MiFIR trading obligations: Is Brexit contingency planning over ?
05 September 2019
With the chance of a no-deal Brexit occurring on 31 October arguably higher than it has ever been, the financial services industry continues to call on regulators to take further action to avoid a fragmentation of financial markets. The European Commission (EC) has repeatedly said that its planning for no-deal has concluded. For financial services, they proposed two measures: guaranteeing access for twelve months to UK central counterparties and providing relief from margin and clearing requirements for contracts transferred from the UK to the continent.
In June 2019, they issued a communication to say that the industry should not expect further action and no measures to mitigate the impact of the Markets in Financial Instruments Regulation (MiFIR) trading obligations have been proposed. For market participants trading shares and derivatives, the impact should not be underestimated.
MiFIR provides that shares and derivatives for which liquidity is sufficient, should be traded on venues located either in the EU, or in “equivalent” jurisdictions. The European Commission makes these determinations, based on a comparison of a regime against EU requirements, to assess if it’s similar enough. As ever with equivalence, what should be a technical determination has the potential to be political.
One would think that the UK, with its plans to on-shore MiFIR into UK rules, should easily meet the criteria. UK regulators have said on multiple occasions there would be no bonfire of regulation post Brexit. Yet the European Commission has to date not committed to deem the UK equivalent under the MiFIR, should it leave with no-deal.
That’s a problem for all segments of the markets, as the scope of the trading obligation is far-reaching, especially the Share Trading Obligation (STO). On 29 May 2019, the European Securities and Markets Authority (ESMA) issued a statement confirming how market participants should interpret the obligation. Post-Brexit, any share with an International Securities Identification Number (ISIN) with an EU27 country code shall be traded either on-shore or an equivalent third country market.
For many of the European shares, a large part (if not the majority in some cases) of liquidity is found on UK trading venues. In a no-deal Brexit, whether you’re an EU asset manager or a broker dealer, you would no longer be able to trade these shares in the UK and have to trade them in the EU. The price differences could be steep, leaving many investors worse-off.
The same problem will occur for derivatives traders. The scope of the derivatives trading obligation (DTO) is much more limited than the STO, covering euro, sterling, U.S. dollar interest rate swaps and some credit default swaps denominated in euros. Yet the UK is also where a large part of EU and non-EU market participants currently meet to conclude these trades.
Changes to the UK rule book add another challenge. The UK is committed to maintain the MiFIR regulatory framework post Brexit. That means having its own obligations for market participants to trade on UK or UK-equivalent venues. The Financial Conduct Authority has confirmed that the UK will have both a DTO and an STO in place after Brexit. Their scope is not yet defined.
Any participants operating in the UK could very much be asked to trade the same European shares on UK venues. For branches of EEA institutions based in the UK, it would be impossible to comply with both rules if they cover the same securities. The FCA has acknowledged firms face the risk of overlapping obligations, and wants to solve the issue through mutual equivalence between the EU and the UK.
Few precedents for this situation exist, but the one example we have does not bode well for the issue to be resolved. Over the summer, the European Commission withdrew an existing equivalence determination allowing EU market participants to trade their shares on Swiss markets. The move did not have anything to do with a change in the Swiss financial markets regulatory framework. It was a response to broader disagreements with Switzerland over trade. Many have seen it as a warning about the shortcomings of equivalence for the UK post-Brexit.
The European Commission could still change its course and deem the UK equivalent, potentially at the last minute. In the meantime, firms should be thinking about where to trade after Brexit day, firms will need to map where they currently trade shares with an EU-27 ISIN to identify where they risk breaching the STO in a no-deal scenario. They will need to review liquidity on EU or equivalent third country venues to determine where to move these trades, and guarantee they have the right memberships for these venues. Buy-side firms will also need to consider the impact of higher trading costs across whole products they offer, particularly passive funds tracking the performance of European shares markets.
Like other Brexit contingency measures, redirecting trading volumes cannot be executed overnight and needs to be carefully thought through. Precedents show that it is difficult to rely on equivalence as a durable solution to access non-EU markets.