with a previous date of 3rd January 2017).

The updated legislative framework covers several newer areas or updates to earlier areas including but not limited to:

Organised Trading Facility (OTF) Introduces a new category of trading venue called Organised Trading Facility (OTF) in addition to earlier defined regulated markets and multi-lateral trading facilities (MTFs). When compared to MTFs, the operator of an OTF plays an active role in bringing together buyers and sellers. OTFs in some cases are allowed to internalise the orders (i.e., trade in principal). OTFs have a restriction to faciliate trading in bonds, structured products, emisssion allowances or derivatives and equities are not allowed to be traded on OTF.

Systematic Internalisers Introduces a new category for investment firms called Systematic Internalisers. Investment Firms who execute client orders outside a trading venue will be considered as a systematic internaliser (SI) based on their frequency and quantity of trading.

Commodity derivatives Emission allowances now fall under the scope of MiFID. And physically settle contracts on OTFs will be in scope of MiFID (except electricity and gas). There are also position limits and position reporting requirements for trading venues.

Algorithmic Trading/High Frequency Trading As per the draft RTS, ESMA categorizes trading algorithms into 2 sets: investment decision algorithms and order execution algorithms. The more famous ones are a comination of both where a decision is taken and order executed.

HFT is defined as a algorithm trading techinique to reduce network latencies like co-location, proximity hosting or high speed direct electronic access.

There is a mention of a kill functionality to withdraw all or a subset of orders where needed. It is therefore necessary to keep track of the algorithm and traders involved in the order. How and when this requirement will arise and how firms will be notified of the need for withdrawal is to be further clarified. There is a mention of manual monitoring by trader(s) of the trading activity arising out of algorithms.

The requirements state to the extent of internal source control and testing requirements of the trading systems and trading algorithms.

There is also a mention of record-keeping requirements to keep records of orders executed by an algorithm for 5 years. The record should contain about 30+ fields like buy/sell, price, quantity, transaction id on trading venue, etc.

• Derivatives Trading Obligation: There is a high level requirement that OTC derivatives transactions which subject to clearing obligation under EMIR need to be traded on Regulated Market, MTF or an OTF. Further guidance is expected on more details on which of the transactions will be in-scope and which will be exempted. There is a consideration of third country trades where the trade or a part of the trade is guaranteed by a financial counterparty in the EU. (* Definition of FC is covered under EMIR and counterparties are im general already classified as FC/NFC/NFC+/NFC-). This requirement definitely calls for a pre-trade jurisdiction obligation determination service for the traders.

• Pre-trade and Post-trade transparency (Trade Reporting) The transparency requirements have been extended beyond equities to cover depository reciepts, ETFs, cerificates and similar equity-like instruments, and bonds, structured products, emission allowances and derivatives

Pre-trade transparency is the reporting of details on the orders like bid and offer price.

Post trade transparency is to report the date and time, instrument identifier, price, quantity, time, venue, etc

The venue scope is extended from current regulated markets to MTFs, OTFs and SIs.

Approved Publication Arrangements (APA) is to be used by SIs to report pre and post-trade data. This requirement in case of SIs for pre-trade transparency is for equity and equity-like instruments and does not apply to other instruments, eg: derivatives. Also this is to be done by the SI if one of the firm is a SI and by the seller if both parties are Sis (the favorite tie-breaker).

The reporting of post-trade trade data will need to be done within 3 minutes of order execution with the requirement stating as instantaneous as technically possible and as close to real-time as possible. The use of word instantanenous itself states it is expected to be reported must faster than the other regulations where the requirements state as soon as technically possible.

It is important to note the need for cancel and rebuild in case of trade amends.

A new type of providers are introduced which are the Consolidated Tape Providers which consolidate the reported data and make it available to public.

Instrument Reference Data Reporting Trading venues and systematic inernalisers require to report instrument reference data. A set of fields has been provided in the RTS and which of the fields need to be populated depends on the type of instrument.

Transaction Reporting The reporting rules are defined under the Article 26 of MiFIR. The transaction reporting scope has been extended in terms of products to FX & Commodity derivatives, trading venues to MTF & newly defined OTF and reporting parties (eg: trading venue to report if the parties executing the trade are not subject to MiFIR).

The number of reportable fields have increased from 23 to over 60 with some new interesting fields to provide the details of how the trade was executed (eg: by an algorithm), unique algorithm code within the investment firm, buyer and seller decision maker details, waiver indicator, etc

Transaction reporting being my favorite area, I will publish a separate post shortly covering that in detail, especially focusing on how it varies from the previous version of MiFID and the other regulations - EMIR, Dodd Frank, JFSA reporting, HKMA reporting, MAS reporting, etc And also about the increasing multi-jurisdiction reporting challenges of trades/trading events.

Overall there are requirements for internal controls, impact to trade execution methods, new categories, new service providers and multiple reports/records to be maintained right from order to T+1 transaction reporting.

I have referred to the documentation on ESMA, EC, FCA and other sites to prepare this blog. Please feel free to comment if there is anything that I might have missed out. As with any new directive/regulation, MiFID 2 will continue to evolve until it comes into effect !

About the author

Vishnu Vardhan Chikoti is a co-author for the book "Hands-on Site Reliability Engineering". He is a technology leader with diverse experience in the areas of Application and Database design and development, Micro-services & Micro-frontends, DevOps, Site Reliability Engineering and Machine Learning.