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