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ISD will lead to greater harmony in EU, but problems remain to be overcome Back  
The revised Investment Services Directive has provoked a great deal of debate amongst the stockbroking and fund management sectors writes Patrick Wilkinson, particularly in relation to the ‚€ėinternationalisation‚€ô of client orders by investment firms.
On 25 September, 2003, the European Parliament approved at first reading the draft Investment Services Directive (the New ISD) published by the European Commission on 19 November, 2002. The New ISD, like the recently issued EU directive on market abuse (2003/6/EC), is part of the ongoing Financial Services Action Plan and adopts the legislative approach recommended in the Lamfalussy Report that was formally adopted by the Stockholm European Council in 2001. The New ISD has provoked a great deal of debate amongst industry participants, particularly in relation to those provisions which deal with the ‚€ėinternalisation‚€ô of client orders by investment firms. This article examines the impact of three of the more important changes proposed by the New ISD.

The Lamfalussy approach
Before examining the detail of the New ISD, it is important to note the context in which this directive has been prepared. The Committee on the Regulation of European Securities Markets that was chaired by Baron Lamfalussy recommended in its report that new European legislation in the financial services area should be more flexible and have the ability to change to meet developing market circumstances. Accordingly, a four level approach to the introduction of such legislation has been adopted going forward, namely (i) framework principles; (ii) implementing measures; (iii) cooperation; and, (iv) enforcement. The framework principles referred to in (i) above will be set out in directives, whilst detailed measures outlining how these principles are to be implemented will be adopted by way of further legislation issued by the European Commission acting with the assistance of a committee. It is worth noting therefore that the New ISD is intended only to provide a framework for the regulation of investment services within the EU and that further details regarding its implementation will be issued from time to time by the European Commission.

Amendments to the scope of the ISD Passport
Perhaps the most important facet of the existing investment services directive (the ‚€ėExisting ISD‚€ô) is the ability of one investment firm to ‚€ėpassport‚€ô those services that it conducts in its home jurisdiction into another EU member state. However, the differing requirements for authorisation as an investment firm amongst various Member States has led to a form of regulatory arbitrage where firms deliberately seek authorisation under the Existing ISD from regulators with less stringent requirements.

The New ISD introduces a single set of detailed requirements that all Member States will have to apply when considering an application for authorisation as an investment firm. These new requirements will provide a level playing field where all firms using the single passport can provide their services within a host Member State on the same basis as firms authorised by the regulator of such Member State.

In addition, certain key financial services were excluded from the Existing ISD. These included the provision of investment advice, commodity derivatives trading and the operation of multilateral trading facilities. (A multilateral trading facility is defined in the New ISD as ‚€ėa multilateral system which brings together multiple third party buying and selling interests in financial instruments ‚€‘ in the system and in accordance with non-discretionary rules ‚€‘ in a way that results in a contract.‚€ô) The New ISD includes these activities within its provisions and this is likely to be of significant benefit to those investment firms providing these services who wish to expand their horizons by availing of the passport now provided by the New ISD. However, it should be noted that whilst such firms may now avail of the passport under the New ISD they will also be faced with the imposition of initial and ongoing capital requirements as set out in the EU Capital Adequacy Directive (93/6/EEC) that may previously not have applied to them.

Conduct of business obligations
Article 18 of the New ISD states that investment firms must act ‚€ėhonestly, fairly and professionally‚€ô when providing investment services to clients. The New ISD goes on to stipulate certain obligations with which investment firms must comply in order to meet the standard set out above. Amongst these is the obligation to provide ‚€ėtimely information ‚€¶ in a comprehensible form ‚€¶ so that [clients] ‚€¶ are ‚€¶ able to understand the precise nature and risks of the investment service and financial instrument that is being offered.‚€ô In providing this information, regard will need to be had to the client‚€ôs circumstances, investment objectives and expertise. This clearly will present a significant burden to execution-only brokers and would not appear to be of significant benefit to those investors who wish only to receive a no-frills service as the costs of providing this advice will clearly be passed on to them.

Obligation to make public firm bid and offers
The principal area of debate, particularly from market participants, has centred on the obligations imposed by article 25 of the New ISD. This deals with the issue of firms that engage in trading off their own book or firms that match customer transactions. This ‚€ėinternalisation‚€ô of client orders by investment firms typically occurs where a firm processes client orders in house without going through a regulated market by matching a sale order in relation to a particular security with a buy order of a similar size. The Commission‚€ôs concern with internalisation is that that such trades occur outside a regulated environment and that, consequently, clients may not receive the best price available in the market. The Commission has now decided to impose certain requirements in relation to this practice.

Under article 25, investment firms will be required to make public a firm bid and offer price for transactions of a size customarily undertaken by a retail investor in shares listed, traded or dealt in on a regulated market. Investment firms must then trade with other investment firms or eligible counterparties at these advertised prices save where there are legitimate commercial reasons for doing otherwise.

The large investment banks, particularly those in Germany and UK where this practice is most developed and widespread, have expressed opposition to these proposals, although it appears that to date these protests have been to no avail. Under the new rules investment firms are unlikely to be able to continue to facilitate large trades from institutions through a combination of processing these in-house and by matching these to orders from other retail clients. The large banks have stated that article 25 will adversely affect the levels of liquidity within the market as large institutional transactions will now have to be carried out on a regulated exchange. In addition they argue that large institutional clients may also face delays in the execution of their orders as well as uncertainty in pricing as a result of the broker‚€ôs inability to trade an entire block of securities in one go. They have also pointed out that whilst pre-trade transparency is a worthwhile concept in principle, it will not work in isolation without the establishment of a uniform clearing and settlement mechanism such as operates within a NASDAQ-type environment where pre-trade transparency does work. It remains to be seen what impact article 25 will have. However any loss of competitiveness by the EU as a market for share trading will be regrettable.

Notwithstanding the ongoing debate regarding the impact of provisions such as article 25, the New ISD is to be welcomed, not least because of the greater level of harmony that it will bring to the financial services industry within Europe. According to the European Commission, greater integration of financial markets would lead to an increase of EU-wide GDP of 1.1 per cent over the next decade. However, with implementing legislation yet to be drafted by the Commission, the devil will be in the detail and the lobbying looks set to continue.

Patrick Wilkinson is an associate solicitor at Arthur Cox.

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