Katie Paxton-Doggett explains how the EU's MiFID will allow investment firms to open a branch in any member state



The Markets in Financial Instruments Directive 2004/39/EC (MiFID) is the most significant EU legislation for investment intermediaries and financial markets in more than a decade. It promises to open a pan-European market for investment products, simplifying the provision of cross-border services.



MiFID will replace the existing Investment Services Directive (ISD), which was adopted in 1993. The directive is a central element in the European Commission's financial services action plan of 1999, and sets out a comprehensive regulatory regime, covering investment services and financial markets in Europe.



Most of the firms currently subject to ISD will be affected by MiFID. Broadly, this includes investment banks, market data companies, trading platforms and exchanges. In addition, MiFID will affect portfolio managers, stockbrokers and broker dealers, corporate finance firms, many futures and options firms, and some commodities firms.



Certain organisations, such as insurance undertakings, employee schemes, persons administering their own assets and undertakings that do not provide investment services and/or perform investment activities, will fall outside the scope of MiFID. While some, such as retail banks and building societies, will be subject to MiFID for some parts of their business, such as selling securities or investment products that contain securities, the rest of their business remains outside its scope. There is an exemption from MiFID for incidental business in the course of a professional activity regulated by legal or regulatory provisions, or a code of ethics governing the profession.



MiFID abolishes the 'concentration rule' through which member states forced investment firms to route orders only through stock exchanges. Therefore, in the future, exchanges will be competing with non-exchange trading platforms known as multilateral trading facilities (MTF) and 'systematic internalisers', such as banks and investment firms, that systematically execute client orders internally on own account, 'off-book', rather than sending them to exchanges.



MiFID distinguishes between 'investment services and activities' and 'ancillary services', which are broadly similar to the categories of core and non-core services currently under the ISD. A firm that performs only ancillary services is not a MiFID firm. However, a firm that carries on investment services and activities as well as ancillary services can benefit from the MiFID passport in respect of all those activities.



MiFID covers a much wider range of services than the ISD. Investment advice will now be classified as an investment service, and there is a new ancillary service of financial analysis and research. There is also a new investment service of operating a multilateral trading facility.



As with the ISD, MiFID provides for a 'single passport' for investment services and activities carried out 'as a regular occupation or business' and on a professional basis. The passport rights created under the ISD are improved and extended to new products and services.



A firm must be authorised in its home member state, generally where it has its registered office, but it will then be able to use the MiFID passport to establish a branch or provide services on a cross-border basis into any other EU member state. The host country will be responsible for ensuring compliance with conduct of business requirements, where services are provided in its territory by a branch of a firm authorised in another member state.



MiFID imposes a range of investor protection measures, particularly in relation to retail clients. A three-tier system of client classification is set out. As with the current UK regime, the full range of protections applies to private or 'retail' customers. More limited rules apply to clients classified as professional clients, such as financial institutions, large undertakings, and government bodies. There is an exclusion for eligible counterparties, which are broadly similar to market counterparties under the current UK regime.



Firms are subject to a general requirement to act honestly, fairly and professionally, and in accordance with the best interests of their clients. In particular, firms are required to ensure that all information addressed to clients or potential clients is fair, clear and not misleading. Clients should not be flooded with information that may be irrelevant to them and difficult for them to understand. The emphasis, instead, is on the fiduciary duties of the firm.



Firms that provide portfolio management or investment advice must undertake a 'suitability' test. Sufficient information about the client must be considered so the firm can recommend products and services suitable to that client. This will take into account the client's experience in the relevant investment field, his financial situation and financial objectives.



Other investment services for retail clients, except execution-only transactions, will be subject to an 'appropriateness' test, similar to the 'suitability' test. The firm must warn the client if it then considers that the product is not appropriate. If insufficient information is available, the firm will be unable to determine whether the product or service is appropriate and, thus, be unable to act.



Execution-only business, where transactions are executed on behalf of clients without providing advice, are limited under MiFID to shares admitted to trading on a regulated market, money market instruments, bonds, or other forms of securitised debt, UCITS (undertakings for collective investment in transferable securities), and other non-complex financial instruments. An execution-only service must be provided solely 'at the initiative of the client', although firms will be able to advertise its execution-only services generally.



MiFID will bring about a number of changes in the area of best execution. The best execution duty under MiFID places a greater emphasis on the best overall result for the client, rather than merely best price. Firms must take all reasonable steps to obtain the best deal for their clients, taking into consideration all factors, such as the price, cost, speed, and likelihood of execution and settlement. Nevertheless, for retail clients, emphasis will remain on ensuring that they get the best price for the instrument and the costs associated with execution.



All firms subject to MiFID will need to review their internal procedures to ensure compliance. Internal control mechanisms must be in place, as well as sound administrative and accounting procedures. MiFID introduces an obligation to have in place a risk management policy. Firms should take reasonable steps to avoid undue additional operational risk arising. Effective control and safeguard arrangements for information processing systems will also be paramount.



MiFID expressly sets out that firms must take all reasonable steps to identify conflicts of interest and have effective systems and controls either to prevent conflicts adversely affecting the interests of customers, or to manage them so that this result is achieved. Where it is not possible to manage conflicts, the general nature and/or sources of the conflict must be disclosed to the client before undertaking business.



MiFID establishes minimum standards of reporting to relevant competent authorities of buy and sell transactions in all financial instruments, even if executed outside a regulated market. 'Systematic internalisers' will be obliged to undertake a form of public market-making obligation, whereby the firm must provide definite bid and offer quotes in liquid shares for orders below standard.



Legislation is expected to be transposed into national law by 31 January 2007, with implementation scheduled for 1 November 2007. It was meant to come into force in April 2006, but, earlier this year, the commission announced that implementation would be delayed by a year to give firms a better chance of complying. Some industry-watchers are predicting that the implementation date will slide back again.



Katie Paxton-Doggett is a solicitor and producer at the Law Channel, Einstein Network