In the wake of the 2008 financial crisis, the European Union (EU) was forced back to the drawing board, like so many other jurisdictions, to review and revise how it regulates and supervises its financial markets. New and enhanced legislation closed loopholes laid bare by the crisis, capturing previously unregulated (or loosely regulated) products and activities, banning others, and substantially increasing disclosures to investors, markets and supervisors. With obsessive attention to detail, policymakers codified definitions of common industry terminology and reclassified clients owed the highest standards of investor protection.
In addition to significant legislative enhancements, the EU restructured its supervisory framework. As one of three independent European Supervisory Authorities (ESAs)1 established in 2011 on the recommendation of the 'de Larosière Report', the European Securities and Markets Authority (ESMA) was charged with the mission "to [safeguard] the stability of the European Union's financial system by ensuring the integrity, transparency, efficiency and orderly functioning of securities markets, as well as enhancing investor protection."2 ESMA executes its duty by vigilantly assessing risks to investors and markets on an ongoing basis. Its experts advise the EU Commission ("the EC" or "the Commission") on proposed technical standards and draft voluntary guidelines required to complete the "single rulebook" of harmonized laws governing EU financial markets.
The sudden onset of contagion spreading across financial centers was one of the most worrying aspects of the crisis. Despite rhetoric on a coordinated approach to regulatory reform such as the 2009 G-20 Commitments, which was signed by the executive branch of participating nations, national legislators responded on impulse with policy prescriptions tailored to their own domestic political and economic circumstances3. Financial institutions operating on a cross-border basis must now manage compliance with an increasingly complex web of laws and regulations from home and abroad.
The EC, the European Council and the European Parliament (EP), buttressed by technical advice from ESMA, promulgated a series of legislative packages that have collectively resulted in the EU emerging as a standard-setter in financial services regulation, especially where it changed the status quo or imposed a new framework on previously unregulated products and services. The EU is influencing market behavior and supervisory expectations in financial markets well beyond the reach of the law that triggered the change. As evidence, this essay describes three examples of EU policy remedies to weaknesses in financial markets and the impact of those actions, either directly or indirectly, on global markets. First, rules requiring the unbundling of research from other investment services is leading to a transformation of the business model. Second, the legally-binding requirements governing financial benchmarks have led to global efforts to replace London Interbank Offered Rate (LIBOR) with risk-free reference rates. Finally, equivalence provisions in certain regulations provides the EU with a potential conduit to influence the functioning of financial markets into the future.
Investment Research
The EU policy response to unchecked conflicts of interest in the financial services industry is transforming the provision of investment research as a business model.
The recast Markets in Financial Instruments Directive and the new Markets in Financial Instruments Regulation (MiFID II/MiFIR) is a massive legislative package implemented in 2018 after years of expert reports and proposals, representing the centerpiece of the European reform agenda4. To ensure that portfolio managers act in the best interest of their clients when deciding where to execute trades, enhanced conflicts of interest provisions in MiFID II/MiFIR require investment firms to unbundle fees for previously free investment research and revenue-generating execution services. Asset managers who provide independent advice must now pay for research to prove that they are not being induced to route other business to investment firms in exchange for the outwardly-free research – the true costs of which was absorbed into execution fees5. Under the new rules, investment firms providing research must substantiate pricing models, which must not take into account the volume of business received from independent investment advisors. Asset managers must demonstrate that they either pay for research directly from their own resources or charge clients by way of a specially-designated research payment account.
This dynamic is changing the market for investment research. For the most part, asset managers are assuming the expense of research because investment management clients are reluctant to pay for a once-free perk6. Smaller firms, unable or unwilling to bear the costs, are deciding not to provide research. Asset managers have reduced the number of investment firms from whom they receive research, which is contracting the market for investment analysts. The large US financial institutions who can afford to absorb the cost of providing research are lowering their prices to sweep up decreasing demand for paid research7.
The new EU framework may also affect current US rules. US broker-dealers are prohibited from receiving payment for research unless they are registered with the US Securities and Exchange Commission (SEC) as investment advisors. Likewise, US money managers who use client commissions to pay for analysis risk breaching the fiduciary duty owed to their clients. To allow US firms to continue providing research to EU clients and receive research from EU firms, the SEC issued temporary no-actions letters with respect to interactions with EU clients and firms only8. The resulting dual-track system with differing rules applicable to US firms and clients means US investors bear the costs previously shared by EU clients. Pressure is mounting to align US rules with MiFID II before the stopgap measures expire in mid-20209.
LIBOR Reform
LIBOR reform is a complicated issue with implications reverberating outward from the EU. The weaknesses that EU policymakers sought to address require some explanation.
The terms reference rate, index and benchmark refer to a financial value (e.g., LIBOR or the federal funds rate) used to determine the amount payable on a financial instrument or contracts such as swaps, bonds, commercial loans and consumer mortgages. Questions surrounding a benchmark’s accuracy could present a considerable systemic risk. LIBOR alone is used in contracts valued at hundreds of trillions of dollars globally. Yet, surprisingly, financial benchmarks were not regulated until global standard-setters and national supervisors tackled the scandals that came to light in the waning days of the financial crisis. Despite early efforts to impose standards of market behavior, global efforts were voluntary and limited in scope.
In 2013, the International Organization of Securities Commissions (IOSCO) published the Principles for Financial Benchmarks10 to address widespread manipulation of previously unregulated reference rates.11 The IOSCO Principles established basic international standards for governance, oversight, input data, and methodology. The EU significantly expanded on this initial step with the EU Benchmarks Regulation (BMR) to ensure the accuracy and integrity of benchmarks used within its borders.12 There are several differences between the IOSCO Principles and BMR, not least of which is the level of prescriptive detail. Whereas IOSCO’s voluntary measures apply to administrators who provide the benchmark, BMR imposes legally enforceable requirements on benchmark administrators, contributors as well as EU-supervised users, who are all subject to hefty penalties for violation.
BMR establishes categories of benchmarks based on sector13 and/or level of criticality to the domestic economy of the EU member state where the administrator is located.14 Mandatory and optional provisions are tailored to the risks of the benchmark in question. LIBOR is provided by a UK-based administrator regulated under BMR.15 Since LIBOR qualifies as both a critical and interest rate benchmark under the regulation, its administrator and contributors must comply with strict rules on hierarchy of input data which prioritizes verifiable transaction data over expert judgements (read: guesstimates).
LIBOR was originally developed to measure the rate at which banks lend to each other. However, due to subsequent changes in how wholesale lending functions, there is insufficient transaction data to calculate the benchmark with accuracy.16 Contributors, wary of legal liability under BMR, negotiated with the UK financial supervisor17 to continue to submit input data for a specified period to calculate LIBOR using an interim methodology developed by the administrator. With a phase-out date looming, working groups comprised of financial supervisors18 and market participants across the financial sector are actively collaborating on the development of alternative reference rates to replace LIBOR and similar benchmarks. ISDA and various trade bodies are developing industry-wide terms for standardized contracts.
The need for LIBOR’s administrator, contributors and users to comply with BMR precipitated the transition away from the world’s most-referenced financial benchmark. To date, the EU is the only jurisdiction with a comprehensive rubric for the regulation of benchmarks. While working groups collaborate on the development of alternate rates and contract terms, financial institutions as well as corporations who use LIBOR must replace it in their contracts with alternative reference rate(s). Moreover, authorities from non-EU jurisdictions have expressed expectations that firms under their supervision make the change.19
Some may argue that global standards, not EU rules, are driving the transition away from LIBOR. While analysis from the Financial Stability Board (FSB)20 and IOSCO21 affects decisions and provides expertise on developing and nominating alternative reference rates, their statements are recommended guidance. These voluntary measures are high-level, lacking in detail. In progress reports, IOSCO found that many of the large benchmarks slated for phasing out because they cannot meet the more stringent BMR requirements did in fact implement the Principles.22 Implementation improved governance and oversight but not the quality of the input data used to calculate the benchmarks. 23
Most importantly, adherence to global standards is merely encouraged, enforceable by institutional peer pressure (e.g., published reports on the status of national implementation). It is no match for the potent motivator of legally-binding, technical prescriptions in a regulation that is subject to criminal and civil penalties. Global standard-setting bodies may have moral authority to sway behavior, but regulators acting under force of law have the power to dictate market conduct.
Equivalence Regime
Not only has the EU shown that it has the means of affecting the behavior of firms and supervisory expectations, its equivalence regime is a conduit to more directly spread its influence to the legal frameworks of other jurisdictions.
Equivalence provisions in certain EU rules provide third country firms (i.e., non-EU firms) with access to its financial markets and customers without the costs and effort of complying with duplicate regulations in both the home and host countries. The equivalence assessment also lessens the likelihood of home and host jurisdictions imposing conflicting rules in key areas of regulation. Subject to additional conditions specified in the regulation, the Commission may rely on supervision by regulators in foreign countries whose legal regimes are deemed sufficiently equivalent to the corresponding regulatory, supervisory and enforcement framework in the EU. The assessment may be based on the similarity of regulatory outcomes as opposed to a direct line-by-line comparison of home and host laws and regulations.
When assessing equivalence, the Commission balances the goals of international supervisory convergence with EU interests, usually some variation on the oft-cited objectives of protecting EU investors and preventing instability of its financial markets. Policymakers also focus on economic goals of drawing business opportunities to the European Single Market and offering its consumers a greater range of financial products and services. The weight accorded to any given objective may vary depending on strategic priorities.
The EC, with input from co-legislators, the European Council and the EP have broad discretion to unilaterally grant an equivalence decision. Crucially, the EC is also empowered to review, amend and withdraw such decisions. Recall that in its role as a technical advisor to the EC, ESMA is tasked with the ongoing monitoring of risks to investors, markets and financial stability. Subsequent changes to a foreign regulatory framework originally deemed equivalent could ostensibly result in amendments to or withdrawals of recognition thereby endowing the EU with the ability to exert — possibly politically or economically motivated — influence in foreign financial markets.
A recent example supports the case. The EC granted equivalence to trading venues in the US, Hong Kong, Australia and Switzerland in mid-December 2017, within a month of the go-live date for MiFID II/MiFIR. The expedited equivalence decisions permitted investment firms using these foreign trading venues to fulfill the EU trading obligation in respect of shares. Even though the EC found that Switzerland met all of the statutory conditions required for an equivalent trading venue, it nevertheless limited the decision to a period of one year, purportedly "[t]o ensure the integrity of financial markets in the Union."24Any subsequent decision to extend that period would depend on "progress made towards the signature of an Agreement establishing [a] common institutional framework." Swiss officials view this as a political maneuver in ongoing negotiations surrounding the more than 100 bilateral agreements which form the basis of the country’s relationship with the EU. The potential for re-assessment, if not outright expiration, of equivalence is being leveraged to motivate Switzerland to develop an agreeable legal framework, potentially one that matches the letter more than merely the spirit of EU rules in order to retain access to an essential neighboring market.25
Conclusion
This list is indicative, not exhaustive. There are additional examples. There is evidence that non-EU firms implemented the higher EU standards globally for research and technological enhancements for MiFID II/MiFIR reporting requirements. Moreover, the EU continues to refine its regulation of financial markets. In late 2018, ESMA issued a consultation paper seeking industry input on proposals to incorporate sustainable finance considerations into MiFID II/MiFIR. EU policymakers are also exploring the regulation of cryptocurrencies. The EU is poised to increase its influence across the financial spectrum, particularly in areas where it is the first to impose comprehensive regulations.
Lastly, a couple of thoughts on Brexit and the flow of influence in both directions between the EU and the U.K. First, in order to retain access to EU markets and customers, the U.K. will have to achieve equivalence as a third country with current and future EU laws and regulations. Although events are still in flux, at last check, it was still the Government’s intention to incorporate all current EU laws into U.K. law,26 then Parliament will decide over time which provisions to retain, amend or repeal. In financial services, most provisions will likely remain, keeping the U.K. bound to the EU in the very manner hardline Brexiteers have so vehemently protested, enforced compliance without an effective voice at the table. This highlights yet another regrettable aspect of the U.K.’s departure from the EU. The contributions of UK regulators and technical experts during the development of the post-crisis financial regulations offered a sound counterbalance to continental tendencies to prioritize retail investor protection considerations over the practical implications for capital markets. Tilting the balance in either direction is flawed. EU policymakers and regulators will in turn bear the loss of the UK’s influence and technical expertise in capital markets — admittedly of its own volition — over ongoing risk monitoring and assessments, policy development, and decision-making in the EU.
Footnotes
1 The other two ESAs are the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA).
2 "Who We Are", Who We Are, European Securities and Markets Authority, https://www.esma.europa.eu/about-esma/who-we-are.
3 "Leaders’ Statement: The Pittsburgh Summit", U.S. Department of State, Diplomacy in Action, link.
4 "Investment services and regulated markets - Markets in financial instruments directive (MiFID)", European Commission, link.
5 Council Regulation No. 2017/593 on the safeguarding of financial instruments and funds belonging to clients, product governance obligations and the rules applicable to the provision or reception of fees, commissions or any monetary or non-monetary benefits, O.J. L 87/500, link.
6 Attracta Mooney, "The definitive list of asset managers that will pay for research," Financial Times, February 22, 2018, link.
7 Hannah Murphy, Stephen Morris and Attracta Mooney, "Mifid II has thrown up several unintended consequences," Financial Times, January 2, 2019, link.
8 "SEC Announces Measures to Facilitate Cross-Border Implementation of European Union’s MiFid II’s Research Provisions", U.S. Securities and Exchange Commission, last modified 2017, link.
9 Siobhan Riding, "End the clash over EU research rule, SEC urged," Financial Times, February 3, 2019, link.
10 The Board of the International Organization of Securities Commission, Principles for Financial Benchmarks, June, 2019. link.
11 Between 2013-15, the UK imposed a national regime of legally-binding requirements on administrators of and contributors to eight specific benchmarks, including LIBOR and SONIA.
12 "Benchmarks", European Securities and Markets Authority, link.
13 BMR "sector benchmarks" include interest rate, commodity and regulated-data benchmarks.
14 BMR "benchmark types," critical, significant or non-significant, are categorised by qualitative and quantitative criteria.
15 As of this writing (winter 2019), the UK is still a full member of the EU and subject to EU law. Moreover, the UK has stated its intention to incorporate BMR into national law when it officially leaves the EU.
16 Financial Conduct Authority, 2017, "The future of LIBOR", link.
17 Financial Conduct Authority, 2017, "FCA statement on LIBOR panels", link.
18 LIBOR is quoted in five currencies (GBP, EUR, USD, JPY and CHF). Working groups in each of the five jurisdictions have designated or developed an alternate risk-free reference rate based on input data available in that currency.
19 Federal Reserve Bank of New York, 2018, "The Transition to a Robust Reference Rate Regime", link.
20 Financial Stability Board, Reforming major interest rate benchmarks: Progress Report, November 14, 2018, link.
21 International Organizations on Security Commissions, 2018, "Statement on Matters to Consider in the Use of Financial Benchmarks", link.
22 The Board of the International Organization of Securities Commissions, Review of the Implementation of IOSCO’s Principles for Financial Benchmarks by Administrators of Euribor, Libor and Tibor, July 2014, link.
23 The Board of the International Organization of Securities Commissions, Second Review of the Implementation of IOSCO’s Principles for Financial Benchmarks by Administrators of Euribor, Libor and Tibor, February 2016, link.
24 Commission Implementing Decision 2017/2441, 2017, O.J. L 344/52, link.
25As of this writing, the EC proposed to extend interim recognition of Swiss trading venues under MiFIR until 30 June 2019, link.
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