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Committee on Economic and Monetary Affairs
16 Sepember 2002
on the Commission's overview Paper and Revised Orientations on the new
Investment Services directive
Committee on Economic and Monetary Affairs
Rapporteur: Theresa Villiers
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Upgrade of the Investment Services Directive
This paper refers to the Commission’s Overview Paper and Revised Orientations on the new
Investment Services directive, published in March 2002, but these may not reflect the
Commission’s final proposal, which is expected in November. The extensive consultation
carried out on this directive is welcome and it may be sensible for the Commission to publish
one last draft, with a short period for comment, before it adopts a final proposal. At this early
stage of discussion, there are a number of issues on which colleagues may want to keep an
open mind. On other issues the committee may feel able to form a more settled view,
particularly in relation to those areas already discussed in the Kauppi and Katiforis reports on
the ISD.
The ISD is a key part of the overall regulatory structure for financial services in the EU. It is
aimed at increasing competition and investor choice by removing barriers to the supply of
investment services in different Member States and securing proper investor protection. The
directive should create the conditions for high quality competitive, integrated, liquid,
transparent, orderly and efficient markets in the EU, responsive to the needs of their users.
The quality of service provided to market users depends on many factors including consumer
protection, transaction costs, price stability and efficient price formation, all of which should
be taken into account in the new ISD. The ISD should not prescribe a particular market
structure and should be flexible enough to accommodate the diversity of market structures in
different EU countries and to allow and encourage innovation. It may be useful if the directive
included some general over-arching principles setting out its aims and to assist in
interpretation and implementation.
It is vitally important that the directive should give proper protection to consumers (ie retail
investors) and help build investor confidence. The new ISD should draw a clear distinction
between retail and wholesale business (see the Kauppi report on ISD Article 11). The type of
regulation vital to protect retail investors can be disruptive, costly and unnecessary if applied
to the wholesale market.
Rules should be proportionate and justified in terms of their costs and benefits and should
seek only to deal with problems where the market and competition are unable to supply an
appropriate solution. It is not sufficient simply to apply similar rules to similar trading
methodologies, regulation of investments services should be risk-based: All rules should be
tailored to the characteristics of individual transaction system or markets and should be a
proportionate response to a thorough assessment of their risks.
The Katiforis report advocated “a well targeted process of reform of certain crucial aspects of
the directive” and opposed “any attempt at wholesale redrafting of the original text or the
additional of unnecessary new cumbersome rules” (para1). Colleagues will wish to consider
whether the Commission’s paper is consistent with this stated objective. The Katiforis report
also emphasised that enforcement of the directive should be improved (para 20). It is vital to
grapple with implementation problems.
Country of Origin
In the Katiforis Report, Econ expressed its strong support for the country of original principle
as the most effective way to encourage cross-border competition in financial services.
Consistent with this approach, the Revised Orientations propose a country of origin approach
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in retail as well as wholesale business but colleagues might like to consider strengthening
these provisions. It should be made clear that country of origin control is exclusive and that
Member States cannot impose further conduct of business, prudential, authorisation or other
rules, on incoming services from other Member States. This would be consistent with the
approach taken in the e-commerce directive.
Related Laws
The new ISD will have an impact on a number of areas and provides definitions used in
various other directives (eg UCITS, market abuse and prospectuses). Most importantly, it is
presently used to define which non-banks are included in the capital adequacy directives
(CAD). Colleagues will need to assess the impact of ISD amendments on CAD and other
It is important that the ISD is consistent with and does not undermine the e-commerce
directive and hence it is necessary to make the country of origin approach the key guiding
principle of the ISD. It is preferable to attain sufficient consistency between the Banking
Consolidation directive to enable bank and non-bank investment firms to obtain passports in
similar circumstances. It is also very important to keep in mind the terms of Insurance
Intermediaries directive if investment advice becomes a core ISD service (see below), since
many small businesses sell both insurance and investment advice. Consideration will also
have to be given as to how to keep the UCITS directives up to date with ISD Level 2
measures, since these directives predate the Lamfalussy structure and cannot be updated at
Level 2.
Structure of the ISD
Econ has expressed its support for the Lamfalussy approach of focusing on high level
principles in the text of the directive (Level 1); adopting more detailed technical matters in
implementing measures (Level 2); with further guidance/standards and detailed rules provided
by regulators (Level 3). One of the most difficult ISD issues to resolve will be drawing the
borderline between levels. The Revised Orientations arguably include rather more detail at
Level 1 than the pre-Lamfalussy existing ISD! There is no easy answer on this issue, nor is
any consensus yet emerging.
It is important not to forget the importance of CESR regulatory cooperation at Level 3. For
example, on conduct of business rules, it may be best to adopt detailed rules at Level 3,
reserving Level 2 for fairly generalised standards. This will enable regulators to react quickly
to changes in the market and any new threats to investor protection.
As yet, no in depth discussion has taken place on whether the Commission is correct to opt for
a directive rather than a regulation.
Investment Advice
The Commission’s indication that it intends to make investment advice a core service under
the new ISD is controversial. In a number of Member States, much financial advice is given
by small businesses. Some are agents for larger investments firms (“tied agents”) and others
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are not (“independent financial advisors” or “IFAs”). In Germany alone, the number of these
SMEs runs into the 100,000s, many of whom have strong local ties and are highly influential
in their community. If they have to comply with the full rigour of the ISD, this could drive
most of them out of business. Particular concern has been expressed about the repeal of
Article 2(2) on mutual funds.
There are a number of ways to deal with this problem: We could stick to the existing regime
and leave financial advice as a non-core service. Although financial advice should obviously
be regulated, there is no pressing case for doing this at the EU level. There is little crossborder trade in investment advice. It would be unfortunate if all the rigours of cross-border
EU regulation were imposed on firms who are neither interested nor capable of using a
passport to give advice in other member states. Alternatively, financial advice could become a
core service but without imposing capital requirements on advice only firms. A third option is
a tailored capital framework for advice only firms, allowing them to use capital reserves
and/or insurance (which would be more consistent with the Insurance Intermediaries
directive) to meet regulatory objectives.
The Revised Orientations indicate that the Commission is considering extending the ISD to
cover certain types of derivatives, including commodity derivatives. If the committee agrees
with this proposal, we will need to examine the ways in which the directive should be
amended to take into account the specific characteristics of derivatives markets.
Conduct of business rules will have to be adapted to reflect the specialised wholesale nature
of the derivatives markets. Capital requirements will need to be amended to encompass the
type of assets held by commodities firms rather than just those held by banks and traditional
investment firms, eg plant and machinery for an energy firm with an energy derivatives
business. Applying bank designed CAD rules to derivatives firms, without taking into account
their special characteristics, would significantly disrupt the derivatives markets and could
jeopardise the EU’s planned energy market liberalisation.
Execution Only Services
A significant number of consumers in the EU choose the shares and investments which they
want to buy/sell, based on their own judgment and analysis of published information, rather
than on the direct advice of investment professionals; using low cost, efficient "execution
only" services. This market is currently regulated using product regulation and benchmarking,
regulation of product promotional and explanatory literature and rules on conduct of business,
contract and money laundering. Schemes such as the German investor classification system
have operated smoothly to regulate this important and successful market, giving a popular
investment option to consumers.
CESR’s Draft Conduct of Business rules suggest that these services should be subject to new
additional regulation by requiring a detailed risk assessment to be carried out for all clients.
The committee should assess whether this is a necessary addition to existing regulation.
Frequent and detailed risk assessments, perhaps requiring meetings or phone calls, could
effectively kill off, “execution-only” services (including internet share dealing), forcing all
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consumers to buy expensive professional advice even when they neither need nor desire it.
This would unreasonably restrict consumer choice and the committee should consider
including an express declaration, at Level 1, that conduct of business rules should reflect the
nature of the service provided and clearly distinguish between “advice” and “non-advice”
Securing Investor Choice: Competition between a range of execution venues
The existing ISD gives regulated entities the option of becoming an investment firm or a
regulated market. The Commission proposes to continue this approach but with changes
reflecting market developments. In the past, almost all trades were executed through
traditional stock exchanges, all of which fall into the ISD’s regulated markets category. In
recent years, these exchanges have demutualised and become profit making companies
competing in the “execution business”. New methods of processing client orders have
emerged, in competition to execution on traditional established exchanges. Investment firms
have established Alternative Trading Systems and have also developed a range of execution
services for their clients, either by matching the orders of clients against one another or
against the trading position of the firm, often referred to as “internalisation” of trades or “offexchange order matching”. This competition has driven improvements in performance of
regulated markets. A variety of execution methods have emerged and no single market model
can accommodate the needs of all market users.
The most controversial question thrown up by the ISD review is what is the appropriate
regulatory response to these changes? It is generally accepted that the investors should be
given choice, that competition between execution venues should be permitted and encouraged
and that the regulatory structure should not confer monopoly rights on particular market
players and artificially force all trades through particular platforms. Even those Member
States who still impose concentration rules (rules requiring trades to be processed through
traditional exchanges) allow some execution to take place in other venues.
There seems to be a very widespread (though not wholly universal) consensus that the
Commission is correct to propose that concentration rules should be abolished and replaced
by a combination of transparency and best execution rules, allowing investors freedom to
choose from a range of execution venues. A great deal of debate surrounds the appropriate
content of the new rules, particularly on transparency. It will not be easy to find a solution
which can be applied to the divergent market and regulatory structures of different EU
Member States.
Best Execution
There is widespread support for imposing a “best execution” rule to ensure the interests of
retail investors are protected. The Revised Orientations define best execution as the obligation
to “process and execute a client’s order in the best interest of the customer, and taking account
of any specific instructions from the client, so as to obtain the best possible result with
reference to the price, costs, speed and likelihood of execution, taking into account the time,
size and nature of customer orders.” Colleagues will note that “best execution” involves more
than just price. Consideration will have to be given to whether the best execution rule should
apply to all investors or just retail.
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Post-trade transparency
There is also extensive support for making post-trade transparency rules a key part of the new
ISD, though views differ on the precise extent of disclosure requirements. The advanced IT
systems of European markets mean that information about completed trades can be circulated
very rapidly, often almost instantaneously, proving extremely useful for the investing public
and for regulators assessing “best execution”. Post-trade transparency rules should focus on
those instruments where the information is valuable to the market and the price formation
Mandatory pre-trade transparency
Despite the controversy, there are areas of consensus. It is generally agreed that large trades
should not be subject to any pre-trade transparency rules, nor should trades in illiquid stocks.
Announcing such trades to the market, before carrying them out, would make them
impossible because the market would move against them. The Revised Orientations limit pretrade transparency to equities and the debate has now focused on whether the new ISD should
oblige ATSs and investment firm “internalised” execution venues to publish their limit orders
(ie orders which instruct a broker to buy or sell a specified amount of a security at a specified
price or at a better price). Given the importance of this issue and range of views, it will be
vital to assess any proposals carefully, comparing the cost they impose on investors and the
nature of the risk they are intended to counter. The arguments are as follows:
The arguments put in favour
Supporters of mandatory pre-trade transparency claim that widespread off-exchange trading
could reduce interaction between buy and sell interests, thereby rendering price formation less
efficient, increasing spreads and adversely impacting on price. They believe that pre-trade
transparency is needed in order to retain liquidity in the traditional exchange. They are
particularly concerned about the impact on order driven, as opposed to quote driven, markets.
Some aver that too much competition has a negative impact. Mandatory pre-trade
transparency is needed, they argue, to prevent fragmentation of the market and to ensure that
all investors have the maximum information about potential buyers and sellers.
It is argued that since limit orders contain information about opportunities to trade (ie prices
at which participants are prepared to trade), disclosure helps investors get a better picture of
the depth of the market and the range of buyers, sellers and prices. They aver that whether a
price is perceived as fair, depends to some degree on the extent to which investors are able to
form a view on the state of the market. They believe that mandating pre-trade transparency is
important to enable investors to evaluate their potential trades and work out if they have
received best execution. Competition will not assist investors, it is argued, who are unable to
pay the admission price of multiple execution venues. Lack of transparency will inhibit
competition if investors do not have access to information about opportunities available in the
They are concerned that it will not be possible to ascertain what is best execution without a
reference price. If trading moves away from the traditional exchange, the prices on the
exchange will no longer reflect the overall state of the market. Where can a reference price for
best execution be found if the exchange price is devalued in this way?
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It is also argued that if investment firms are performing functions which are similar to those
carried out on regulated markets, they should be subject to the same pre-trade transparency
requirements. Concern has also been expressed about whether it will be possible to police
“best execution” and market abuse rules where trades are internalised, particularly where they
are set off against the proprietary trade position of the firm acting on the investor’s behalf.
The arguments put against
Opponents of mandatory pre-trade transparency maintain that all the required regulatory goals
can be achieved by combining best execution with post-trade transparency. They argue that
mandatory pre-trade transparency is impractical and unworkable and would amount to a de
facto introduction of concentration rules in Member States which do not have them and
retention in those states where they still exist. It would be a step back to conferring a
monopoly on principal exchanges and would stunt competition which benefits investors by
providing lower transaction costs, better prices, reduced volatility and increased liquidity.
Fragmentation of the market will not occur because arbitragers, new technology and post
trade transparency will link different areas of liquidity, bringing prices together and ensuring
that intermediaries have the necessary information to provide best execution.
It is argued that relationships between investment firm execution venues and their customers
can be properly governed by competitive pressure, best execution and conduct of business
rules. Markets which allow investment firms to compete for execution business with regulated
markets have seen investors (particularly retail) benefit from more choice, narrower spreads,
better prices and lower transaction costs. Retail investors will be assisted in accessing
multiple execution venues by intermediaries who will seek the best available price. Best
execution in a competitive market is generally better than the exchange price. Investors will
be able to assess available prices using rapid post-trade transparency, which technology
makes readily available. Post trade transparency will also enable investors and regulators to
identify "best execution" because it will demonstrate the range of prices are being obtained in
the markets. Mandatory pre-trade transparency may be misleading if it discloses prices to
which only the members of a particular specialist system can access.
Investment firms, it is argued, increase not decrease liquidity across the market as a whole by
using their capital to facilitate trades by their clients. It is wrong to impose the same
requirements on investment firm execution venues as regulated markets because they are
providing a different service. The investment firm often deploys its own capital as part of the
transaction but the regulated market does not. If the investment firm is required to disclose its
order book, so much information would be available about the firm’s proprietary position that
the market would move against it, making internalised execution impossible. This would
reduce the liquidity which investment firms bring to the market. Revealing client orders may
cause the market to move against them, making trades very difficult and pushing liquidity to
jurisdictions outside the EU. Mandatory pre-trade transparency could thus reduce liquidity
and increase volatility. Internalisation has reduced volatility in markets around the world.
Alternative Trading Systems
The Revised Orientations propose a new regulatory framework for Alternative Trading
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Systems, defined as: “A multilateral system that brings together multiple third party buying
and selling interests in financial instruments – in the system according to non-discretionary
rules set by the system’s operator – in a way that forms or results in a contract” (Para 2.5.1).
ATSs are run by investment firms and are regulated under the existing ISD under the rules
governing investment firms. Colleagues will need to consider whether new specific regulation
is needed for ATSs or whether the general rules for investment firms continue to cover all
relevant activities.
The Commission adopts a functional approach to regulation which seeks to impose rules
based on the model of regulated markets on ATS because they perceive ATSs as carrying out
the same or similar functions. Rather than simply applying identical regulation to similar
trading methodologies, it is preferable to look at whether different trading platforms raise the
same risks. The Revised Orientations seem rather prescriptive and focused more on
hypothetical than real risks. ATSs do not involve the same systemic risks as regulated
markets. The amount of business they process is small and they are overwhelmingly geared
towards specialised wholesale markets. The Commission proposes the same transparency
obligations for ATSs as for investment firm execution venues (see above).
Econ will also need to consider whether more flexibility should be built into any new
framework for ATSs. CESR has acknowledged that a wide range of trading venues will be
captured by its definition (which has been used in the Revised Orientations). It is therefore
essential that the ISD differentiates between the requirements and characteristics of different
systems. It would make sense to adopt a spectrum approach which spans the different types of
ATSs, from those which might need a significant amount of regulation to those where it is
safe to rely on the market for most customer protection.
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