Spot FX could be dragged into Mifid II

The European Commission is looking to Australia as it considers pulling spot foreign exchange into Mifid II, the regime that exists for equities, bonds and derivatives – a radical change that industry lawyers and lobbyists have been hoping would fade from view, following intense criticism.

That hasn’t happened yet. In an email, an EC spokesperson points to the Australian model as a precedent for regulation of spot currency trading alongside securities markets.

“Market integrity laws like those for insider trading, market manipulation, and other market misconduct apply to spot FX – the design of Australian laws means essentially the same provisions apply to spot FX as to other products like other derivatives, futures, bonds and equities,” says the spokesperson.

The spokesperson also notes that firms and markets that provide spot FX services in the country require an Australian financial services licence.

“From our side we would be interested to observe and see whether [Australia’s regime] is a good precedent for clean FX markets worldwide,” they add.

Industry lawyers and lobbyists insist it is not. The Mifid II threat arises because the European Securities and Markets Authority is seeking to apply existing market abuse rules to spot FX. This could be achieved by redefining the product’s regulatory status, triggering a cascade of other requirements.

“It would take us a year to analyse what the consequences would be,” says Rob Moulton, a partner at law firm Latham & Watkins.

The issue came to light in October last year when Esma sought public comment on whether spot FX should be included in Europe’s Market Abuse Regulation (Mar), as part of a broader review of the regime.

Mar’s regulatory scope is drawn from the definition of financial instruments under the second Markets in Financial Instruments Directive, which does not currently include spot FX.

From our side we would be interested to observe and see whether [Australia’s regime] is a good precedent for clean FX markets worldwide

A European Commission spokesperson

Following this, the EC on February 17 published a consultation reviewing Mifid II and its accompanying regulation, Mifir. Though spot FX was outlined as a non-priority area within the consultation, the commission said it had received concerns from stakeholder and competent authorities “as regards the regulatory gap”.

It asked respondents whether “the current regulatory framework is adequately calibrated to prevent misbehaviours in the area of spot foreign exchange transactions”. If respondents didn’t believe the current framework was sufficient, it asked for suggestions about how to “improve the robustness” of the regulatory framework.

In Australia, spot FX transactions are regulated financial products, with market participants and platforms required to have licences. Under the Corporations Act 2001 and the Australian Securities and Investment Commission Act 2001, misconduct by licence holders can lead to enforcement actions. 

Introducing spot FX into Mifid II, though, could open up the asset class to the same rules as the equities and fixed income markets, such as trade reporting, best execution and electronic execution requirements, while trading platforms may have to register as multilateral trading facilities.

In its consultation, Esma noted the spot FX markets “might need to develop features required by Mifid II to trading venues and market participants regarding systems and controls, transparency, conduct requirements, and reporting obligations”.

That prospect has sparked heavy criticism from industry lawyers and lobbyists.

“I just hope the commission received sufficient signal to refrain from acting,” says Vincent Dessard, senior regulatory policy adviser at the European Fund and Asset Management Association.

“In a dream world, I would think that would be enough. With a more realistic approach, I think we’ve seen cases where up to the very last minute regulators decided to push forward,” Dessard adds.

Others argue that introducing potentially far-reaching regulations in just one jurisdiction may see trading shift away to other centres.

“We can understand and support that regulators want to look at how to improve conduct in their jurisdictions, but for FX, a global approach to a global market is our recommendation. Therefore, looking at a specific piece of legislation in the EU doesn’t seem to us to make the most sense,” says James Kemp, managing director of the global foreign exchange division of the Global Financial Markets Association.

Concerns centre around the sheer magnitude of changes that would be required of the spot FX market should it be dragged into scope of Mifid II.

“The moment you’ve got spot FX within the scope of Mifid and Mar that means all the Mifid rules apply to it. How will the product governance rules apply? Who created a currency and for which market? How would you apply best execution to a spot FX transaction? There are so many, almost unintended, consequences,” says Moulton at Latham & Watkins.

Lawyers say including spot FX in transparency, reporting and record-keeping requirements under Mifid II could result in significant additional costs for market participants. And with the Mifid II reporting regime designed for financial instruments that are significantly different to spot FX, transaction reporting fields would need to be amended.

Including spot FX in a sub-section of Mar may be the way forward, according to William Yonge, a partner at law firm Morgan Lewis. As the regulation focuses on exchange-traded financial instruments, he says it is difficult to see how spot FX would fit under the existing regulation.

Many industry responses argue the FX Global Code is the right way to tackle conduct on a global scale, suggesting any concerns could be addressed during its three-year review being conducted this year.

But there are worries the code isn’t working as efficiently as a regulatory regime would.

“With what is essentially a voluntary code, you don’t get market announcements when somebody has breached the code or been found to breach the code,” says Hannah Meakin, a partner at law firm Norton Rose Fulbright.

“There aren’t enforcement cases, or there isn’t a regulator that will take that case in the same way as you would do with a breach of Mar,” she adds.

In June last year, the UK Financial Conduct Authority confirmed its recognition of the FX code – meaning any individual subject to the Senior Managers and Certification Regime must follow “proper standards of market conduct” as outlined by the code.

Some industry sources say these regulatory tools are sufficient to ensure the code is being adhered to in the UK.  

“That’s a pretty significant set of sticks to beat the industry up with,” says one industry source.

The FCA declined to comment on the record.

It is understood that if any changes were made to Mifid II or Mar they would apply after the Brexit transition period, which ends in December. After that time, decisions on whether the UK would follow the European Union in adding spot FX to its version of Mifid II would lie with HM Treasury.