Trading and Compliance: EU Regulatory Developments and Trading on EU Markets

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Trading and Compliance: EU Regulatory
Developments and Trading on EU Markets
Sean Donovan-Smith, Partner, K&L Gates
Philip Morgan, Partner, K&L Gates
15th January 2013
Copyright © 2012 by K&L Gates LLP. All rights reserved.
Overview
 Practical Issues on the EU’s Short Selling
Regulations
 Transaction Reporting Issues
 Restrictions on Computer Based Trading
Strategies
 Order Allocation, Trading Errors and Conflicts of
Interest
 What’s Next on the Regulatory Horizon
2
Practical Issues on the EU’s Short Selling
Regulations
3
Practical Issues on the EU’s Short Selling
Regulation
 Recap (focusing on disclosure).
 Scope issues.
 Which regulator should a report be made to?
 Aggregation issues.
 Registration with national regulators.
4
Practical Issues on the EU’s Short Selling
Regulation
 Recap (focusing on disclosure re: shares)
 Scope – (i) financial instruments (MiFiD
definition), which includes shares, admitted to
trading on a trading venue (Regulated Market
(“RM”) or MTF) in the EU, including such
instruments when traded outside a trading venue
(plus derivatives relating to the same);
 (ii) debt instruments issued by an EU Member
State or the EU (plus derivatives relating to the
same).
5
Practical Issues on the EU’s Short Selling
Regulation
 Net short positions include transactions which
have the same economic effect as a short-sale;
also delta-adjusted [NB naked shorts banned].
 Private, confidential, reporting to relevant EU
regulator when the position equals 0.2% of the
issued share capital of the company concerned,
and at each 0.1% above that; public disclosure at
0.5% and at each 0.1% above that. Disclosure
must be made when a threshold is reached,
exceeded or crossed downwards [NB different
thresholds for sovereign debt].
6
Practical Issues on the EU’s Short Selling
Regulation
– Disclosure by 3.30 pm on the next trading day
(defined by reference to relevant EU Member
State).
7
Practical Issues on the EU’s Short Selling
Regulation
 Scope issues
 ESMA Q&A, Question 1a: “Neither the domicile or
establishment of the person entering into a transaction on
these financial instruments nor the place where the
transactions take place, including in third countries, are of
any relevance in this regard”.
 Place of execution or booking of trade irrelevant re
reporting rules.
 Third country firms making “jurisdiction" arguments.
 Note that Article 10 SSR only expressly seeks to extend
jurisdiction to non-EU persons in relation to notification
and disclosure requirements.
8
Practical Issues on the EU’s Short Selling
Regulation
 Which regulator should a report be made to?
 The "relevant" competent authority.
 Sovereign debt of a Member State: the
competent authority of that Member State.
 For a financial instrument (other than, broadly,
sovereign debt): the competent authority of the
"most relevant market in terms of liquidity for that
financial instrument" – see Regulation
1287/2006/EC, Chapter III.
9
Practical Issues on the EU’s Short Selling
Regulation
 Shares/units in CIS – competent authority of the
Member State where the share or unit was first
admitted to trading on an RM.
 Derivative contract or a financial contract for
differences – where the underlying security is a
share admitted to trading on a regulated market,
the competent authority of the Member State
where the share was first admitted to trading on an
RM; where the underlying is an index composed of
shares all of which are traded on a particular
regulated market, the competent authority of the
Member State where that RM is situated.
10
Practical Issues on the EU’s Short Selling
Regulation
 In any other case, the Member State where the
RM that first admitted the transferable security
or derivative contract to trading is located (there
may not be one, in which case, move on!) [NB
more nuances where first admission in more
than one RM simultaneously].
 For a financial instrument not dealt with by the
above, the competent authority of the Member
State in which the financial instrument was first
admitted to trading on a trading venue.
11
Practical Issues on the EU’s Short Selling
Regulation
 Definition of trading day – by reference to the time
in the Member State of the relevant competent
authority to whom the relevant position must be
notified.
12
Practical Issues on the EU’s Short Selling
Regulation
 Aggregation issues
 Discretionary management entity has the
reporting obligation re managed funds/portfolios
(NB separate management entities within a
group are considered separately).
 Net short positions of all funds/portfolios running
a "short strategy" in relation to a particular
relevant name need to be aggregated; NB long
positions held by other managed funds/portfolios
not netted off for this purpose.
13
Practical Issues on the EU’s Short Selling
Regulation
 Exclude positions of funds and portfolios the
management of which has been delegated to a
third party.
 Interests held as a result of non-management
activities (i.e. direct investment by entity itself)
dealt with separately and aggregated on both an
entity basis and group basis, with long positions
and short positions netted against one another at
an entity level, and as between all the entities in
the group.
14
Practical Issues on the EU’s Short Selling
Regulation
 Thus single entity may have two separate
reporting obligations, one in relation to its
discretionary management activities and one in
relation to its direct investments.
 If, in relation to non-management activities, there
is a reporting obligation at a group level,
individual entities within the group which would
otherwise have a reporting obligation do not also
need to report.
15
Practical Issues on the EU’s Short Selling
Regulation
 Individual entities in a group which does not have
a group-level reporting obligation in relation to
non-management activities need to report if a
relevant threshold is crossed by the relevant
entity in relation to non-management activities.
16
Practical Issues on the EU’s Short Selling
Regulation
 Registration with national regulators
 SSR Art 9(3) – means of notification needs to ensure confidentiality
of the information and incorporate mechanisms for authenticating
the source of the notification.
 Each national regulator has a relevant website page which should
indicate how notifications are to be made (e.g. by e-mail, post, fax
etc).
 Different procedures in different Member States (in the UK: e-mail
notification).
 If you are not currently "authenticated" in a jurisdiction and believe
that you may need to make short selling disclosures then it is worth
investigating further.
 In the UK – need to send the FSA a signed letter, on printed
headed paper including the address, outlining the contact details of
those individuals who will be notifying positions on their behalf.
17
Transaction Reporting Issues
18
The FSA’s Transaction Reporting Regime
 The FSA’s Transaction Reporting Regime
 SUP 17 of the FSA’s handbook of rules and
guidance.
 “Reportable” transaction reports submitted by
the end of the following business day.
 Transaction Reporting User Pack (“TRUP”).
 FSA's Transaction Monitoring Unit (“TMU”).
 Not the same as trade reporting.
19
SUP 17.1.4R: “Reportable” transactions
 A relevant firm (within the scope of SUP 17.1)
executes a transaction:
 in any financial instrument admitted to trading
on a Regulated Market (“RM”) or a Prescribed
Market, or
 in any over-the counter (“OTC”) derivative, the
value of which is derived from, or which is
otherwise dependent upon, an equity or debtrelated financial instrument which is admitted to
trading on an RM or on a Prescribed Market.
20
Firms within scope of SUP 17
 SUP 17.1.1R:
 MiFID investment firms.
 Third country investment firms (e.g. non-EEA
firms).
 Operators of an Approved Reporting Mechanism
(“ARM”) or of an RM or a Multilateral Trading
Facility (“MTF”).
 Managers or operators of collective investment
schemes and pension schemes.
21
Making a Transaction Report
 Responsibility for making a transaction report.
 Not just market-facing side.
 Transaction reports may be made via (see SUP
17.2):
 A third party agent acting on a firm’s behalf.
 An ARM.
 An RM or MTF through whose systems the
transaction was completed.
22
FSA’s Continuing Focus
“Accurate transaction reports are a key tool in our
efforts to tackle market abuse. We will take action
where necessary to ensure firms – regardless of size
– comply with their reporting obligations. As well as a
financial penalty, firms can also expect to incur the
cost of resubmitting historically inaccurate reports.”
- David Lawton, FSA Director of Markets
23
Key Themes Arising
 Unaware that the regime applied.
 Failure to make complete and accurate transactions
reports.
 Failure to capture transactions in scope of the
regime.
 Incorrect data fields.
 Failure to resubmit failed reports.
 Failure of third party systems.
24
FSA’s Thematic Review by the TMU
 Review of sample trading records before the visit.
 Ensure that transaction reports match the trading
book.
 Check the accuracy of data quality.
 Review transaction reporting training procedures.
 Ensure documentation is adequate.
 Assess internal validation procedures.
 Check accuracy of reference data.
 Review change management procedures.
 Assess compliance with the FSA Systems and
Controls (“SYSC”) rules.
25
Proposed Changes to the Transaction
Reporting Regime
MiFID II
 Mirror scope of the Market Abuse Directive.
 Harmonise requirements across EU Member
States.
 Reception and transmission of orders.
 Scope extended to all financial instruments
(Articles 21-23 of the proposed Markets in
Financial Instruments Regulations (“MiFIR”).
 Avoid double reporting under MiFID and EMIR.
26
MiFID II: Extended Scope
 Extension of the scope
 Financial instruments traded on an MTF and an
Organised Trading Facility (“OTF”).
 Instruments whose value depends on that of a
financial instrument admitted to trading on an
RM, MTF and OTF.
 Instruments which have an impact or are likely
to have an impact on instruments which are
admitted to trading a RM, MTF and OTF.
 Non-Securities derivatives (e.g. commodity
derivatives).
27
Interaction of EMIR and MiFID
 Reporting under EMIR, Article 9
 Wider scope than MiFID
 Reporting on conclusion, modification and termination of
contract.
 Applies to all OTC and exchange-traded derivatives not only
those subject to central clearing under EMIR.
 Reporting to a trade repository the responsibility of "counterparties
and CCPs" but can delegate, and must ensure that there is only
one report – may extend to non-EU counterparties.
 Implementation ("best guess") – July 2013 – reporting for credit and
interest-rate derivatives; January 2014 for other classes – need to
establish connectivity with trade repositories.
 EMIR reporting will satisfy MiFIR reporting requirements – provided
EMIR report contains all of the data required by MiFIR.
28
Transaction Reporting Resources
 FSA’s Transaction Reporting Homepage:
http://www.fsa.gov.uk/doing/regulated/returns/mtr
 FSA’s Transaction Reporting Users Pack:
http://www.fsa.gov.uk/static/pubs/guidance/fg1207.pdf
 FSA’s Transaction Reporting Forum:
http://www.fsa.gov.uk/doing/regulated/returns/mtr/fo
rum
 MiFID Database of equity instruments admitted to
trading: http://mifiddatabase.cesr.eu/
29
Restrictions on Computer Based Trading
Strategies
30
IOSCO Report (October 2011)
 Regulatory Issues Raised by the Impact of
Technological Changes on Market Integrity and
Efficiency
 Transparency and dark liquidity.
 Direct Market Access.
 Principles for the oversight of screen-based
trading systems for derivative products.
 Outsourcing by markets and market
intermediaries.
 Error trades.
 Trading halts and market closures.
31
ESMA Guidelines: Regulated Markets/MTFs
 Adequate pre-trade controls.
 Conformance tests to ensure that users’ IT
systems are compatible.
 Automatic and discretionary mechanisms to limit or
halt trading.
 Due diligence of users.
 Clear organisational requirements for members
which are not regulated entities.
 Rules and procedures designed to prevent, identify
and report instances of possible market abuse and
market manipulation.
32
ESMA Guidelines: Investment Firms
 Appropriate governance process for developing
algorithms.
 Pre-trade controls which address erroneous order
entry and maintain pre-set risk management
thresholds, including thresholds on maximum
exposure to individual clients.
 Responsibility for all order flow to venues from
clients using direct market access or sponsored
access, including the ability to immediately halt
trading by these clients.
33
FOA Guidance on Systems and Controls for
Electronic Trading Environments
 Standards to judge the appropriateness of control
environments.
 Clarify obligations and responsibilities of market
participants.
 Example documentation and information required to
be provided.
 Standards for:
 Technical and functional conformance and
stress testing.
 Definition of "naked access”.
 Pre-trade risk controls.
 Live-market access restrictions (e.g. "kill
switches").
34
MiFID II
 Article 17 MiFID.
 Market-maker requirement.
 Minimum tick sizes.
 Execution venues to instate order-to-trade ratios.
 500 millisecond minimum resting time for orders.
 Ban of maker-taker pricing model.
 Extension of scope to proprietary trading firms.
35
Other European initiatives
 Germany has just introduced separate legislation
covering HFT firms.
 Proposed Financial Transaction Tax.
 Additional provisions in the EU’s Market Abuse
Directive to deem certain HFT strategies abusive.
36
Order Allocation, Trading Errors and Conflicts
of Interest
37
FSA’s Conflicts of Interest Paper
 Thematic review of 15 asset managers.
 Highlighted failings in firms’ culture, controls
framework and governance arrangements.
 Identified specific breaches of COBS rules.
 Some firms to obtain section 166 skilled person
reports and further enforcement action being
considered.
 Attestation required by 28 February 2013.
38
Specific Trading Issues: Trade Allocation
 Trade allocation
 Generally firms allocated trades fairly, but there
were some instances of poor practice.
 Cross-trades.
 Must accurately record, allocate and document
trades.
 Demonstration of benefits to customer.
 Fiduciary duty.
39
Specific Trading Issues: Trading Errors
 Trading errors
 Generally limited to hedge fund managers.
 Contractual provisions / limitations.
 Exclusion of liability save for gross negligence.
 Lack of disclosure.
 Amending documentation.
 Reporting to customers.
40
Specific Trading Issues: Corporate Access
 Corporate access
 COBS 11.6.3R: Use of dealing commission.
 Market distortion and lack of transparency.
 Failure to demonstrate benefits.
 Effect is a general prohibition.
 Impact on buy-side analysts.
41
What’s Next on the Regulatory Horizon for
Trading Firms
 FSA splitting to the FCA/PRA
 Other aspects of MiFID
 Consolidated tape
 Introduction of OTFs
 Exchange trading of OTC derivatives
 EMIR
 OTC Derivative Clearing
 Collateral and portability
 Position limits
42
Questions
43
Trading and Compliance: EU Regulatory
Developments and Trading on EU Markets
Sean Donovan-Smith
Partner, K&L Gates
sean.donovan-smith@klgates.com
020 7360 8202
Copyright © 2012 by K&L Gates LLP. All rights reserved.
Philip Morgan
Partner, K&L Gates
philip.morgan@klgates.com
020 7360 8123
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