European Institute - Address by Prudential Director on MiFID European Institute Address by  Con Horan, Prudential Director, Financial Regulator 14 June 2007 The MiFID in Ireland and the Impact on the Asset Management Industry Introduction First, let me thank the European Institute for inviting me here today to address senior executives of the asset management industry.  After many years of gestation and negotiation the Market in Financial Instruments Directive or MiFID as it is more commonly known is becoming a reality, with implementation now just 5 months away.  We are fully aware of the tight timelines to which everyone is working and it is a challenging time both for regulators and firms. The asset management industry is one of the main sectors that will be impacted by MiFID.  Today I would like to give you an understanding as to how we have and are approaching this important project and what we see as the main issues affecting your business. Our Approach Let me begin by updating you on where we are on the transposition of the directive into Irish law and how we have gone about implementation and engagement with the industry domestically.  The framework Directive and the implementing Directive were transposed into Irish legislation in February.  As we currently understand the position, we are one of only three countries along with the United Kingdom and Romania to have transposed the Directive into domestic law.  Commissioner McCreevy has publicly spoken on this problem. He has urged all Member States to keep to the timetable and has pointed out that failure to transpose could put investment firms at a competitive disadvantage.  As expected, this position will be backed up with action and there have been indications that the EU Commission will launch infringement proceedings against those Member States that have not yet transposed.  While the extent of transposition is low, it is also our understanding that, in general, those jurisdictions that have not yet completed the process have arrangements in place to get themselves across the line and a number are coming on stream over the next few months. What might happen to firms in any country that fails to transpose is as yet unclear and we are hopeful that this situation will not arise. Domestically we have actively engaged with industry principally through the establishment of the MiFID Implementation Forum. This body which was established and is chaired by the Financial Regulator operates as a clearing house for dealing with some of the challenging issues that have quite naturally arisen. Its membership includes the Irish Stock Exchange, Department of Finance, Irish Association of Investment Managers, Irish Funds Industry Association and the Irish Bankers Association. Through this forum and a number of sub groups it established, we have dealt with the implementation of this complex and far-reaching suite of legislation.   For the most part, agreement has been achieved although, as you might expect, there a still some difficulties to be resolved.  I would like to put on record my thanks to all of those involved. This engagement has been very positive to date and we look forward to it continuing. As most of you are probably already aware, since its establishment in 2003 the Financial Regulator has operated a principles-led approach to regulation and this is central to how we have approached this directive. Boards and management in financial institutions are expected to be aware of the requirements and to identify the most suitable mechanisms for ensuring compliance. At the outset we agreed with industry that in terms of making decisions on discretionary issues, we would be guided by five high level principles.  The principles are: · Principle 1 – We would have as a key objective (i) investor protection and (ii) the promotion of the soundness, competitiveness and reputation of the Irish financial services market. · Principle 2 - We will follow CESR guidance on all aspects. · Principle 3 - We will be open, transparent and consultative. · Principle 4 - We will not be super -equivalent to the MiFID unless it is justified.  Such instances were and are expected to be the exception rather than the rule. ·  Principle 5 - We will be proportionate and risk based in our implementation. We consider that we have been true to these principles and that having them in place from an early stage has been beneficial to industry and the Financial Regulator alike. By way of example, we have taken a very minimalist approach on super-equivalence and we have in the main a straight copy-out into national legislation of both the Framework and implementing directives.  This is consistent with our desire to be efficient in the regulatory process and to foster competitiveness. The only area where we are seeking to retain requirements not contained in the directive is in the area of Client Asset rules.  What we have done here is essentially maintained our current position as this reflects Irish case law that has been developed, particularly in the area of set off. We are currently in discussions with the European Commission on this issue and we expect that our proposal will be accepted.  This requirement has also generally been accepted   by industry. Guidance and Consultation with CESR   Given that the core objective of MiFID is the desire to create a single market for securities in Europe, we strongly believe that the work being done by the Committee of European Securities Regulators (CESR) is critical and probably the most important area for firms to consider in preparation for MiFID.  In this regard, we have participated fully in the CESR work on the preparation of guidance and recommendations, and we have been very frequent travellers on the Dublin – Paris route over recent times.  In the past fortnight CESR published four key papers dealing with Best Execution, Inducements, Passporting and certain aspects of transaction reporting.  These papers add to the two issued in February on the list of minimum records and on the publication and consolidation of market transparency data. In addition to the legal text of the directive these are the documents which we consider should guide firms in terms of what is expected of them in the new regime. While they will not address every issue that industry and regulators may identify following the 1 November commencement date, these are the areas that regulators and industry identified as being among the most important in the public consultations that have taken. Minimum Records Before looking at the most recent developments, I would briefly like to draw your attention back to the paper on minimum records. This was issued last February and accordingly is an area where firms should have made progress already. The paper sets out the minimum records a firm must maintain in respect of all services and transactions.  The type of records which must be maintained include records of the identity and categorisation of each client, client details, records of complaints and records of transactions undertaken on behalf of clients.  While it may be perceived that this is a major administrative burden, the record of identity and categorisation of clients is an important protection for institutions. It provides an audit trail showing that the proper questions were asked so that a suitable service could be provided. It will show that you properly categorised your clients into retail, professional or eligible counterparty clients and, as such, provided the appropriate levels of protections in carrying out securities transactions.    This list of documents is a useful checklist for firms but it is not exhaustive and does not provide a safe harbour for firms from the record keeping obligations set out in the framework directive and implementing measures. This is where principles based regulation comes into play. The boards and management of institutions, who understand the business in detail, must ensure that they have appropriate systems in place to reflect the nature of the service they provide. The guidance will of course help them with this. It should be noted that the guidance published by CESR does not seek to harmonise the content, timing or form of the different documents in the list. CESR will however try to reach progressive convergence on this issue and has committed to completing a review in 2008 on the approach of the competent authorities to the implementation of the guidance. Transaction Reporting As mentioned, the most recent meeting of CESR has resulted in agreement and publication of a number of very important guidance papers and I would like to take you through these as they represent areas of importance to asset managers and our likely to be the areas of greatest interest to regulators in terms of monitoring adherence to MiFID post 1 November.  Let me begin with transaction reporting.  The two main areas covered by this guidance are   'what constitutes the execution of a transaction 'and ‘what are the reporting obligations of branches’. In relation to the first item, there were different views as to what constituted the execution of a transaction, with some parties believing that it applies to all the potential parties in the chain between order and final execution and others considering that it only comes into play at the final element. As an interim solution, it has been determined that only   'market facing ' firms must report transactions.   If a firm executes an order with the market directly or matches the order against its own book then that firm must report the transaction.  As I mentioned this is an interim solution and CESR will review this after one full years operation of the Transaction Reporting Exchange Mechanism. The second area covered is on the reporting of transactions by branches and how this should be treated where a branch executes orders in more than one Member State. CESR has sought and achieved a practical solution to reduce the burden for such firms  -it has been determined that such branches may choose to report all transactions to the host member state who will then forward them to the home competent authority. It is probably worth mentioning for those of you who may not be familiar with the Transaction Reporting Exchange Mechanism known as TREM that this is the system being developed by CESR to facilitate the exchange of transaction reports between Member States.  CESR is building a ‘hub’ and this hub is currently undergoing testing by a limited number of Member States.  The TREM project will enable regulators to exchange transaction data on a daily basis in order to improve the capacity of the authorities to tackle market abuse. This is a major project and is considered to be an important element in the development of the single market. In the main, the transaction reporting requirements are unlikely to apply to a major extent to asset managers, but it is important to be aware that in some instances they will apply. This will primarily be in a situation where an asset manager concludes a transaction by either transacting with an execution venue directly or by concluding the transaction ‘in-house’.  Passporting Arrangements The next area I want to talk about is the arrangements for your business to be able to sell its products or services in new jurisdictions, these arrangements are commonly know as the passport arrangements. The achievement of a more speedy mechanism to allow for more efficient passporting by investment firms has come about in a number of ways, for example. · Firms that do not have branches in other EU member States and only provide services on a cross border basis, will only have to comply with one set of conduct of business rules regardless of where they provide their services; and  · Secondly CESR has drafted a passporting protocol which will ensure consistency of treatment of passporting notifications regardless of the jurisdiction in which the firm operates. There a number of difficulties in this area that still need to be resolved.   The most important issue relates to which competent authority will be responsible for the supervision of conduct of business in respect of the provision of a service by a branch, into another jurisdiction.  CESR considered this to be a legal issue and has referred the matter to the European Commission.  The EU Commission is currently finalising a paper on this matter.  As a branch does not have a separate legal identity one view which is the one we would support, is that it is the head office that is providing the services on a cross border basis and consequently it is the competent authority of the home Member State that assumes responsibility for supervision in that case.  However, other Member States have different views on this matter.  Best Execution Let me move on to the issue of Best Execution. CESR issued its guidance on Best Execution in the form of a series of questions and answers. This is a very useful format as it answers many of the questions that were posed by yourselves in the course of consultation of this sometimes controversial but important element of MiFID.  Best Execution serves two purposes:  it protects investors and fosters efficiency.  MiFID sets a specific standard for Best Execution, requiring firms to take all reasonable steps to obtain the best possible result for the execution of client orders, taking into account all relevant considerations including price, costs, speed, likelihood of execution and settlement, size and the nature of transaction.  There are also requirements in respect of policy; disclosure and client consent in relation to Best Execution.    The CESR guidance provides certain clarification on the distinction between when the full obligations apply to asset managers and when they do not. One of the questions that were raised by your industry during the consultation on this subject was the scope of the Best Execution requirements and in particular whether asset managers are captured when they execute client orders.  The application of the MiFID to listed funds is a complicated issue and discussions are on going as we speak in that regard.  Let me set out the situation as it currently stands in broad terms; · Managers of collective investment undertakings and pension funds are exempt from the MiFID. · Portfolio managers providing services to eligible counterparties (this category of client includes collective investment schemes and pension funds) are not subject to Best Execution requirements · Portfolio managers providing services to professional and retail clients are subject to the full rigours of the Best Execution requirements where they execute client orders. Where they transmit orders to a broker for execution they will have to provide a ‘transmission policy’ which ensures that the broker they have chosen offers a high probability of the Best Execution of the order. Additionally, Administrators and distributors of Collective Investment Undertakings may   fall within the provisions of the MiFID depending on the precise nature of the activity they provide.  I will not go into more detail on the best execution paper other than to say it deals with 27 different questions which will provide very useful background knowledge for senior management as to the standards that will be expected in the new environment. Inducements Last, but by no means least, l would like to update you on the paper issued on inducements.  This is a very important issue for the funds industry and one on which you commented in great detail in response to the consultation process.  Inducements cover any fee or commission or non-monetary benefit that an investment firm may receive or pay in connection with the provision of investment services to clients.  The MiFID sets standards for the payment and receipt by investment firms of inducements.  The reason these standards have been put in place is to avoid circumstances that may place firms in a situation where they are not acting in the best interest of the clients.    In its guidance CESR maintains that the provisions on inducements apply to payment between companies within the same group as well as between an institution and third parties.  One of the other key issues raised in the consultation on this subject was the issue of a level playing field as the provisions only apply to financial instruments falling within the scope of MiFID. Instruments that are very similar in nature for example, certain Insurance policies are not subject to the same onerous obligations.   We acknowledge that this is a problem and this potential arbitrage has been signalled to the Commission by CESR.  I cannot advise you at this time as to how this matter will be dealt with by the Commission. Outsourcing One area of the MiFID where there has not yet been a huge amount of discussion is the area of outsourcing.  The framework Directive sets out high-level principles on when outsourcing is permitted. The MiFID states that important operational functions may not be outsourced if such outsourcing would materially impair the quality of the firms internal control systems and the ability of the supervisor to monitor compliance.  Where a firm outsources functions or investment services it must remain fully responsible for discharging all of its obligations under the Directive.  We have recognised that the area of outsourcing is a critical area across a number of sectors we regulate and we propose to issue guidelines for firms in the near future.  Challenges So finally, what are the key implementation challenges over the next 5 months? You have probably all set the wheels of your MiFID projects in motion at this stage, it is important that the real business issues such as the relations with clients, distributors and brokers and the operational aspects of the MiFID are fully mapped out.  If not done already there is now a need to implement the new client classification regime – as mentioned, the MiFID introduces a third category of client, eligible counterparties and many of the clients of asset managers will fall into this category.  As I mentioned earlier only 3 countries have transposed the MiFID and the late transposition by Member States makes it difficult for firms impacted and also other regulators.  We have good relationships with other regulators and will work with them to try to ensure that Irish firms are not adversely impacted by these delays. Conclusion CESR has now published the main part of its guidance and it is time now to consider this in detail and the impact that it will have on your firm.  MiFID is a reality. It is ambitious and a lot of time effort and political support has been invested in it.  It also creates the opportunity to achieve significant benefits. If firms look on it as merely a compliance exercise they will miss the strategic benefits and challenges that that will arise.  Yes we all acknowledge that throughout Europe we are operating to an extremely tight time-frame. With CESR having only published a major part of its guidance at the end of May it will be difficult to implement all aspects of the MiFID on time.  What do we expect from firms? - We expect firms to have made a reasonable, professional effort in terms of complying with the main provisions of the MiFID by 1 November. We will expect key tasks to be well progressed and will be seriously concerned if this has not happened.  Given the challenges that are faced, we should not lose sight of the potential benefits of what is, a cornerstone of the Financial Services Action Plan. Thank you for your attention.  -ENDS- Return to the home page www.mifid.ie