If they have not already done so, firms must identify the parts of their businesses to which the EU's Markets in Financial Instruments Directive applies straight away, then they must contact their regulators swiftly to find out whether or not they are registered.

On 3rd July 2017, the deadline passed for firms to submit their applications for MiFID II authorisation. Combined with the publication earlier that month of the FCA’s long-awaited final policy statement, this provided much-needed clarity regarding the types of firm that must adhere to the directive and what will be required of them. Firms governed by MiFID II now have less than six months to ready themselves for the commencement date on 3rd January 2018, so their preparations are taking on an urgent character.

MiFID II will affect almost 9,000 firms that operate in the EU, including 6,500 small and medium-sized enterprises (SMEs) such as hedge funds, wealth managers, mutual funds and pension funds. Many of these firms wrongly believe that they are not directly affected, but will find themselves particularly hard hit by MiFID II because the directive requires them to manage and be accountable for their own regulatory compliance. So far, these firms have been able to rely on larger institutions to handle their record keeping and reporting obligations.

If they have not already done so, firms must identify the parts of their businesses to which MiFID II applies straight away. Then they must contact the regulator swiftly to find out whether they are registered. The next, and probably the most time-consuming, step is for them to design policies to implement the regulation and then, of course, they must implement them.

Assessment

MiFID II is a notoriously complex piece of regulation and has many moving parts. To achieve compliance by the deadline, firms must examine it and work out the steps they ought to take to avoid being banned from trading or from servicing their clients. Here are some of the pitfalls they face.

Businesses in some sectors (for example commodities) that MiFID I does not govern will be classed as financial service firms under MiFID II and will therefore be subject to its rules. These firms will have to be especially rigorous in their assessment of the directive’s requirements as they will be working towards compliance without any MiFID I-related experience on which to fall back.

Most British advisory firms that are currently exempt from MiFID I are likely to wish to maintain this status. These firms may be exempt from MiFID II under article 2, article 3, or article 8, or they may fall under the label of "Exempt Capital Adequacy Directive Firms." These firms must determine which of the exemptions apply to them and then take the right steps to maintain this exemption.

Firms that engage in high frequency algorithmic trading (HFAT) strategies, which are currently exempt from MiFID I, must now be authorised for the purposes of MiFID II if they wish to continue. They will also be required to notify the UK's Financial Conduct Authority and relevant trading venues that they engage in HFAT. This will be a major change for these traders; at the moment they are largely free from regulatory supervision.

Register

The 3 July deadline for applying for authorisations and "variations of permission" has passed. Although firms can still make these applications to the FCA, there is no guarantee that it will processed them in time for the implementating deadline of 3rd January.

Another key date of which firms should be aware is the "passporting gateway" that opened on 31st July. Any firm that wants to undertake business regulated in accordance with MiFID II in another European country must apply for a 'passport' that contains the necessary authorisation. The deadline for these submissions is 2nd December 2017.

Registration is a complex progress and penalties for firms that fail to obtain the appropriate 'permissions' by the implementation date are likely to be substantial. Unless a firm is absolutely certain that it understands its duties to the letter in order to continue MiFID II-style activities, it should seek advice from an independent specialist.

Policy

Given the importance of the new rules for the future shape of the market and the costs of implementing them, 'buy-in' from all levels across the financial services community is going to be vital to the success of every firm that has to obey them. Irrespective of the size of the business, "senior stakeholder engagement" will be vital. This will ensure that all policies and procedures will be designed with business considerations in mind and will encourage the cultural changes that have to occur. Likewise, due to the directive’s effect on investment and execution strategies, firms will have to brief their front office staff early in the process about ways in which their jobs will be affected.

Due to the directive’s size and complexity, managers may find it hard to identify the precise policies they need to comply with it, especially when it comes to estimating timelines and cost. In addition to the largely well-understood area of research unbundling, a typical MiFID II implementation plan should include policies that govern transaction reporting, recordkeeping, the protection of investors from sharp practice, 'transparency' and trading controls. Commodities firms also have to consider the systems they will be using to monitor the new 'position limits' the regulators set; if their current systems cannot do this, they will have to develop or replace them. New policies and systems must be adaptable to any further changes to the market landscape once the regulation has taken hold.

The changes that MiFID II promises are far-reaching and will span many areas of many a business. The process of designing policies and systems will necessitate a huge investment of both time and capital. Large firms will find this affordable; SMEs may find themselves at a disadvantage, struggling to allocate scarce resources. Firms that begin early are more likely to meet the deadline, thereby avoiding financial sanctions and/or reputational damage.

Firms that have not yet embraced MiFID II, or that are unable to allocate adequate time and staff to do so, might want to appoint external consultants to examine their operations and work out how MiFID II will affect them. Such people (all of whom are very familiar with both the directive and the work required for compliance) will then be able to spot the areas on which the businesses ought to concentrate and the steps required in each case. They must also be adept at drafting the requisite documents, which include 'client documents' and terms and conditions.

Although MiFID II is a huge drain on resources, businesses that fail to make the investment now are likely to find themselves operating in a manner ill-suited to the new market landscape. Their margins are likely to tighten and their compliance costs are likely to soar as a result. An absence of proper preparation will probably prompt such business to fall behind their better-prepared competitors and become unable to trade with their counterparties.

Systematic implementation

As in any period of change, a firm that tries to comply with MiFID II will not do it successfully if it does not brief its staff about its new policies and systems and train them comprehensively in any new business practices and internal procedures.

Data/reporting

MiFID II’s extensive data and reporting requirements are not limited to a single article in the regulation, but run through its core. Firms will be required to keep records for all services, activities and transactions for up to seven years. This includes records for any intended transaction, even if it never takes place. The records must be readily retrievable in an online, electronic, tamper-proof form. Even for the largest firms this is an intimidating prospect, but for smaller firms that may not have the online storage capacity, IT expertise or resources, it will be an immense problem.

Recording telecommunications and electronic communications

Article 6(7) of MiFID II states that affected firms will have to record communications and conversations that relate to “transactions concluded when dealing on own account and the provision of client order services that relate to the reception, transmission and execution of client orders.” This obligation applies to conversations and electronic communications that relate to transactions that actually occur, as well as those that do not. Audio recordings take up a lot of space and must be kept on file for five years; smaller firms may not have enough storage space for this.
 
Trade reconstruction (the need to reconstruct trade records) may be hard for firms as they will be required to store and, upon demand, hand over all order and trade data, electronic communications, and voice records to the regulators. Firms must respond to regulatory requests for trade reconstruction or data retrieval within a reasonable time frame; under the US Dodd Frank regime this is defined as 72 hours and MiFID II is largely expected to mimic this.

'Best execution'

Articles 44-46, which relate to 'best execution' or the need for firms to execute the best trades for clients, are also likely to cause numerous headaches for the managers of SMEs that are struggling to comply with MiFID II. They oblige firms to ensure that their compliance processes and methods are consistent with their 'best execution' obligations at every organisational level. The burden will be raised from “all reasonable steps” to “all sufficient steps”, with the aim of making firms achieve the best results for their clients.

Firms will be required to disclose their top five execution venues for each class of financial instrument and will be obliged to have order execution policies in place to explain the choice of venues in terms of execution quality. These records must be available so that each firm can, upon demand, show its clients, its internal supervisory committee or its regulators that its 'best execution' policy has been consistently good. In order to achieve this, it must make 'client documentation' a priority, ensure that people can see how any "publicly available policies" work, and explain its approach to 'best execution' to its clients with the utmost clarity.

Small and mid-sized firms may again find themselves at a disadvantage here, as the necessary investment in time and technology will be onerous.

Research payments

Under Article 13, fund managers will be required to pay for sell-side research and will no longer be permitted to receive research in return for placing trades with banks or brokerages. Fund managers will also be required to provide investors with a clear breakdown of the cost of any research they undertake. These developments are causing shockwaves to pulse through the asset management industry and will make life harder for smaller boutique fund managers. Although some larger firms have opted to pay for equity research themselves, thereby avoiding the need to pass the costs onto their customers, smaller boutique firms may struggle to meet these costs without doing so and might suffer competitive disadvantages as a result. It might therefore be wise for SMEs to use 'third party' systems.

Nobody ought to make the mistake of thinking that the job is finished on 3rd January 2018. It will be essential for every firm to review its policies and systems continually to overcome teething troubles, to ensure that it attacks areas of weakness and to exploit any opportunities that arise on the MiFID II landscape.

* Matt Smith is the CEO of SteelEye, a compliance tech and data analysis firm whose software reports on transactions and keeps records. Visit https://www.steel-eye.com