Now that UK PM Theresa May has triggered Article 50, let’s hope this doesn’t happen…
UK regulator the FCA recently published findings from supervisory work in relation to best execution of client orders at investment management firms in the UK. This followed on from an FCA thematic review into best execution in 2014. The FCA’s findings were that these firms were still failing to ensure effective oversight of best execution and they had largely failed to take on board the findings of the thematic review.
In this piece, I outline what best execution is, what the FCA would like investment managers (IMs) to improve on and the key changes to the best execution obligation under MiFID II.
What is Best Execution?
Under MiFID I as implemented in COBS 11.2 of the FCA Handbook, the overarching best execution obligation requires firms, when executing client orders, to take all reasonable steps to obtain the best possible result, taking into account a range of execution factors – price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order. Where a firm executes an order on behalf of a retail client, the best possible result must be determined in terms of total consideration (total price and all costs).
The FCA’s Questions for Improvement
The FCA expects IMs to have a strategy to ensure that all relevant parts of their business are compliant in ensuring best execution. There should also be clear management responsibility and co-ordination between the Front Office and Compliance to ensure a robust monitoring framework.
In order to improve their approach, the FCA now wants IMs to consider the following 7 questions in relation to best execution and make improvements where necessary:
- Who would the FCA hold responsible if the firm fails in its obligation to ensure it consistently achieves best execution?
- Do we have a comprehensive strategy for overseeing best execution?
- Have we tested that funds and client portfolios are not paying too much for execution? Where we identified they have paid too much did we compensate the investors?
- Does our order execution policy accurately reflect our firm’s business model rather than being a generic policy?
- What trades or trends have been identified as deficient through our regular monitoring?
- Is our gift and entertainment policy in line with the guidance set out in the FCA’s Finalised Guidance 14/1 and the 2012 guidance re conflicts of interest?
- Have our staff been adequately trained to ensure they understand what best execution means and its consequences? How can we evidence this to the FCA?
Interestingly, IMs were not looked at as part of the FCA’s 2014 thematic review on best execution, which focussed more on sell side firms. The FCA has conducted a separate study into the asset management industry in 2016 although this is still at an interim report stage and only contains passing references to best execution.
The thematic review is worth reviewing in detail not least because it contains many informative examples of good and poor practices at firms in relation to best execution.
Best Execution and MiFID II
The EU Markets in Financial Instruments Directive 2014/65/EU (MiFID II) will apply from 3 January 2018 and places a specific obligation (Article 27) on firms to execute orders on terms most favourable to the client.
Best execution: key changes under MiFID II, Level 1, Article 27:
- Firms will be required to take all sufficient steps to achieve the best possible results (Article 27(1)), rather than all ‘reasonable’ steps as currently required;
- There is an explicit prohibition of remuneration for executing client orders which is contrary to the rules on inducements or conflicts of interest (Article 27(2));
- A requirement for all trading venues to publish data on the execution quality obtained (including price, costs, speed and likelihood of execution for individual financial instruments) at least annually, which will assist firms in delivering their monitoring requirements (Article 27(3));
- Requirements for firms to provide information to clients on execution of different classes of financial instruments, detail on how they have applied the execution factors and obtain the prior consent of clients to the order execution policy (Article 27(5));
- A requirement on all firms to publish data on the top five trading venues where they executed client orders and information on the quality of execution obtained on an annual basis (Article 27(6)).
MiFID II Article 27 will also be supplemented by Level 2 measures: Regulatory Technical Standards (RTSs) No. 27 on execution quality data to be provided by trading venues and RTS No. 28 on the annual report by firms on the quality of execution on identified trading venues.
Next Steps and Conclusion
The FCA says it will revisit best execution in 2017 to see what steps IMs have taken to assess gaps in their approach and how they can evidence that funds and client portfolios are not paying too much for execution. If it finds that IMs are still not fulfilling their best execution obligations, the FCA will consider making more detailed investigations into specific firms, individuals or practices.
Such an investigation would be the last thing an IM would want and so it would be prudent for IMs and other firms to consider the questions for improvement outlined above, the detailed findings of the thematic review, the changes being brought by MiFID II and to then take the appropriate steps in relation to best execution.
The UK Chancellor of the Exchequer, Philip Hammond, delivered the latest UK Budget on 8 March 2017. It was billed as “the final Spring Budget” because budgets are set to be delivered in the Autumn going forward. On the face of it, there was not much ground-breaking policy in this budget, certainly not much directly aimed at the financial services industry.
I examine some key points from the budget that will probably be of interest to financial services firms – especially banks, large corporates and the people that work for them.
1 – The Macro Picture: UK open for business as the second fastest growing G7 economy
There was an upbeat yet cautious outline of the UK economy in the budget. On the one hand, the UK’s GDP growth forecast was upgraded from 1.4% to 2% for 2017 and the Chancellor said that the UK had grown faster than every other G7 economy apart from Germany in 2016. However, the road ahead (basically the Brexit uncertainty) meant that GDP growth was forecast lower at 1.6%, 1.7%, 1.9% in subsequent years, returning back to 2% in 2021-22.
As an incentive for businesses in the UK, the Chancellor said that the UK corporation tax rate would, as planned, be cut to 19% from April 2017 and to 17% from April 2020. He pointed out that the UK’s corporation tax rate is the lowest in the G20. Clearly, businesses considering moving because of Brexit would need to take this tax competitiveness into account.
2 – National Insurance increase for the self-employed: Will employers who use them be next?
National Insurance Contributions (NICs) for the self-employed will go up from 9% to 10% in April 2018 and then to 11% in 2019 on earnings between £8,060 and £43,000. Earnings above £43,000 will continue to be taxed at 2% while those below £8,060 will not be taxed. Employees currently mostly pay 12% NICs.
The Chancellor sees this as a fairer balancing in the labour market given that self-employed people make up a larger proportion of the workforce than ever before and are now entitled to certain benefits like the state pension. Self-employed people could of course argue that compared to employees, they get fewer benefits (e.g. no sick pay or holidays) and so paying a lower level of NICs was fair.
The NICs rise is a clear breach of the spirit if not also the wording of Conservative Party Manifesto pledge of raising no new taxes in this Parliament. It may also signal a direction of travel: if the Chancellor is prepared to raise higher NICs from the self-employed in the name of fairness, will there be a future tax raid on the companies that use such self-employed labour? The likes of Uber, Deliveroo and other “gig economy” players may seem the most obvious future targets but plenty of banks and other corporates use self-employed contractors too – everywhere from IT to legal.
3 – Tax-free dividend allowance reduced: Crackdown on investors and service companies?
From April 2018, the total amount of dividends that individual company shareholders can receive tax-free from their company will fall from £5,000 to £2,000 per year.
According to the Chancellor, half of the people who have benefited most from this tax break are company directors with a shareholding in their business (they can effectively pay themselves £5,000 above any salary they may also get from their company) and the other half are investors who hold £50,000-plus of investments outside their usual ISA allowance (set to rise to £20,000 from April 2017).
Again, this cut was meant to address unfairness in the economy. Generally, there seemed to be signals that using a service company only to get a tax break (UK corporation tax can be much lower than income tax) is something that may soon be the subject of further tax reform.
4 – Shares in Lloyds Banking Group and RBS & UK Debt Markets
The budget gives an update on the sale by the UK government of shares it acquired during the crisis. In relation to Lloyds, it is following a divestment plan laid out in October 2016, is on track to sell all its shares by 2017-18 and fully recover the £20.3 billion taxpayer funds used. In relation to RBS, there were “legacy issues”, which have so far prevented any opportunities for disposal. The budget also provided an update in relation to UK Asset Resolution Limited (UKAR) – the company set up to hold the mortgage assets of Bradford & Bingley and Northern Rock – whose balance sheet had reduced from £115.8 billion in 2010 to £36.9 billion in 2016.
To help the UK debt markets, there will be withholding tax exemptions in relation to the interest of debt traded on a Multilateral Trading Facility (MTF). A consultation in Spring 2017 will be launched about how this policy should be implemented.
5 – Brexit
Brexit was conspicuous by its absence from the substance of the budget. The Chancellor is clearly keeping his powder dry for the next budget (in Autumn 2017) when the UK will probably have invoked Article 50 of the Lisbon Treaty and talks about exiting the EU will have been underway for some time. The Chancellor did joke however that the UK’s public sector net borrowing was predicted to fall to 2.6% of GDP this year, meeting the EU target of 3% for the first time in 10 years – but that he was not holding his breath for a congratulatory letter from (EC President) Jean-Claude Juncker.
On 23 November 2016, the European Commission (EC) outlined proposals to amend the Capital Requirements Regulation (EU/575/2013) (CRR) and the Capital Requirements Directive (2013/36/EU) (CRD) (and together referred to as CRD IV). These proposals are likely to form part of the next version of these measures i.e. CRD V. Links to the proposals are here (CRR) and here (CRD).
One proposed CRD V measure is a requirement for non-EU banking groups (including US groups) operating in the EU to consolidate their subsidiaries under a single “Intermediate Parent Undertaking (IPU)” in the EU, which will need to be separately authorised and capitalised. I discuss this and similar measures introduced by the US for non-US banking groups operating there. I also consider the impact of the proposals in relation to Brexit.
The EC proposals would see a new Article 21b added into CRD to cover IPUs, which would stipulate that:
- if a third country group (i.e. a non-EU group) has two or more institutions (i.e. banks or investment firm subsidiaries) in the EU, it must have an EU-based IPU above them;
- such an IPU must be separately authorised and be subject to EU capital requirements or be an existing bank or investment firm authorised under CRR;
- there must be a single IPU for all subsidiaries that are part of the same group; and
- the threshold for this requirement to apply would be if: (a) the total value of assets in the EU (both subsidiaries and branches) of the non-EU group is at least Euro 30 billion; or (b) the third country group is a non-EU G-SII (i.e. global systemically important institution or bank – see list maintained by the FSB).
These proposals would require non-EU banking groups to hold EU bank and broker-dealer (investment firm) subsidiaries through a single EU-based IPU that would be subject to capital, liquidity, leverage and other prudential standards on a consolidated basis.
The IPU requirement may have been added late into the draft CRD V proposals and it seems to have been included without following the usual discussion and impact assessment process for such measures. It has been suggested that this is a retaliatory action to similar measures introduced by the US (discussed below). It is possible that EU Member States will decide to alter or even drop this measure before CRD V is adopted into law.
Possible Effect of the EC Proposals on US Banking Groups
Due to strict limitations on transactions between a US Federal Deposit Insurance Corporation (FDIC)-insured bank (and its subsidiaries – the “bank chain”) on the one hand and its bank holding company parent and sister companies (the “non-bank chain”) on the other, the large US bank holding companies operate their US broker-dealer subsidiaries as sister companies of their FDIC-insured banks and often do the same with their non-US broker-dealer subsidiaries.
Such large US bank holding companies operate in the EU through branch offices of their FDIC-insured banks as well as through locally-incorporated bank subsidiaries of those banks and separate (non-bank chain) broker-dealer subsidiaries.
To comply with the EC poposals on IPUs, a US bank holding company would need to transfer its EU bank subsidiaries so that they and the EU broker-dealer subsidiaries become indirect subsidiaries of the parent bank holding company via a single EU IPU. Doing so, could severely limit transactions between the US FDIC-insured bank including its EU branch offices and the EU bank subsidiaries (as well as the other EU subsidiaries) of the US bank holding company.
All this is likely to mean that US banking groups may have to totally rethink their existing holding structures in Europe – they may already be doing so due to Brexit (see below).
US Intermediate Holding Company Rule
Title 12 of the US Code of Federal Regulations (12 CFR Part 252.153) introduced a similar rule in March 2014 requiring that any foreign banking organisation with US non-branch assets (i.e. subsidiaries) of USD 50 billion or more must establish a US intermediate holding company (US IHC) or designate an existing subsidiary as such.
As you can see, the US IHC rule has a much higher threshold (USD 50 billion) than that of the corresponding EC proposal (Euro 30 billion) and the US threshold only considers assets of subsidiaries, whereas the EC proposal also counts branch assets.
The US IHC rule was viewed as addressing the capital position of large US broker-dealer subsidiaries of non-US banking groups because such subsidiaries were not otherwise subject to US prudential banking regulations including on risk and leverage. In the EU however, broker-dealer (investment firm) subsidiaries of US banking groups are currently subject to Basel-based prudential requirements.
The EC may or may not have had Brexit in mind when it came up with this proposed IPU measure. Post-Brexit, depending on any negotiated arrangements, the UK will be outside the EU and thus, on the face of it, UK banking groups will be in the same boat as other non-EU groups with regard to the CRD V proposals and may need to establish IPUs in the EU to hold their EU subsidiaries. Some UK and non-EU banking groups that are not G-SIIs may review the scope of their activities in the EU in light of these requirements.
Also, from the point of view of US and other non-EU banking groups who currently operate in Europe out of the UK, the need for a separately capitalised holding company in Frankfurt or Luxembourg, for example, could make London a less attractive headquarters for European operations. Given that most banking groups are currently looking at their structures in light of Brexit, the EC proposals on IPUs will add a further layer of complexity to these considerations.
Next Steps and Conclusion
The EC intends that the CRD V proposals will apply two years after the legislative text is finalised. This would take us well into 2019 at the earliest and therefore, the IPU measure is unlikely to be applicable when the UK leaves the EU – assuming that the UK invokes Article 50 of the Lisbon Treaty in early 2017 and leaves the EU in the two year period provided.
The EC proposal for IPUs will probably be welcomed by European banking groups that have found themselves on an uneven playing field with US rivals. However, most banking groups are reluctant to hold multiple pools of capital around the world, overseen by different regulators, which they see as less efficient than a centrally managed capital pool regulated by their home bank regulatory authority.
Whether or not the EC proposals on IPUs are adopted into law as they are currently drafted, there does seem to be a growing regulatory trend towards a fragmentation in financial rules, as key jurisdictions like the EU and the US seek to assert control and seem comfortable taking tit-for-tat action even at the risk of duplicating or complicating internationally-settled regulatory measures.
The EU Markets in Financial Instruments Regulation EU/600/2014 (MiFIR) and Markets in Financial Instruments Directive 2014/65/EU (together referred to as MiFID II) will apply from 3 January 2018. This date is much closer than it seems and banks and investment firms are currently scrambling to implement MiFID II-compliant measures in their systems, controls and client documentation.
MiFID II replaces and partially recasts the existing MiFID regime under the directive 2004/39/EC (MiFID I) and in many places introduces new concepts or extends the meaning of existing concepts.
In this piece, I consider some of the main new MiFID II concepts and the inevitable jargon that goes with them.
Algorithmic or high-frequency trading (HFT): trading in financial instruments by a computer algorithm with limited or no human intervention. MiFID II will require such trading to be conducted by authorised investment firms, be supervised and have controls and other safeguards to ensure it does not cause any disruption in the market.
APA (Approved Publication Arrangement): MiFID II introduces the concept of an APA who will assist in price discovery by publishing post-trade transparency data. An APA could be a new market participant or a new activity conducted by Trading Venues such as exchanges. An APA will be subject to authorisation and organisational requirements.
ARM (Approved Reporting Mechanism): a new concept introduced by MiFID II for enabling transaction reporting by investment firms to regulators. An ARM will be subject to authorisation and organisational requirements.
CTP (Consolidated Tape Provider): MiFID II envisages a new provider that will consolidate post-trade disclosures and make them publicly available (a continuous electronic live data stream providing price and volume data). A CTP will be subject to authorisation and organisational requirements.
DRSP (Data Reporting Service Provider): an APA, ARM or CTP.
Financial Instruments: this is a wider concept under MiFID II and refers not only to shares and other “transferable securities” but also to money-market instruments, units in collective investment schemes, emission allowances and derivatives such as options, futures, swaps and forward rate agreements.
Independent Advice: the provision of personal recommendations to a client. MiFID II will oblige firms to ensure that staff are not remunerated or assessed in a way that could conflict with the duty to act in a client’s best interest.
OTF (Organised Trading Facility): a trading venue for bonds, structured products or derivatives (i.e. non-equity financial instruments). This is a new concept and MiFID II will now regulate OTF platforms (e.g. broker crossing networks).
MTF (Multilateral Trading Facility): a venue where financial instruments can trade outside of a regulated market e.g. an internal matching system at a firm that executes client orders in shares. This is a MiFID I concept but MTFs (as also OTFs) will now need enhanced financial resources, measures for risk management and conflicts of interest identification.
Post-trade transparency: publication of transaction data via an APA by the operators of Trading Venues or SIs immediately following a trade – to be available on commercial terms immediately or for free after 15 minutes.
Pre-trade transparency: continuous publication of bid and offer prices of financial instruments by operators of Trading Venues (e.g. exchanges) or publication of firm quotes by SIs, in either case, before a trade takes place.
Regulated Market: a stock market or exchange regulated by an EU member state for trading in publicly-listed financial instruments e.g. the London Stock Exchange.
SME Growth Market: a new category of MTF that will enable small and medium-sized entities (SMEs) to access capital. At least 50% of the issuers on such an MTF must be SMEs.
SI (Systematic Internaliser): traditionally called “market maker” this is an investment firm which routinely deals on its own account by executing customer orders in shares outside a Trading Venue such as an exchange. MiFID II will extend this concept to cover all financial instruments not just shares. SIs will also need to publish firm quotes and post-trade data.
Trading Venue: an OTF, MTF or Regulated Market. MiFID II will require Trading Venues to have better systems, controls and circuit-breakers and there will be rules on minimum tick size (price increments). They will also need to publish annual data on execution quality.
Transaction Reporting: MiFID II envisages the reporting of transaction data by investment firms that execute transactions in financial instruments to the regulator (e.g. the FCA) within 1 day of the trade via an ARM.
TTCA (Title Transfer Collateral Arrangement): this not a MiFID concept as such but MiFID II prohibits firms from entering into TTCAs with retail clients and obliges firms to consider the appropriateness of a TTCA for the other categories of clients – i.e. professional clients or eligible counterparties.