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Brexit to add ambiguity, as investment firms grapple to interpret MiFID II rules

Brexit could drive a wedge between financial market regulation in the U.K. and the EU, which increases the challenge for investment firms that are still coming to grips with the latest rules.

The EU's second Markets in Financial Instruments Directive, or MiFID II, took effect in January 2018 with the intention of improving investor protection and competition in investment services. Preparing for it has cost companies a lot of time and money, and the financial sector continues to adjust to it, observers say.

Brexit is "a potentially significant disruptive event" as it could cause more divergence of regulation, said Michael Thomas, a U.K.-based partner at global law firm Hogan Lovells.

MiFID II was "very ambitious" in its aim to harmonize the entire investment business rulebook to begin with and still requires more guidance from the regulators, Thomas said in an interview.

Transaction reporting

As Brexit poses questions about what financial market regulation will look like, transaction reporting is shaping up to be among the key problem areas with MiFID II.

Based on current guidance by both the U.K. Financial Conduct Authority and the European Securities and Markets Authority, if the U.K. leaves the EU without a deal, some transactions originated at U.K. and EU trading venues would not be reportable. This will likely disrupt derivatives trading and over-the-counter transactions on both sides of the channel.

It would take time before firms are able to review all U.K. and EU transactions and find overlaps in the reporting, according to Ron Finberg, a product specialist at banking compliance and regulation technology firm Cappitech.

They will probably test what regulators are accepting and rejecting and then adapt it, Finberg said in an interview.

"It is very hard to fully prepare now because there are too many things in the air," he added.

A no-deal scenario looks less likely after the EU and the U.K. agreed on a flexible extension of the Brexit deadline until Oct. 31, though the British Parliament still must approve the extension.

In any case, U.K. and EU regulators will have to agree on a new relationship post-Brexit because as Britain leaves the EU single market, firms there will lose passporting rights to offer services across the bloc.

The current system of equivalence the EU has for third countries is not entirely fit to provide an alternative and needs to be expanded or revised, according to regulatory experts.

One size does not fit all

Given the vast number of financial regulatory issues the framework addresses, MiFID II's one-size-fits-all approach leaves room for interpretation, Thomas said.

The status quo aggravates many in the industry.

German Banking Association BdB on April 8 decried the high costs of MiFID II implementation — estimated at about €5.5 billion — saying the rules have resulted in disclosures and reports that many clients, especially professional investors, do not want, and had even chased customers away from capital markets. The BdB called for revising the MiFID II rules to prevent further costs to banks and customers.

Brexit will likely add further ambiguity to the whole process. But even without it, the new regulation remains a puzzle to be solved in many cases as it does not cover all areas with sufficient precision.

Because the primary responsibility for applying the rules rests with national competent authorities, the different member states can decide on how to interpret the various requirements, Thomas said.

Moreover, the market structures and products on offer are not comparable between jurisdictions. There is a big difference in the way people save for retirement and invest in different countries, he said.

Different interpretations

The different interpretations across jurisdictions are tough on both buy-side and sell-side firms.

The sell-side, consisting of firms that issue products and are potential market makers, has been grappling with the approach of the Financial Conduct Authority in relation to MiFID II inducement rules and how they affect relationships between product manufacturers and trading platforms, Thomas said.

Jurisdictional divergence is also a challenge on the reporting side because of slight differences in the required official data, according to Finberg. For example, the required documentation for client identification in the onboarding process can vary by country. This means firms need to change their reports across jurisdictions to comply.

Exercises such as the Financial Conduct Authority's review of costs and charges disclosure from Feb. 28 help because they give firms a clearer idea of what the regulator expects. Modifications as a consequence of that review should follow, Thomas said.

At an EU level, the European Securities and Markets Authority also has a way to issue such guidance in the form of question-and-answer documents. National regulators are not obliged to apply the guidance but are generally expected to do it.

"You cannot really interpret the law properly without looking at the Q&A documents," Thomas said.

European authorities should review the MiFID II rules in the near future to assess its implementation and whether further intervention or clarification is required, Thomas said.