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Markets in Financial Instruments Directive

Markets in Financial Instruments Directive (MiFID) and Contracts for Differences

Q:How does the Markets in Financial Instruments Directive (MiFID) affect contracts for differences?

A: In November 2007 the infamous new EU regulatory regime for investment services, stock exchanges and alternative trading facilities took effect. The Markets in Financial Instruments Directive (MiFID) applies to investment firms and credit institutions when providing investment services and to regulated markets. MiFID is a comprehensive regulatory regime covering investment services and financial markets in Europe and introduces common standards for investor protection throughout the European Union.

Basically MiFID essentially relaxes the way shares can be sold, and one of the big impacts will be that companies based in the European Union will be able to to advertise their services across the EU. MiFID will lift restrictions on some forms of betting in the EU, and simplify the legal framework for foreign operators, opening a path for spread-betting and CFD trading companies to offer their services across the European region. With the boom in CFD and spread-betting business continuing unabated in the UK, the advent of MiFID in November has providers gearing up to market their products across Europe.

However, MiFID may also increase administration costs and lose investors. Under MiFID, providers of ‘complex’ products such as CFDs will have to ‘ask the client or potential client to provide information regarding his knowledge and experience in the investment field relevant to the specific type of product or service offered or demanded so as to enable to investment firm to assess whether the investment service or product envisaged is appropriate for the client.’ This essentially means that firms will be subject to far stricter controls on making sure they do not sell overly complex products to clients without the experience and capability to handle them.

Assessing Suitability: If an investor is offered a CFD as part of an investment advice package or as part of a portfolio management service, then the CFD can only be offered if the product is suitable for the investor. Suitability requires the investment firm to obtain sufficient information from the investor to have a reasonable basis for believing that the specific transaction to be recommended or entered into (as part of a portfolio management service) satisfies the investment objectives of the client and does not expose the client to risk of a kind he/she is not able to bear financially or understand. This places an obligation on CFD brokers to screen potential investors. If the firm does not obtain information from the investor to determine suitability, then the firm must not recommend the financial instrument to the investor. Where any other investment service is provided on a CFD (a complex product for regulatory purposes), then the investment firm must obtain information regarding the investor’s knowledge and experience of CFDs and make a determination of appropriateness. If on the basis of the information received the product is not appropriate then the (potential) client must be warned. The suitability and appropriateness test can only be avoided in limited circumstances, essentially where at the initiative of the client, execution and/or the reception and transmission of client orders on non complex financial instruments is provided.

Best Execution: Investment firms are also obliged to offer best execution when executing orders on behalf of a client – this principle also applies to many derivative products including CFDs and Spread Betting. Best execution is the obligation when acting on behalf of a client, to take all reasonable steps to obtain the best possible result for the execution of the client orders, having due regard to the wider market in any relevant instrument. The execution process has to be reflected in an execution policy, which must specify the execution venues and, where derivatives are concerned, must address and distinguish between exchange traded derivatives and OTC products. Additionally the client has to consent to the execution policy. The more onerous part of the best execution regime is the requirement that the investment firm demonstrates if required, to the investor that his orders have been executed according to the firm’s execution policy. Achieving best execution for derivatives like contracts for difference which are executed over-the-counter is not a simple proposition for brokers as in many cases the benchmarks particularly on pricing may not be available.

Lack of transparency: Lack of transparency with respect to substantial economic interests obtained through CFDs, allows the use of those interests as a means of exerting influence over, or to gain control of the voting rights attached to the underlying shares. Also, hedge funds may outflank traditional institutional investors by using economic interests obtained through CFDs to influence companies and that is a risk that some investors may be disadvantaged by investing in a market where others may have better information. The UK FCA (as well as other regulators) are taking steps to address this by requiring disclosure of substantial economic interests (this is defined as a 3% holding) in shares held through derivatives like CFDs.

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