The new Market in Financial Instruments Regulation (MiFIR) will introduce a share trading obligation which requires EU investment firms to trade shares on an EU trading venue, an EU systemic internaliser or on an equivalent third country exchange only. Should the Swiss legal framework not be considered equivalent to the EU regulation as of the date of the launch of MiFID II/MiFIR (3 January 2018), EU investment firms would be required to trade dual-listed shares outside of Switzerland, even if the deepest pool of liquidity is in Switzerland. This article briefly describes the EU equivalence regimes in general, the requirements and effects of the relevant equivalence provision with regard to the share trading obligation, as well as its effects on Swiss trading venues.
By Marco Toni / Lea Hungerbühler (Reference: CapLaw-2017-15)
1) Introduction
In order to enhance transparency in the EU stock market, article 23 MiFIR will introduce a trading obligation for shares. Trades by EU investment firms in shares traded on an EU trading venue must be executed (i) on an EU regulated market or multilateral trading facility (MTF), (ii) with an EU systematic internaliser (SI), or (iii) on a third country trading venue assessed as equivalent in accordance with article 25(4) of the Market in Financial Instruments Directive (MiFID II). The share trading obligation only applies to EU investment firms, i.e. firms regulated by MiFID II, but not to other entities such as alternative investment fund managers (AIFMs) or managers of UCITS funds (Undertakings for Collective Investments in Transferable Securities).
Each EU trading venue will benefit from a passport for the purpose of the share trading obligation. For third country trading venues like SIX Swiss Exchange AG (SIX), there is a possibility to get an equivalence recognition by the EU, which would allow EU investment firms to execute share trades on the respective third country trading venue as well.
2) Different concepts of equivalence
Various passporting possibilities ensure a level playing field among financial services providers located within the EU. For market participants outside of the EU, the EU established a variety of third country regimes. Most of these regimes are based on an equivalence decision, i.e. a decision by the EU Commission (Commission) which determines that the legal regime in the respective third country is equivalent to the one in the EU in the particular area of regulation.
Until today, the EU has taken 212 equivalence decisions for the benefit of various third countries. However, equivalence can by no means be understood as one single particular concept. There is a broad array of several dozens of equivalence provisions in EU financial markets regulations and each equivalence provision has its own peculiarities. The most important common feature of all equivalence provisions in EU law is the fact that a particular authority has the task to compare the legal and supervisory framework of a third country with the one of the EU. Based on such assessment, the equivalence of a third country’s legal framework will be recognized (or not). Of course, there is also a political and, hence, unpredictable component in the assessment and decision procedure.
3) Equivalence assessment for the purpose of the new EU share trading obligation
a) Requirements and procedure for equivalence
With regard to granting equivalence under the new share trading obligation, article 23 MiFIR refers to article 25(4) MiFID II. According to article 25(4)(a) MiFID II, the legal and supervisory framework of a third country must be equivalent to the requirements applicable to EU regulated markets resulting from (i) the Market Abuse Regulation, (ii) MiFID II, (iii) MiFIR, and (iv) the Transparency Directive. In particular, third country trading venues need to be subject to authorization and effective supervision and enforcement on an ongoing basis, they must have clear and transparent rules regarding admission to trading, security issuers have to be subject to periodic and ongoing information requirements, and market transparency and integrity need to be ensured.
The most onerous aspect of this equivalence procedure is the initiation of the equivalence assessment. According to article 25(4) MiFID II, the competent authority of a member state may request the adoption of an equivalence decision regarding a third country by the Commission. Before a decision is taken, it will be discussed by the Expert Group of the European Securities Committee (EGESC). The requesting national authority has to indicate why it considers the respective third country as equivalent and provide the relevant information to demonstrate equivalence. This procedure is similar to the one laid down in article 4 of the Prospectus Directive – interestingly enough, there has been no single equivalence decision under this provision of the Prospectus Directive so far.
There are several questions in connection with the equivalence assessment under article 23 MiFIR/article 25(4) MiFID II that cannot be answered today:
- It is currently unclear whether there will be two separate equivalence decisions for article 25 MiFID II and article 23 MiFIR or a combined one.
- The wording of article 25(4) MiFID II (“third country regulated markets”) seems to provide the Commission with an equivalence decision mandate for regulated markets only. It remains to be seen whether in fact only regulated markets will benefit from the equivalence decision, and MTFs and SIs located in third countries would remain expelled. Interestingly, the parallel provision for the trading obligation for derivatives (article 28 MiFIR) explicitly mentions that there might be separate decisions for the different types of trading venues.
- It is uncertain whether equivalence decisions by the Commission will be taken with regard to certain third countries in their entirety or specific local trading venues only.
b) Timing
The share trading obligation implemented by MiFID II/MiFIR will be applicable as of 3 January 2018 (in contrast to the trading obligation for derivatives, which will be applicable upon instruction by the European Securities Markets Authority (ESMA)).
Due to the cumbersome equivalence procedure requiring a specific request submitted by a national authority, it is currently unclear whether and when such equivalence decisions will be taken. There have been indications that the EGESC conducted a consultation regarding the countries which should be prioritized, pointing to the intention to have a first set of equivalence decisions in place at the beginning of 2018. Countries so chosen shall have the possibility to submit their equivalence analysis by May 2017. Between June and October 2017, the Commission would conduct its evaluations and issue a decision which would then be published in the official journal in December 2017.
4) Other equivalence assessments of third country trading venues
Article 19 MiFID I contained a similar equivalence provision to article 25(4) MiFID II. However, under article 19 MiFID I, no decision was taken by the Commission.
Article 28 MiFIR includes a trading obligation for derivatives. In contrast to article 23 MiFIR, the trading obligation for derivatives will only apply once ESMA has decided which classes of derivatives are subject to the trading obligation. Accordingly, there is less time pressure for the issuance of equivalence decisions in this regard.
Article 2a European Market Infrastructure Regulation (EMIR) contains a provision which qualifies derivatives traded on equivalent third country trading venues as exchange traded instead of over-the-counter (OTC) traded for EU law purposes. Various third countries were assessed as equivalent for this purpose, but not Switzerland.
According to article 25 EMIR, a third country central counterparty (CCP) may only provide clearing services for OTC derivatives in the EU where the third country regulation has been determined as equivalent. The equivalence decision regarding the Swiss regulation for this purpose was issued in November 2015.
Finally, the Capital Requirements Regulation (CRR) contains an equivalence provision regarding third country exchanges (article 107). The beneficiaries of this equivalence decision are mainly EU banks, since they may treat exposures to third country exchanges similar as exposures to EU exchanges. Switzerland has not yet been considered as equivalent for this purpose.
5) Will Switzerland be deemed equivalent under the new EU share trading obligation?
Apparently, Switzerland is among the third countries listed in the first group of equivalence assessments (besides the US, Japan, Canada, Australia, Korea, Hong Kong, Singapore and certain Latin American countries). In general, the Commission does not only consider technical aspects when deciding upon equivalence. Instead, also aspects such as financial stability, investor protection, the integration of EU financial markets and regulatory convergence are taken into account. In the end, the Commission has full discretion on whether or not to pass a positive equivalence decision – this is a purely unilateral and discretionary act by the EU.
Therefore, it remains to be seen whether the issues which are generally considered as critical in an international comparison, such as the self-regulation system of the Swiss exchanges, will be a hurdle. The Financial Market Infrastructure Act (FMIA) filled some gaps between the Swiss and the EU regulation and lead to a positive equivalence decision by the Commission with regard to CCPs. Unfortunately, the Commission has not taken any positive equivalence decision with regard to Swiss trading venues yet, while at the same time various other third countries were deemed equivalent, be it under EMIR (article 2a) or CRR (article 107). The last batch of decisions was published in December 2016, i.e. at a point in time when the FMIA was already in force. Therefore, it cannot be taken for granted that the Swiss regulation will be assessed as equivalent by the Commission for the purpose of the share trading obligation.
6) Challenges for market participants in case of an absence of an equivalence decision under the new EU share trading obligation
a) In general
A delay by the Commission in rendering equivalence decisions under the new EU share trading obligation will cause a variety of issues for the market participants.
In particular, EU investment firms might be required to execute share trades outside the jurisdiction with the deepest pool of liquidity. Generally, low liquidity leads to wider spreads, resulting in worse prices. In particular, but not exclusively, dual-listed shares will be affected. An example is Apple, Inc.: Apple’s deepest pool of share trade liquidity is outside the EU, but its shares are also traded in the EU, at a significantly lower level of liquidity. If an EU investment firm undertakes a trade in Apple shares, either directly as arranger/transmitter or via booking arrangements, it will have to execute it on an EU trading venue, even though the price might be more favorable on a US exchange. Such discrepancies might cause market disruption, especially since those firms which are not bound by the trading obligation (e.g. AIFMs) may make use of deeper liquidity pools available at trading venues outside the EU.
In addition to the economic disadvantage, the constellation with different market conditions in- and outside the EU also creates an issue with regard to the EU investment firms’ obligation of best execution. This principle (article 27 MiFID II) obliges EU investment firms to execute orders on terms most favorable to the client, taking into account aspects like price, costs and speed. Hence, an investment firm might have to decide whether it infringes the best execution principle or the share trading obligation.
b) For Swiss trading venues
A large part of the share trading activities on SIX derives from EU investment firms. According to SIX, a substantial portion of shares traded on its trading venue would be affected by the lack of an equivalence decision. If the trading obligation cannot be fulfilled by trading on a Swiss trading venue (because Switzerland is not considered equivalent), EU investment firms have to switch to other trading venues which are recognized for the purpose of the share trading obligation. Therefore, the equivalence decision under article 23 MiFIR is crucial for Swiss trading venues.
Apart from Swiss trading venues, also Swiss branches of EU investment firms might be affected. Based on a strict reading of article 23 MiFIR, a trade undertaken by a third country branch of an EU investment firm might also fall under the share trading obligation as it is, eventually, a trade by the EU parent. Consequently, such trade could not be executed on a non-equivalent third country trading venue.
7) Conclusion
A positive equivalence decision under article 23 MiFIR in connection with article 25(4) MiFID II is of utmost importance for the Swiss trading venues. In case of a lack of equivalence, EU investment firms will be forced to execute trades in dual-listed stock on another trading venue outside of Switzerland. This potential consequence would be harmful to the Swiss financial market in its entirety, since a strong share trading venue with an international circle of participants is crucial for an international financial center like Switzerland.
We believe that the introduction of the FMIA will increase the probability of a positive equivalence assessment by the Commission regarding Swiss trading venues. Even though various aspects of the equivalence procedure are still unclear and, furthermore, technical equivalence does not ensure a positive decision on a political level, current signs are promising and Swiss exchanges could be among the first third country trading venues which will be considered equivalent for the purpose of the share trading obligation.
Marco Toni (marco.toni@loyensloeff.com)
Lea Hungerbühler (lea.hungerbuehler@loyensloeff.com)