Intended audience:

  • Heads of regulatory affairs, regulatory strategy, or public policy at UK and EU investment banks, asset managers and trading firms.
  • Other senior executives and NEDs interested in understanding the potential for UK-EU regulatory divergence and its impact.
  • Compliance and risk teams at UK or EU investment banks, asset managers and trading firms.

Reading time: 10 minutes

At a glance:

  • The FCA’s recent MIFID consultation paper fires the starting gun on what is likely to be a much bigger set of MIFID related reforms.
  • The FCA consultation paper proposes exempting SME and FICC research from MIFID’s research unbundling rules as well as scrapping two sets of best execution reporting requirements.
  • While these changes resemble those in the EU’s MIFID quick fix package, a more substantial set of divergent reforms is likely to be set out in HMT’s forthcoming summer consultation document.
  • The Chancellor has confirmed this will include proposals to abolish the Share Trading Obligation (STO) and double volume cap. We also think there are likely to be changes to commodity position limits and a number of reporting requirements.
  • We expect any reforms to MIFID to reflect the government’s wider economic agenda on competitiveness and levelling up. These issues are also likely to shape any future regulatory divergence across other regulations.
  • While firms based exclusively in the UK may welcome such changes, there is a risk that firms with a UK/EU cross-border presence face an additional compliance burden from having to deal with two sets of increasingly divergent regulations.

Introduction

In our first blog on regulatory divergence we explored how post-Brexit Britain might diverge from EU regulation and set out the overall direction of travel for financial regulation in the UK. In our second blog we looked at the specific ways in which the UK might diverge on prudential regulation across the banking, insurance and investment management sectors.

In this blog we look at how the regulation of the UK’s capital markets is likely to change and explore the various ways in which the UK’s on-shored MIFID directive might diverge from the EU’s own version of MIFID.

What’s changing?

The FCA recently published a consultation paper (CP21/19)  on “Changes to UK MIFID’s conduct and organisational requirements.” The consultation paper proposes two sets of reforms to UK MIFID:

1) Rules governing investment research for SMEs and Fixed Income, Currencies and Commodities (FICC) markets. The FCA proposes exempting research on listed or unlisted SMEs with a market cap below £200m and FICC research from the inducement/unbundling rules, by allowing firms to consider such research a “minor non-monetary benefit”. Research from independent research providers and any openly available written material will also be exempted from the inducement rules.

2) Best execution reporting obligation. The FCA proposes removing two sets of reporting obligations on firms:

  • RTS 27, which requires execution venues to publish a report on a variety of execution quality metrics to enable market participants to compare execution quality at different venues.
  • RTS 28, which requires investment firms which execute orders to produce an annual report setting out the top five venues used for executing client orders and a summary of the execution outcomes achieved.

The changes to the investment research rules go some way to addressing the concern that MIFID II’s research unbundling requirements would lead to less research being produced for smaller companies. Although the FCA disputes this argument, noting that it “has not found that introducing research and unbundling requirements within MiFID II has significantly affected research analyst coverage for smaller UK public companies” the FCA also found that “79% of public companies with a sub‑£250m market cap have either no research coverage or are covered by a sole analyst.” Its proposed reforms are designed to encourage greater amounts of investment research into these small companies which currently have limited or no coverage.

These changes are also superficially similar to those introduced by the EU’s MIFID quick fix, which exempted companies with a market cap below EUR 1bn from the research unbundling rules. The FCA’s reforms are in some ways more extensive as they cover a broader range of areas including FICC research and independent research providers, but its £200m cap for SME research is much lower than the EU’s EUR 1bn cap, meaning fewer companies will be exempt. Ultimately, although both sets of reforms aim to revise the original MIFID II’s research unbundling rules, they have ended up in similar yet divergent places.

With respect to the two RTS reports, the FCA notes that they were introduced to try and increase the quality of information available to market participants. However, the FCA says that “we have found that the intended audiences for the reports, including retail and wholesale market participants, do not view the reports.” Given this, the FCA is proposing their abolition in order to reduce the compliance burden on firms.

The EU’s MIFID quick fix exempts firms from RTS 27 reports for two years, so again there are some similarities to the FCA’s proposed changes. However, the FCA’s proposed reforms scrap the RTS 27 reports permanently and also eliminate RTS 28 reporting. As with the research unbundling changes, the EU and UK’s reforms to MIFID identify a similar issue, although end up in slightly different set of changes.

What principles will govern the UK’s wider capital markets regulatory reforms?

These two reforms are only the start of a much larger package of reforms to alter the UK’s capital markets regulation and diverge from the EU’s version of MIFID. The FCA’s paper notes that “following this consultation paper, in the summer a consultation paper by the Treasury will look at the broad themes of capital markets reform and cover a range of high-level and more detailed questions.” The FCA also says that it will publish two further consultation papers this year, one on the consequences of Brexit and LIBOR transition for the Derivatives Trading Obligation (DTO) and another on “changes to markets requirements in the Handbook and technical standards that can be effective without significant supporting legislative change.” Consequently, firms should expect a more substantive range of changes to be put forward for consultation in due course.

While we are yet to see the detail of these proposed reforms, the FCA’s current consultation paper outlines the overarching objectives and principles that will underpin any changes. These include the FCA’s statutory objectives, but also the contents of the FCA remit letter the Chancellor of Exchequer sent to the FCA’s Chief Executive in March 2021. The letter notably asks the FCA to consider the government’s wider economic policies, including its “levelling up” agenda, its desire to enhance the UK’s competitiveness and the importance of tackling climate change and ensuring the UK remains a hub for green finance. We noted in our original blog that the government might seek to use financial regulation to try and help achieve these economic policies, and the FCA’s reference to this letter confirms our earlier prediction. The FCA goes on to say that in line with the letter and its wider objectives, its capital market reforms will aim to “reduce burdens on investment firms while having regard to growth and the competitiveness of UK financial services.”

Our first blog also explored the policy constraints the UK might face in making any reforms noting that “politicians may find they have greater scope to reshape regulations governing wholesale financial markets.” We continue to think this is true, and whilst we have already seen the UK begin to diverge in a number of areas, the forthcoming package of wholesale markets reforms will give is the first clear indication of where the UK is headed and how radical it intends to be.

However, we also noted that the UK might feel constrained in diverging from the EU’s capital markets regulations because any divergence could risk the UK failing to gain (or subsequently) losing equivalence across a wide range of areas. Since then, the balance of risks the UK faces has now changed. The EU has so far withheld equivalence decisions across the board, meaning the UK now has less to lose from divergence. The one exception relates to CCPs, where the EU has granted temporary equivalence. Consequently, whilst we expect the UK both to maintain its commitment to international agreements and to try and ensure any changes it makes do not lead to different regulatory outcomes when compared to the EU’s version of MIFID, our view is that the UK will be more willing to look at substantive regulatory changes than if it already had equivalence in important areas and faced the possibility of losing these. Importantly however, the UK’s reforms will be focused on MIFID, and the rules governing CCPs, largely confined to EMIR, are unlikely to be changed, perhaps reflecting the UK’s desire for equivalence in this area.

It’s also worth noting that the EU is due to begin its own review of MIFID and MIFIR at the end of 2021/early 2022. The EU’s review is likely to look at many of the same issues the UK has identified, which could mean that the EU and UK ultimately end up in similar places, having made changes to their respective versions of MIFID. However, as with the changes to research unbundling and best execution reporting requirements, the EU and UK may arrive at different destinations despite both sides looking to address similar issues, ultimately driving further divergence.

What other changes might there be to the UK’s MIFID rules?

Given the context set out above, what other changes do we expect to see the UK make to its version of MIFID in due course?

The UK’s Chancellor of the Exchequer, Rishi Sunak, has already confirmed the UK’s plans to remove the STO and double volume cap, announcing in a speech of April 2021 that “ambitious reforms to the UK’s wider capital markets regime will also be consulted on this summer, including proposals to delete the share trading obligation and double volume cap”.

UK regulators have long been critical of the STO, with Andrew Bailey, then FCA CEO, saying in speech of April 2019, that “I simply fail to understand why we need such a rule when there is a well-established principle that firms must obtain best execution for their clients. In such a world, through applying a trading obligation and limiting options for best execution, we harm a regulatory objective we are seeking to achieve. Furthermore, in a world where one jurisdiction applies a trading obligation, it may force others to do the same and drive fragmentation in markets. Taking the lessons of experience, I think it’s safe to say that there are things we would have done differently with EU rules if we had developed them unilaterally.” These public remarks provide a clear indication that senior UK regulators do not see any benefit to keep the STO and want to remove it in order to improve execution and liquidity, as well as to prevent market fragmentation. While removing the STO may mean UK based venues risk losing some trading activity (although much of potential lost activity may have already shifted due to the EU’s withholding of STO equivalence), the move is likely to benefit UK based traders and their end clients, who will have a wider range of execution venues to choose from.

Similar reasons underpin the UK’s desire to scrap the double volume cap and lift the limits on off-exchange or “dark pool” trading. UK regulators see these limits as harmful to firms’ best execution mandates and are likely to favour firms having a wider choice of execution venues.

Despite having a similar effect to the STO, the DTO is likely to remain in place. This because unlike the STO, the DTO was introduced as part of the post financial crisis international regulatory reform agenda, to improve the stability and functioning of derivative markets. Many of the wider derivatives related rules in MIFID and MIFIR also stem from post-financial crisis agreements. Senior UK regulators have repeatedly affirmed the UK’s commitment to such international standards, making it likely the DTO will stay as part of the UK’s ongoing efforts to uphold them.

Commodity position limits are likely to be revisited. The UK was a vocal opponent of their introduction when MIFID II was being debated, and we think it likely the UK will either raise these limits significantly or scrap them altogether.

Further changes to lighten the burden of reporting requirements are also likely. MIFID II greatly expanded the amount of transaction and trade data firms needed to report. Reporting obligations were also expanded to include asset classes such as bonds and derivatives, having previously only covered equities. The UK is likely to try and streamline some of these requirements to reduce the operational burden on firms, although it is unlikely that currently covered asset classes will be removed from the regime.

Conclusion

The FCA’s recent MIFID consultation paper is the start of what is likely to be a much bigger set of regulatory reforms to the UK’s version of MIFID. Whilst many firms are likely to welcome the changes to SME research and the scrapping of two sets of reporting requirements, these changes are relatively small in scale and unlikely to move the dial on the UK’s competitiveness.

However, HMT’s larger consultation document, due this summer, will contain a more substantial set of changes. These will include proposals to the scrap the STO and double volume cap (but not the DTO) and potentially cover reforms to commodity position limits and a number of reporting requirements.

These changes reflect the government’s desire to use financial regulation to deliver its wider economic agenda on competitiveness and levelling up. These economic policies are also likely to shape any future regulatory divergence across other regulations.

Much of this is likely to be welcomed by firms based exclusively in the UK, which will see their compliance burden reduced and also have greater freedom over how and where they execute trades. However, international firms with a presence in both the UK and EU may face an additional compliance burden from having to deal with two increasingly divergent sets of rules. While they will benefit from a reduced UK compliance burden, this will be offset (and possibly outweighed) by the loss of efficiency in having a unified set of rules to comply with across the UK and EU.

As firms prepare to engage with the HMT’s larger summer consultation they will no doubt make the Treasury aware of any trade-offs involved and thereby help shape the future of the UK’s capital markets regulatory framework more generally. As when combined with the other forthcoming FCA consultations, this is likely to amount to the largest and most substantive UK regulatory divergence to date.