MIFID: The legal challenge

With the arrival of MiFID, it is important for managers to be clear as to the basis on which their brokers are dealing with them, explains Richard Frase and Jessica Brescia

On 1 November 2007 the Markets in Financial Instruments Directive, (MiFID), was due to be implemented across Europe, replacing the old Investment Services Directive and initiating a major restructuring of financial services markets.

Much of this process has focused on broker-dealers, with the position of asset managers often seeming to be tacked on as an afterthought. Two particular examples of this are best execution and transaction reporting.

Although the best execution debate has now reached a largely happy conclusion, much of the last two years seem to have been spent trying to redesign the markets to fit the rules rather than the rules to fit the markets.  Initial MiFID rode roughshod over the whole concept of dual capacity broker-dealing, by insisting that all intermediaries must offer best execution unless they were dealing with clients who were classified as eligible counterparties. This pretty much compelled brokers to force their investment manager clients into the eligible counterparty category, meaning that the managers had no right to best execution. At the same time the managers themselves were still expected to provide best execution to their own clients, whom they were not allowed to classify as eligible counterparties. It simply didn’t add up.

But now it is agreed that a best execution obligation arises where the broker is acting ‘on behalf of’ its manager client, rather than simply dealing ‘with’ it. Whether a firm is dealing ‘on behalf of’ its client is a matter of fact, but this will normally be the case where:

• The broker executes the manager’s order by dealing as agent (‘agency execution’);
• The broker executes the order by dealing as a riskless principal (‘riskless principal execution’); or
• The broker executes the other side of the manager’s order from its own book, if this is on the understanding that the firm will execute at the best market price available (‘own account best execution’).

By contrast, the firm will not be dealing on behalf of its client where it is simply acting as a proprietary trader, quoting prices at which it is prepared to deal, or responding to a ‘request for quote’, without assuming any responsibility to the client for the quality of the price or the transaction generally (‘own-account counterparty execution’).

It is thus important for managers to be clear as to the basis on which their brokers are dealing with them, and use their services accordingly.  A manager who wants to rely on its broker to find the best price should not be dealing with a broker who is quoting a two-way spread off its own trading book.

There remains the eligible counterparty problem.  The new approach described above makes life a good deal easier. But MiFID still automatically categorises asset managers as eligible counterparties, and if a manager wants best execution it will have to negotiate this as a contractual matter with each broker it uses. While most brokers are amenable, some are not, and managers will need to adjust the business they send to these refusniks accordingly.

Then there is the curious structure of the MiFID best execution process. The original process was designed for executing brokers, and adapted only at second level directive stage for managers. As a result there is one execution regime for the manager who executes a transaction directly with a counterparty, and another for the manager who executes by placing an order with an executing broker. The immediate reaction of many managers is that they only execute through brokers. However, there will often be at least some situations, such as bond transactions, where this is not the case.  Most managers are therefore likely to find themselves juggling two different regulatory execution policies.

Our second issue is transaction reporting, by which we mean the obligation on a firm to report transactions it executes to its local regulator. While there has been a general presumption that a manager’s executing broker will take care of these reporting obligations, this has not always been the case, most notably where the executing broker was based in another EEA state which was not subject to equivalent transaction reporting rules. Unfortunately, this mismatch seems set to continue.

Under MiFID the regulatory reporting system is being harmonised at a pan-European level. The range of financial instruments now covered includes all instruments admitted to trading on a regulated market or a prescribed market, including transactions in commodity, interest rate and foreign exchange derivatives. But exactly what comes within the definition of ‘reportable transaction’ is still somewhat unclear. Different interpretations apply in different member states. The FSA appears to be taking a particularly wide interpretation, as well as extending the system to include OTC derivative instruments, where they are based on an underlying instrument traded on a regulated market.

Managers are still entitled to rely on their brokers to report on their behalf, but must have reasonable grounds for believing that this will happen. 

If the manager uses a broker which is not subject to MiFID, or uses a broker in another EEA state which takes a narrower view of a ‘reportable transaction’, then the manager cannot rely on its broker and is faced with having to make the report itself. Situations where a manager is required to do this are likely to be infrequent. It had been hoped that a practical solution could be reached.

But the FSA seems dismissive of the asset managers’ position, simply asserting that they must follow the same rules as full brokerage houses. The effect is seriously disproportionate. UK managers are being told to build and operate full electronic reporting systems (manual reporting is not allowed) for minimal regulatory benefit. It is most unlikely that managers in other EU states will be subjected to equivalent requirements.

© fe November 2007

• Richard Frase is a partner and Jessica Brescia an associate at Dechert LLP