Remarks delivered to the Irish MiFID Industry Association
Good morning ladies and gentlemen. I want to thank you for the invitation to speak at today’s Irish MiFID Industry Association (IMIA) event.
In my remarks, I will spend some time discussing the implementation of MiFID II and what we have seen as supervisors in its first year. I will also provide you with an insight into some of the Central Bank of Ireland’s related supervisory priorities for 2019.
But first I would like to acknowledge the good work that the IMIA has undertaken since its formation in 2017. From a Central Bank viewpoint, it is encouraging to see that an association, initially formed to discuss issues on the implementation of MiFID II, has developed into a permanent industry body, providing a forum for regular peer interaction and the promotion of good practice, including hosting events like this morning. I wish the Association continued success and at the Central Bank we look forward to further engagement over the years to come.
The journey to MiFID II
It is important to begin by reflecting on how we arrived at MiFID II.
In 2007 we witnessed the introduction of MiFID I. MiFID I developed and extended the scope of EU regulation under the Investment Services Directive (ISD). Critically, it imposed more extensive requirements on investment firms relating to their organisational structure and conduct of business. At the time, MiFID I represented a significant expansion of EU regulation of financial markets.
However, the years that followed exposed a number of weaknesses in the legislation. For example:
- It became clear that there was a lack of transparency requirements, particularly with regards to non-equity markets.
- It was evident that a considerable volume of trading was taking place under the radar.
- We saw financial markets evolve at a dramatic pace, to the extent that MiFID I became outdated very quickly.
In response to this, MiFID II brought new activities into scope, removed or narrowed exemptions and extended MiFID’s coverage to new financial instruments and products such as emission allowances, commodity derivatives and structured deposits. Other key changes included new organisational requirements, new product intervention powers for regulators and enhanced conduct of business rules.
At its core, consumer/investor protection underpins the majority of these changes in MiFID II, identifying clear steps for investment firms to take:
- To ensure that the products provided serve the needs of clients.
- That the level of risk is appropriate to each client.
- That the client is aware and understands the risk that goes hand in hand with their investment.
Key to this is correct client categorisation. Firms must consider a client’s knowledge and experience, their financial situation, risk tolerance, objectives and needs. Moreover, in developing products for target clients, manufacturers must also consider these criteria and so too must distributors with reference to their own client base.
As the client relationship develops, MiFID II has also introduced enhancements aimed at tackling the risks to the delivery of fair client outcomes. For example, the definition of non-complex instruments has narrowed – this increases the appropriateness testing that firms must undertake. Furthermore, where National Competent Authorities have significant investor protection concerns, we now have product intervention powers as well as the power at ESMA to intervene on a temporary pan-EU basis. We can also use these powers where we see threats to the orderly functioning and integrity of the financial markets.
ESMA has used its temporary product intervention powers under MiFIR to prohibit the sale of binary options to retail clients and to place certain restrictions on the sale to retail clients of contracts for difference (CFDs). As you will be aware the Central Bank had particular concerns regarding the investor protection risks posed by CFDs for some time (a thematic in 2016 illustrated that 74% of retail clients lost on average €2,700 when investing in CFDs1). We continue to support the ESMA measures and the Central Bank notified the market in January2 that it was considering using the product intervention powers in MiFIR, in the event that the ESMA measures elapse, to ensure the continued protection of retail investors in relation to the sale of CFDs and binary options.
Of course, stepping back from the technical detail of these regulatory requirements, underlying them is a recognition of the need for financial services to be trustworthy if the true benefit of a single EU securities market is to be achieved. One cannot truly understand (or properly interpret) the requirements of MiFID II without keeping this fundamental point in mind. Indeed, without trust, how can you expect to develop long-term relationships with your clients and how can we expect there to be a stable and orderly EU securities market.
Costs and charges
One of the most important things for clients to have trust in of course is how they are being charged for the service they are receiving. Investment firms have had to meet strengthened requirements on disclosing information about costs and charges to clients, both on an ex-ante and ex-post basis. At ESMA we continue to carry out extensive work on this topic and ESMA recently published Q&As which provide clarity regarding the consistency of information to be disclosed.
I would like to remind firms of the ESMA Q&A tool, which allows interested stakeholders to submit questions directly for its consideration. This is an excellent resource and we encourage you to take advantage of this direct line to ESMA. The Q&As will continue to be updated with the aim of promoting common supervisory approaches and practices.
At this juncture I would like to focus on how MiFID II has changed market infrastructures.
Under MiFID II, the abolition of broker crossing networks, limitations on dark pool trading and the trading obligation were designed to bring the majority of trading across Europe “on-venue” to either an existing Regulated Market or MTF or alternatively onto a new venue type – an OTF. Additionally in order to capture and increase transparency of OTC trading MiFID II set out clearly defined thresholds for becoming an SI. As the Chair of ESMA, Steven Maijoor, recently remarked, the MiFID II transparency regime is about providing the right amount of transparency that contributes to efficient price formation and to a level-playing field between the different types of trading venues while avoiding adverse market impact.3 It is becoming clear that these rules are altering the structure of markets in Europe and this complex and shifting landscape of trading is being monitored closely by European regulators to ensure the core transparency objectives of MiFID II are being delivered.
This brings me to the topic of market surveillance.
A key challenge for firms and regulators under MiFID II is the volume of data to be collected and reported. As I have said on a number of occasions, in securities markets, we are now supervising things the human eye cannot see and the human brain cannot comprehend. With the rise of algorithmic trading we are also increasingly supervising the conduct of machines as well as the conduct of individuals. We need technology to do our job.
In the performance of our market surveillance work, therefore, we are increasingly seeking to use technology to assess compliance and to identify market patterns, trends and outliers in order to gain insights into market conduct. This activity, and the increased levels of transparency that come from the data, are a core component of the protections envisaged by MiFID II.
However, the foundation for such surveillance is ensuring that data is accurate, timely and properly understood. This can be a challenge when one looks at the significantly increased reporting obligations on firms under MiFID II and the corresponding obligation on NCAs and ESMA to gather and interrogate this data. The list of financial instruments covered has been extended to almost all instruments traded in European markets and the information to be provided on each trade has increased. The Central Bank’s systems have been developed to receive, validate and store this increased volume of transaction reports from investment firms. In December 2018, following a valuable period of engagement with a number of firms that participated in the testing process, the Central Bank launched a new Machine-to-Machine (‘M2M’) submission channel for MiFIR transaction reporting. This channel complements the Central Bank’s Online Reporting System (‘ONR’), so transaction reports may now be submitted via ONR or M2M. As of last month, approximately 67% of our monthly 21.3 million MiFID II transaction reports from Irish firms were received through the M2M channel.
We also engage with ESMA and fellow NCAs on data and reporting matters, including at the recently established ESMA Data Standing Committee, as data analysis becomes increasingly central to EU securities market supervision.
In 2018 this approach of data driven supervision lead to the suspension of the use of pre-trade transparency waivers by relevant trading venues where breaches of MiFIR double volume caps were identified and the analysis of the extent of algorithmic trading on Irish venues. It is also helping us develop a greater understanding of cross-venue linkages.
The ability of firms to opt into the systematic internaliser regime has resulted in Ireland moving from a position where we had no SIs under MIFID I to a position where we are now looking at a number of SIs in operation in the Irish state in the low double figures. We should expect this to increase the level of transparency in the marketplace.
Thematic Work on MiFID II
Alongside such data-lead supervisory approaches, our more traditional firm-specific and thematic supervisory reviews continue. Implementation of MiFID II will remain a vital part of our PRISM supervisory model and will continue to be a focal point of our engagement meetings. In addition to this ongoing firm engagement, in Q4 2018, we began thematic reviews on product governance and investment research. Further work under the MiFID II headings of transparency and client protection is also being scoped for later in 2019.
The ongoing product governance review seeks to gain an understanding of (i) how each firm is complying with the new product governance requirements and (ii) the barriers and challenges encountered by firms in complying with these requirements.
As you will know, the MiFID II product governance requirements are intended to ensure that appropriate products are developed in line with the needs of a target market identified in advance by the investment firm. As such, these requirements are one of the key investor protections of MiFID II. They seek to ensure that firms that manufacture or distribute financial instruments act in the clients’ best interests during all stages of the product life cycle. Product Governance will therefore continue to be a key area of focus for the Central Bank.
Concerning the investment research review, following the introduction of rules around inducements and research under MiFID II, there has been much debate on this topic within the industry. Given this and the Central Bank’s interaction with industry in Ireland in the lead up to the implementation of MiFID II, a focussed review is currently underway across asset management and stockbroking firms. The objective of this review is to assess how firms are treating investment research under MiFID II and whether it is in compliance with the relevant MiFID II rules. The review is also seeking to determine the implications that these rules are having on the sector.
Brexit – Cliff effects and new landscape
It is impossible to discuss EU financial regulation in 2019 and not mention Brexit.
For many of you Brexit will have been a standing item on your engagement with our supervisory teams for some time now. The evolving nature of the Brexit negotiations and the complexities of the UK leaving the European Union is unquestionably a challenge for firms and regulators alike. We continue to have a heightened engagement with firms to ensure they have given due consideration to how the evolving situation may impact on their business and have appropriate contingency plans in place. The Central Bank expects firms to be fully prepared for all plausible Brexit scenarios, with as little disruption to clients as possible.
Another Brexit related matter which has come under increased focus over the last 12 months is the continued access of the Irish market to a Central Security Depository (CSD) when the UK leaves the EU. We welcomed therefore the European Commission’s decision4 late last year, which found the UK’s CSD supervisory and legal regime equivalent for the purposes of CSDR. Together with ESMA’s decision to recognise Euroclear UK and Ireland5, this alleviates the short-term cliff edge risk. However, it requires that an alternative long-term CSD arrangement for Ireland be in place by the end of this period. To this end, Euronext Dublin has selected Euroclear Bank Belgium as their preferred long-term CSD provider. The Central Bank continues to monitor the implementation of this complex project and to engage with the key stakeholders.
Finally, with respect to our gatekeeper role, it will come as no surprise when I say that Brexit has given rise to a considerable uplift in applications for authorisation and also from firms seeking permission to expand their existing business. What is striking in my mind is the diversity of firms involved, ranging from multilateral and organised trading facilities, broker dealers, depositories, systematic internalisers, asset managers and MiFID firms. As these firms stand up, we will see a new landscape take shape with a wide range of business models. We need to evolve our supervisory approaches to take account of this evolution and both new and existing authorised firms can expect our risk based and intrusive approach to supervision to continue.
Wholesale Market Conduct Supervision
Before concluding, one aspect of the evolution of our supervisory approach that merits mention in a MiFID II context is the topic of what we refer to as ‘wholesale market conduct supervision’ – that is the supervision of conduct on wholesale securities markets (as opposed to the direct protection of retail clients). The increasing complexity of financial markets and their regulatory framework requires that as regulators we have a more structured risk-based framework for this aspect of our statutory mandate. At the Central Bank, the advent of Brexit has also accelerated our work on this front as we see the nature, scale and complexity of investment services carried on in and from Ireland continue to grow.
Having designed an initial framework and applied it to a number of Brexit-related applicants over the course of 2018, we commenced our wider wholesale market conduct supervisory engagement with firms on 11 March with the issue of an Industry Expectations Letter.6 This letter went out to MiFID firms and banks engaged in MiFID activities, setting out our high-level expectations of how firms should identify, mitigate and manage wholesale market conduct risk. Firms have been requested to provide a copy of the Industry Expectations Letter to their board at the next board meeting and for the resulting discussions to be reflected in the minutes of that board meeting. We will continue to engage with industry in relation to wholesale market conduct risk, guided by our principles for a proper and effectively regulated securities market, which is one that:
- Provides a high level of protection for investors and market participants.
- Is transparent as to the features of products and their market price.
- Is well governed (and comprises firms that are well governed).
- Is trusted, by both those using the market to raise funds and those seeking to invest.
- Is resilient enough to continue to operate its core functions in stressed conditions and to innovate appropriately as markets evolve.
To conclude then, has MiFID II delivered on its potential? In most important respects I believe that it either has or is in the process of doing so. However, if MiFID II is to make its full contribution to an EU securities market that lives up to the principles I have outlined, we all bear a responsibility to live its spirit as well as its letter.