RegTech Intelligence 
JWG analysis.
‘What is proportional?’ is a question that firms may well find themselves pondering in the coming months as they begin implementation planning for MiFID II … and the same question is going to be asked by risk and compliance specialists on a regular basis once MiFID II goes live in 2017.
This is because, as ESMA made clear in their discussion paper, they will be relying on the ‘proportionality principle’ (they initially laid this out in the ESMA guidelines on ‘systems and controls in an automated trading environment for trading platforms, investment firms, and competent authorities’) when setting out the organisational requirements for investment firms. (Which include a mandatory twice-annual self-assessment on the application of the said principle.)
However, it is hardly a well-established regulatory principle, and the vague nature in which ESMA have laid it out is sure to cause plenty of confusion. This article will discuss a number of issues this lack of clarity is likely to cause.
The specific application of the principle is to risks stemming from algorithmic trading activities, and the organisational requirements which are mandated to mitigate such risks. By this, ESMA mean the overloading of the systems, duplicative or erroneous orders, or malfunctioning that may create disorderly markets. The necessary organisation requirements are laid out in article 17 of MiFID II and include effective systems and risk controls, the provision of a description of the nature of algorithmic trading strategies, market making obligations and DEA controls. This obligation will also include – in instances when a firm does not think a particular rule applies to them – the ability to explain why.
The rationale for this is that MiFID II will affect such a diverse array of firms in terms of size and operation that the rules cannot be applied uniformly. In theory this should allow firms to fine tune the requirements in a way which applies more appropriately to their business. Whilst this is undoubtedly sensible, it conflicts with the need for clear enforceability from ESMA’s point of view, creating a trade-off between enforceability and flexibility that ESMA is doing its best to negotiate, but which is patently a tough ask.
The reason that this will be a never ending question is that ESMA says investment firms should be able to demonstrate, at all times, to their respective NCAs how they are applying the proportionality principle. This is in addition to the aforementioned expectation that investment firms will be expected to complete a bi-annual self-assessment.
In relation to questions 196 to 198, the discussion paper provides a non-exhaustive list of considerations to be involved in the application of the proportionality principle and these span the ‘nature, scale and complexity’ of a firm’s business. By ‘nature’, ESMA primarily means the role that the firm plays in the market, its strategies and its level of automation. ‘Scale’ is in terms of volume, value and the number of algos, trading desks and markets accessed. ‘Complexity’ is defined as primarily being regarded in terms of algo coding, trading strategies and infrastructure.
There will be some concerns within the industry about how closely ESMA are actually sticking to their own principle, and this ties into the debate around prescription versus principles, which came out of the 7/8 July Paris hearing. To briefly recap; the EU has taken a hard swing towards prescription, but has not necessarily had the stomach to write down all of the necessary specifics. Nor should they want to, or will ever be able to. For a lot of these terms, some level of judgement will always need to be applied.
Such concerns may well be raised since ESMA lay down minimum organisation requirements alongside, stating their intention to rely on the proportionality principle, which arguably compromises the flexibility that the principle should give to firms, particularly small and medium sized ones.
This is a critical issue since the minimum standards will not apply equally, but will give large firms a natural advantage due to the fact that they have more resources to be able to comply, and prove that they comply. This has further implications. It could damage the market itself if the minimum standards are onerous enough to force out smaller players and, therefore, reduce competition which is, of course, the opposite of one of MiFID II’s core objectives.
There is also a problem in the sense that a lot of the proportionality measurements are subjective to the point of becoming meaningless. For instance, how a firm should measure the level of automation of its processes remains far from clear, as does how it measures the nature of the strategies that it employs.
The problems do not end here. As we spelt out in our previous article on the ownership of regulatory problems within firms, the use of reasonable, adequate and responsible are all terms that will provide similar headaches.
It is also worth noting that these are not problems exclusive to MiFID II. A wide array of regulations, across numerous jurisdictions, use the word ‘proportional’ in varying ways in reference to slightly different issues, thus making the definition even more confusing. For instance, under Dodd-Frank it is used in reference to the monitoring of conflicts of interest and the term is also used, not necessarily in the same context, in CRDs, Basel III and EMIR, to name just a few.
It may be sensible to assume that ESMA will keep their hands clean on this and it will ultimately come down to NCAs and the way that they regard the investment firms under their jurisdictions. The real danger for firms is that they could be subject to the whim of whomever has been assigned to ‘measure their proportions’ at any given time. And where the home and host regulators take different approaches, there may be a need for varying control systems, policies and procedures.
This will be one of the many topics of discussion at the Capital Markets Forum in London on 23 September, which will have representatives from, amongst many others, the European Commission, the FCA and the Bank of England. Book your place by 29 August to get an early bird discount and hear what they have to say.