Although a lot of ink has been spilled, and a lot of money spent, on getting ready for MiFID II, there is another regulation out there that is actually more dangerous, the EU’s Market Abuse Regulation, or MAR. Along with its sibling, the Market Abuse Directive, or MAD, they pose a double threat to market participants worldwide.
The first threat has to do with timing. Although MiFID II is currently scheduled to go into effect in January 2017, and there has been lots of discussion about a one-year delay, MAR/MAD is scheduled for July 2016, and there has been no indication of a delay in it. Thus it behooves every market participant to understand these regulations, their applicability and how to comply.
The second threat has to do with applicability. MAR says that it applies to any instrument traded on an EU venue, any instrument where the underlying trades on an EU venue, or any benchmark based on instruments traded on an EU venue. Importantly, it purports to apply to any market participant who trades these or who executes orders in them, no matter where the trade was done.
What the Rules Say
MAR/MAD covers two main subjects – insider trading and market manipulation. Let’s look at insider trading first.
Insider trading is covered in Chapter 2 of MAR and Article 3 of MAD. They define insider trading as “where a person possesses inside information and uses that information by acquiring or disposing of, for its own account or for the account of a third party, directly or indirectly, financial instruments to which that information relates. The use of inside information by cancelling or amending an order” is also culpable. That last sentence is very important because it is distinctly different from the SEC’s approach, contained in Rule 10b-5. Rule 10b-5 says that trading on what it calls material non-public information is culpable, although CFTC Rule 180 prohibits attempts to manipulate, and MAR/MAD says that even attempting to trade on it is a violation.
MAD says “that insider dealing, recommending or inducing another person to engage in insider dealing … , constitute criminal offences at least in serious cases and when committed intentionally.” Article 4 of MAR says that the monitoring and reporting obligation applies to “investment firms,” but doesn’t mention third country firms as defined in MiFID II. Finally, MAR/MAD makes it clear that brokers who execute orders for customers, but don’t trade as principal, are responsible for monitoring customer order flow for suspicious activity.
Market manipulation is covered in Article 12 of MAR and Article 5 of MAD. MAR defines manipulation as “entering into a transaction, placing an order to trade or any other behaviour which:
- gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of, a financial instrument, a related spot commodity contract or an auctioned product based on emission allowances; or
- secures, or is likely to secure, the price of one or several financial instruments, a related spot commodity contract or an auctioned product based on emission allowances at an abnormal or artificial level;
- unless … such transaction, order or behaviour ha[s] been carried out for legitimate reasons, and conform with an accepted market practice.”
That’s not all it has to say, however. It also lists “any other activity or behaviour … which employs a fictitious device or any other form of deception or contrivance,” and “providing false or misleading inputs in relation to a benchmark.”
MAD has much the same definition, so at least there is some consistency there. It does call out that “Member States shall take the necessary measures to ensure that the attempt to commit any of the offences referred to in Article 3(2) to (5) and (7) and Article 5 is punishable as a criminal offence.” So the EU regulators are pretty clear that unsuccessful attempts to manipulate the markets are as bad as successful ones. This raises one question, however, since the logic of enforcement has relied on the concept of damage to other market participants. If attempts to manipulate are unsuccessful, one wonders how the regulators will demonstrate damage.
Implications
The first implication is that, as with MiFID and Dodd-Frank, global market participants are facing different, and possibly competing, regulations from different regulators. For example, US persons transacting in EU instruments will be subject to MAR/MAD, while EU persons transacting in US instruments will be subject to SEC or CFTC rules. This is particularly important with insider trading because a recent decision by the US Second Circuit Court of Appeals eliminated insider trading culpability if the tippee (the trader) did not know that the tipper (the insider) was gaining financially from the information. Since no such ruling has been made in the EU, it is reasonable to conclude that comparable surveillance practices in the US and EU will not necessarily turn up comparable infractions, even for identical activities.
The second implication is that surveillance systems need specific patterns and metrics in order to issue alerts, and no such metrics are contained in any of the rules or the accompanying Regulatory Technical Standards (RTSs) issued by ESMA. The RTSs, which are about five times as long as MAR and MAD combined, spend a lot of time talking about such allowed procedures as buy-backs, stabilizations and market soundings, but no time addressing metrics. In fact, all the documents tend to define manipulative behaviors in terms of intent, as opposed to results. That will very likely lead to two possible outcomes – 1) excessive false positives, or 2) a lot of missed manipulations.
A third implication is that the reporting formats are different between the US suspicious activity report (SAR) and the EU suspicious trade or order report (STOR). A field-by-field analysis shows a significant number of fields in the STOR that aren’t in a SAR. For example: the name and position of the reporting person, the relationship of the reporter to the subject, the reasons for the suspicion, and the acting capacity of the reporting entity with respect to the subject.
Impacts
For US market participants there are three major impacts of MAR/MAD: surveilling unexecuted orders, preparing STORs, and reconciling US and EU approaches to insider trading.
Since Rule 10b-5 only applies to executed trades, complying with MAR/MAD will require introducing surveillance of unexecuted orders. To begin with, many trading systems either don’t keep unexecuted orders, or purge them after a short period. The same applies to dealer and multi-party networks. To the extent that those systems handle EU instruments and the parties are subject to MAR/MAD, order records will have to be retained and monitored.
Those systems that prepare and submit SARs in the US will have to be updated to create and submit STORs. That will mean determining whether the systems even capture the extra data elements identified above, and then the STOR messages will have to be formatted and sent to the appropriate regulator.
Finally, any monitoring and reporting system will need different logic for reporting suspected insider trading in the US and the EU. Since reporting any suspicious behavior on the part of a client carries significant risk to the relationship, investment firms will be walking a tightrope in either domicile.
Over all of these uncertainties is the biggest one, the fact that there are no metrics provided for determining when an activity is suspicious. As a result, firms will be left to grope their way down a dark corridor, trying to find a happy medium between over-reporting and missing an obvious event. Given the threat in MAR of being held criminally liable, it is no wonder that the prospect of implementing these rules by mid-July has left many firms not only unhappy, but downright angry.
