FINANCIAL INSTITUTIONS
ENERGY
INFRASTRUCTURE, MINING AND COMMODITIES
TRANSPORT
TECHNOLOGY AND INNOVATION
PHARMACEUTICALS AND LIFE SCIENCES
Dodd Frank / MiFID II: Where the US leads,
will Europe follow?
A US / Europe comparison
MIG Seminar
Financial Services Team
Norton Rose LLP
April 2013
What this session covers




The new marketplace: MTFs/OTFs v SEFs and mandatory trading
The impact on equities and derivatives
Access to Europe and trading cross-border
Some key themes tie together the EU and US legislative agenda
– The trust problem: Fundamentally there is a perception that the contract
between the City/Wall Street and the Public/Main Street has been breached:
This has led to calls for tough new intervention powers and more regulation –
good example is commodity derivatives
– The end of the free market world? Suspicion of free market liberal economics:
When are barriers legitimate with the outside world and when should regulators
decide on structures?
– The pace of change: Technology has outpaced regulation: The catch up game
– Sorting out co-ordination problems: The internal EU problems of co-ordination
and the global issues: Does this create significant arbitrage?
2
MiFID II
Developments in European legislation: Where the
trade side fits in
30 January 2013: Draft statutory instruments published
19 December:
Bill receives
Royal Assent
UK Government
15 March 2015
most RTS enter
into force and
CCPs can seek
reauthorisation
16 August
2012:
EMIR
came into
force
EMIR
2011
MiFID II
19 February 2013: Provisions relating to appointing senior members of FPC, FCA and PRA
come into force
15 June and 15 July
2013: Equivalence
decisions for first and
second phase third
country CCPs
2012
25-26 October 2012: EU
Parliament votes on
amendments to draft
legislation but then refers
matters back to ECON for
further consideration
2013
13 December
2012: Council
progress report of
MiFID II
UK FSA
2 April 2012: FSA moves to ‘twin peaks’ operating
model reflecting how PRA and FCA will operate
4
Mid 2014: First
clearing
obligations
expected to apply
1 April 2013: Cutover to
FCA and PRA
2014
8 October 2013: EU
Parliament to vote
on MiFID II legislative
proposals
2015
Implementation of
MiFID II legislative
proposals (at the
earliest
The Timeline
• The main point is the differential timing between EU post trade
and trade implementation
• The trade side contrasts with the US “single framework” under
Dodd Frank
• A number of questions about unintended arbitrage opportunities,
eg lighter platform requirements in the absence of SEF regime in
Europe until MiFID changes are implemented
• Significant time difference in this context
5
Issue 1: Trading venues - New concepts and
boundaries

Regulated
Markets (RMs)
- Non-discretionary
execution of transactions
- Managed by market
operator
-Operating is not an investment
activity or service
Council proposal that
a firm that operates
an internal automatic
electronic matching
system is an MTF or
OTF
Systems that bring together third party
trading interests and result in
contracts
Multilateral Trading
Facilities (MTFs)
- Non-discretionary
execution of transactions
- Operating as an investment
service but can be operated by
market operators
-Few conduct of business rules apply
6
Organised
Trading
Facilities (OTFs)
(Commission proposal)
- Discretion over
execution of transactions
- Investor protection,
conduct
of business and best
execution requirements
- Cannot trade against
proprietary capital
- Operating as an investment
service but can be operated
by market operator
-
Issue 1: Trading venues – OTFs
• Political background is the broker crossing system debate: View
against unregulated trading venues and close link to the SI debate
• Broadly defined: All types of organised execution and arranging of
trading which does not correspond to RM or MTF
• Includes:
– Broker crossing systems which execute client orders against other client orders
– Systems eligible for trading clearing-eligible and sufficiently liquid derivatives
• Does not include:
– Facilities where there is no genuine trade execution or arranging taking place in
the system, such as bulletin boards, entities aggregating or pooling potential
interests or electronic post-trade confirmation
– Bilateral systems
• There are two different levels of discretion:
– When deciding to place an order on the OTF or to retract it again
– When deciding if, when and how much of two or more client orders it wants to
match within the OTF
7
Issue 1: Trading venues – OTFs
• Clarification that simultaneous matched principal trading is
permitted subject to strong conflicts management – UK
Government agrees
• Boundaries of “discretion” for purposes of the definition not
entirely clear
8
Issue 1: Trading venues - The SI debate
• Concern on the equities side at only 10 registered SIs:
– Commission given powers to clarify criteria for when a firm is an SI:
Complementing material commercial relevance test with quantitative thresholds
– Broader range of equity like instruments, e.g. exchange traded funds and DRs
– SIs to maintain minimum quote size – 10% of SMS
• Extension of SI regime to bonds and derivatives which are
clearing eligible or admitted to trading on a RM, MTF or OTF
• Recognition that the equities and derivatives worlds are different:
See slide on transparency: Headlines are:
– Liberalisation on price improvement in relation to equities: Now price
improvement permitted for retail investors and in justified cases where price
falls within public range close to market conditions and removal of current ban
on price improvement where below retail size transactions
– On derivatives Commission to set size limits about when obligations apply
• Controversial approach under which pre-trade obligations will only
not apply to “ad-hoc and irregular” dealings
9
Issue 1: Trading venues - The SI debate
• What the whole SI and OTF discussion illustrates is a deep
suspicion of the “open architecture” approach to regulation: Lack
of trust and pace of technological change have come together
10
Issue 2: Mandatory on-platform trading
Mandatory on-platform trading for derivatives under MiFIR: Reflects G20 commitment
11

Derivatives that are subject to clearing obligation in EMIR which:
– are traded on at least one RM, MTF or OTF
– are considered sufficiently liquid to only trade on these venues
– the Commission and ESMA will define eligible derivatives through technical standards

ESMA also has an own initiative power to identify derivatives for this purpose. Unclear whether this
allows ESMA to include instruments which are not CCP cleared but this appears so

Must be traded on a RM, MTF, OTF or certain third country trading venues which the Commission
deems to be equivalent and where third country provides equivalent recognition for EU trading
platforms

Same scope as EMIR in relation to counterparties:
– trades between financial counterparties and in-scope non-financial counterparties
– trades between an EU captured entity and third country entities that would be subject to EMIR
– trades between third country entities that would be subject to EMIR if they were established in
the EU where their transactions could have a direct, substantial and foreseeable effect within
EU and this is necessary to avoid evasion
– excludes certain intra-group transactions and large in scale trades

The only derivatives contracts that will in future continue to trade OTC are those that do not meet the
test of being ‘clearing eligible and sufficiently liquid’

Council proposes obligation that investment firms trade liquid shares on a RM, MTF, OTF or SI save
in certain circumstances
Issue 3: Active intervention in markets


12
The four layer sandwich on position limits for commodity derivatives:
Layer 1
Competent authority shall impose position limits to prevent market abuse or
support orderly pricing and settlement conditions
Layer 2
Commission will adopt technical standards to determine criteria regulators
should factor in when setting position limits
Layer 3
Regulators can set more restrictive limits than those of the Commission
where objectively justified and proportionate taking account of liquidity and
orderly market for 6 monthly renewable periods or when necessary to
ensure integrity and orderly markets
Layer 4
ESMA must opine on whether this is necessary and plays coordination role
Participants on RMs and MTFs must report to market their own positions
and those of their clients and underlying clients
Issue 3: Active intervention in markets

Trading venues must have position management powers for commodity
derivatives:
– Monitoring open positions
– Access to information about positions
– Require a person to terminate or reduce a position
– Require a person to provide liquidity back into the market


Competent authorities can request a person to reduce positions and
exposures in any derivative
ESMA can:
– Request information about size and position of any derivative and require a
person to reduce it
– Limit ability of a person to enter into a commodity derivative

Position reporting by trading venues for commodity derivatives, emission
allowances and derivatives on them:
– By category of trader, commercial undertaking, investment firm etc
– Information available to regulators in detail and public in aggregate
13
Issue 3: Active intervention in markets cont’d

Note considerable toughening of commodities exemptions to parallel this:
Ancillary activities (Article 2(1)(i)):
– First part of the exemption (persons dealing on own account in financial
instruments) now excludes persons who deal on own account by executing
client orders
– Both this and the provision of services limb of exemption are as currently
subject to ancillary activity to main business on group basis test plus main
business must not be financial services plus link back to high frequency trading
– BUT important to note that there is now Commission Level 2 power to clarify
ancillary and specific reference to just being for hedging

14
Article 2(1)(k) deleted and Article 2(1)(d) no longer applicable to
commodity derivatives although cumulative with Article 2(1)(i)
Issue 4: The tough new approach to new technology
• Providing electronic access to clients
– Systems and controls, including
suitability of clients, pre-set trading and
credit thresholds, monitoring clients
– Responsible for ensuring clients comply
with rules, monitoring and report
breaches, disorderly trading and market
abuse
– Written agreement
– Notify competent authority which trading
venues it provides access to
• Algorithmic trading
– Systems and controls to avoid
disorderly markets and market
abuse
– Notify competent authority of
trading venues if they may require
strategy
• Algorithmic trading pursuing
market making strategy
– Must market make continuously
during specified proportion of
trading hours
– Take into account risk
management, liquidity, scale and
nature of market and
characteristics of instruments
– Systems and controls
– Only acts for persons that meet
clear criteria and are suitable in
order to reduce risks to firm and
market
Investment firms –
systems and
controls to be further
defined in technical
standards
N.B. There are Level II powers in this area
15
• General clearing member
– Only act for persons that meet criteria
to reduce risks to firm and market
– Written agreement
Issue 4: Themes in the technology debate
• Generally the Council has been more pragmatic on these issues
for example rejecting an outright ban on direct market access
called for by the Parliament draft
• The compromise on direct and sponsored market access has
been to go with the ESMA guidelines approach:
– Politically, this still reflects considerable intervention in the shape of the market
and an example of the trust problem
• Algo and high frequency trading have been the focus of a lot of
attention and reflect a combination of a lack of trust in the impact
of trading on market price formation and grappling with the
changes to technology
• A lot of detail to be worked through in Level 2: In some ways,
ESMA is being left with some of the hard political choices
• Examples of some of the detail: Algo systems must have:
– Resilient trading systems with sufficient capacity
– Appropriate thresholds and limits to prevent erroneous orders, disorderly
trading and market abuse
– Effective business continuity and testing arrangements
16
Issue 4: Themes in the technology debate
• Much will depend on the detail at Level 2 and also how these tests
are applied
• Other example is suitability test for clients whom firms providing
direct electronic access allow to use their facilities
17
Issue 4: Themes in the technology debate
• Draft report by the European Parliament rapporteur calls for a
more differentiated approach on algorithmic trading:
– Proposes definitions for HFT and HFT strategy to identify a particular subset of
algorithmic trading
– Ban of direct electronic access
– Adds proposals to strengthen circuit breakers include trading venues to ensure that
their fee structures contain higher fees for placing an order which is cancelled than
for an order which is executed
• European Parliament:
– Prohibits firms from providing sponsored and naked market access to a trading
venue
– Requires investment firms engaging in HFT to store in an approved form the raw
audit trail of any quotation and trading activities performed on any trading venue
– Requires investment firms and market operators operating an MTF or an OTF to
have arrangements in place to identify any conflicts of interest between the interest
of the MTF or OTF, its owners or its operator and the sound operation of the MTF or
OTF
– Inserts new provisions on systems resilience, circuit breakers and electronic trading
concerning tick sizes and synchronisation of business clocks
18
Issue 4: The tough new approach to new technology
• Relevant trading systems
• Capacity for peak order
and message volumes
• Give competent
authority access to
order book on request
• Systems to:
– reject orders that exceed thresholds
or are erroneous
– temporarily halt or constrain trading
if there is a significant price
movement
– cancel, vary or correct transactions
• Ensure orderly trading
in times of stress
• Effective business
continuity
• Must have schemes to
incentivise market makers
to post firm quotes and
provide liquidity
– written agreement
between venue and MM
19
Trading venues details to be included in
technical standards
• Rules on colocation services
and fee structures
• Identify orders
generated by
algorithmic trading,
different algorithms and
persons using them
• Systems to prevent algorithmic
trading contributing to disorderly
trading
– limit ratio of unexecuted orders to
transactions
– slow down flow of orders if close
to capacity
– limit net size
• If allowing direct electronic
access:
– to be provided by banks and
investment firms only
– risk controls and thresholds
– need ability to stop such
orders separately from other
orders
Issue 5: Extension of transparency regime – Trading
platforms
Shares and equity-like instruments
Pre-trade





Post-trade




Other instruments
Extended to equity-like instruments such as depositary
receipts, exchange traded funds and certificates
Make public bid and offer prices and depth of trading interest
Extended to actionable indications of interest
Commission sets framework for waivers
ESMA will opine on use of waivers before their use and has
powers to oppose their use: 8% overall trading limit
proposed for price taking waiver

Extended to equity like products
As close to real time as possible
Deferred publication for large in scale where authorised by
competent authority within framework set by Commission
Make public price, volume and time of trades








20
Extended to bonds, structured finance
products, emission allowances and
derivatives
Same as for equity-like instruments
Competent authority can temporarily
suspend disclosure where liquidity drops
Extended to bonds, structured finance
products, emission allowances and
derivatives
Deferred publication for large in scale and
illiquid where authorised by competent
authority within framework set by
Commission
Competent authority can temporarily
suspend disclosure where liquidity drops
Info must be available on reasonable commercial basis as soon as possible and free of charge within 15
minutes
Must offer pre and post-trade information separately
Commission to clarify details
Issue 5: Extension of transparency regime –
Investment firms
Shares and equity-like instruments
Pre-trade


Applies to SIs: Extended to equity-like
instruments such as depositary receipts,
exchange traded funds and certificates traded on
a trading venue
Some amendments including minimum quote
size, two way quotes and price improvement for
retail as well as professional clients
Other instruments




Post-trade




21
Investment firms must make public trades
through an Approved Publication Arrangement
Applies to instruments traded on a trading venue
but if venue can defer, this should also apply to
OTC trades
Make public volume, price and time of
transaction
Unclear how this will work in buy/sell side chains
of firms




New SI regime extended to bonds, structured
finance products, emissions allowances and
derivatives
Must provide quotes where liquid market and asked
by clients
Must make available to other clients and trade if up
to certain size
Price improvement permitted in justified cases
Investment firms must make public trades through
an Approved Publication Arrangement
Detailed information requirements to be set by Level
2
Competent authority can permit deferral, or
restricted disclosure and can suspend and this also
applies to OTC trades
Unclear how it applies to lookalikes
Issue 6: Access of third country firms to EU
Council has pulled back from Commission’s proposal:
 No restrictions on third country firms trading with or providing
services to eligible counterparties and per se professional clients
in EU: This would be left to a Member State decision
 A third country firm wishing to provide services to retail clients
(including opt ups) in EU must establish a branch – the major
change is the deletion of an equivalence test but various indirect
tests including:
– Branch must be properly authorised in its third country
– Branch must have sufficient initial capital
– Third country must not be on FATF non-compliant list
– Third country must have entered into cooperation arrangement with EU
regulator
– Third country must have signed OECD model tax convention
22
Issue 6: Access of third country firms to EU



23
Exception where the service is provided at “the exclusive initiative”
of the client and no advertising or promotion in the EU by the firm
Numerous problems with the exclusive initiative test: For example,
does it allow another group entity to advertise and does it mean
that any generic or internet advertising puts the firm offside?
Complex example of the tensions between liberal and statist
instincts in Europe
Issue 6: Access of third country firms to the EU
• The contrasting approach – the European Parliament pushes for a
common EU
• A third country firm wishing to provide services to retail clients
(including opt ups) in the EU must establish a branch:
– Important to note that the equivalence test remains
– Note additional requirement that Member State must be satisfied that third
country firm intends to provide a significant proportion of investment services or
perform significant quantity of its investment activities within the Member State
where the branch is established: Unclear what “significant proportion” means
– The carrot remains: The EU passport in article 44 of the recast Directive
– Subject to the exclusive initiative of the client
• A third country firm wishing to provide services to eligible
counterparties and per se professionals:
– Per Commission’s original proposals that the firm must be subject to
registration by ESMA and to the supervision in the third country
– Member States may not impose additional requirements on the third country
firm in respect of matters covered by MiFID or MiFIR
– Subject to the exclusive initiative of the client
24
Dodd-Frank
Issue 1: Swap Execution Facilities (SEFs) and
Security-Based SEFs (SB-SEFs)
• Dodd-Frank Definition: The term “SEF” means a “trading system or
platform in which multiple participants have the ability to execute or trade
swaps by accepting bids or offers made by multiple participants in the
facility or system, through any means of interstate commerce…”. The
term SB-SEF is defined similarly
• The statutory goal is to promote the trading of swaps on swap execution
facilities and promote pre-trade price transparency in the swaps market
(but this language was not included with respect to SB-swaps)
• CFTC: Order execution is divided into two types of transactions:
Required Transactions and Permitted Transactions:
26
Issue 1: Swap Execution Facilities (SEFs) and
Security-Based SEFs (SB-SEFs) Cont’d….
– a Required Transaction is subject to the execution requirements and is made
available for trading pursuant to Section 37.10 of the SEF rules, and is not a
block trade
– a Permitted Transaction is one that meets any of the following criteria: is not
subject to mandatory trading or clearing, is a block trade, or is an illiquid or
bespoke swap. CFTC proposes to require SEFs to provide for execution of
Required Transactions on an order book or an RFQ system (to no less than 5
participants). Permitted Transactions could be executed via an order book,
RFQ or a voice-broker SEC: Has proposed a different approach, an order book
or an RFQ to as few as one other participant
• Registration: SEFs must register with the CFTC, and SB-SEFs with the
SEC
• Foreign Boards of Trade (FBOTs) that register with the CFTC may offer
swaps to U.S. persons
27
RMs, MTFs, OTFs and SEFs: How do they compare
• MiFID rules will not come into effect until Q3/Q4 2015
• No Swap Execution Facility (SEF) detail equivalent for EU venues,
but MiFID Level 2 rules will provide more specifics
• MiFID obligations more or less the same across venues (see
table), but more cost effective for MTFs and OTFs
• Scope of financial products available for trading significantly
differs: SEFs cover only swaps; whereas, RMs, MTFs and OTFs
cover swaps, equities, commodities and other derivative contracts
• OTFs not only have discretion over who they accept to trade but
also, crucially, over how those trades are executed
• SEF is a facility, trading system or platform in which multiple
participants have the ability to execute or trade swaps by
accepting bids and offers made by other participants that are open
to multiple participants in the facility or system, through any
means of interstate commerce
28
RMs, MTFs, OTFs and SEFs: How do they compare
• Voice brokerage excluded under SEFs: probably for OTFs
• SEFs have real-time data reporting requirements that create
significant additional costs for operators, but result in additional
commercial opportunities
• SEFs/OTFs have the potential to make the swaps market more
electronic, transparent, and competitive, but not all transparency is
equal; venues must be able to attract liquidity
• Price discovery could be hindered unless careful consideration is
taken to make the rules adaptable and to reflect the fact that the
swaps market is less liquid than some people imagine
29
RMs, MTFs, OTFs and SEFs: What is the difference?
Regulated Market
Multilateral Trading Facility
Organised Trading Facility
Swap Execution
Facilities
Pre and posttrade
transparency
Yes
–
however,
pre-trade
transparency provisions are calibrated
towards different models. Post-trade
transparency
is
subject
to
authorisation of deferred publication
and applies to firms concluding
transactions across trading venues.
Same as for RM
Same as for RM
Yes – includes posting
both firm and indicative
quotes on a centralised
electronic
screen
accessible to all market
participants
(excludes
block trades)
Transaction
reporting to
competent
authority
Yes, where a firm trading on the
venue is not subject to reporting
obligation
Same as for RM
Same as for RM
Yes
Organisation
al
requirements
Organisational requirements specific
to operators of RMs
Organisational requirements
applicable to all investment
firms
Same as for MTFs. Not allowed to
operate an OTF and SI within the
same legal entity; OTFs can engage
another investment firm to carry out
market making on an OTF on an
independent basis (Parliament)
Organisational
requirements specific to
operators of SEFs; limit on
dealer ownership of SEFs
and a minimum proportion
of public directors on their
boards
Monitoring
Requirement to monitor compliance
with rules and transactions for breach,
disorderly trading and abuse
Same as for RM
Same as for RM
Same as for RM (more
detail provided in DoddFrank)
Client
protections
Investor protection rules in MiFID do
not apply
Investor protection rules in
MiFID do not apply; however,
MTFs must ensure that
members/participants
do
comply
with
these
requirements
Investor protection, conduct of
business, order handling and best
execution rules apply
Yes
30
Issue 2: Dodd-Frank Act Trading Requirement for
Cleared Swaps “Made Available to Trade”
• DFA imposes a new mandatory “trading requirement” for certain
swaps and security-based swaps
• CFTC Swap Trading Requirement: A swap that is required to be
cleared and is “made available for trading” is also required to be
executed on a designated contract market (“DCM”) or a swap
execution facility (“SEF”)
• SEC SB-Swap Trading Requirement: An SB-swap that is required
to be cleared and is “made available for trading” is also required to
be executed on a registered securities exchange or a SB-swap
execution facility (“SB-SEF”)
• Exemptions from Trading Requirement:
• Trading requirement does not apply to an end-user eligible for the
end-user exemption from the clearing requirement, or
• If no exchange or SEF or SB-SEF “makes the swap available for
trading”
31
Issue 2: Dodd-Frank Act Trading Requirement for
Cleared Swaps “Made Available to Trade”
• “Made Available for Trading” determination still not resolved
• CFTC Proposal: SEF/DCM make the determination subject to
CFTC oversight based on a multi-factor test, including: (1) number
of ready and willing buyers and sellers, (2) frequency or size of
transactions, (3) trading volume, (4) number and types of market
participants, (5) bid/ask spread, (6) number of resting bids/offers,
or (7) will the platform support trading in the swap. If one SEF or
DCM make a swap available for trading this would require all other
SEFs/DCMs to treat the contract (and economically related
contracts) as subject to mandatory trading
• SEC Proposal: SEC will determine whether an SB-swap is made
available to trade based on objective measures after it has
sufficient data. SEC is considering such measures such as overall
volume in the SB-swap, minimum number of transactions or
notional value during a given time period
32
Issue 3: Futurisation?



Movement away from OTC swaps to futures
Oct. 15, 2012 – ICE converted energy swaps to futures & CME
allowed cleared energy swaps to be executed as futures block
trades
Jan. 31, 2013, the CFTC held a public roundtable to discuss the
“futurisation” of swaps. The roundtable addressed:
– Concerns regarding the futurisation of swaps in different asset classes; clearing
and different margin requirements for swaps and futures; block rules for swaps
and futures; and effect of the conversion of swaps to futures on end-users


33
Movement away from OTC swaps driven by risks and uncertainty
from Dodd-Frank swaps regulation
Will the CFTC “level the playing field” between the swaps and
futures markets by requiring consistent block sizes and margin
requirements for cleared products
Pegasus: our online technical resource for MiFID
34
Disclaimer
The purpose of this presentation is to provide information as to
developments in the law. It does not contain a full analysis of the law nor
does it constitute an opinion of Norton Rose LLP on the points of law
discussed.
No individual who is a member, partner, shareholder, director, employee or
consultant of, in or to any constituent part of Norton Rose Group (whether
or not such individual is described as a “partner”) accepts or assumes
responsibility, or has any liability, to any person in respect of this
presentation. Any reference to a partner or director is to a member,
employee or consultant with equivalent standing and qualifications of, as
the case may be, Norton Rose LLP or Norton Rose Australia or Norton
Rose Canada LLP or Norton Rose South Africa (incorporated as Deneys
Reitz Inc) or of one of their respective affiliates.
35