EMAC Working Paper on ISD

17 September 2002



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The Secretariat of the EP Economic and Monetary Affairs Committee (EMAC) today published the Working Document of Mrs Theresa Villiers, MEP, on the Investment Services Directive. There will be a discussion in EMAC Committee on 1/2 October.

Mrs Villiers stated in the Document that 'the ISD Directive should create the conditions for high quality competitive, integrated, liquid, transparent, orderly and efficient markets in the EU, responsive to the needs of their users. It should not prescribe a particular market structure and should be flexible enough to accommodate the diversity of market structures in different EU countries.'

'Rules should be proportionate and justified in terms of their costs and benefits' she went on. 'It is not sufficient simply to apply similar rules to similar trading methodologies.'

Problems:

  • Country of Origin. It should be made clear that country of origin control is exclusive and that Member States cannot impose further conduct of business, prudential, authorisation or other rules, on incoming services from other Member States.

  • Related Laws. The new ISD will have an impact on a number of areas and provides definitions used in various other directives. Most importantly, it is presently used to define which non-banks are included in the capital adequacy directives.

  • Structure of the ISD. One of the most difficult ISD issues to resolve will be drawing the borderline between levels. The Revised Orientations arguably include rather more detail at Level 1 than the existing, pre-Lamfalussy ISD.

  • Investment Advice. The Commission’s indication that it intends to make investment advice a core service under the new ISD is controversial. In a number of Member States, financial advice is given by small businesses.
    Possible Solutions:
    - Retain the existing regime and leave financial advice as a non-core service.
    - Financial advice could become a core service but without imposing capital requirements on advice-only firms.
    - A tailored capital framework for advice-only firms. The EU could keep the existing regime and leave financial advice as a non-core service.

  • Derivatives. The Commission is considering extending the ISD to cover certain types of derivatives, including commodity derivatives. EMAC will need to examine the ways in which the Directive should be amended to take into account the specific characteristics of derivatives markets.

  • Execution-Only Services. A significant number of consumers in the EU choose the shares and investments which they want to buy or sell. CESR’s Draft Conduct of Business rules suggest that these services should be subject to new additional regulation by requiring a detailed risk assessment to be carried out for all clients.

  • Securing Investor Choice. The existing ISD gives regulated entities the option of becoming an investment firm or a regulated market. The Commission proposes to continue this approach but with changes reflecting market developments.

    A variety of execution methods have emerged and no single market model can accommodate the needs of all market users. There seems to be a very widespread consensus that the Commission is correct to propose that concentration rules should be abolished and replaced by a combination of transparency and best execution rules, allowing investors freedom to choose from a range of execution venues.

  • Best Execution. There is widespread support for imposing a “best execution” rule to ensure the interests of retail investors are protected. Consideration will have to be given to whether the best execution rule should apply to all investors or just retail.

  • Post-trade transparency. There is also extensive support for making post-trade transparency rules a key part of the new ISD, though views differ on the precise extent of disclosure requirements.

  • Mandatory pre-trade transparency. It is generally agreed that large trades should not be subject to any pre-trade transparency rules, nor should trades in illiquid stocks.

    Arguments put in favour of pre-trade transparency:
    - Widespread off-exchange trading could reduce the interaction between buy and sell interests, thereby rendering price formation less efficient, increasing spreads and adversely impacting prices;
    - Mandating pre-trade transparency is important to enable investors to evaluate their potential trades and work out if they have received best execution;
    - If investment firms are performing functions which are similar to those carried out on regulated markets, they should be subject to the same pre-trade transparency requirements.

    Arguments put against:
    - Mandatory pre-trade transparency is impractical and unworkable and would amount to a de facto introduction of concentration rules in Member States;
    - Mandatory pre-trade transparency may be misleading if it discloses prices to which only the members of a particular specialist system have access;
    - Mandatory pre-trade transparency could reduce liquidity and increase volatility.

  • Alternative Trading Systems. The EU needs to consider whether specific new regulation is needed for ATSs or whether the general rules for investment firms continue to cover all relevant activities.

    The Commission is adopting a functional approach to regulation which seeks to impose on ATSs the rules based on the model of regulated markets because they perceive ATSs as carrying out the same, or similar, functions.

    EMAC will also need to consider whether more flexibility should be built into any new framework for ATSs.

    Note: The paper refers to the Commission’s Overview Paper and Revised Orientations on the new Investment Services Directive, published in March 2002, but that may not reflect the Commission’s final proposal, which is expected in November.

    Working Document

    © European Parliament