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Your current location:Home >Challenges for Chinese Futures Companies on LME by MiFID Ⅱ

Challenges for Chinese Futures Companies on LME by MiFID Ⅱ

发布日期:2019-12-11

Keywords - A quick tour of MiFID Ⅱ
Ø The full implementation began on January 3, 2018, which is the biggest reform with respect to EU financial regulation in the last decade
Ø Covering almost all asset types and capital market participants in the EU's financial services industry
Ø Regulating OTC transactions and essentially pushing them to Exchanges or other regulated entities
Ø Improving expense transparency, transaction tracking and reporting, separate pricing for research reports, limiting leverage ratios and positions...
Introduction:As European financial market plays a pivotal role in global financial markets, the full implementation of MiFID II (The Markets in Financial Instruments Directive II) can be said to have set off a global financial regulatory compliance storm with an impact far-reaching and ongoing. In the field of metal trading, MiFID II has and will continue to change the way of metal futures trading. The UK may exit the European Union, but London-centered metal trading would never bypass MiFID II, which is bringing to London and the global metal market huge changes and reforms. In the meantime, it has also brought challenges and opportunities to Chinese futures institutions entering the European financial market, especially the LME (London Metal Exchange) market.
I. Directory of LME’s rule adjustment influenced by MiFID II
Among its 1.4 million articles within more than 7,000 pages (Directive 2014/65/EU on MiFID II), MiFID II covers all European capital market participants, including market infrastructure providers, LME and LME Clear shall therefore be regulated by the direct obligations under MiFID II. It includes not only the MiFID II and MiFIR (Regulation (EU) No 600/2014 on markets in financial instruments), but also regulatory technical standards (RTS) and implementing technical standards (ITS), as well as the constantly updated interpretations and guidance of the European Securities and Markets Authority (ESMA).
Since the official launch and implementation of MiFID II, LME has been subject to severe regulatory impacts and make for LME market users a considerable amount of updates on transactions and regulatory compliance. Responding to the interpretations, instructions and guidance updated from time to time by FCA (UK Financial Conduct Authority) and ESMA, this situation will continue with an increasingly growing influence. The key directory of LME’s regulatory adjustment in compliance with the latest requirements of MiFID II is as follows:
1.Position limits, position reporting and position management
In case of a breach of the prescribed position limit, the regulator will contact the position holder directly to ensure that it reduces its position. The LME, its members, members’ clients and their clients’ clients (if applicable) each bear different reporting duties (subject to MiFID II). LME’s adjustments concern the following key aspects: (i) Position limits (ii) LME position management rules (iii) Position reporting (iv) Commitment of Traders Report (CoTR).
2. Market microstructure
MiFID II also introduces various obligations on market infrastructure providers, including the LME, which accordingly introduces changes to its own rules. LME members shall remain aware of these areas of proposed change to ensure continued compliance with its rules, mainly with respect to the following areas: (i) Prevention of disorderly trading conditions (ii) Member due diligence (iii) Conformance testing.
3. Transparency and order record keeping requirements
LME will also be publishing supplementary data in satisfaction of the MiFID II transparency requirements, which will be available through LMEwire or a data vendor. The adjustment mainly involves: (i) Pre-trade transparency (ii) Post-trade transparency (iii) Order record keeping (iv) International Securities Identification Number (ISIN).
4. Clock synchronization
Under MiFID II, market infrastructure providers are required to timestamp all reportable events to a level of granularity that is dependent on the gateway to gateway latency of that market. In the case of the LME, both the maximum permitted divergence and the granularity of timestamps for LMEselect is no greater than one millisecond. The inter-office market and the Ring are permitted time stamps and divergence limits of one second. Members are subject to an equivalent obligation accordingly.
5. Mandatory clearing and straight through processing
MiFID II introduces mandatory clearing for on-exchange traded derivatives, a requirement that complements the mandatory clearing requirement for OTC derivatives introduced under the EMIR (European Market Infrastructure Regulation), supported by the general requirement for “straight through processing” of cleared derivative instruments, indicating that OTC will also shift to mandatory clearing, and LME can as well benefit from the shift through its Real-time clearing house - LME Clear. In order to prevent members being subject to these onerous time limits, the LME and LME Clear have elected to change the way in which LME contracts are formed, processed and cleared.
6. Best execution
One of the key changes in MiFID II is the more comprehensive and stringent ‘best execution requirements’ (already included in MiFID I requirements). Accordingly, service providers need to take sufficient steps when executing client’s orders to ensure that clients get the best order execution results, which need to consider price, cost, speed, execution, clearing, scale, nature and other factors. According to Article 104, ‘as the best execution obligation applies to all financial instruments, whether on-exchange or OTC, investment companies should obtain relevant market data to verify whether the OTC quotes provided to clients are fair and whether the best execution obligations are fulfilled.’
Therefore LME bears now a new obligation to publish data relating to ’quality of execution’ on the venues. This includes details of price, cost, speed and likelihood of execution. This is intended to enable brokers to make an objective assessment of the most suitable venue for their clients’ orders. Under the current metal market structure, in order to achieve ‘best execution’ for illiquid regular transactions (many metal contracts lack liquidity due to low participation rates or few trading days), brokers may need to reconsider how to manage clients’ requests, especially how to provide pricing information.
Ⅱ. How non-EU companies (including Chinese futures institutions) adapt to LME regulatory compliance under MiFID II
Non-EU entities that trade in the EU and/or provide services to EU-based clients (including Chinese futures institutions entering the LME market) need to pay close attention to regulatory compliance in the following key areas:
1. In terms of providing services to the EU, if the non-EU company provides services to EU-based clients, MiFID II will affect the way non-EU companies continue to provide their services, depending on many variable factors, such as the type of services provided, the Member State in which the services are provided and the level of sophistication of clients.
2. Subject to the MiFID II rules relating to position limits and position reporting.
3. Subject to enhanced reporting obligations——reporting and order record keeping requirements, LEI (Legal Entity Identifier, also known as ‘LEI Code’), personal details of the ‘investment decision maker’.
The Legal Entity Identifier (LEI) is a 20-character, alpha-numeric code which connects to key reference information that enables clear and unique identification of legal entities participating in financial transactions. Each LEI contains information about an entity’s ownership structure and thus answers the questions of 'who is who’ and ‘who owns whom’. Simply put, the publicly available LEI data pool can be regarded as a global directory, which greatly enhances transparency in the global marketplace. Regarding how to get LEI and its cost, you can check the LEI official website (in Chinese language) for relevant information: https://www.gleif.org/zh/
In addition, MiFID II has adopted a series of HFT (High Frequency Trading) regulatory measures similar to the real-name system. The reporting of actual decision-maker’s information is an important supplement to the existing penetrating regulation.
4. Direct Electronic Access (DEA). MiFID II defines DEA as an arrangement in which a member, participant or client of a trading venue allows someone or algorithmic trading to use their access to transmit directly to the trading venue their orders related to financial instruments in an electronic way. Non-EU members of a trading venue that provide DEA will be subject to additional MiFID II related requirements, which are required to be embedded in the venue's rules. If non-EU companies provide their clients with DEA to an EU venue, then they will need to review their client due diligence and risk management procedures.
5. MiFID II introduces a regime for the mandatory on-exchange trading of derivative instruments as they may require. The obligations would prevent all firms, including non-EU entities, from trading the relevant derivative OTC within the EU. There is no expectation that metal derivatives would be immediately subject to these requirements.
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Taken as a whole, MiFID II has a very wide range of impacts, whose new regulatory requirements will definitely affect non-EU companies doing business within the EU or with EU counterparties, even if they are located outside the EU. It is also inevitable for Chinese futures institutions entering the LME market to adapt to MiFID II obligations and requirements, follow up on regulatory compliance and adjust the layout and scheme in real time.
It is worth noting that non-compliant companies may face ‘large fines’ issued by the FCA. For example, the record-keeping rules set out in Article 16 of MiFID II require companies to keep all records of orders, services, and activities, including telephone conversation and electronic correspondence, which came into effect on January 3, 2018. Companies that violate Article 16 of MiFID II may face a fine of up to 5 million euros or 10% of their annual turnover. The current huge real risk is that as of the second half of 2019, a significant percentage of financial services companies still do not have sufficient technology and process to record and capture real-time communications.
Ⅲ. Nine ways MiFID II obligations could bind Asia-Pacific companies (including Chinese companies)
The international convergence of financial systems means that the rules formulated by important Economies will have an impact beyond national borders. Given that MiFID II and its related regulatory measures are a set of extremely complex regulations, and that the derivatives market is the one that has been subject to the most changes and has thus been the most affected, many Asia-Pacific companies (especially companies from China, which has gradually opened up its financial industry in recent years), have been trying hard to understand how the EU MiFID II would directly and indirectly affect them. Specifically, Asia-Pacific firms, including Chinese companies, are also bound by MiFID II obligations in the following nine ways [1]:
1. Branches and subsidiaries of Asia Pacific firms that operate in the EU will be directly subject to MiFID II obligations.
2. Asia Pacific firms may need to obtain a Legal Entity Identifier (LEI) for any dealings with an EU counterparty.
3. An Asia Pacific firm offering products or services to an EU-based client through an EU based placement agent may be required to provide certain information so that the agent can meet MiFID II product governance requirements.
4. Commodity positions of an EU firm’s non- EU end client may need to be reported to ensure position limits are not exceeded.
5. Asia Pacific firms that provide research and execution services to EU firms might need to carve out research fees, as the EU firm will be prohibited from receiving the services in a bundle.
6. An Asia Pacific firm dealing with an EU counterparty may be required to provide specific data and disclosures so that the EU counterparty can meet their own MiFID II reporting requirements.
7. An EU firm that has outsourced an important function to an Asia Pacific firm may require MiFID compliance by the Asia Pacific firm as part of the outsourcing agreement.
8. Asia Pacific trading venues have to be recognized as equivalent if instruments subject to MiFID II obligations are to be traded.
9. Non-EU firms that wish to have direct market access to an EU trading venue must be authorised under MiFID II, Capital Requirements Directive IV (CRD IV) or deemed equivalent rules (i.e. essentially MiFID II compliant).
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In general, MiFID II surpassed the previous Directive in 2007 with a goal to improve market transparency, to shift trade to a more structured market, to obtain low-cost market data, to further improve ‘best execution’, and to ensure orderly trade in the market and more transparent expenses for trade and investment. Due to the cross-border nature of today's investment environment, the ongoing implementation of MiFID II has impacted companies that directly or indirectly relate to European market to varying degrees. For non-EU companies that invest in and/or have property rights in foreign markets are also very likely to assume risks and obligations under MiFID II.
Although the cost of regulatory compliance will inevitably increase, the above-mentioned risk must not be underestimated, especially in terms of the reporting compliance. We have repeatedly seen that financial services companies subject to EMIR, MiFID, and MiFID II are fined by FCA or other financial regulators because of non-compliance with reporting obligation. For example, Goldman Sachs International was fined by FCA a sum of £ 34,344,700 in March, 2019, because the company failed to provide 220.2 million order reports to FCA in a timely and accurate manner from November 2007 to March 2017. In another case this year, FCA fined UBS a sum of 27.6 million pounds due to his misreporting 136 million orders over the past 10 years. Such cases are numerous, with the FCA also fining Merrill Lynch, Deutsche Bank, Plus500UK, Credit Suisse, Barclays Bank, etc.
Ⅳ. Challenges and opportunities for Chinese futures institutions entering the European market
Since the official launch and implementation of MiFID II in 2018, the regulatory requirements of the entire European financial market have been enhanced in all directions, bringing landmark reforms to the European financial services industry (including retail and institutional clients), and reaching almost every corner of the European capital market. Even if Brexit keeps approaching, metal trading in LME market is still deeply affected by MiFID II, which has and will continue to change the way metal futures are traded, especially in the two key areas of price discovery and clearing. MiFID II has brought to the metal market huge changes and reforms.
So far we have seen that the LME constantly modifies and updates trading and regulatory rules, but the impact of MiFID II on financial Exchanges such as the LME is by no means achieved overnight. There are still many new regulatory requirements that are delayed for implementation and wait for gradual progress. For example, FCA has allowed LME and ICE Futures Europe to temporarily suspend the implementation of ‘open access requirements for on-exchange derivatives under Article 36 of MiFID II’ until July 2020. In addition, as far as the incomplete and insufficient data, ESMA also postponed the implementation of systematic internaliser (SI) of derivatives under MiFID II for the second time. MiFID II will continue to expand its influence on global financial markets as well as on European financial market participants and investors worldwide.
In the context of the above-mentioned international financial environment and the full opening of Chinese financial industry, what would be the biggest challenge that face Chinese futures institutions to ‘go-global’? Perhaps it is that the domestic financial supporting services provided to them are seriously lagging behind. For example, the risk management services related to derivatives are also an important part of financial services, but the domestic risk management and regulatory compliance in this regard is distant from forming a systematic and mature service industry. On the one hand, it will increase the company's operating costs and affect market liquidity, which is objective and existent fact; on the other hand, in the process of liberalization and globalization of financial markets, there is a trend of convergence (or ‘regulatory coordination’) to some extents with respect to rules and regulations between different countries and regions. For example, China ’s ‘penetrating regulation’ reflects the trend of global regulatory convergence to a certain extent, revealing the impact on Asia-Pacific region by the strict regulatory environment represented by MiFID II. As a result, Chinese companies 'going global' also have to take the initiative to adapt to the regulations of global mainstream financial market. Based on this background, the new era of comprehensive opening-up of Chinese financial industry will expect these Chinese futures institutions who ‘go global’ to maintain an open mind and broad horizons with the ability to continue learning, to improve cross-cultural and cross-jurisdiction adaptability, and to be equipped with professional financial services providers who are proficient in both civil law and common law systems, then it is possible to form a normalized, standardized and globalized system for risk management and regulatory compliance.
 
 
Legal Team for International Commodity Trading,
Shanghai Harvest Sight Law Firm
 
 
 
[1]See Financial Services Regulatory Outlook 2018, Deloitte, P19.
 
 
 


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