This article was written by Ronen Kertis, CEO of Cappitech.
When any new financial regulation is passed and put into effect, a major question for firms is what falls under the scope of the new rules. Due to ambiguity and conflicts with other existing regulations and loopholes, many details of how to comply with the regulation can take years to finalize.
This dilemma is no different for MiFID II and its far-reaching overhaul of rules, due to take effect in January 2018. Within the online retail forex and CFD brokerage industry, there is currently much debate over whether leveraged forex trades are under the scope of transaction reporting requirements.
What are Transaction Reports under MiFID II?
MiFID II regulation is divided into several different rule sets. One of them is called Markets in Financial Instruments and Amending Regulation, or MiFIR. MiFIR is focused on supervisory and reporting rules around the execution of financial trades.
Among the sections of MiFIR is Title IV “Transaction Reporting”. Similar to the reporting obligated under EMIR regulation, MiFIR Transaction Reporting is a T+1 report that itemizes information related to individual trades. Relevant information that needs to be reported is buyer information, seller information, price, quantity, venue, ticket number, maturity data, and the underlying currency of the product.
What needs to be reported?
A big change from MiFID I to MiFID II is the widening of the selection of financial instruments under scope. MiFID I focused on exchange traded equity trades and derivatives based on equities. MiFID II has expanded reporting to include all financial instruments traded or based on venue traded product.
Detailing the obligation, Article 26.2 of MiFIR states:
- The obligation laid down in paragraph 1 shall apply to:
(a) financial instruments which are admitted to trading or traded on a trading venue or for which a request for admission to trading has been made;
(b) financial instruments where the underlying is a financial instrument traded on a trading venue; and
(c) financial instruments where the underlying is an index or a basket composed of financial instruments traded on a trading venue
The obligation shall apply to transactions in financial instruments referred to in points (a) to (c) irrespective of whether or not such transactions are carried out on the trading venue.
As seen from the above text, both venue traded products and derivatives based on them fall under the scope of MiFID II Transaction Reporting.
In the forex and CFD industry, this includes equity indexes, CFDs of EU based futures such as the FTSE, DAX and CAC, and single share CFDs of European based stocks like BMW, Unilever and Banco Santander.
What about forex trading offered by retail forex, CFD and binary options brokers?
When it comes to retail forex trading, we first need to define the product. Retail forex products are:
- Over the counter (OTC)
- Based on spot FX prices
- No immediate delivery
Due to these characteristics, the EU Commission has classified retail forex products as a financial instrument due it being “indefinitely renewed” and therefore like a CFD derivative. Due to this definition, most European financial regulators including the FCA in the UK and CySEC in Cyprus consider retail forex trades to be derivatives under EMIR Reporting regulation.
However, for MiFID II, just being a derivative doesn’t cause a product to be under scope for Transaction Reporting.
However, for MiFID II, just being a derivative doesn’t cause a product to be under scope for Transaction Reporting. Also required is that the derivative itself or underlying product that the instrument is based on be traded through a venue.
Regarding forex trading, products offered by retail brokers are based on OTC forex pricing and not venue based trades. As a result, this would theoretically nullify retail forex products from falling under MiFIR obligations.
However, although more than 99% of rolling spot forex trades are OTC based, there is a small percentage transacted on EU-registered trading venues such as LMAX. In addition, MiFID II definitions of trading venue will cause some bilateral ECNs to become registered venues as well. This should ultimately boost the amount of spot forex trading taking place on trading venues. As a result, one could argue that these venue listed forex products will thus cause the retail version of the product to fall under the scope of MiFIR Transaction Reporting.
The answer as to where forex falls isn’t just one of the extra work involved in the reports. This question also has major monetary effects. The more that has to be reported, the higher a firm’s costs, which can lead to thousands of dollars a month in additional expenses.
What’s the industry doing?
There are two main schools of thought on where retail forex trading products fall.
“Err on the side of caution” – One approach is to be safe and put in place a system to report forex trades (how to report them is a separate question due to a lack of ISIN number but that could be resolved prior to MiFID II going into effect).
There are two opinions behind this approach. One belief is that even if you take the approach that spot forex derivatives aren’t based on venue traded products, financial regulators will close this loophole and include forex in the future. Therefore, it makes sense to plan for it now. The other belief is based on the reasoning that spot forex products are appearing on trading venues and therefore do need to be reported.
This sentiment of taking the safe approach is widely seen around UK-based banks and the consultants serving them. However, it is worth pointing out that for firms such as banks, retail forex is a small percentage of their overall trading volumes and reporting them has only a minor impact on their operations.
“It’s not venue traded” – The other approach is that retail forex trading does not need to be reported. This is based on the assumption that the underlying products used to price retail spot forex are OTC based and not venue traded.
ESMA and country regulators haven’t issued specific opinions whether forex trades are under scope for MiFIR.
ESMA and country regulators have not issued specific opinions as to whether forex trades must be reported. However, several firms that have interpreted the answer as no have received feedback from local regulators that their reading is correct.
In this regard, brokers are looking for an extra layer of certainty by also submitting their opinions and requests for comment from their local regulators. Also, feedback from lawyers representing brokers has been that in lieu of clear cut rules, regulators will very often accept from brokers a legal opinion from a third party.