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Author: | Published: 30 Sep 2004
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The nature and scale of investment activity in the European Community has undergone enormous change since the Investment Services Directive (the ISD) was implemented in 1995. The new Markets in Financial Instruments Directive (Mifid) will replace the ISD, and will govern most investment services and the activities of exchanges across the EU. It will result in changes to rules on matters such as financial promotion, best execution, order handling, conflicts of interest, and information disclosure, among others.

Table 1: Financial instruments covered by Mifid

  1. Transferable securities
  2. Money-market instruments
  3. Units in collective investment undertakings
  4. Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices or financial measures that may be settled physically or in cash
  5. Options, futures, swaps, forward rate agreements and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event)
  6. Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market and/or an MTF
  7. Other options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled and not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, among others, they are cleared and settled through recognized clearing houses or are subject to regular margin calls
  8. Derivative instruments for the transfer of credit risk
  9. Financial contracts for differences
  10. Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates, emission allowances or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event), and any other derivative contracts relating to assets, rights, obligations, indices and measures that have the characteristics of other derivative financial instruments, having regard to whether, among others, they are traded on a regulated market or an MTF, are cleared and settled through recognized clearing houses or are subject to regular margin calls

Mifid in context

Mifid is part of a wider move towards integration of the European financial services industry through the implementation of the Financial Services Action Plan (FSAP). One of the FSAP's stated goals is, so far as practicable, to replace the myriad of regulations in each member state with a single set of regulations that applies to all firms operating within the EU, helping to make the single market a reality in financial services.

As with the ISD, Mifid provides both a basis for harmonized rules and a means for firms authorized in one member state to operate across the EU on the basis of that authorization - so-called passporting. Because Mifid covers a wider range of services and instruments than the ISD, Mifid will offer greater opportunities than the ISD for passporting activities.

Although Mifid itself has been adopted, a large number of detailed provisions are still to be determined at a European level by way of the Level 2 procedure. The areas where this applies are summarized in Table 2.

Scope of Mifid

The ISD divides investment services into core services and non-core services in relation to specified instruments. Mifid retains this distinction, but renames the categories investment services and ancillary services and includes a new list of instruments to which it applies. These are set out in Annex 1 to Mifid (see table 1).

Investment advice is promoted from a non-core service to an investment service and there is a new investment service of operating a multilateral trading facility (MTF). Pure advisory firms will be able for the first time to operate across the EEA on the basis of home state authorization, and the full Mifid conduct-of-business rules will apply to investment advice.

By contrast, financial analysis and research is an ancillary service, so firms that provide these services will be subject to Mifid only if they combine research and analysis with other core investment services.

One of the main areas where Mifid will expand on the scope of the ISD is in the case of derivatives, including commodity and credit derivatives, and others such as derivatives on freight rates, emission allowances, or economic statistics.

There are a number of exemptions, set out in Article 2 of Mifid, including an exemption for investment services provided purely intra-group. There is also an exemption for firms undertaking own-account transactions in any Mifid instruments where their main business is neither the provision of investment services under Mifid nor banking services under the Banking Consolidation Directive.

Mifid does not cover settlement and clearing but the Commission has plans to deal with this separately.

Conflicts of interest

In response to concerns about conflicts of interest resulting from the increasing range of activities that many investment firms and banks undertake, Mifid contains a number of provisions in this area. Firms must:

  • take all reasonable steps to identify conflicts of interest;
  • have effective systems and controls either to prevent conflicts adversely affecting the interests of customers or to manage them so that this result is achieved; and
  • if these arrangements are not enough to ensure with reasonable confidence that client interests will not suffer damage, disclose clearly the general nature and/or sources of the conflict to the client before undertaking business.

So firms will be under a duty to manage conflicts of interest through measures such as Chinese walls. Disclosure will only be used to deal with conflicts where there is not enough assurance that the organizational solution has been effective.

Client classification

Mifid implements a three-tier client classification regime, broadly similar to the UK's system, enabling different levels of protection to be afforded to different types of client. The full conduct-of-business rules apply to private customers. A less restrictive regime applies to professional clients (such as financial institutions, large undertakings and government bodies), and an exclusion from conduct-of-business rules is available when dealing with eligible counterparties (broadly equivalent to the UK's existing market counterparty category but narrower). However, some of the details of client classification differ from the UK's rules. An added complication is that whether a large corporate may be treated as an eligible counterparty will be determined by its home state rather than (if different) the state of origin of the service provider.

Markets and transparency obligations

Client order handling rules

Mifid envisages that investment firms should provide the investor with an order execution policy that allows clients to obtain for their orders the best possible result in the circumstances. The policy must cover at least the execution venues that allow the firm to obtain, on a consistent basis, best results for the client. Firms must also monitor the effectiveness of their order execution policy and address any shortcomings.

Pre-trade disclosure

Mifid contains no explicit pre-trade disclosure obligation for investment firms conducting internalized trading. However, any investment firm authorized to deal on its own account that is an important liquidity provider to the market will be required to make public a firm bid and offer price for retail sized transactions. The firm will be required to trade at those prices except where there is a legitimate commercial justification related to settlement for not doing so.

Post-trade disclosure

There will be an obligation on investment firms dealing on a principal or agency basis in equities that are admitted to trading on a regulated market to disclose the volume and price of the transactions (whether the transaction is executed on a regulated market, an MTF or through a firm's own systems).

Creating a single European market

One test of whether Mifid is successful will be the extent to which it makes the cross-border marketing and execution of investment services easier and more cost-effective.

Under Mifid, investment firms will, as now, be subject to prudential regulation by their home state - that is, the member state in which they are based. At present, however, conduct-of-business regulation is determined by each member state in which they carry on business. So, for example, an investment firm based in Germany and providing its services from its office in Germany to customers in Germany, France and Belgium will be subject to prudential regulation by the BaFin in Germany, but will have to comply with the conduct-of-business rules of each of Germany, France and Belgium in relation to the business that it carries on in those states.

Under Mifid, by contrast, the conduct-of-business rules will be those of the relevant service's state of origin. For the most part the state of origin will be the firm's home state, meaning that, using our example, the firm will be required to comply with the German conduct-of-business rules alone. The benefits of having to follow only one set of rules should be obvious.

However, where a service is provided from a branch of a firm to customers in the member state of that branch, it will generally be the member state of the branch whose conduct-of-business rules will apply. But, if the branch provides services to customers in another state it will be the rules of the home state that apply.

This may sound rather confusing, but it does mean that the host state, where the customer is located, will lose its powers to impose general good conduct-of-business rules other than in exceptional circumstances, helping to ensure a greater degree of harmonization across member states.

Table 2: Areas to be covered by Cesr at Level 2
Mifid reference Subject Deadline for Cesr's advice
Article 4 – Annex 1 section C Definition of financial instruments covered by Mifid, in particular commodity derivatives that can be physically settled and non-financial non-commodity derivatives April 30 2005
Article 4(4) Definition of investment advice April 30 2005
Article 4(7) Definition of systematic internalizer April 30 2005
Articles 13 and 18 Organizational requirements, including compliance obligations, internal systems, rules on resources and procedures, outsourcing and record-keeping obligations, protection of client's funds and dealing with conflicts of interest January 31 2005
Article 19 Conduct-of-business rules, including client classification, communications, information provided to clients and client records January 31 2005
Article 19 Conduct-of-business rules, including the obligation to act fairly, honestly and professionally and in the best interests of the client, the suitability test, the criteria for permitting execution-only services April 30 2005
Article 21 Order execution obligations and client order handling rules January 31 2005
Article 22 Limit orders display April 30 2005
Article 24 Eligible counterparties April 30 2005
Article 25 Reporting of transactions January 31 2005
Article 27 Pre-trade transparency – meaning of a liquid market in an individual share, and the determination of standard market size/classes of shares April 30 2005
Article 27 Multiple quotes, the publication of quotes, withdrawal, updating and protection against multiple hits, transactions exempted from the rule that quotes must be firm, and retail size orders April 30 2005
Articles 28, 29, 30, 43 and 44 Transparency requirements January 31 2005
Article 39 Admission of financial instruments to trading January 31 2005
Article 56 Obligation of regulators to cooperate January 31 2005
Article 58ß Exchange of information between regulators January 31 2005


The Level 2 process

Many of prudential and conduct-of-business rule provisions in Mifid have Level 2 powers hanging off them. This means that Mifid operates as a framework directive, with many of the more detailed rules being made through a consultation process led by the Committee of European Securities Regulators (Cesr).

To date, the Commission has published two mandates to Cesr requesting its advice on a wide range of areas where Mifid itself provides only a framework. Based on Cest's advice, further directives or regulations will follow. Although this process enables a more detailed degree of involvement by national regulators in the European law-making process, the fact that Cesr's advice on the second mandate is not due until the end of April 2005 is likely to result in a tight timetable for member states to implement Mifid by the April 30 2006 deadline.

Author biographies

Jonathan Herbst

Norton Rose

Jonathan is a partner in the Norton Rose financial services group and was previously head of European law at the Financial Services Authority. He provides project-related and transactional financial services advice and is a frequent speaker at financial services conferences.

Jonathan was a member of the drafting committee set up by HM Treasury and the FSA to give detailed input on the text of Mifid and is a member of the FSA's scope committee considering the impact of Mifid on intermediaries.


Mathew Rutter

Norton Rose

Mathew is a senior associate in the Norton Rose financial services group with extensive experience of advising a wide range of financial institutions on regulatory issues.



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