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JULY 29, 2016

SIDLEY UPDATE

MiFID II 2016 Update – Implications for EU and Non-EU Investment Managers Introduction MiFID II, which is to be implemented throughout the EU on January 3, 2018, represents a comprehensive and far-reaching set of reforms that will reshape the way in which EU markets and their participants (banks, securities firms, investment managers and others) operate.

This Update considers the implications of MiFID II for investment managers. It should be noted that the MiFID II reforms will be felt not only by investment managers that are authorised in the EU, but also by any investment manager that deals with EU counterparties, trades through EU execution venues, or seeks access to EU investors.

Given that the detailed “Level 2” rules implementing MiFID II have, to a large degree, been finalised,1 there is now sufficient certainty for investment managers to begin the process of considering cost, workload and investment strategy implications across their business. EU Member State regulators have also started their local implementation processes. For example, on July 29, 2016, the UK Financial Conduct Authority (FCA) published its second consultation paper (CP16/19)2 on MiFID II implementation. This follows from the FCA’s first MiFID II consultation paper (CP15/43)3 which was published on December 15, 2015. A third FCA MiFID II consultation paper is expected to be published after the summer.

Immediate Action Points for Investment Managers

To the extent they have not already started to do so, investment managers should consider taking the following steps to prepare for MiFID II implementation:

• Determine, with the assistance of internal and/or external counsel, the scope of the manager’s legal obligations under MiFID II.

• Plan, prioritise, budget for and execute internal processes with a view to compliance with the new MiFID II requirements. This may entail building new systems, revising existing policies and procedures and carrying out training to familiarise staff with the new requirements.

1 Subject to a period during which the European Parliament and Council of the European Union may raise objections – see “The MiFID II Implementation Process” below. 2 Available here.

3 Available here.

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• Engage externally with sell side firms in order to determine the extent of MiFID II compliance being imposed contractually by the sell side. This will include negotiating new onboarding, counterparty and trading terms and checking the nature of any changes (as to whether they reflect regulatory changes as opposed to commercial changes).

• Continue to monitor the national regulators’ implementation of MiFID II, along with evolving EU-level guidance from ESMA.

Terminology Used • MiFID I – the existing Markets in Financial Instruments Directive (Directive 2004/39/EC), which will be

replaced by MiFID II.

• MiFID II – Directive 2014/65/EU on markets in financial instruments (the MiFID II Directive), together with Regulation (EU) No 600/2014 on markets in financial instruments (MiFIR).

• ESMA – the European Securities and Markets Authority (the European supervisory authority tasked with drafting the majority of the MiFID II implementing measures).

• Regulatory Technical Standards (RTS) – the majority of detailed “Level 2” measures required to implement MiFID II take the form of RTS.

• Regulated market – an EU multilateral trading system run in accordance with non-discretionary rules, where the most standardised, liquid instruments are traded. Examples of regulated markets include ICE Futures, the Main Market of the London Stock Exchange, NYSE Euronext London, the Main Securities Market of the Irish Stock Exchange and Euronext Paris.

• Multilateral trading facility (MTF) – an EU multilateral trading system run in accordance with non-discretionary rules, subject to a slightly lighter regulatory regime in relation to the admission and trading of instruments. Examples of MTFs include the Alternative Investment Market (AIM) (operated by the London Stock Exchange), the Euro MTF (operated by the Luxembourg Stock Exchange) and the Global Exchange Market (GEM) (operated by the Irish Stock Exchange).

• Organised trading facility (OTF) – a new type of EU authorised multilateral trading system, which allows for discretionary trade matching. Equities may not be traded on OTFs.

• Trading venue – a regulated market, MTF or OTF.

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The MiFID II Implementation Process

The process MiFID II entered into force on July 2, 2014. Following this date, ESMA published detailed technical advice (on December 19, 2014)4 and final drafts of 28 technical standards (on September 28, 2015),5 setting out detailed rules on how the MiFID II framework should apply.

The European Commission has now adopted the majority of the technical standards proposed by ESMA, which are currently subject to a period during which the European Parliament and Council of the European Union may raise objections to the content of the technical standards. This period will run for one month in the case of the majority of the RTS, and three months for the RTS on debt transparency and commodity derivative position limits (as a result of certain revisions required to be made to these standards). Given that the European Parliament in particular had a significant level of involvement in shaping the RTS (notably on transparency and position limits), it would be surprising if any significant objections were raised during this period. We have referred where relevant in this Update to the RTS as adopted by the European Commission.

Although MiFIR (as an EU regulation) will apply automatically in each EU Member State (with no need for local implementing measures), Member State regulators will be required to adopt and publish measures implementing the MiFID II Directive into national law by July 3, 2017. As noted above, national consultations on MiFID II implementation have already been published. It is also likely that ESMA will release EU-level guidance on the application of certain MiFID II provisions up to and following January 3, 2018, from which date MiFID II will apply.

A note on Brexit On June 23, 2016, the United Kingdom held an “in-or-out” referendum on the UK’s membership of the European Union, the result of which favoured the exit of the UK from the EU (commonly referred to as “Brexit”).

On June 24, 2016, when the result of the referendum was made clear, the FCA released a statement on its website, noting:

“Much financial regulation currently applicable in the UK derives from EU legislation. This regulation will remain applicable until any changes are made, which will be a matter for Government and Parliament.

Firms must continue to abide by their obligations under UK law, including those derived from EU law and continue with implementation plans for legislation that is still to come into effect.”

The UK is unlikely to leave the EU before the end of 2018. Given that MiFID II will be implemented in the UK by January 3, 2018, this means that UK based investment firms will be subject to MiFID II and accordingly need to plan for its implementation, including monitoring FCA consultations and policy statements.

4 Available here.

5 Available here.

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Topics Covered This Update forms an overview of:

• the obligations that will apply directly to EU investment managers (including EU sub-managers) of non-EU investment managers that are authorised as investment firms under MiFID; and

• the impact of MiFID II on investment managers that are established outside of the EU (e.g. in the United States and Asia), and that may have exposure to EU counterparties or execution platforms.

It addresses in particular the following topics:

• Scope and classification issues

• Inducements/dealing commission/investment research

• Best execution

• Transaction reporting

• Market structure reform

• Pre- and post-trade transparency

• Algorithmic trading

• High frequency trading

• Direct electronic access

• Market making

• Exchange trading requirements

• Equities trading obligation and tick size regime

• Derivatives trading obligation

• Straight-through-processing and clearing obligation for derivatives

• Commodity derivative position limits

• Commodity derivative position reporting

• Ability of non-EU firms to provide services to EU clients

• Call recording

• Recordkeeping

• Clock synchronisation

• Product governance

• Corporate governance

• Conduct of business requirements

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Scope and Classification Issues

Regulatory perimeter MiFID II will alter the regulatory perimeter of the current MiFID I regime in a number of significant ways. Most importantly:

• FX. At present, spot foreign exchange (FX) contracts and, in certain EU Member States, FX forwards, fall outside the scope of the existing MiFID I regime. MiFID II will implement a harmonised EU-wide definition of “spot FX” contracts, and override current national exemptions relating to spot FX contracts. It is also set to implement a new exemption for FX contracts entered into for “payment purposes.”

• Commodity Derivatives. Physically-settled commodity derivatives which are traded on an OTF will be brought within the scope of MiFID II (unless they are already regulated under REMIT).6

• Structured Undertakings for Collective Investment in Transferable Securities (UCITS). Structured UCITS will be deemed “complex” rather than simple products under MiFID II, meaning that retail investors will be required to seek professional advice before investing in them.

• Local Authority Classification. Local authorities will be reclassified as retail rather than professional clients. This may, in particular, create issues for firms providing services to local authority pension funds, which, if unsegregated from the authority itself, could be caught by the scope of the local authority’s retail client classification.

• Exemptions. Certain exemptions from authorisation will significantly decrease in scope under MiFID II (e.g. the “dealing on own account” exemption), although these changes are unlikely to be of great significance to investment managers.

Application of MiFID II to AIFMs and UCITS Managers Investment managers that are authorised as Alternative Investment Fund Managers (AIFMs) under the EU Alternative Investment Fund Managers Directive (AIFMD), or as UCITS management companies (ManCos) under the UCITS Directive, fall outside the scope of MiFID II where they simply manage or market Alternative Investment Funds or UCITS. However, even where AIFMs and UCITS ManCos are not directly caught by the scope of MiFID II, they may be affected by it in the following ways:

• individual Member States may choose to extend some of the requirements set out in MiFID II to AIFMs and UCITS ManCos (i.e. Member States could “gold plate” the MiFID II requirements at a national level);7

• in a similar manner to non-EU investment managers, AIFMs and UCITS ManCos will be indirectly affected by a number of requirements impacting EU financial markets as a whole, such as transparency and the unbundling of investment research costs from execution costs; and

6 Regulation (EU) No 1227/2011 of the European Parliament and of the Council of October 25, 2011 on wholesale energy market integrity and transparency. 7 Nevertheless, we note in this regard that although the UK FCA has previously extended certain MiFID I requirements to non-MiFID authorised firms, it has proposed that once MiFID II applies, it will no longer extend the MiFID transaction reporting requirements to investment managers that are not performing MiFID-regulated activities (i.e. AIFMs and UCITS ManCos).

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• eventually, there is the potential during future reviews of the AIFMD and UCITS Directive for certain requirements set out in MiFID II to be extended to AIFMs and UCITS ManCos.

Inducements/Dealing Commission/Investment Research EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

The new rules on inducements will apply to EU Managers and Sub-Managers given that they are MiFID-authorised. As such, they will need to consider how best to allocate research costs.

The new rules on inducements will not apply directly to non-EU Managers, although they may affect the price of investment research in the EU.

Under Article 24 of the MiFID II Directive, firms providing independent investment advice and portfolio management services are not permitted to accept and retain fees, commission or any monetary or non-monetary benefits provided by a third party in relation to the relevant client services (inducements). “Minor non-monetary benefits” capable of enhancing the quality of client service are excluded from this prohibition, although they must be clearly disclosed to clients.

A Commission Delegated Directive8 sets out the conditions under which investment firms can meet this overarching requirement not to accept and retain inducements. Importantly, the Delegated Directive makes clear that the provision of research by third parties to portfolio managers (e.g. EU Managers or Sub-Managers) will be treated as a prohibited “inducement” unless it is unbundled from execution costs and received in return for:

• direct payments by the portfolio manager out of its own resources; or

• payments from a separate research payment account (RPA) controlled by the portfolio manager.

RPAs may only be funded by “a specific research charge to the client,” and the firm must regularly assess the quality of the research provided and provide information relating to the research charge to clients.

The investment firm must agree the research charge with clients and the frequency with which the charge will be deducted from the client’s resources over the year. The firm may increase the research budget only after the provision of “clear information” to clients about the intended increase.

Sidley Comment

For detailed commentary on this issue, including the likely impact on commission sharing arrangements (CSAs), please see our Update “Dealing Commission and Investment Research – the Final European Commission Position,” available here.

8 Available here.

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Best Execution EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

In addition to complying with the general best execution standard, EU Managers and Sub-Managers will be required to publish a list of their top five brokers (and/or execution venues in circumstances where they execute client orders directly on a trading venue etc.), the percentage of trading volumes that they route through each and demonstrate execution quality.

Non-EU Managers will not be subject to best execution under MiFID II, but, where relevant, could consider how to leverage the substantial amount of new data on execution quality that will be available to the market under MiFID II.

Under Article 27(1) of the MiFID II Directive, investment firms are required to “take all sufficient steps to obtain, when executing orders, the best possible result for their clients” (best execution). The MiFID II best execution standard will broadly reflect existing rules under MiFID I. At present, however, firms are simply required to take all “reasonable” steps to ensure best execution; it is not yet clear how the shift to all “sufficient” steps will be interpreted by regulators in practice. The most significant change from the perspective of EU investment managers, however, is the requirement set out in Article 27(6) for “investment firms who execute client orders” to “summarise and make public on an annual basis for each class of financial instruments, the top five execution venues in terms of trading volumes where they executed client orders in the preceding year and information on the quality of execution obtained.”

This requirement will apply not only to brokers that directly execute client orders themselves, but also to firms that transmit or place client orders with or to other entities for execution, given that the relevant Commission Delegated Regulation9 (the “Conduct DR”) extends the obligation to cover these firms. In other words, the requirement will apply down the chain to investment managers, which will be required to publish a list of their top five brokers and percentage trading volumes sent to these brokers.

Investment firms will also need to take steps to evidence that they are receiving best execution (for example, they will be required to monitor execution quality over time). To this end, “execution venues” will be required to publish quarterly information on their quality of execution. Trading venues, systematic internalisers, market makers and other liquidity providers all fall within the scope of the term “execution venue” in this context.

Sidley Comment

The “top five” execution venue publication requirement will effectively require EU Managers and Sub-Managers to publish information on the percentages of trading volumes which they route through their top five execution brokers, by class of financial instrument. This publication requirement will lead to individual brokers having the ability to view where they “rank” among other brokers to whom investment managers send orders, which raises a concern that it could adversely affect the ability of investment managers to negotiate with brokers on pricing and the terms of execution services. The new requirement for all execution venues to publish quarterly

9 Available here.

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information on their quality of execution will also represent a significant shift in the amount of information made available to the market regarding execution quality, and investment managers should consider how they can assess this new information in order to satisfy the requirement to demonstrate execution quality.

Transaction Reporting EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

EU Managers and Sub-Managers will be subject to the transaction reporting requirements under MiFID II. The removal of the ability for investment managers to rely on their EU brokers to carry out the transaction reporting will mean, in practice, that managers will need to be prepared to build systems to carry out the necessary reporting.

Non-EU Managers will not be subject to the transaction reporting requirements under MiFID II.

MiFID II extends the scope of the current MiFID I transaction reporting regime beyond instruments admitted to trading on regulated markets to include instruments admitted to trading or otherwise traded on MTFs and OTFs and instruments where the underlying is traded on an EU trading venue (or is an index or a basket composed of financial instruments traded on a trading venue).

The transaction reporting requirement will apply when firms “execute” transactions. “Execution” is defined in very broad terms pursuant to the relevant RTS10 to include (as relevant to investment managers):

• the reception and transmission of orders in relation to one or more financial instruments;

• the execution of orders on behalf of clients; and/or

• the making of an investment decision in accordance with a discretionary mandate given by a client.

Given the broad definition of “execution” for these purposes, EU Managers and Sub-Managers will be required to report transactions in the following situations: (i) when transmitting an order received from an affiliate to a broker or otherwise executing an order with a broker for the benefit of their funds; (ii) when executing orders on any trading venue; or (iii) when placing an order to deal with a broker for execution under a discretionary mandate.

Investment firms which “execute” transactions, as described above, will be required to file a transaction report either: (i) directly with their competent authority (e.g. the UK FCA); (ii) to an Approved Reporting Mechanism (ARM); or (iii) to the trading venue through which the transaction was undertaken. Transactions must be reported as quickly as possible, and no later than the close of the business day following execution (i.e. T+1).

Under the existing MiFID I regime, firms may rely on a “third party” to file a transaction report on their behalf. The UK FCA has interpreted this ability fairly broadly, meaning that UK investment managers are permitted to

10 Available here.

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rely on their brokers (assuming that their broker is a MiFID investment firm) to report the transactions. This ability to rely on brokers to report will disappear under MiFID II, and will be replaced by a new regime whereby firms that “transmit orders” will not have a reporting obligation (instead the broker receiving the order would report) provided: (i) the receiving firm agrees to report pursuant to a transmission agreement; and (ii) the investment firm transmits certain specified information alongside the order.

Sidley Comment

For Managers and Sub-Managers established in the UK,11 the removal of the existing exemption for investment managers is a significant development, given that many investment managers rely on the exemption. From January 3, 2018, such UK managers will need to start reporting from scratch. Although, as noted above, there is an ability for firms to leave the reporting to brokers to whom they have transmitted orders, many investment managers will find it more efficient to report themselves rather than negotiating transmission agreements with every one of their brokers. There is no guarantee in any event that the brokers will be willing to enter into such transmission agreements.

MiFID II will also require a substantial step up in the number of transactions that are required to be reported. Although the UK used its discretion to extend transaction reporting to OTC derivatives referencing debt or equity instruments admitted to trading on a regulated market, it chose to exclude transactions in commodity, interest rate and FX derivatives admitted to trading on regulated markets. Under MiFID II, transactions in these instruments will need to be reported, which will mean a significant increase in the number of MiFID transaction reports required to be filed in relation to derivative transactions in particular.

There is also a significant amount of new data required to be reported under MiFID II, including information identifying individual traders or algorithms that made either an “investment decision” or which executed the transaction. The number of reportable fields will, for example, increase from 23 to over 60. In the case of traders, this could include sensitive personal data, such as national insurance numbers (in the UK), so EU Managers and Sub-Managers will need to give thought as to how this data can be tracked and reported in a secure way.

Finally, MiFIR provides that where the European Market Infrastructure Regulation (EMIR)12 transaction reports have been filed with a dual-registered trade repository/ARM, the details provided in those transaction reports do not need to be reported for a second time under MiFID II. However, it seems unlikely that investment managers will be able to take advantage of this provision since, under EMIR, transaction details will be reported in relation to the trading counterparty (i.e. the fund) rather than the investment manager, whereas under MiFID II, the reporting obligation applies directly to the investment manager itself.

11 Note, however, our comment above on the possible exclusion of AIFMs and UCITS ManCos from UK transaction reporting requirements. 12 Regulation (EU) No 648/2012 of the European Parliament and of the Council of July 4, 2012 on OTC derivatives, central counterparties and trade repositories.

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Market Structure Reform EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

The changes to market structure envisaged under MiFID II will result in many trades which are currently executed in an “unlit” environment becoming transparent. This will affect a significant proportion of trades that EU Managers and Sub-Managers enter into with EU counterparties.

Changes to market structure envisaged under MiFID II may affect trades that non-EU Managers enter into with EU counterparties, particularly in relation to transactions concluded on EU exchanges.

Organised trading facilities MiFID II introduces a new type of trading venue, the “organised trading facility” (OTF), which is intended to capture a range of currently unregulated platforms, including broker crossing networks. OTFs will have the following features:

• OTF operators will be permitted to exercise discretion when matching orders (unlike regulated markets and MTFs);

• OTF operators will not be permitted to trade against their own capital other than in a “matched principal” capacity;

• equity instruments may not be traded on OTFs, which will therefore primarily act as a marketplace for derivatives and debt instruments; and

• OTF operators will be subject to the same conduct of business rules as other investment firms (unlike MTFs and regulated markets).

MTFs and regulated markets The current categories of regulated market and MTF will remain substantially similar under MiFID II, with certain changes designed to align the two categories of venue as closely as possible.

Systematic internalisers MiFID II substantially extends the existing MiFID I category of “systematic internaliser” (SI) in scope, to capture entities which undertake a substantial amount of proprietary trading (to be measured against certain EU-wide trading thresholds), without being regulated as a trading venue.13 The SI categorisation should not, however, apply to investment managers, given that they would not typically engage in proprietary trading.

13 Under MiFID II, a “systematic internaliser” or “SI” is defined as an authorised investment firm which, on a “frequent, systematic and substantial basis,” deals on own account by executing client orders outside a regulated market, an MTF or an OTF without operating a “multilateral” trading system.

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SIs are most notably subject to a requirement to publish transparency data under MiFID II. There is also a new requirement in certain circumstances for SIs to “stand by” quotes that they make public (i.e. such that other clients are able to trade at the same published price).

Sidley Comment

The new OTF category of trading venue, along with the extension in scope of the SI regime, will push many trades into a transparent environment. This will in turn result in greater standardisation in documentation, and a significant amount of new transparency data becoming available to the market. The effect of these developments on market liquidity, however, is at present uncertain.

For those investment managers that may be required to publish transparency data themselves (see “Pre- and Post-trade Transparency” below), it will be important to track which of their dealers are likely to be classified as SIs under MiFID II (i.e. given that the SI would take on the transparency publication obligation in trades with investment managers). Unfortunately, this may not be clear for some time given that to assess their classification, dealers will need to rely on certain EU-wide trading data to be published by ESMA.

Pre- and Post-trade Transparency EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

All trades concluded through EU trading venues will be affected by the new transparency regime, although the obligation for ensuring that transparency requirements are met will rest with trading venues. For non-exchange traded transactions, investment managers may, however, be required to comply with certain post-trade transparency requirements, unless they trade with a systematic internaliser (see below).

Transparency requirements are expected to have a substantial impact on the way in which instruments are traded in practice, and investment managers will need to analyse the likely impact on their trading strategies.

All trades concluded through EU trading venues will be affected.

For those non-EU Managers that conclude a substantial amount of trades through EU trading venues, analysis may need to be undertaken on the likely impact of increased transparency on the Manager’s trading strategies.

The new transparency requirements differ depending on the instrument being traded:

• Equities. Existing pre- and post-trade transparency requirements applying to shares traded through MTFs and regulated markets will be extended to cover other “equity-like” instruments (depositary receipts, exchange-traded funds and certificates) traded on regulated markets and MTFs. Along with certain adjustments to the existing transparency bands, a “cap” will be introduced on the use of transparency

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reference price and negotiated price waivers (to be set at 4 percent per trading venue and 8 percent overall across the EU).

• Non-equities. MiFID II will introduce a new pre- and post-trade transparency regime for bonds, structured finance products, emissions allowances and derivatives which are traded on regulated markets, MTFs and OTFs. However, pre-trade waivers and post-trade deferrals will be available for: (i) transactions in “illiquid” instruments; (ii) orders or transactions which are large in scale, along with orders held pending disclosure; and (iii) transactions that are above a size that would expose liquidity providers to undue risk (although in this last case, pre-trade transparency waivers are limited to actionable indications of interest in request-for-quote (RFQ) and voice trading systems). ESMA has proposed a maximum permissible delay of 15 minutes for the publication of post-trade transparency information, although after a three year transitional period, this deadline will be reduced to five minutes. Any permitted deferrals from post-trade transparency requirements would be capped at 48 hours,14 although national competent authorities may extend this period in certain situations.

Generally, these transparency requirements will be fulfilled either by trading venues or SIs. However, where an investment firm trades in instruments belonging to a class that is “traded on a trading venue” (i.e. a regulated market, MTF or OTF), but does not execute the transaction through a trading venue or transact with an SI, it will be required to utilise an “Approved Publication Arrangement” to make public the volume and price of the transaction and the time at which it was concluded, within 15 minutes of execution. If two investment firms are transacting with one another, this post-trade transparency obligation must be fulfilled by the “seller” of the financial instrument.

Sidley Comment

A key outcome of MiFID II is the dramatic extension in transparency requirements for fixed income products and derivatives, which will result in a decrease in trading through unlit or “dark” liquidity pools. Those investment managers that frequently trade through EU dark pools should anticipate substantial changes to the trading environment that they are currently familiar with.

It should be borne in mind that the type of trading system operated by each trading venue will affect the nature of the transparency requirements it is required to implement. The role of transparency in voice trading and RFQ trading systems has in particular generated substantial debate. Little guidance has been given on how transparency requirements are likely to function in a voice traded environment, and concerns have also been raised with regard to the possibility of quotes in an RFQ system being publicised to the market as a whole, given that under current market practice, the participant requesting a quote would be the only counterparty to which that quote would be disclosed.

Finally, the scope of post-trade reporting is very broad, in that it covers all instruments “traded on a trading venue.” In theory this could mean that, for example, an EU Manager/Sub-Manager that concludes a transaction in a non-EU issuer’s bonds on a non-EU stock exchange is required to make public that transaction so long as that non-EU issuer’s bonds are also traded on an EU regulated market, MTF or OTF.

14 Note that if these proposals are reflected in the final regime, it could have a substantial impact on trading in the fixed income market, where it can take substantially longer than 48 hours to offset risk depending on the liquidity profile of the instrument.

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Algorithmic Trading EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

To the extent that an EU Manager or Sub-Manager engages in “algorithmic trading” (i.e. trading in financial instruments where a computer algorithm automatically determines individual parameters of orders, with limited or no human intervention), its transactions will be caught by the MiFID II rules on algorithmic trading.

Although the algorithmic trading requirements set out in Article 17 of the MiFID II Directive apply to firms operating under an exemption to MiFID authorisation as well as authorised firms, it is unlikely that they will extend to non-EU firms given that such firms fall outside the territorial scope of the MiFID authorisation regime (and thus would not be operating under an “exemption” in the usual sense). Therefore, no trades should be affected.

“Algorithmic trading” is defined as trading in MiFID-regulated financial instruments where a computer algorithm automatically determines individual parameters of orders, such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention.15 However, this term does not include any system used only to route orders to one or more trading venues or to process orders with no determination of trading parameters, confirmation of orders or post-trade processing of executed transactions.

MiFID II provides that investment firms which engage in algorithmic trading must have in place effective systems and risk controls to ensure that their trading systems are resilient, have sufficient capacity and are subject to appropriate trading thresholds and limits. In addition, firms must have effective business continuity arrangements in place and ensure appropriate testing and monitoring of their trading systems. Finally, firms must keep records to evidence their compliance with the requirements of Article 17 of the MiFID II Directive.

These overarching requirements are described in a much greater level of detail in the relevant Commission Delegated Regulation16 (the “Algorithmic Trading DR”). Some points to take note of are as follows:

• Prior to the initial deployment or substantial update of an algorithm, algorithmic trading system or strategy, investment firms must set up “clearly delineated” development and testing methodologies. These methodologies must be adapted to the specific trading venues and markets where the algorithms are to be deployed and must fulfil a number of conditions, most notably that “the trading system, trading algorithm or trading strategy...does not contribute to disorderly trading conditions.”

• There is a requirement for the “controlled deployment of algorithms,” which involves setting certain limits on trading algorithms deployed in a production environment, e.g. in relation to the number of financial instruments traded, the price, value and number of orders and the number of trading venues to which orders are sent.

15 See Article 4(1)(39) of the MiFID II Directive.

16 Available here.

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• There is a requirement for investment firms to perform an annual self-assessment and validation process, following which a “validation report” will need to be produced and audited by the firm’s internal audit function (where such a function exists). It is unclear whether auditing is required where a firm does not have an internal audit function.

• There is an annual stress testing requirement, which involves running high messaging and high trade volume tests.

Sidley Comment

The new algorithm testing requirements and trading controls aim to reduce the potential for algorithms to malfunction or interact with the market in an unexpected way.

There is also an increasing focus in MiFID II on involving compliance and risk teams in monitoring the functioning of algorithms and algorithmic trading practices. For example, there is a requirement for firms’ risk control functions to undertake “real-time monitoring” of trading activities, alongside a requirement for compliance staff to stay in “continuous contact” with “persons within the firm who have detailed technical knowledge of the firm’s algorithmic trading systems and algorithms.” Such requirements could in particular pose issues for firms whose compliance staff are located in a different time zone from trading personnel.

Open questions: a number of questions are likely to arise for investment managers in implementing the new obligations:

• The Algorithmic Trading DR notes that firms may calibrate new trading controls to their trading strategies, risk tolerance and experience, but it is as yet unclear how much discretion this ability will provide in practice, given the detailed nature of the required controls.

• In practice, not all algorithms interact directly with trading platforms (they may, for example, simply perform the function of making investment decisions without then going on to perform execution). Such “investment decision” algorithms will fall outside the scope of the algorithm testing requirements, but only where they are “executed by non-automated means,” and questions may, therefore, arise regarding what exactly falls within the scope of this definition. For example, those investment decision algorithms that communicate automatically with execution algorithms would appear to be subject to the full range of requirements set out in the Algorithmic Trading DR.

• It is unclear how the standard of avoiding “disorderly trading conditions” will be applied by Member State regulators, and further guidance may be needed from ESMA on this point.

High Frequency Trading EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

The high frequency trading (HFT) requirements arguably should not apply to EU Managers or Sub-Managers, assuming they do not “deal on own account.”

Although the drafting of the “Level 1” text is not entirely clear on this point, it is unlikely that non-EU firms will be subject to the MiFID II provisions on HFT. In any event, as with EU Managers, the HFT

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requirements arguably should not apply to non-EU Managers, assuming they do not “deal on own account.”

A “high frequency algorithmic trading technique” is defined in MiFID II as an algorithmic trading technique characterised by: (i) low-latency trading infrastructure; (ii) initiation, routing or execution of orders without human intervention; and (iii) “high message intraday rates.” This “high message intraday rate” is to be measured on an annual basis against a threshold of at least two messages per second for any single financial instrument traded on a trading venue, and at least four messages per second for all financial instruments traded on a trading venue. Importantly for investment managers, under the relevant Commission Delegated Regulation,17 messages will only be included in the test where they have either been introduced for the purpose of dealing “on own account,” or where the firm’s execution technique is structured in a manner that is designed to avoid execution taking place “on own account.”

Firms that are at risk of being caught by the HFT rules will need to track their message rates to assess whether they fall within the above thresholds. To the extent that they do, they will need to create and hold a time sequenced, detailed record of each placed order for a period of five years. Aside from certain authorisation issues, which should not affect investment managers, this recordkeeping requirement is the only additional requirement applying to high frequency traders under MiFID II (albeit that, given the detailed nature of the records and the number of transactions involved, it is a significant one).

Sidley Comment

Firms that may be classed as high frequency traders should note that, once a firm’s trading activities cross the HFT threshold, it appears that that firm will then be required to retain the order records detailed above for all trading activities (including non-HFT activities). However, as noted above, an investment manager which does not deal “on own account” arguably should not be caught by the scope of the HFT rules.

Direct Electronic Access EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

All trades executed by EU Managers and Sub-Managers on EU trading venues via DEA arrangements provided by EU investment firms will be caught indirectly.

All trades executed by non-EU Managers on EU trading venues via DEA arrangements provided by EU investment firms will be caught indirectly.

EU investment firms that provide their clients with direct electronic access (DEA) to trading venues will be subject to certain detailed new requirements under MiFID II. In addition, EU trading venues will be required to

17 Available here.

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apply the same rules to non-EU firms providing DEA services, so investment managers, regardless of global location, can expect the rules to have an impact on them.

There is an overarching requirement for DEA providers to retain responsibility for the trading that DEA clients carry out in their name, along with a detailed new list of issues that a DEA provider’s due diligence of its client must cover. DEA providers must also:

a. apply pre- and post-trade controls to the order flow of their clients;

b. set up real-time market surveillance and order monitoring procedures (note that these procedures are required to distinguish between individual traders submitting orders), along with an ability to automatically block or cancel orders;

c. record certain data relating to orders (along with order modifications and cancellations) submitted by DEA clients; and

d. carry out an annual risk-based reassessment of the adequacy of their clients’ systems and controls.

Sidley Comment

The new requirements applying to DEA providers under MiFID II mean that many of the elements underpinning the MiFID II rules on algorithmic trading described above will extend beyond the EU, to any investment manager or other entity utilising DEA arrangements to trade on EU trading venues. Investment managers currently using such DEA arrangements should be aware that the cost of providing such services may increase under MiFID II, and it will be important to scrutinise any new documentation from DEA providers against the requirements of MiFID II as to whether they reflect only regulatory changes and not also commercial changes. It will also be important for investment managers to ensure that the new information to be diligenced or held by DEA providers on their trading strategies, order submission and risk control systems, is held in a secure manner, with adequate IT security and confidentiality safeguards.

Market Making EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

EU Managers and Sub-Managers should not be caught by the scope of the term “market maker” under MiFID II.

Non-EU Managers should not be caught by the rules on market making.

Under MiFID II, investment firms that engage in algorithmic trading to pursue a “market making strategy” will be required to carry out their market making activity continuously during 50 percent of their trading venue’s trading hours, except under exceptional circumstances (e.g. a temporary suspension of transparency requirements or “extreme” market volatility). “Market Maker” means “a firm whose strategy, when “dealing on own account,” involves posting firm, simultaneous two-way quotes of comparable size and at competitive prices”

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for at least 30 percent of daily trading hours. As noted above, this definition arguably should not capture investment managers who do not “deal on own account” for the purposes of MiFID II.

Sidley Comment

Although investment managers should not be caught by the new market making requirements, they are expected to have a significant impact on the provision of liquidity across the EU. Whilst the new requirements will make it more difficult for liquidity providers to withdraw liquidity during volatile periods, there are concerns that the new requirements could undermine the willingness of market makers to continue providing liquidity (i.e. where their trading strategy is not compatible with the continuous liquidity obligation).

Exchange Trading Requirements EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

Any trades undertaken by investment managers accessing EU trading venues directly will be affected by the new “systems resilience” requirements applying to EU trading venues, given that trading venues will apply them directly to members and participants.

Note that the relevant requirements will also affect EU Managers and Sub-Managers that access EU trading venues through an intermediary DEA provider. There is a clear requirement in the relevant Commission Delegated Regulation18 (the “Trading Venue DR”) for DEA providers to “establish policies and procedures to ensure that trading of DEA clients complies with the trading venue’s rules.”

Any trades undertaken by investment managers accessing EU trading venues directly will be affected by the new “systems resilience” requirements applying to EU trading venues, given that trading venues will apply them directly to members and participants.

Note that the relevant requirements will also affect non-EU Managers that access EU trading venues through an intermediary DEA provider. There is a clear requirement in the Trading Venue DR for DEA providers to “establish policies and procedures to ensure that trading of DEA clients complies with the trading venue’s rules.”

MiFID II includes a range of systems resilience and organisational requirements applying to trading venues, many of which will affect the way in which their members and participants of those trading venues trade. In particular, the new requirements cover:

• Due diligence. Detailed standards for due diligence of members and participants will apply, with a further “risk-based assessment” to be conducted at least once a year.

• Arrangements to prevent disorderly trading. Trading venues will need to ensure that they have in place: (a) limits per member on the number of orders sent per second (throttle limits); (b) mechanisms to manage volatility (including an ability to trigger “trading halts” or pauses in trading); and (c) pre-trade controls (taking the form of maximum order value, maximum order volume and price collars).

18 Available here.

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• Testing requirements. Conformance testing will be required prior to accessing the trading venue’s system, and prior to the deployment or “substantial update” of the member’s trading system, algorithm or strategy. Such conformance testing must include functional testing (i.e. relating to order submission, modification and cancellation functionalities), along with technical tests assessing connectivity, recovery, and the handling of suspended instruments or stale market data. The Trading Venue DR will also require members of trading venues to certify that their algorithms have been tested to avoid creating or contributing to disorderly trading conditions.

• Order-to-transaction ratio. Trading venues must require their members to limit the ratio of unexecuted orders to transactions that may be sent to the venue.

• Co-location services. The Trading Venue DR contains a general requirement for users that have subscribed to the same co-location services to be provided with network access under “equivalent” conditions, including space, power, cooling, cable length, access to data, market connectivity, technology, technical support and messaging types.

• Fees. The Trading Venue DR requires trading venues to charge the same price and provide the same conditions to all users of the same type, in accordance with published and objective criteria. There are additional transparency requirements surrounding fee structures, and users will be permitted to request services on an unbundled basis.

Sidley Comment

MiFID II will give trading venues new tools to combat volatility, and the new testing requirements should in theory decrease the risk of members’ and participants’ trading algorithms behaving abnormally. The requirement for co-location services and fee structures to be offered on a non-discriminatory basis is also positive news for market participants, given that they will now be able to hold trading venues to this standard. However, the new testing requirements may make rolling out new trading strategies more time-consuming, and there is also the issue that members will need to certify that their algorithms have been tested to avoid creating or contributing to disorderly trading. This is a rather vague standard, which raises a degree of compliance risk.

Equities Trading Obligation and Tick Size Regime EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

To the extent that EU Managers or Sub-Managers trade in equities, they will need to comply with the trading obligation unless an exemption (e.g. transfers between funds) applies.

EU Managers and Sub-Managers will also need to comply with the new tick size regime to the extent that they trade on EU trading venues.

Non-EU Managers will not be subject to the equities trading obligation, although they will need to comply with the new tick size regime when trading on EU trading venues.

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Under MiFID II, investment firms are required to ensure that any transactions they undertake in shares that are admitted to trading on a regulated market or “traded on a trading venue” are executed through a regulated market, MTF, systematic internaliser or an “equivalent” non-EU venue. However, there are two circumstances in which this requirement will not apply:

• where transactions are “non-systematic, ad-hoc, irregular and infrequent”; and

• where transactions are entered into between eligible counterparties and professional clients (i.e. more sophisticated investors, as classified under MiFID II), and where they do not contribute to the price discovery process. Examples of such transactions would be give-up trades, securities financing transactions and transfers of shares between funds in the context of portfolio management.

MiFID II will also introduce a harmonised “tick size” regime across the EU. This will require trading venues to implement minimum tick sizes (that is, the smallest increment by which the price of a financial instrument can move) in relation to shares, depositary receipts and exchange traded funds.

Sidley Comment

EU Managers and Sub-Managers involved in equities trading will need to monitor which shares are admitted to trading on a regulated market or are otherwise traded on a regulated market or MTF, so they are aware of the situations in which the equities trading obligation may apply. There will likely be a number of questions surrounding when exemptions to the trading obligation will apply.

Derivatives Trading Obligation EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

The derivatives trading obligation will directly apply to the trading activities of funds that are classified as NFC+s or FCs for the purposes of the EMIR regime.

Once classes of derivatives are declared subject to the trading obligation, EU managers must determine which type of trading venue suits their trading strategy best, and must consider how to access the venue (i.e. directly or through an intermediary). Related points such as documentation, due diligence required to be conducted by the trading venue, and pre-trade testing requirements must all be considered.

Transactions will be subject to the derivatives trading obligation where non-EU investment funds that would be classified as NFC+s or FCs if they were established in the EU trade with EU counterparties classified as FCs or NFC+s.

A key issue for managers established in the U.S. will be whether U.S. Swap Execution Facilities (SEFs) are declared “equivalent” to EU trading venues such that they can be used to satisfy the trading obligation, and the circumstances in which their funds can rely on “substituted compliance” under Dodd-Frank rather than the MiFID II trading obligation.

Under Article 28 of the MiFIR, all classes of derivatives which are declared by ESMA to be subject to the MiFID II “trading obligation” must be traded either through an EU trading venue (i.e. a regulated market, MTF or OTF), or through an “equivalent” non-EU trading venue. The derivatives trading obligation will apply to trading

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counterparties classified as financial counterparties (FCs) or non-financial counterparties which are above the EMIR clearing threshold (NFC+s), where they trade with other FCs or NFC+s, or with non-EU counterparties that would be classified as an FC or NFC+ if they were established in the EU.

Two third country (i.e. non-EU) firms trading with one another will be subject to the MiFID II trading obligation in two limited circumstances: (i) where the transaction has a “direct, substantial and foreseeable effect” within the EU; or (ii) where imposing the trading obligation is necessary or appropriate to prevent the evasion of MiFIR. The intention is for the “direct, substantial and foreseeable” test to mirror an equivalent test applying to the application of the clearing obligation under EMIR,19 which is relatively narrow in scope and which should generally not be relevant for non-EU investment managers or funds (i.e. given that they would not ordinarily operate under a guarantee from an EU FC counterparty, or through an EU branch).

Sidley Comment

There remain a number of open questions which will be of importance to investment managers, in particular:

• the circumstances in which counterparties can comply with a non-EU regime, such as Dodd-Frank rather than with MiFID II (i.e. substituted compliance); and

• the circumstances in which third country exchanges will be considered “equivalent” to EU exchanges, such that they can be used to satisfy the trading obligation (although we note that certain designated contract markets (DCMs) have now been declared equivalent to regulated markets under EMIR).20

In addition, separate consultations on the individual classes of derivatives proposed to be made subject to the trading obligation will be released later, on an individual basis. Thus, it is not yet clear exactly which derivatives will become subject to the trading obligation. Those categories of derivatives that are either subject to the EMIR clearing obligation or are currently proposed to become subject to mandatory clearing (i.e. certain categories of interest rate swaps and credit default swaps) are likely to be considered initially for the purposes of the derivatives trading obligation, with others following later.

For those investment managers that are affected by the derivatives trading obligation, an important consideration will be the type of trading venue they choose to transact through. It remains to be seen how successful the new “OTF” category of trading venue will be, and whether derivatives are instead routed through regulated markets and MTFs. For those investment managers that are established outside of the EU but trade with EU counterparties, it will be important to monitor whether any local (non-EU) execution platforms are likely to be declared “equivalent” by the European Commission, so that the trading obligation can be satisfied by trading through those platforms. However, based on continuing delays to central counterparty (CCP) equivalence under EMIR, it is possible that such equivalence assessments could take some time.

19 Under the Commission Delegated Regulation on “the direct, substantial and foreseeable effect of derivative contracts within the Union and the prevention of the evasion of rules and obligations,” where at least one of the third country counterparties benefits from a guarantee by an FC which covers all or part of its liability resulting from an OTC derivative contract, the contract will have direct, substantial and foreseeable effect in the EU to the extent that the arrangement satisfies both of the following conditions: (i) the guarantee covers OTC derivatives contracts with a gross notional amount of at least €8 billion; and (ii) the guaranteed obligations represent at least 5 percent of the aggregate current exposures in OTC derivatives of the guarantor. Transactions will also be considered to have direct, substantial and foreseeable effect under ESMA’s proposals where both third country entities enter into the transaction through EU branches and where they would be categorised as FCs if they were established in the EU.

20 Available here.

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Straight-Through-Processing and Clearing Obligation for Derivatives EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

The clearing obligation will apply to all transactions in derivatives that are executed through an EU regulated market. The STP obligation will affect trades which are undertaken through EU trading venues, cleared by an EU CCP, or which are cleared through an EU regulated CCP clearing member.

The impact will be the same as for EU Managers and Sub-Managers.

STP Under MiFID II, CCPs, trading venues and clearing members are required to have effective systems, procedures and arrangements in place in order to ensure that cleared derivative contracts are submitted and accepted for clearing “as quickly as technologically practicable using automated systems” (also known as “straight-through-processing” (STP). This standard is detailed in an accompanying Commission Delegated Regulation,21 which sets out a number of deadlines relating to different stages in the execution-to-clearing process, with variations depending on whether the relevant derivative is executed on a trading venue or bilaterally.

Clearing obligation and indirect clearing Whereas EMIR requires the clearing of “OTC derivatives” (defined to mean derivatives that are not traded on EU regulated markets), MiFID II “closes the gap,” and imposes mandatory clearing of derivatives traded on regulated markets. Importantly, MiFID II also requires that indirect clearing arrangements relating to “exchange-traded derivatives” are only permissible to the extent that they do not increase counterparty risk and provided that they ensure equivalent levels of protection to EMIR (in terms of segregation and account structures). “Indirect clearing” refers in this context to arrangements whereby the immediate or “direct” clients of CCP clearing members take on further, “indirect” clients, such that the direct clients provide clearing services to indirect clients.

Sidley Comment

Investment managers that already clear derivatives in the U.S. are likely to be prepared for the STP obligation, as STP standards have applied to the U.S. cleared derivatives market under the Dodd-Frank Act for some time. However, it should be noted that an implementing act on equivalence will be required before compliance with U.S. STP rules will be considered to satisfy the MiFID II STP requirement.

The move towards regulating indirect clearing arrangements may be significant for those investment managers that trade exchange-traded derivatives, where such arrangements are relatively common. For example, where a fund trades through an executing broker which acts as the “direct” client of a clearing member, it is conceivable that an indirect clearing relationship could arise. The ability for the fund to request a segregated account

21 Available here.

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structure could prove to be a significant change in practice.

Commodity Derivative Position Limits EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

Any person trading in commodity derivatives through an EU trading venue will be required to comply with EU position limits. Limits will therefore apply to investment managers’ clients and funds with positions in commodity derivatives traded through EU trading venues or in “economically equivalent” bilaterally traded commodity derivatives.

Given that the position limits regime has not explicitly been limited to EU market participants (instead, the MiFID II Directive uses the neutral term “person”), any person trading in commodity derivatives through an EU trading venue (whether that entity is established in the EU or not) will be required to comply with EU position limits.

Limits will therefore apply to investment managers’ clients and funds with positions in commodity derivatives traded through EU trading venues, or “economically equivalent” OTC commodity derivatives.

MiFID II requires Member State regulators to apply position limits to the size of a net position which can be held in commodity derivatives traded on EU trading venues, and in “economically equivalent” OTC derivative contracts. The draft RTS on position limits22 sets a “methodology” to be used by national authorities in setting these limits, rather than specifying actual limits. This methodology has proven to be one of the more controversial aspects of MiFID II, given that it needs to operate across a wide range of different commodity derivative contracts. The UK FCA, for example, has stated that it will be responsible for setting limits for over 1,700 contracts. Based on the RTS, the main features are as follows:

• Baseline for setting limits. The methodology sets a 25 percent “baseline” limit of either open interest (for non-spot months) or deliverable supply (for spot months), to be varied between 5 percent (or 2.5 percent for certain agricultural commodity derivatives with an underlying asset that qualifies as food) and 35 percent depending on a number of specified factors. An adjustment in position limits will in particular be necessary where there is a significant discrepancy between open interest and deliverable supply.

• New and illiquid commodity derivatives. For commodity derivatives traded on a trading venue with a total combined open interest in spot and other months’ contracts not exceeding 10,000 lots (measured over a three month period), a position limit of 2,500 lots will apply.

• Economically equivalent OTC derivatives. The test for “economic equivalence” is fairly narrow in scope, and applies to OTC derivatives with “identical contractual specifications, terms and conditions,” other than lot size specifications, delivery dates (which may diverge by less than one calendar day) and post-trade risk management arrangements.

22 On May 2, 2016, ESMA published a finalised draft RTS on position limits; available here.

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• Aggregation. Parent undertakings will be required to determine their net position by aggregating: (i) the parent’s own net position; and (ii) the net positions of each of its subsidiaries. However, by way of derogation to this test, the RTS provide that the parent undertaking of a collective investment undertaking (CIU, i.e. a fund), or the parent of a management company appointed by the CIU, should not aggregate its positions with the CIU where it does not exercise influence over the CIU’s investment decisions.

• Netting. A person’s net position in a commodity derivative will be the aggregation of its positions held: (a) in that commodity derivative traded on a trading venue; (b) in commodity derivatives traded on EU trading venues that are considered the “same” as that commodity derivative (i.e. derivatives with identical contractual specifications and which belong to a single pool of open interest); and (c) in economically equivalent OTC derivative contracts. Where a person holds both long and short positions in any of these commodity derivatives, the long and short positions must be netted in order to determine the person’s overall net position.

Sidley Comment

As yet, it is difficult to assess what the full impact of the position limits regime will be, given that national regulators such as the UK FCA have not yet begun to calculate and apply position limits to individual classes of commodity derivatives. Issues surrounding phase-in and grandfathering of existing positions will likely only become clear once national regimes have been finalised. However, position limits are likely to have a significant impact on liquidity in the commodity derivatives markets, particularly in relation to cash-settled transactions.

A key issue for investment managers throughout the drafting of MiFID II has been the potential for aggregation of positions across funds. The approach to aggregation taken by the MiFID II Directive is simply based on aggregation across parent-subsidiary relationships in the corporate sense (i.e. as defined under the EU Accounting Directive); such a test should not, therefore, require aggregation across investment funds even where they are managed by the same investment manager. However, the additional RTS wording on aggregation by “the parent company” of a management company in cases where there is trading control somewhat confuses the issue. This test may be intended simply to capture situations where an investment management company is an investor in funds itself, but further guidance will be needed to give comfort on this point.

Commodity Derivative Position Reporting EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

EU Managers and Sub-Managers who are members or participants of EU trading venues will need to report positions in commodity derivatives to trading venue operators where they trade commodity derivatives through EU trading venues. They will also be required to file reports with their national competent authority on positions in any commodity derivatives which are traded on a trading venue and in economically

Non-EU Managers who are members or participants of EU trading venues will need to report positions in commodity derivatives to trading venue operators where they trade commodity derivatives through EU trading venues.

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equivalent OTC contracts.

Under Article 58 of the MiFID II Directive, all members and participants of regulated markets, MTFs and OTFs must submit daily reports of their positions in commodity derivative contracts traded on that trading venue to the trading venue operator, along with the positions “of their clients and the clients of those clients until the end client is reached.”

In addition, MiFID-authorised investment firms (e.g. EU Managers or Sub-Managers) which trade in commodity derivatives outside a trading venue must provide their national competent authority with a daily breakdown of their positions in any commodity derivatives which are traded on a trading venue and in economically equivalent OTC contracts. Again, these reports must identify not only the firm’s positions, but “those of their clients, the clients of those clients and so on until the end client is reached.”

Sidley Comment

There is little guidance in MiFID II on the format of the reports and the practicalities surrounding position reporting. It therefore seems likely that such guidance will be released at a later date either by ESMA or national authorities. There are particular concerns surrounding the way in which data on end client positions is to be passed through a chain of intermediaries. This requirement will, for example, extend the impact of position reporting to non-EU entities using EU brokers to trade on their behalf. It will therefore be vital to ensure that data on end clients’ identity is protected from leaks and kept confidential as far as possible.

There is also an open question as to how the requirement for “daily” report submission will be defined in this context. Previous ESMA proposals have suggested that reports will need to be submitted by 9:00 a.m. on the business day following execution, but this point has not yet been finally settled.

Ability of Non-EU Firms to Provide Services to EU Clients EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

The third country regime is not applicable to EU investment firms.

Non-EU investment managers seeking to provide portfolio management or advisory services to EU investors will need to take the third country regime into account from the date on which their jurisdiction is declared “equivalent” in nature to the EU.

Under the existing MiFID I regime, non-EU firms wishing to do business with EU investors and clients are required to comply with the national “access” regime applying in each EU Member State; there is no single point of entry.

MiFID II will introduce a new “third country” regime applying to non-EU investment managers seeking to provide investment services, including portfolio management services, to EU clients.

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For services provided to retail clients, Member States are able to choose whether to require the investment manager to set up a branch in their territory (so far, the UK FCA has indicated that it will not implement this “branch requirement”).

For services provided to professional clients and eligible counterparties, non-EU Managers will be able to register with ESMA once the regime has come into force. The ability to register with ESMA depends on an “equivalence” determination having been made by the European Commission in relation to the non-EU manager’s home country. Before such a decision has been made, existing national Member State regimes governing the provision of services by foreign firms will remain in place.

Sidley Comment

Following a UK exit from the EU, UK investment managers would need to rely on the equivalence/ESMA registration regime to access EU professional clients to the extent that the financial services passport does not survive. If the ESMA registration regime works as intended, it should, in theory, form a workable solution for UK firms, assuming the UK is determined to be “equivalent.”

Call Recording EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

EU Managers and Sub-Managers will in the future need to put in place call recording procedures for both internal and external calls. For UK Managers, the FCA’s existing exemption for investment managers from call recording may no longer apply.

Non-EU Managers will not be subject to the call recording requirements under MiFID II.

Firms will be required to keep records of telephone conversations or electronic communications relating to transactions concluded when dealing on own account, and when providing “client order services” (i.e. receipt, transmission and execution of client orders). This call recording obligation will entail:

• implementing “technology neutral” call recording policies, and keeping a record of individuals with firm or privately owned devices that have been approved for firm use;

• undertaking “risk based and proportionate” monitoring of call records; and

• notifying both new and existing clients that telephone conversations and communications are being recorded and that a copy will be made available to them on request for up to seven years.

Sidley Comment

For those jurisdictions where there are currently no call recording rules in place, MiFID II will require significant changes to compliance procedures for investment managers and other regulated firms.

For Managers and Sub-Managers established in the UK, although there is currently an FCA call recording regime in place, an exemption is available for investment managers. However, the FCA has proposed to remove

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that exemption when the UK implements MiFID II. The scope of the call recording requirements may well lead EU Managers and Sub-Managers to take the decision simply to record all internal calls as well as external calls (i.e. as a precaution to ensure that the recordkeeping requirements are being fulfilled).

A key implementation question will be what exactly is required by the “periodic” record monitoring obligation, and how much time and resources will need to be devoted to call monitoring.

Recordkeeping EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

EU Managers and Sub-Managers will be subject to the new recordkeeping requirements set out in MiFID II in relation to MiFID regulated transactions.

Non-EU Managers will not be subject to the recordkeeping requirements under MiFID II.

MiFID II will require a substantial amount of new information to be held on the features of individual transactions. Importantly, transaction records must be made at two points in time: (i) “immediately” upon receiving an “initial” order from a client, or making an “initial” decision to deal; and (ii) “immediately” after receiving a client order or making a decision to deal.

Other recordkeeping requirements (such as records required to be retained in relation to costs and charges, conflicts of interest etc.) will be harmonised under MiFID II. Finally, firms’ recordkeeping practices will need to allow for IT or other “efficient exploitation” of the data where effective analysis of the data could not otherwise be carried out due to its volume.

Sidley Comment

EU investment managers may already be keeping much of the data required by MiFID II on file pursuant to EMIR and existing MiFID I recordkeeping requirements. There are, however, certain required additions to this data under MiFID II, most notably the requirement to keep internal records identifying the “trader” or algorithm within the investment manager that made the relevant “investment decision” (i.e. the decision to enter into the transaction), and also the trader or algorithm responsible for the execution of the transaction. The fact that records must be produced “immediately” upon transacting or deciding to transact will be of particular concern in the context of faster paced trading strategies, and questions will likely arise about when exactly execution occurs in the case of voice trades.

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Clock Synchronisation EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

Where EU Managers or Sub-Managers are members or participants of trading venues, they will need to comply with the MiFID II clock synchronisation requirements.

Where EU Managers or Sub-Managers are not direct members or participants of a trading venue, but rather rely on a broker to place orders on trading venues, the clock synchronisation requirements should not apply, although they will still need to ensure that timestamps in transaction records and reports are accurate.

Article 50 of the MiFID II Directive requires that all “members or participants” of EU trading venues synchronise the business clocks they use to “record the date and time of any reportable event.” Although this requirement is not clearly limited to EU firms, the term “reportable event” covers obligations such as MiFID transaction reporting and recordkeeping, which do not apply to non-EU Managers. Thus, the obligation to synchronise business clocks with trading venues should not, in theory, apply to non-EU Managers even where they trade through EU trading venues, although this will depend on the approach of national regulators and trading venues in implementing the new requirement.

Operators of trading venues and their members and participants will be required to “synchronise the business clocks they use to record the date and time of any reportable event.” “Reportable event” in this context includes events that would require a transaction report to be filed or a transaction record to be made. In general, firms must ensure that their business clocks are synchronised according to the following accuracy requirements:

• For activity using a high frequency algorithmic trading technique: (i) the maximum permitted divergence from Coordinated Universal Time (UTC) will be 100 microseconds; and (ii) timestamps must be accurate to one microsecond or better.

• For: (a) trading activity on voice trading systems; (b) trading activity on RFQ systems requiring human intervention or which do not allow for algorithmic trading; and (c) the conclusion of negotiated transactions:

o the maximum permitted divergence from UTC will be 1 second; and

o timestamps must be accurate to one second or better.

• For any other trading activity:

o the maximum permitted divergence from UTC will be one millisecond; and

o timestamps must be accurate to one millisecond or better.

Sidley Comment

Throughout the MiFID II consultation process, concerns have been expressed about the costs involved in implementing clock synchronisation, with fears expressed that it will keep smaller firms, which are less able to invest in the infrastructure required to meet the new standard, from trading directly on trading venues.

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Product Governance Impact on EU Managers/Non-EU Managers

with EU Sub-Manager Impact on Non-EU Managers with no EU

Presence

EU Managers which manufacture or distribute financial instruments will be subject to numerous new obligations.

Non-EU Managers may be asked by EU firms which act as manufacturer or distributor of financial instruments to enter into arrangements which enable the EU Manager to fulfil its obligations under the product governance rules.

The new MiFID II product governance regime sets out a range of obligations for those firms which manufacture (i.e. design, create, develop or issue) or distribute (i.e. offer or sell) financial instruments, with such firms being “manufacturers” and “distributors” respectively. Essentially, the rules are concerned with ensuring that the financial instruments manufactured or distributed by firms meet the needs of end clients in identified target markets and are free from conflicts of interest.

To this end, firms caught by the rules as either a manufacturer or distributor will be required to implement product governance processes which are under the effective control of the firm’s management body and subject to monitoring and review by the compliance function.

Under the product governance rules, firms will be required to identify a “target market” for each financial instrument which they manufacture or distribute. This target market will need to be identified with a level of granularity appropriate to the particular financial instrument. This means that for simpler, more mainstream investments, the target market may be identified with less detail.

Amongst other things, manufacturers specifically will need to:

• implement a product approval process which identifies the target market, assesses the risks to clients and considers the appropriate distribution channels for each instrument;

• perform a scenario analysis for each instrument which assesses the risks of poor outcomes for clients;

• identify crucial events which would affect the potential risk or return expectations of the instrument and take appropriate action if such events occur; and

• periodically assess whether the product functions as intended.

Distributor firms will be required to make their own assessment as to the target market for the product and ensure that the product offered by them is compatible with the needs, characteristics and objectives of that market. Distributors will also be required to provide sales and other data on the product to the manufacturer.

In this regard, the rules generally envisage significant information exchange between manufacturer and distributor firms. Putting effective arrangements in place to achieve the above may be an issue, especially in cases where one of the firms is a non-MiFID or third country (non-EU) firm. In this case, vertically integrated firms which both manufacture and distribute financial instruments may find themselves at an advantage.

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Sidley Comment

The scope of the product governance rules has been the subject of confusion for investment managers for some time. ESMA has stated that it considers that there may be scope for guidance to assess the criteria used for identifying target markets.

The increased exchange of data envisaged between manufacturer and distributor firms may prove to be problematic if non-MiFID or third country firms are involved.

Corporate Governance EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

EU Managers and Sub-Managers will need to ensure that the new requirements are implemented from January 3, 2018.

Non-EU Managers will not be subject to corporate governance requirements under MiFID II.

MiFID II will apply the corporate governance requirements currently set out in CRD IV across all investment firms. One of the key corporate governance requirements in CRD IV is that members of the management body of a “significant” investment firm must hold no more than either: (i) one executive directorship with two non-executive directorships; or (ii) four non-executive directorships. In addition, members of management bodies will be required to commit sufficient time to perform their functions, and show that they have adequate collective knowledge, skills and experience to be able to understand the firm’s activities and the main risks it faces. Finally, MiFID authorised firms will be required to implement a policy promoting diversity of the management body.

MiFID II will also strengthen firms’ compliance functions. Compliance guidelines previously published by ESMA have been incorporated into the Delegated Directive, and new requirements have been added (e.g. a requirement that the compliance function utilise a risk-based approach when it establishes its monitoring programme).

Sidley Comment

EU Managers and Sub-Managers will need to ensure that their management bodies have adequate access to information and documents necessary to oversee and monitor decision-making and compliance generally. Thought should also be given to whether their compliance functions will need to increase current levels of compliance monitoring.

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Conduct Of Business Requirements EU Managers/EU Sub-Managers of Non-EU

Managers Non-EU Managers with no EU Presence

Conduct of business requirements will apply directly to EU Managers and Sub-Managers, although their impact on Sub-Managers will be offset by the fact that such entities will often only have one “client” for these purposes (i.e. their affiliate investment manager).

Non-EU Managers will not be subject to conduct of business requirements under MiFID II.

Information to Clients MiFID I obligations regarding information to clients will remain in place but with certain additions, set out in the Conduct DR. These include a requirement to inform clients about: (i) the functioning and performance of financial instruments in both positive and negative market conditions; (ii) any risks to “disinvestment” (i.e. selling or exiting an instrument); and (iii) the estimated time frame for the sale of the financial instrument before recovering the initial costs of the transaction.

Sidley Comment

Managers will need to ensure that their policies on information to clients and other conduct requirements are up to date and reflect the above requirements by January 3, 2018.

Costs and Charges MiFID II extends the MiFID I requirement to provide information on costs and charges to retail clients to cover professional clients and eligible counterparties. MiFID II also provides for certain additional costs data to be disclosed; for example, costs will need to be aggregated so that clients can understand the overall costs attaching to each transaction. Clients will also need to be informed of the cumulative effect of costs on any returns expected from financial instruments, and information will need to be disclosed throughout the life of any investment.

Sidley Comment

Any information given to the Manager’s clients on costs and charges will need to be fully redrafted, and potentially delivered on a more frequent basis.

Conflicts of Interest The Conduct DR will introduce certain new requirements surrounding disclosure of conflicts of interest, including a move towards disclosure to clients being treated as a “last resort,” and disclosure being specifically tailored to those clients to whom it is addressed. Firms will also need to assess and periodically review (at least annually) their conflicts of interest policy, and take all appropriate measures to address any deficiencies.

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Sidley Comment

Managers will need to review whether and where conflicts of interest may arise throughout their business, and potentially alter their approach to addressing these conflicts (and in particular to how they are disclosed). Managers will also need to ensure that their conflicts of interest policy is reviewed and kept updated at least annually.

Suitability and Appropriateness The current presumption that professional clients have the requisite level of experience and knowledge to understand the risks involved in relation to those products or services for which they are classified as professional clients will in future be limited to less complex financial instruments. In addition, where an investment firm provides investment advice recommending a “bundled” package of services or products, the overall bundled package must be suitable. There is also a new requirement for a “suitability statement” to be delivered to clients in advance of any transaction.

Sidley Comment

EU Managers’ and Sub-Managers’ policies on suitability and appropriateness may need to be reviewed and revised on the basis of the new rules, also taking into account the “suitability statement” which will need to be delivered on a more frequent basis.

Conclusion It is clear that investment managers, whether EU or non-EU, have a significant task ahead as MiFID II enters its implementation phase at national level. In particular, we can expect that, during 2018, the position of brokers and other sell side firms will become clearer. At that stage, investment managers will be faced with significant new documentation from the sell side. With that in mind, investment managers should consider carrying out their internal implementation work for MiFID II sooner rather than later, so that they can focus on dealing with sell side firms efficiently when the time comes.

If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or

Leonard Ng Partner +44 20 7360 3667 LNg@sidley.com

Matthew Dening Partner +44 20 7360 3646 MDening@sidley.com

John Casanova Partner +44 20 7360 3739 JCasanova@sidley.com

Rachpal K. Thind Partner +44 20 7360 3721 RThind@sidley.com

Investment Funds, Advisers and Derivatives Practice Sidley has a premier, global practice in structuring and advising investment funds and advisers. We advise clients in the formation and operation of all types of alternative investment vehicles, including hedge funds, fund-of-funds, commodity pools, venture capital and private equity funds, private real estate funds and other public and private pooled investment vehicles. We also represent clients with respect to more traditional investment funds, such as closed-end and open-end registered investment companies (i.e., mutual funds) and exchange-traded funds (ETFs). Our advice covers the broad scope of legal and compliance issues that are faced by funds and their boards, as well as investment advisers to funds and other investment products and accounts, under the laws and regulations of the various jurisdictions in which they may operate. In particular, we advise our clients regarding complex federal and state laws and regulations governing securities, commodities, funds and advisers, including the Dodd-Frank Act, the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act, the USA PATRIOT Act and comparable laws in non-U.S.

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