The revised EU Markets in Financial Instruments package—known as MiFID II—takes effect on January 3, 2018. New rules on trading inducements, research, best execution, market transparency and the regulation of algorithmic trading are some of the key areas where a non-EU fund manager may find that it is impacted, directly or indirectly. Non-EU fund managers should consider how these new requirements will affect how they do business in the EU or with EU counterparties from the start of next year.

Introduction

The MiFID II package is made up of a revised Markets in Financial Instruments Directive II,^[1] the new Markets in Financial Instruments Regulation^[2] and supplementary secondary legislation and guidance. These will replace the existing directive and its implementing legislation (“MiFID I”)^[3] from January 3, 2018 (the effective date for the new rules).

A non-EU fund manager without any EU place of business is not generally within scope of MiFID I and usually requires no license in the EU. That position will remain the same under MiFID II, because current national “regulatory perimeters” are generally preserved.

EU fund managers that provide services only to regulated funds, such as undertakings for collective investments in transferable securities (“UCITS”) or alternative investment funds regulated under the Alternative Investment Fund Managers Directive (“AIFMD”), are not generally within the direct scope of MiFID II. However, an EU fund manager that also provides managed account services to particular clients will be directly subject to relevant MiFID II requirements. Moreover, some regulators, notably the Financial Conduct Authority (“FCA”), have decided to extend the scope of some MiFID II rules to all kinds of fund managers regulated in their member state, i.e. including UCITS managers and Alternative Investment Fund Managers (“AIFMs”).

Even if a non-EU fund manager is not regulated in the EU, it will in certain instances be indirectly impacted in its dealings with EU firms that are subject to the full MiFID II requirements. The way in which this indirect application occurs varies, depending on the relevant requirement, as illustrated in Figure 1. In this note, we refer to fund managers that will become subject to the MiFID II standards as a result of this type of gold plating by a member state as “in-scope fund managers.”

Figure 1: MiFID II issues on which non-EU fund managers should focus, where relevant.

A non-EU fund manager will be affected by MiFID II in the context of:

• Dealings with EU brokers-dealers (i.e. regulated EU investment firms)

EU broker-dealers will be required to apply key provisions of MiFID II, including the requirement for best execution and the “unbundling” of research, to their clients around the world, regardless of nationality. A non-EU fund manager will find that its bundled research costs (commonly known as “soft dollars”) will become unbundled and separately invoiced when it deals with an EU broker-dealer. To implement the new requirements imposed on it, the EU broker-dealer will also need to agree amended terms of business and provide new MiFID-based disclosures to the non-EU fund managers.

• Structures involving EU fund managers

EU fund managers acting for a non-EU fund—whether as primary manager or sub-manager—will not necessarily be subject to MiFID II. However, an EU fund manager that also provides managed account services to clients will be within its scope. Moreover, where EU countries, such as the UK, have opted to extend some of the MiFID II standards to all EU fund managers, the new rules will apply. In these scenarios, the EU fund manager will be required to apply certain provisions of MiFID II, those on unbundling of research and best execution, across all of its in-scope funds and in respect of all investors around the world, regardless of nationality. A non-EU sub-manager to an in-scope EU manager may be indirectly impacted if the EU manager opts to harmonize its compliance with the new standards across the group, or otherwise impose back-to-back compliance on the non-EU sub-manager.

• Algorithmic trading on EU venues

Funds which engage in algorithmic trading strategies may be required under MiFID II to be locally licensed in an EU member state if they trade on a local exchange cross-border into that member state. This is not the case in all countries. The UK is maintaining its “overseas persons exclusion” and so will exempt many foreign algorithmic traders from local licensing requirements.

“Inducements” & Unbundling Research

Dealings With EU broker-dealers

MiFID I currently requires that commission or fee payments and other non-monetary benefits should not impair an EU investment firm’s duty to act in the best interests of its client, that these enhance the quality of the service being provided to the client and that they are disclosed to the client. MiFID II will also apply those requirements to EU investment firms providing portfolio management services or providing independent advice. The UK will extend these rules to all fund managers (see below). MiFID II also restricts the receipt or payment of inducements by applying the rules to all types of third party payments. EU investment firms subject to these rules will need to inform their clients about the fees, commissions and benefits that have been received in connection with any investment advice or ancillary service^[4] to a client.

Specific new rules will apply to inducements for research—or “soft dollar” commissions applied to research. Research provided by any third party (regardless of where that party is located) to an EU investment firm providing portfolio management (i.e. managing portfolios which include one or more financial instruments based on mandates from clients on a discretionary client-by-client basis) or other investment or ancillary services to clients will be regarded as an “inducement,” unless the research is received in return for either direct payment by the investment firm out of its own resources or payment from a separate research payment account (“RPA”). The RPA must be controlled by the EU investment firm and the operation of the RPA must meet certain criteria (discussed below). There is an exemption for any inducement that is a minor, non-monetary benefit.

An EU investment firm that provides both execution and other (including research) services to clients (regardless of where the client is located)^[5] will need to identify separate execution and research costs as well as separate charges for each of the other services. Charges for services other than the execution services must not be linked to the volume of or levels of payment for execution services. Various models for pricing research and other non-execution services may be possible, including annual fees, research-specific purchase charges or hourly rates. For EU investment firms, these unbundling rules apply regardless of the status or geographical location of the research provider. A non-EU fund manager that uses EU brokers will be indirectly impacted and may find that it is repapered and that its research costs will be unbundled and separately invoiced by its EU brokers.

Structures Involving In-Scope Fund Managers

Extension of the Scope of the Rules by Individual EU Member States

Subject to the broad principles set out above, implementation of these rules will vary somewhat between member states. The MiFID II rules will not apply solely as a result of a portfolio manager having EU clients. Instead, they will apply to all portfolio managers which are regulated in any EU member state, no matter where those clients are located.

Moreover, the FCA is proposing to broaden the scope of the new rules on inducements and unbundling research so as to apply them to all UK authorized firms that carry out investment management of collective investment schemes, including UK AIFMs, UK branches of EEA AIFMs and managers of UCITS funds. It is expected that the FCA will publish its final rules and Policy Statement at the end of June 2017.^[6] The outcome of the FCA’s review of dealing commission expenditure across certain investment managers, published in March 2017,^[7] implies that the FCA expects in-scope fund managers to push the research rules down onto its sub-managers, in order to ensure compliance with its own obligations.

It may be that EU funds of a non-EU fund manager will expect unbundling to be provided as a matter of market practice in the future, notwithstanding that non-EU fund managers would not otherwise be required to comply with these rules. Some firms will wish to apply the same standards globally, while others may apply different compliance policies to different parts of their group. A fund manager may also have funds that, for regulatory or other fund-specific reasons, may not be ready or able to pay for research in hard dollars. A fund manager affected by these changes, whether directly or indirectly, may have to revisit its trading and other operating and compliance policies.

Where an in-scope fund manager uses an RPA to comply with the MiFID II unbundling rules, the RPA must only be funded by a specific research charge to the fund, the cost and frequency of which must be agreed with the fund. The research charge must not be linked to the volume and/or value of transactions executed on behalf of a fund.

Any surplus in the RPA must be returned to the fund at the end of the period or offset against the combined research budget and charge calculated for the next period.

An in-scope fund manager must set and regularly assess a research budget, based on its reasonable assessment of the need for third party research. The total amount of research charges received by the fund manager may not exceed its research budget. The allocation of the research budget must be subject to appropriate controls and senior management oversight so that it is managed and used in the best interests of the in-scope fund manager’s funds. There should be an audit trail of payments made to research providers. The research budget and RPA must not be used to fund an in-scope fund manager’s internal research.

An in-scope fund manager must assess the quality of any research purchased based on robust quality criteria set out in a written research policy. This assessment should be used as part of pricing. The research policy must also set out the extent to which research may benefits funds’ portfolios, including by taking into account investment strategies applicable to various types of portfolios and how the fund manager will allocate the costs fairly to the various funds’ portfolios. Research policies must be provided to funds.

An in-scope fund manager will remain responsible for the RPA, although it may delegate the administration of the account to a third party provided that: (i) research is still purchased in the name of the fund manager; and (ii) payments made to research providers are made in the name of the fund manager and without any delay.

In addition, an in-scope fund manager must provide its funds with information about the budgeted amount for research, the amount of the estimated research charge for each fund and annual information on the total costs that each fund has incurred for third party research. Before any increase to a research charge, an in-scope fund manager must provide clear information to the fund about the proposed increase.

RPAs differ from MiFID I compliant Commission Sharing Agreement (“CSA”) arrangements because a budget must be set, there must be greater selection over research and any excess in the account must be returned to the fund or fund manager. The FCA has stated that firms using an RPA will need to implement changes to their current CSA accounts to ensure that there is sufficient control and oversight by the firm as required by the RPA rules.

Managers of multiple funds will need to be careful when splitting research costs across funds. The European Securities and Markets Authority (“ESMA”) has published some guidance on the issue in the form of Q&As.^[8] The FCA’s consultation paper on this topic also contains important guidance.^[9] ESMA has confirmed that a research budget may be set at a desk or investment strategy level if portfolios have sufficiently similar mandates and investment objectives such that investment decisions would be informed by the same research inputs. A pro rata allocation across such funds would therefore be allowed in such circumstances. Neither the FCA nor ESMA guidance addresses the question of a non-EU fund manager with a combination of in-scope and out-of-scope clients or funds that are serviced by an EU broker. The inclusion of an EU sub-manager or manager in a fund firm’s structure will mean that some business will be covered by these provisions while other aspects will not be. These fund managers will need to consider ways to allocate costs. A pro rata allocation is one way, but not the only way, of allocating costs.

In-scope fund managers may instead choose to adopt a direct payment structure, which involves payments in “hard dollars”. Such a direct payment of cash in exchange for research can be contrasted with the compensation of research through the direction of transaction execution to a broker-dealer in exchange for providing the research product. This route may, however, present issues if a US broker-dealer is providing the research. Under US laws, the compensation of research with hard dollars generally implicates regulation of the research provider as an investment adviser. US broker-dealers tend to want to avoid being classified as an “investment adviser,” in part because of the fiduciary duties and related rules that entails.

Best Execution

MiFID II maintains the core principles in MiFID I on best execution, including investor protection, integrity of the price formation process and competition between trading venues. The requirement to obtain the best possible results on a consistent basis when executing client orders remains in place. However, the MiFID II requirements are more prescriptive than under MiFID I and are phrased differently in some ways. There are also new reporting and disclosure obligations for trading venues and firms.

Extension of the Scope of the Rules by Individual EU Member States

As with the inducement and unbundling research rules, the FCA is proposing to “gold-plate” (voluntarily enhance) the MiFID II best execution requirements by applying them to UK UCITS and AIFMs and UK branches of EEA managers, with modifications. The FCA’s statement on its review into the application of best execution rules and practices by investment managers indicates that the FCA already expects in-scope fund managers to be complying with rules that are similar to the MiFID II standards.^[10]

Best Execution Policies

EU broker-dealers executing trades for their non-EU fund manager will need to provide their clients with appropriate information on their order execution policy, including how orders will be executed by the firm for the fund manager. The fund manager’s prior consent to the execution policy must be obtained. Non-EU fund managers which use an EU broker subject to MiFID II will likely find that the broker needs to repaper its clients with a new policy complying with the new standards.

In-scope fund managers will also need to comply with the same obligations with regards to any trades that they execute on behalf of their funds.

Best Execution Disclosures

EU investment firms and in-scope EU regulated fund managers will have an obligation annually to publish information on their websites about the top five execution venues in terms of trading volume where they have executed client or fund orders and information on the quality of execution. The disclosure will not be client-specific or fund-specific.

Repapering of Brokerage and Other Agreements

As outlined above, MiFID II rewrites certain existing conduct of business rules for investment firms, much of which is currently found at national level. Most notably there are revised frameworks for conflicts of interest, suitability and appropriateness, inducements and best execution.

Dealings With EU Brokers or Dealers

Among the changes are requirements for EU investment firms to disclose more information to their clients. Non-EU fund managers which use an EU broker subject to MiFID II will find that the broker needs to repaper the fund manager with new terms of business. Fund managers may need legal advice as to the proposed revised terms of their brokerage agreements.

Structures Involving In-Scope Fund Managers

Non-EU funds with an EU manager or sub-manager will also need to consider which aspects, if any, will require them to repaper funds or investors. For example, the terms governing any situation where the unbundling rules apply to an EU manager may need to be reconsidered.

Transparency

The MiFID I transparency (meaning public trade reporting) regime applies to equities admitted to trading on regulated markets. MiFID II extends this regime to equity-like instruments, such as depositary receipts, exchange traded funds and certificates and to non-equity instruments, such as bonds, structured finance products, emission allowances, derivatives traded on a trading venue and package orders. Furthermore, the new transparency obligations will apply to non-equity financial instruments traded on an Organised Trading Facility—a new regulatory category of trading venue introduced under MiFID II.

MiFID II requires details of equity and non-equity trading to be reported publicly, pre- and post-trade. Trading venues will make public on a continuous basis during normal trading hours current bid and offer prices and the depth of trading interests in those prices which are advertised through their systems for equity, equity-like and non-equity instruments. The same applies for any actionable indication of interest. This data is anonymized.

Anonymized details of actual transactions in in-scope equity instruments must be made public by EU brokers as close to real time as possible but in any event within one minute of trading. For non-equities, the same “as close to real time as possible” standard applies, but with a backstop of 15 minutes, reducing to five minutes in 2020.

Impact for Non-EU Fund Managers

The new transparency regime will not impose any specific requirements on non-EU fund managers but the data published by EU trading venues and EU brokers will include anonymized information about all transactions on EU trading venues and in certain other products. The transparency regime is intended to help users and the buy-side by making more information available. However, some aspects of trading strategies may be impacted by this new public information.

Algorithmic Trading by Non-EU Entities

MiFID II generally requires the regulation of firms engaging in algorithmic trading^[11] and seeks to prevent unregulated firms, including those outside the EU, from engaging in such trading on EU trading venues. However, the application of these requirements to a non-EU fund management group depends on the precise regulatory perimeter in different EU member states. A non-EU fund manager which is not located in the UK will be able to continue engaging in algorithmic trading on a UK exchange without regulation. However, if it has a subsidiary established in the UK, that subsidiary could only do so if it complies with various systems and controls requirements (although it will not need to be authorized or obtain a license). The UK’s approach to regulating algorithmic trading differs to how most other EU member states are implementing the requirements. Several other European member states appear to require foreign algorithmic traders to be locally licensed as a condition to gaining any access to an exchange in that member state. Fund managers will need to assess their trading activities to determine whether they need to become locally authorized or subject to systems and controls requirements. Firms with an algorithmic strategy are likely to need to cease accessing some continental EU trading venues or obtain a local license in the relevant member states.