'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.
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
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
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
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
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
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
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
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.
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