Guidance of questionable legal accuracy from the European Securities and Markets Authority (ESMA) casts doubt on the ability of non-EU members of EU exchanges to provide client access to such exchanges through a technique referred to as “direct electronic access” (DEA). If ESMA’s guidance were correct, clients wishing to access EU exchanges would only be able to do so through EU-regulated entities who are members of the relevant exchange. This is likely significantly to reduce the attractiveness of and liquidity on those EU exchanges. ESMA’s interpretation is based on a linguistic legal interpretation of a particular provision without reference to other conflicting EU legislation. By contrast, the UK has already taken the clear and rational view in its legislation that non-EU members of UK exchanges can provide DEA to those exchanges for their customers since this is expressly permitted in other provisions of the same legislative package. There is now a conflict between the UK’s statutes—which prevail within the UK—and ESMA’s guidance.

On 15 November 2017, ESMA published new questions and answers (Q&A)^[1] on the EU’s Markets in Financial Instruments Directive (MiFID II) and related Regulation (MiFIR), which come into effect this January. The Q&A include new guidance prohibiting non-EU entities from offering client trading services as EU exchange members, based on Article 48(7) of MiFID II. ESMA overlooked that such access is inextricably linked to the MiFID II activities of “execution of orders on behalf of clients” and “reception and transmission of orders.”^[2] These activities may be carried out by third-country firms under Article 54(1) of MiFIR. For that reason the UK took the view in its legislation implementing MiFID II^[3] that third-country firms may provide DEA to UK exchanges.

ESMA’s new stance puts it on a collision course with UK legislators. It is also unattractive commercially for non-UK EU exchanges. This note explains the ESMA guidance, highlights why it is of questionable legal accuracy and discusses the enforceability of this guidance and interpretation in the UK, France and Germany. The note also considers the implications of the guidance in the context of Brexit.

Whether a Firm Needs to be Locally Regulated Under Mifid II to Provide DEA to an EU Trading Venue?

In its Q&A, ESMA has answered this question in the affirmative, stating that “Article 48(7) of MiFID II provides that trading venues should only permit a member or participant to provide DEA ‘if they are investment firms authorised under [MiFID II] or credit institutions authorised under Directive 2013/36/EU.’ Therefore, non-EU firms (including non-EU firms licensed in an equivalent jurisdiction) or EU firms without a MiFID II licence are not allowed to provide DEA to their clients. This applies regardless of where the clients using the DEA service are located.”

Is ESMA’s Q&A Binding?

ESMA’s Q&A is informal interpretative guidance that is not held out to be legally binding, as confirmed by ESMA on its website.^[4] The intention of the Q&A is to enhance the consistent application of EU law, which is one of ESMA’s general objectives. Both MiFIR and MiFID II contain provisions requiring ESMA formally to prepare guidelines on aspects of MiFID II. ESMA also has certain powers under Article 16 of the ESMA Regulation.^[5] However, this Q&A is not issued under such powers and, moreover, MiFIR does not empower ESMA to develop formal guidelines in relation to Article 54(1). As a result, the status of ESMA’s Q&A is not definitive as to the effect of that provision.^[6] Given the informal nature of the ESMA Q&A on this topic, it does not by its nature prevail over a UK statute or other contradictory member state laws. UK laws therefore will prevail over the Q&A.

A separate and more difficult question may arise as to, if the ESMA guidance is a correct interpretation of MiFID II, whether MiFID II would then over-ride a contradictory member state law, such as the UK statutory instruments implementing MiFID II. In our view, under the EU treaties and EU case law, even if ESMA were correct, their interpretation of Article 48(7) of MiFID II would not override the UK’s statutory instrument.

MiFID II, which is a directive and contains the troublesome provisions on DEA, can have direct effect in some circumstances, even if the UK were to be found to have failed to implement MiFID II into national laws or to have implemented it incorrectly.^[7] The first principle in interpreting apparently contradictory EU directives and member state laws is to attempt to reconcile them so as to achieve the purpose of the directive.^[8] However, national courts cannot apply such an interpretative approach where a member state law and EU directive are in direct, irreconcilable conflict, as is the case here.^[9] Where there is a direct conflict, the EU directive then cannot prevail over national laws so as to impose an obligation on individuals.^[10] This principle has been somewhat eroded in recent case law as regards civil obligations. However, it remains a cornerstone of EU law that an untransposed directive cannot have the effect of imposing or exacerbating criminal liability.^[11] The EU courts have also been reluctant to interpret EU laws so as to impose tax code breaches and the same principle should likely apply to regulatory breaches. The UK’s regulatory perimeter^[12] is in any event a criminal law regime. ESMA’s interpretation of MiFID II is one that eliminates rights of certain persons to carry on certain activities so as to render such activities potentially criminal. The UK implementation preserves such rights and does not criminalise third-country entities providing access to UK exchanges for their clients. As a result, exchanges and third-country firms acting according to the requirements of UK laws implementing MiFID II would not be subject to UK criminal or regulatory liability due to any acts in contravention of ESMA’s interpretation of MiFID II.

As a legally binding EU regulation, in contrast, MiFIR has “direct effect,” which means that, broadly speaking, the provisions of MiFIR (including Article 54(1) on the regulatory perimeter) can be invoked and relied on by individuals or corporations in national courts.

As a result of the above, ESMA’s non-binding Q&A or its interpretations of MiFID II could not be relied upon in the UK courts or by local regulatory or criminal authorities so as to enforce a breach of EU or UK legislation, because (i) ESMA’s guidance is informal and has no EU legal status of its own; and (ii) as a matter of EU law, EU directives which create criminal liabilities cannot prevail over national laws which do not recognise such criminal liabilities.^[13] UK markets and members of UK exchanges may therefore as a matter of law continue operating in a way that allows DEA access by overseas persons, unless and until the relevant UK statutory instruments are amended.

Is ESMA’s Guidance Legally Supportable?

ESMA’s Q&A repeats the language of Article 48(7) of MiFID II and so, as far as that goes, might seem reasonable. However, ESMA’s Q&A is, in our view, incorrect. This is because Article 48(7) of MiFID II is in direct contradiction of Article 54(1) of MiFIR, which states that “[t]hird-country firms shall be able to continue to provide services and activities in Member States, in accordance with national regimes^[14] until three years after the adoption by the Commission of a decision in relation to the relevant third country in accordance with Article 47 [of MiFIR].”^[15] Because MiFIR is directly applicable,^[16] it will override any incompatible national member state legislation implementing Article 48(7).^[17] As a result, national measures implementing Article 48(7) of MiFID II, including any such measures giving effect to ESMA Q&As, must be read subject to Article 54(1) of MiFIR.

From a purely linguistic legal perspective, it could be argued that the DEA provisions are not “investment services and activities” within the meaning of MiFID II, since the definitions of “DEA”^[18] and “investment services and activities” use different words. ESMA’s reasoning seems to be based on such linguistic interpretations. ESMA’s conclusion must be based on a concept that DEA and investment services are distinct activities, one of which requires local regulation but the other of which does not. However, from a practical perspective, DEA is nothing more than a subset of the MiFID investment services and activities of “execution of orders on behalf of clients”^[19] or “reception and transmission of orders.” The provision of DEA services to clients will inevitably involve the DEA provider’s systems being used to enter into trades on the execution platform on the client’s behalf, with contractual consequences involving agency at both exchange and clearing house level. The DEA provider will also, often, be involved in order transmission in a meaningful way, triggering the “reception and transmission” activity. Since DEA is nothing more than a particular kind of investment service or investment activity, the restriction in MiFID II on DEA is, on a proper interpretation, inconsistent with the third-country provisions of MiFIR—as was concluded by the UK authorities in their implementation measures—and must be read as subject to such permissions.

The prevalence of Article 54(1) of MiFIR is also supported from the perspective of “purposive” interpretation principles, which underpin EU legislation. MiFIR enshrined an important policy approach that MiFID II should not interfere with the “regulatory perimeter” of EU member states.^[20] This provision was hard-fought by the UK and other “open markets” in Europe, after attempts by certain EU member states (notably Germany and France) and the European Commission (in its original MiFID II proposal) to close Europe’s doors to third-country cross-border business, except where a “reverse solicitation” exists or where the Commission had approved the relevant third country’s regulatory regime as “equivalent.” Whilst an equivalency regime exists in the final version of MiFIR, in the absence of any equivalence determinations, the regulatory perimeter for financial services and activities is clearly reserved, on a three-year transitional basis, for member states to determine. ESMA’s Q&A flies in the face of these important structural principles underlying MiFID II.

The UK, and other open market jurisdictions of the EU (such as Ireland and, to a lesser extent, Luxembourg), have historically operated “overseas persons” regimes, which allow cross-border wholesale financial sector business to take place without local regulation of foreign participants. Such approaches have been fundamental to the success of the City—and the emergence of Ireland and Luxembourg as important secondary financial centres in Europe. Difficulties on the part of non-EU entities to access customers, market participants and market infrastructure in other, more protectionist, member states has resulted in their financial markets being primarily domestic or regional. MiFIR expressly provides for these existing national perimeter regimes to be preserved. It is doubtfully correct to reinterpret such an important point of policy underlying the MiFID II legislative package on the account of a technical provision relating to organizational requirements for exchanges.

Conflict With the UK Implementation

The UK implementation of the DEA restriction in MiFID II takes into account the impact of Article 54(1) MiFIR. The UK expressly permits third-country firms that fall either under the “overseas persons exclusion”^[21] or under the MiFIR equivalence regime also to provide DEA on UK exchanges. This implementation is found in The Financial Services and Markets Act 2000 (Recognition Requirements for Investment Exchanges and Clearing Houses) Regulations 2001^[22] and The Financial Services and Markets Act 2000 (Markets in Financial Instruments) Regulations 2017. The latter UK statutory instrument states that: “In this regulation the provision of direct electronic access is in accordance with the relevant United Kingdom national regime for the purposes of Article 54.1 (transitional provisions) of the markets in financial instruments regulation if it is an activity subject to the exclusion in Article 72 (overseas persons) of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2000.”^[23]

The updated provisions of the rulebooks of some of the main UK exchanges contain no restrictions on overseas persons providing client trading services and some of their proposed rules expressly refer to “overseas persons” under UK legislation as permissible providers of such services, as a result of this legislation.

The Position in Other Member States

Germany has also announced a moratorium on applications for investment firm status, which may buy members of its exchanges—such as Eurex—a few months to restructure themselves, if this becomes necessary. German national legislation implementing MiFID II^[24] omits an express obligation on exchanges to ensure that DEA providers are authorised under MiFID II. The non-inclusion of wording tracking Article 48(7) (but not other parts of Article 48) is noteworthy. It appears that the German legislator intended for the regulators to deal with this issue when approving the rules and regulations of exchanges.

The Netherlands has a national recognition regime for some countries, such as Switzerland and the US, which may now need reconsidering in light of the ESMA Q&A.

Many other countries, notably France, has simply copied Article 48(7) of MiFID II into local law without derogations with respect to the national perimeter. Entities accessing exchanges in these countries for purposes of client trading will now need either to discontinue client trading services, restructure them in a way that does not involve DEA or intermediate exchange access through a locally-regulated entity. Since MiFID II comes into force in January 2018 and regulatory authorisations typically take many months to approve, this late and surprising move from ESMA may create compliance difficulties for some continental exchanges and their members.

What Next?

UK laws and ESMA guidance are in direct contradiction. This raises interesting questions of what should happen next:

• Optionally, ESMA could helpfully clarify that its Q&A only applies to “DEA to the extent that the same is not an investment service or activity” and not to DEA in general. That would result in an approach that is consistent with both MiFID II and MiFIR. In our view, firms are likely to be able to conclude in many circumstances that “DEA which is not an investment service or activity” is a nil set.
• The UK could bring its legislation into line with the ESMA Q&A. In the current political environment and with Brexit on the horizon, it would seem unlikely that Parliament would pass legislation so detrimental to the City and so contrary to its historical legal foundations. This is all the more so given the contradiction between ESMA’s Q&A and the UK’s hard fought policy position on the regulatory perimeter, as established and enshrined in Article 54 of MiFIR. Enacting such legislation would give effect to EU regulatory authority guidance that is in our view incorrect. Such a legislative change would also doubtless have impacts in the context of the current machinations in the UK Parliament on Brexit and create an unwelcome distraction, given that the ESMA guidance could only be implemented in the UK through statutory instrument (not through regulatory rules or guidance), which requires the review of Parliament.
• In contrast, the likelihood of France or other countries introducing new legislation at this stage and in contradiction of ESMA guidance seems unlikely.

This situation brings with it implications in several fields:

• First, the future of third-country memberships for exchanges, particularly Euronext, for purposes of intermediated client trading and access is quite bleak, assuming that ESMA’s approach is followed in relevant countries. Several continental exchanges have—by a stroke from ESMA—suddenly become less competitive in the short term for attracting liquidity than comparable UK or international exchanges, and possibly, German exchanges, which offer similar instruments for trading. ESMA’s Q&A provides some comfort about possible delegation of client access via third-country affiliates^[25] which should allow business restructuring on a compliant basis. However, such structures entail multiple layers of intermediation between clients and exchanges, which create new insolvency and operational risks for clients and require repapering, a process that adds costs, takes time and risks business attrition.
• Secondly, what will happen next with respect to the UK position and UK laws? Will ESMA or the European Commission raise an enforcement case against the UK? If so, would they succeed in the ECJ in light of the contradictory requirements of Article 54(1) of MiFIR? Even if such a case were brought, might that be heard before Brexit?
• Thirdly, what of Brexit? It is almost unthinkable that the UK would adopt laws resembling this ESMA Q&A after Brexit, since it runs contrary to the fabric of open markets which the City relies on to operate. If the UK is pushed to change its laws while still in the EU, will the presenting of such laws to Parliament harden pro-Brexiteers’ resolve? And after Brexit, what consequences could the UK’s position, if it remains the same, have for the goals of “equivalence” or “mutual recognition?” The answer to the latter point is it should have no impact since the UK’s approach does not give rise to systemic risk, let alone in the EU more generally. However, that remains to be seen.
• Fourthly, could not MiFID II be corrected to address such an obvious drafting infelicity.