EU Securities and Financial Markets Regulation (Oxford European Union Law Library) [4 ed.] 9780198844877, 0198844875

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OX F O R D E U L AW L I B R A RY General Editors: ROBERT SCHÜTZE Professor of European and Global Law, Durham Law School and Co-Director, Global Policy Institute, Durham Law School PIET EECKHOUT Professor of Law, King’s College London and Director of the College’s Institute of European Law

EU Securities and Financial Markets Regulation Fourth Edition

OX F O R D E U L AW L I B R A RY The aim of the series is to publish important and original studies of the various branches of EU law. Each work provides a clear, concise, and critical exposition of the law in its social, economic, and political context, at a level which will interest the advanced student, the practitioner, the academic, and government officials. other titles in this series EU Constitutional Law Koen Lenaerts, Piet Van Nuffel, Tim Corthaut

EU Anti-​Discrimination Law Second Edition Evelyn Ellis and Philippa Watson

EU Customs Law Third Edition Timothy Lyons

The EU Common Security and Defence Policy Panos Koutrakos

Principles and Practice in EU Sports Law Stephen Weatherill

EU External Relations Law Second Edition Piet Eeckhout

EU Justice and Home Affairs Law Fourth Edition Steve Peers EU Procedural Law Koen Lenaerts, Ignace Maselis, Kathleen Gutman, Janek Tomasz Nowak

EU Employment Law Fourth Edition Catherine Barnard The EU Common Fisheries Policy Robin Churchill and Daniel Owen

EU Securities and Financial Markets Regulation Fourth Edition N IA M H M O L O N EY

Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © Niamh Moloney 2023 The moral rights of the author have been asserted First Edition published in 2002 Third Edition published in 2014 Fourth Edition published in 2023 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Public sector information reproduced under Open Government Licence v3.0 (http://​www.natio​nala​rchi​ves.gov.uk/​doc/​open-​gov​ernm​ent-​lice​nce/​open-​gov​ernm​ent-​lice​nce.htm) Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number: 2023930687 ISBN 978–​0–​19–​884487–​7 DOI: 10.1093/​law/​9780198844877.001.0001 Printed and bound in the UK by TJ Books Limited Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work.

To my mother, Mary, and in memory of my father, Noel

Preface EU Securities and Financial Markets Regulation addresses the harmonized regulatory regime and supporting institutional arrangements which govern the EU financial markets. The first edition of this book (2002) went to press as the 1999 Financial Services Action Plan reform agenda, the first major reform agenda in EU securities and financial markets regulation, was constructing the bones of the current system of EU securities and financial markets regulation. The second edition (2008) went to press in early autumn 2008 as the EU financial system was about to be gripped by a series of monumental crises which led to a reform process of titanic and historic proportions, a process which was addressed by the third edition (2014). This fourth edition (2023) also addresses a period of significant change, albeit one less marked by crisis and instability. The defining feature of the period since 2014 has been the ever-​intensifying influence of technocracy, particularly in the shape of the European Securities and Markets Authority (ESMA), as the mammoth financial-​crisis-​era ‘single rulebook’ has been amplified in intricate and immense detail through administrative rules and soft law, and as supervisory arrangements of increasing maturity and institutional sophistication have developed. Legislative reform has also continued apace, including the new prudential regime for investment firms (the 2019 Investment Firm Directive/​Investment Firm Regulation), the revised prospectus regime (the 2017 Prospectus Regulation), the new regimes for money-​market funds and for benchmarks (the 2017 Money Market Fund Regulation and the 2016 Benchmark Regulation), and the new regimes for securitizations and securities financing transactions (the 2017 Securitization Regulation and the 2015 Securities Financing Transactions Regulation), as well as the swathe of legislative reforms to measures adopted over the financial crisis era. Alongside, the market and political context that shapes EU securities and financial markets regulation has proved highly dynamic. The adoption of the Capital Markets Union agenda, the rise of sustainable finance, and the withdrawal of the UK from the EU are only three of the forces that have shaped EU securities and financial markets regulation since 2014. All these developments are considered in this fourth edition which is, in very large part, a new work. A note on scope is warranted. EU Securities and Financial Markets Regulation addresses market-​based financial intermediation between suppliers of capital and firms seeking capital. It accordingly addresses how the array of market actors engaged (including issuers of securities, market ‘gatekeepers’ such as credit rating agencies, investment firms, investment funds, and market infrastructures such as trading venues and central clearing counterparties) are regulated and supervised. It does not address the particular rules and supervisory arrangements that govern deposit-​taking entities as regards their banking activities and so does not address Banking Union, save as regards its interaction with investment firms and services. Cognate spheres of regulation, including the EU regime relating to financial crime (including anti-​money laundering and anti-​terrorism financing rules), EU company law (including takeover regulation), and the governance of Economic and Monetary Union (EMU), are not addressed. Digital finance also falls outside the scope of

viii Preface this book as its coverage is concerned with ‘financial instruments’ and so it does not address crypto-​assets where these assets are not characterized as financial instruments. The new Markets in Crypto-​Assets Regulation (MiCAR) is, accordingly, not addressed. Over the twenty-​five years or so during which this book has been written and new editions published, EU securities and financial markets regulation has been transformed out of all recognition. EU financial markets are now governed by a regulatory regime the depth, breadth, sophistication, and dynamism of which would have been difficult to predict in 2002; while the supervisory arrangements that support this regime are of an intricacy, maturity, and degree of centralization that would also have been hard to predict. Relatedly, the move towards the EU (and not the Member States) being the location for the development and adoption of financial markets regulation has been decisive. Prediction remains perilous, but the technocratic capacity the EU now has as regards financial markets governance, the extent to which EU financial markets regulation extends across the financial market population, and the dynamism of ESMA’s evolution and of the development of supervisory arrangements all suggest that the regime will continue to deepen and evolve. Much of this book was written over a period of research leave over 2021–​2022 from the Law School of the London School of Economics and Political Science, for which I am very grateful. I continue to learn from my LSE students and colleagues: the Law School is an intellectually exciting and warmly supportive place to work. Over the last twenty-​five years or so I have benefited hugely from the insights of the many academic colleagues, regulators, policy-​makers, and practitioners who have deepened my understanding of the complexities and subtleties of this field. I owe a special debt of gratitude to Professors Guido Ferrarini, Klaus Hopt, and Eddy Wymeersch, whose pioneering work in this field sparked my interest in this area, and to Professors Kern Alexander, Pierre-​ Henri Conac, Eilís Ferran, and Jennifer Payne, with whom I have discussed many of the issues addressed in this edition. I am very grateful to Oxford University Press and, in particular, to Louise Karam and Eilidh Burnett, who oversaw the production process for a large and complex manuscript with exemplary professionalism. Any errors or material omissions are my responsibility. My greatest debt of gratitude is to my wonderful husband, Iain. His constant patience and support and his unflagging interest and enthusiasm made it possible for me to write this fourth edition, and he has been steadfast in his support since the first edition of this book in 2002. The book aims to state the law and major policy developments as at 1 November 2022. It has, however, been possible to squeeze in some later developments in places. Niamh Moloney Dublin and London 1 February 2023

Contents Detailed Contents  Table of Cases Table of Legislation List of Abbreviations I. The Institutional Setting  II. Capital-​Raising 

xi xxi xxiii xliii 1 67

III. Collective Investment Management 

231

IV. Investment Firms and Investment Services 

347

V. Order Execution Venues 

441

VI. Trading 

529

VII. Rating Agencies 

637

VIII. Market Abuse 

679

IX. Retail Markets 

755

X. Third Countries  Index 

849 911

Detailed Contents Table of Cases  Table of Legislation  List of Abbreviations  I. The Institutional Setting 

I .1 EU Securities and Financial Markets Regulation  I.2 The Objectives of Financial Markets Regulation  I.3 Financial Markets Regulation and the EU: Building an Integrated EU Financial Market  I.3.1 The Treaties and the Single Market: The Role of Law  I.3.2 Market Finance, Financial Market Integration, and Capital Markets Union  I.4 From the Segré Report to the Covid-​19 Pandemic  I.5 EU Financial Markets Governance: Law-​making and Supervision  I.5.1 Law-​making  I.5.2 Supervision and Enforcement  I.6 EU Financial Markets Governance: ESMA  I.6.1 ESMA  I.6.2 Origins and Evolution  I.6.3 Governance, Powers, and Legitimation  I.6.4 Regulatory Governance  I.6.5 Supervisory Convergence, Risk Monitoring, and Direct Intervention  I.6.6 Centralized Supervision, ESMA, and the EU Financial Market  I.7 Looking to the Future  I.7.1 Bending to Uniformity?  I.7.2 Sustainable Finance  I.7.3 Technological Innovation and Digital Finance 

I I. Capital-​Raising 

II.1 Introduction  II.1.1 Introduction  II.1.2 The EU Issuer Disclosure Rulebook  II.2 Capital Markets, Issuer Disclosure, and the EU  II.2.1 Capital Markets and Issuer Disclosure  II.2.2 Issuer Disclosure and the EU: Market Finance and Market Integration  II.3 The Evolution of the Issuer Disclosure Regime  II.3.1 A Dynamic History  II.3.2 Early Efforts  II.3.3 The FSAP and Reform  II.3.4 The Global Financial Crisis Era  II.3.5 In the Wake of the Global Financial Crisis: Capital Markets Union and the Covid-​19 Pandemic  II.3.6 The SME Agenda  II.4 The Prospectus Regulation 

xxi xxiii xliii 1 1 2

6 6 11 17 20 20 26 31 31 32 38 45 49 53 56 56 58 62

67 67 67 68 70 70 78 82 82 83 84 85 85 87 90

xii  Detailed Contents I I.4.1 The Evolution of the Prospectus Regime  II.4.2 The Prospectus Rulebook: Legislation, Administrative Rules, and Soft Law  II.4.3 Setting the Perimeter: Public and Private Markets  II.4.4 The Prospectus: Disclosure  II.4.5 Prospectus Format: The Standard Form  II.4.6 Publication and Dissemination  II.4.7 Prospectus Supplements  II.4.8 Prospectus Validity  II.4.9 Calibration and Differentiation: Multiple Prospectus Formats  II.4.10 Market Integration: Prospectus Approval and the Passport Mechanism  II.4.11 Advertising  II.4.12 Supervision and Enforcement  II.5 Ongoing and Periodic Disclosure: The Transparency Directive and the Market Abuse Regime  II.5.1 The Transparency Directive  II.5.2 The Transparency Directive: Evolution  II.5.3 The Transparency Rulebook: Legislation, Administrative Rules, and Soft Law  II.5.4 The Transparency and Prospectus Rules: An Integrated Regime?  II.5.5 Transparency Directive: Scope  II.5.6 Transparency Directive: Differentiation, Exemptions, and SMEs  II.5.7 Transparency Directive: The Issuer Disclosure Regime  II.5.8 Transparency Directive: Ongoing Disclosure on Major Holdings  II.5.9 Transparency Directive: Market Integration and Home Member State Control  II.5.10 Transparency Directive: Supervision and Enforcement  II.5.11 Ad Hoc Disclosure and the Market Abuse Regime  II.6 Financial Reporting and International Financial Reporting Standards (IFRS)  II.6.1 The EU Financial Reporting Framework  II.6.2 IFRS and the IAS Regulation  II.6.3 Incorporating IFRS in the EU: The Endorsement Mechanism  II.6.4 IFRS, ESMA, and Supervisory Convergence  II.7 Filing and Dissemination of Issuer Disclosures  II.7.1 Substantive and Operational Harmonization  II.7.2 Filing Ongoing Issuer Disclosures  II.7.3 Dissemination of Ongoing Issuer Disclosure  II.8 Admission to Trading and to Official Listing  II.8.1 Trading Venues and Capital-​raising  II.8.2 Regulated Markets and Perimeter Control  II.8.3 The Admission of Securities to Trading  II.9 Capital-​raising and Investment Research  II.9.1 Investment Research, Gatekeeping, and Regulation  II.9.2 The Evolution of the EU’s Response  II.9.3 Presentation Requirements and Conflict of Interest Management  II.9.4 Unbundling the Cost of Investment Research  II.10 Issuer Disclosure and Sustainable Finance  II.11 Capital-​raising and Digital Finance  II.11.1 The Issuer Disclosure Regime and Digital Assets  II.11.2 The 2020 Crowdfunding Regulation 

90 99 101 111 117 118 119 120 120 138 144 146 155 155 156 160 162 162 162 163 167 171 172 175 176 176 178 180 184 186 186 187 188 190 190 193 194 202 202 204 205 207 210 215 215 216

Detailed Contents  xiii I I.12 The Wider Regulatory Ecosystem Supporting Capital-​raising  II.13 Issuer Disclosure, Admission to Trading Venues, Reform, and the Market 

III. Collective Investment Management 

I II.1 Introduction: Collective Investment Management  III.2 The EU Collective Investment Management Rulebook  III.3 The Evolution of the Collective Investment Management Regime  III.3.1 From the UCITS Regime to the Global Financial Crisis  III.3.2 The Post Global Financial Crisis Era: Stability Risks and Non-​Bank Financial Intermediation, Capital Markets Union, and Technocracy  III.4 The UCITS Regime  III.4.1 The Regulatory Context  III.4.2 The Evolution of the UCITS Regime  III.4.3 The UCITS Rulebook: Legislation, Administrative Rules, and Soft Law  III.4.4 Setting the Perimeter: Scope of the UCITS Regime  III.4.5 Market Integration: Authorization, the Passport, and UCITS Mergers  III.4.6 Asset Allocation and Investment Limits  III.4.7 The Management Company: Ongoing Regulation  III.4.8 The Depositary  III.4.9 UCITS Disclosure  III.4.10 The Retail Markets  III.4.11 Supervision and Enforcement  III.5 The AIFMD  III.5.1 The Regulatory and EU Context  III.5.2 The Evolution of the AIFMD  III.5.3 The AIFMD Rulebook: Legislation, Administrative Rules, and Soft Law  III.5.4 The Directive: Objectives  III.5.5 Calibration and Differentiation  III.5.6 Setting the Perimeter: Scope  III.5.7 Authorization and the AIFM Passport  III.5.8 Operational and Organizational Requirements  III.5.9 Risk Management  III.5.10 Leverage: Macroprudential Risk Management and Loan Origination  III.5.11 The Depositary  III.5.12 Disclosure and Supervisory Reporting  III.5.13 Private Equity AIFs  III.5.14 The Retail Markets  III.5.15 Supervision and Enforcement  III.6 Discrete AIF Regulation: The EuVECA, EuSEF, and ELTIF Vehicles  III.6.1 Fund Vehicles and Capital-​raising  III.6.2 The EuVECA Regulation  III.6.3 The EuSEF Regulation  III.6.4 The European Long-​term Investment Fund  III.7 Money-​Market Funds  III.7.1 Money-​Market Funds and Liquidity Risks  III.7.2 The MMF Regulation  III.7.3 The March 2020 Liquidity Crisis and MMF Reform 

222 227

231 231 232 235 235 236 244 244 246 253 255 257 263 274 278 282 288 290 294 294 297 303 304 304 305 307 312 315 316 319 321 323 324 325 326 326 327 330 331 338 338 340 343

xiv  Detailed Contents

IV. Investment Firms and Investment Services 

I V.1 Introduction: The Intermediation Process, Investment Firms, and Regulation  IV.2 The EU Investment Firm Rulebook  IV.2.1 MiFID II/​MiFIR: A Brief Tour  IV.2.2 Beyond MiFID II/​MiFIR  IV.2.3 Organization of Coverage  IV.3 The Evolution of MiFID II  IV.3.1 Initial Developments and the 1993 Investment Services Directive  IV.3.2 Pre-Global Financial Crisis: The Financial Services Action Plan and MiFID I  IV.3.3 MiFID II: The MiFID I Review, the Global Financial Crisis, and the MiFID II Negotiations  IV.3.4 The Post Global Financial Crisis Era: Prudential Regulation, Technocracy, and Legislative Reform  IV.3.5 Sustainable Finance  IV.4 The MiFID II Rulebook: Legislation, Administrative Rules, and Soft Law  IV.5 Setting the MiFID II Perimeter: Scope  IV.5.1 A Functional Approach  IV.5.2 Investment Services and Activities  IV.5.3 Financial Instruments  IV.6 Calibration and Differentiation under MiFID II  IV.6.1 Exemptions  IV.6.2 Client Classification  IV.7 The MiFID II Authorization Process  IV.7.1 Jurisdiction to Authorize and the Home NCA  IV.7.2 The Authorization Process  IV.8 MiFID II Operating Conditions: Organizational and Conduct Requirements  IV.8.1 A Multi-​layered Regime  IV.8.2 Organizational and Operational Requirements  IV.8.3 Conflict-​of-​interest Management  IV.8.4 Conduct Regulation  IV.8.5 Trading Rules, Trading Venues, and Transaction Reporting  IV.9 Prudential Regulation  IV.9.1 A Distinctive Regime  IV.9.2 The Evolution of the Prudential Regime  IV.9.3 The IFD/​IFR  IV.9.4 CRD IV/​CRR  IV.10 The Passport for Investment Services and Activities  IV.10.1 Passport Rights and the Home NCA  IV.10.2 Host Control and the Host NCA  IV.10.3 The Notification Process  IV.11 Supervision and Enforcement  IV.11.1 MiFID II and IFD/​IFR-​CRD IV/​CRR  IV.11.2 The MiFID II Supervisory Framework  IV.11.3 Prudential Supervision and the SREP  IV.11.4 Enforcement and Administrative Sanctions 

V. Order Execution Venues 

V.1 Order Execution Venues and Regulation  V.1.1 Introduction 

347 347 351 351 353 353 354 354 355 357 360 361 362 364 364 365 367 369 369 372 375 375 378 383 383 383 388 393 394 394 394 397 403 413 425 425 426 427 429 429 429 434 438

441 441 441

Detailed Contents  xv .1.2 Regulating Order Execution Venues  V V.1.3 Regulating Trading Venues and the EU  V.2 The Evolution of the Venue Regime  V.2.1 From Concentration to Competition: MiFID I  V.2.2 Market Impact and MiFID I  V.2.3 The MiFID I Review and the MiFID II/​MiFIR Proposals  V.2.4 The MiFID II/​MiFIR Negotiations  V.2.5 From 2014 to the 2021 MiFID III/​MiFIR 2 Proposal  V.3 The Venue Rulebook: Legislation, Administrative Rules, and Soft Law  V.4 MiFID II/​MiFIR and the Regulation of Order Execution Venues: Regulatory Design and Scope  V.4.1 Multilateral and Bilateral Trading  V.4.2 Multilateral Systems and ‘Traded on a Trading Venue’  V.4.3 Bilateral Systems  V.4.4 Financial Instruments and Asset Classes  V.5 Venue Classification  V.5.1 The Classification System  V.5.2 Regulated Markets  V.5.3 Multilateral Trading Facilities  V.5.4 Organized Trading Facilities  V.5.5 Systematic Internalizers  V.5.6 Investment Firms  V.6 Authorization and Ongoing Regulation of Trading Venues: Regulated Markets  V.6.1 A Flexible Regime  V.6.2 Authorization  V.6.3 Ongoing Requirements  V.7 Authorization and Ongoing Regulation of Trading Venues: Multilateral Trading Facilities  V.7.1 Authorization  V.7.2 Ongoing Requirements  V.8 Authorization and Ongoing Regulation of Trading Venues: Organized Trading Facilities  V.9 Authorization and Ongoing Regulation of OTC Execution Venues: Dealing on Own Account  V.9.1 Systematic Internalizers  V.9.2 Dealing on Own Account  V.10 Shrinking the OTC Space: The Share Trading Obligation  V.11 Transparency Regulation  V.11.1 The Transparency Framework  V.11.2 The Equity/​Equity-​like Markets  V.11.3 The Non-​equity Markets  V.12 Data Distribution and Consolidation  V.12.1 Enhancing the Data Framework  V.12.2 Data Publication  V.12.3 The Regulation of Data-​reporting Services Providers (DRSPs)  V.12.4 The 2021 MiFID III/​MiFIR 2 Proposal and the Consolidated Tape Reform  V.13 Supervision and Enforcement  V.13.1 The MiFID II Framework  V.13.2 Transaction Reporting 

442 449 450 450 454 456 458 460 464 466 466 467 469 469 470 470 471 472 472 475 477 477 477 478 479 485 485 485 488 488 488 489 489 491 491 493 503 511 511 513 514 516 518 518 519

xvi  Detailed Contents V.14 Post-​trading, the Settlement Process, and the Central Securities Depositories Regulation 

V I. Trading 

VI.1 Introduction  VI.1.1 Regulating Trading  VI.1.2 Regulating Trading and the EU: A Distinct Setting  VI.2 MiFID II/​MiFIR: The Regulation of Trading  VI.2.1 The MiFID II/​MiFIR and IFD/​IFR/​CRD IV/​CRR Framework  VI.2.2 The Order Execution Process  VI.2.3 Algorithmic Trading and High Frequency Trading  VI.2.4 Market-​making  VI.2.5 The Commodity Derivatives Market and Position Management  VI.3 The Regulation of Short Selling  VI.3.1 Short Selling Regulation and the EU  VI.3.2 The Evolution of the Short Selling Regulation  VI.3.3 The Short Selling Rulebook: Legislation, Administrative Rules, and Soft Law  VI.3.4 Setting the Perimeter: Scope and Exemptions  VI.3.5 Restricting Short Sales: The Uncovered Short Sales Prohibition and ‘Locate’ Rules  VI.3.6 Transparency of Net Short Positions: Supervisory Reporting and Public Disclosure  VI.3.7 Intervention in Exceptional Circumstances  VI.3.8 Supervision and Enforcement  VI.3.9 Extraterritorial Reach  VI.4 The Securities Financing Transactions Regulation  VI.4.1 Securities Financing Transactions and the EU  VI.4.2 The Regulation  VI.4.3 Experience with the SFTR  VI.5 The European Market Infrastructure Regulation and the OTC Derivatives Market  VI.5.1 The Regulation of OTC Derivatives Trading and the EU  VI.5.2 The Evolution of EMIR  VI.5.3 The EMIR Rulebook: Legislation, Administrative Rules, and Soft Law  VI.5.4 Setting the Perimeter: Scope and Exemptions  VI.5.5 Calibration for Small Financial Counterparties and NFCs: The Clearing Thresholds  VI.5.6 The CCP Clearing Obligation  VI.5.7 The Risk Mitigation Obligation for non-​CCP-​cleared Derivatives: Margin and Collateral  VI.5.8 Reporting  VI.5.9 Infrastructure Regulation and Supervision: CCPs  VI.5.10 Infrastructure Regulation and Supervision: TRs  VI.5.11 The Derivatives Trading Obligation and MiFIR 

V II. Rating Agencies 

VII.1 Introduction: Rating Agencies and Regulation  VII.1.1 The Gatekeeper Function  VII.1.2 The Global Financial Crisis and Reform 

523

529 529 529 531 533 533 534 540 543 544 551 551 554 559 561 564 568 573 583 583 584 584 586 588 589 589 594 600 602 605 608 615 618 619 630 633

637 637 637 639

Detailed Contents  xvii II.2 The EU CRA Rulebook  V VII.3 The Evolution of the EU Regime  VII.3.1 Initial Efforts: The IOSCO Code and the EU  VII.3.2 The Global Financial Crisis  VII.3.3 The CRA Regime Negotiations  VII.3.4 From the Global Financial Crisis to Capital Markets Union  VII.4 The CRA Rulebook: Legislation, Administrative Rules, and Soft Law  VII.5 Setting and Securing the Regulatory Perimeter  VII.6 Differentiation and Calibration  VII.7 The Registration Process  VII.8 Conflict-​of-​interest Management and Organizational Requirements  VII.9 Methodologies  VII.10 Disclosure and Supervisory Reporting  VII.11 Discrete Regulation and the Financial Crisis: Sovereign Debt Ratings and Securitization Instruments  VII.11.1 Sovereign Debt Ratings  VII.11.2 Securitization Instruments  VII.12 Over-​reliance  VII.13 Regulation, Market Discipline, and Market Structure  VII.14 ESMA and Supervision  VII.14.1 The CCRAR Framework  VII.14.2 Experience Since 2011  VII.14.3 Enforcement of the CCRAR and ESMA  VII.15 The CCRAR and Civil Liability  VII.16 CRAs and Sustainable Finance 

V III. Market Abuse 

VIII.1 Introduction  VIII.2 The Rationale for Prohibiting Insider Dealing and Market Manipulation and the EU  VIII.2.1 The Rationale for Prohibiting Insider Dealing and Market Manipulation  VIII.2.2 The EU and the Prohibition of Market Abuse  VIII.3 The Evolution of the Regime  VIII.3.1 From the Insider Dealing Directive to the Market Abuse Directive  VIII.3.2 The Global Financial Crisis Era and the Market Abuse Regulation  VIII.3.3 From the Global Financial Crisis to the Covid-​19 Pandemic: A Decade of Stability  VIII.4 The MAR Rulebook: Legislation, Administrative Rules, and Soft Law  VIII.5 Setting the Perimeter: Scope  VIII.5.1 Financial Instruments and Commodities  VIII.5.2 Venues  VIII.5.3 Jurisdictional Scope  VIII.6 The Prohibition on Insider Dealing  VIII.6.1 Inside Information  VIII.6.2 Persons Subject to the Prohibition  VIII.6.3 The Prohibition: Dealing, Recommending, and Disclosing 

643 644 644 645 646 648 650 651 655 655 656 659 662 663 663 665 665 666 668 668 670 672 675 676

679 679 680 680 684 686 686 687 689 692 693 694 695 695 696 696 703 704

xviii  Detailed Contents VIII.7 Disclosure Obligations  VIII.7.1 Issuer Disclosure  VIII.7.2 Insider Lists  VIII.7.3 Disclosure of Insider Transactions: Managers’ Transactions  VIII.8 The Prohibition on Market Manipulation  VIII.8.1 The Prohibition on Market Manipulation and Identification of Market Manipulation  VIII.8.2 Accepted Market Practices and Liquidity Contracts  VIII.8.3 Stabilization and Buy-​Backs  VIII.9 Supervision and Enforcement  VIII.9.1 Context  VIII.9.2 Supervision and Prevention  VIII.9.3 Enforcement  VIII.10 Benchmark Abuse and Benchmark Regulation  VIII.10.1 The Reform Context  VIII.10.2 Market Abuse and Benchmarks  VIII.10.3 The Benchmark Regulation 

IX. Retail Markets 

IX.1 Introduction  IX.1.1 Regulating the Retail Markets  IX.1.2 Regulating the Retail Markets and the EU: A Challenging Setting  IX.2 The Evolution of EU Retail Market Regulation  IX.2.1 Initial Developments  IX.2.2 The FSAP, the Pre Global Financial Crisis Period, and the Retail Markets  IX.2.3 The Global Financial Crisis  IX.2.4 From the Global Financial Crisis to Capital Markets Union  IX.2.5 Retail Markets, Digital Finance, and Sustainable Finance  IX.3 The Retail Rulebook: Legislation, Administrative Rules, and Soft Law  IX.3.1 The Retail Rulebook  IX.3.2 Silos and the Retail Markets  IX.3.3 ESMA and Supervisory Convergence  IX.4 MiFID II/​MiFIR and the Retail Markets  IX.4.1 Context and Coverage: Retail Distribution  IX.4.2 Evolution  IX.4.3 Scope and the Impact of Technology  IX.4.4 Segmentation and Classification  IX.4.5 Fair Treatment  IX.4.6 Marketing Communications  IX.4.7 Disclosure  IX.4.8 Know-​your-​Client: Suitability and Appropriateness  IX.4.9 Know-​your-​Client: The Execution-​only Context  IX.4.10 Conflict-​of-​interest Management and Investment Advice  IX.4.11 Product Governance  IX.4.12 Product Intervention  IX.4.13 Distribution and the Insurance Distribution Directive  IX.5 The PRIIPs Regulation, Disclosure, and the Retail Markets  IX.5.1 Context and Coverage  IX.5.2 The Evolution of the PRIIPs Regime 

709 709 714 716 717 717 721 724 725 725 726 732 739 739 740 741

755 755 755 759 764 764 765 766 767 769 770 770 772 776 777 777 778 782 785 787 788 790 792 798 801 809 816 825 828 828 829

Detailed Contents  xix



I X.5.3 The PRIIPs Regulation  IX.5.4 The PRIIPs KID in Action and Reform  IX.6 The Investor Compensation Schemes Directive  IX.6.1 Compensation Schemes, Retail Investor Protection, and the EU  IX.6.2 The 1997 ICSD  IX.6.3 Reviewing the ICSD 

832 838 841 841 843 846

X. Third Countries 

849

Index

911



X.1 The EU, Third Countries, and the International Financial Market  X.1.1 Introduction  X.1.2 Access to Financial Markets Internationally  X.2 Access to the EU Financial Market  X.2.1 The Access System  X.2.2 The Equivalence Regime  X.3 The Institutional Context: The Commission and ESMA  X.4 The Evolution of the Third Country Regime  X.5 The Collective Investment Management Regime and Third Countries  X.5.1 Delegation and the Collective Investment Management Sector  X.5.2 The AIFMD Passport  X.6 The Issuer Disclosure Regime and Third Countries  X.6.1 The Prospectus Regime  X.6.2 Ongoing Disclosures and IFRS  X.7 The Rating Agency Regime and Third Countries  X.7.1 The Legislative Scheme: Endorsement and Certification  X.7.2 The CRA Third Country Regime in Practice  X.8 The Investment Services Regime and Third Countries  X.8.1 MiFID II/​MiFIR and Market Access  X.8.2 MiFID II/​MiFIR and Export Effects  X.9 EMIR and Third Countries  X.9.1 The OTC Derivatives Markets, Third Countries, and EMIR  X.9.2 EMIR and CCP Access  X.9.3 EMIR and Trade Repositories  X.9.4 EMIR and Global Derivatives Markets  X.10 Central Securities Depositaries and Benchmarks and Third Countries  X.10.1 CSDs and Third Countries  X.10.2 Benchmark Administrators, Benchmarks, and Third Countries  X.11 The UK as a Third Country and the Trade and Cooperation Agreement  X.11.1 The Path to the TCA  X.11.2 The TCA  X.11.3 The Third Country Regime and the UK 

849 849 850 852 852 855 858 860 864 864 866 869 869 871 873 873 875 877 877 884 885 885 887 893 893 894 894 896 899 900 903 905

Table of Cases EUROPEAN COURT OF JUSTICE: ALPHABETICAL LIST OF CASES A v AMF (Case C-​302/​20) (ECLI:EU:C:2022:190)������������������������������������������������������������������������ 699–​700 Almer Beheer BV and Daedalus Holding BV v Van den Dungen Vastgoed BV and Oosterhout II BVBA (Case C-​441/​12) (ECLI:EU:C:2014:2226)��������������������������������������������103 Alpine Investments BV v Minister van Financiën (Case C-​384/​93) (ECLI:EU:C:1995:126) ���������������������������������������������������������������������������������������������������8–​9, 10, 78–​79 BaFIN v Baumeister (Case C-​15/​16) (ECLI:EU:C:2018:464)������������������������������������������������������������������10 Bankia SA v UMAS (Case C-​910/​19) (ECLI:EU:C:2021:433) ������������������������������������������������������� 154–​55 Commission v Germany (Case 205/​84) (ECLI:EU:C:1986:463) ��������������������������������������������������������� 8–​9 Commission v Italy (Case C-​101/​94) (ECLI:EU:C:1996:221)��������������������������������������������������������� 8–​9, 10 DB v Consob (Case C-​481/​19) (ECLI:EU:C:2021:84)����������������������������������������������������������������������������733 di Puma v Consob and Zecca v Consob (Cases 596/​16 and 597/​16) (ECLI: EU:C:2018:192)����������������������������������������������������������������������������������������������������������������������733 ECB v UK (Case T-​496/​11) (ECLI:EU:T:2015:133)������������������������������������������������������������������������� 624–​25 FBF v ACPR (Case C-​911/​19) (ECLI:EU:C:2021:599)���������������������������������������������������10, 46–​47, 810–​11 Garlsson Real Estate and Others v Consob (Case C-​537/​16) (ECLI: EU:C:2018:193)������������������������733 Genil 48 SL and Comercial Hostelera de Grandes Vinos SL v Bankinter SA, Banca Bilbao Vizcaya Argentaria SA (Case C-​604/​11) (ECLI:EU:C:2013:344)����������������������������� 10, 151–​52, 367 Germany v Parliament and Council (Case C-​233/​94) (ECLI:EU:C:1997:231)������������������������������������842 Getl v Daimler AG (Case C-​19/​11) (ECLI:EU:C:2012:397) ��������������690–​91, 696–​97, 700, 710–​11, 712 Grøngaard and Bang (Case C-​384/​02) (ECLI:EU:C:2005:708) ����������������������������������������������������� 680–​82 Hirmann v Immofinanz AG (Case C-​174/​12) (ECLI:EU:C:2013:856)����������������������������������������� 151–​52 IMC Securities v AFM (Case C-​445/​09) (ECLI:EU:C:2011:459)�������������������������������������696–​97, 718–​19 Khorassani v Pflanz (Case C-​678/​15) (ECLI:EU:C:2017:451) ��������������������������������������������������������������366 Kolossa v Barclays Bank plc (Case C-​375/​13) (ECLI:EU:C:2015:37)��������������������������������������������� 154–​55 Lafonta v AMF (Case C-​628/​13) (ECLI:EU:C:2015:162) ���������������������������������������������������696–​97, 700–​1 Meroni v High Authority (Case 9-​56) (ECLI:EU:C:1958:7)����������������������������������� 22–​23, 41–​43, 46–​47, 576, 647, 672, 816–​17 Oikonomikon and Amfissas v Georgakis (Case C-​391/​04) (ECLI:EU:C:2007:272) ������������������� 680–​82 Rewe-​Zentral AG v Bundesmonopolverwaltung für Branntwein (Cassis de Dijon ruling) (Case 120/​78) (ECLI:EU:C:1979:42)����������������������������������������������������������������������������������������� 354–​55 Robeco Hollands Bezit NV and Others v AFM Case (C-​658/​15) (ECLI:EU:C:2017:870) ����������������468 Romano v Institut National d’assurance Maladie (Case 98/​80) (ECLI:EU:C:1981:104)��������������� 41–​43 Spector Photo Group NV and Van Raemdonck v Commissie voor het Bank-​, Financie-​en Assurantiewezen (CBFA) (Case C-​45/​08) (ECLI:EU:C:2009:806) ���������������� 680–​82, 696–​97, 702, 707–​8 Timmel v Aviso Zeta AG (Case C-​359/​12) (ECLI:EU:C:2014:325)������������������������������������������������������122 UK v Council and Parliament (Case C-​270/​12) (ECLI:EU:C:2014:18)�����������������10, 22–​23, 41–​43, 576 UK v Council and Parliament (Case C-​507/​13) (Case withdrawn)����������������������������������������� 10, 422–​23 UK v Council (Case C-​209/​13) (ECLI:EU:C:2014:283)������������������������������������������������������������� 10, 530–​31 EUROPEAN COURT OF JUSTICE: NUMERICAL LIST OF CASES Case 9-​56 Meroni v High Authority (ECLI:EU:C:1958:7)��������������������������������������� 22–​23, 41–​43, 46–​47, 576, 647, 672, 816–​17 Case 120/​78 Rewe-​Zentral AG v Bundesmonopolverwaltung für Branntwein (the Cassis de Dijon ruling) (ECLI:EU:C:1979:42) ����������������������������������������������������������������� 354–​55 Case 98/​80 Romano v Institut National d’assurance Maladie (ECLI:EU:C:1981:104)������������������� 41–​43 Case 205/​84 Commission v Germany (ECLI:EU:C:1986:463)������������������������������������������������������������� 8–​9

xxii  Table of Cases Case C-​384/​93 Alpine Investments BV v Minister van Financiën (ECLI:EU:C:1995:126) ���������������������������������������������������������������������������������������������������8–​9, 10, 78–​79 Case C-​101/​94 Commission v Italy (ECLI:EU:C:1996:221)����������������������������������������������������������� 8–​9, 10 Case C-​233/​94 Germany v Parliament and Council (ECLI:EU:C:1997:231)��������������������������������������842 Case C-​384/​02 Grøngaard and Bang (ECLI:EU:C:2005:708)��������������������������������������������������������� 680–​82 Case C-​391/​04 Oikonomikon and Amfissas v Georgakis (ECLI:EU:C:2007:272)����������������������� 680–​82 Case C-​45/​08 Spector Photo Group NV and Van Raemdonck v Commissie voor het Bank-​, Financie-​en Assurantiewezen (CBFA) (ECLI:EU:C:2009:806)����������680–​82, 696–​97, 702, 707–​8 Case C-​445/​09 IMC Securities v AFM (ECLI:EU:C:2011:459) ���������������������������������������696–​97, 718–​19 Case C-​19/​11 Getl v Daimler AG (ECLI:EU:C:2012:397)������������������690–​91, 696–​97, 700, 710–​11, 712 Case T-​496/​11 ECB v UK (ECLI:EU:T:2015:133) ��������������������������������������������������������������������������� 624–​25 Case C-​604/​11 Genil 48 SL and Comercial Hostelera de Grandes Vinos SL v Bankinter SA, Banca Bilbao Vizcaya Argentaria SA (ECLI:EU:C:2013:344)��������� 10, 151–​52, 367 Case C-​174/​12 Hirmann v Immofinanz AG (ECLI:EU:C:2013:856)��������������������������������������������� 151–​52 Case C-​270/​12 UK v Council and Parliament (ECLI:EU:C:2014:18) �������������������10, 22–​23, 41–​43, 576 Case C-​359/​12 Timmel v Aviso Zeta AG (ECLI:EU:C:2014:325)���������������������������������������������������������122 Case C-​441/​12 Almer Beheer BV and Daedalus Holding BV v Van den Dungen Vastgoed BV and Oosterhout II BVBA (ECLI:EU:C:2014:2226)��������������������������������������������������103 Case C-​209/​13 UK v Council (ECLI:EU:C:2014:283)��������������������������������������������������������������� 10, 530–​31 Case C-​375/​13 Kolossa v Barclays Bank plc (ECLI:EU:C:2015:37),����������������������������������������������� 154–​55 Case C-​507/​13 UK v Council and Parliament (Case withdrawn)��������������������������������������������� 10, 422–​23 Case C-​628/​13 Lafonta v AMF (ECLI:EU:C:2015:162) �������������������������������������������������������� 696–​97, 700–​1 Case C-​658/​15 Robeco Hollands Bezit NV and Others v AFM (ECLI:EU:C:2017:870)��������������������468 Case C-​678/​15 Khorassani v Pflanz (ECLI:EU:C:2017:451)������������������������������������������������������������������366 Case C-​15/​16 BaFIN v Baumeister (ECLI:EU:C:2018:464)���������������������������������������������������������������������10 Case C-​537/​16 Garlsson Real Estate and Others v Consob (ECLI: EU:C:2018:193)��������������������������733 Cases 596/​16 and 597/​16 di Puma v Consob and Zecca v Consob (ECLI: EU:C:2018:192)��������������733 Case C-​481/​19 DB v Consob (ECLI:EU:C:2021:84)��������������������������������������������������������������������������������733 Case C-​910/​19 Bankia SA v UMAS (ECLI:EU:C:2021:433)����������������������������������������������������������� 154–​55 Case C-​911/​19 FBF v ACPR (ECLI:EU:C:2021:599)�����������������������������������������������������10, 46–​47, 810–​11 Case C-​302/​20 A v AMF (ECLI:EU:C:2022:190)��������������������������������������������������������������������������� 699–700 EUROPEAN SUPERVISORY AUTHORITIES (ESAS) BOARD OF APPEAL DECISIONS A v ESMA, 12 March 2021 (Decision 2021-​D-​02)����������������������������������������������������������������������������� 52–​53 FinancialCraft Analytics Sp. zo.o v ESMA, 3 July 2017 (Decision BoA 2017 01)��������������������������������671 Global Private Rating Company v ESMA, 10 January 2014 (Decision BoA 2013-​14)��������� 671, 672–​73 Scope Ratings GmbH v ESMA, 28 December 2020 (Decision 2020-​D-​03) ��������������������������������� 651–​52 Svenska Handelsbanken AB, Skandinaviska Enskilda Banken AB, Swedbank AB, and Nordea Bank AB v ESMA, 27 February 2019 (BoA Decision 2019 01-​04) (the Nordic Banks Decision)����������������������������������������������������������������������������������������������� 652–​55, 671 EUROPEAN SECURITIES AND MARKETS AUTHORITY (ESMA) BOARD OF SUPERVISORS DECISIONS Binary Options, ESMA BoS Decision (EU) 2018/​795 [2018] OJ L136/​31, May 2018 ����������������� 823–25 CfDs, ESMA BoS Decision (EU) 2018/​796 [2018] OJ L136/​50, May 2018����������������������������������� 823–​25 Moody’s, ESMA BoS Decision, 23 May 2017�������������������������������������������������������������������������������������������674 Nordea Bank AB, ESMA BoS Decision, 11 July 2018����������������������������������������������������������������������� 653–​54 Scope Ratings GmbH, ESMA BoS Decision, 28 May 2020��������������������������������������������������������������������661 Standard & Poor’s, ESMA BoS Decision, 20 May 2014 ��������������������������������������������������������������������������664

Table of Legislation EU LEGISLATION Treaties Charter of Fundamental Rights of the EU ������������������������������������������������� 690–​91 Arts 47 to 50 ��������������������������������������������������733 Single European Act���������������������� 83–​84, 354–​55 Treaty of Lisbon ������������������������������������������� 34–​35 Treaty on European Union (TEU) Art 3(3) ��������������������������������������������������������������7 Art 5������������������������������������������������������� 9, 22–​23 Art 13������������������������������������������������������������������9 Art 50��������������������������������������������������������� 901–​2 Treaty on the Functioning of the European Union (TFEU) Art 4(2) ����������������������������������������������������� 22–​23 Art 26������������������������������������������������������������������7 Art 50(2)(g)����������������������������������������������� 22–​23 Art 53(1) ��������������������������������������������������� 22–​23 Arts 56 to 62 ������������������������������������������������� 8–​9 Arts 63 to 66 ��������������������������������������������� 22–​23 Art 83(2) ������������������������������������������������� 735–​36 Art 114������������������������������������������������������� 22–​24 Art 115������������������������������������������������������� 22–​23 Art 127������������������������������������������������������� 23–​24 Art 127(6) ������������������������������������������������� 27–​28 Art 134����������������������������������������������������������������9 Art 258��������������������������������������������������������������10 Art 263��������������������������������������������������������������44 Art 265��������������������������������������������������������������44 Art 267������������������������������������������������������� 46–​47 Art 288����������������������������������������������������������������9 Art 290������������������������������������������25–​26, 33–​34, 41–​43, 45, 857 Art 290(1) and (2)��������������������������������������������25 Art 291����������������25–​26, 33–​34, 41–​43, 46, 857 Art 291(1) ��������������������������������������������������������26 Art 291(3) ��������������������������������������������������������26 Art 294������������������������������������������������������� 23–​24 Art 300����������������������������������������������������������������9 Art 352������������������������������������������������������� 27–​28 Regulations Regulation (EC) 1606/​2002 on International Accounting Standards (2002 IAS Regulation) [2002] OJ L243/​1���������� 1–​2, 69, 84, 155, 157–​58, 176–​77, 178–​83, 189–​90 recital 9����������������������������������������������������� 180–​81 Art 1����������������������������������������������������������������179

Art 2����������������������������������������������������������������179 Art 3����������������������������������������������������������������180 Art 3(2) ��������������������������������������������������� 180–​81 Art 4����������������������������������������������������������������179 Art 5����������������������������������������������������������������179 Art 6����������������������������������������������������������������180 Art 7����������������������������������������������������������������182 Art 24(4)(h)����������������������������������������������������182 Regulation (EU) 1060/​2009 on credit rating agencies (2009 CRA I) [2009] OJ L302/​1���������������� 1–​2, 34–​35, 39, 643–​44, 645–​46, 648–​78, 855–​56, 861, 873–​77, 896–​97 Regulation (EU) 1092/​2010 on EU macro-​ prudential oversight of the financial system and establishing a European Systemic Risk Board (2010 ESRB Regulation) [2010] OJ L331/​1����������������������2 Regulation (EU) 1095/​2010 establishing a European Supervisory Authority (European Securities and Markets Authority), amending Decision No 716/​2009/​EC and repealing Commission Decision 2009/​77/​EC (2010 ESMA Regulation) [2010] OJ L331/​84 �������������������������������������� 1, 25–​26, 37–​43, 776–​77 Art 1(2) �����������������������������������������40–​41, 46–​47 Art 1(5) ���������������������������� 38–​39, 40–​41, 46–​47 Art 1(6) ������������������������������������������������������������41 Art 2������������������������������������������������������������29, 38 Art 3����������������������������������������������������������� 43–​44 Arts 5 and 6������������������������������������������������������38 Art 8���������������������������������� 39–​40, 46–​47, 49–​50 Art 8(1) and (2)����������������������������������������� 39–​40 Art 8(1)(a)������������������������������������������� 41, 61–​62 Art 8(3) ������������������������������������������������������������41 Art 9(1) ����������������������������������������������������� 39–​40 Art 9(3) ����������������������������������������������������� 39–​40 Art 9(5) �����������������������������������������39–​40, 53–​55 Art 9a��������������������������������������������������� 40, 48–​49 Arts 9a to 16�����������������������������������������������������40 Art 10����������������������������������������������������������������45 Arts 10 to 14 ����������������������������������������������������45 Arts 10 to 15 ��������������������������������������� 41–​43, 45 Arts 10 to 16 ����������������������������������������38, 40, 44 Art 15����������������������������������������������������������������46 Art 16���������������������������������������������41–​43, 46–​47 Art 16(2a) ������������������������������������������������� 46–​47

xxiv  Table of Legislation Art 16b������������������������������������� 41–​43, 44, 46, 47 Art 17��������������������������������������������� 37, 38, 52–​53 Arts 17 to 19 ��������������������������32, 33–​34, 39–​40, 41–​43, 44, 52–​55 Art 18��������������������������������������������������������� 52–​55 Art 19������������������������������������ 38, 52–​55, 722–​23 Arts 21 to 32 ��������������������������������������� 40, 49–​50 Art 22(4) ����������������������������������������������������������38 Art 29��������������������������������������������������� 37, 47–​50 Art 29(2) ��������������������������������������������������� 49–​50 Art 29a������������������������������������������������������� 49–​50 Art 30��������������������������������������������������������� 49–​50 Art 31��������������������������������������������������������� 49–​50 Art 31(2)(c)����������������������������������������������� 48–​49 Art 31b������������������������������������������������������������729 Art 33����������������������������������������������������������������40 Arts 35 and 36��������������������������������������������������40 Art 37����������������������������������������������������������������44 Art 38��������������������������������������������������������� 52–​53 Arts 40 to 44 ����������������������������������������������������38 Art 41����������������������������������������������������������������38 Art 42��������������������������������������������������������� 38–​39 Art 43��������������������������������������������������������� 43–​44 Art 43a������������������������������������������������������� 43–​44 Art 44��������������������������������������������������� 38, 52–​53 Arts 45 to 47 ����������������������������������������������������38 Art 46��������������������������������������������������������� 38–​39 Arts 48 and 49��������������������������������������������������38 Art 49��������������������������������������������������������� 38–​39 Arts 51 to 53 ����������������������������������������������������38 Art 52��������������������������������������������������������� 38–​39 Arts 54 to 56 ����������������������������������������������������38 Arts 54 to 57 ��������������������������������������������� 38–​39 Arts 58 to 61 ����������������������������������������������������44 Art 60a��������������������������������������������������������������44 Art 61��������������������������������������������������������� 43–​44 Art 62��������������������������������������������������������� 43–​44 Arts 62 to 65 ��������������������������������������������� 43–​44 Regulation (EU) 182/​2011 laying down the rules and general principles concerning mechanisms for control by Member States of the Commission’s exercise of implementing powers [2011] OJ L55/​13 ����������������������������������25, 26 Regulation (EU) 513/​2011 amending Regulation (EU) 1060/​2009 on credit rating agencies (2011 CRA II) [2011] OJ L145/​30 ��������������� 1–​2, 643, 646–​47, 668, 672, 673–​74, 748 Regulation (EU) 1227/​2011 (2011 REMIT Regulation) [2011] OJ L326/​1�����������������679, 694–​95, 698 Regulation (EU) 236/​2012 on short selling and certain aspects of credit default swaps (2012 Short Selling Regulation) [2012] OJ L86/​1 ������������� 1–​2, 34–​35, 39–​40, 41–​43, 520, 551–​84, 817, 818–​19 recital 1������������������������������������������������������������561

recital 2������������������������������������������������������������561 recital 5������������������������������������������������������������561 recital 26�������������������������������������������������� 562–​63 Art 1��������������������������������������������������������� 561–​62 Art 2(1) ��������������������������������������������������� 562–​63 Art 2(1)(g)������������������������������������������������������571 Art 2(1)(h)������������������������������������������������������569 Art 2(1)(j) ����������������������������������������������� 567–​68 Art 2(1)(j)(i)��������������������������������������������������566 Art 3����������������������������������������������� 262, 569, 571 Art 4������������������������������������������������������� 564, 566 Art 5�����������������������������������������257, 261–​62, 564 Art 6���������������������������������257, 262, 565, 570–​71 Art 7��������������������������������������������������������� 571–​72 Art 7(1) ����������������������������������������������������������258 Art 8�������������������������� 257, 565, 567–​68, 571–​72 Art 9����������������������������������������������������������������572 Art 9(4) ��������������������������������������������������� 560–​61 Art 10����������������������������������������������������� 583, 679 Art 11�����������������������������������������������560–​61, 572 Art 12�����������������������������������������������������255–​565 Art 12(1)(c)������������������������������������������� 257, 258 Art 13���������������������������������������258, 564, 565–​66 Art 13(3) and (4)��������������������������������������������258 Art 14������������������������������������������������������� 571–​72 Art 14(1) ��������������������������������������������������������258 Art 14(2) ������������������������������������������������� 567–​68 Art 16(1) ������������������������������������������������� 583–​84 Art 16(2) ������������������������������������������������� 560–​61 Art 17���������������������������������������� 562–​63, 583–​84 Art 17(2) ������������������������������������������������� 583–​84 Art 17(13) ����������������������������������������������� 560–​61 Arts 18 to 21 �������������������������� 573–​479, 575–​76 Art 21(5) ������������������������������������������������� 571–​72 Art 23������������������������������������������������������� 573–​74 Art 24��������������������������������������������������������������574 Art 26��������������������������������������������������������������574 Art 27��������������������������������������������������������������574 Art 28�������������������������������� 560–​61, 574, 575–​76 Art 31��������������������������������������������������������������575 Art 32��������������������������������������������������������������583 Art 33��������������������������������������������������������������583 Arts 35 to 37 ��������������������������������������������������583 Art 38��������������������������������������������������������������584 Art 41�����������������������������������������������560–​61, 583 Art 46(2) ������������������������������������������������� 567–​68 Regulation (EU) 648/​2012 on OTC derivatives, central counterparties and trade repositories (2012 EMIR) [2012] OJ L201/​1 ������������������������1–​2, 34–​35, 48–​49, 51, 353, 378–​79, 532–​33, 544–​45, 586, 588–​635, 680, 748, 855–​56, 861, 885–​95, 907–​8 recital 19�������������������������������������������������� 609–​10 Art 1������������������������������������������������������� 602, 603 Art 2����������������������������������������������������������� 602–​3 Art 2(7) ��������������������������������������������������� 893–​94 Art 2(11) ������������������������������������������������� 609–​10

Table of Legislation  xxv Art 2a������������������������������������������������������� 893–​94 Art 3������������������������������������������������������� 604, 609 Art 4������������������������������ 604, 605–​6, 608–​9, 894 Art 4(1)(a)������������������������������������������������������603 Art 4a�������������������������������������������������605–​6, 609 Art 5��������������������������������������������������������� 609–​10 Art 5(2) ����������������������������������������������������������608 Art 6b������������������������������������������������������� 613–​14 Art 7����������������������������������������������������������������615 Art 9�������������������������� 604, 618–​19, 630–​32, 894 Art 10�����������������������������������������605–​6, 609, 894 Art 11����������������������������������������604, 605–​6, 615, 617–​18, 894 Art 11(12) ������������������������������������������������������603 Art 13��������������������������������������������������������������894 Art 14�����������������������������������������������608, 621–​22 Art 16������������������������������������������������������� 628–​29 Art 17������������������������������������������������������� 622–​23 Art 18������������������������������������������������������� 622–​23 Art 19������������������������������������������������������� 622–​23 Art 20������������������������������������������������������� 622–​23 Art 21������������������������������������������������������� 621–​23 Art 22������������������������������������������������������� 621–​22 Art 23a����������������������������������������������������� 623–​24 Art 24a����������������������������������������������������� 623–​24 Art 24a(10) ��������������������������������������������� 891–​92 Art 25������������������������������������������������������� 890–​91 Art 25a������������������������������������������������������������892 Art 25b����������������������������������������������������� 891–​92 Art 26��������������������������������������������������������������627 Art 27��������������������������������������������������������������627 Art 28��������������������������������������������������������������627 Art 29�����������������������������������������������627, 893–​94 Arts 30 to 32 ��������������������������������������������������627 Art 31��������������������������������������������������������������634 Art 32������������������������������������������������������� 621–​23 Art 33��������������������������������������������������������������627 Art 34��������������������������������������������������������������627 Art 35�����������������������������������������������621–​23, 627 Arts 36 to 39 ��������������������������������������������������627 Art 39��������������������������������������������������������������608 Art 40������������������������������������������������������� 629–​30 Art 41������������������������������������������������������� 627–​28 Art 42������������������������������������������������������� 628–​29 Art 43������������������������������������������������������� 628–​29 Art 44������������������������������������������������������� 629–​30 Art 45������������������������������������������������������� 628–​29 Art 46������������������������������������������������������� 627–​28 Art 48�����������������������������������������������608, 628–​29 Art 49���������������������������������������� 621–​23, 629–​30 Art 52��������������������������������������������������������������630 Art 53��������������������������������������������������������������630 Art 55������������������������������������������������������� 630–​31 Arts 55 to 74 ��������������������������������������������������631 Art 75��������������������������������������������������������������893 Art 77(1) ��������������������������������������������������������893 Arts 78 to 81 ������������������������������������������� 630–​31 Art 89��������������������������������������������������������������609

Regulation (EU) 345/​2013 on European venture capital funds (2013 EuVECA Regulation) [2013] OJ L 115/​1����������1–​2, 235, 240, 242, 327–​28, 329–​32 Art 2����������������������������������������������������������������328 Art 3��������������������������������������������������������� 328–​29 Art 4����������������������������������������������������������������329 Art 5������������������������������������������������������� 328, 329 Art 6����������������������������������������������������������������329 Arts 7 to 16 ����������������������������������������������������329 Art 10��������������������������������������������������������������328 Regulation (EU) 346/​2013 on European Social Entrepreneurship Funds (2013 EuSEF Regulation) [2013] OJ L115/​18 �������� 1–​2, 235, 240, 242, 330–​31 Art 3(1)(d)����������������������������������������������� 331–​32 Art 10������������������������������������������������������� 330–​31 Regulation (EU) 462/​2013 amending Regulation (EU) 1060/​2009 on credit rating agencies (2013 CRA III) [2013] OJ L146/​1���������������������������1–​2, 641–​42, 643, 651–​52, 656, 657–​58, 875–​76 Regulation (EU) No 575/​2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/​2012 (2013 Capital Requirements Regulation (CRR)) [2013] OJ L 176/​1��������������1–​2, 225–​26, 396, 485, 532, 854, 878 Regulation (EU) 1024/​2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions (2013 ECB/​SSM Regulation) [2013] OJ L287/​63���������� 27–​28, 415–​16, 436 Art 1����������������������������������������������������������������395 Art 4����������������������������������������������������������������395 Regulation (EU) 596/​2014 on market abuse and repealing Directive 2003/​6/​EC and Commission Directives 2003/​124/​EC, 2003/​125/​EC and 2004/​72/​EC (2014 MAR) [2014] OJ 173/​1�������������1–​2, 24, 69–​70, 104–​5, 123–​24, 189–​90, 201, 212, 679–​738 recital 2����������������������������������������������������� 684–​85 recital 14���������������������������������������������������������702 recital 15���������������������������������������������������������702 recital 17������������������������������������������������ 700, 701 recital 19���������������������������������������������������������700 recital 20���������������������������������������������������������698 recital 23�������������������������������������������������� 680–​82 recitals 32 to 34����������������������������������������������705 Art 1�����������������������������������������684–​85, 693, 736 Art 2(1) ����������������������������������������������������������694 Art 2(1)(a)-​(d) ����������������������������������������������695 Art 2(2)(a)-​(c)����������������������������������������� 694–​95

xxvi  Table of Legislation Art 2(3) ����������������������������������������������������������695 Art 2(4) ����������������������������������������������������������696 Art 3�������������������������������������������� 205–​6, 736–​37 Art 3(1)(1)������������������������������������������������� 708–​9 Art 3(1)(15)�������������������������������������694–​95, 698 Art 3(1)(16)�������������������������������������694–​95, 698 Art 3(1)(20)����������������������������������������������������694 Art 3(1)(32)����������������������������������������������������706 Art 4���������������������������������������������������205–​6, 694 Art 4(5) ��������������������������������������������������� 736–​37 Art 5����������������������205–​6, 724–​25, 726, 736–​37 Art 6�������������������������������������������205–​6, 694, 738 Art 7����������������������������������������������������������������738 Art 7(1)(a)����������������������������������������������� 697–​98 Art 7(1)(b)������������������������������������������������������698 Art 7(1)(c)������������������������������������������������������699 Art 7(1)(d)������������������������������������������������������699 Art 7(2) ����������������������������������������������������������700 Art 7(2) and (3)����������������������������������������������700 Art 7(4) ����������������������������������������������������������702 Art 8�������������������������������������������703, 704–​5, 738 Art 8(1) ����������������������������������������������������� 707–​8 Art 8(4) ����������������������������������������������������������703 Art 9���������������������������������������������������707, 708–​9 Art 10�����������������������������������������703, 704–​5, 736 Art 10(1) ��������������������������������������������������������714 Art 11��������������������������������������������������������� 705–​6 Art 12������������������������������������������������������� 717–​21 Art 12(1) ��������������������������������������������������������721 Art 12(1)(d)��������������������������������������������� 740–​41 Art 13���������������������������������������� 718–​19, 721–​24 Art 14����������������������������������������������������� 703, 733 Art 14(a) to 14(c) ����������������������������������� 704–​83 Art 15��������������������������������������������� 718, 720, 733 Art 16��������������������������������������������������������������733 Art 16(1) ��������������������������������������������������������731 Art 16(2) ��������������������������������������������������������731 Art 17�����������������������������������������������709–​14, 733 Art 17(1) ������������������������ 699–​700, 709–​13, 714 Art 17(2) �����������������������������������������694, 709–​10 Art 17(8) ������������������������������������������������� 713–​14 Arts 18 to 20 ��������������������������������������������������733 Art 18������������������������������������������������������� 714–​15 Art 19������������������������������������������������������� 716–​17 Art 20��������������������������������������������������������������705 Art 20(12) ������������������������������������������������� 205–​6 Art 21��������������������������������������������������������������705 Art 22������������������������������������������������������� 695–​96 Art 23���������������������������������������726, 727, 728–​29 Art 25��������������������������������������������������������������727 Art 25(5) ��������������������������������������������������������729 Art 25(8) ��������������������������������������������������������729 Art 26����������������������������������������������������� 696, 729 Art 30(1) ��������������������������������������������������������733 Art 30(1)(b)����������������������������������������������������733 Art 30(2) ��������������������������������������������������������733 Art 31��������������������������������������������������������������733

Art 38������������������������������������������������������� 689–​90 Annex I ��������������������������������������������������� 720–​21 Regulation (EU) 600/​2014 on markets in financial instruments and amending Regulation (EU) 648/​2012 (2014 MiFIR) [2014] OJ L173/​84 ��������1–​2, 13–​14, 18–​19, 24, 34–​35, 39–​40, 45, 51, 53–​55, 59–​60, 64–​65, 69, 89, 104, 105–​6, 152–​53, 189–​90, 193–​94, 198, 288–​89, 333, 351–​53, 357–​59, 360–​61, 363, 371–​72, 383, 384–​85, 395, 403–​4, 413–​14, 429–​34, 439–​40, 441–​42, 452–​55, 456–​57, 458–​62, 464–​65, 466–​67, 468, 469, 472–​73, 475, 476–​77, 479–​80, 482, 484, 485, 488–​94, 502–​3, 551, 562, 583, 588–​89, 590, 602–​3, 633–​35, 679, 680, 689–​91, 694–​95, 727, 736, 743, 767, 768–​69, 770–​77, 781–​82, 798–​99, 807, 808–​10, 816–​26, 849–​50, 854–​56, 857, 858–​59, 861, 862–​63, 864, 869, 877–​78, 880–​85 recital 3��������������������������������������������������� 464, 471 recital 7������������������������������������������������������������472 recital 8����������������������������������������������������� 472–​73 recital 19�������������������������������������������������� 472–​73 recital 20�������������������������������������������������� 475–​76 Art 2(1)(6)������������������������������������������������������608 Art 2(1)(17)(b)����������������������������������������������500 Art 2(1)(27)��������������������������������������������� 469–​70 Art 2(1)(28)��������������������������������������������� 469–​70 Art 2(1)(29)�������������������������������������469–​70, 471 Art 2(1)(46)��������������������������������������������� 469–​70 Arts 3 to 11 ����������������������������������������������������513 Art 3����������������������������������������������������������������494 Art 3(1) ����������������������������������������������������������513 Art 3(3) ����������������������������������������������������������513 Art 4���������������������������������� 468–​69, 494, 495–​97 Art 5����������������������������������������������������������������496 Art 6�������������������������������������������������468–​69, 501 Art 6(1) �������������������������������������������498–​99, 513 Art 6(2) ����������������������������������������������������������513 Art 7(1) ����������������������������������������������������������499 Art 8�������������������������������������������� 468–​69, 504–​5 Art 8(1) ����������������������������������������������������������513 Art 8(3) ����������������������������������������������������������513 Art 8(4) ����������������������������������������������������� 507–​8 Art 9����������������������������������������������������������� 505–​6 Art 10������������������������������������������������������� 468–​69 Art 10(1) ����������������������������������������������� 508, 513 Art 10(2) ��������������������������������������������������������513 Art 11��������������������������������������������������������������509 Art 12��������������������������������������������������������������513 Art 13��������������������������������������������������������������513 Art 14��������������������������������������������������������� 500–​1 Art 15��������������������������������������������������������������501 Art 15(1) �������������������������������������������500–​1, 513 Arts 16 to 18 ��������������������������������������������������816 Art 17��������������������������������������������������������������501

Table of Legislation  xxvii Art 18������������������������������������������������������� 509–​10 Art 18(8) ��������������������������������������������������������513 Art 20��������������������������������������������������������������501 Art 21��������������������������������������������������������������510 Art 21(1) ��������������������������������������������������������513 Art 22(1)(b)��������������������������������������������� 517–​18 Art 23��������������� 468–​69, 884–​85, 901–​2, 904–​5 Art 24������������������������������������������������������� 518–​19 Arts 25 and 26������������������������������������������������679 Art 25(4) ������������������������������������������������� 884–​85 Art 26���������� 468–​69, 515–​16, 517–​18, 519–​22, 557, 569, 570, 583–​84, 630, 728 Art 27���������������������� 521, 531–​50, 694, 777, 778 Art 27b������������������������������������������������������������514 Art 27c����������������������������������������������������� 514–​15 Art 27da��������������������������������������������������� 517–​18 Art 27g������������������������������������������������������������515 Art 27h������������������������������������������������������������515 Art 27i ����������������������������������������������������� 515–​16 Art 28���������������������������������������� 633–​35, 884–​85 Arts 28 to 34 ������������������������������������������� 633–​34 Art 32������������������������������������������������������� 634–​35 Art 33������������������������������������������������������� 893–​94 Art 38��������������������������������������������������������������880 Art 39(1) ��������������������������������������������������������821 Art 39(3) ��������������������������������������������������������817 Arts 40 to 3 ������������������������������ 777–​78, 781–​82 Art 40�������������������������������� 819–​20, 821–​22, 824 Art 41��������������������������������������������������������������816 Art 42���������������������������������������817, 818–​22, 823 Art 43������������������������������������������������������� 818–​19 Art 45�������������������������������� 545, 549–​50, 595–​96 Art 46������������������������������������������ 880–​84, 906–​7 Art 47��������������������������������������������������������������883 Art 49������������������������������������������������������� 881–​82 Art 52������������������������������������������������������� 463–​64 Regulation (EU) 909/​2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/​26/​EC and 2014/​65/​EU and Regulation (EU) 236/​2012 (2014 CSDR) [2014] OJ L257/​1��������1–​2, 13–​14, 64–​65, 255, 321, 523–​27, 559–​60, 584, 855–​56, 894–​96 recital 4����������������������������������������������������� 894–​95 recital 13�������������������������������������������������� 894–​95 recital 34�������������������������������������������������� 894–​95 Art 1����������������������������������������������������������������524 Art 2(1)(1)������������������������������������������������������524 Art 3��������������������������������������������������������� 525–​26 Art 5��������������������������������������������������������� 525–​26 Arts 6 to 8������������������������������������������������� 525–​26 Art 9��������������������������������������������������������� 525–​26 Art 23(6) ������������������������������������������������� 526–​27 Art 25������������������������������������������������������� 894–​96 Art 48������������������������������������������������������� 894–​95 Art 53��������������������������������������������������������������526

Annex������������������������������������������������������� 894–​95 Regulation (EU) 1286/​2014 on key information documents for packaged retail and insurance-​based investment products (PRIIPs) (2014 PRIIPs Regulation) [2014] OJ L352/​1������1–​2, 30, 45, 70, 136–​38, 189–​90, 285–​86, 287, 353, 767, 768–​77, 828–​32, 838–​41 recital 22���������������������������������������������������������837 Art 1��������������������������������������������������������� 832–​33 Art 2(1) and (2)��������������������������������������� 832–​33 Art 3(2) ��������������������������������������������������� 833–​34 Art 4(1) to (6) ����������������������������������������� 832–​33 Art 5��������������������������������������������������������� 835–​36 Art 5(1) and (2)����������������������������������������������834 Art 6(1) to (6) ������������������������������������������������834 Art 7����������������������������������������������������������������834 Art 8�������������������������������������������������834–​36, 837 Art 9����������������������������������������������������������������834 Art 11��������������������������������������������������������������837 Arts 13 and 14����������������������������������������� 836–​37 Arts 22 to 29 ��������������������������������������������������837 Annexes IV to VII����������������������������������� 835–​36 Regulation (EU) 2015/​760 on European long-​term investment funds (2015 ELTIF Regulation) [2015] OJ L123/​98 ��������������1–​2, 235, 236, 240, 242, 331–​32, 336–​38, 768, 773–​74, 794–​95 Art 1����������������������������������������������������������������332 Art 2(3) and (4)����������������������������������������������332 Arts 3 to 6��������������������������������������������������������332 Art 6(1) ����������������������������������������������������������333 Art 9(1) ��������������������������������������������������� 333–​34 Art 9(2) ��������������������������������������������������� 334–​35 Art 10������������������������������������������������������� 333–​34 Art 11������������������������������������������������������� 333–​34 Art 13��������������������������������������������������������������334 Art 13(1) ������������������������������������������������� 333–​34 Art 15(1) ��������������������������������������������������������334 Art 16������������������������������������������������������� 334–​35 Art 17(1) ��������������������������������������������������������334 Art 18��������������������������������������������������������������333 Art 19��������������������������������������������������������������333 Art 21��������������������������������������������������������������333 Arts 23 to 25 ��������������������������������������������������335 Art 27��������������������������������������������������������������335 Art 28���������������������������������������� 335–​36, 794–​95 Art 29��������������������������������������������������������������336 Art 30���������������������������������������� 335–​36, 794–​95 Arts 31 and 32������������������������������������������������332 Arts 31 to 35 ������������������������������������������� 332–​33 Regulation (EU) 2015/​2365 on transparency of securities financing transactions and of reuse and amending Regulation (EU) 648/​2012 (EU) 2015/​2365 [2015] OJ L337/​1 ���������1–​2, 51, 282–​83, 584, 586–​89, 630 Art 2(1) ��������������������������������������������������� 586–​87

xxviii  Table of Legislation Art 3(11) ������������������������������������������������� 586–​87 Art 4��������������������������������������������������������� 586–​87 Art 4(1) ����������������������������������������������������������586 Art 4(4) ����������������������������������������������������������586 Arts 5 to 12 ����������������������������������������������������586 Art 12��������������������������������������������������������������586 Art 13��������������������������������������������������������������587 Art 14��������������������������������������������������������������587 Art 15������������������������������������������������������� 587–​88 Art 19��������������������������������������������������������������893 Regulation (EU) 2016/​679 on the protection of natural persons with regard to the processing of personal data and on the free movement of such data, and repealing Directive 95/​ 46/​EC Regulation (EU) (2016 General Data Protection Regulation (GDPR)) [2016] OJ L119/​1 �����������������������696, 764–​65 Regulation (EU) 2016/​1011 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/​48/​EC and 2014/​17/​ EU and Regulation (EU) 596/​2014 (2016 Benchmark Regulation) [2016] OJ L171/​1���������� 1–​2, 353, 364, 366, 395–​96, 399–​424, 429, 434–​36, 437–​38, 485, 488, 489, 532, 533–​34, 679, 740, 741, 742–​48, 854, 855–​56, 878, 879–​80, 882–​83, 896–​99 Art 3(1) ������������������������������������ 743–​44, 750–​51 Art 4����������������������������������������������������������������745 Art 4(1) ��������������������������������������������������� 414–​15 Art 5����������������������������������������������������������������745 Art 6����������������������������������������������������������������745 Art 7�������������������������������������������������745, 746–​47 Art 8����������������������������������������������������������������745 Art 9����������������������������������������������������������������745 Art 10��������������������������������������������������������������745 Art 11��������������������������������������������������������������745 Art 12��������������������������������������������������������������745 Art 13����������������������������������������������������� 745, 751 Art 15������������������������������������������������������� 745–​46 Art 16������������������������������������������������������� 745–​46 Art 17��������������������������������������������������������������748 Art 18��������������������������������������������������������������748 Art 19��������������������������������������������������������������748 Art 19d����������������������������������������������������� 750–​51 Art 20������������������������������������������������������� 746–​47 Art 20(1) �������������������������� 748, 749–​50, 752–​53 Art 21������������������������������������������������������� 746–​47 Art 22������������������������������������������������������� 746–​47 Art 23������������������������������������������������������� 746–​47 Arts 23a to 23c����������������������������������������� 752–​53 Art 24��������������������������������������������������������������748 Art 25��������������������������������������������������������������748

Art 26��������������������������������������������������������������748 Art 27����������������������������������������������������� 745, 751 Art 28��������������������������������������������������������������746 Art 29(2) ����������������������������������������������������������70 Art 30������������������������������������������������������� 896–​97 Art 31��������������������������������������������������������������897 Art 32������������������������������������������������������� 896–​98 Art 33���������������������������������������� 896–​97, 898–​99 Art 34������������������������������������������������������� 744–​45 Art 34(1a) ����������������������������������������������� 746–​47 Arts 37 to 45 ������������������������������������������� 748–​49 Art 40(1) �����������������������������������������749, 897–​98 Art 46���������������������������������������� 746–​47, 749–​50 Arts 47 and 48����������������������������������������� 748–​49 Arts 48a to 48n ����������������������������������������������749 Regulation (EU) 2016/​1033 amending Regulation (EU) 600/​2014 on markets in financial instruments, Regulation (EU) 596/​2014 on market abuse and Regulation (EU) 909/​2014 on improving securities settlement in the European Union and on central securities depositories [2016] OJ L175/​1 ��������������������������������������460 Regulation (EU) 2016/​2340 amending Regulation (EU) 1286/​2014 on key information documents for packaged retail and insurance-​based investment products as regards the date of its application [2016] OJ L354/​35��������� 838–​39 Regulation (EU) 2017/​1129 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/​ 71/​EC (2017 Prospectus Regulation) [2017] OJ L168/​12 ��������� 1–​2, 13–​14, 68–​70, 72–​73, 80–​81, 82, 85–​86, 88–​90, 95–​101, 161–​62, 172, 187, 189–​90, 201, 224–​25, 285–​86, 706–​7, 771–​72, 855–​56, 860–​61, 869–​71, 872 recital 15���������������������������������������������������������133 recital 17���������������������������������������������������������131 recital 28�������������������������������������������������� 136–​37 recital 36���������������������������������������������������������121 recital 39�������������������������������������������������� 122–​23 recital 41�������������������������������������������������� 124–​25 recital 51���������������������������������������������������������132 recital 64�������������������������������������������������� 144–​45 Art 1������������������������������������������������������� 101, 103 Art 1(2) ����������������������������������������������������������106 Art 1(3) ����������������������������������������������������� 108–​9 Art 1(3) to (5) ������������������������������������������������131 Art 1(4) �������������������������������������������107–​10, 129 Art 1(4) to (6) ������������������������������������������� 102–​3 Art 1(5) �������������������������������������� 108–​9, 110–​11 Art 1(6) ��������������������������������������������������� 110–​11

Table of Legislation  xxix Art 2����������������������������������������������������������������141 Art 2(a) ����������������������������������������������������� 105–​6 Art 2(b) and (c)����������������������������������������������106 Art 2(e)������������������������������������������������������ 107–​8 Art 2(f)������������������������������������������������������������131 Art 2(h) and (i)����������������������������������������������101 Art 2(j)������������������������������������������������������������104 Art 2(k) �������������������������������������������120–​21, 145 Art 2(m)����������������������������������������������������������138 Art 2(m)(ii)��������������������������������������������� 129–​30 Art 2(n) ��������������������������������������������������� 141–​42 Art 2(p) and (q)����������������������������������������������106 Art 2(z)������������������������������������������������������������118 Art 3���������������������������������������������������101–​2, 138 Art 3(1) �����������������������������������������101–​2, 105–​6 Art 3(2) ���������������������������������������������108–​9, 131 Art 3(3) �������������������������������� 101–​2, 104, 105–​6 Art 4�������������������������������������������� 102–​3, 126–​27 Art 4(1) ��������������������������������������������������� 109–​10 Art 4(2)(b)������������������������������������������������� 107–​8 Art 5(1) and (2)����������������������������������������� 107–​8 Art 6���������������������������111–​12, 113–​14, 126–​27, 130, 131, 151–​52, 211 Art 6(3) �������������������������������������������117–​18, 120 Art 7����������������������������127–​28, 131–​34, 136–​38 Art 7(1) ����������������������������������������������������������130 Art 8�����������������������������������������117, 120, 121–​22 Art 8(1)(b)����������������������������������������������� 120–​21 Art 8(4) ��������������������������������������������������� 120–​21 Art 9�������������������������� 105, 117, 122–​24, 126–​27 Art 10������������������������������������������������������� 117–​19 Art 10(1) ��������������������������������������������������������119 Art 10(2) ������������������������������������������������� 117–​18 Art 10(3) ������������������������������������������������� 122–​23 Art 11������������������������������������������������������� 153–​54 Art 12(1) ��������������������������������������������������������120 Art 13�����������������������������������������������126–​27, 130 Art 14����������������������������������������104–​5, 110, 111, 117, 125–​27 Art 14(4) and (5)��������������������������������������������123 Art 14a������������������������ 104–​5, 111, 117, 127–​28 Art 15���������������������������������������105, 117, 131–​33 Art 16������������������������������������������������������� 112–​13 Art 17���������������������������������������115, 121, 126–​27 Art 17(1) ������������������������������������������������� 115–​16 Art 18�����������������������������������������������111, 115–​16 Art 19�����������������������������������������������116–​17, 123 Art 20�����������������������������������������������138, 139–​41 Art 20(6) ������������������������������������������������� 123–​25 Art 20(12) ������������������������������������������������������149 Art 21����������������������������������������������������� 118, 121 Art 22������������������������������������������ 101–​2, 144–​46 Art 23�����������������������������������������������119, 123–​24 Art 23(2a) ����������������������������������������������� 127–​28 Art 24�����������������������������������������������138, 141–​42 Art 25��������������������������������������������������������������142 Art 26����������������������������������������������������� 121, 141

Art 27(5) �����������������������������������������130, 143–​44 Art 28������������������������������������������������������� 870–​71 Art 29������������������������������������������������������� 870–​71 Art 31��������������������������������������������������������������146 Art 32������������������������������������������������������� 146–​47 Art 33������������������������������������������������������� 147–​48 Art 34������������������������������������������������������� 147–​48 Art 35������������������������������������������������������� 146–​47 Art 36������������������������������������������������������� 146–​47 Art 37��������������������������������������������������������������144 Arts 38 to 43 ������������������������������������������� 151–​52 Art 38������������������������������������������������������� 152–​53 Art 39������������������������������������������������������� 152–​53 Art 39(2) ��������������������������������������������������������153 Art 40��������������������������������������������������������������146 Art 41������������������������������������������������������� 152–​53 Art 42������������������������������������������������������� 152–​53 Art 43��������������������������������������������������������������153 Art 48������������������������������������������������������� 97, 133 Art 78������������������������������������������������������� 125–​27 Annexes 1 to 5����������������������������������������� 113–​14 Annex 3��������������������������������������������������� 126–​27 Annex 8��������������������������������������������������� 126–​27 Annex 12������������������������������������������������� 126–​27 Annex 16������������������������������������������������� 126–​27 Regulation (EU) 2017/​1131 on money market funds (2017 Money Market Fund (MMF) Regulation) [2017] OJ L169/​8����������������������������1–​2, 250, 340–​45 Art 2(1) ��������������������������������������������������� 340–​41 Art 3��������������������������������������������������������� 341–​42 Art 4��������������������������������������������������������� 340–​41 Art 5��������������������������������������������������������� 340–​41 Art 7��������������������������������������������������������� 340–​41 Art 10��������������������������������������������������������������342 Art 11��������������������������������������������������������������342 Art 16��������������������������������������������������������������342 Art 17��������������������������������������������������������������342 Art 17(2) ��������������������������������������������������������342 Art 18��������������������������������������������������������������342 Arts 19 to 23 ������������������������������������������� 342–​43 Art 24������������������������������������������������������� 342–​43 Art 25������������������������������������������������������� 342–​43 Art 27������������������������������������������������������� 342–​43 Art 28������������������������������������������������������� 342–​43 Arts 29 to 34 ������������������������������������������� 341–​42 Art 34������������������������������������������������������� 342–​43 Art 35������������������������������������������������������� 340–​41 Arts 36 and 37����������������������������������������� 341–​42 Regulation (EU) 2017/​119 amending Regulation 345/​2013 on European venture capital funds and Regulation (EU) 346/​2013 on European social entrepreneurship funds (2017 EuVECA/​EuSEF Reform Regulation) [2017] OJ L 293/​1 �������� 275–​76, 327, 328–​31

xxx  Table of Legislation Regulation (EU) 2017/​2402 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation, and amending Directives 2009/​65/​EC, 2009/​138/​EC and 2011/​61/​EU and Regulations (EC) 1060/​2009 and (EU) 648/​2012 (2017 Securitization Regulation) [2019] OJ L347/​35 ���������������������� 1–​2, 51, 70, 223–​26, 315, 630, 648–​49, 862 Art 2(1) ��������������������������������������������������� 225–​26 Art 3������������������������������������������ 225–​26, 794–​95 Art 5��������������������������������������������������������� 225–​26 Art 6��������������������������������������������������������� 225–​26 Art 7��������������������������������������������������������� 225–​26 Art 7(1)(c)������������������������������������������������������226 Art 8��������������������������������������������������������� 225–​26 Arts 10 to 17 ������������������������������������������� 225–​26 Arts 18 to 22 ������������������������������������������� 225–​26 Arts 27 and 28����������������������������������������� 225–​26 Regulation (EU) 2019/​834 amending Regulation (EU) 648/​2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-​mitigation techniques for OTC derivative contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories (2019 ‘EMIR Refit’ Regulation) [2019] OJ L141/​42������������261–​62, 327, 329–​31, 591, 593, 598–​99, 602, 604–​5, 607–​8, 610–​11, 613, 618–​19, 633–​34, 690–​91 recital 7������������������������������������������������������������262 Art 4(1) ��������������������������������������������������� 310–​11 Arts 9 to 11 ����������������������������������������������������262 Art 9(5) ����������������������������������������������������������575 Regulation (EU) 2019/​876 amending Regulation (EU) 575/​2013 as regards the leverage ratio, the net stable funding ratio, requirements for own funds and eligible liabilities, counterparty credit risk, market risk, exposures to central counterparties, exposures to collective investment undertakings, large exposures, reporting and disclosure requirements, and Regulation (EU) 648/​2012 (2019 Capital Requirements Regulation (CRR 2)) [2019] OJ L150/​1 ������353, 364, 383, 395–​96, 399–​400, 402, 408, 413, 414–​15, 416–​17, 418, 423–​24, 533–​34 Regulation (EU) 2019/​1238 on a pan-​ European Personal Pension Product (PEPP) [2019] OJ L198/​1������������������� 15, 772

Regulation (EU) 2019/​2033 on the prudential requirements of investment firms and amending Regulations (EU) 1093/​2010, (EU) 575/​2013, (EU) 600/​2014 and (EU) 806/​2014 (2019 Investment Firm Regulation (IFR)) [2019] OJ L314/​1�������������������������������������13–​14, 24, 308, 353, 378, 379, 383, 395–​96, 400–​12, 413, 414, 416–​17, 429, 437–​38, 485, 489, 532, 533–​34, 862–​63, 878, 879–​80, 882–​83 Art 1����������������������������������������������������������������403 Art 1(2) ������������������������������������������������� 403, 404 Art 1(5) ����������������������������������������������������������404 Art 4(1) ����������������������������������������������������� 407–​9 Art 9������������������������������������������������������� 406, 407 Art 11��������������������������������������������������������������406 Art 12��������������������������������������������������������� 404–​5 Art 13�������������������������������������������������406–​7, 409 Art 14��������������������������������������������������������� 406–​7 Art 15���������������������������������������������406–​7, 408–​9 Art 16��������������������������������������������������������������407 Art 17��������������������������������������������������������������407 Art 18��������������������������������������������������������������407 Art 21��������������������������������������������������������������408 Art 23��������������������������������������������������������������408 Art 24������������������������������������������������������� 408–​10 Arts 25 to 32 ��������������������������������������������� 408–​9 Art 25�������������������������������������������������408–​9, 410 Arts 26 to 34 ��������������������������������������������������410 Art 27��������������������������������������������������������� 408–​9 Art 28��������������������������������������������������������������410 Art 29��������������������������������������������������������� 408–​9 Art 30������������������������������������������������������� 410–​12 Art 32������������������������������������������������������� 410–​12 Art 33������������������������������������������ 408–​9, 410–​12 Art 34��������������������������������������������������������� 406–​7 Art 35��������������������������������������������������������� 408–​9 Art 38��������������������������������������������������������� 408–​9 Art 41��������������������������������������������������������� 408–​9 Art 43��������������������������������������������������������������409 Regulation (EU) 2019/​2088 on sustainability-​related disclosures in the financial services sector (2019 Sustainable Finance Disclosure Regulation (SFD Regulation)) [2019] OJ L 317/​1��������� 60–​61, 212–​13, 214, 243, 361–​62, 816 Art 1����������������������������������������������������������� 60–​61 Art 2(1) ����������������������������������������������������� 60–​61 Art 2(17) ��������������������������������������������������� 60–​61 Art 2(22) ��������������������������������������������������� 60–​61 Art 2(24) ��������������������������������������������������� 60–​61 Art 6����������������������������������������������������������� 60–​61 Art 8����������������������������������������������������������� 60–​61 Art 9����������������������������������������������������������� 60–​61 Regulation (EU) 2019/​2089 amending Regulation (EU) 2016/​1011 as regards

Table of Legislation  xxxi EU Climate Transition Benchmarks, EU Paris-​aligned Benchmarks and sustainability-​related disclosures for benchmarks [2019] OJ L 317/​17�����������������������������������59–​60, 742 Regulation (EU) 2019/​2099 amending Regulation (EU) 648/​2012 as regards the procedures and authorities involved for the authorisation of CCPs and requirements for the recognition of third-​country CCPs (2019 EMIR 2.2) [2019] OJ L322/​1 ��������������������������23–​24, 36–​37, 55, 591–​92, 598–​99, 620, 621, 622–​23, 625–​26, 629–​30, 862–​63, 887, 888–​90, 907 Regulation (EU) 2019/​2115 amending Directive 2014/​65/​EU and Regulations (EU) 596/​2014 and (EU) 2017/​1129 as regards the promotion of the use of SME growth markets (2019 SME Regulation) [2019] OJ L320/​1����������������85–​86, 88–​89, 98, 126–​27, 198–​99, 201, 352–​53, 689–​90, 692, 712, 714–​15 recital 6������������������������������������������������������� 706–​7 Regulation (EU) 2019/​2160 amending Regulation (EU) 575/​2013 as regards exposures in the form of covered bonds [2019] OJ L328/​1 ����������������������������������������70 Regulation (EU) 2019/​2175 amending Regulation (EU) No 1093/​2010 establishing a European Supervisory Authority (European Banking Authority), Regulation (EU) No 1094/​ 2010 establishing a European Supervisory Authority (European Insurance and Occupational Pensions Authority), Regulation (EU) No 1095/​ 2010 establishing a European Supervisory Authority (European Securities and Markets Authority), Regulation (EU) No 600/​2014 on markets in financial instruments, Regulation (EU) 2016/​1011 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds, and Regulation (EU) 2015/​847 on information accompanying transfers of funds (2019 ESA Reform Regulation) [2019] OJ L334/​1�����������������1, 13–​14, 47, 49–​50, 55, 61–​62, 150–​51, 185, 742, 749, 751, 859–​60, 862–​63, 865–​66, 887, 896 Regulation (EU) 2020/​852 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/​2088

(2020 Taxonomy Regulation) [2020] OJ L198/​13 ������� 60–​61, 211, 212–​14, 243, 361–​62, 797, 816 Art 1������������������������������������������������������������������61 Art 3������������������������������������������������������������������61 Regulation (EU) 2020/​1503 on European crowdfunding service providers for business, and amending Regulation (EU) 2017/​1129 and Directive (EU) 2019/​1937 (2020 Crowdfunding Regulation) [2020] OJ L347/​1������������ 13–​15, 36–​37, 55, 62–​63, 70, 216–​22, 352–​53, 768 recital 1������������������������������������������������������������218 recital 16���������������������������������������������������������218 Art 1����������������������������������������������������������������218 Art 2������������������������������������������ 218–​19, 221–​22 Art 3��������������������������������������������������������� 219–​20 Art 4��������������������������������������������������������� 219–​20 Art 5��������������������������������������������������������� 219–​20 Art 7��������������������������������������������������������� 219–​20 Art 8��������������������������������������������������������� 219–​20 Art 9��������������������������������������������������������� 219–​20 Art 10������������������������������������������������������� 219–​20 Art 11������������������������������������������������������� 219–​20 Art 12������������������������������������������������������� 219–​20 Art 14������������������������������������������������������� 219–​20 Art 16������������������������������������������������������� 219–​20 Art 18��������������������������������������������������������������219 Art 19������������������������������������������������������� 220–​21 Art 21���������������������������������������� 221–​22, 794–​95 Art 22������������������������������������������������������� 221–​22 Art 23������������������������������������������������������� 220–​21 Art 23(15) ����������������������������������������������� 220–​21 Art 27������������������������������������������������������� 220–​21 Art 45������������������������������������������������������� 221–​22 Annex 1��������������������������������������������������� 220–​21 Regulation (EU) 2021/​23 on a framework for the recovery and resolution of central counterparties and amending Regulations (EU) 1095/​2010, (EU) 648/​2012, (EU) 600/​2014, (EU) 806/​2014 and (EU) 2015/​2365 and Directives 2002/​47/​EC, 2004/​25/​EC, 2007/​36/​EC, 2014/​59/​EU and (EU) 2017/​1132 (2021 CCP Recovery and Resolution Regulation) [2021] OJ L 22/​1 �������������������������������������613–​14, 630 Regulation (EU) 2021/​168/​EU amending Regulation (EU) 2016/​1011 as regards the exemption of certain third-​country spot foreign exchange benchmarks and the designation of replacements for certain benchmarks in cessation, and amending Regulation (EU) 648/​2012 [2021] OJ L49/​6 ����������������������������������������899

xxxii  Table of Legislation Regulation (EU) 2021/​337 amending Regulation (EU) 2017/​1129 as regards the EU Recovery prospectus and targeted adjustments for financial intermediaries and Directive 2004/​ 109/​EC as regards the use of the single electronic reporting format for annual financial reports, to support the recovery from the COVID-​19 crisis (2021 Covid-​19 Recovery Prospectus Regulation) [2021] OJ L 68/​1 �������� 82, 127–​29 recital 4������������������������������������������������������� 108–​9 recital 8������������������������������������������������������������127 recital 10���������������������������������������������������������128 Regulation (EU) 2021/​557 amending Regulation (EU) 2017/​2402 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation to help the recovery from the COVID-​19 crisis [2021] OJ L116/​1 ��������������������� 224–​25 Regulation (EU) 2021/​2259 amending Regulation (EU) 1286/​2014 as regards the extension of the transitional arrangement for management companies, investment companies and persons advising on, or selling, units of undertakings for collective investment in transferable securities (UCITS) and non-​UCITS [2021] OJ L 455/​1 ��������������������������������������������������840 Regulation (EU) 2022/​858 on a pilot regime for market infrastructures based on distributed ledger technology, and amending Regulations (EU) 600/​2014 and (EU) 909/​2014 and Directive 2014/​65/​EU (2022 DLT Market Infrastructure Pilot Regime Regulation) [2022] OJ L151/​1 ������������ 62–​63, 65, 331–​32 Consolidated Credit Rating Agency Regulation (CCRAR)������������1–​2, 34–​35, 39, 643–​44, 668–​78, 855–​56, 861, 873–​74, 891–​92, 896–​97 Art 1��������������������������������������������������������� 651–​52 Art 2��������������������������������������������������������� 652–​53 Art 3��������������������������������������������������������� 652–​53 Art 3(1) �������������������������������������������653–​54, 656 Art 3(1)(v)����������������������������������������������� 663–​64 Art 4������������������������������������������ 873–​74, 876–​77 Art 4(1) ���������������������� 70, 653, 665–​66, 669–​70 Art 5��������������������������������������������������������� 873–​76 Art 5a�������������������������������� 665–​66, 669–​70, 676 Arts 5b and 5c����������������������������������������� 665–​66 Arts 6 to 12 �������������������������������������������874–​660 Art 6�����������������������������������������655, 656, 658–​59

Art 6a����������������������������������������������������� 656, 659 Art 6b��������������������������������������������������������������667 Art 7��������������������������������������������������������� 658–​59 Art 7(4) ����������������������������������������������������������874 Art 6a��������������������������������������������������������������656 Art 8��������������������������������������������������������� 659–​62 Art 8(2) ��������������������������������������������������� 665–​66 Art 8(3) ����������������������������������������������������������671 Art 8(4) ����������������������������������������������������������665 Art 8(5) ����������������������������������������������������������664 Art 8a������������������������������������������������������� 663–​64 Art 8b������������������������������������������������������� 648–​49 Art 8c�����������������������������������������������665, 669–​70 Art 8d�����������������������������������������������667, 669–​70 Art 9����������������������������������������������������������������653 Art 10��������������������������������������������������������������662 Art 10(3) ��������������������������������������������������������665 Art 11������������������������������������������������������� 662–​63 Art 11a����������������������������������������������������� 662–​63 Art 12��������������������������������������������������������������663 Arts 14 to 20 ��������������������������������������������������655 Art 14��������������������������������������������������������������655 Art 14(1) ������������������������������������������������� 652–​53 Art 14(3) ������������������������������������������������� 661–​62 Art 14(5) ��������������������������������������������������������655 Arts 15 to 20 ������������������������������������������� 655–​56 Art 19(1) ������������������������������������������������� 655–​57 Art 21������������������������������������������������������� 668–​69 Art 22a������������������������������������������������������������660 Art 23�����������������������������������������������659, 661–​62 Arts 23b–​23d������������������������������������������� 668–​69 Art 23e����������������������������������������������������� 672–​73 Art 24��������������������������������������������������������������673 Art 25������������������������������������������������������� 672–​73 Art 25a����������������������������������������������������� 669–​70 Art 30������������������������������������������������������� 669–​70 Art 35a����������������������������������������������������� 675–​76 Art 36a����������������������������������������������������� 673–​74 Art 39��������������������������������������������������������������667 Annex I ������������������������650, 658, 659, 662, 663, 664, 667 , 874–​75 Annex II������������������������������������ 655–​56, 659–​60 Annex III������������������������������������������������� 672–​74 Delegated Regulations Delegated Regulation (EC) 809/​2004 [2004] OJ L149/​1 ���������������99–​100, 112, 115 Delegated Regulation (EC) 1569/​2007 [2007] OJ L340/​66 ������������������������������������872 Delegated Regulation (EU) 583/​2010 [2010] OJ L176/​1.��������������� 253–​54, 285–​86, 287, 694, 798–​99 Delegated Regulation (EU) 1031/​2010 [2010] OJ L302/​1 ��������������������������������������694 Delegated Regulation (EU) 272/​2012 [2012] OJ L90/​6 ��������������������������������� 655–​56

Table of Legislation  xxxiii Delegated Regulation (EU) 449/​2012 [2012] OJ L140/​32 ����������������������������� 655–​56 Delegated Regulation (EU) 918/​2012 [2012] OJ L274/​1 ��������������560, 562, 566–​67, 569, 571–​72, 573–​74, 575–​76 Delegated Regulation (EU) 231/​2013 [2013] OJ L83/​1 �������������� 303, 306, 308, 312, 313, 314, 315–​16, 317–​18, 319–​21, 322 Delegated Regulation (EU) 2015/​514 [2015] OJ L82/​5 ����������������������������������������303 Delegated Regulation (EU) 2016/​438 [2016] OJ L78/​11 ���������������� 253–​54, 279–​81 Delegated Regulation (EU) 2016/​522 [2016] OJ L 88/​1���������� 692–​93, 694, 720–​21 Delegated Regulation (EU) 2017/​565 [2017] OJ L87/​1 �64, 200–​1, 205–​7, 362–​63, 367–​68, 369–​70, 374–​75, 383, 385, 386–​88, 391–​93, 464, 465, 475, 777–​78 Delegated Regulation (EU) 2017/​592 [2017] OJ L 87/​492���������������������371–​72, 771 Delegated Regulation (EU) 2017/​2294 [2017] OJ L329/​4 �����������������������465, 475–​76 Delegated Regulation (EU) 2021/​1383 [2021] OJ L298/​1 ��������������������������������������340 Delegated Regulation (EU) 2018/​1619 [2018] OJ L271/​6 ���������������� 253–​54, 279–​80 Delegated Regulation (EU) 2019/​442 [2019] OJ L77/​56 �����������������������465, 476–​77 Delegated Regulation (EU) 2019/​443 [2019] OJ L77/​59 ��������������������������������������465 Delegated Regulation (EU) 2019/​819 [2019] OJ L134/​1 ������������������������������� 330–​31 Delegated Regulation (EU) 2019/​820 [2019] OJ L134/​8 ��������������������������������������328 Delegated Regulation (EU) 2019/​980 [2019] OJ L166/​26 ��������������� 68–​69, 99–​101, 113–​15, 117, 121, 122, 123, 124, 130, 132–​33, 134, 141 Delegated Regulation (EU) 2020/​1304 [2020] OJ L305/​13 ������������������������������������872 Delegated Regulation (EU) 2019/​815 [2019] OJ L143/​1 ���������������� 99–​100, 109–​10 Delegated Regulation (EU) 2021/​1253 [2021] OJ L277/​1 �������������������������59–​60, 797 Delegated Regulation (EU) 2021/​1269 [2021] OJ L277/​137 ����������������������������� 59–​60 Delegated Regulation (EU) 2021/​1270 [2021] OJ L277/​141 ����������������������������� 59–​60 Delegated Regulation (EU) 2021/​1383 [2021] OJ L298/​1 ��������������������������������������340 Delegated Regulation (EU) 2021/​2139 [2021] OJ L442/​1 ����������������������������������������61 Delegated Regulation (EU) 2022/​27 [2022] OJ L6/​9 ���������������������������557–​58, 570 Delegated Regulation (EU) 2022/​1214 [2022] OJ L188/​1 ����������������������������������������61

Directives Directive 79/​279/​EEC coordinating the conditions for the admission of securities to official stock exchange listing (1979 Admissions Directive) [1979] OJ L66/​21 �����������83, 91, 193–​94, 196 Directive 80/​390/​EEC coordinating the requirements for the drawing-​up, scrutiny and distribution of the listing particulars to be published for the admission of securities to official stock exchange listing (1980 Listing Particulars Directive (LPD)) [1980] OJ L100/​1���������������������������������������� 83, 91–​92 Directive 82/​121/​EEC on information to be published on a regular basis by companies the shares of which have been admitted to official stock exchange listing (1982 Interim Reports Directive (IRD)) [1982] OJ L48/​26�������������������������83, 157 Directive 85/​611/​EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (1985 UCITS Directive) [1985] OJ L375/​3 �����189–​90, 233–​36, 239–​43, 246–​47, 259, 764 Directive 88/​627/​EEC on the information to be published when a major holding in a listed company is acquired or disposed of (1988 Substantial Shareholdings Directive (SSD)) [1988] OJ L348/​62 ���������������83–​84, 157, 167 Directive 89/​298/​EEC coordinating the requirements for the drawing-​up, scrutiny and distribution of the prospectus to be published when transferable securities are offered to the public (1989 Public Offers Directive (POD)) [1989] OJ L124/​8���������������������������������������� 83–​84, 91 Directive 89/​592/​EEC coordinating regulations on insider dealing (1989 Insider Dealing Directive (IDD)) [1989] OJ L334/​30�����������������������679, 686–​87, 703–​5, 790–​91 recital 4���������������������������������������������680–​82, 686 recital 5����������������������������������������������������� 680–​82 Art 1(1) ��������������������������������������������������� 690–​91 Directive 89/​646/​EEC on the coordination of the laws, regulations and administrative procedures relating to the taking-​up and pursuit of the business of credit institutions and amending Directive 77/​ 780/​EEC (1989 Second Banking Co-​ordination Directive (BCD II)) [1989] OJ L386/​1 �����������������������������������355, 397

xxxiv  Table of Legislation Directive 93/​6/​EC on the capital adequacy of investment firms and credit institutions (1993 Capital Adequacy Directive (CAD)) [1993] OJ L141/​1�������������������355, 397 Directive 93/​22/​EEC on investment services in the securities field (1993 Investment Services Directive (ISD)) [1993] OJ L141/​27 ������������247, 355–​56, 376, 397, 450–​51, 764, 778, 843 Art 11����������������������������������������������������������� 355–​56 Directive 94/​18/​EC amending Directive 80/​390/​EEC with regard to the obligation to publish listing particulars (1994 Eurolist Directive) [1994] OJ L135/​1 ����������������������������������������91 Directive 94/​19/​EC on deposit-​guarantee schemes (1994 Deposit Guarantee Directive (DGD)) [1994] OJ L135/​5������������������������������������766–​67, 843 Directive 97/​9/​EC on investor compensation schemes (1997 Investor Compensation Schemes Directive (ICSD)) [1997] OJ L84/​22������ 372, 383, 765, 766–67, 770–71, 771–​72, 842–​43, 846–47 recital 11�������������������������������������������������� 843–​44 recital 13�������������������������������������������������� 843–​44 recital 23���������������������������������������������������������845 Art 1(4) ��������������������������������������������������� 843–​44 Art 2(1) ������������������������������������������������� 843, 845 Art 2(2) ����������������������������������������������������������844 Art 2(4) ����������������������������������������������������������844 Art 4(1) ��������������������������������������������������� 843–​44 Art 4(3) ��������������������������������������������������� 843–​44 Art 5(1)–​5(2)��������������������������������������������������845 Art 7(1) and (2)����������������������������������������������846 Art 8(1)–​(2)����������������������������������������������������844 Art 9����������������������������������������������������������������844 Art 10(1) ��������������������������������������������������������845 Art 10(3) ��������������������������������������������������������845 Art 13������������������������������������������������������� 845–​46 Annexes I and II������������������������������������� 843–​44 Directive 2000/​31/​EC on certain legal aspects of information society services, in particular electronic commerce, in the internal market (2000 E-​Commerce Directive (ECD)) [2000] OJ L178/​1 ������������������������������� 764–​65 Directive 2001/​34/​EC on admission of securities to official stock exchange listing and on information to be published on those securities (2001 Securities Consolidated Directive (SCD)/​Consolidated Admission Requirements Directive (CARD)) [2001] OJ L184/​1 ��������������������������������������������69, 83 Art 1��������������������������������������������������������� 196–​97 Art 2(1) ����������������������������������������������������������197 Arts 5 to 7������������������������������������������������� 196–​97

Art 6(1) ����������������������������������������������������������197 Art 8����������������������������������������������������������������197 Arts 8 and 9��������������������������������������������� 196–​97 Arts 11 to 15 ������������������������������������������� 196–​97 Art 11��������������������������������������������������������������197 Art 12��������������������������������������������������������������197 Art 16������������������������������������������������������� 196–​97 Arts 17 to 19 ������������������������������������������� 196–​97 Arts 42 to 51 ��������������������������������������������������197 Arts 42 to 64 ������������������������������������������� 196–​97 Art 43��������������������������������������������������������������197 Art 44��������������������������������������������������������������197 Art 46��������������������������������������������������������������197 Art 48(5) ��������������������������������������������������������197 Arts 52 to 63 ��������������������������������������������������197 Art 54��������������������������������������������������������������197 Art 58��������������������������������������������������������������197 Arts 105 to 107 ��������������������������������������� 196–​97 Directive 2001/​107/​EC on management companies and simplified prospectuses (2001 Management Company and Prospectus Directive (UCITS III)) [2002] OJ L41/​20�������� 189–​90, 247–​48, 259, 263–​64, 266, 267–​68, 270–​71, 273–​74, 285–​86, 798–​99 Directive 2001/​108/​EC on UCITS investments (2001 Product Directive (UCITS III)) [2002] OJ L41/​35�������� 189–​90, 233, 247–​48, 259, 263–​64, 266, 267–​68, 270–​71, 273–​74, 285–​86, 798–​99 Directive 2002/​65/​EC concerning the distance marketing of consumer financial services (2002 Distance Marketing of Financial Services Directive (DMD)) [2002] OJ L271/​16 Art 6��������������������������������������������������������� 788–​89 Directive 2002/​92/​EC on Insurance Mediation (2002 Insurance Mediation Directive (IMD I)) [2003] OJ L9/​3�������������������������� 764–​65, 773, 774–​75 Directive 2003/​6/​EC on insider dealing and market manipulation (2003 Market Abuse Directive (MAD I)) [2003] OJ L96/​16������������������ 84, 204–​5, 679, 680–​82, 684–​85, 686, 687–​88, 689, 690–​91, 692, 696–​97, 700–​1, 702, 703, 707–​8, 710–​11, 712–​13, 714–​15, 716, 717–​18, 721–​23, 724–​25, 727, 730–​31 Directive 2003/​71/​EC on the prospectus to be published when securities are offered to the public or admitted to trading (2003 Prospectus Directive) [2003] OJ L345/​64 ������������������68–​69, 77–​78, 80–​81, 82, 84–​86, 90, 92–​94, 95–​96, 104–​5, 107, 108–​9, 112, 117–​18, 120, 122, 129, 131–​32, 134, 136, 139, 144–​45, 146, 153–​54, 160, 233, 870

Table of Legislation  xxxv Directive 2003/​87/​EC (Emission Trading Scheme Directive (ETS Directive)) [2003] OJ L275/​32 ������������������������������������368 Directive 2004/​39/​EC on markets in financial instruments (2004 Markets in Financial Instruments Directive (MiFID I)) [2004] OJ L145/​1 ���������� 193–​94, 195, 204–​5, 297, 298–​99, 355–​61, 366, 369, 370, 372, 373, 379, 385, 388–​89, 390, 391–​93, 426–​27, 429, 438, 439–​40, 441–​42, 450–​53, 454–​58, 460–​61, 463–​64, 467–​68, 470, 475, 477, 479, 489–​90, 492, 493–​95, 499, 501, 502, 512, 530, 533–​34, 535, 540–​41, 765–​66, 773, 778–​79, 780, 782–​83, 785, 798–​99, 804, 843–​44, 846, 860–​61 Art 2(1)(k)������������������������������������������������������187 Art 3(1) ����������������������������������������������������������187 Art 19��������������������������������������������������������������187 Art 19(1) ����������������������������������������������� 787, 796 Art 41��������������������������������������������������������������883 Directive 2004/​109/​EC on the harmonization of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market (2004 Transparency Directive) [2004] OJ L390/​38���������� 1–​2, 69, 84, 100–​1, 104–​5, 114–​15, 122–​23, 155, 156–​57, 158, 159–​60, 161–​62, 163, 165–​66, 173–​74, 176–​77, 184, 187, 855–​56 Art 1��������������������������������������������������������� 189–​90 Art 1(2) ����������������������������������������������������������162 Art 2(1) ����������������������������������������������������������171 Art 2(1)(a)������������������������������������������������������162 Art 2(1)(d)������������������������������������������������������162 Art 2(1)(e)����������������������������������������������� 168–​69 Art 2(1)(n)����������������������������������������������� 168–​69 Art 3(1) ������������������������������������������������� 160, 171 Art 3(1)(a)������������������������ 160, 165–​66, 168–​69 Art 3(2) ����������������������������������������������������������171 Art 4����������������������������������������������������������������164 Art 4(1) ��������������������������������������������������� 163–​64 Art 4(7) ��������������������������������������������������� 188–​89 Art 5��������������������������������������������������������� 164–​65 Art 8(1)(a)������������������������������������������������������162 Art 8(1)(b)). ��������������������������������������������������163 Art 8(2) ����������������������������������������������������������162 Art 9������������������������������������������ 168–​69, 170–​96 Art 9(1) ��������������������������������������������������� 168–​69 Art 9(2) ��������������������������������������������������� 168–​69 Art 9(4) ��������������������������������������������������� 168–​69 Art 9(5) ����������������������������������������������������������169 Art 9(6) ����������������������������������������������������������169 Art 9(6)(a)������������������������������������������������������169 Art 10����������������������������������������������������� 170, 171 Art 11��������������������������������������������������������������169

Art 12������������������������������������������������������� 168–​69 Art 13��������������������������������������������������������������170 Art 13(1) ��������������������������������������������������������170 Art 13(a) ��������������������������������������������������������170 Art 14������������������������������������������������������� 169–​70 Art 15������������������������������������������������������� 168–​69 Art 16(1) ��������������������������������������������������������166 Art 16(2) ��������������������������������������������������������166 Art 17(1) ������������������������������������������������� 166–​67 Art 17(2) ������������������������������������������������� 166–​67 Art 18������������������������������������������������������� 166–​68 Art 20��������������������������������������������������������������172 Art 21��������������������������������������������������������������188 Art 21a����������������������������������������������������� 188–​89 Art 23(1) ������������������������������������������������� 871–​72 Art 24���������������������������������������� 172–​73, 174–​75 Art 25�����������������������������������������������173, 174–​75 Art 26��������������������������������������������������������������171 Directive 2007/​36/​EC on the exercise of certain rights of shareholders in listed companies [2007] OJ L184/​17���������� 166–​67 Directive 2009/​65/​EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (2009 UCITS IV Directive) [2009] OJ L302/​32 ������������1–​2, 189–​90, 233, 247–​51, 253, 259, 263–​64, 276, 285, 294, 340–​41, 345, 378–​79, 410–​12, 421, 587, 765–​66, 773–​74, 864–​66 recital 41���������������������������������������������������������267 recital 50���������������������������������������������������������270 Art 1(1) ����������������������������������������������������������255 Art 1(2) ����������������������������������������� 255, 264, 266 Art 1(3) ��������������������������������������������������� 256–​57 Art 2(1) �����������������������������������255, 257–​58, 265 Art 2(1)(a)����������������������������������������������� 256–​57 Art 2(1)(b)����������������������������������������������� 256–​57 Art 2(1)(f)����������������������������������������������� 260–​61 Art 2(1)(o)������������������������������������������������������342 Arts 3 to 7��������������������������������������������������������265 Arts 3 to 14 ����������������������������������������������������281 Art 3(1) ����������������������������������������������������������257 Arts 4 to 21 ��������������������������������������������� 276–​77 Art 4(1)(a)������������������������������������������������� 305–​6 Arts 5 to 7��������������������������������������������������������261 Art 5(1) �������������������������������������������258, 260–​61 Art 5(2) ����������������������������������������������������������258 Art 5(4) �������������������������������������������258, 278–​79 Art 5(4)(a)������������������������������������������������������258 Art 5(5) ����������������������������������������������������������259 Art 5(6) ����������������������������������������������������������258 Art 6(1) ��������������������������������������������������� 259–​60 Art 6(2) ����������������������������������������������������������260 Art 6(3) ����������������������������������������������������������260 Art 7����������������������������������������������������������������260 Art 8����������������������������������������������������������������260

xxxvi  Table of Legislation Art 9(1) ����������������������������������������������������������342 Arts 10 to 12 ������������������������������������������� 274–​75 Arts 10 to 16 ��������������������������������������������������342 Art 10������������������������������������������������������� 262–​63 Art 10(2) ������������������������������������������������� 259–​60 Art 13������������������������������������������������������� 275–​76 Art 14�����������������������������������������������276, 289–​90 Art 14(b) ������������������������������������������������� 312–​13 Art 15��������������������������������������������������������������276 Art 16��������������������������������������������������������������262 Art 17��������������������������������������������������������������262 Art 17(4) ������������������������������������������������� 259–​60 Art 17(5) ������������������������������������������������� 259–​60 Art 18��������������������������������������������������������������262 Art 18(3) ������������������������������������������������� 259–​61 Art 19���������������������������������������� 259–​60, 262–​63 Arts 20 to 23 ������������������������������������������� 280–​81 Art 20��������������������������������������������������������������263 Art 21��������������������������������������������������������������262 Arts 22 to 29 ������������������������������������������� 276–​77 Art 22�����������������������������������������������280, 281–​82 Art 22(3) ��������������������������������������������������������278 Art 22(4) ������������������������������������������������� 289–​90 Art 23(1) ������������������������������������������������� 278–​79 Art 23(2) ��������������������������������������������������������280 Art 24��������������������������������������������������������������282 Art 25(1) ������������������������������������������������� 278–​79 Art 25(2) �����������������������������������������276, 280–​81 Arts 27 to 29 ��������������������������������������������������260 Arts 27 to 31 ��������������������������������������������������258 Art 30�����������������������������������������������277, 289–​90 Art 31��������������������������������������������������������������277 Art 32(1)(o)��������������������������������������������� 264–​65 Arts 36 and 37����������������������������������������� 285–​86 Arts 37 to 48 ��������������������������������������������������263 Arts 38 to 45 ��������������������������������������������������272 Art 40(4) ������������������������������������������������� 271–​72 Art 50������������������������ 264–​65, 266, 267, 849–​50 Art 50(1) �����������������������������������������255, 269–​70 Art 51������������������������������������������������������� 271–​72 Art 52�����������������������������������������������268, 271–​72 Art 53(1) ��������������������������������������������������������269 Art 54������������������������������������������������������� 268–​69 Art 55������������������������������������������������������� 269–​70 Art 56��������������������������������������������������������������269 Art 58��������������������������������������������������������������270 Arts 58 to 64 ��������������������������������������������������270 Art 69������������������������������������������������������� 282–​83 Art 70���������������������������������������� 270–​71, 282–​83 Art 70(1) ��������������������������������������������������������270 Art 71(1) ������������������������������������������������� 282–​83 Art 72��������������������������������������������������������������282 Art 74��������������������������������������������������������������283 Art 75������������������������������������������������������� 283–​84 Art 76������������������������������������������������������� 283–​84 Arts 78 to 81 ������������������������������������������� 285–​86 Art 78(5) ��������������������������������������������������������286

Art 79(1) and (2)��������������������������������������������286 Art 80��������������������������������������������������������������286 Art 82(1) ��������������������������������������������������������286 Art 82a����������������������������������������������������� 285–​86 Art 84���������������������������������������255–​56, 263, 265 Art 84(1) ��������������������������������������������������������255 Art 84(2) ��������������������������������������������������������255 Arts 91 to 96 ��������������������������������������������������261 Art 91(1) ��������������������������������������������������������261 Art 91(2) ������������������������������������������������� 260–​61 Art 92������������������������������������������������������� 261–​62 Art 93��������������������������������������������������������������261 Art 93(a) ��������������������������������������������������������262 Art 94��������������������������������������������������������������261 Art 94(1)(b)����������������������������������������������������286 Art 97��������������������������������������������������������������290 Art 98�����������������������������������������������285–​86, 290 Art 99��������������������������������������������������������������293 Art 99(3) ������������������������������������������������� 290–​91 Art 100������������������������������������������������������������294 Art 101����������������������������������������������������� 290–​91 Arts 102 to 104 ��������������������������������������� 290–​91 Art 106������������������������������������������������������������290 Arts 107 to 110 ����������������������������������������������263 Art 108������������������������������������������������������������291 Art 109������������������������������������������������������������291 Art 110(1) ������������������������������������������������������291 Annex I ��������������������������������������������������� 282–​83 Annex II����������������������������������������������������������260 Directive 2010/​73/​EU amending Directive 2003/​71/​EC on the prospectus to be published when securities are offered to the public or admitted to trading and 2004/​109/​EC on the harmonization of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market (2010 Prospectus Amending Directive) [2010] OJ L327/​1�������90, 92–​93, 94–​96, 97–​98, 101, 102, 104–​5, 107, 120, 122, 125, 130, 131–​32, 134, 136, 139–​40, 146, 767 Directive 2010/​76/​EU amending Directives 2006/​48/​EC and 2006/​49/​EC as regards capital requirements for the trading book and for re-​securitisations, and the supervisory review of remuneration policies (Capital Requirements Directive III (CRD III)) [2010] OJ L329/​3�������������������������� 421, 422–​23 Directive 2011/​61/​EU on Alternative Investment Fund Managers and amending Directives 2003/​41/​EC and 2009/​65/​EC and Regulations (EC) 1060/​2009 and (EU) 1095/​2010 (2011 AIFMD) [2011] OJ L174/​1 �������������������� 1–​2, 13–​14, 24, 189–​90, 233–​35, 239–​43,

Table of Legislation  xxxvii 248–​50, 252–​53, 267–​68, 271–​72, 273, 275–​76, 277–​78, 280, 282, 294–​96, 298–​99, 300, 301, 302, 305, 312, 316, 318–​19, 322–​23, 325, 326, 328, 329, 331–​33, 340–​41, 345, 378–​79, 410–​12, 421, 587, 773–​74, 777–​78, 790–​91, 843, 861, 864–​69 recital 2������������������������������������������������������������304 recital 3������������������������������������������������������� 305–​6 recital 24���������������������������������������������������������305 recital 34������������������������������������������������ 319, 321 recital 36���������������������������������������������������������321 Art 2(1) ����������������������������������������������������� 306–​7 Art 2(2) ����������������������������������������������������� 305–​6 Art 3������������������������������������������������������� 303, 308 Art 3(1)–​3(2)��������������������������������������������������306 Arts 4 to 7������������������������������������������������� 310–​11 Art 4(1) �����������������������������������309–​10, 311, 313 Art 4(1)(b)������������������������������������������������������306 Art (4)(1)(1) ��������������������������������������������� 306–​7 Art 5(1) to 5(3)����������������������������������������������306 Arts 6 to 11 ��������������������������������������������� 316–​17 Art 6����������������������������������������������������������� 307–​8 Art 6(3) ����������������������������������������������������������332 Art 7����������������������������������������������������������������307 Art 7(2) ����������������������������������������������������������332 Art 7(3)(a)������������������������������������������������������317 Art 8����������������������������������������������������������������308 Art 8(4) ����������������������������������������������������������308 Arts 9 to 12 ��������������������������������������������� 310–​11 Art 9����������������������������������������������������������������308 Art 12��������������������������������������������� 310, 312, 313 Art 13������������������������������������������������������� 312–​13 Art 14����������������������������������������������������� 310, 313 Art 15��������������������������������������������������������������315 Art 15(1) ��������������������������������������������������������305 Art 15(4) ��������������������������������������������������������317 Art 16������������������������������������������������������� 315–​16 Art 16(1) ��������������������������������������������������� 304–​5 Art 17��������������������������������������������������������������315 Art 18����������������������������������������������������� 304, 314 Art 19��������������������������������������������������������������314 Art 19(3) ��������������������������������������������������� 304–​5 Art 20����������������������������������������������������� 314, 315 Art 21������������������������������������������������������� 319–​21 Art 22��������������������������������������������������������������322 Art 23(2) �����������������������������������������316–​17, 322 Art 24����������������������������������������������������� 317, 322 Art 25������������������������������300–​1, 303–​4, 317–​18 Arts 26 to 30 ��������������������������������������������������323 Art 27������������������������������������������������������� 323–​24 Art 28������������������������������������������������������� 323–​24 Art 30��������������������������������������������������������������324 Art 30a������������������������������������������������������������311 Arts 31 and 32������������������������������������������������311 Arts 31 to 33 ������������������������������������������� 309–​10 Art 32a����������������������������������������������������� 310–​11

Art 33������������������������������������������������������� 309–​10 Arts 35 and 36����������������������������������������� 866–​67 Arts 39 to 41 ��������������������������������������������������867 Art 42����������������������������������������������������� 305, 867 Art 43�����������������������������������������������305, 324–​25 Art 43a������������������������������������������������������������312 Art 44��������������������������������������������������������������325 Art 45�����������������������������������������������305, 309–​10 Art 46��������������������������������������������������������������325 Art 47��������������������������������������������������������������325 Art 47(4) ��������������������������������������������������������867 Art 48��������������������������������������������������������������326 Art 50��������������������������������������������������������������325 Art 51��������������������������������������������������������������325 Art 52��������������������������������������������������������������325 Art 54��������������������������������������������������������������325 Art 55��������������������������������������������������������������325 Art 67������������������������������������������������������� 867–​69 Art 69��������������������������������������������������������� 301–​2 Art 69a������������������������������������������������������������312 Annex II�������������������������������������� 307–​8, 312–​13 Annexes III to IV ������������������������������������������309 Directive 2013/​14/​EU amending Directive 2003/​41/​EC, Directive 2009/​65/​EC, and Directive 2011/​61/​EU in respect of over-​reliance on credit ratings (2013 CRA IV Directive) [2013] OJ L145/​1��������������155–​57, 158–​60, 163–​64, 165, 167, 176, 212, 382, 643, 658, 662–​63, 665, 667–​68, 675–​76 Directive 2013/​36/​EU on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/​87/​EC and repealing Directives 2006/​48/​ EC and 2006/​49/​EC (2013 Capital Requirements Directive (CRD IV)) [2013] OJ L176/​338 ������������������ 1–​2, 10, 308, 353, 364, 366, 395–​96, 399–​424, 429, 434–​36, 437–​38, 485, 488, 489, 532, 533–​34, 854, 878, 879–​80, 882–​83 Arts 73 to 87 ��������������������������������������������������418 Art 73����������������������������������������������������� 418, 424 Art 74��������������������������������������������������������������418 Art 74(1) ��������������������������������������������������� 46–​47 Art 76����������������������������������������������������� 418, 424 Art 88������������������378–​79, 380–​81, 383, 420–​21 Art 91������������������������ 378–​79, 380–​81, 420, 423 Art 92������������������������������������������������������� 421–​22 Art 94(1)(b)��������������������������������������������� 422–​23 Art 95������������������������������������������������������� 421–​22 Arts 97 to 110 ����������������������������������������� 435–​36 Art 98������������������������������������������������������� 435–​36 Art 104����������������������������������������������������� 435–​36 Art 104a��������������������������������������������������� 435–​36 Art 104b��������������������������������������������������� 435–​36

xxxviii  Table of Legislation Directive 2013/​50/​EU amending Directive 2004/​109/​EC, Directive 2003/​71/​EC and Commission Directive 2007/​14/​ EC (2013 Transparency Amending Directive) [2013] OJ L294/​13������ 69, 104–​5, 155, 156, 160, 164–​65, 167–​93, 174–​75, 187, 188–​89 Directive 2014/​49/​EU on deposit guarantee schemes [2014] OJ L173/​149 ����������������������������� 365, 843, 847 Directive 2014/​59/​EU establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Directive 82/​891/​EEC, and Directives 2001/​24/​EC, 2002/​47/​EC, 2004/​25/​EC, 2005/​56/​EC, 2007/​36/​EC, 2011/​35/​ EU, 2012/​30/​EU and 2013/​36/​EU, and Regulations (EU) 1093/​2010 and (EU) 648/​2012 [2014] OJ L173/​190 (2014 Bank Recovery and Resolution Directive (BRRD))���������������������106, 112–​13 Art 44a����������������������������������������������������� 794–​95 Directive 2014/​65/​EU on markets in financial instruments and amending Directive 2002/​92/​EC and Directive 2011/​61/​EU (2014 MiFID II) [2014] OJ L173/​349 ��������������������������������1–​2, 13–​14, 18–​19, 20–​21, 24, 45, 46–​47, 51, 59–​60, 64–​65, 69, 89, 107–​8, 113, 132, 152–​53, 155–​56, 162, 169, 189–​90, 196–​201, 205, 206–​8, 215–​16, 219–​22, 225–​26, 231, 259–​60, 264–​65, 274, 276–​77, 288–​89, 297, 301–​2, 307–​8, 309–​10, 311–​12, 324–​25, 328–​29, 332, 333, 335–​37, 351–​94, 395, 400–​1, 403–​4, 405–​6, 409, 410–​12, 413–​14, 415, 416, 425–​34, 453–​55, 456–​57, 458–​62, 464–​65, 466–​67, 468, 469, 472–​73, 475–​76, 477, 485–​88, 492–​93, 502–​3, 505, 507, 510–​13, 514, 517–​18, 551, 561–​62, 583, 588–​89, 590, 602–​3, 633, 634, 679, 680, 689–​92, 694–​95, 736, 743, 764, 767, 768–​816, 828–​29, 830–​31, 832–​33, 834–​36, 846, 849–​50, 854–​56, 857, 861, 864, 869, 880, 884–​85, 893–​94 recital 74���������������������������������������������������������806 recital 83���������������������������������������������������������790 Art 1(2) ����������������������������������������������������������364 Art 1(3) ������������������������������������������������� 364, 365 Art 1(4) ������������������������������������������������� 775, 782 Art 1(7) ��������������������������������������������������� 468–​69 Art 2(1) ������������������������������������ 369–​72, 541–​42 Art 2(1)(d)������������������������������������������������������543 Art 2(1)(m)���������������������� 836–​37, 839–​40, 845 Art 3����������������������������������������������������������������372 Art 4������������������������������������������������������� 365, 366 Art 4(1) �������������������������������������������381–​82, 425

Art 4(1)(1) and (2)) ��������������������������������������782 Art 4(1)(4) and (5)��������������������������������� 782–​83 Art 4(1)(7)���������������������������������������370–​71, 467 Art 4(1)(10) and (11)������������������������������������786 Art 4(1)(14)����������������������������������������������������501 Art 4(1)(18)����������������������������������������������������471 Art 4(1)(19)����������������������������������������������������467 Art 4(1)(20)����������������������������������������������������475 Art 4(1)(21)������������������������������������������� 104, 471 Art 4(1)(22)����������������������������������������������������472 Art 4(1)(24)����������������������������������������������������467 Art 4(1)(38)����������������������������������������������������474 Art 4(1)(39)��������������������������������������������� 541–​42 Art 4(1)(44)����������������������������������������������� 105–​6 Art 4(1)(44a)������������������������������������������� 814–​15 Art 4(1)(45)��������������������������������������������� 469–​70 Art 4(1)(46)��������������������������������������������� 469–​70 Art 4(1)(55)����������������������������������������������������376 Art 4(1)(57)����������������������������������������������������878 Art 4(1)(60)�������������������������������������469–​70, 471 Art 5��������������������������������������������������������� 375–​76 Art 5(4) ����������������������������������������������������������376 Art 6��������������������������������������������������������� 375–​76 Art 6(1) ������������������������������������������������� 366, 425 Art 7��������������������������������������������������������� 375–​76 Art 7(2) ����������������������������������������������������������382 Art 8����������������������������������������������������������������378 Art 9��������������������378–​79, 380–​81, 420, 812–​13 Art 9(3) ���������������������� 365, 388–​89, 802–​3, 811 Art 10������������������������������������������������������� 381–​82 Arts 11 to 13 ��������������������������������������������������382 Art 14������������������������������������� 365, 383, 843, 845 Art 16������������������������������365, 382, 383–​85, 388, 425, 426–​27, 485–​86 Art 16(3) ������������������� 206–​7, 388–​89, 390, 393, 430–​31, 538–​39, 777–​78, 802, 811–​13, 814, 826 Art 16(11) ������������������������������������������������������362 Art 16a����������������������������������������������������� 814–​15 Arts 17 to 20 ��������������������������������������������������383 Art 17������������������������������������������������������� 541–​43 Art 18�����������������������������������������������485–​86, 524 Art 18(2) ������������������������������������������������� 487–​88 Art 18(3) ������������������������������������������������� 486–​87 Art 18(5) ��������������������������������������������������������480 Art 18(7) ��������������������������������������������������������543 Art 18(10) ������������������������������������������������������485 Art 19������������������������������������������������������� 485–​87 Art 20(1) ��������������������������������������������������������474 Art 20(2) ��������������������������������������������������������474 Art 20(3) ��������������������������������������������������������474 Art 20(4) ������������������������������������������������� 473–​74 Art 20(5) ������������������������������������������������� 473–​74 Art 20(6) ����������������������������������������������� 473, 474 Art 20(7) ��������������������������������������������������������474 Art 20(8) ������������������������������������������������� 473–​74 Art 20(12) ������������������������������������������������������488

Table of Legislation  xxxix Art 21���������������������������������������375–​76, 383, 425 Arts 23 to 26 ��������������������������������������������������365 Art 23����������������� 206–​7, 383, 384, 388–​89, 390, 489–​91, 538–​39, 802, 826 Art 24�����������207–​8, 373–​75, 383, 390, 392–​93, 426–​27, 483–​84, 536–​37, 538–​39, 777–​78, 790–​91, 805–​6, 826–​27 Art 24(1) �����������������������������������������787, 788–​89 Art 24(2) �����������������������������������������788, 811–​12 Art 24(9) ��������������������������������������������������������804 Art 24(9)–​(10)������������������������������������������� 802–​3 Art 24(12) ������������������������������������������������������362 Art 25�������� 374–​75, 383, 393, 426–​27, 483–​84, 486–​87, 519, 777–​78, 787, 792–​95, 827 Art 25(4) �������������������������������798, 799–​800, 884 Art 25(6) ��������������������������������������������������������790 Art 26��������������������������������������������������������������519 Art 27������������������������������� 373–​74, 383, 426–​27, 483–​84, 486–​87, 534–​39 Art 28��������� 365, 373–​74, 383, 486–​87, 539–​40 Art 28(2) ��������������������������������������������������������501 Art 29����������������������������������������������������� 365, 383 Art 29(4) ��������������������������������������������������������430 Art 30������������������������������������������������������� 373–​74 Arts 31 to 33 ��������������������������������������������������383 Art 31��������������������������������������������������������������487 Art 33���������������������������������������������198, 199–​201 Art 33(3)(d)�������������������������������������125–​26, 131 Art 34�����������������������������������������������425, 427–​28 Art 34(6) ��������������������������������������������������������487 Art 35����������������������������������������������������� 425, 428 Art 35(8) ������������������������������������������������� 426–​27 Art 36��������������������������������������������������������������484 Arts 39 to 43 ������������������������������������������� 878–​79 Art 39������������������������������������������������������� 878–​81 Art 41������������������������������������������������������� 879–​80 Art 42������������������������������������������������������� 883–​84 Art 44��������������������������������������������������������������477 Art 47������������������������ 479–​80, 481–​82, 486, 524 Art 48�����������������������������������������������480–​82, 486 Art 48(11) ������������������������������������������������������484 Art 49���������������������������������������480, 482–​83, 486 Art 49 (2)������������������������������������������������� 476–​77 Art 49(1) ������������������������������������������������� 476–​77 Art 50��������������������������������������������������������������483 Art 51��������������������������������������������������������������194 Art 52����������������������������������������������������� 194, 196 Art 53(1) ������������������������������������������������� 483–​84 Art 53(3) ������������������������������������������������� 486–​87 Art 54��������������������������������������������������������������484 Art 54(10) ������������������������������������������������������797 Art 57������������������������������� 545, 547–​48, 549–​50, 595–​96, 798–​99 Art 57(5) ��������������������������������������������������������549 Art 58����������������������������������������������������� 545, 549 Art 66(6) ������������������������������������������������� 536–​37 Art 67������������������������������������������������������� 429–​31

Art 68(1) ��������������������������������������������������������430 Art 69��������������������������������������381, 430, 439–​40, 441–​42, 548, 549–​50 Art 69(2) ����������������������������������������������� 519, 814 Art 70������������������������������������������������������� 438–​39 Art 71���������������������������������������� 373–​74, 438–​39 Art 72�����������������������������������������������430, 438–​39 Art 73������������������������������������������������������� 430–​31 Art 76��������������������������������������������������������������430 Art 77(1) ������������������������������������������������� 430–​31 Art 79�������������������������������� 431–​32, 522, 531–​50 Art 79(1) ������������������������������������������������� 438–​39 Art 81������������������������������������������������������� 432–​33 Art 82(1)(a)����������������������������������������������������433 Art 83��������������������������������������������������������������433 Art 84��������������������������������������������������������������376 Art 86(1) ��������������������������������������������������������426 Art 86(2) ��������������������������������������������������������427 Art 86(3) ��������������������������������������������������������522 Art 87������������������������������������������������������� 431–​32 Art 90������������������������������������������������������� 463–​64 Annex I ��������������������������������������������������� 469–​70 Annex I(A) ����������������������������������������������������366 Annex I(B)������������������������������������������������������366 Annex I(C) ������������������������������ 367–​68, 469–​70 Annex II�������������������� 372–​73, 374–​75, 782, 786 Directive 2014/​91/​EU amending Directive 2009/​65/​EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards depositary functions, remuneration policies and sanctions (UCITS V) [2014] OJ L257/​186������ 189–​90, 233, 249–​51, 276, 277, 278–​80, 312–​13, 319 Directive 2014/​95/​EU amending Directive 2013/​34/​EU as regards disclosure of non-​financial and diversity information by certain large undertakings and groups (Non-​ Financial Reporting Directive (NFRD)) [2014] OJ L 330/​1 ���������������������59–​60, 61, 155, 159–​60, 212–​14 Directive (EU) 2016/​97 on insurance distribution (Insurance Distribution Directive (IDD)) [2016] OJ L26/​19������ 365, 767, 772, 774–​76, 807–​8, 825–​27, 828–​29, 832–​33 Art 2(1)(1)����������������������������������������������� 825–​26 Art 2(1)(15)����������������������������������������������������826 Art 2(1)(17)��������������������������������������������� 825–​26 Arts 17 to 20 ������������������������������������������� 825–​26 Art 25������������������������������������������������������� 825–​26 Arts 26 to 30 ������������������������������������������� 825–​26 Arts 27 and 28��������������������������������������� 826, 827 Art 29(1) ��������������������������������������������������������826

xl  Table of Legislation Art 29(3) ������������������������������������������������� 826–​27 Art 30��������������������������������������������������������������827 Art 26������������������������������������������������������� 825–​26 Directive 2017/​828/​EU amending Directive 2007/​36/​EC as regards the encouragement of long-​term shareholder engagement (Shareholder Rights Directive II) [2017] OJ L 132/​1�����������������������������������������166–​67 Directive (EU) 2019/​878 amending Directive 2013/​36/​EU as regards exempted entities, financial holding companies, mixed financial holding companies, remuneration, supervisory measures and powers and capital conservation measures (2019 Capital Requirements Directive V (CRD V)) [2019] OJ L150/​253�������� 353, 364, 379, 395–​96, 399–​400, 402, 413, 414, 415, 416–​17, 421, 423–​24, 436, 533–​34 Art 1����������������������������������������������������������������413 Directive (EU) 2019/​1023 on preventive restructuring frameworks, on discharge of debt and disqualifications, and on measures to increase the efficiency of procedures concerning restructuring, insolvency and discharge of debt, and amending Directive (EU) 2017/​1132 (Business Restructuring and ‘Second Chance’ Directive) [2019] OJ L172/​18��������� 15 Directive (EU) 2019/​2034 on the prudential supervision of investment firms and amending Directives 2002/​87/​EC, 2009/​65/​EC, 2011/​61/​EU, 2013/​36/​EU, 2014/​59/​EU and 2014/​65/​EU (2019 Investment Firm Directive (IFD)) [2019] OJ L314/​64���������� 10, 24, 353, 378, 379, 383, 395–​96, 400–​12, 413, 414, 416–​17, 429, 437–​38, 485, 489, 532, 533–​34, 878, 879–​80, 882–​83 Art 1����������������������������������������������������������������403 Art 2(1) ����������������������������������������������������������403 Art 2(2) ����������������������������������������������������������404 Art 5����������������������������������������������������������������404 Art 9����������������������������������������������������������� 405–​6 Art 12��������������������������������������������������������������437 Art 13(1) ��������������������������������������������������������437 Art 15��������������������������������������������������������������437 Art 19��������������������������������������������������������������437 Arts 36 to 45 ��������������������������������������������������437 Art 36��������������������������������������������������������������437 Art 39��������������������������������������������������������������437 Directive (EU) 2019/​2162 on the issue of covered bonds and covered bond public supervision and amending Directives 2009/​65/​EC and 2014/​59/​EU (2019 Covered Bonds Directive) [2019] OJ L328/​29������������������������������������������ 70, 226–​27

Directive (EU) 2021/​338 amending Directive 2014/​65/​EU as regards information requirements, product governance and position limits, and Directives 2013/​36/​EU and (EU) 2019/​878 as regards their application to investment firms, to help the recovery from the COVID-​19 crisis (2021 MiFID II ‘Quick Fix’ Directive) [2021] OJ L 68/​14��������������� 352–​53, 360–​61, 544, 545–​46, 548, 549 recital 5����������������������������������������������������� 374–​75 Directive (EU) 2021/​2261 amending Directive 2009/​65/​EC as regards the use of key information documents by management companies of undertakings for collective investment in transferable securities (UCITS) [2021] OJ L 455/​15��������������������287 Directive (EU) 2022/​2464 amending Regulation (EU) 537/​2014, Directive 2004/​109/​EC, Directive 2006/​43/​EC and Directive 2013/​34/​EU, as regards corporate sustainability reporting (Corporate Sustainability Reporting Directive (CSRD)) [2022] OJ L 322/​15����������������������������������������� 212–​14 Delegated Directives Delegated Directive 2003/​124/​EC [2003] OJ L339/​70 ������������������������������������������������700 Delegated Directive 2003/​125/​EC [2003] OJ L339/​73 ������������������������������������������� 204–​5 Delegated Directive 2007/​14/​EC [2007] OJ L69/​27 ������������������������������ 158–​59, 160–​61, 165, 167, 169 Delegated Directive 2007/​16/​EC [2007] OJ L79/​11������������������������������������253–​54, 255 Delegated Directive 2010/​42/​EU [2010] OJ L176/​28 ����������������������������������������� 253–​54 Delegated Directive 2010/​43/​EU [2010] OJ L176/​42 ������������������������� 253–​54, 271–​72, 276–​77, 289–​90 Delegated Directive 2017/​565 [2017] OJ L 87/​1 ������������� 777–​78, 780, 782–​83, 784, 788–​89, 790–​91, 792–​94, 797, 798–​99, 803–​4, 805–​6, 828–​29, 845 Delegated Directive 2017/​567 [2017] OJ L87/​90��������������������771, 816–​17, 818, 822 Delegated Directive 2017/​593 [2017] OJ L87/​500 ����������������362–​63, 383, 385, 386, 771, 810, 812–​15 Delegated Directive 2021/​1253 [2021] OJ L277/​1���������������������������������������������������781 Delegated Directive 2021/​1269 [2021] OJ L277/​137 ������������������������������������� 781, 816

Table of Legislation  xli Regulatory Technical Standards (RTSs) RTS 447/​2012 [2012] OJ L140/​14 (2012 CRA Methodologies RTS)������������������������650 RTS 826/​2012 [2012] OJ L251/​1 (2012 Short Selling Reporting RTS)�����������������560, 572, 583–​84 RTS 919/​2012 [2012] OJ L274/​16 (2012 Short Selling Calculations RTS)��������������560 RTS 149/​2013 [2013] OJ L152/​11 (2013 EMIR Clearing Obligation RTS) ������ 600–​1, 606–​7, 609–​10, 615, 616, 629–​30 RTS 153/​2013 [2013] OJ L52/​41 (2013 EMIR CCP RTS)������600–​1, 626–​30, 890–​91 RTS 694/​2014 [2014] OJ L138/​18 (2014 AIFM Types RTS)��������������������������������������303 RTS 2015/​2 [2015] OJ L2/​24 (2015 CRA Periodic Reporting RTS)��������������������������650 RTS 2015/​761 [2015] OJ L120/​12 (2015 Major Holdings Notification RTS)������ 160–​61 RTS 2016/​908 [2016] OJ L153/​3 (2016 MAR AMP RTS)������������������ 692–​93, 722–​23 RTS 2016/​958 [2016] OJ L160/​15 (2016 Investment Recommendations RTS)��������������������� 205–​6 RTS 2016/​960 [2016] OJ L160/​29 (2016 MAR Market Soundings RTS)�����692–​93, 706 RTS 2016/​1052 [2016] OJ L173/​34 (2016 MAR Buy-​Backs and Stabilization RTS)�����������������������692–​93, 725 RTS 2016/​2251 [2016] OJ L340/​9 (2016 EMIR Margin RTS) ������������� 597–​99, 600–​1, 615, 617–​18 RTS 2017/​568 [2017] OJ L87/​117 (2017 Admissions RTS)����������� 195, 196, 464 RTS 2017/​577 [2017] OJ L87/​174 (RTS 3)����������������������������������������������� 465, 496 RTS 2017/​583 [2017] J L87/​229 (RTS 2)������������������������������������ 464–​65, 503–​4 RTS 2017/​587 [2017] OJ L87/​387 (RTS 1)�����������������������������������������464–​65, 494 RTS 2017/​588 [2017] OJ L87/​411 (RTS 11)������������������������ 464, 476–​77, 482–​83 RTS 2017/​589 [2017] OJ L87/​417 (2017 Algorithmic Trading RTS)�����������534, 540–​41, 543 RTS 2017/​591 [2017] OJ L87/​479 (2017 Position Limits RTS) ���������534, 545, 547–​48 RTS 2017/​653 [2017] OJ L100/​1 (2017 PRIIPs KID RTS)�������� 771, 831–​37, 838–​40 RTS 2018/​480 [2018] OJ L81/​1 (2018 ELTIF RTS)��������������������������������������332 RTS 2019/​979 [2019] OJ L166/​1 (2019 Prospectus RTS)������������������� 68–​69, 99–​100, 118–​19, 136–​37, 142, 145 RTS 2021/​2268 [2021] OJ LI455/​1 (2021 PRIIPs KID Reform RTS)��������832, 833–​34, 835–​36, 839–​41

Decisions Commission Decision 2001/​527/​EC establishing the Committee of European Securities Regulators [2001] OJ L191/​43 ������������������������������� 33–​34 Commission Decision 2008/​961/​EC on the use by third countries’ issuers of national accounting standards and International Financial Reporting Standards [2008] OJ L340/​112����������������872 Commission Decision 2010/​342/​EU exempting the Banque de France from the application of Regulation (EC) No 1060/​2009 of the European Parliament and of the Council on credit rating agencies [2010] OJ L 154/​29������������������������������������������� 33–​34 Commission Implementing Decision 2014/​755/​EU on the equivalence of the regulatory framework of Australia for central counterparties to the requirements of Regulation (EU) No 648/​2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories [2014] OJ L311/​66 ����������������������������� 887–​88 Commission Implementing Decision 2016/​377/​EU on the equivalence of the regulatory framework of the United States of America for central counterparties that are authorised and supervised by the Commodity Futures Trading Commission to the requirements of Regulation (EU) No 648/​2012 of the European Parliament and of the Council [2016] OJ L70/​32���������������������������������887–​88 Commission Implementing Decision 2016/​2269/​EU on the equivalence of the regulatory framework for central counterparties in India in accordance with Regulation (EU) No 648/​2012 of the European Parliament and of the Council [2016] OJ L342/​38��������������� 887–​88 Commission Implementing Decision 2017/​2238/​EU on the equivalence of the legal and supervisory framework applicable to designated contract markets and swap execution facilities in the United States of America in accordance with Regulation (EU) No 600/​2014 of the European Parliament and of the Council [2017] OJ L320/​11 �������������� 859–​60, 884–​85 Commission Implementing Decision 2017/​2441/​EU on the equivalence of

xlii  Table of Legislation the legal and supervisory framework applicable to stock exchanges in Switzerland in accordance with Directive 2014/​65/​EU of the European Parliament and of the Council [2017] OJ L344/​52����������������������862 Commission Implementing Decision 2018/​2031/​EU determining, for a limited period of time, that the regulatory framework applicable to central counterparties in the United Kingdom of Great Britain and Northern Ireland is equivalent, in accordance with Regulation (EU) No 648/​2012 of the European Parliament and of the Council [2019] OJ L325/​50 ������������������������������������907 Commission Implementing Decision 2022/​174/​EU determining, for a limited period of time, that the regulatory framework applicable to central counterparties in the United Kingdom of Great Britain and Northern Ireland is equivalent, in accordance with Regulation (EU) No 648/​2012 of the European Parliament and of the Council [2022] OJ L28/​40������907 INTERNATIONAL INSTRUMENTS Basel Accords Basel II 2004 �����������������������397, 398, 640, 644–​45 Basel III 2010����������������223–​24, 397–​400, 417–​18

EU/​Canada Comprehensive Economic and Trade Agreement (CETA)��������� 852–​53 EU/​Japan Trade Agreement ����������������������������904 EU/​UK Trade and Cooperation Agreement (TCA) �������������������850, 899–​909 Arts 182 to 189 ����������������������������������������������904 EU/​UK Withdrawal Agreement����������������� 901–​2 NATIONAL LEGISLATION Spain Securities Markets Act 1988 ����������������������������354 United Kingdom Financial Services Act 1986������������������������������354 Financial Services and Markets Act 2000������������������������������������������������� 905–​6 Prevention of Fraud (Investments) Act 1958������������������������������������������������������354 United States Credit Rating Agency Reform Act 2006������������������������������������������������������640 Dodd-​Frank Act 2010 �����������������������553, 876–​77 s 619 (‘Volcker Rule’)������������������������������������530 Jumpstart Our Business Startups Act 2012 (JOBS Act)������������������������������������73 Sarbanes-​Oxley Act 2000����������������������������������203 SEC Regulation Fair Disclosure (FD) (2000)����������������������������������������� 713–​14 Securities Act 1933��������������������������������������� 74–​75 Securities Exchange Act 1934��������������������� 74–​75

List of Abbreviations BLJ A ACER ADR AG AIF AIFM AIFMD ALER Am Econ Rev Am J Comp L APA ARC Art ASA AUM BAC BCD II BCS Bell J Econ and   Management Sci BJIBFL BoS Brooklyn J Int L Brooklyn LR BTS Cal LR Cardozo LR CCP CCRAR CDO CDS CEBS CEIOPS CESR CfD CFILR Ch CIS CJIL CME CMG CMH CMLJ

American Business Law Journal Agency for the Co-​operation of Energy Regulators Alternative Dispute Resolution Advocate General Alternative Investment Fund Alternative Investment Fund Manager Alternative Investment Fund Managers Directive American Law and Economics Review American Economic Review American Journal of Comparative Law Approved Publication Arrangement Accounting Regulatory Committee Article Assets Safeguarded and Administered Assets Under Management Banking Advisory Committee Second Banking Co-​ordination Directive Broker Crossing System Bell Journal of Economics and Management Science Butterworths Journal of International Banking and Financial Law Board of Supervisors Brooklyn Journal of International Law Brooklyn Law Review Binding Technical Standard California Law Review Cardozo Law Review Central Clearing Counterparty Consolidated Credit Rating Agency Regulation Collateralized Debt Obligation Credit Default Swap Committee of European Banking Supervisors Committee of European Insurance and Occupational Pensions Supervisors Committee of European Securities Regulators Contract for Difference Company, Financial and Insolvency Law Review Chapter Collective Investment Scheme Chicago Journal of International Law Co-​ordinated Market Economy Clearing Margin Given Client Money Held Capital Markets Law Journal

xliv  List of Abbreviations MLR C CMU COH Col J Transnat’l Law Col LR CON Cornell LR CRA CRD IV CRR CSD Denver J of Int’l L   and Policy DLT DORA DTF Duke LJ EBA EBLR EBOLR ECB ECFR ECMH ECOFIN ECON EESC EFAMA EFC EFRAG EFSIRs EFSL EIOPA ELJ ELR ELTIF EMIR EMU ERP ESA ESAP ESCB ESG ESFS ESMA ESME ESRB ETF EU Euro Rev Contract L EuSEF

Common Market Law Review Capital Markets Union Client Orders Handled Columbia Journal of Transnational Law Columbia Law Review Concentration Risk Cornell Law Review Credit Rating Agency Capital Requirements Directive IV Capital Requirements Regulation Central Securities Depositary Denver Journal of International Law and Policy Distributed Ledger Technology Digital Operational Resilience Act Daily Trading Flow Duke Law Journal European Banking Authority European Business Law Review European Business Organization Law Review European Central Bank European Company and Financial Law Review Efficient Capital Markets Hypothesis Economic and Financial Affairs Council Economic and Monetary Affairs Committee European Economic and Social Committee European Fund and Asset Management Association Economic and Financial Committee European Financial Reporting Advisory Group European Financial Stability and Integration Reviews European Financial Services Law European Insurance and Occupational Pensions Authority European Law Journal European Law Review European Long Term Investment Fund European Market Infrastructure Regulation Economic and Monetary Union European Ratings Platform European Supervisory Authority European Single Access Point European System of Central Banks Environmental, Social, and Governance European System of Financial Supervision European Securities and Markets Authority European Securities Markets Expert Group European Systemic Risk Board Exchange Traded Fund European Union European Review of Contract Law European Social Entrepreneurship Fund

List of Abbreviations  xlv uVECA E FAQs FCA FESCO Fordham Int LJ FSA FSAP FSB FSC FTT GAAP GDP G-​SIFI Harv B Rev Harv Int LJ Harv LR HFT Hofstra LR Houston LR IA IAS IASB ICCLJ ICLQ ICMA IDD IFD IFLR IFR IFR IFRS IIMG IMD I IMF Ind LJ Int’l Rev of   L and Econ IOSCO IPO ISCD ISD ISLA ITS J Comp Bus and   Capital Markets L J Consumer Res J Corp L J Fin Intermed J Fin J L and Econ

European Venture Capital Frequently Asked Questions UK Financial Conduct Authority Federation of European Securities Commissions Fordham International Law Journal UK Financial Services Authority Financial Services Action Plan Financial Stability Board Financial Services Committee Financial Transaction Tax Generally Accepted Accounting Principles Gross Domestic Product Global Systemically Important Financial Institution Harvard Business Review Harvard International Law Journal Harvard Law Review High Frequency Trading Hofstra Law Review Houston Law Review Impact Assessment International Accounting Standards International Accounting Standards Board International and Comparative Corporate Law Journal International and Comparative Law Quarterly International Capital Market Association Insurance Distribution Directive Investment Firm Directive International Financial Law Review International Financing Review Investment Firm Regulation International Financial Reporting Standards Inter-​institutional Monitoring Group Insurance Mediation Directive International Monetary Fund Indiana Law Journal International Review of Law and Economics International Organization of Securities Commissions Initial Public Offering Investor Compensation Schemes Directive Investment Services Directive International Securities Lending Association Implementing Technical Standard Journal of Comparative Business and Capital Markets Law Journal of Consumer Research Journal of Corporation Law Journal of Financial Intermediation Journal of Finance Journal of Law and Economics

xlvi  List of Abbreviations J Legal Studies J of Accounting  Research J of Business J of Econ Lit J of Econ Perspectives J Portfolio Mgmt J JACF JBL JCLS JCMS JEPP JFE JFRC JIBFL JIBL JIEL JILB JLE JLEO JPE KID KIID L Pol Int Bus LFMR LIEI LJ LMCLQ LME LQ LR MAR MiCAR Mich LR MiFID MiFID I MiFID II MiFIR MLR MMF MoU MTF NAV NCA NFC NFR NLJ NorthWestern JILB Notre Dame LR

Journal of Legal Studies Journal of Accounting Research Journal of Business Journal of Economic Literature Journal of Economic Perspectives Journal of Portfolio Management Journal Journal of Applied Corporate Finance Journal of Business Law Journal of Corporate Law Studies Journal of Common Market Studies Journal of European Public Policy Journal of Financial Economics Journal of Financial Regulation and Compliance Journal of International Banking and Financial Law Journal of International Banking Law Journal of International Economic Law Journal of International Law & Business Journal of Law and Economics Journal of Law, Economics & Organization Journal of Political Economy Key Information Document Key Investor Information Document Law and Policy of International Business Law and Financial Markets Review Legal Issues of European Integration Law Journal Lloyd’s Maritime and Commercial Law Quarterly Liberal Market Economy Law Quarterly Law Review Market Abuse Regulation Markets in Crypto-​Assets Regulation Michigan Law Review Markets in Financial Instruments Directive Markets in Financial Instruments Directive I Markets in Financial Instruments Directive II Markets in Financial Instruments Regulation Modern Law Review Money-​Market Fund Memorandum of Understanding Multilateral Trading Facility Net Asset Value National Competent Authority Non-​Financial Corporate/​Counterparty Non-​Financial Reporting New Law Journal NorthWestern Journal of International Law and Business Notre Dame Law Review

List of Abbreviations  xlvii PR N NYU LRev OECD OEIC OJLS OTC OTF para POD PRA PRIIPs PRIPs Q QJ Econ QMV REIT Rev Fin Studies RtC RtF RtM RTS SEC sect SEF SI SME SMS So Cal LR SREP SRM SSM Stanford LR TCA TCD TEU Texas LR TFEU TLR TREM TRV TESG TTIP UCITS UK University of   Chicago LR University of   Colorado LR U Pa JIEL U Pa JIL

Net Position Risk New York University Law Review Organization for Economic Co-​operation and Development Open-​ended Investment Company Oxford Journal of Legal Studies Over-​the-​counter Organized Trading Facility paragraph Public Offers Directive UK Prudential Regulation Authority Packaged Retail and Insurance-​based Investment Products Packaged Retail Investment Products Quarter Quarterly Journal of Economics Qualified Majority Vote Real Estate Investment Trust Review of Financial Studies Risk-​to-​client Risk-​to-​firm Risk-​to-​market Regulatory Technical Standard US Securities and Exchange Commission Section Social Entrepreneurship Fund Systematic Internalizer Small and Medium-​Sized Enterprise Standard Market Size Southern California Law Review Supervisory Review and Evaluation Process Single Resolution Mechanism Single Supervisory Mechanism Stanford Law Review Trade and Cooperation Agreement Trading Counterparty Default Treaty on European Union Texas Law Review Treaty on the Functioning of the European Union Tulane Law Review Transaction Reporting Exchange Mechanism Trends, Risks, and Vulnerabilities Technical Expert Stakeholder Group Transatlantic Trade and Investment Partnership Undertaking for Collective Investment in Transferable Securities United Kingdom University of Chicago Law Review University of Colorado Law Review University of Pennsylvania Journal of International Economic Law University of Pennsylvania Journal of International Law

xlviii  List of Abbreviations Pa LR U URD Va LR Vanderbilt J   Transnat’l L VAR Villanova LR VJIL VoC Washington   University JLP Yale J Reg Yale LJ YBEL

University of Pennsylvania Law Review Universal Registration Document Virginia Law Review Vanderbilt Journal of Transnational Law Value at Risk Villanova Law Review Virginia Journal of International Law Varieties of Capitalism Washington University Journal of Law and Policy Yale Journal of Regulation Yale Law Journal Yearbook of European Law

I THE INSTITUTIONAL SETTING I.1  EU Securities and Financial Markets Regulation This book addresses EU securities and financial markets regulation (hereafter EU financial markets regulation). It considers the harmonized rules which govern financial markets in the EU and is concerned therefore with market-​based financial intermediation between suppliers of capital and firms seeking capital, and with the wide range of relationships and related risks which this form of financial intermediation produces.1 It examines how the EU regulates the major actors in market-​based finance, including issuers of securities, investment funds, investment firms, rating agencies, and market infrastructures, such as trading venues and central clearing counterparties (CCPs). It also examines, as regards these actors, the process through which their regulatory regimes have emerged, how their supervision is organized, and the role of the European Securities and Markets Authority (ESMA), established in January 2011 as part of the European System of Financial Supervision (ESFS), and one of the three European Supervisory Authorities (ESAs).2 The main elements of this regulatory system address:3 issuers (2017 Prospectus Regulation, 2004 Transparency Directive, and 2002 International Accounting Standards Regulation (IAS Regulation));4 collective investment funds and managers (2009 Undertakings for Collective Investment in Transferable Securities (UCITS) Directive, 2011 Alternative Investment Fund Managers Directive (AIMFD), 2013 European Venture Capital and European Social Entrepreneurship Fund Regulations (EuVECA and EuSEF Regulations), 2015 European Long-​term Investment Fund Regulation (ELTIF Regulation), and 2017 Money Market Fund Regulation (MMF Regulation));5 investment firms and trading venues (2014 Markets in Financial Instruments Directive II (MiFID II) and 2014 Markets in Financial Instruments Regulation (MiFIR); and 2019 Investment Firm

1 This book covers market-​based intermediation and so does not address the regulation of bank-​based finance (the nature of bank-​and market-​based finance is discussed below in this chapter). As noted in the Preface, the book also does not cover areas associated with EU financial markets regulation more generally, such as rules relating to financial crime (such as anti-​money-​laundering rules) or the regulation of digital assets (which are not, unless they have the characteristics of financial instruments, treated as financial instruments under EU financial markets regulation and which are to be regulated under a discrete regime, as noted in section 7 of this chapter). 2 Established under Regulation (EU) No 1095/​2010 [2010] OJ L331/​84 (as recently amended by the 2019 ESA Reform Regulation (Regulation (EU) 2019/​2175 [2019] OJ L334/​1). The other ESAs address banking (European Banking Authority, EBA) and pensions/​insurance (European Insurance and Occupational Pensions Authority, EIOPA). 3 Most of these measures have been revised since their adoption, as noted across this book. 4 Regulation (EU) 2017/​1129 [2017] OJ L168/​12; Directive 2004/​109/​EC [2004] OJ L390/​38; and Regulation (EC) No 1606/​2002 [2002] OJ L243/​1. 5 Directive 2009/​65/​EC [2009] OJ L302/​32; Directive 2011/​61/​EU [2011] OJ L174/​1; Regulation (EU) No 345/​ 2013 [2013] OJ L115/​1; Regulation (EU) No 346/​2013 [2013] OJ L115/​18; Regulation (EU) 2015/​760 [2015] OJ L123/​98; and Regulation (EU) 2017/​1131 [2017] OJ L169/​8.

2  The Institutional Setting Directive (IFD) and Investment Firm Regulation (IFR));6 retail market investment product disclosure (2014 Packaged Retail and Insurance-​based Investment Products (PRIIPs) Regulation);7 benchmarks and benchmark administrators (2016 Benchmark Regulation);8 credit rating agencies (Consolidated Credit Rating Agency Regulation (CCRAR));9 short selling (2012 Short Selling Regulation);10 market abuse (2014 Market Abuse Regulation);11 and post-​trading (2012 European Market Infrastructure Regulation (EMIR) and 2014 Central Securities Depositaries (CSD) Regulation (CSDR)).12 In addition, specific transactions are addressed by the 2015 Securities Financing Transactions Regulation and the 2017 Securitization Regulation.13 This regulatory regime is supervised through the ESFS, by the national regulators (national competent authorities (NCAs)) that supervise the regime and by ESMA, which coordinates NCAs and supports consistency in supervision but which also supervises, on an exclusive basis, a small if expanding cohort of regulated actors. The ESFS also includes ESMA’s parallel authorities (the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA)) and their coordinating Joint Committee, as well as the European Systemic Risk Board (ESRB) which is responsible for the macroprudential oversight of the EU financial system in order to prevent or mitigate systemic risks to financial stability.14

I.2  The Objectives of Financial Markets Regulation Financial markets regulation addresses the actors which raise capital on, manage risk through, and seek returns from the financial markets, and the related infrastructures and intermediating actors which support this process. While the perimeter of financial markets regulation shifts along with cycles of market development and regulatory reform, it is broadly concerned with issuers of securities, the vast array of actors which provide market-​ based financial intermediation services and carry out related activities (such as brokerage; dealing (taking positions in financial instruments and relatedly providing liquidity); underwriting; and risk management in the form of the issuance of risk-​management and

6 Directive 2014/​65/​EU [2014] OJ L173/​349 and Regulation (EU) No 600/​2014 [2014] OJ L173/​84; and Directive (EU) 2019/​2034 [2019] OJ L314/​64 and Regulation (EU) 2019/​2033 [2019] OJ L314/​1. Alongside, certain investment firms are also subject to prudential regulation under the CRD IV/​CRR regime: Directive 2013/​36/​ EU [2013] OJ L176/​338 (Capital Requirements Directive IV (CRD IV)) and Regulation (EU) No 575/​2013 [2013] OJ L176/​1 (Capital Requirements Regulation (CRR)). 7 Regulation (EU) No 1286/​2014 [2014] OJ L352/​1. 8 Regulation (EU) 2016/​1011 [2016] OJ L171/​1. 9 The EU’s rating agency regime is split across three legislative measures: Regulation (EU) No 1060/​2009 [2009] OJ L302/​1 (CRA I); Regulation (EU) No 513/​2011 [2011] OJ L145/​30 (CRA II); and Regulation (EU) No 462/​2013 [2013] OJ L146/​1 (CRA III) (the Commission’s informal consolidation of these measures through the Consolidated Credit Rating Agency Regulation (CCRAR) is at ELI ). Alongside, Directive 2013/​14/​EU [2013] OJ L145/​1 regulates other financial institutions as regards over-​reliance on ratings, 10 Regulation (EU) No 236/​2012 [2012] OJ L86/​1. 11 Regulation (EU) No 596/​2014 [2014] OJ L173/​1. 12 Regulation (EU) No 648/​2012 [2012] OJ L201/​1 and Regulation (EU) No 909/​2014 [2014] OJ L257/​1. 13 Regulation (EU) 2015/​2365 [2015] OJ L337/​1 and Regulation (EU) 2017/​2402 [2019] OJ L347/​35. 14 Established under Regulation (EU) No 1092/​2010 [2010] OJ L331/​1. Its remit includes monitoring the financial stability risks generated by financial markets, which it monitors under its non-​bank financial intermediation agenda in particular, including as regards the risks posed by investment funds (see Ch III).

I.2  The Objectives of Financial Markets Regulation  3 risk-​transfer products, including derivatives), and the infrastructures (including trading venues) which support trading and risk management. As outlined further in subsequent chapters, financial markets, through different institutional mechanisms, reduce information asymmetries and support liquidity, and thereby facilitate price formation, exchange, risk management, exit from investments, and, in consequence, capital allocation. Financial markets have accordingly long been associated with economic growth generally,15 although the extent to which intermediation through financial markets should be supported or constrained by means of public intervention has long been contested, with the 2007–​2009 global financial crisis a defining but not the only inflection point in this regard.16 Financial markets have also long been associated with regulation. The different bundles of regulation which address the different segments of the financial markets have discrete (if often closely related) objectives, drivers, and components, as discussed in subsequent chapters. But, overall, financial markets regulation is primarily directed to the support of market efficiency, transparency, and integrity, and with related consumer/​investor protection; and, since its most recent defining trauma, the global financial crisis, to the securing of financial stability.17 These objectives can be observed in all major systems of financial markets regulation globally and in the international standards that underpin these systems.18 A vast multi-​dimensional and multi-​disciplinary literature explores these objectives, the structure of financial markets regulation, and the forces shaping the development of financial markets regulation, including from legal/​institutional, political economy/​international political economy, regulatory governance/​theory, and economic/​financial economic perspectives, and in, inter alia, empirical, analytical, and normative settings, as well as in domestic, regional, and, reflecting the role played by the international standard-​setting bodies (ISSBs) in shaping financial markets regulation, international frameworks.19 The depth and 15 An extensive literature probes the nature and dynamics of the relationship between financial market growth and economic development. From the foundational analyses see Levine, R and Zervos, S, ‘Stock Markets, Banks and Economic Growth’ (1998) 88 Am Econ Rev 537; Levine, R, ‘Financial Development and Economic Growth: Views and Agenda’ (1997) 35 J of Econ Lit 35 688; and Demirgüc-​Kunt, A and Maksimovic, V, ‘Law, Finance and Firm Growth’ (1998) 53 J Fin 2107. 16 This debate is multi-​faceted, including as regards the relative merits of market-​based and bank-​based financial intermediation, as noted below in this chapter. For a post-​financial-​crisis review see Mayer, C, ‘Economic Development, Financial Systems and the Law’ in Moloney, N, Ferran, E, and Payne, J (eds), The Oxford Handbook of Financial Regulation (2015) 41. Among its many iterations is the debate on the merits of ‘financialization’, or the extent to which markets should continue to expand and become ever more ‘complete’, including through risk management products which can change the nature of risk and how it is transferred (a theoretically complete market is one in which individuals can hedge against all contingencies: Spencer, P, The Structure and Regulation of Financial Markets (2000) 2–​3). For perspectives from the financial-​crisis era (a period which saw the extent of financial market intermediation widely questioned) see Kingsford Smith, D, ‘Regulating Investment Risk: Individuals and the Global Financial Crisis’ (2009) 32 University of New South Wales LJ 514; and Deakin, S, ‘The Rise of Finance: What Is It, What Is Driving It, What Might Stop It?’ (2008) 30 Comparative Labour Law & Policy J 67. 17 Financial stability can be described as a condition in which the financial system is capable of withstanding shocks and the unravelling of financial imbalances, and that mitigates the prospect of disruptions in the financial intermediation process that are severe enough to adversely impact real economic activities (a definition frequently used by the ECB). It is associated with the identification, management, and reduction of systemic risks which can reach across financial markets. For post-​financial-​crisis considerations of the objectives and design of financial markets regulation see Armour, J, et al, Principles of Financial Regulation (2016) and The Oxford Handbook of Financial Regulation, n 16. 18 The objectives and principles of securities regulation adopted by the major international standard-​setting body (ISSB) for financial markets, IOSCO (the International Organization of Securities Commissions), identify the three governing principles as the protection of investors; ensuring that markets are fair, efficient, and transparent; and the reduction of systemic risk: IOSCO, Objectives and Principles of Securities Regulation (2017). 19 Since the financial crisis, international standards adopted by the ISSBs, including IOSCO (financial markets) and the Basel Committee (prudential and bank regulation), have come to shape much of financial markets

4  The Institutional Setting range of these analyses, which intersect to varying degrees, have expanded with something akin to exponential effect since the global financial crisis, when the implications of financial market failure, and of failure in the design of financial markets regulation, were exposed to catastrophic effect (as outlined in subsequent chapters). The scale of the literature also reflects the different dimensions of financial markets regulation discourse: from the debate on the extent to which regulation should support or promote household engagement with the financial markets, which extends from financial economics/​household finance analyses on the need for wider household participation, to legal examinations of the extent to which law can support or protect investors;20 to the debate on how global derivatives markets regulation should be designed, which extends from legal examinations of related property rights and how they are enforced by the courts, to analyses of the preferences and capacities that frame the political economy of international derivatives market regulation.21 This book is situated within the legal/​institutional setting for financial markets regulation in that it is concerned with the legal rules and related institutional arrangements that govern financial markets in the EU,22 although it draws on the lessons from major cognate schools of analysis. It is perilous to identify from a scholarship of such depth and range, and which has been shaped by disruptive and resetting episodes of market turmoil, core framing principles and related debates. The association between financial markets regulation and the correction of market failures (failures in a market’s self-​regulatory mechanism which obstruct the efficient allocation of resources by an otherwise perfect market)23 has, however, been a long one.24 The major market failures as regards financial markets relate to, first, asymmetric information, a failure which is often exacerbated by the principal/​agent risks which arise where a financial market agent (such as an investment firm) acts on behalf of a principal client (whether a sophisticated market participant such as a hedge fund drawing broking services from an investment bank ‘prime broker’; or a retail investor trading through a ‘zero commission’ trading app); and to, second, externalities or wellbeing-​influencing consequences visited on a third party by the actions of another,25 such as the instability-​generating regulation. A related extensive political economy literature examines this development. See, eg, Newman, A and Posner, E, ‘Transnational Feedback, Soft Law, and Preference in Global Financial Regulation (2016) 23 Rev of IPE 123. 20 eg, Campbell, J, ‘Household Finance’ (2006) 61 J Fin 1553 (the former) and Langevoort, D, Selling Hope, Selling Risk: Corporations, Wall Street and the Dilemmas of Investor Protection (2016) (the latter). 21 eg, Braithwaite, J, The Financial Courts. Adjudicating Disputes in Derivatives Markets (2020) (the former) and Quaglia, L, The Politics of Regime Complexity in International Derivatives Regulation (2020) (the latter). 22 It can accordingly be situated with the legal/​institutionalist literature that regards law as being an essential component of the architecture that supports financial markets and the capitalist economy more generally. eg, Langenbucher, K, Economic Transplants. On Lawmaking for Corporations and Capital Markets (2017); Deakin, S et al, ‘Legal Institutionalism: Capitalism, and the Constitutive Role of Law’ (2017) 45 JCE 188; and Ferran, E, Building an EU Securities Market (2000). 23 See, eg, Ogus, A, Regulation, Legal Form and Economic Theory (1994). Market failures are generally characterized in terms of resulting in risks not being correctly priced in the marketplace. 24 For a foundational analysis see Mahoney, P, ‘Mandatory Disclosure as a Solution to Agency Problems’ (1995) 62 U of Chicago LR 1047. The extent to which market failure analysis should shape regulatory design has generated a rich scholarship as to the nature and extent of market failures and the limitations of market failure analysis as an analytical tool. For a recent meta reassessment in light of the ever-​increasing complexity and interdependence of financial markets see Awrey, D and Judge, K, ‘Why Financial Regulation Keeps Falling Short’ (2020) 61 BC LR 2295. 25 An externality (and a justification for regulation) arises ‘when the well-​being of one economic agent (consumer or firm) is directly affected by the actions of another’: Kay, J and Vickers, J, ‘Regulatory Reform: An

I.2  The Objectives of Financial Markets Regulation  5 effects which can be caused when a market participant fails and which can be associated with the financial-​crisis-​era resetting of financial regulation to address stability risks. Two major families of corrective regulation can be identified: conduct regulation, which is associated with client-​facing and market-​facing conduct; and prudential regulation, which is directed to the stability and soundness of financial market actors and of the financial system as a whole and which has a particular focus on the management and regulation of risk.26 The nature and intensity of financial markets regulation varies according to the actor in question. Non-​financial corporate issuers (NFCs) seeking capital on the markets, for example, do not pose significant financial stability risks, and so their regulation is not oriented in that way, but they are subject to an array of disclosure-​related requirements designed to support market efficiency and integrity and to protect investors, given information asymmetry risks. Investment firms, by contrast, are subject to an array of client-​facing conduct rules, reflecting the information risks of the principal/​agent relationship, as well as to prudential rules designed to support firm stability and financial stability generally, given the intricate and systemic interconnections between investment firm activities and the financial markets and the potential for externalities to arise. The nature and intensity of financial markets regulation also varies as regulation moves through cycles of reform.27 The mechanisms which drive regulatory change in the financial markets are many and complex but chief among them are political preferences; market conditions, as exemplified by the global financial crisis; the extent to which influential actors are resourced, informed, and have the technical and institutional capacity to respond to change (in particular, the extent to which states have significant ‘regulatory capacity’, or the ability to achieve outcomes through the adoption, monitoring, and enforcing of rules);28 and the features of the pre-​existing regulatory setting.29 The global financial crisis, to take an epochal example, and its exposure of the large-​scale failure of financial markets regulation and supervision to capture and manage risk transmission,30 saw financial stability and related prudential regulation, previously second-​order concerns for financial markets regulation, come to the fore.31 Framed by the G20 reform agenda,32 the related reform period

Appraisal’ in Majone, G (ed), Deregulation or Re-​regulation. Regulatory Reform in Europe and the United States (1990) 221, 226. 26 Prudential regulation has macro (system-​wide) and micro (firm-​focused) dimensions, as noted in Ch III. 27 On the regulatory ‘sine curve’, see Coffee, J, ‘The Political Economy of Dodd-​Frank: Why Financial Reform Tends to be Frustrated and Systemic Risk Perpetuated’ (2012) 97 Cornell LR 1019. 28 See, eg, Bach, D and Newman, A, ‘The European Regulatory State and Global Public Policy: Micro-​ institutions, Macro-​Influence’ (2007) 14 JEPP 827. 29 An extensive political economy/​governance literature considers the multiple drivers and complex dynamics of financial markets governance change. For a literature review see Moschella, M and Tsingou, E, ‘Regulating Finance After the Crisis: Unveiling the Different Dynamics of the Regulatory Process’ (2013) 7 Regulation & Governance 407. 30 For a contemporaneous review of the massive literature see Lo, A, ‘Reading about the Financial Crisis: A 21 Book Review’ (2012) 50 J of Econ Lit 151. 31 eg, Anand, A (ed), Systemic Risk, Institutional Design and the Regulation of Financial Markets (2016) and Anand, A, ‘Is Systemic Risk Relevant to Securities Regulation’ (2010) 60 University of Toronto LJ 941. 32 Initially, Washington G20 Summit, November 2008, Declaration of the Summit on Financial Markets and the World Economy, Action Plan to Implement Principles for Reform and, subsequently, London G20 Summit, April 2009, Leaders’ Statement on ‘Strengthening the Financial System’ and Pittsburgh G20 Summit, September 2009, Leaders’ Statement on ‘Strengthening the International Financial Regulatory System’.

6  The Institutional Setting saw the regulatory perimeter around financial markets expand significantly,33 and regulation become materially more intensive, data-​driven, and risk-​oriented.34 Since the global financial crisis, and despite subsequent shocks (albeit of a materially lesser order), chief among them the acute volatility unleashed by the Covid-​19 pandemic in March 2020, and the elevated volatility in certain commodity derivatives markets following the Russian invasion of Ukraine in 2022, the main tenets of financial markets regulation have remained broadly stable and the related rulebooks in operation internationally have proved broadly resilient.35 To the extent there is a dominant theme in regulatory developments over the decade or so since the financial crisis, and as the financial-​crisis-​era reforms have been finalized, implemented, and refined, it can reasonably be related to the continuing preoccupation with financial stability, particularly as regards the financial stability risks posed by the significant growth in non-​bank financial intermediation, including through investment funds, since the financial crisis36 This preoccupation can be expected to continue given current macroeconomic and geopolitical risks and interest rate volatility. An operational turn can also be detected, most notably as regards the extent to which financial markets regulation is increasingly requisitioning data, basing regulation on data-​ based metrics, and deploying data-​based supervisory strategies,37 a trend that is one of the marked features of EU financial markets regulation in the decade or so since the financial crisis.

I.3  Financial Markets Regulation and the EU: Building an Integrated EU Financial Market I.3.1  The Treaties and the Single Market: The Role of Law EU financial markets regulation addresses the preoccupations of financial markets regulation generally. But it has a distinctive quality. While now forming a behemoth ‘single rulebook’,38 and supported by a considerably larger administrative rulebook and similarly vast 33 The pre-​financial-​crisis regulatory era was not a deregulatory era. But the governing assumption was that in weighing the costs and benefits of intervention and of market discipline, the latter would prove more efficient: Langevoort, D, ‘Global Securities Regulation after the Financial Crisis’ (2011) 13 JIEL 799. 34 From the many considerations and from a contemporaneous/​EU-​oriented legal perspective see Avgouleas, E, Governance of Global Financial Markets (2012) and Ferran, E, Moloney, N, Hill, J, and Coffee, J, The Regulatory Aftermath of the Global Financial Crisis (2012). 35 eg, IOSCO, Operational Resilience of Trading Venues and Market Intermediaries during the Covid-​19 Pandemic. Consultation Report (2022) (finding trading venues and intermediaries to have been broadly resilient); and Financial Stability Board (FSB), Holistic Review of the Market Turmoil (2020) (finding that the financial system proved stable, albeit with weaknesses in the short-​term debt markets (discussed in Ch III). The response of financial markets regulation to the disruption wrought by the pandemic was largely operational, in particular as regards ‘supervisory forbearance’ (typically, the short-​term suspension of regulatory requirements). See Judge, K, Stress Testing During Times of War, ECGI Law WP No 529/​2020, available via (the US experience); Chiu, I, Kokkinis, A, and Miglionico, A, Regulatory Suspensions in Times of Crisis: The Challenge of Covid-​19 and Thoughts for the Future, ECGI Law WP No 517/​2020, available via (the UK experience); and Moloney, N and Conac, PH, ‘EU Financial Market Governance and the Covid-​19 Crisis’ (2020) ECFR 363 (the EU experience). 36 Which is regularly reviewed by the FSB, eg, FSB, Global Monitoring Report on Non-​Bank Financial Intermediation (2021). See further Ch III. 37 eg, Berner, R and Judge, K, ‘The Data Standardization Challenge’ in Arner, D, Avgouleas, E, Busch, D, and Schwarcz, S (eds), Systemic Risk in the Financial Sector: Ten Years After the Global Financial Crisis (2020). 38 ‘Single rulebook’ is a term-​of-​art in EU financial markets policy and relates to the political and institutional commitment over the financial-​crisis era to the adoption of a densely harmonized rulebook which would remove

I.3  Building an Integrated EU Financial Market  7 soft law ‘rulebook’, and constituting a mature, multi-​layered, and increasingly sophisticated system of financial markets governance,39 it is, at bedrock, concerned with the construction and regulation of a single, integrated financial market.40 This longstanding project is currently framed by the Capital Markets Union (CMU) agenda.41 EU financial markets regulation is based on the EU’s objective of constructing (and on its competence to construct) an internal (single) market (Article 3(3) Treaty on European Union (TEU)).42 The single financial market, the construction of which has generated the rules of EU financial markets regulation, is part of a wider project to create a single market comprising ‘an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured’ (Article 26 Treaty on the Functioning of the EU (TFEU)). A single or integrated financial market—​within which, supported by a harmonized legal infrastructure, financial market actors can access national markets across the EU—​has long been assumed to broaden and deepen pools of capital in the EU. It has also long been assumed that integration should, relatedly, drive a reduction in the cost of capital for firms, promote stronger risk management, and lead to stronger growth and employment.43 This governing presumption can be traced back to 1966 and the seminal Segré Report, the first articulation of the EU’s role in developing and regulating an integrated financial market.44 As EU financial markets regulation developed, efforts to identify the features of an integrated market and its benefits became more sophisticated. For example, one of the first major assessments was carried out in the context of the Financial Services Action Plan (FSAP) era of 1999–​2004,45 the first major period of related regulatory reform.46 Since then, destructive divergences in Member States’ regulatory regimes. It is also used in this book as shorthand for the swathe of legislative measures that comprise EU financial markets regulation. 39 ‘Governance’ is used in this book to capture the matrix of harmonized rules, supervisory arrangements and practices, and institutional structures which regulate, support supervision, and allocate the cost of risk within the EU financial market. 40 This book refers to ‘financial markets in the EU’ and to the ‘EU financial market(s)’ interchangeably, reflecting the interconnection between the single rulebook, which applies to the EU financial market(s) regarded as a whole, the component national financial markets which constitute the EU financial market(s) and which the single rulebook seeks to integrate, and the different types of financial market (for capital, derivatives, and so on) which are regulated through the single rulebook. 41 Set out in the 2015 and 2020 CMU Action Plans (Commission, Action Plan on Building a Capital Markets Union (COM(2015) 468) and Commission, A Capital Markets Union for People and Businesses. New Action Plan (COM(2020) 590)). 42 References to ‘the Treaty’ are to the two Treaties which govern the EU: the Treaty on European Union (TEU) and the Treaty on the Functioning of the EU (TFEU). 43 The ECB, over the financial-​crisis era when the risks of integration were exposed to disastrous effect, described the benefits of integration as follows: ‘The importance of fostering financial integration lies partly in the fact that reducing financial barriers between Member States is expected to create productivity gains which will increase the efficiency and competitiveness of the EU’s economy. In addition, financial integration, by opening up new financial opportunities for individuals and businesses (especially small businesses), is, if properly regulated, a potentially powerful tool to attain higher standards of freedom, equity, and welfare for society as a whole. In an integrated market, producers and consumers can better tailor their risk and return profiles to their preferences or requirements, and unjustified rents and hidden exploitation opportunities for dominant players are more easily identified and removed. Financial integration promotes cross border contacts between financial institutions, which in turn helps institutions to learn from each other and in this way promotes general welfare.’ ECB, Financial Integration in Europe (2012) 33. 44 Report by a Group of Experts Appointed by the EEC Commission, The Development of a European Capital Market (1966). 45 The FSAP reform agenda was set out in the 1999 FSAP Action Plan: COM(1999) 232. 46 London Economics, Quantification of the Macro-​Economic Impact of Integration of EU Financial Markets. Final Report to the EU Commission (2002). It reported that integration of financial markets would generate higher risk-​adjusted returns for investors through enhanced opportunities for portfolio diversification and more liquid

8  The Institutional Setting the pace and depth of integration has been closely monitored by the Commission and the European Central Bank (ECB), with the CMU agenda enhancing the metrics used, as noted below in this chapter.47 As discussed throughout the course of this book, the construction of an integrated financial market is a complex business. Integration depends on a wide range of variables, including market conditions (for example, acute market volatility and accommodative monetary policy can each shape integration48), taxation, infrastructure and intermediation mechanisms, and investor demand (and in particular the reduction of the investor home bias which privileges domestic investments49). Many of these variables are not immediately susceptible to regulatory intervention, but this is the main mechanism at the EU’s disposal. The EU has, accordingly, in pursuit of financial market integration, focused on the removal of regulatory barriers and on the reduction of the costs which flow from diverging regulatory regimes and, thereby, on creating a regulatory environment supportive of cross-​border activity. Most recently, intervention has taken a more muscular turn, including as regards the construction of facilitative legal structures.50 At the start of the single financial market regulatory programme, which can be dated to the late 1970s, considerable variations existed across the EU as to how financial markets were regulated. Even where rules were not actively obstructionist and designed to protect national markets from competition, the prevalence of regulatory divergences imposed frictions on the construction of the single market: regulatory divergences and the duplication of rules can amount to non-​tariff barriers, given that the costs they represent for market participants can obstruct access to other Member States’ markets; and they can thereby distort competition between market participants and prevent the development of the level playing field on which the single market depends. The foundation Treaty free movement guarantees, which support the single market generally, go some way to removing regulatory obstacles. The freedom to provide services (Articles 56–​62 TFEU) and the freedom to establish (Articles 49–​55 TFEU) are the Treaty cornerstones on which the single market is based. They provide the basis for market access by virtue of the prohibition they place on discriminatory and free-​movement-​restrictive national rules.51 They are, however, subject to exceptions which allow Member States to and competitive capital markets, that the corporate sector would benefit from generally easier access to financing capital, and that competition in the intermediation sector would offer companies a wider range of financial products at attractive prices. 47 Financial integration, as measured by the ECB in its bi-​annual financial integration reports, is associated with a series of metrics, including price-​based criteria (relating to financial instrument price convergence) and quantity-​based criteria (ie the extent of cross-​border bond and equity holdings). For discussion see Hoffmann, P, Kremer, M, and Zaharia, S, Financial Integration in Europe through the Lens of Composite Indicators, ECB WP 2319 (2019). 48 As can be traced in the EU’s assessments over time. On the impact of the Covid-​19 pandemic, eg, see ECB, Financial Integration and Structure in the Euro Area (2022). 49 Investors tend to invest a disproportionately large proportion of their equity portfolios, eg, in geographically proximate stocks. See, eg, Coval, J and Moskowitz, T, ‘Home Bias at Home: Local Equity Preference in Domestic Portfolios’ (1999) 54 J Fin 2045. 50 Such as the facilitative fund vehicles that have been adopted (including the ELTIF long-​term investment fund, adopted in 2015 in the wake of the financial crisis) (Ch III section 6.4); and the CMU-​related 2021 proposal for a European Single Access Point for regulated data (Ch II section 7.3). 51 eg Case C-​101/​94 Commission v Italy (ECLI:EU:C:1996:221), in which the Court of Justice struck down Italy’s ‘SIM’ law which imposed non-​discriminatory but obstructive regulatory requirements on non-​Italian EU investment firms.

I.3  Building an Integrated EU Financial Market  9 retain free-​movement-​restricting rules in certain circumstances and, in particular, where the public interest justifies such rules.52 Where the single market cannot be achieved by means of the free movement guarantees alone and national regulatory barriers remain in place (as is typically the case in the financial markets sphere, given the strong public interest in retaining national rules), the harmonization process steps in by supporting the adoption of harmonized rules which remove regulatory obstacles to integration by putting common standards in place which replace national measures. As outlined in section 5 of this chapter, harmonizing measures must meet the Treaties’ competence (in that the measure falls within a competence to act conferred on the EU), proportionality, and subsidiarity (in that, broadly, the outcome sought is best achieved at EU level) requirements (Article 5 TEU); are adopted in accordance with the Treaties’ law-​making procedures and by the Treaties’ law-​making institutions;53 and take the form of legislative and delegated/​administrative rules, which are supported by a vast soft law ‘rulebook’ adopted by ESMA. Under Article 288 TFEU, binding EU rules (whether legislative or administrative) can take three forms: regulations, directives, and decisions. Regulations are the most intrusive or intensive of EU measures in that they are self-​executing: they apply in the Member States once adopted and do not depend on further action at Member State level. Directives are binding as regards the result to be achieved but leave the choice of form and method of implementation to the Member State. They will contain an implementation date, which varies according to the extent of the changes required to existing rules or the new rules demanded and the degree of market upheaval which might be expected, by which the obligations in question must be implemented by the Member States. Decisions have specific addressees which may include private parties. Until the financial-​crisis era, the directive was the dominant type of measure used in EU financial markets regulation, due to the flexibility it allowed Member States. Large-​scale reliance on directives, however, led to the EU regime becoming porous in places, as the implementation process can lead to regulatory divergence. The financial-​crisis era saw greater reliance on regulations (in pursuit of the single rulebook agenda; see section 4) and, in the decade since, they have come to dominate. In addition, a vast array of soft law, primarily generated by ESMA, supports the binding EU rulebook. The EU’s institutions are also, however, empowered to adopt non-​binding recommendations and opinions, and the Commission, in particular, has deployed such measures in the financial markets sphere.

52 The Court of Justice’s ‘general good’ jurisprudence allows Member States to retain an obstructive rule where the measure is non-​discriminatory, proportionate, necessary to meet the objective in question, and serves a legitimate public policy goal (the ‘general good’ requirement) (eg Case 205/​84 Commission v Germany (ECLI:EU:C:1986:463)). See, eg, Case C-​384/​93 Alpine Investments v Minister van Financiën (ECLI:EU:C:1995:126) in which the Court confirmed the validity of a Dutch prohibition on cold-​calling which prevented firms from accessing markets outside the Netherlands but which the Court accepted was necessary to protect the reputation of Dutch financial markets. 53 The Treaty-​based institutions of the EU are the Council of Ministers (representing the Member States at ministerial level), the European Council (composed of the heads of government), the European Parliament (representing the citizenry directly), the Commission (the EU’s executive), the ECB, the Court of Auditors, and the Court of Justice (Art 13 TEU). The Treaties also provide for other actors, including advisory committees, two of which are of relevance to financial markets regulation: the Economic and Financial Committee (EFC) (Art 134 TFEU), which primarily supports the work of the Council, and the European Economic and Social Committee (EESC) (previously ECOSOC) (Art 300 TFEU), which provides opinions on legislative initiatives and represents civil society generally, but which has become less influential on EU financial markets regulation over time.

10  The Institutional Setting The Court of Justice also shapes the EU rulebook through its interpretation of EU law. Prior to the financial crisis, it had not played a major role in the development of EU financial markets regulation. Its financial markets jurisprudence was in the main concerned with interpreting the foundation Treaty free movement guarantees,54 although it had ruled on substantive aspects of the harmonized regime,55 notably the market abuse regime.56 The financial-​crisis era saw the Court take a more central role, particularly as the UK took a series of actions that challenged the Treaty validity of ESMA’s powers as regards short selling,57 the ‘bonus cap’ introduced under the EU’s major banking measure (the 2013 Capital Requirements Directive IV),58 and the proposed Financial Transaction Tax then being adopted among a group of Member States under the Treaty-​based ‘enhanced cooperation’ mechanism.59 These actions by the UK were not successful and indicated the Court’s support for an expansive interpretation of the Treaty competences that support financial market harmonization. They also, however, illustrated the significant UK unease at the time as regards the scale of the financial-​crisis-​era reforms.60 In the intervening decade since the financial crisis, the Court’s financial markets jurisprudence has continued to expand, albeit that it is now typically mainly concerned with the interpretation of single rulebook measures61 and less concerned with the matters of significant constitutional import as regards the allocation of competence between the EU and the Member States which characterized the UK’s earlier series of challenges.62 The EU rulebook is also shaped by the international standard-​setting bodies (ISSBs), including the International Organization of Securities Commissions (IOSCO), the Basel Committee on Banking Supervision, and the Financial Stability Board (FSB).63 While the Basel Committee has long shaped bank regulation in the EU, since the outbreak of the financial crisis, and over the intervening decade since, international standard-​setters have come to play a more pivotal in shaping the EU rulebook; so too have the related competitiveness dynamics associated with the regulation of the international market, as discussed in Chapter X on the EU’s regime governing third country access to financial markets in the EU.

54 eg, Commission v Italy n 51 and Alpine Investments n 52. The Commission also takes action against Member States before the Court with respect to their failure to implement elements of EU financial markets regulation, as it is empowered to do under the Treaty (Art 258 TFEU), albeit that these actions are relatively infrequent. 55 Including on the pivotal Markets in Financial Instruments Directive (2004 MiFID I) 2004/​39/​EC [2004] OJ L145/​1. See, eg, Case C-​604/​11 Genil 48 SL, Comercial Hostelera de Grandes Vinos SL v Bankinter SA, Banca Bilbao Vizcaya Argentaria SA (ECLI:EU:C:2013:344). 56 See Ch VIII. 57 Case C-​270/​12 UK v Council and Parliament (ECLI:EU:C:2014:18). 58 Case C-​507/​13 UK v Council and Parliament. The case was subsequently withdrawn. 59 Case C-​209/​13 UK v Council (ECLI:EU:C:2014:283). 60 See further Moloney, N, ‘Bending to Uniformity: EU Financial Regulation with and without the UK’ (2017) 40 Fordham Int’l LJ 1335. 61 In particular as regards the market abuse regime. See Ch VIII. The Court has also, eg, examined the nature and extent of NCA information exchange obligations in light of legislative confidentiality requirements (see, eg, Case C-​15/​16 BaFIN v Baumeister (ECLI:EU:C:2018:464). 62 The most material recent litigation in this regard did not concern EU financial markets governance although it had relevance for ESMA. It related to the Court’s rejection of a challenge to EBA’s power to adopt Guidelines: Case C-​911/​19 FBF v ACPR (ECLI:EU:C:2021:599). See n 254 and Ch IX section 4.11.1. 63 With respect to respectively (and very broadly) conduct, prudential requirements, and financial stability, including as regards non-​bank financial intermediation.

I.3  Building an Integrated EU Financial Market  11

I.3.2  Market Finance, Financial Market Integration, and Capital Markets Union The financial market integration project, and so EU financial markets regulation, is also designed to wean the EU financial system from its long and persistent dependence on bank-​ based finance and to support and promote market-​based finance, a longstanding project with its roots in the 1966 Segré Report and that has reached its apotheosis, but not its resolution, with the current CMU agenda.64 In very broad terms, in economies based on market finance (or on market-​based financial intermediation) non-​bank intermediaries play a significant role in the capital intermediation process; banks typically rely heavily on fee-​based income sources, trading activities, and non-​deposit liabilities; and there is significant reliance on financial products to manage risks (such as securitization products and derivatives). In addition, firms rely on market-​based financing through the issuance of securities. In economies based on bank finance (or on bank-​based financial intermediation), banks take deposits and make loans and are the major form of financial intermediation between capital suppliers and seekers, relying on net interest income as their main source of income.65 The EU economy has long been predominantly based on bank-​based finance,66 although market-​based finance is strengthening. Whether or not, and how, bank-​or market-​finance-​based economic systems should be adopted or supported, given their respective risks and benefits, has been the subject of a rich debate. It engages discussion of the relative merits of market finance or bank lending, in terms of firm-​level and economy-​level effects, including as regards the implications for financial stability where reliance on funding through non-​bank sources increases;67 and also discussion of how different economic systems develop and evolve68 and

64 This account of a complex and subtle debate which engages a range of distinct analyses, including from financial economics and comparative political economy perspectives, is necessarily brief and in outline only. 65 As characterized by the IMF in its assessment of the performance of market-​finance-​based and bank-​based economic systems over the financial crisis: IMF, Global Financial Stability Report, October 2012, Ch 3 (The Reform Agenda: An Interim Report on Progress Towards a Safer Financial System) and Ch 4 (Changing Global Financial Structures: Can they Improve Economic Outcomes). Bank and market finance systems are also associated with different forms of firm governance: very broadly, dispersed ownership with the market finance system and block-​holder-​based, stakeholder governance with the bank finance system. 66 The related data and analyses stretch back to the FSAP era (1999–​2004) when the first sustained efforts were made to collect data through annual Commission reports on financial integration. For more recent analysis as the financial crisis was receding, and from the initial stages of the CMU agenda (the CMU agenda was first adopted in 2015), see Commission, European Financial Stability and Integration Review (SWD(2017) 171); Commission, Economic Analysis Accompanying the Commission Communication on the Mid-​Term Review of the Capital Markets Union Action Plan (SWD(2017) 224); Commission, European Financial Stability and Integration Review 2016 (SWD(2016) 146); and Commission, Initial Reflections on the Obstacles to the Development of Deep and Integrated EU Capital Markets (SWD(2015) 13). The monitoring process underwent a step-​change in 2021 when the Commission adopted a ‘tool-​kit’ of indicators to monitor annually progress towards CMU: Commission, Monitoring Progress towards a Capital Markets Union: a tool-​kit of indicators (SWD(2021) 544). The first annual update followed in July 2022: Commission, Overview of CMU Indicators (2022). ESMA also reports on EU financial market features more generally, including through its semi-​annual ‘Trends, Risks, and Vulnerabilities’ (TRV) Reports and, since 2020, its annual reviews of EU securities markets. 67 In the EU context and from a financial economics perspective see, eg, Kremer, M and Popov, A, ‘Special Feature A: Financial Development, Financial Structure and Growth: evidence from Europe’ in ECB, Financial Integration in Europe (2018) 65 and Pagano, M and Langfield, S, Bank Bias in Europe: Effects on Systemic Risk and Growth, ECB Working Paper No 1797 (2015). 68 The influential Varieties of Capitalism literature is noted below.

12  The Institutional Setting the related determinative factors, including social and cultural factors69 and political forces and interest-​group dynamics.70 Very broadly, market finance is typically associated with more flexible financing techniques for firms, particularly innovative, growth firms. Market-​based intermediation also allows funding sources to be diversified, in particular where credit intermediation is carried out through financial market channels such as money-​market funds or other funds, and so can stabilize sources of funding and reduce financial stability risks. By contrast, banks may have conservative lending policies and may stunt innovative growth strategies. As the financial crisis showed to devastating effect, bank finance can also be subject to paralyzing credit squeezes which impact the real economy: the sharp decrease in bank lending over the financial-​crisis period led to corporate bond markets, in particular, acting as substitutes for loan financing, a trend which became structural in the EU.71 The financial crisis also, however, underlined the financial stability risks which markets can generate, revealing how intense levels of market intermediation can create destructive levels of risk and lead to a proliferation of risk transmission channels.72 Overall, economic systems display an evolutionary bias to becoming more market-​based, as advances in financial engineering, technological developments, and the globalization of funding markets give market-​based funding a competitive advantage over bank funding.73 The monitoring and managing of the risks associated with non-​bank (market-​based) financial intermediation remain major preoccupations of financial market policy internationally, however, well exemplified by the central bank intervention in early March 2020 to support the short-​term debt markets when a severe liquidity contraction struck in response to the Covid-​19 pandemic-​related volatility, and by the subsequent reform agenda.74 Whatever the respective risks and benefits of different financial intermediation models, the EU’s commitment to market finance and to the related benefits of financial market integration has long been a feature of EU financial markets regulation and came to the fore over the 1999–​2004 FSAP reform era. In 2000, for example, the Commission75 asserted that ‘[t]‌he assessment that market-​based financing heralds substantial benefits for European investors and issuers is not overturned by periodic bouts of volatility or occasional market corrections’.76 The financial-​crisis period saw EU financial markets regulation being framed in terms of financial stability, but this period did not lead to a resiling from support for market finance.77 The market finance agenda is now framed by the CMU agenda, initially set out in the 2015 CMU Action Plan and subsequently refined in the 2020 CMU Action 69 See, eg, Guiso, L, Sapienza, P, and Zingales, L, ‘The Role of Social Capital in Financial Development’ (2004) 94 Am Econ Rev 526. 70 See, eg, Rajan, R and Zingales, L, ‘The Great Reversals: the Politics of Financial Development in the Twentieth Century’ (2003) 69 JFE 5. 71 In the EU, the financial-​crisis-​era recourse to bonds became structural over time: 2021 Commission CMU Indicators Report, n 66 and Oxera, Primary and Secondary Equity Markets (2020) (a CMU-​related review for the Commission). 72 As is discussed in subsequent chapters. 73 FCA, Market-​based Finance: Its Contributions and Emerging Issues, Occasional Paper 18 (2016). 74 See further Ch III. 75 The ECB also emerged as a strong supporter of integrated financial markets over the FSAP era given in particular the role of markets in supporting monetary policy goals: ECB, Review of the Application of the Lamfalussy Framework to EU Securities Markets (2005) 2. 76 Commission, Communication on Upgrading the Investment Services Directive (COM(2000) 729). 77 For discussion by this author see Moloney, N, ‘The Legacy Effects of the Financial Crisis on Financial System Regulation in the EU’ in Ferran et al, n 34, 111.

I.3  Building an Integrated EU Financial Market  13 Plan.78 Adopted as the EU emerged from the financial-​crisis era, and designed to facilitate new and wider sources of funding, support financial stability by diversifying funding sources, and strengthen household access to finance, the CMU agenda now frames the development and reform of EU financial markets regulation more generally. A somewhat malleable and elastic term, CMU has been associated with: easier firm, particularly small and medium-​sized enterprise (SME), access to funding; capital flowing easily to where it best meets long-​term societal needs (including as regards sustainable finance); competitive and transparent markets; efficient and non-​discriminatory access to information and infrastructure; wider consumer choice; no explicit or implicit barriers to cross-​border investment; and investment decisions being governed by a single rulebook, applicable directly and in the same manner to all market operators.79 The initial 2015 CMU Action Plan was designed to address the persistent fragmentation and underdevelopment of the EU capital market,80 underlining the totemic finding that, despite years of regulatory reform, while the EU economy was as large as the US economy, its equity markets were less than half the size and its debt markets less than a third of the size of the US markets. It proposed a series of reforms relating to widening funding choices for businesses, particularly SMEs; making it easier to enter and raise capital on public markets; ensuring an appropriate regulatory environment for long-​term and sustainable investment in and financing of the EU’s infrastructure; increasing investment and choices for retail and institutional investors; enhancing bank capacity to lend; and facilitating cross-​border investment. Chief among the related proposals for regulatory reform were those for what have become the 2017 securitization regime; the 2017 Prospectus Regulation, which recast the prospectus regime; the reforms to the issuer disclosure and trading venue regimes to support SMEs, adopted in 2019; the 2020 Crowdfunding Regulation; the series of reforms to the collective investment scheme/​fund management regime, including as regards venture capital, loan origination by investment funds, and cross-​border fund distribution; the 2019 Investment Firm Directive and Investment Firm Regulation which put in place a new prudential regime for investment firms; and the series of reforms to the EU’s supervisory superstructure for financial markets, mainly achieved through the 2019 ESA Reform Regulation, which have strengthened ESMA’s powers. The 2020 Action Plan which followed built on the 2015 Action Plan but was shaped by the intervention of a series of forces, chief among them the 2016 decision of the UK to withdraw from the EU, the rise of the sustainable finance agenda, and the damage wrought by the Covid-​19 pandemic to the EU economy and the need for financial markets, and private risk-​sharing, to support the economic recovery. It was designed to accelerate progress by means of three objectives: supporting a green, digital, inclusive, and resilient economic recovery by making financing more accessible to European companies; making the EU an ‘even safer place’ for individuals to save and invest long term; and integrating national capital market into a genuine single market. The Action Plan was accompanied by a series of reforms, including as regards the development of a public, ESMA-​based ‘European Single Access Point’ for a range of mandatory disclosures required of regulated actors; supporting SME access to public markets; and reviewing EU

78 See n 41. 79 2020 CMU Action Plan, n 41, 2–​3. The Commission has also adopted a suite of more hard-​edged metrics to measure progress: 2021 Commission CMU Indictors Report, n 66. 80 While the CMU agenda uses the term ‘capital market’ it can be associated with financial markets generally.

14  The Institutional Setting financial markets regulation as regards retail investor protection.81 The different elements of the CMU agenda and their implications are outlined in subsequent chapters. The CMU agenda does not represent a significant shift in EU financial markets regulation. Its concern to promote market finance is an enduring one for EU financial markets regulation. It is not, despite the superficial resonances with Banking Union (within which the banks of participating Member States are supervised through the Single Supervisory Mechanism, as noted in section 6), an institutional project and does not, unlike Banking Union, engage Member State risk-​sharing. It deploys the harmonization tools long used by EU financial markets regulation. And organizationally, CMU follows the example set by the earlier 1999 FSAP reform agenda in that it establishes a policy frame for a period of reform, which frame has the advantage of focusing political, institutional, and stakeholder attention on the reform process. The CMU project has certainly produced a sprawling reform agenda, extending from facilitating issuers and financial market intermediaries to addressing how market intermediation, including through securitization, can release bank capacity for lending; and seeking to address areas of ‘stickiness’ which have long posed intractable difficulties to the market finance agenda (chief among them how to increase levels of household participation in the financial markets and strengthen SME access to market-​ based funding). But it cannot, nonetheless, easily be termed a radical agenda. Most of its financial market reforms are designed to tweak and refine Legislative measures (in particular to support SMEs), others are designed to complete the single rulebook (such as the 2019 reforms to the investment firm prudential regime), and the entirely new measures (such as the securitization reforms) have optional elements.82 The more radical reforms are largely operational in nature, chief among them the European Single Access Point reform, proposed in 2021, for facilitating public access to regulated disclosures, including issuer disclosures. The CMU agenda has, however, framed the development of EU financial markets regulation since 2015. It has enjoyed consistent political support,83 despite the withdrawal of the UK, a major voice in favour of market finance,84 and European Parliament support;85

81 The 2020 Action Plan was comprised of sixteen actions which ranged from reviews (including of the supervisory structure, of the central securities depositaries/​securities settlement regime, of the securitization regime, of shareholder voting rights, of withholding tax systems, and of barriers to SME investment); to legislative proposals (including for a ‘consolidated tape’ of trading data and for the European Single Access Point (ESAP) for regulated disclosures); to wider policy initiatives (including as regards financial literacy). A host of proposals followed across 2021 and 2022, including to construct the consolidated tape (by reforms to MiFID II/​MiFIR) and the ESAP (2021); to revise the ELTIF and AIFMD fund regimes (2021); and to revise the CSD Regulation (2022). 82 The 2020 Crowdfunding Regulation is an exception in that imposes a new mandatory regime on crowdfunding service providers. See Ch II section 11.2. 83 The Council has repeatedly affirmed its support for the CMU agenda and stressed the need to progress the reforms. eg, ECOFIN Council Conclusions on the Commission’s CMU Action Plan, 2 December 2020 (Council Document 12898/​1/​20), framing CMU in terms of the need to strengthen markets in light of Brexit and the Covid-​ 19 pandemic in particular; and ECOFIN Council Conclusions on the Deepening of the Capital Markets Union, 5 December 2019 (Council Document 14815/​19). 84 On the roots of the CMU agenda and the factors and preferences shaping it, including as regards Brexit, see previous work by this author (Moloney, N, ‘EU Financial Governance after Brexit: The Rise of Technocracy and the Absorption of the UK’s Withdrawal’ in Alexander, K, Barnard, C, Ferran, E, Lang, A, and Moloney, N, Brexit and Financial Services: Law and Policy (2018) 61 and Moloney, N, ‘Capital Markets Union: “ever closer union” for the EU financial system’ (2016) 41 ELR 307) and Ringe, WG, The Politics of Capital Markets Union, ECGI Law WP No 469/​2019 (2019), available via https://​ssrn.com/​abstr​act=​3433​322>; and, for a political economy perspective, Quaglia, L, Howarth, D, and Liebe, M, ‘The Political Economy of European Capital Markets Union’ (2016) 54 JCMS 185. 85 eg, European Parliament, Resolution on Further Development of the Capital Markets Union, 8 October 2020 (P9_​TA(2020)0266).

I.3  Building an Integrated EU Financial Market  15 drawn stakeholder attention and support;86 led to the production of new and extensive data on the status of market finance in the EU as well as metrics for monitoring whether CMU is being achieved;87 and can be associated with a series of regulatory reforms as well as with the strengthening of ESMA’s powers over the decade since the financial crisis. Nonetheless, it remains to be seen how enduring the impact of the CMU agenda will be.88 It can certainly be associated with the almost permanent state of reform that has, as charted across this book, attended EU financial markets regulation over the decade or so since the financial crisis, and that is driving the regime to become ever more specified, proceduralized, and operational. But it is not the sole influence on the shape of the single rulebook. Most of the CMU reforms have specific drivers and contexts, while cognate but independent factors, including the ratcheting effect of the ‘review clauses’ embedded in all legislative measures adopted over and since the financial crisis, the impact of the swathe of financial-​crisis-​era reforms and the need for consequential revision, as well as the technocratic influence wielded by ESMA and the reform capacity it has given the EU, have all had determinative influence on the current highly dynamic quality of the single rulebook. The largest question relates to whether the CMU agenda will strengthen recourse to market finance and increase levels of financial market integration. The CMU agenda is not limited to financial markets regulation but addresses the wider ecosystem of rules that shape market finance, including through its reform of the capital treatment of equity investments by banks and insurance companies;89 its securitization and covered bond reforms which are designed to facilitate the market intermediation of credit risk and thereby increase bank lending capacity; its construction of a new EU pension vehicle for institutional investment and as a vehicle for household savings (the Pan European Personal Pension Product);90 its taxation initiatives;91 and its insolvency reforms.92 It also has materially enhanced data on levels of, and the factors shaping, market finance in the EU.93 And it has an operational orientation, in particular as regards the enhancement of information flows to the market. All this augurs well as regards the effectiveness of the CMU reforms, but the task remains a mighty one. 86 Industry and other stakeholder engagement has been extensive. For a representative example see the report of the (Commission-​established) ‘high-​level forum’ on CMU: High-​Level Forum on the Capital Markets Union, A New Vision for Europe’s Capital Markets (2020). 87 Progress on the CMU agenda has been reviewed by the Commission since 2015, but a more standardized approach was adopted in 2021 when the Commission adopted a series of metrics for assessing progress: 2021 Commission CMU Indicators Report, n 66. 88 For discussion of the CMU agenda, its context, and its different components see, eg, Allen, F, Faia, E, Haliassos, M, and Langebucher, K (eds), Capital Markets Union and Beyond (2019) and Busch, D, Avgouleas, E, and Ferrarini, G (eds), Capital Markets Union in Europe (2018). 89 Including through reform of the treatment of long-​term infrastructure and private equity investments by insurance companies under the ‘Solvency II’ regime which governs the reserves to be maintained by insurance companies. 90 Adopted in 2019: Regulation (EU) 2019/​1238 [2019] OJ L198/​1 (noted in Ch IX). 91 The 2015 Action Plan included reviews of withholding taxes, discriminatory tax obstacles to cross-​border investment by pension funds and life insurers, and tax incentives for venture capital and angel investors (which followed in 2016 and 2017). It also included the longstanding negotiations on the Common Consolidated Corporate Tax base proposal, as regards the debt-​equity bias. 92 The 2015 Action Plan led to the adoption of the 2019 Business Restructuring and ‘Second Chance’ Directive (Directive (EU) 2019/​1023 [2019] OJ L172/​18). Further reforms were proposed in December 2022 (COM(2022) 702). 93 The 2015 Action Plan included a series of reviews which led to sixteen studies on different aspects of CMU and which informed subsequent proposals (available via ). See also n 66.

16  The Institutional Setting Recourse to market finance has been increasing, particularly since the 1999–​2004 FSAP era,94 but progress is slow:95 in 2022, the ECB warned that post-​pandemic financing needs required deeper and more dynamic capital markets, a call echoed earlier by the Commission in its 2020 package of ‘Covid-​19 recovery’ reforms which were designed to ease access to the capital markets.96 The financial-​crisis period earlier saw greater recourse to bond financing as bank lending capacity contracted,97 and shares traded on trading venues came to represent an increasingly large source of funds,98 albeit that overall equity issuance patterns remained volatile.99 Since then, while levels of market-​based finance have increased, public equity markets have struggled, and financial markets, while continuing to integrate, remain fragmented, including as regards, for example, securitization markets and venture capital markets, with Brexit associated with a deepening of fragmentation as Member States sought competitive advantage in different market segments.100 Among the headline features are increased NFC reliance on market funding relative to bank lending over 2011–​2019 (38.0 per cent of funding in 2011 to 42.8 per cent in 2019), although patterns vary widely across the Member States, but limited growth in reliance on share-​based funding and a decline in initial public offerings (IPOs) since the pre-​financial-​crisis period.101 Relatedly, admissions to trading of shares declined by 12 per cent over 2010–​2018, although GDP grew by 24 per cent over this period.102 The increased recourse to market finance is primarily a function of bond markets.103 Financial market integration levels, however, have been strengthened, including by reference to, and over 2015–​2019, a reduction in the home bias of portfolios and increased levels of cross-​border distribution of funds.104 Levels of integration are also recovering more quickly after market shocks than previously.105 It is a truism to note that the host of variables that shape recourse to market finance caution against endowing the CMU agenda with transformative effects, not least given the persistent stickiness of bank finance after the over twenty five years of regulatory reform

94 Among the headline figures from this period are that stock market capitalization increased as a percentage of GDP from 22 per cent in 1992 to 56 per cent in 2013, while the stock of outstanding debt securities increased from 74 per cent of GDP to 171 per cent: Commission, Green Paper on CMU (COM(2015) 63) 7. 95 As evidenced by the Commission’s CMU Indicators Reports, first published in 2021, which show slow progress since 2015 (aside from the spike in initial public offers in 2021 which reflected global market trends). Capital-​raising outside the public markets, including through private equity funds and venture capital investors, has, however, increased: 2021 CMU Commission Indicators Report and 2022 Commission CMU Indicators Update, n 66. On earlier developments up to and over the financial crisis period see Moloney (2016), n 84 and Hardie, I and Howarth, D (eds), Market-​Based Banking and the International Financial Crisis (2013). For an earlier review see Van der Elst, C, ‘The Equity Markets, Ownership Structures and Control: Towards an International Harmonization’ in Hopt, K and Wymeersch, E (eds), Capital Markets and Company Law (2003) 3. 96 2022 ECB Financial Integration Report, n 48, 18; and Commission, Staff Working Document for the Capital Markets Recovery Package (SWD(2020) 120) 2–​3. 97 2017 CMU Economic Analysis, n 66 and 2016 EFSIR, n 66, 35. 98 2016 EFSIR, n 66, 39. 99 2017 CMU Economic Analysis, n 66, 39, reporting on a 27 per cent drop in the number of initial public offerings in 2016 as compared to in 2015. 100 See Ch II on funding markets and Ch X on Brexit. 101 As reported in the 2021 Commission CMU Indicators Report, n 66. 102 2020 Oxera Report, n 71. A host of factors, however, have shaped the contraction in public equity markets, as outlined in Ch II section 2. 103 —​2022 ECB Financial Integration Report, n 48, 12 and 17. 104 As reported in the 2021 Commission CMU Indicators Report, n 66. 105 2022 ECB Financial Integration Report, n 48, 5–​6, reporting that the ‘moderate and volatile recovery’ in financial integration since the global financial crisis was still intact despite the Covid-​19 shock and, similarly, Commission, European Financial Stability and Integration Review (SWD(2022) 93) 17.

I.4  From the Segré Report to the Covid-19 Pandemic  17 which followed the 1999 FSAP reform agenda.106 That caution is, increasingly, being signalled by the Commission.107 Economic and market conditions matter, as is exemplified by the impact on funding markets of the reversal in mid-​2022 of the accommodative monetary policy that had prevailed since the financial crisis.108 So do the structural factors that shape different varieties of capitalism (VoC), as has been charted in the influential VoC literature which, very broadly, characterizes the main forms of economic model in terms of the Liberal Market Economy (LME) form of capitalism, very broadly associated with market organization/​capital-​market-​based funding and more limited regulatory intervention; and the Co-​ordinated Market Economy (CME), very broadly associated with strategic coordination/​bank-​based finance and heavier levels of intervention.109 Member States derive a comparative advantage from these interlinked institutional infrastructures and related economy types, and can be expected to protect these institutions, whether through the imposition of their preferences on EU regulatory negotiations, competition, or otherwise.110 The law and finance scholarship, which probes the relationship between law and financial market development and which has led to a wide-​ranging if inconclusive debate on the extent to which law can drive market development and on which legal systems are most supportive of market development,111 also counsels caution. While it suggests that law may have transformative effects with respect to the development of strong financial markets, the causal relationship between law and strong markets is contested, with challenges relating to the direction of causation, the institutions which can substitute for laws (such as networks of private capital and trading venues), the particular rules which have transformative effects, and the relative impact of ‘law on the books’ and ‘law in action’ (enforcement).112

I.4  From the Segré Report to the Covid-​19 Pandemic It is a truism that systems of financial markets regulation are dynamic. Sometimes their evolution is incremental and primarily a function of technocracy and of action by regulators; sometimes it is rapid and disruptive and primarily a function of political reaction to convulsion. The long arc of EU financial markets regulation, which bends from 1966 and the Segré Report’s identification of financial markets regulation as forming part of the integration project, to the present day and the framing of EU financial markets regulation 106 For a wide-​ranging and empirically informed review see CEPS-​ECMI, Rebranding Capital Markets Union: A Market Finance Action Plan (2019). 107 The 2020 CMU Action Plan, eg, warned that deepening CMU was a complex exercise, that no single measure would complete it, and that ‘the only way to progress was to move steadily in all areas where barriers to the free movement of capital still exist’: n 41, 1. Similarly, the 2021 Commission CMU Indicators Report noted that it would be difficult to disentangle the impact of CMU from other factors shaping economic and market development: n 66, 11. 108 eg, reporting on lower volumes of bond issuance, Johnston, I, ‘End of Cheap Money Era Scuppers Dozens of Corporate Bond Deals’, Financial Times, 15 July 2022. 109 For the foundational work see Hall, P and Soskice, D (eds), Varieties of Capitalism. The Institutional Foundations of Comparative Advantage (2001). 110 See n 134 below. 111 The research was originally spearheaded by the work of financial economists La Porta, Lopez de Silanes, Shleifer, and Vishny (LLSV). See, eg, La Porta, R, Lopez de Silanes, F, and Shleifer, A, ‘The Economic Consequences of Legal Origins’ (2008) 46 J of Econ Lit 285 and La Porta, R, Lopez de Silanes, F, Shleifer, A, and Vishny, R, ‘Law and Finance’ (1998) 106 JPE 1113. 112 For a review of the now extensive literature and its implications see Deakin S, ‘The Evolution of Theory and Method in Law and Finance’ in Moloney et al, n 16, 13.

18  The Institutional Setting within the CMU agenda, has primarily been shaped by political priorities, but it is increasingly being shaped by technocracy in the form of ESMA. Over this nearly sixty-​year period, Member States have contested the location of intervention (EU/​Member States) in the EU financial markets and the purpose and intensity of EU intervention, the nature of EU regulatory and supervisory intervention has changed, institutional reform has been significant and recurring, and the forces shaping EU intervention have evolved. The outcome has been a decisive shift of control to the EU, a monumental single rulebook of vast range, supported by a weighty administrative rulebook and accompanying soft law ‘rulebook’, and a supervisory architecture which, while based on NCA supervision, is framed by an ongoing ‘Europeanization’ of NCA supervisory practices steered by ESMA.113 In addition, operational and infrastructure reforms, particularly as regards data collection, have come to form part of EU financial markets regulation. EU financial markets regulation has, for the most part, developed incrementally, reflecting, as cognate political economy scholarship predicts and documents, a host of determinative factors which have, at different times and in different ways, shaped the regime. These include financial market conditions, prevailing political preferences, and the EU’s institutional capacity. The EU’s first attempts (in the 1970s) were, reflecting the then-​ embryonic state of EU financial markets, limited in scope and, reflecting the rudimentary nature of EU harmonization techniques generally, based on detailed, standardization-​ based measures, riddled with exceptions and derogations, which failed in their objective of supporting cross-​border capital-​raising. In the 1980s/​early 1990s, the minimum harmonization/​mutual recognition device pioneered by the Court of Justice and Commission, combined with policy and political recognition of the potential of an internal financial market to support growth, led to the first regulatory growth spurt: minimum-​harmonization directives were adopted to support regulatory ‘passports’ to the internal market (based on ‘home’ NCA supervision of cross-​border activity) for the actors then most strongly associated with the still nascent EU financial market (firms seeking capital, investment firms, and investment funds).114 A second, and more significant, growth spurt took place over the Financial Services Action Plan (FSAP) era (1999–​2004) when, reflecting a host of factors including the global equity market boom, political support for liberalization, the adoption of the euro, and international pressure for reform, a liberalizing and regulatory reform agenda of great range and depth was pursued. It led to an intensification of EU harmonization (supported by the first sustained application of administrative rule-​making techniques), the conferral of regulatory passports on a much wider set of financial market actors, and the first attempt at supervisory coordination through the ‘Lamfalussy’ reforms, noted below in this chapter.115 Following a subsequent ‘dynamic consolidation phase’ (2005–​

113 ‘Europeanization’ relates to NCA supervisory decision-​making increasingly following ‘harmonized’ best practices, and pursuing objectives, that are adopted and set by ESMA. See n 264. 114 Legal scholarship was relatedly concerned over this period with whether the EU or its Member States was the optimal rule-​maker for the EU financial market. See the pioneering work of Buxbaum, Hopt, and Wymeersch: Wymeersch, E, Control of Securities Markets in the European Economic Community, Collection Studies. Competition—​Approximation of Legislation Series No 31 (1977) and Buxbaum, R and Hopt, K, Legal Harmonisation and the Business Enterprise (1988). 115 The scholarly debate was largely concerned with the relative merits of harmonization and of regulatory competition and drew heavily on the US federal experience with corporate law. See, eg, Enriques, L, ‘EC Company Law Directives and Regulations: How Trivial Are They’ (2006) 27 U Pa JIEL (2006) 1. A parallel line of scholarship focused less on the location of intervention and more on the nature of the new rules: eg, Ferrarini, G, ‘The European

I.4  From the Segré Report to the Covid-19 Pandemic  19 2007),116 a further and defining reform period took place over the financial-​crisis era (2008–​2014).117 The titanic convulsions which the financial crisis brought to the EU financial system in Autumn 2008, and the subsequent catastrophic damage to the EU’s banking system and the consequent existential threat to the euro area as sovereigns threatened to buckle under the weight of the costs of bank rescue, led, as regards financial markets, to the EU becoming, in effect, the monopoly regulator:118 the ‘single rulebook’ became the reform prescription for the regulatory gaps, weaknesses, and arbitrage risks exposed by the financial crisis. Relatedly, the establishment of ESMA within the ESFS was designed to support the single rulebook but also to address the supervisory effectiveness and coordination failures which the crisis had exposed and which had laid bare the risks of cross-​border activity and of related risk transmission.119 By time this reform period closed in 2014 (the last major group of legislative reforms were adopted in April 2014), a single rulebook of materially greater specification and technicality than the previous legislative regime was in place; an administrative rulebook of immense scale and intricacy, and of a heavily proceduralized and granular quality, was being constructed; and ESMA was testing and applying its soft powers, in particular as regards soft law and supervisory convergence, and also exercising its direct supervisory powers (these were initially conferred in 2011 in relation to rating agencies).120 Between 2014 and 2022, EU financial markets regulation continued to ‘bend towards uniformity’.121 The single rulebook was expanded through legislative measures under the CMU agenda; it was also refined, as the swathe of reviews required by the ‘review clauses’ embedded in all the financial-​crisis-​era legislative measures assessed the impact of these measures, and as the ‘REFIT’ process provided an additional impetus for review.122 In addition, the construction of what is now the behemoth administrative rulebook that supports the financial-​crisis era and related legislative reforms was completed; these rules were also quickly revised and refined, reflecting the technocratic capacity ESMA has brought to EU Regulation of Stock Exchanges: New Perspectives’ (1999) 36 CMLRev 569. Scholarship also began to grapple with whether EU regulation could deliver transformative effects: Ferran, n 22. 116 Commission, White Paper on Financial Services Policy 2005–​2010 (COM(2005) 629). 117 The ‘financial-​crisis era’ is used across this book to refer to the 2008–​2014 period which (broadly) covers the initial period of disruption when the global financial crisis roiled EU markets, the subsequent euro area crisis as sovereigns came under pressure and the euro came under threat, and the related regulatory reform period (which can be regarded as ending in April 2014 when a major and final set of reforms, including MiFID II/​MiFIR, were agreed). 118 On the factors shaping the financial-​crisis-​era reform period see Howarth, D, and Quaglia, L, ‘Banking Union as Holy Grail: Rebuilding the Single Market in Financial Services, Stabilizing Europe’s Banks, and “Completing” Economic and Monetary Union’ (2013) 51 JCMS 103, Ferran, E, ‘Crisis-​driven Regulatory Reform: Where in the World is the EU Going?’ in Ferran et al, n 34, 1, and the discussions in the (2009) 47 Special Edition of the JCMS. 119 The reform agenda, including the need for ESMA, was set out in the de la Rosière Report, the EU’s major diagnostic and remedial review on the financial crisis and which shaped the reform process: High Level Group on Financial in the EU, Report (2009). 120 The financial-​crisis era saw an explosion in legal scholarship which tested the logic and resilience of the reforms (eg the 2013(2) issue of the JCLS). 121 This expression is drawn from a Brexit-​related speech by UK Prime Minister May (17 January 2017). On the UK’s perception that, as regards financial markets regulation, the UK tilted towards flexibility and the EU towards uniformity see Moloney, n 60. 122 The Commission’s ‘regulatory fitness and performance programme’ (REFIT), which forms part of the Commission’s Better Regulation agenda, is designed to systematically review rules to ensure that they are ‘simpler, more targeted, and easier to comply with’. While in place in some form since 2002, it is only since the financial-​ crisis period that the REFIT programme has had significant impact on EU financial markets regulation, including, eg, the 2019 reforms to the investment fund regime (Ch III).

20  The Institutional Setting financial markets regulation. A considerable degree of regulatory instability can accordingly be associated with the post-​crisis period. Relatedly, the reach of ESMA’s soft law ‘rulebook’ and of its supervisory convergence agenda continued to expand. ESMA also exercised its exceptional powers of intervention for the first time (its 2018 prohibition on the marketing of binary options to retail investors and its restriction of the marketing of contracts for difference (CfDs) to retail investors) and it acquired new powers of direct supervision which tilted the supervisory architecture incrementally towards centralization. As outlined across this book, EU financial markets regulation also sustained a series of shocks over this period, chief among them the UK’s withdrawal from the EU, but also market disruptions, notably the acute volatility wreaked by the Covid-​19 pandemic in early 2020 and the elevated volatility in certain derivatives markets in 2022 following Russia’s invasion of Ukraine. It has, however, proved resilient. Major failures in regulatory design have not been exposed, albeit that the quality and consistency of NCA supervision of the single rulebook can be a weakness, as exemplified by the 2020 Wirecard scandal.123 The following section considers the governance architecture that has supported and shaped the evolution of EU financial markets regulation.

I.5  EU Financial Markets Governance: Law-​making and Supervision I.5.1  Law-​making I.5.1.1 Law-​making and the EU Financial markets regulation can be regarded as developing in an empirical manner; it responds to observed events and forces, often, as previously noted, crisis-​driven.124 But its development is not haphazard; process (and related institutional capacity) matters. The process or institutional risks to effective financial markets regulation, at legislative and administrative levels, are many. The standard roll-​call includes information asymmetries with respect to the regulated sector, capture, bureaucratic inertia, political risks, organizational weaknesses, and limited resources,125 all of which can distort the delivery of efficient outcomes and which can be exacerbated in crisis conditions.126 The heightened dependence on highly technical administrative rules, particularly since the financial crisis, can also generate risks,127 particularly where such rules can have significant market impacts, a risk associated with the MiFIR transparency rulebook, for example.128 Relatedly, the EU law-​making process matters. The extent to which it engages with and manages the risks to

123 The 2020 Wirecard scandal, which exposed weaknesses in the German supervisory architecture and in pan-​ EU coordination, is noted in Ch II section 6 (financial reporting) and Ch VI section 3 (short selling). For a review see Möllers, T, ‘The Wirecard Accounting Scandal in Germany and how the Financial Industry Failed to Spot It’ (2021) 54 Int Lawyer 325 and Langenbucher, K et al, What are the Wider Supervisory Implications of the Wirecard Case? Study for the European Parliament ECON Committee (2020). 124 Allen, F and Gale, D, Understanding Financial Crises (2007) 190–​215. See also Moschella and Tsingou, n 29. 125 eg, Enriques, L and Hertig, G, ‘Improving the Governance of Financial Supervisors’ (2011) 12 EBOLR 357. 126 The financial-​crisis period, eg, exposed the risks associated with a lack of international coordination. eg Verdier, P-​H, ‘The Political Economy of International Financial Regulation’ (2013) 83 Indiana LJ 1405. 127 For a financial-​crisis-​era perspective on whether administrative rule-​making can lead to a productive correction of legislative error or stymie political choices see Coffee, n 27. 128 See Ch V.

I.5  EU Financial Markets Governance: Law-making and Supervision  21 effective regulation shapes the single rulebook, but it also drives the location and intensity of regulation and so the balance of power between the EU and the Member States. The institutional process for adopting EU financial markets regulation is framed by the Lamfalussy model129 which organizes financial market rules as: ‘level 1’ legislative measures, designed to establish normative principles and adopted by the co-​legislators; ‘level 2’ technical, administrative rules, adopted by the Commission; ‘level 3’ soft law/​supervisory convergence measures, adopted by ESMA (and also the Commission); and ‘level 4’ enforcement by the Commission, using its Treaty powers of enforcement against Member States for breach of EU law. The law-​making process operates through three related institutional channels. First, at the level 1/​legislative level, primary choices as to the nature of regulation are made by the co-​legislators (the European Parliament and Council) who revise, negotiate, and adopt legislative proposals presented by the Commission. Second, level 2 rule-​making occurs through administrative channels. Administrative rules can take the form of, first, ‘delegated’ or ‘implementing’ rules, which are developed and adopted by the Commission, subject to oversight procedures (designed to protect the co-​legislators’ legislative prerogatives and to ensure oversight of the relevant delegation of law-​making powers from the co-​ legislators to the Commission) which depend on the form of administrative rule engaged; or, second, ‘Regulatory Technical Standards’ (RTSs) or ‘Implementing Technical Standards’ (ITSs) (together, ‘Binding Technical Standards’ (BTSs)), proposed by ESMA and adopted by the Commission, subject also to oversight procedures. Finally, at level 3 ESMA can adopt a range of soft law/​supervisory convergence measures, including Guidelines, Q&As, Public Statements, and a host of similar measures. The Commission also adopts soft measures, typically in the form of recommendations and Q&As, although ESMA is the primary source of soft law. This process has developed incrementally over time, building on Treaty revisions to the foundational legislative and administrative rule-​making processes and also on related institutional experiments, and in response to political, institutional, and market conditions.130 Its main features are outlined in the following sections. How this process operates in practice, however, depends on the range of preferences that shape the law-​making process in the EU. National political preferences, expressed primarily in the Council but also influential in the European Parliament, have long been the dominant influence on EU financial markets legislation (which, in turn, shapes administrative rules and soft law). These preferences are shaped by an array of factors, but prominent among these are the Member States’ institutional economic foundations,131 traditionally classified in terms of, as noted in section 3, the Liberal Market Economy (LME), very broadly associated with market organization/​capital-​ market-​based funding and more limited regulatory intervention; and the Co-​ordinated Market Economy (CME), very broadly associated with strategic coordination/​bank-​based finance and heavier levels of intervention.132 As the EU financial system and Member States’ 129 The ‘Lamfalussy model’ relates to a major review, mandated by the ECOFIN Council and which reported in 2001, of how the law-​making process (then regarded as cumbersome, slow, and ill-​equipped for financial regulation) could best support the FSAP reforms. It called for greater use of administrative rule-​making as well as for legislative measures to be confined to foundational principles: Final Report of the Committee of Wise Men on the Regulation of European Securities Markets (2001). 130 For an extended review of the evolution of the law-​making process see the third edition of this work at 858–​84. 131 Story, J and Walter, L, The Political Economy of Financial Integration in Europe. The Battle of the Systems (1997). 132 Hall and Soskice, n 109.

22  The Institutional Setting financial systems have evolved,133 Member States’ preferences have (very broadly) been classified as those of the more liberally oriented ‘market-​making’ Member States and those of the more interventionist ‘market-​shaping’ Member States.134 The Council ‘market-​making’ coalition, usually composed of Member States with stronger financial markets and a significant international presence in their markets, including the Nordic Member States and the Netherlands (and previously the UK), has typically advocated for a style of regulation which is facilitative and promotes market access and liberalization; is supportive of disclosure techniques and open to market substitutes for intervention; tolerates a degree of national discretion; and is wary of centralization through institutional reform. The market-​shaping coalition, often associated with France, Spain, and Italy, typically takes a more interventionist posture, displays a more prominent regulatory bias, and is more supportive of institutional centralization. Multiple forms of coalition can, however, be identified, depending on the particular issue at stake, the structure of the relevant market segment, and related Member State preferences. These preferences and their impact on different aspects of the single rulebook are noted in subsequent chapters.

I.5.1.2 The Law-​making Process: Legislation The breadth and depth of the single rulebook suggests that the EU has untrammelled powers to intervene in financial markets. This is not the case. EU financial market measures must have a basis in a law-​making competence granted to the EU and set out in the Treaties, and must respect the Treaty-​based subsidiarity and proportionality requirements, albeit in practice these requirements do not significantly constrain the law-​making process. Under the Article 5 TEU conferral principle, the EU can only act within the limits of the competences conferred on it by the Member States in the Treaties to attain the objectives set out therein; must respect the subsidiarity principle (in that, in areas that do not fall within its exclusive competence,135 the EU can act only and insofar as the objectives of the proposed action cannot be sufficiently achieved by the Member States and can therefore, by reason of the scale or effects of the proposed action, be better achieved by the Union); and respect the proportionality principle (in that the content and form of the relevant action does not exceed what is necessary to achieve the objectives of the Treaties). As regards the competence requirement, financial markets legislation has, for the most part, been based on: Article 50(2)(g) TFEU (directives designed to coordinate the safeguards required by Member States of companies or firms); Article 53(1) TFEU (directives designed to coordinate Member States’ rules on the taking up and pursuit of activities as self-​employed persons and the provision of services); Article 115 TFEU (directives for the approximation of Member States’ rules which directly affect the establishment or functioning of the common market); and Article 114 TFEU (measures for the approximation of Member States’ rules which have as their object the establishment and functioning of the internal market). The free movement of capital competence (Articles 63-​66 TFEU) has also been called in aid. 133 Jackson, G and Deeg, R ‘The Long-​Term Trajectories of Institutional Change in European Capitalism’ (2012) 19 JEPP 1109. 134 See, eg, Burns, C, Clifton, J, and Quaglia, L, ‘Explaining Policy Change in the EU: financial reform after the crisis’ (2018) 25 JEPP 728; Quaglia et al, n 84; Hardie and Howarth, n 95, and Quaglia, L, ‘The “Old” and “New” Politics of Financial Services Regulation in the EU’ (2012) 17 New Political Economy 15. These classifications are fluid, with Member States models shifting over time. 135 Which includes financial markets regulation: Art 4(2) TFEU identifies the internal market as an area of shared competence.

I.5  EU Financial Markets Governance: Law-making and Supervision  23 Most usually, Article 114 is used. The competence, subsidiarity, and proportionality constraints have, at times, been a source of inter-​institutional tension and challenge in EU law-​ making generally, but in the financial markets sphere they have rarely braked the adoption of legislation.136 In particular, the Treaty competences for financial markets regulation are, by now, well-​tested, with contestation most likely to be associated with ESMA’s burgeoning powers and with whether it is staying within its constitutional bounds as an agency.137 Process-​wise, legislative rules in the financial markets sphere are adopted under the Article 294 TFEU ‘ordinary legislative procedure’: the main single market competence for law-​making (Article 114) provides that the Article 294 process be used for the adoption of Article 114 measures; and Article 294 is used for the vast majority of legislative measures generally. Adopted in 1992 and finessed in 1999, the procedure is based on the principle of parity between the co-​legislators and is designed to ensure that legislation cannot be adopted without the assent of each co-​legislator (the Council and European Parliament). The process is initiated by the Commission’s adoption of a proposal: the Commission has the sole right of initiative, although it may be requested by the Council or Parliament to propose a measure. Proposals are typically adopted after repeated rounds of consultation,138 and engagement with stakeholders, including through Commission-​established expert groups.139 An impact assessment of the proposal is also undertaken and reviewed by the Commission’s Impact Assessment Board. Commission proposals typically form part of a wider regulatory agenda driven by the political priorities set by the European Council and the Council, currently the CMU agenda as well as the sustainable finance and digital finance agendas noted below in this chapter. The financial-​crisis-​era institutional reforms brought the ESRB into this process; the recommendations it issues can include calls for legislative action.140 These reforms also brought ESMA’s technocratic capacity to bear, in particular through the reviews it undertakes for the Commission under the review clauses now typically contained in legislation. Opinions can also be delivered by the ECB and the Economic and Social Committee (EESC).141 National parliaments are empowered to send

136 This can be associated with the elastic interpretation by the Court of Justice of Art 114 in particular (for an assessment of the case law see Weatherill, S, ‘The Functions and Limits of Legislative Harmonization in Making the Internal Market’ (2021), available via ) and a broadly supportive political and institutional environment. The failed UK challenge to Art 114 as the legal basis for ESMA’s powers under the Short Selling Regulation remains a significant exception (UK v Council and Parliament, n 57). In that ruling, the Court, reflecting its Art 114 jurisprudence generally, took a liberal approach, finding that Art 114 could support agency construction (and not just rule harmonization), in particular given the financial stability context as well as the technical expertise which ESMA brought to EU financial markets governance: 137 On the related Meroni ruling see section 6.3.3 below. 138 Consultations have changed over time. Before and over the financial-​crisis era they took the form of policy papers that presented the context and the potential reforms and their purpose/​risks/​benefits. Increasingly, and particularly as regards the CMU agenda, consultations take the form of a series of questions seeking to elicit feedback on specific issues, have only limited narrative, and so are less informative on the Commission’s approach. 139 eg, the Technical Expert Stakeholder Group (TESG) on SMEs whose report, part of the CMU agenda, informed the Commission’s 2021 SME-​focused ‘Listing Act’ Consultation and related 2022 Listing Act reform agenda (TESG, Empowering EU Capital Markets for SMEs (2021)); and the Technical Expert Group on Sustainable Finance which supported, inter alia, the taxonomy project (noted below in this Ch section 7.2). 140 eg, ESRB Recommendation on Reform of Money Market Funds (2021) (ESRB/​2021/​9). 141 The European Economic and Social Committee (EESC) (previously ECOSOC) provides opinions on legislative initiatives and represents civil society generally. The ECB is to be consulted on all EU acts within its field of competence (Art 127 TFEU). It does not opine on all financial market proposals, but typically engages in relation to financial stability issues.

24  The Institutional Setting a reasoned opinion on the proposal’s compliance with the subsidiarity principle to the Council, European Parliament, and Commission.142 The full, multi-​staged Article 294 procedure is not, in practice, used for financial market measures which are almost always adopted under the ‘fast track’ or first reading procedure. This procedure is based on political agreement being reached by the Council and Parliament before the Parliament’s first reading, and the measure being adopted by the Parliament at its first reading and by the Council thereafter. It has become the standard process under Article 294.143 Under this process, before the European Parliament reaches a first reading, informal tripartite meetings attended by the Parliament, the Council, and the Commission (the ‘trilogues’) are held, on the basis of the Parliament’s and Council’s previously agreed negotiating texts.144 During the trilogues, agreement is sought on the Parliament’s amendments, such that they can be adopted in a plenary Parliament session (the first reading) and the measure subsequently adopted by the Council. In practice, and as outlined in subsequent chapters, trilogue negotiations can be bruising and they can also take place under considerable time pressure where they approach the end of a Parliament’s term.145 On average, the ordinary legislative process takes in the region of eighteen months, although where a measure is contested this can be significantly longer.146 The extensive technocratic support now provided by the ESAs, however, has facilitated the legislative process and its capacity to manage technical regulatory design choices.147

I.5.1.3 The Law-​making Process: Administrative Rules Agencies, typically characterized as non-​majoritarian institutions operating under delegated powers from representative/​legislative bodies, have become a familiar part of the apparatus for governing the modern state. The well-​documented rise of the ‘regulatory state’, and the related deploying by governments of regulatory tools to achieve policy outcomes

142 The Swedish Parliament, eg, issued a subsidiarity opinion relating to the reforms proposed by the Commission to strengthen the supervision of CCPs under what would become the 2019 EMIR 2.2 Regulation (for a review see European Parliament, Briefing, Review of EMIR (2018) 6). 143 Over the 2009–​2014 Parliament term 85 per cent of files were adopted at first reading; this had increased to 89 per cent over 2014–​2019: European Parliament, Handbook on the Ordinary Legislative Procedure (2020) 50. 144 As regards the adoption of the Parliament’s negotiating text, a resolution for a negotiating text is proposed by the relevant committee (the Economic and Monetary Affairs Committee (ECON) although other committees, in particular the Legal Affairs Committee, may be engaged) and then adopted by the Parliament after plenary debates which typically revise, to greater or less extents, the committee’s recommendations. As regards the adoption of the Council’s negotiating text (the ‘general approach’), in practice, negotiations take place in Council working groups which are chaired by the Council Presidency and which report to the influential COREPER (the Committee of Permanent Representatives, composed of Member States’ permanent delegations to the EU), which prepares the Council’s work. Depending on the level of contestation, multiple rounds of negotiation may be required before a general approach is agreed. The Council operates under a qualified majority vote (QMV): at least 55 per cent of Member States, comprising at least fifteen of them and representing Member States comprising at least 65 per cent of the total EU population: Art 16 TEU. 145 As was the case with the final suite of financial-​crisis era measures, including MiFID II/​MiFIR, which were finally adopted on 15 April 2014 (‘Super Tuesday’) during the final plenary session of the Parliament’s 2009–​2014 term. Trilogues also raise legitimation risks given their limited transparency. See, eg, Rosén, G and Stie, AE, ‘Balancing Seclusion and Inclusion: EU trilogues and democratic accountability’ (2022) 29 JEPP 383. 146 The crisis period saw major measures adopted in unprecedently quick time frames, notwithstanding often significant contestation on specific elements. The 2010 ESA reform, for example, was proposed in September 2009 and agreed in September 2010; the 2011 AIFMD proposed in April 2009 and agreed in November 2010; and the 2012 EMIR proposed in September 2011 and agreed in March 2012 147 The complex 2019 IFD/​IFR investment firm prudential regime, eg, did not experience an unduly lengthy process reflecting in large part the extensive preparatory work done by EBA on the regime’s novel approach to the capital treatment for investment firms. See Ch IV section 9.

I.5  EU Financial Markets Governance: Law-making and Supervision  25 and to manage an increasingly complex risk environment, has increased reliance on agencies to deliver policy goals, including by their adoption of administrative rules under powers delegated from the legislature.148 In the financial markets sphere, independent agencies (financial market regulators) have come to be the standard means for delivering policy choices, including by their adoption of administrative rules.149 In the EU, the regulatory demands of the single market have led to a massive expansion in the ‘administrative state’150 and to a material ‘agencification’ of EU governance, including through the establishment of the ESAs and ESMA. But under the EU Treaties, the Commission is the constitutional location for administrative rule-​making (exercising powers delegated from the Council and European Parliament) (Articles 290 and 291 TFEU). However functionally desirable it may be from an ‘output’ perspective, EU agencies may not adopt administrative rules, given the prohibition which the need to respect the institutional balance established by the Treaties places on any ‘sub-​delegation’ of discretionary rule-​making power from the Commission to agencies. Following a series of Treaty and legislative revisions, in particular by the Lisbon Treaty, administrative rule-​making is governed by Articles 290 and 291 TFEU and by Regulation 182/​2011.151 Two forms of administrative rule-​making are, relatedly, supported by the Treaties. First, the Article 290/​291 TFEU process (introduced by the Lisbon Treaty) permits a direct delegation of (Article 290) or conferral of (Article 291) rule-​making power to or on the Commission. Article 290 provides that a legislative act may delegate to the Commission the power to adopt ‘non-​legislative acts of general application to supplement or amend certain non-​essential elements of the legislative act’ (Article 290(1)). It also specifies that the ‘essential elements’ of an act must be reserved to the legislative act and cannot be delegated, and that the nature (objectives, content, scope, and duration) of any delegation must be specified in the relevant legislative measure which confers the delegation. Article 290(2) further provides that the relevant delegating legislative acts are to explicitly lay down the conditions to which the delegation is subject, and specifies that these conditions may be as follows: the European Parliament or the Council may revoke the delegation; and the delegated act may enter into force only if no objection has been expressed by the Parliament or Council within the period set by the legislative act. In each case, the Parliament acts by a majority of its members and the Council by a qualified majority. Article 290 ‘delegated acts’ (in practice, typically delegated regulations) form a major component of the administrative rulebook for financial markets, although they have been overtaken, in the decade since the financial crisis, by RTSs. RTSs are a derivation of Article 290 delegated acts. Also adopted by the Commission, they are, however, proposed by ESMA under the discrete procedure established under the ESMA Regulation (noted in section 6). By contrast, ESMA is not formally engaged in the Article 290 process although in practice it is invariably asked to provide technical advice to the Commission on the design and content of delegated acts.152

148 For an account of the rise of the regulatory state and of agencies see Yeung, K, ‘The Regulatory State’ in Baldwin, R, Cave, M, and Lodge, M (eds), The Oxford Handbook of Regulation (2010) 64. 149 For a survey of the role of financial regulators see Ferran, E, ‘Institutional Design: The Choices for National Systems’ in Moloney et al, n 16, 97. 150 As examined in Majone’s pioneering work: Majone, G, Regulating Europe (1996). 151 Regulation (EU) No 182/​2011 [2011] OJ L55/​13. 152 On the adoption of Art 290 measures in the financial markets sphere see Moloney, N, The Age of ESMA. Governing Financial Markets (2018) 116–​19 and 126–​9.

26  The Institutional Setting Article 291 addresses executive powers and related implementing rules. These powers are primarily located with the Member States, who are required to adopt all measures of national law necessary to implement legally binding Union acts (Article 291(1)). Article 291 provides, however, that the Commission (and in specified cases the Council), where uniform conditions for implementing legally binding EU acts are needed, may be conferred, through a legislative act, with ‘implementing powers’ to adopt implementing rules of general application (or, as appropriate, individual administrative decisions). The line between Article 290 ‘delegated acts’ and Article 291 ‘implementing acts’ can, however, be a fine one and the distinctive features of both types of rule have been contested.153 But arguably, the defining feature of Article 290 delegated acts is their quasi-​legislative colour (although this is an elusive quality); Article 291 implementing acts, by contrast, are executive in nature and designed to support implementation. The procedural framework for the adoption of Article 291 TFEU implementing acts is set out in Regulation 182/​2011, the adoption of which was envisaged in the Treaty (Article 291(3)). It provides for committee-​based oversight through committees of Member State representatives conferred with, depending on the type of committee, varying powers to oversee and (in some circumstances) veto Commission proposals for implementing acts. Article 291 implementing acts (on which ESMA also provides technical advice to the Commission) are much rarer than delegated acts in the administrative rulebook for financial markets, typically being used only to adopt equivalence-​related decisions under the third country regime. Relatedly, ITSs are a derivation of Article 291 implementing acts, but are proposed by ESMA and adopted under the process established under the ESMA Regulation (section 6).

I.5.2  Supervision and Enforcement I.5.2.1 Supervision, Enforcement, and the EU Financial market rules are operationalized by the granular business of supervision, which is usually entrusted to a financial regulator. It engages the exercise of a wide set of tools ranging from teaching tools (including soft law and industry outreach); information/​ surveillance-​based tools (such as requests for information, on-​site inspections, annual supervisory visits, data interrogation, themed entity-​level investigations, and sector-​wide thematic investigations on specific issues); remediation tools (including the formal remediation plans adopted by financial regulators for regulated actors); and follow-​up action, ultimately engaging ex-​post enforcement.154 As with regulation, financial market supervision poses challenges, as the failures over the financial-​crisis era exposed.155 Relatedly, supervisory models, which can include, inter alia, ‘nimble,’ ‘responsive,’ ‘flexible,’ ‘smart’, and ‘adaptive’ approaches, and which aim to equip regulators to engage effectively with the regulated sector, adapt in a data-​informed and iterative manner as environmental conditions require, and retain hierarchical authority, have 153 eg Craig, P, ‘Delegated Acts, Implementing Acts, and the New Comitology’ (2011) 36 ELJ 671. 154 The standard supervisory ‘tool-​kit’ is usually characterized as including inspection, investigation, surveillance, and enforcement tools: IOSCO, Objectives and Principles of Securities Regulation (2017), principles 10–​12. 155 Ford, C, ‘New Governance in the Teeth of Human Frailty: Lessons from Financial Regulation’ (2010) Wisconsin Law Review 441 and Lo, A, ‘Regulatory Reform in the Wake of the Financial Crisis of 2007–​2008’ (2009) 1 Journal of Financial Economic Policy 4.

I.5  EU Financial Markets Governance: Law-making and Supervision  27 evolved over time.156 In practice, financial market supervision is usually operationalized through the regulator’s bespoke proprietary supervision model which is typically amplified by supervisory manuals/​handbooks and related risk assessment frameworks. ‘Risk-​ based’ supervisory models, for example, are common internationally (and in the EU) and are based on identification of the extent to which (specified) risks may materialize or on identification of when risks to a regulator’s mandate or objectives might arise.157 But despite repeated cycles of experimentation, the determinants of optimal supervision remain uncertain, as is indicated by the debate on how conduct and culture risk should be supervised.158 Further, the opportunities for supervisory learning and refinement can be limited as the factors which shape supervision and which have a bearing on optimal outcomes are often context dependent and reflect local markets, cultures, and political features. Supervision is also increasingly grappling with how best to manage and interrogate the now massive supervisory data-​sets provided by regulated actors (reflecting reforms adopted over and since the financial-​crisis era); and with the related opportunities afforded by technological innovation, including ‘Regtech’ and ‘Suptech’ tools (the use of technology to support regulatory compliance and supervision),159 as well as the challenges (including as regards regulators’ resources, technical capacity, and legitimation (particularly where artificial intelligence-​ based tools are used)). The difficulties are all the more significant in the EU where supervision must, while grappling with the challenges of financial market supervision generally, also respond to the operational risks associated with cross-​border activity and risk transmission and with the anchoring of cross-​border supervision to the ‘home’ NCA (usually the NCA of the Member State where the regulated actor is registered and authorized). Supervision remains a national, NCA-​based competence, reflecting myriad factors including legal and constitutional complexities;160 political reluctance to cede sovereignty over supervisory decisions with potential fiscal implications; national technocratic/​regulator resistance; and functional challenges relating to the supervision at EU-​level of a vast population of financial market actors.161 The EU supervisory framework is, in consequence, intricate and multi-​layered,

156 eg, Ford C, Innovation and the State: Finance, Regulation and Justice (2017). 157 Risk-​based supervision implies the use of a systematized framework of inspection or supervision to manage regulatory or institutional risk and which allows a regulator to prioritize its supervisory activities: Black, J, ‘Risk Based Regulation: Choices, Practices and Lessons Being Learned’ in OECD, Risk and Regulatory Policy: Improving the Governance of Risk (2010). 158 In relation to which the FSB has been a pathfinder, developing a tool-​kit for supervisors: eg FSB, Strengthening Governance Frameworks to Mitigate Misconduct Risks: A Tool-​kit for Firms and Supervisors (2017). 159 The Bank for International Settlements, eg, is investigating how technology can support supervision, including through ‘Project Ellipse’ which is exploring how artificial intelligence (AI) can help to identify risks: BIS, Project Ellipse. An Integrated Regulatory Data and Analytics Platform (2022). 160 Ranging from the difficulties in using the agency vehicle, given the constraints imposed by the Meroni ruling (as outlined below in this Ch section 6.3.3), to the Council unanimity required were the Treaties’ backstop competence (Art 352 TFEU) to be used to construct a central supervisor. Workarounds can be found. The mid-​2021 movement of certain investment firms into Banking Union’s Single Supervisory Mechanism (SSM) which, under the SSM’s founding Regulation (Council Regulation (EU) No 1024/​2013 [2013] OJ L287/​63, adopted under Art 127(6) TFEU which provides the legal base for the conferral of prudential supervision powers on the ECB as regards credit institutions and ‘other financial institutions’, apart from insurance companies) covers credit institutions within the scope of the SSM Regulation, was achieved by expanding the definition of a ‘credit institution’ to include the specified largest and most complex investment firms. See Ch IV section 9. 161 Further, the risk-​sharing imperative which drove the establishment of Banking Union and its supervisory structures is much less pressing as regards financial markets. For discussion see Howell, E, ‘The Evolution of ESMA and Direct Supervision: Are There Implications for EU Supervisory Governance’ (2017) 54 CMLRev 1027 and

28  The Institutional Setting being designed to ensure the NCA-​based scheme can capture and manage pan-​EU activity and contain related risks. It is, accordingly, framed by ESMA’s coordination and supervisory convergence powers but it also includes elements of supervisory centralization, somewhat awkwardly bolted on. In addition, the ex-​post enforcement mechanisms which regulatory systems deploy also support the achievement of the outcomes sought by regulation, with the quality and intensity of administrative enforcement by regulators and, relatedly, ‘credible deterrence’,162 assuming a stronger priority in the wake of the financial crisis,163 not least given increasing evidence of the deterrent effects of administrative sanctions.164 Here too, however, the complexities are considerable,165 ranging from the relative merits of public administrative enforcement by regulators and of private enforcement through civil liability actions,166 to the myriad design issues raised by public/​regulatory enforcement167 (including as regards the foundational question as to the extent to which a regulator should persuade or punish168 and, relatedly, the extent to which a regulator is ‘enforcement-​led’ or is more oriented to compliance-​and dialogue-​related strategies). The EU context raises additional challenges. The nature of regulatory or administrative enforcement, and the factors that shape its effectiveness (from regulators’ independence, resources, powers, supervisory/​enforcement models, and cultures; to the strength of market discipline and the impact of market structure; to local political conditions), are deeply embedded in domestic institutional settings.169 Enforcement is accordingly not easily amenable to an EU harmonized response. Since the financial crisis, however, the single rulebook has increasingly come to focus on administrative enforcement, in particular by specifying the administrative sanctions which NCAs must have at their disposal, although civil Moloney, N, ‘EU Financial Governance and Brexit: Institutional Change or Business as Usual?” (2017) 42 ELR 112; and, for a political economy perspective, Howarth, D and Quaglia, L The Political Economy of Banking Union (2016). 162 IOSCO, Credible Deterrence in the Enforcement of Securities Regulation (2015), reviewing approaches to enforcement internationally and calling for regulators to integrate ‘credible deterrence’ in their enforcement strategies. 163 For a financial-​crisis-​era perspective see Carvajal, A and Elliott, J, IMF, Working Paper No 09/​168, The Challenge of Enforcement in Securities Markets: Mission Impossible? (2009). 164 Armour, J, Mayer, C, and Polo, A, ‘Regulatory Sanctions and Reputational Damage in Financial Markets’ (2017) 52 J of Fin and Quantitative Analysis 1429, finding that reputational losses for publicly listed firms following from regulatory enforcement action can amount to (on average) nine times the size of the financial penalty imposed. 165 For analysis of the design issues and the related cross-​disciplinary literature see MacNeil, I, ‘Enforcement and Sanctioning’ in Moloney et al, n 16, 280. 166 From the extensive literature that considers the impact of different enforcement models on market development see, eg, Armour, J, Black, B, Cheffins, B, and Nolan, R, ‘Private Enforcement of Corporate Law: An Empirical Examination of the UK and US’ (2009) 6 J of Empirical Legal Studies 701; La Porta, R, Lopez-​de-​Silanes, F, and Shleifer, A, ‘The Law and Economics of Self Dealing’ (2008) 88 JFE 430; Ferran, E and Cearns, K, ‘Non-​ Enforcement Led Public Oversight of Financial and Corporate Governance Disclosure and of Auditors’ (2008) 8 JCLS 191; Coffee, J, ‘Law and the Market: The Impact of Enforcement’ (2007) 156 U Pa LR 229; Jackson, H and Roe, M ‘Public and Private Enforcement of Securities Laws: Resource-​Based Evidence’ (2009) 93 JFE 207 and La Porta, R, Lopez-​de-​Silanes, F, and Shleifer, A, ‘What Works in Securities Laws’ (2006) 61 J Fin 1. 167 From the extensive regulatory studies literature see, eg, Baldwin, R and Black, J, ‘Really Responsive Regulation’ (2008) 71 MLR 59. 168 One influential model for regulatory decision-​making suggests a model based on a graduated application of regulatory techniques, including voluntary compliance, supported by dialogue, education, and the threat of intervention: Ayres, I and Braithwaite, J, Responsive Regulation—​Transcending the Deregulation Debate (1992). 169 MacNeil, n 165. Relatedly, the 2020 Wirecard scandal saw discussion of the effectiveness of enforcement by the German authorities as regards Wirecard’s financial reporting compliance and of the related institutional setting of enforcement in Germany (see n 123).

I.5  EU Financial Markets Governance: Law-making and Supervision  29 liability, rooted in different national legal, judicial, and procedural systems, remains outside the single rulebook, for the most part.

I.5.2.2 The Supervisory and Enforcement Framework The supervisory architecture through which the single rulebook is monitored, supervised, and enforced is based on NCA supervision, coordinated through the ESFS. Established over the financial-​crisis era, the objective of the ESFS is to ensure that the rules applicable to the financial sector are adequately implemented to preserve financial stability and to ensure confidence in the financial system as a whole and effective and sufficient protection for the customers of financial services.170 The ESFS is composed of the NCAs that ground the ESFS; the three sectoral ESAs (ESMA as regards financial markets) and their coordinating Joint Committee; and the ESRB. NCAs are the cornerstone of the ESFS. The single rulebook allocates jurisdiction across NCAs, almost always conferring jurisdiction on the ‘home’ NCA (the NCA of the Member State in which the regulated actor is registered) as the ‘anchor’ supervisor for a regulated actor’s pan-​EU activities; host NCAs can typically exercise precautionary powers, and, in some limited instances, specified powers, over cross-​border actors. The single rulebook also specifies the tasks of and the minimum powers required for NCAs; since the financial crisis, the specification of NCA tasks and powers has become increasingly more precise. In addition, the single rulebook has begun to bring a degree of procedural harmonization to the operational business of supervision. This has been mainly achieved through the ‘supervisory review and evaluation process’ (SREP), familiar from the EU banking regime but adopted for most investment firms in 2019 under the investment firm prudential regime,171 but also through the host of administrative rules that now specify how different NCA supervisory reviews, approvals, waivers, and actions are to be carried out. The single rulebook in addition imposes the myriad NCA-​NCA-​ESMA cooperation and information exchange obligations that support home-​NCA-​based supervision of cross-​border activity. In addition, discrete supervisory arrangements apply in certain financial market segments, reflecting the different degrees of pan-​EU supervisory coordination required by, and, relatedly, the varying levels of financial stability risks posed by, different populations of regulated actor. These discrete arrangements have become more intricate and centralized in the decade or so since the financial crisis, most notably, the arrangements governing the coordination of CCP supervision through colleges of supervisors.172 The NCA-​based supervisory system is supported by the extensive supervisory convergence powers wielded by ESMA, as outlined in section 6. In addition, two forms of centralized supervision form an exception to the NCA-​based supervisory model. First, as outlined in section 6 and as discussed across this book, ESMA has been conferred with exclusive supervisory powers over a limited cohort of regulated actors. Second, the largest and most complex investment firms are supervised, since mid-​2021, and for prudential regulation purposes only, through Banking Union’s Single Supervisory Mechanism (SSM), through which the prudential supervision of SSM-​scope

170 The ESFS is constituted under each of the ESAs founding Regulations (for ESMA, the constitutive statement is at ESMA Regulation Art 2). 171 See Ch IV section 11.3. 172 See Ch VI section 5.9.1.

30  The Institutional Setting ‘credit institutions’ (deposit-​taking banks and now in-​scope investment firms) is either carried out directly by, or overseen by, ECB Banking Supervision.173 The centralization of the supervision of investment firms through ECB Banking Supervision and within Banking Union constitutes a significant exception to how financial market supervision is otherwise organized. The ESFS (within which single market financial market supervision sits) and Banking Union (which is primarily concerned with the supervision of euro area deposit-​taking entities) are very different constructs. The ESFS is a single-​market-​oriented, coordination-​based arrangement which captures the vast population of regulated financial actors in the EU. Banking Union is an operational and executive construct, primarily euro area in scope (although other Member States can join), based on centralized supervision and risk mutualization, and is currently limited in scope to prudential regulation, credit institutions, and, recently, specified investment firms. Both arrangements have been shaped by different forces. The roots of Banking Union are in the EU’s fiscal and sovereign debt crisis which followed the outbreak of the financial crisis and, relatedly, in the destructive feedback loop which developed between bank failure, sovereign rescue of banks, sovereign fragility, and the viability of the euro, and the consequent overwhelming political imperative to break the link between sovereigns and banks.174 The ESFS is similarly a creature of the financial crisis, but its coordination-​based design has long been a feature of EU financial markets supervision and predates the financial crisis. Enforcement, whether public/​administrative or private, remains a national competence (save as regards ESMA’s competences with respect to the actors it supervises), nested within national regulatory, procedural, investigatory, and judicial settings. As outlined in subsequent chapters, since the financial-​crisis era public/​administrative enforcement by NCAs has become subject to significantly greater harmonization, as regards the specification of the administrative sanctions which must be available to NCAs, and as regards how these sanctions are to be used.175 The now regular reporting by NCAs to ESMA on sanctions, however, points to continuing and significant divergences in sanctioning practices, as noted in subsequent chapters. Private enforcement/​civil liability touches only lightly on the single rulebook, being a matter of national competence, albeit that Member States are (unusually) required to provide for harmonized civil liability regimes as regards breach of the rating agency regime and of the PRIIPs Regulation; the compensatory dimension of enforcement therefore remains largely outside the single rulebook176 173 See Ch IV section 9. A now massive literature considers the origins and operation of Banking Union and the SSM. See, eg, Grundmann, S and Micklitz H-​W (eds), The European Banking Union and Constitution (2020); the bi-​annual proceedings of the ECB Legal Conference (eg, ECB, Building Bridges: central banking law in an interconnected world (2019); and Busch, D and Ferrarini, G (eds), European Banking Union (1st edn 2015; and 2nd edn 2020). 174 From the extensive political economy literature on the response to the euro area crisis see, eg, Schoeller, M, ‘Providing Political Leadership? Three Case Studies on Germany’s Ambiguous Role in the Eurozone Crisis’ (2017) 24 JEPP 1; Epstein, R and Rhodes, M, ‘The Political Dynamics behind Europe’s New Banking Union’ (2016) 39 West European Politics 415; and Howarth, D, and Quaglia, L, ‘Internationalized Banking, Alternative Banks, and the Single Supervisory Mechanism’ (2016) 39 West European Politics 438. 175 The then-​new approach to sanctioning was set out in Commission, Communication on Reinforcing Sanctioning Regimes in the Financial Sector (COM(2010) 716). The approach to the harmonization of sanctions varies across the single rulebook, however, particularly as regards the quantum of pecuniary sanctions. 176 See further Ch II section 4.12.4 on the interaction between private enforcement/​civil liability and the single rulebook, in the context of prospectus disclosure. The rating agency and PRIIPs regimes are unusual in providing for harmonized liability regimes: Ch VII section 15 and Ch IX section 5.3.4. For discussion see Gargantini, M, Regulatory Harmonization and Fragmented Enforcement in the Capital Markets Union, JMN EULEN WP Series (2022).

I.6  EU Financial Markets Governance: ESMA  31

I.6  EU Financial Markets Governance: ESMA I.6.1 ESMA ESMA’s technocratic influence, which is threaded across this book, has come to be a determinative factor shaping both regulatory and supervisory governance in the decade or so since ESMA’s establishment in 2011. This is evident from the increasingly technical but also responsive quality of the single rulebook, in particular its administrative rules, the ongoing ‘Europeanization’ of the NCA-​based supervisory framework, and the technocratic capacity ESMA has given the EU as regards financial markets governance generally.177 ESMA’s March 2022 response to the outbreak of the war in Ukraine provides a clear illustration of the extent to which ESMA has become embedded in EU financial markets governance.178 This scene-​setting outline sets out ESMA’s origins, governance and operation, and main powers.179 ESMA is an independent EU agency, constituted under its founding 2010 ESMA Regulation, as most extensively revised by the 2019 ESA Reform Regulation. It operates through its decision-​making Board of Supervisors (BoS), composed of the NCAs of the twenty-​seven Member States. Part of the ESFS, ESMA’s widely cast objective is to protect the public interest by contributing to the short-​, medium-​, and long-​term stability and effectiveness of the financial system, for the Union economy, its citizens and businesses, by contributing to improving the functioning of the internal market (including a sound level of regulation and supervision); ensuring the integrity, transparency, efficiency, and orderly functioning of financial markets; strengthening international supervisory coordination; preventing regulatory arbitrage and promoting equal conditions of competition; ensuring the taking of investment and other risks are appropriately regulated and supervised; enhancing consumer and investor protection; and enhancing supervisory convergence across the internal market (Article 1(5)). To this end, ESMA is conferred with a series of tasks and competences, under its founding Regulation but also under the single rulebook, relating to regulatory governance (chief among them advising the Commission on the adoption of administrative rules and proposing BTSs; and adopting ESMA soft law); supervisory convergence (or the support of coordination between, and the consistent application of the single rulebook by, NCAs, including through adopting soft law, reviewing NCA action, and peer review); and direct supervision (of an expanding cohort of specified 177 eg, to engage in infrastructure-​oriented reforms, such as the European Single Access Point (ESAP) reform for the distribution of regulated disclosures outlined in Ch II section 7.3. 178 ESMA inter alia monitored CCPs as regards volatility risks in the energy and commodity derivatives markets; engaged with rating agencies regarding ratings; sought to verify the impact on benchmarks; monitored the impact on investment funds, including as regards liquidity, in coordination with NCAs; monitored, with NCAs, the impact on trading venues and CSDs; facilitated information gathering and sharing on cyber security; engaged in market risk assessment; and made a series of recommendations to market participants relating to sanctions compliance, market disclosures, and financial reporting: ESMA, Public Statement (Regulatory Response to War in Ukraine), 14 March 2022. 179 The significance of ESMA’s role is now of such a scale that it cannot be considered fully in a discussion of this nature. For legal/​regulatory governance perspectives see Moloney, n 152; Božina Beroš, M, ‘Examining Agency Governance in the European Union Financial Sector. A Case Study of ESMA’ (2017) 30 Economic Research 1743; Spendzharova, A, Becoming a Powerful Regulator: the European Securities and Markets Authority in European financial sector governance, TARN Working Paper 8/​2017, available via ; and Howell, n 161. For discussion of ESMA in the context of the ESAs generally see Weismann, P, European Agencies and Risk Governance in EU Financial Market Law (2016).

32  The Institutional Setting entities). All these powers must be exercised in accordance with the ESMA Regulation and within ESMA’s scope of action under Article 1(2) (a widely drawn provision covering, in effect, the single rulebook).180 Since its 2011 establishment, ESMA has become a decisive technocratic influence on the governance of the EU financial market, to the extent that it is not unreasonable to characterize EU financial markets regulation as being segmented into the pre-​and post-​ESMA periods. By way of illustration, over 2020–​2022, a decade or so on from its 2011 establishment, ESMA took direct action relating to short selling as the Covid-​19 pandemic roiled markets in early 2020; took over the direct supervision of data reporting services providers, administrators of EU critical benchmarks, and third country CCPs, following the related conferrals of power by the co-​legislators in 2019; produced a host of soft law measures, including in response to the 2021 Gamestop/​meme-​stock episode; played a critical role in post-​Brexit UK/​EU financial relations by assessing the major UK CCPs as regards whether they should be required to repatriate to the EU to provide EU clearing services; and was embedded in the massive MiFID II/​MiFIR review, producing a host of reports that have informed the review of these pillar single rulebook measures.181 Some but not all of these actions could have been predicted in 2011. Most controversy then attended the extent to which ESMA might be able to take enforcement action against, mediate between, or impose emergency measures on NCAs under the-​then totemic ‘Articles 17–​19’ powers it was conferred with under the ESMA Regulation. Only the mediation power appears to have been used by ESMA since and, generally, these powers remain of more symbolic than practical importance (albeit that the Commission has repeatedly called on the ESAs to use these powers where appropriate).182 ESMA’s purposeful and at times entrepreneurial exercise of its competences as regards regulatory governance, its soft supervisory convergence powers, and its incrementally acquired direct supervisory powers, however, have placed it at the centre of EU financial markets governance.

I.6.2  Origins and Evolution ESMA’s central role in EU financial markets governance has not been achieved by radical, punctuated change.183 ESMA’s powers are conferred through the EU legislative process. They have, accordingly been conferred in an incremental manner and in light of the co-​legislators’ and the Commission’s experience of, and preferences as regards, ESMA in

180 Article 1(3) also empowers ESMA to act ‘in the field of activities of financial market participants’ as regards issues not directly covered by the specified Art 1(2) acts, including matters of corporate governance, auditing, and financial reporting, and taking into account sustainable business models and the integration of environmental, social and governance related factors, as long as such action is necessary to ensure the effective and consistent application of those acts; and to take ‘appropriate action’ in the context of take-​over bids, clearing and settlement and derivative issues. In practice, the reach of the single rulebook is now so wide that there are few real constraints on ESMA’s field of operation, albeit that the 2019 ESA Reform Regulation reforms underline that ESMA must operate within the limits of its legislative framework (Art 8(3)). 181 These interventions are outlined in subsequent chapters. 182 ESMA’s public reports have noted its use of binding mediation in the case of NCA UCITS supervision: ESMA, Notification Frameworks and Home-​Host Responsibilities under UCITS and AIFMD. Thematic Study among NCAs (2017) 14. The Commission most recently called on the ESAs to use these powers more frequently in its May 2022 ESA Review: COM(2022) 228. 183 See generally Moloney, n 152.

I.6  EU Financial Markets Governance: ESMA  33 action. The caution with which the legislative process has approached empowerments to ESMA has also meant that ESMA has developed in a broadly sustainable manner. While ESMA is increasingly becoming associated with supervision, its evolution can be traced through the history of the EU’s attempts to establish a process for financial market administrative rule-​making. The initial, faint traces of financial market ‘agencification’ can be traced to the late 1970s/​early 1980s and the first measures of EU financial markets regulation which, in a partial and limited manner, addressed the admission of securities to trading venues and the disclosure required on offers to the public. These measures also saw the EU take the first steps towards institutional governance reform with their related ‘Contact Committees,’ composed of national technical experts/​regulators and charged with advising the Commission on legislative reform and with facilitating Member State coordination. The first serious attempt at institutional reform was driven by NCAs, in the form of the 1997 establishment of FESCO (the Forum of European Securities Commissions), an informal forum for cooperation between NCAs, designed to address the weaknesses of what had come to be regarded as a sclerotic legislative process by adopting soft common standards. FESCO’s greater significance, however, was in the template it provided for the first institutional reform in this area which would follow in 2001: the establishment of the Committee of European Securities Regulators (CESR), composed of the EU’s NCAs, under the Lamfalussy process.184 CESR’s primary concern was with regulatory governance, being charged with advising the Commission on the adoption of administrative rules (the 2001 Lamfalussy Report’s ‘hierarchy of norms’ approach, which was endorsed by the institutions, involved systematic reliance on administrative rules for technical financial market regulatory matters and the reserving of foundational principles to legislative measures,185 as noted in section 5), although CESR was also empowered to adopt soft measures, including measures to support supervisory convergence. Over its ten years or so, CESR came to deploy its soft powers to some effect, developing a raft of soft law and advising the Commission on administrative rules, but also taking EU financial markets governance into the then-​unchartered territory of supervisory convergence.186 In the immediate run-​up to the financial crisis there was some political and institutional support for a strengthening of CESR’s soft powers, but little support for radical change.187 The financial crisis was the proximate cause of the transformation of CESR into ESMA. The financial crisis exposed not only the significant weaknesses in the EU’s rulebook for financial markets; it also exposed the inability of the EU’s NCA-​based supervisory governance arrangements to deliver effective supervisory coordination and to manage crisis conditions.188 184 CESR was constituted as an independent advisory body for ‘reflection, debate and advice’: Commission Decision 2001/​527/​EC: [2001] OJ L191/​43. Parallel committees were adopted in the banking and insurance/​occupational pensions sectors, alongside sectoral political committees (the European Securities Committee for financial markets) which were charged with overseeing the adoption by the Commission of delegated rules (under the ‘comitology’ (committee oversight) process which prevailed prior to the Lisbon Treaty reforms and the adoption of Articles 290 and 291 TFEU). 185 2001 Lamfalussy Report, n 129. 186 On the CESR era and the embedding of the Lamfalussy process see the third edition of this work at 862–​80 and 951–​8; Ferrarini, G, ‘Contract Standards and the Markets in Financial Instruments Directive: An Assessment of the Lamfalussy Regulatory Architecture’ (2005) 1 Eur Rev Contract L 19; and Ferran, n 22, 61–​126. 187 As was clear from the Commission’s pre-​crisis 2007 Lamfalussy Review. The review culminated in the December 2007 ECOFIN Conclusions which confirmed political support for CESR remaining a soft law body: ECOFIN Council Conclusions, 4 December 2007 (Council Document 15698/​07). 188 As set out in the EU’s major diagnostic report on the financial crisis: DLG Report, n 119. For a legal/​institutional perspective see Ferran, n 118 and Moloney, N, ‘EU Financial Market Regulation after the Global Financial Crisis: ‘More Europe’ or More Risks?’ (2010) 47 CMLRev 1317; for a political economy perspective see Ioannou, D,

34  The Institutional Setting ESMA, a key element of the EU’s reform prescription for these weaknesses,189 represented a material strengthening of CESR, being constituted as an independent EU agency, with more extensive competences, including a suite of binding powers to impose decisions on NCAs and on market participants in identified, exceptional circumstances (ESMA Regulation Articles 17–​19). Nonetheless, the binding powers conferred on ESMA were (and remain) limited and exceptional, and ESMA’s primary means for influencing supervision was its extensive but soft supervisory convergence tool-​kit, which was more extensive than but not dissimilar to CESR’s. Similarly, while ESMA’s powers in relation to regulatory governance were more extensive than CESR’s, they represented an incremental strengthening of CESR’s role in regulatory governance. By 2009, when the ESMA Regulation negotiations were underway, the Lisbon Treaty had provided a Treaty settlement to the long-​running battle between the European Parliament and the Council on the nature of, and control over, delegated/​administrative rule-​making, allowing for the adoption by the Commission of administrative rules in accordance with Articles 290 and 291 TFEU.190 ESMA was injected into this process as adviser to the Commission in its adoption of delegated acts, but also, in a new form of Article 290/​291 rule-​making, as the proposer of BTSs to be adopted by the Commission, following the procedure set out in the ESMA Regulation. Accordingly, and notwithstanding the chaotic market conditions which attended its establishment, ESMA emerged from a long sequence of institutional designs and reforms. The facilitation by the Lisbon Treaty of administrative rule-​making, the EU’s by then well-​established and maturing agency infrastructure,191 and the availability of the CESR model as an ‘off the shelf ’ institutional vehicle, meant that institutional mechanisms and vehicles were available when the financial crisis led to political and institutional preferences moving in support of more centralized administrative governance and away from the informal CESR model. Over the 2009–​2010 ESMA Regulation negotiations, there was broad political consensus on the need for stronger supervisory coordination, reflecting Member States’ need to signal credible commitment to securing financial stability as markets roiled, albeit that the extent to which ESMA should have direct supervisory powers generated contestation in the Council.192 Since then, incrementalism, and a related steady expansion of ESMA’s influence, have continued to characterize ESMA’s development. Prior to 2019, when a series of legislative reforms significantly expanded ESMA’s powers (as outlined below), the legislative expansion of ESMA’s powers had been achieved through incremental, sector-​specific, legislative amplification of ESMA’s powers and as regards all three of ESMA’s main areas of activity: regulatory governance; supervisory convergence; and direct supervision. The first major expansion related to direct supervision and came in 2011 when ESMA was conferred with direct and exclusive supervisory powers over credit rating agencies under the CCRAR.

Leblond, B, and Niemann, A, ‘European Integration and the Crisis: Practice and Theory’ (2015) 22 JEPP 155 and Howarth and Quaglia, n 118. 189 Parallel authorities were established for the banking (EBA) and insurance/​occupational pensions (EIOPA) sectors. 190 See, eg, Mendes, J, ‘Delegated and Implementing Rule Making: Proceduralisation and Constitutional Design’ (2013) 19 ELJ 22. 191 By the time the ESAs were under construction over 2009–​2010, agency governance in the EU was burgeoning, with the Commission earlier adopting a major communication on the future for and reform of agencies: Commission, The European Agencies—​the Way Forward (COM(2008) 135). 192 See below section 6.6.

I.6  EU Financial Markets Governance: ESMA  35 These powers were followed by direct supervisory powers over trade repositories in 2012 under EMIR, and by a series of more limited, sector-​specific direct intervention powers in relation to short selling (2012 Short Selling Regulation), services/​product intervention (2014 MiFIR), and intervention in the commodity derivatives markets (2014 MiFIR). In addition, ESMA was given an array of mandates, from 2011 on, to support the Commission’s adoption of administrative rules under all the major financial-​crisis-​era legislative measures; together, these mandates led to ESMA becoming a decisive influence on the behemoth administrative rulebook. All these legislative measures also, as they were adopted, amplified ESMA’s supervisory convergence powers, typically empowering and/​or requiring ESMA, in different financial market sectors, to, inter alia, support NCA coordination, engage in peer review, review specified NCA decisions, gather and host different market disclosures, and develop and host data infrastructures of various types. This incremental legislative strengthening of ESMA reflected the cautious approach taken by the major reviews of ESMA over this period. The Commission’s initial 2013–​2014 ESA Review was careful in tone, reporting on generally good progress but not making major proposals for reform.193 The IMF’s 2013 review was similar, calling for calibrations but broadly supportive of ESMA.194 More sector-​ specific reviews, notably the 2015 review of ESMA’s supervision of rating agencies, were likewise supportive, while identifying areas of weakness.195 Incrementalism, and steadily expanding influence, were also characteristics of how ESMA deployed and developed its powers. ESMA’s first five years or so were dominated by organizational capacity building, its different mandates to support the administrative rule-​making process, and the need to establish itself as a credible supervisor of credit rating agencies and trade repositories.196 From 2016, a marked if still incremental shift in ESMA’s ambitions could be observed, notably in relation to its supervisory convergence activities which burgeoned from its 2015 adoption of its 2016–​2020 ‘Strategic Orientation’:197 ESMA asserted in the Strategic Orientation that its ‘start-​up’ phase was over and that it was entering a new phase of development, characterized by a shift away from supporting rule-​making and towards supporting convergence of NCAs’ supervisory practices, a shift that can be seen in its extensive supervisory convergence activities, charted in the following chapters. 2017–​2019 saw more punctuated legislative change, with a series of forces combining to enhance ESMA’s powers, and also its governance and legitimation arrangements, through legislative reform. The pivotal 2017 Commission review of all the ESAs was, as regards ESMA, framed by the 2016 decision of the UK to withdraw from the EU, the 2015 CMU Action Plan, some seven years of experience with ESMA, and, relatedly, increasing institutional familiarity with its powers and its intensifying influence. While the 2017 Review produced a broad consensus that the ESAs (including ESMA) were fit for purpose, but also a concern to protect NCA supervisory discretion/​autonomy from further 193 Commission, Report on the Operation of the European Supervisory Authorities and the European System of Financial Supervision (COM(2014) 509) and the related SWD(2014) 261. 194 IMF, Financial Sector Assessment Program, European Union. European Securities and Markets Authority. Technical Note. IMF Country Report No 13/​69 (2013). 195 European Court of Auditors, EU Supervision of Credit Rating Agencies—​Well Established but not yet Fully Effective (2015). 196 For early assessments see Schammo, P, ‘EU Day to Day Supervision or Intervention-​Based Supervision: Which Way Forward for the European System of Financial Supervision’ (2012) 32 OJLS 771; and Moloney, N, ‘The European Securities and Markets Authority and Institutional Design for the EU Financial Markets—​a Tale of Two Competences: Part (2) Supervision’ (2011) 12 EBOLR 177. 197 ESMA, Strategic Orientation 2016–​2020 (2015).

36  The Institutional Setting ESA-​driven centralization,198 the Commission’s proposals for reform were, nonetheless, significant and oriented to reducing NCA influence and to strengthening ESMA’s capacity to oversee NCAs.199 The proposed governance reforms would have diluted the powers of ESMA’s decision-​making BoS (composed of NCAs) by establishing a new, bureaucratic Executive Board (composed entirely of independent officials appointed by the European Parliament and Council) that would have been conferred with management powers but also, and controversially, with some of the BoS’ powers that the Commission regarded as being vulnerable to NCA conflict of interests and so to dis-​use (notably ESMA’s powers to proceed against or impose decisions on NCAs under Articles 17–​19). The proposed reforms also addressed ESMA’s funding model, proposing that, in the interests of independence and cost-​sharing, the funding model change to being based on industry contributions (rather than on EU/​Member State contributions). The proposed supervisory convergence reforms were directed to enhancing ESMA’s powers, including by means of an empowerment to adopt EU supervisory priorities for NCAs to follow. Finally, new direct supervision powers were proposed for ESMA, chief among them as regards certain EU prospectuses and all third country prospectuses; three EU fund types (the EuVECA, the EuSEF, and the ELTIF); MiFIR data reporting services providers; and certain benchmark administrators under the Benchmark Regulation. The Commission’s proposals did not, as regards the governance reforms and the scale of the proposed direct supervisory empowerments, receive political support, reflecting the persistent political sensitivities associated with empowerments of ESMA and with any dilution of Member State influence on ESMA’s operation. The 2019 ESA Reform Regulation which followed made a series of reforms to ESMA’s governance which reflected this political wariness. These reforms were tilted towards confining ESMA’s discretion and to addressing the legitimation risks associated with its soft law powers, including by means of a new procedure for ESMA’s adoption of soft ‘Q&As’, previously not proceduralized under the Regulation; the further specification of ESMA’s mandate by additional objectives, including as regards the achievement of environmental, social, and governance (ESG) objectives; the embedding of proportionality in ESMA’s operation; and the refining of ESMA’s decision-​making governance, including by the imposition of additional transparency requirements on the BoS. The Regulation also, however, strengthened ESMA’s capacity to support supervisory convergence, including by conferring on it the new tasks of adopting European supervisory priorities for NCAs and of constructing a soft ‘supervisory handbook’ for NCAs, and, additionally, by strengthening its peer review powers. Further, it conferred additional direct supervisory powers on ESMA, in particular over data reporting services providers, previously supervised by NCAs under MiFID II/​MiFIR, and over administrators of EU critical benchmarks, previously supervised by NCAs through college of supervisors arrangements under the Benchmark Regulation. In addition, the 2018 Crowdfunding Proposal had proposed that ESMA be conferred with direct supervisory powers over crowdfunding service providers, but this reform did

198 Commission, Feedback Statement on the Public Consultation on the operation of the European Supervisory Authorities (2017). 199 COM(2017) 536. The Proposal was subsequently revised by COM(2018) 644 to address the anti-​money laundering powers since conferred on EBA. The Proposal was an omnibus measures covering the three ESAs.

I.6  EU Financial Markets Governance: ESMA  37 not gain political support and was not adopted in the 2020 Crowdfunding Regulation.200 The 2018 EMIR 2.2 Proposal did, however, lead to a significant enhancement of ESMA’s powers (under the 2019 EMIR 2.2 Regulation), most materially as regards its direct supervision of certain third country CCPs, although the Regulation did not strengthen ESMA’s powers over EU CCPs to the extent envisaged in the Proposal.201 Legislative reform aside, over the pivotal 2017–​2019 period and also since, ESMA has continued to deploy its powers in a manner that suggests a purposeful concern to shape EU financial markets governance (as well as some cohesion and sense of mission on its BoS), as outlined in the following chapters. Among the more eye-​catching developments has been the speed with which ESMA used its novel binding product intervention powers under MiFIR, deploying them to impose a ban on the marketing of binary options, and restrictions on the marketing of contracts for difference, to retail investors in summer 2018, shortly after MiFIR came into force in January 2018.202 The most longstanding effects on EU financial markets governance, however, are likely to come from the supervisory convergence powers through the exercise of which ESMA shapes how NCAs supervise the single rulebook, in particular as ESMA is increasingly using more operationally oriented convergence measures. These include ‘Common Supervisory Actions’, a form of supervisory convergence measure through which NCAs carry out ESMA-​coordinated thematic supervisions of aspects of the single rulebook.203 ESMA also now has, as noted below in this section, an immense and expanding data capacity which further enhances its ability to shape supervisory convergence as well as to influence regulatory governance. All the signs are that, given the technocratic capacity and potential it affords the EU, ESMA’s powers will continue to expand, particularly as regards supervisory convergence. The 2022 CSD Proposal, for example, proposes that ESMA have oversight powers over CSD colleges of supervisors, while the 2021 European Single Access Point Proposal charges ESMA with the construction and oversight of the new ESAP, a reform which will further embed ESMA as an immense data-​node in EU financial markets governance.204 This direction of travel was also indicated in the Commission’s May 2022 review of the ESAs generally, in which it underlined the importance of ESMA’s supervisory convergence powers and indicated little appetite for significant new direct supervision empowerments.205

200 COM(2018) 113 and Regulation (EU) 2020/​1503 [2020] OJ L341/​1. 201 COM(2017) 331 and Regulation (EU) 2019/​2099 [2019] OJ L322/​1. See further Ch VI section 5.9.1 and Ch X section 9.2. 202 Discussed in Ch IX section 4.12. 203 ESMA has developed this tool under its general supervisory convergence competence (ESMA Regulation Art 29) and has used it to, eg, address MiFID II know-​your client requirements (2019) and cost and charges requirements (2022), as well as investment fund costs and fees (2022) and investment fund liquidity management (2021). ESMA’s 2023-​2028 Strategy underlines its continuing focus on supervisory convergence and on ‘bringing together supervisory capabilities and approaches to ensure effective and efficient supervision’: ESMA, Strategy 2023/​2028 (2022) 6. 204 COM(2022) 120 and COM(2021) 723. 205 See n 182. The review, which reported on broad stakeholder support for ESMA’s powers, led the Commission to conclude that no reforms were necessary, albeit that it reserved the right to propose additional empowerments if market conditions so required, and underlined its longstanding concern that the Art 17 breach of EU law tool was rarely used by the ESAs.

38  The Institutional Setting

I.6.3  Governance, Powers, and Legitimation I.6.3.1 Governance ESMA is an EU body with legal personality (Article 5), comprised of a Board of Supervisors (BoS), a Management Board, a Chair, an Executive Directive, and a Board of Appeal (Article 6).206 It forms part of the ESFS (composed, as previously outlined, of NCAs, the three ESAs, and the ESRB) and is charged with cooperating with ‘trust and full mutual respect’ with ESFS members (Article 2); it cooperates with its peer ESAs through the Joint Committee of the ESAs, which is also a constituent part of the ESFS (Articles 54–​56). Its decision-​making body is the BoS, which must act independently and objectively in the sole interests of the EU, and which is composed of the independent ESMA Chair (voting207), the heads of the twenty-​seven NCAs (voting), and a representative from each of the Commission, ESRB, and EBA and EIOPA (all non-​voting); it acts by simple majority vote, save as regards its regulatory governance (Articles 10–​16) activities which are by qualified majority vote (Articles 40–​44). Specific decision-​making procedures apply to sensitive decisions or where NCAs may face conflicts of interests: namely, exercise of the Article 17 (enforcement action against an NCA), Article 19 (mediation between NCAs), and Article 22(4) inquiry (into whether a financial activity, product, or conduct poses potential threats to financial market integrity, financial stability, or investor/​customer protection, and the adoption of related recommendations for the relevant NCAs) powers.208 ESMA is represented by its independent Chair (Articles 48–​49) and its work is managed by its independent Executive Director (Articles 51–​53), who oversee an agency of some 280 personnel.209 In practice, ESMA’s key operations are managed through its Management Board, which oversees ESMA’s work and proposes key operational decisions for adoption by the BoS, including ESMA’s annual and multi-​annual work programmes (Articles 45–​47);210 and are supported by the series of Standing Committees, each chaired by a BoS member, which steer ESMA’s work.211 Specific arrangements apply as regards CCP oversight, which is managed through the CCP Executive Committee which prepares related decisions for the BoS.212 ESMA is an independent authority (Article 1(5)). This independence is reinforced by the separate independence obligations that apply to the BoS (Article 42), the Management Board (Article 46), the Chair (Article 49), and the Executive Director (Article 52). While the presence of the Commission on the BoS might be associated with chilling effects detrimental to independence, as might the dependence of ESMA’s budget in part on an EU 206 ESMA is based in Paris: Art 6. The location of the ESAs has been politically contested, including as regards the seat of the EBA, which transferred from London to Paris following a Council vote. 207 Previously, the ESMA Chair was non-​voting, but the 2019 reforms conferred voting power on the Chair, save as regards Art 10–​Art 16 quasi-​rule-​making activities (relating to soft law and the development of administrative rules). 208 In these cases, an independent panel of neutral NCAs and the Chair proposes the relevant decisions, which are to be adopted by the BoS. These panels are to operate by consensus, failing which a ¾ majority: Arts 41 and 44. 209 ESMA, Annual Report on 2021 (2022) 85, reporting on 282 staff. 210 The Management Board is composed of the Chair and six NCAs elected by the BoS. The Commission and the Executive Directive sit as non-​voting members. 211 The SCs illustrate the breadth of ESMA’s mandate, covering: CCP Policy; CCP Supervision; Economic and Markets Analysis; Corporate Finance; Corporate Reporting; Data; Financial Innovation; Investment Management; Investor Protection and Intermediaries; Market Integrity; Post-​ trading; Secondary Markets; Supervisory Committee; and Proportionality. 212 See further Ch VI section 5.9.1.

I.6  EU Financial Markets Governance: ESMA  39 subsidy (as noted in this section below), in practice ESMA can reasonably be regarded as independently minded. For example, and as regards ESMA’s regulatory governance powers, while instances of ESMA disagreement with the Commission where the Commission revises an ESMA BTS proposal are rare, they are not unheard of.213 But while an independent actor, ESMA is also a network actor, including within the ESFS. EBA, EIOPA, and the ESRB sit on its BoS and it coordinates its activities with EBA and EIOPA through the Joint Committee of the ESAs (through which the ESAs adopt joint positions and measures, including but not only as regards advice on/​proposals for administrative rules where a joint ESA mandate is given in the relevant legislation).214

I.6.3.2 Tasks and Powers ESMA’s foundational tasks and powers are specified in and conferred by the ESMA Regulation. But its tasks and powers are also specified in and conferred by the different legislative measures of the single rulebook. Its tasks and related powers across the single rulebook range from the review powers ESMA exercises over NCAs (ie in relation to short selling decisions (Short Selling Regulation) and transparency waivers (MiFIR)); to its advisory powers relating to key Commission decisions (ie those relating to the scope of the CCP clearing obligation under EMIR; and third country equivalence decisions); to its data requisition and interrogation powers (ie in relation to sanctions across the single rulebook generally, prospectuses under the Prospectus Regulation, and transaction reporting/​transparency data under MiFIR); to its direct intervention powers (ie its product intervention powers under MiFIR); and to its direct supervision powers (ie over rating agencies under the CCRAR, trade repositories under EMIR, and third country CCPs under EMIR). The range of tasks and powers conferred on ESMA is now vast, such that only the framing architecture set out in the ESMA Regulation can be outlined here and then only as regards its main features.215 ESMA’s powers are framed by its foundational Article 8 tasks, some fourteen in all, which include its core tasks relating to contributing to the establishment of high-​quality common regulatory and supervisory standards (including developing draft RTSs and ITSs for Commission adoption); developing an EU ‘supervisory handbook’ (a supervisory convergence task relating to the support of supervisory best practices and high-​quality methodologies); contributing to the consistent application of legally binding EU acts (in particular by contributing to a common supervisory culture, organizing and conducting peer reviews, and monitoring market developments); and fostering consumer and investor protection (Article 8(1)). In support of these tasks, ESMA is conferred with a series of powers, specified in Article 8(2) and further specified across the ESMA Regulation (and across the single rulebook). Among its key Article 8(2) powers (some fourteen in all) are the powers to develop proposals for RTSs and ITSs; adopt Guidelines/​Recommendations, Q&As, and ‘no-​action’ letters (all regulatory governance powers); issue EU strategic supervisory priorities for NCAs (a supervisory convergence power); and take individual decisions as regards NCAs and market actors in accordance with its Article 17–​19 powers to take enforcement 213 See n 246. 214 The Joint Committee is constituted under each of the ESA Regulations (as regards ESMA, ESMA Regulation Arts 54–​57). The mandate for administrative rules under the PRIIPs Regulation, eg, was a joint mandate and was managed through the Joint Committee. 215 ESMA’s powers are referenced across this book as regards specific single rulebook measures.

40  The Institutional Setting action against/​mediate between/​impose emergency measures on NCAs. Article 9 specifies ESMA’s tasks relating to consumer protection, including as regards data collection and financial literacy (Article 9(1)), issuing warnings (Article 9(3)), and the power to temporarily prohibit or restrict the marketing, distribution, or sale of financial products, instruments, or activities, where so specified under the single rulebook, or where required in the case of an emergency.216 These tasks and powers are amplified across the Regulation, primarily as regards regulatory governance (Articles 9a–​16: covering the proposal of RTSs and ITSs and the adoption of Guidelines, Opinions, and Q&As (Articles 10–​16), as well as the issuing of ‘no-​action’ letters where a measure is causing difficulties (Article 9a)); direct intervention (Articles 17–​19: covering the power to take enforcement action against/​mediate between/​impose emergency measures on NCAs); supervisory coordination/​supervisory convergence (Articles 21–​32: covering, inter alia, college of supervisors; monitoring systemic risk; supporting delegation between NCAs; building a common supervisory culture and relatedly building an EU supervisory handbook; adopting EU strategic supervisory priorities; peer review; NCA coordination; and market monitoring/​stress tests); international relations, including equivalence assessments (Article 33); and information-​gathering (Article 35). In addition, ESMA, as a member of the ESFS is charged with a series of related coordination tasks, including with the ESRB (Article 36).

I.6.3.3 Legitimation The legitimation arrangements which are designed to ensure that ESMA’s actions, as a technocratic, non-​majoritarian agency, are legitimate are multi-​layered,217 but are broadly designed to ensure that ESMA, exercising delegated power from its EU principals (the European Parliament and Council), operates within its mandate.218 These arrangements are primarily based, accordingly, on its constitutive Regulation which, adopted by the European Parliament and Council as the delegating principals, specifies its objectives, tasks, and powers, and confines ESMA action to action under the Regulation and the legislative measures specified in Article 1(2) (in practice, those of the single rulebook).219 These objectives, 216 The Art 9(5) power has been activated by means of the Short Selling Regulation and also the MiFIR product intervention power (Chs VI section 3.7 and IX section 4.12). The conditions under which ESMA’s emergency powers jurisdiction is activated are set out in Art 18. 217 ESMA poses a series of challenges as regards legitimation, some of which are related to the powers and influence of EU agencies generally, but some of which flow from its specific powers and the multiple channels through which it exerts influence. See, eg, on ESMA’s legitimation arrangements, Moloney, n 152, 41–​103 and, from the extensive legal and political science literature on EU agencies’ legitimation generally, Egeberg M and Trondal, J, ‘Researching EU Agencies: what have we learned (and where do we go from here?)’ (2017) 55 JCMS 675, Mendes, J ‘Discretion, Care and Public Interests in the EU Administration: probing the limits of law’ (2016) 53 CMLRev 419, Chiti E, ‘Is EU Administrative Law Failing in some of its Crucial Tasks?’ (2016) 22 ELJ 576, and Busuioc, M, European Agencies. Law and Practice of Accountability (2013). 218 The principal/​agent relationship is typically used to examine the legitimation of technocratic agencies generally, and in the EU. See Thatcher, M and Stone Sweet, A, ‘Theory and Practice of Delegation to Non-​Majoritarian Institutions’ (2002) 25 Western European Politics 1 and Majone, n 150. The notion of legitimation is, however, complex, not least given that the Commission could also be regarded as a delegating actor (given that it is the seat of executive power in the EU), and also insights from EU constitutional theory which suggest that legitimation can extend beyond the EU’s representative institutions (the Parliament and Council) and relate to the EU as a multi-​faceted ‘demoicracy’ and so include legitimation through the Member States, their institutions, and related transnational networks, such as NCAs and their relationships. See Buess M, ‘European Union Agencies and their Management Boards: an assessment of accountability and demoi-​cratic legitimacy’ (2015) 22 JEPP 94. 219 Constitutive legislative measures relate to ‘input’ legitimacy or democratic representativeness. The other two main forms of legitimation relate to ‘throughput’/​‘procedural’ legitimacy and include decision-​making processes as well as transparency and judicial review requirements; and to ‘output legitimacy’ which is functionally

I.6  EU Financial Markets Governance: ESMA  41 tasks, and powers are further specified by the series of directions given to ESMA, including that it act independently, objectively, and in a non-​discriminatory and transparent manner in the interests of the EU as a whole and respect, where relevant, the principle of proportionality (Article 1(5)). In practice, however, the breadth of ESMA’s mandate, and the predominantly soft and generally thinly proceduralized nature of its powers, gives it significant scope for action. The 2019 reforms expanded ESMA’s mandate in a number of ways, particularly as regards supervisory convergence, but they also placed additional constraints on ESMA, reflecting some political and industry concern regarding the costs of regulation and ESMA’s burgeoning soft law activities, and thereby reinforcing how ESMA’s constitutive Regulation can be used to constrain its operation. The 2019 reforms introduced, for example, a requirement for ESMA to, as regards its measures and actions and in particular its quasi-​regulatory activities (adoption of Guidelines, Recommendations, Opinions, Q&As, and draft RTSs and ITSs), ‘fully respect’ the applicable provisions of the Regulation and relevant single rulebook measures (Article 1(5)).220 The reforms also embedded a proportionality constraint, requiring, inter alia, that ESMA’s actions and measures, to the extent permitted and relevant under its legislative mandates, and in accordance with the principle of proportionality, take due account of the nature, scale, and complexity of the risks inherent in the business of a financial market participant (Article 1(5)); and that ESMA establish a committee to advise on proportionality (Article 1(6)).221 In response, ESMA has, while emphasizing the need for a ‘strong single rulebook,’ committed to following a proportionate approach by tailoring its initiatives to what is needed to achieve its objectives, and to engaging in related dialogue with national authorities; it has also underlined that its risk-​based approach to supervision implies that its regulatory and supervisory efforts are more limited as regards smaller and less complex entities and that more effort is required for larger and more complex entities.222 Relatedly, ESMA’s regulatory governance powers (as regards the proposal of RTSs and ITSs (Articles 10-​15) and the adoption of Guidelines and Q&As (Articles 16 and 16b)) are proceduralized,223 as are ESMA’s executive powers, in particular as regards its Articles oriented and relates to technical capacity or problem-​solving ability. All these forms can be associated with ESMA’s arrangements. 220 Similarly, Art 8(3) requires that ESMA act based on and within the limits of the legislative framework. 221 Similarly, Art 8(1a) and (3) require ESMA to carry out its tasks taking into account the different types, business models, and sizes of financial market participants, and with due regard to the proportionality principle. 222 ESMA, Strategic Orientation 2020–​2022 (2020) 11–​12. On ESMA’s approach to the supervision of rating agencies, eg, see Ch VII section 14. An ESMA Standing Committee on Proportionality has also been established. Proportionality has, however, long framed ESMA’s activities, with a notable example relating to its treatment of the proportionality of the rules governing the remuneration of investment fund managers (Ch III section 4.7.2). Proportionality has become a framing theme of ESA action generally, with EBA developing a highly articulated and metrics-​based framework for the assessment of the proportionate treatment of institutions as regards prudential regulation: EBA, Discussion Paper on Proportionality Assessment Methodology (2021). On the increasing importance of the proportionality principle in financial markets governance see the discussions in ECB, Continuity and Change. How the Challenges of Today Prepare the Ground for Tomorrow. Proceedings of ECB Legal Conference (2021). 223 The framing of agency action within procedural rules has been identified as supporting legitimacy by providing structure to the multiple contacts an agency has with other actors, addressing information asymmetries, allowing the balancing of competing interests, and thereby acting as an instrument of political control: Curtin, D, Hoffman, H, and Mendes, J, ‘Constitutionalising EU Executive Rule-​Making Procedures: A Research Agenda’ (2013) 19 ELJ 1. While the process for the adoption of RTSs and ITSs and ESMA’s role was, from the outset, proceduralized under the ESMA Regulation, as was the adoption of Guidelines, the 2019 ESA Reform Regulation,

42  The Institutional Setting 17-​19 powers to impose decisions on NCAs (proceduralization is also a feature of ESMA’s supervisory powers under the single rulebook, as outlined in subsequent chapters). This proceduralization is in part a function of political sensitivities but it is also in part a function of the Meroni ruling,224 which constrains the powers of EU agencies and thereby supports their legitimation.225 Meroni only permits the delegation of executive powers the exercise of which can be subject to strict review in light of objective criteria determined by the delegating authority; the delegation of discretionary powers, implying a wide margin of discretion which may make possible the execution of actual economic policy, is prohibited. This principle has had constitutive influence on ESMA’s design: the strict conditionality imposed on ESMA’s supervisory powers, for example, is an expression of Meroni.226 The Meroni constraint is, however, not only legal. It has long been used to achieve institutional and political preferences to constrain ESMA’s operation.227 As EU agencies have developed, the Meroni principle has been subject to extensive analysis, being either supported as a means of ensuring discretionary agency action operates within the rule of law and is appropriately legitimated by democratic organs; or criticized for fettering EU agencies in effectively carrying out their tasks as expert non-​majoritarian actors and as needing to be replaced with other legitimating devices such as accountability mechanisms. Meroni has also been criticized for stunting the development of adequate governance arrangements for EU agencies. By creating the legal fiction that wide-​ranging discretion cannot be conferred on agencies, it has, it has been argued, led to the development of a ‘hidden discretion’ which risks not being appropriately legitimated.228 ESMA exemplifies the difficulties. On the one hand, Meroni acts as constitutive and legitimating legal principle: it delimits ESMA’s activities, has shaped and framed its powers, and acts as a basis for judicial review. On the other, ESMA’s burgeoning activities and its intensifying technocratic influence might be regarded as having burst the bounds of Meroni, while procedural efficiency might call for its removal. The Meroni ruling was applied to the specificities of ESMA’s functions in the 2014 UK v Council and Parliament ruling which applied Meroni to the exceptional direct intervention powers given to ESMA under the 2012 Short Selling Regulation.229 The Court did not revisit Meroni. But it took a flexible approach to its application, emphasizing that if reflecting concerns as to the legitimacy of ESMA’s burgeoning soft law ‘rulebook’, introduced new (if limited) procedures governing Q&As and further specified the procedures relating to RTSs/​ITSs and Guidelines. 224 Case 9-​56 Meroni v High Authority (ECLI:EU:C:1958:7). 225 See, from the extensive literature, Mendes, J (ed), EU Executive Discretion and the Limits of Law (2019). 226 Busuioc, M, ‘Rulemaking by the European Financial Supervisory Authorities: walking a tight rope’ (2013) 19 ELJ 111 and Chamon, M, ‘EU Agencies Between Meroni and Romano or the Devil and the Deep Blue Sea’ (2011) 48 CMLRev 1055. 227 The Commission has frequently used Meroni to restrict ESMA’s operating freedom, including to limit ESMA’s enforcement powers over rating agencies (2010 Rating Agency Proposal Impact Assessment (SEC(2010)678) 13). At Member State level, the UK frequently relied on the Meroni principle to restrict ESMA’s powers: Moloney, n 60. 228 Chiti, n 217. 229 UK v European Parliament and Council, n 57. The UK challenged ESMA’s powers under the 2012 Short Selling Regulation to require market participants to notify to the relevant NCA or to disclose to the public details of a net ‘short position’ or to prohibit or impose conditions on short sales (Art 28(1)), subject to conditions linked to threats to market integrity, functioning, and stability, and to NCA failure to act appropriately. The Meroni challenge was based on a number of grounds, including ESMA’s powers entailing a ‘very large measure of discretion’; ESMA being given a wide range of choices as to which measures to impose, measures which would, the UK argued, have had very significant policy implications given their potential impact on financial markets; the factors which ESMA was required to take into account being highly subjective; the ongoing ability of ESMA to renew any measures being without any overall time limit; and, overall, the conferral of broad discretion on ESMA to apply policy in a particular case.

I.6  EU Financial Markets Governance: ESMA  43 appropriate conditions adopted by the legislature applied to the exercise of discretion, the Meroni requirement would be met. It found as regards the Short Selling Regulation that ESMA’s powers of intervention were circumscribed by the different conditions and criteria which limited ESMA’s discretion under the Regulation, and also by the related administrative rules.230 Accordingly, while ESMA’s powers entailed the exercise of discretion, they were ‘precisely delineated and amenable to judicial review in light of the objectives established by the delegating authority’ and complied with Meroni. While the implications of the ruling for the Meroni principle are contested,231 it can be read as loosening the Meroni constraint and as widening the operating space within which ESMA’s actions can be regarded as legitimate.232 This is because the conditions which bounded ESMA’s exercise of the relevant powers under the Regulation can reasonably be regarded as general and high-​level, and as the powers in question engaged complex choices requiring a balancing of public interests in a sensitive area; it is difficult to examine the relevant powers as purely technical in nature.233 The ruling released some of the Meroni pressure on ESMA’s operating model, but Meroni remains something of a sticking plaster as regards legitimacy: the incongruity between the Meroni principle and the scale of ESMA’s technocratic influence in practice is becoming increasingly apparent.234 In addition, ESMA’s legitimation is supported by a series of interlocking mechanisms. Chief among these are its direct accountability arrangements: ESMA is accountable to the European Parliament and to the Council and subject to associated annual reporting requirements and required to attend Parliament hearings (Article 3). Relatedly, the BoS must adopt and provide the European Parliament, Council, and Commission with an annual work programme, multi-​annual work programme, and annual report (Article 43). The BoS is similarly subject to transparency requirements.235 ESMA’s funding arrangements also support accountability, with its funding based on an EU component but also a contribution from the Member States who, via the NCAs who sit on the BoS, exert indirect budgetary oversight (Article 62).236 ESMA’s budgetary process further supports its accountability, with 230 The Court also pointed to the procedural conditions on ESMA action, including the consultation obligations imposed on ESMA, the temporary nature of the ESMA decision, and the obligation on ESMA to review any measure imposed on a three-​month review cycle 231 The ruling produced an extensive literature. See, eg Bergstrom, C, ‘Shaping the New System for Delegation of Powers to EU Agencies: United Kingdom v European Parliament and Council (Short Selling)’ (2015) 52 CMLRev 219; Howell, E, ‘The European Court of Justice: Selling Us Short’ (2014) 11 ECFR 454; Marjosola, H, ‘Bridging the Constitutional Gap in EU Executive Rule-​Making’ (2014) 10 European Constitutional LR 500; and Chamon, M, ‘The Empowerment of Agencies under the Meroni Doctrine and Article 114: comment on UK v Parliament and Council (Short Selling) and the proposed Single Resolution Mechanism’ (2014) 39 ELR 380. 232 Further opening the way to a wider agency operating space, the Court also ruled that the Romano ruling (Case 98/​80 Romano v Institut National d’assurance Maladie (ECLI:EU:C:1981:104)) which prohibits the conferral of power to adopt acts having the force of law on bodies other than the EU legislature did not imply that ESMA could not be empowered to adopt measures of general application, as long as the Meroni conditions were met; and that Art 290/​291 TFEU did not establish an exclusive framework within which the power to adopt administrative measures of general application could be delegated or conferred. 233 See further Ch VI section 3 on the Short Selling Regulation and its context. 234 A similarly expansive approach to Meroni was followed by the General Court in its five related June 2022 rulings on the operation of the Single Resolution Board, in the context of the Board’s 2017 resolution of Spanish bank Banco Popular. Similarly, the 2021 FBF ruling saw the Court reinforce the importance of the ESAs’ operating within their constitutive Regulations but, at the same time, adopt an expansive interpretation of their power to adopt Guidelines: n 62. For a critical review, arguing for Meroni to be over-​ruled, see Annunziata, F, The Remains of the Day: EU Financial Agencies, Soft Law and the Relics of Meroni, EBI WP No 106/​2021, available via https://​ ssrn.com/​abstr​act=​3966​980. 235 Including, in a 2019 reform, that minutes are made available within six weeks of each meeting: Art 43a. 236 ESMA’s budget is based on a Member State/​NCA contribution, an EU subsidy, supervisory fees, voluntary contributions from Member States or observers, and fees for agreed services provided to NCAs. Most recently,

44  The Institutional Setting the Commission, European Parliament, and Council involved in the complex oversight process (Articles 62–​65).237 In addition to review by the European Court of Auditors, ESMA is also subject to judicial and quasi-​judicial review. Member States and EU institutions, as well as natural and legal persons having standing, can institute proceedings relating to ESMA decisions in accordance with Article 263 TFEU (the annulment action) and also as regards the Article 265 TFEU failure to act action (Article 61), in each case in accordance with Court of Justice jurisprudence regarding standing. A quasi-​judicial review mechanism operates alongside through the Board of the Appeal of the ESAs. The Board of Appeal is an independent administrative review panel, constituted under the ESA Regulations.238 Any natural or legal person, including an NCA, may appeal against an ESMA decision under Articles 17-​19 and any other decision taken by ESMA which is addressed to that person, or against a decision which, although in the form of a decision addressed to another person, is of direct and individual concern to that person. In practice, as regards ESMA, most Board of Appeal cases have related to ESMA’s direct supervision of rating agencies (as outlined in Chapter VII), but its jurisdiction is likely to expand along with ESMA’s direct supervision powers.239 ESMA’s Securities and Markets Stakeholder Group (SMSG) also supports ESMA’s legitimation by providing for some degree of representativeness (Article 37). Composed of representatives of major stakeholder constituencies,240 it must be consulted by the BoS regarding ESMA’s quasi-​regulatory (Articles 10–​16) activities, and it may provide advice on any of ESMA’s tasks, but in particular those related to its quasi-​regulatory activities and to supervisory convergence. Relatedly, references to consultation abound across the Regulation and further support ESMA’s legitimation.241 ESMA’s legitimation arrangements have a dynamic quality. The 2019 reforms to its governance strengthened these arrangements by, inter alia, imposing a degree of proceduralization on soft Q&As (Article 16b) and providing a right for any natural or legal person to send ‘reasoned advice’ to the Commission if they are of the opinion that ESMA has exceeded its competences, including as regards failure to respect the proportionality principle, when adopting Guidelines or Q&As (Article 60a). More informally, ESMA has shown some care to secure its legitimation, including through extensive publication of its work plans and regular engagement with the European Parliament.242

the NCA contribution (40.8 per cent) and EU subsidy (26.2 per cent) constituted the bulk of ESMA’s budget, with rating agency supervisory fees following at 17.5 per cent: 2021 ESMA Annual Report 65. 237 The Parliament’s related Discharge Resolutions include extensive resolutions relating to ESMA’s operation and can raise concerns as to aspects of ESMA’s operation. Its 2021 Discharge Resolution, eg, called on ESMA to pay attention to compliance with EU law and the proportionality principle and for a strict focus by ESMA on its mandate to ensure resource efficiencies: Discharge Resolution on 2018 Budget, 29 April 2021 (T9-​0200/​2021). 238 As regards the ESMA Regulation, under Arts 58–​60 and 61. It operates under its Rules of Procedure (BoA 2020 01). For a review see Ramos-​Muňoz, D and Lamandini, M, ‘Law and Practice of Financial Appeal Bodies: a view from the inside’ (2020) 57 CMLRev 119 and, from the early days of the BoA’s operation, Blair, W, ‘The Board of Appeal of the European Supervisory Authorities’ (2013) 24 EBLRev 165. 239 As at July 2022, the BoA had issued nineteen decisions, ten in relation to ESMA. 240 Thirteen members represent financial market participants; thirteen represent employees’ representatives of financial market participants, consumers, users of financial services, and SMEs; and four are academics. 241 Consultations must be carried out in preparing draft RTSs and ITSs and, where appropriate, Guidelines (unless they would be disproportionate given the nature of the measure or its urgency). 242 See further Moloney, n 152, Ch 2.

I.6  EU Financial Markets Governance: ESMA  45

I.6.4  Regulatory Governance There are three aspects to ESMA’s regulatory governance role. First, ESMA shapes EU legislative and policy change by advising the Commission and the co-​legislators, although it is not a legislative actor and is not formally engaged with the legislative process. It has, however, become increasingly embedded in the legislative review process in that the Commission is typically required to consult ESMA when reviewing legislation in accordance with the review clauses that are now a feature of EU financial markets legislation.243 Second, it is heavily engaged with administrative rule-​making, although it is not formally a rule-​maker. Under the ESMA Regulation, ESMA is charged with proposing BTSs for Commission adoption. The BTS process is proceduralized under the ESMA Regulation (Articles 10–​15) which sets out the operating and oversight procedures which apply to RTSs (Articles 10–​14) and ITSs (Article 15). These procedures reflect the status of BTSs as derivations of the EU’s two forms of administrative rule. RTSs, which form the bulk of the administrative rulebook for financial markets, are a derivation of delegated acts (which are adopted by the Commission under Article 290 TFEU, as noted in section 5).244 The highly articulated, multi-​stage Article 10–​14 procedure for RTSs has a number of elements,245 but is based on ESMA proposing the RTS, following a consultation/​impact assessment process and reflecting the Commission’s typically detailed mandate; and the Commission either rejecting, revising, or adopting the proposed RTS. Where an ESMA proposal for an RTS is revised or rejected, the Commission is required to consult further with ESMA who is empowered to issue an amending opinion, although the Commission ultimately can adopt the RTS where ESMA disagrees. The European Parliament and the Council must be notified across the process (including where the Commission does not adopt or revises an ESMA proposal) and can exercise a veto once an RTS is adopted by the Commission. In practice, and with a decade and more of institutional experience, and despite the potential for ESMA (the location of technical expertise) and Commission (the constitutional location of rule-​ making power) contestation, this process works well and with only limited institutional friction, as outlined across this book.246 243 Its extensive reports on the MiFID II/​MiFIR Review, eg, illustrate the importance of this function. See further Ch V. 244 An Art 290 delegated act is an act of general application which supplements or amends certain non-​essential elements of the legislative act. RTSs are technical, must not imply strategic decisions or policy choices, and their content is to be delimited by the legislation on which they based (Art 10). On the relationship between delegated acts/​RTSs and legislation, including as regards the qualities of delegated acts/​RTSs that distinguish them from legislation and that distinguish delegated acts from RTSs see, eg, Busuioc, n 226. In practice, in EU financial markets regulation it can be difficult to distinguish between detailed legislative provisions and delegated acts/​RTSs, and between delegated acts and RTSs, although there has been very little contestation in this regard, save that the Commission occasionally expresses concern where the co-​legislators use RTSs rather than delegated acts (given that it has more control over the delegated act process), as it did in relation to the adoption of MiFID II/​MiFIR. 245 It was slightly nuanced by the 2019 reforms, primarily as regards notification of the European Parliament and Council. 246 Instances of the Commission rejecting or revising an ESMA RTS proposal are rare, but they are not unheard of (see, eg, ESMA, Opinion (Insider Lists), 29 April 2022, disagreeing with Commission revisions to its RTS proposal on the market abuse insider lists regime, in part as the revisions would have, in ESMA’s view, reduced the utility of the lists for NCAs as regards market abuse investigations). The process has been facilitated by the adoption of an ‘early legal review’ process under which the Commission reviews the relevant proposal for compliance with its legislative mandate and to avoid technical legal difficulties once the proposal is submitted to the Commission. It is even rarer for the European Parliament or Council to veto an RTS. It has happened only once, in the case of the Parliament’s 2016 veto of the PRIIPs Regulation RTS (Ch IX section 5.2).

46  The Institutional Setting ITSs, typically used for formats and templates,247 are a derivation of implementing acts, which are adopted under Article 291 TFEU. The ITS process (Article 15) is less articulated but is similar, as regards the Commission/​ESMA relationship, to the RTS process; the Parliament and Council do not, and reflecting Article 291, have veto powers. ESMA is also closely engaged with the adoption by the Commission of Article 290 delegated acts and Article 291 implementing acts by providing the Commission with related ‘technical advice’,248 but it does not propose these measures and its institutional position is not protected, as it is with RTSs and ITSs. In addition, ESMA is empowered to adopt soft law on its own initiative under the ESMA Regulation and can also be mandated by the co-​legislators to adopt specific soft measures under other legislative measures. Article 16 addresses the adoption of the Guidelines249 that form the core of ESMA’s ‘soft rulebook’.250 ESMA has a wide scope of action here,251 and the process is only lightly proceduralized, including by Article 16 requiring proportionate consultations and impact assessment, where appropriate, that Guidelines not merely refer to or reproduce elements of legislative acts, and that existing Guidelines be reviewed before a new one is adopted, to avoid duplication. Guidelines operate under a ‘comply or explain’ mechanism which hardens their non-​binding status:252 they can be addressed to NCAs or to financial market participants (most usually they are addressed to NCAs although in practice they accordingly impose obligations on market participants253) who must ‘make every effort to comply’; and NCAs are subject to a ‘comply or explain’ obligation in that they must confirm their compliance or non-​compliance and this status is recorded in ESMA’s Guidelines Compliance Tables. In practice, NCA non-​compliance is exceptional. As outlined in subsequent chapters, Guidelines, typically detailed and often similar to administrative rules in their design, have become akin to a soft law ‘rulebook’ for NCAs and, relatedly, for the financial markets. There are, in practice, few formal constraints on ESMA’s powers to adopt Guidelines, not least given the scale of the single rulebook legislative measures that set its scope of action and the wide objectives and tasks that frame its competences under the ESMA Regulation, and also the facilitative approach adopted by the Court of Justice in the 2021 FBF ruling as regards EBA’s parallel powers.254 Nonetheless, the 2019 ESA Reform 247 ITSs are technical, must not imply strategic decisions or policy choices and their content is to determine the conditions of application of the relevant legislation: Art 15. 248 ESMA’s technical advice is similarly usually accepted by the Commission, in large part. 249 Article 16 refers to Guidelines or Recommendations, but in practice ESMA adopts Guidelines. 250 Circa 100 sets of Guidelines, relating to different aspects of the single rulebook, have been adopted, often in forms that are akin, in their level of specification, to administrative rules. 251 Guidelines are to be adopted ‘with a view to establishing consistent, effective, and efficient supervisory practices within the ESFS, and to ensuring the common, uniform, and consistent application of Union law’ and must be in accordance with the empowerments for ESMA under the Art 1(2) legislative measures specified. 252 The Court of Justice in the FBF ruling described the issuance of Guidelines as ‘intended to exert a power of exhortation and persuasion’ on NCAs and financial institutions and noted that Guidelines could lead to the adoption of related national law and be taken into account in judicial proceedings: n 62, Ruling of the Court, paras 69–​70. 253 Guidelines are directly addressed to rating agencies, eg, as ESMA is the direct supervisor of rating agencies. 254 In the FBF ruling (n 62) the Court of Justice took an expansive approach to the Art 16 power under the EBA Regulation, reinforcing thereby the reach of ESMA’s powers. At issue was whether EBA’s Guidelines on product governance (contained within EBA, Guidelines on Internal Governance (2011); these have since been overtaken by a 2015 version) were validly adopted, given that the banking rulebook did not contain an express provision on product governance (by contrast with MiFID II under which ESMA has adopted product governance Guidelines (see Ch IX section 4.11)). The Court ruled that the Guidelines, as soft law, could not be challenged under the Art 263 annulment action, but that it could issue a ruling on their validity under the Art 267 preliminary ruling procedure. Reflecting the Meroni ruling, the Court found that the EU legislature had ‘precisely delineated’ EBA’s power to issue Guidelines, on the basis of objective criteria, and that the exercise of this power must be amenable

I.6  EU Financial Markets Governance: ESMA  47 Regulation revisions to the Guidelines process indicate some persistent institutional and political wariness as to the Guidelines power,255 while their adoption depends on NCA support.256 In addition, ESMA, using its general supervisory convergence powers under Article 29, adopts a host of other soft law measures, often in the form of Public Statements and Opinions (these are not proceduralized by the ESMA Regulation). Chief among these measures, however, are the lengthy and often highly technical ‘Q&As’ which, responding to stakeholder questions (usually from regulated actors), are designed to set out ESMA’s expectations as to how the single rulebook is to be applied. The 2019 ESA Reform Regulation saw Q&As formally brought within the ESMA Regulation and thinly proceduralized,257 reflecting some political, NCA, and industry concern, clear over the 2017 ESA Review, as to the legitimacy of Q&As which had been burgeoning and which had (and have) the colour of binding rules given that they are closely followed by regulated actors. One of the most significant changes concerns the Commission now providing ‘answers’ where the issue is determined to rest on an interpretation of EU law. The injection of the Commission into the Q&A format comes with some loss to agility, but it buttresses what is a responsive and market-​facing tool against the charges of invalidity to which ESMA soft law is vulnerable, particularly where proceduralization is light.

to ‘stringent judicial review’ in light of those criteria (that Guidelines do not product binding effect did not affect the scope of such review). The Court relatedly found that ‘to accept that EBA may freely issue guidelines irrespective of the specific framework established by the EU legislature’ would be liable to undermine the allocation of powers between the institutions, bodies, offices, and agencies of the EU; and that EBA only had competence to issue Guidelines to the extent expressly provided by the EU legislature. The Court accordingly found that exercise of the Guidelines power was subject to EBA’s compliance with the EBA Regulation (including with EBA’s Art 1(5) objectives and its Art 8 tasks and powers), and the specific requirements imposed by Art 16, notably the need for Guidelines to fall within EBA’s scope of action. In this regard, the Court found that, as the Guidelines dealt with the establishment of product oversight and governance arrangements ‘as an integral part of the general organizational requirements linked to the internal control systems of firms’, they fell within the specified legislation framing EBA’s scope of action. In particular, they fell within CRD IV (the pillar banking measure), given that CRD IV requires firms to have ‘robust governance arrangements’, including as regards internal controls and risk management (Art 74(1)). That product governance was not expressly mentioned in Art 74(1), or the Guidelines’ consumer protection orientation (CRD IV is a prudential measure), did not call into question their validity under CRD IV, given that the Guidelines supported banks’ internal processes and risk management, and also given that Art 74(1) did not imply that ‘robust governance arrangements’ were to be narrowly construed by reference only to the technical criteria specified in Art 74(1). The Court therefore concluded that the Guidelines fell within EBA’s scope of action. It also found that the Guidelines fell within EBA’s governing legislative framework under the EBA Regulation generally, as contributing to the achievement of EBA’s Article 1(5) objectives (as regards depositor/​investor protection and as regards ensuring the taking of risks is appropriately regulated and supervised); and as contributing to the establishment of consistent, efficient, and effective supervisory practices within the ESFS, in accordance with Arts 8 and 16.   While the Court accordingly reinforced the limits placed by their constitutive Regulations on the ESAs, the ruling can be regarded as facilitative and expansive, as the Court did not require a specific legislative basis for the contested Guidelines, finding them to be valid under high-​level and generally worded organizational requirements applicable under the banking rulebook. 255 The 2019 reforms saw the requirements that Guidelines not simply reproduce legislative acts and that existing Guidelines be reviewed prior to the adoption of new Guidelines to avoid duplication added: Art 16(2a). Across the 2017 ESA Review, stakeholders noted the value of Guidelines but raised some concerns as to their scale and proliferation. 256 For extended discussion of the nature of ESMA Guidelines, their quasi-​binding quality, and the legitimation challenges see Moloney, n 152, 145–​62. 257 ESMA Regulation Art 16b ties the adoption of Q&As to the legislative measures within ESMA’s mandate, underlines that they are non-​binding, requires ESMA to forward questions that require interpretation of EU law to the Commission, and provides a mechanism whereby BoS members can, inter alia, request that a Q&A take the form of a Guideline, be reviewed, or subject to a cost benefit analysis.

48  The Institutional Setting Finally, the ESMA Regulation grapples, if to a limited extent, with the constitutional complexities associated with suspending or amending rules. As the single rulebook has become increasingly dense and intricate, and as its transformative effects on market structure have intensified, the need for some form of suspensive or adjustment power has become more pressing. This is particularly the case with RTSs as they operationalize legislative obligations, often through highly specified and quantitative requirements derived from market data which can change; the identification, by means of RTSs, of the derivatives subject to the CCP clearing obligation under EMIR is the totemic example, but there are many others. These RTSs can require nimble adjustment or suspension when market conditions change, but such action is not accommodated within the RTS process. A suspensive mechanism, which lies with the Commission (advised, in this regard, by ESMA), has been adopted relating to the RTSs that impose the CCP clearing obligation, but the difficulty remains more generally.258 Following a 2019 reform, ESMA is now empowered, under ESMA Regulation Article 9a, to issue a ‘no action’ letter to the Commission and to NCAs in exceptional circumstances when it considers that the application of a legislative or administrative act is liable to ‘raise significant issues’, as either that act conflicts with another act, the absence of administrative acts raises legitimate doubts as to the legal consequences of the act in question (where it is a legislative act), or the absence of Guidelines or Recommendations would raise practical difficulties concerning the application of the act in question. Article 9a does not empower ESMA to suspend the relevant measure, reflecting ESMA’s lack of competence to adopt binding rules, but ESMA is to advise the Commission on the appropriate action and to adopt Guidelines/​Recommendations as necessary. ESMA may, however, issue related Opinions with a view to furthering ‘consistent, efficient, and effective’ supervisory and enforcement practices, and the common, uniform and consistent application of EU law. The Article 9a competence supports accordingly informal ‘supervisory forbearance’ action by ESMA as regards the contested measure.259 Outside the Article 9a ‘no action’ context, ESMA, in order to address difficulties that have arisen in practice with rules, has also issued a series of ‘supervisory forbearance’ Public Statements, in what constitutes an expansive use of its soft supervisory convergence powers. The most striking example relates to the deepening of the Covid-​19 pandemic in early 2020 when ESMA issued a series of Public Statements, each calling for NCAs ‘not to prioritize supervisory action’ and, relatedly, to apply their risk-​based supervisory powers in a proportionate manner, as regards specified legislative and administrative requirements. These Statements were all adopted under Article 31(2)(c) of the ESMA Regulation, a supervisory-​convergence-​related power which empowers ESMA to take appropriate measures in the event of developments which may jeopardize the functioning of financial markets, with a view to coordinating actions

258 See Ch VI section 5.6 on the EMIR suspension process. 259 In ESMA’s first application of the Art 9a power, it advised the Commission of its concerns regarding the serious difficulties certain aspects of the sustainability-​related disclosures required under the EU’s Benchmark Regulation generated for NCA supervision and enforcement in the absence of the required administrative rules. It called for remedial delegated acts to be adopted and recommended supervisory forbearance by NCAs with regard to the application of the disclosure regime in the interim: ESMA, Opinion (to Commission), 29 April 2020 and ESMA, No Action Letter (to NCAs), 29 April 2020. In the letter ESMA advised that NCAs ‘not prioritize’ any supervisory or enforcement action in relation to the requirements in question. See Ch VIII section 10.3.5 on the context. The 2022 ESA Review reported on widespread dissatisfaction with the no-​action power, given its non-​ binding quality and the related lack of certainty. The Commission committed to assessing the power but warned that the no-​action process had to operate within the constraints imposed by EU law: n 182, 6.

I.6  EU Financial Markets Governance: ESMA  49 undertaken by NCAs.260 While such Article 31(2)(c) measures are still rare, ESMA has also adopted other supervisory forbearance measures which do not specify the relevant ESMA Regulation competence, albeit that Article 29, the general supervisory convergence competence, could be associated with such action.261 ESMA’s usual supervisory forbearance formula, a statement that it expects NCAs ‘not to prioritize supervisory action’ and to deploy their risk-​based supervisory powers in a proportionate manner, is somewhat elliptical, but the effect is clear in terms of the de facto suspension of the relevant obligation.262 Such informal supervisory forbearance action is functionally appealing, but it nonetheless raises legitimation risks and underlines how the administrative rule-​making process, and particularly RTS adoption, can struggle to respond to market conditions.

I.6.5  Supervisory Convergence, Risk Monitoring, and Direct Intervention I.6.5.1 Supervisory Convergence ESMA’s extensive supervisory convergence powers, which are of a soft law character, relate to the support of the consistent application of the single rulebook, the facilitation of cross-​border supervisory coordination, and the development and diffusion of best supervisory practice.263 In practice, and as discussed across this book, these powers have become the vehicle for an ongoing and increasingly dense ‘Europeanization’ of NCAs’ supervisory practices;264 ESMA has characterized its related and multi-​dimensional role as facilitator, coordinator, coach, and policeman.265 ESMA has a series of related soft powers (Articles 21–​32) including to engage in peer review, support cross-​border supervisory inspections, oversee colleges of supervisors, and adopt soft law. Among the pivotal measures is Article 29, which empowers ESMA to ‘play an active role in building a common supervisory culture and consistent supervisory practices’ and which has supported ESMA’s adoption of a vast array of soft measures directed to shaping NCAs’ supervisory practices. ESMA also has related coordination powers, including as regards information exchange (Article 31). 260 A series of such statements were adopted over March to April 2020 relating primarily to the informal extension of deadlines for reporting requirements and to the informal delay of certain specified measures applying. See further Moloney and Conac, n 35. 261 ESMA’s ‘supervisory forbearance’ statements are relatively rare but they nonetheless form a key part of its arsenal for supporting supervisory convergence and have been used in particular as regards the application of EMIR (see Ch VI section 5), with one of the first such statements adopted jointly with EBA and EIOPA in 2017 and relating to EMIR margin requirements. ESMA eg adopted a supervisory forbearance statement to address the time-​lag between the adoption of a Commission Delegated Regulation, which extended to 2023 the transitional exemption for pension schemes from the EMIR CCP clearing obligation, and the end of the original transition period: ESMA, Public Statement (Clearing Obligation for Pensions Scheme), 16 June 2022. These interventions, typically in the form of Public Statements, do not ordinarily specify a particular ESMA Regulation competence. 262 Albeit that ESMA’s sensitivity to the legitimation risks is also clear as the Public Statement will often reference that neither ESMA nor NCAs have the formal power to disapply a directly applicable measure (eg, the June 2022 Public Statement on EMIR (n 261). 263 And so relate to its Art 8 tasks as regards, inter alia, contributing to the consistent application of legally binding Union acts (Art 8(1)(b)). For extended treatment by this author see Moloney, n 152, 169–​240. 264 The intensifying ‘Europeanization’ of domestic regulatory decision-​making associated with the establishment of EU agencies is charted in the agency literature: eg Ruffing, E, ‘Agencies between Two Worlds: Information Asymmetry in Multilevel Policy-​making’ (2015) 22 JEPP 1109 and Bach, T, Ruffing, E, and Yesilkagit, K, ‘The Differential Empowering Effects of Europeanization on the Autonomy of National Agencies’ (2015) 28 Governance 285. 265 2016–​2020 Strategic Orientation, n 197, 1.

50  The Institutional Setting While these powers are all of a soft nature, they sit on a spectrum, with ESMA’s peer review powers in particular having a more hard-​edged quality (as do ESMA’s powers to review identified NCA actions; these powers are specified in certain single rulebook measures266). ESMA’s peer review powers (Article 30), which were further hardened by the 2019 ESA Reform Regulation to strengthen ESMA’s role,267 are deployed in accordance with its Peer Review Methodology.268 Two peer reviews are typically carried out a year and, as noted in subsequent chapters, they are becoming increasingly more granular and robust in tone as regards any NCA weaknesses identified and the remediations recommended. The peer review process may also have some wider potential in addressing supervisory weaknesses: it was used by the EU as a ‘first response’ to the 2020 Wirecard scandal, with ESMA charged by the Commission with reviewing the actions of the German authorities. While a ‘soft’ exercise, it at least led to an early airing of the reforms needed.269 In practice, ESMA’s exercise of its supervisory convergence powers was already impliedly constructing a ‘supervisory handbook’ for NCAs, but the 2019 reforms formalized this organic development, tasking ESMA with constructing a single supervisory handbook (Article 29(2)). The 2019 reforms also, and further strengthening ESMA’s capacity as regards supervisory convergence, require it to set two ‘EU strategic supervisory priorities’, to be taken into account by NCAs (Article 29a).270 ESMA’s tool-​kit of supervisory convergence powers is, as discussed in subsequent chapters, extensive, but it is also malleable and thinly proceduralized, allowing ESMA significant headroom to shape NCA supervision. The related ongoing and incremental ‘Europeanization’ of NCA supervision, while of a less dramatic order than the conferral on ESMA of direct supervisory powers, has the potential to lead to a material de facto centralization of EU financial market supervision over time. There is, in effect, a ‘sedimentary’ quality to ESMA’s extending influence as it sinks deeper into NCAs’ national supervisory practices.271 As ESMA drills deeper into and shapes NCA operational practices, however, it could lead to an overly rigid ‘Europeanization’ of NCA decision-​making that is at odds with the heterogeneity that still characterizes local financial markets in the EU.272 It could also generate legitimation risks. ESMA’s supervisory convergence powers sit on the unstable fault-​line running between current national supervisory competences and potential EU-​level supervisory centralization. As ESMA incrementally intensifies its influence over national supervision through its supervisory convergence activities, it risks destabilizing this fault-​line by placing itself in a vertical relationship with NCAs as a hierarchically superior overseer 266 eg, ESMA’s powers to review NCA transparency waivers (Ch V), short selling action (Ch VI), and product intervention action (Ch IX). 267 Including by requiring that ESMA chair the ad hoc peer review committees through which peer reviews are carried out and that follow-​up reports are carried out. 268 ESMA, Peer Review Methodology (2020). 269 See Ch II sections 5 and 6. 270 ESMA’s first Union Strategic Supervisory Priorities (USSPs) were issued in 2020 and related to costs and performance (a retail market USSP) and data quality (a market USSP) and supported a series of related supervisory convergence measures. 2021 ESMA Annual Report, 58. 271 Ford has identified the phenomenon of ‘sedimentary innovation,’ which concerns layers of apparently unremarkable and ‘unflashy’ innovation (including regulatory innovation) which collectively can be highly consequential and lead to a markedly different regulatory landscape: n 156, 194. 272 Sliding from ‘learning’ into ‘surveillance’ has been identified as a risk to optimal coordination in international financial governance: Riles, A, ‘Is New Governance the Ideal Architecture for Global Financial Regulation?’ (2013) 31 Monetary and Economic Studies 65.

I.6  EU Financial Markets Governance: ESMA  51 of national supervision, and by ratcheting down national supervisory autonomy. ESMA’s supervisory convergence powers accordingly bring it closer to politically contested territory than its regulatory governance powers do.

I.6.5.2 Risk Monitoring and Data Collection Intertwined with its supervisory convergence powers and supportive of them, ESMA has extensive tasks and competences under the ESMA Regulation relating to risk monitoring and assessment. These sit within the wider data and reporting system established by the single rulebook. The single rulebook can, in some respects, be regarded as a form of ‘regulation-​by-​data-​requisition’ given the scale on which it requires regulated actors to provide public disclosures and supervisory reports,273 and given the new reporting infrastructures it has put in place, chief among them the trade repositories that host the vast data flows on the EU’s derivatives, securitization, and securities financing transactions markets (under EMIR, the Securities Financing Transactions Regulation, and the Securitization Regulation, respectively). All the indications suggest that data-​reporting obligations and so the EU’s data capacity are likely to be expanded and strengthened, in particular given ESMA’s appetite for fine-​tuning the relating administrative rules.274 In addition, the Commission has committed to overhauling its approach to data management and to developing an integrated data reporting system (as set out in its 2020 European Data Strategy275), as is reflected in sectoral reforms,276 and in data infrastructure reforms, chief among these the 2021 European Single Access Point Proposal.277 Relatedly, the ever-​expanding, sector-​specific competences conferred on ESMA across the single rulebook as regards data collection and the development of data infrastructures, and its own-​initiative risk monitoring and data assessment activities, have seen it develop as a critical data-​node for EU financial markets governance. These competences and activities (noted in subsequent chapters) range from its collection and interrogation of a swathe of sectoral reports from NCAs (which build on the supervisory reporting required of, and the public disclosures made by, regulated actors); to its publication of a widening range of risk monitoring and statistical reports;278 to its construction and hosting of key MiFID II/​MiFIR databases on transaction reporting and trade transparency (Chapter V); to its hosting of registers (including the ESMA Prospectus Register which holds approved prospectuses (Chapter II)); to its supervision of the EU’s trade repositories (Chapter VI) and data reporting services providers (Chapter V); and on to its likely future competences, including its proposed hosting of the proposed European Single Access Point (Chapter II). 273 eg, the trade transparency and transaction reports required under MiFID II/​MiFIR and the derivatives markets reports required under EMIR: Chs V sections 11 and 13.2 and VI section 5. 274 ESMA’s 2021 MiFID II/​MiFIR review of transaction reporting, eg, proposed a series of potential reforms, primarily to be pursued through RTS reform, in order to streamline reporting, but it also underscored ESMA’s commitment to exploring how digital technologies could be used to facilitate reporting. 275 COM(2020) 66. The strategy, which is oriented towards greater data standardization, interoperability, and the construction of ‘common European data spaces’, contains a specific commitment to a Common European Financial Data Space. 276 Including the proposal to explore an overhauling of UCITS reporting, so that it forms an integrated reporting system, in the 2021 UCITS/​AIFMD Proposal (COM(2021) 721). 277 See Ch II section 7.3. 278 These include its annual statistical reports on derivatives markets, securities markets, and the alternative investment fund market (based on the swathe of data now available, through the single rulebook, on these markets), and its twice-​annual Trends, Risks and Vulnerabilities (TRV) Reports which also include ‘deep dives’ into different market segments.

52  The Institutional Setting In consequence, ESMA now has a significant capacity to gather, interrogate, enhance the quality of,279 and use data to inform supervision and drive supervisory convergence, but also to shape regulatory reform. ESMA’s data-​related (and risk monitoring) capacity can be expected to strengthen, particularly as it has embedded data collection and risk assessment as a priority activity. Its 2022 Annual Work Programme, for example, saw ESMA commit to further intensifying its use and analysis of its proprietary financial market data but also to ‘increase its interactions with NCAs to act as a data hub and to exploit economies of scale in data . . . while respecting the respective institutional roles’.280 These ESMA activities are not cost free, including for NCAs and as regards their reporting to ESMA, particularly where NCAs are at different stages of development as regards their data capacity. But they have the promise of supporting more effective data-​based supervision and of facilitating supervisory efficiencies through technologically supported tools (‘Suptech’), a direction of travel supported by the Commission’s Digital Finance Strategy (section 7).

I.6.5.3 Direct Intervention and Supervision Finally, ESMA has been conferred with a suite of direct intervention/​supervision powers. First, ESMA has powers under ESMA Regulation Articles 17–​19 to direct NCAs and market participants to take specified action when the exceptional circumstances set out in these provisions arise and in relation to breach of EU law by NCAs (Article 17), in emergency conditions (Article 18), and in relation to ESMA mediation between NCAs (Article 19). These provisions were highly contested over the original ESMA Regulation negotiations, given the related consequent incursions into NCA autonomy and also given the potential fiscal risks to Member States from such ESMA decisions. The difficulties are evident from the extensive conditionality to which these powers are subject; ESMA’s related internal proceduralization;281 the ‘fiscal safeguard’ (Article 38) that allows Member States to suspend an Article 18 or 19 decision where it impinges on fiscal responsibilities; and the specific decision-​making procedures that apply.282 In practice, however, these provisions have not, more than a decade on, been used to any material extent by ESMA, reflecting a series of factors, including stable market conditions, some likely BoS caution in exercising these powers against a peer NCA, but also intensifying supervisory convergence.283 ESMA’s supervisory convergence tools, including ‘harder’ convergence tools like peer review, have in practice carried the weight as regards ensuring NCA consistency in applying the single rulebook. Second, ESMA has been conferred with sector-​specific intervention powers in 279 ESMA’s supervisory agenda includes the enhancement of trade repository data on which it reports annually: eg, EMIR and SFTR Data Quality Report 2021 (2022). 280 ESMA, Annual Work Programme (2022) 6. 281 The breach of EU law power is subject to a distinct ESMA procedure (Decision of the BoS, Rules of Procedure on Breach of EU Law Investigations (2022)) as is the mediation power (Decision of the BoS, Rules of Procedure on Mediation (2022)). 282 While specific procedures always applied, the 2019 reforms refined these procedures to ensure that BoS decisions in these contexts were proposed by independent NCAs: Art 44. 283 The binding mediation tool appears to be used, if to a limited extent (n 182). Art 17 does not appear to have been deployed, or at least to the point of a formal finding being made against an NCA. As an Art 17 action can be triggered by a complaint from a legal or natural person, ESMA facilitates the making of such complaints, but retains the discretion whether or not to act (a discretion which has been underlined by the Board of Appeal in dismissing related appeals: eg A v ESMA, 12 March 2021 (Decision D 2021 02). In 2021, however, ESMA noted that an NCA had voluntarily changed its practices, following a complaint, relating to the disclosure of information, and thereby had removed the need for a formal Art 17 process: ESMA Annual Report (2021) 43.

I.6  EU Financial Markets Governance: ESMA  53 relation to short selling, product/​service intervention, and commodity derivatives markets. Finally, ESMA has exclusive direct supervisory jurisdiction over a cohort of regulated actors: rating agencies; trade repositories; data reporting services providers; administrators of EU critical benchmarks; and specified third country actors, in particular CCPs. These direct intervention and supervisory powers are discussed in subsequent chapters.

I.6.6  Centralized Supervision, ESMA, and the EU Financial Market While prediction is perilous, ESMA is likely to continue to develop in an incremental manner, albeit that the discussion as to whether it will be transformed into/​replaced by some form of central EU supervisor is perennial. Supervisory centralization was debated long before the FSAP-​era reforms which laid the groundwork for the single rulebook;284 formed part of the FSAP-​era debate;285 was raised in the context of the Lamfalussy reforms;286 was raised over the financial-​crisis era as a solution to the supervisory risks the crisis exposed; and has come and gone periodically since the financial crisis, often in connection with the Banking Union reforms which have normalized the notion of centralized supervision, and also in relation to Brexit.287 The CMU agenda gave fresh impetus to the debate,288 albeit that supervisory convergence remains the frame within which CMU is being pursued: the 2020 CMU Action Plan underlined that ‘truly integrated and convergent supervision’ was an essential condition for CMU, but focused on the related importance of an enhanced single rulebook and on monitoring progress towards supervisory convergence. It did not frame CMU in terms of centralized supervision, albeit that it committed to considering whether further measures as regards direct supervision were needed.289 While a series of preferences, including those of the Commission and European Parliament, shape how the organization of financial market supervision in the EU develops, the high degree of related political contestation,290 reflected in the Member States’ parsimonious approach in Council negotiations to ESMA empowerments, cautions against predictions of major reforms, at least over the short to medium term. The movement of supervision from NCAs to the EU-​level/​ESMA represents a significant incursion into Member States’ autonomy which exposes Member State markets (and the domestic political process) to the risks of supervisory error and failure. Centralization can also impose fiscal costs on Member

284 See Wymeersch, E, ‘From Harmonisation to Centralisation to Integration in European Securities Markets’ (1981) 3 J of Comp Corp L and Securities Regulation 1. 285 eg, Karmel, R, ‘The Case for a European Securities Commission’ (1999) 38 Co J Transnat’l L 9. 286 eg, Pan, E, ‘Harmonization of US-​EU Securities Regulation: the case for a single European Securities Regulator’ (2003) 34 L and Policy in Int’l Bus 499. 287 The ECB earlier supported centralized EU financial market supervision as a means for supporting Banking Union. eg, ECB, Financial Integration in Europe (2016) 97, noting its preference for a ‘single European capital markets supervisor’). For a Brexit-​related call for centralized supervision as a means for addressing fragmentation risks see Schoenmaker, D and Véron, N, Brexit Should Drive Integration of EU Capital Markets, Bruegel Blog Post, 24 February 2017. 288 eg, Lannoo, K, Spotify’s US Listing Highlights Europe’s Failings, ECMI Commentary No 51, April 2018. 289 2020 CMU Action Plan, n 41, 14 (the 2022 ESA Review was similar in tone (n 182)). Attesting to the sensitivities, the High Level Forum on CMU did not reach a consensus position on centralized supervision v. the current supervisory-​convergence-​framed model: n 86, 24–​5. 290 See, eg, Burns et al, n 134, Quaglia, L, ‘Financial Regulation and Supervision in the European Union after the Crisis’ (2013) 16 J of Economic Policy Reform 17 and A Spendzharova, ‘Is More ‘Brussels’ the Solution? New European Union Member States’ Preferences about the European Financial Architecture’ (2012) 50 JCMS 315.

54  The Institutional Setting States, particularly in a rescue/​resolution context, as well as, in exceptional circumstances, limit Member States’ ability to wield economic levers; EU-​level supervisory action could conceivably impact on sovereign borrowing costs or limit liquidity to the prejudice of the funding capacity of a State and its economy (for example, where margin requirements were increased for CCPs). Member States have, over time, displayed different preferences regarding the extent of any such centralization, which have been influenced by their different economic and financial system models, but they have consistently been cautious as to direct supervisory empowerments for ESMA. Political commitment to greater supervisory coordination through ESMA was strong over the financial-​crisis-​era ESMA Regulation negotiations, reflecting the weaknesses in pan-​EU supervisory governance exposed by the financial crisis and so political tolerance for a common defence against stability risks.291 But supervisory convergence was the preferred supervisory governance response. Over the negotiations, the European Council underlined that any ESMA supervisory decisions should not carry fiscal consequences for the Member States,292 the ECOFIN Council called for extensive specification of any ESMA direct supervision powers and for veto powers to protect Member States from fiscal risks,293 and ESMA’s NCA-​oriented binding powers under ESMA Regulation Articles 17–​19 generated significant contestation.294 Subsequently, the UK was a prominent ‘footdragger’ on any further supervisory centralization through ESMA,295 but suspicion of supervisory centralization was not confined to the UK: the MiFIR negotiations on ESMA’s direct intervention powers, for example, struggled,296 while the CMU agenda has since repeatedly seen the Council indicate its preference for supervisory convergence as the organizing model for EU supervision.297 Similarly, there is little evidence of distinct euro area preferences emerging in support of additional ESMA powers.298 The legal constraints on euro area/​Banking Union preferences taking priority over wider single market preferences are few,299 particularly as a euro area/​Banking Union QMV is now in place in the Council. Different financial market models prevail across the euro area/​Banking Union zone, however, and it is not clear that a distinct euro area/​Banking Union political preference on ESMA/​financial markets supervisory governance is emerging.300 The sensitivities 291 Cuocolo, L and Miscia, V, The Gentle Revolution of European Banking Regulation: models and perspectives in supervision, BAAFI Center Research Paper Series No 2014-​164, available via . 292 European Council Conclusions, 18–​19 June 2009 (Council Document 11225/​92/​09) 8. 293 ECOFIN Council Conclusions, 9 June 2009 (Council Document 10737/​09). 294 Relatedly, the European Parliament’s more ambitious proposals regarding ESMA’s direct supervision powers were either rejected or significantly scaled back by the Council over the negotiations. The Council conceded, however, the Parliament’s proposal that the Art 18 emergency and Art 19 binding mediation powers include an ESMA power to direct financial market participants, as well as the Parliament’s proposal for an enabling power for ESMA emergency intervention (now Art 9(5)). 295 See Howarth, D and Quaglia, L, ‘Brexit and the Single European Financial Market’ (2017) 55 JCMS 1335 and Moloney, n 60. 296 Danish Presidency Progress Report on MiFID II/​MiFIR, 20 June 2012 (Council Document 11536/​12). 297 eg, 2020 ECOFIN CMU Conclusions, n 83 and ECOFIN Council Conclusions, 11 July 2017 (Council Document 460/​17). The European Parliament position has, reflecting a longstanding approach, been more supportive of additional grants of power to ESMA, including as regards ‘gradually granting’ ESMA power over CCPs and CSDs—​both highly systemic infrastructures: 2020 Parliament CMU Resolution, n 85, para 35. 298 The political economy literature has identified the spill-​over effects of Banking Union as including the formation of potential new political and economic preferences: eg, Schimmelfennig, F, ‘A Differentiated Leap Forward: Spillover, Path-​Dependency, and Graded Membership in European Banking Regulation’ (2016) 39 West European Politics 483. 299 Dashwood, A, ‘Living with the Eurozone’ (2016) 53 CMLRev 3. 300 2015–​2016 saw some euro area institutional support for financial markets governance reform, however, in the form of a ‘Financial Union’ which would include a centralized financial market supervisor, sit alongside

I.6  EU Financial Markets Governance: ESMA  55 can also be seen in the incremental manner in which ESMA’s supervisory powers have been conferred and in the extent to which pre-​tested templates have been relied on. This cautious incrementalism exemplifies the typically marginal adjustments that can be associated with politically contested and complex governance design choices, as well as with how the status quo bias tends to accompany the related negotiations.301 Some straws in the wind that might presage a change in conditions might be identified. The 2020 Wirecard scandal exposed how weaknesses in NCA supervision and coordination can disrupt markets, albeit that centralized supervision is not a proxy for zero-​failure supervision. The withdrawal of the UK from the EU removed the strongest opponent of centralization in the Council, although Member State resistance to centralization remains significant, as the negotiations on the 2017 EMIR 2.2 Proposal, the 2017 ESA Reform Regulation Proposal, and the 2018 Crowdfunding Regulation Proposal, all of which saw ESMA’s proposed new competences scaled back, illustrate. While the Parliament remains supportive of enhancing ESMA’s powers, as the 2020 Wirecard scandal underlined, political resistance remains considerable.302 The 2021 Proposal for a new Anti-​Money-​L aundering Authority (AMLA) might suggest greater appetite for centralized supervision, but this proposal derives from specific anti-​money-​laundering failures associated with the coordination of banking supervision, is nested within the distinct harmonized regime governing anti-​money-​laundering, and does not carry the fiscal risks associated with supervision of financial market actors.303 By contrast, the mid-​2021 transfer to Banking Union’s SSM of the largest and most complex investment firms and as regards their prudential supervision,304 represents a material centralization of operational supervisory power. But it is related to prudential supervision only and can be regarded as an organic extension of the SSM’s reach, given the financial stability risks posed by such investment firms. And while ESMA’s direct supervisory powers are increasing, all of the actors it supervises, save for third country CCPs, have in common their distinctly pan-​EU operating models, limited financial stability and thereby fiscal risks, and relatively small population; the third country CCP empowerment, while of a different order, has distinct dynamics, reflecting in particular Brexit interests and tensions.305 Political conditions aside, the challenges remain considerable, including in relation to functional capacity (given the vast and heterogenous population of financial market actors) and the EU’s legal capacity (in particular given the Treaty requirements relating to competence, proportionality, and subsidiarity).

Banking Union, and serve to ‘complete EMU’: The Five Presidents’ Report, Completing Europe’s Economic and Monetary Union (2015). 301 eg, Spendzharova, n 290. 302 In its 2020 CMU Resolution, eg, the Parliament queried whether the Wirecard failures could have been prevented by direct EU supervision and called for a related assessment of the supervisory framework: n 85, para 36. By contrast, the Council’s 2020 CMU Conclusions did not address supervision and Wirecard: n 83. 303 COM(2021) 421. The negotiations are proving to be complex, including as regards whether the AMLA should have direct supervisory powers over regulated financial actors (as called for by the Council in its June 2022 ‘partial position’ on the Proposal). 304 Section 5.2.2 and Ch IV section 9. 305 See further Ch X sections 9.2 and 11.3.

56  The Institutional Setting

I.7  Looking to the Future I.7.1  Bending to Uniformity? Looking to the future, a tentative prediction might be made that the single rulebook is now relatively well-​settled, as least as regards its core elements. It can, however, be expected to continue to bend towards uniformity, expansion, and ever greater specification. Legislative reform, driven by the ratcheting effect of ‘review clauses’, is becoming more frequent, as the increasing prevalence of ‘quick fix’ reforms (outlined in subsequent chapters) indicates. ESMA’s technocratic capacity, expressed in the empirical heft it is bringing to the process of legislative review and in its decisive influence on the development, adjustment, and refinement of the administrative rulebook, is also gearing the regulatory scheme toward continual refinement and expansion. So is the massive expansion in the EU’s data capacity which has been transformed in the decade or so since the financial crisis, as noted in section 6; relatedly, the outcomes of regulatory reform are being examined more closely (informed by more extensive data306), a process which is likely to lead to further reforms. These trends augur well for the agility and responsiveness of the regulatory scheme, but they also pose risks, including as regards costs, unexpected market impacts, and, particularly as regards ESMA’s influence, legitimation. Political preferences, however, will continue to set the direction of regulatory reform and of supervisory organization. There are few signs, so far, of any major changes to the Council’s posture, which, given the pace and nature of regulatory reform under the CMU agenda since 2015, can be characterized as supportive of market finance and CMU, and of a broadly regulatory orientation. Nonetheless, national preferences continue to diverge, as the varying treatments of short selling in early 2020, as markets roiled in response to the deepening of the Covid-​19 pandemic, suggest.307 It remains unclear how the withdrawal of the UK from the EU will shape the Council.308 A more dirigiste approach might be expected,309 but there is little sign of resetting change so far, save as regards the more restrictive approach to the third country regime, but this is a function of a distinct set of preferences relating to post-​Brexit EU/​UK relations.310 By contrast, the Covid-​19 pandemic saw political support for some degree of de-​regulation to facilitate markets in mobilizing private capital to support the recovery, under the 2020 Capital Market Recovery Package,311 while the speedy 2021 agreement on the 2020 Proposal for an experimental pilot regime for market infrastructures for digital/​crypto-​assets suggests an appetite for facilitative

306 As is exemplified by the adoption of metrics to monitor CMU but also the data-​driven approach of the review of MiFID II/​MiFIR, as outlined in Chs V and IX, for example. 307 See Ch VI section 3.7. 308 See, eg, Howell, E, ‘Brexit, Covid-​19, and Possible Frameworks for Future UK/​EU Financial Governance Co-​ operation’ (2021) 84 MLR 1227 and Moloney, N, ‘Brexit and Financial Services: (Yet) Another Restructuring Of EU Institutional Governance for Financial Services’ (2018) 55 CMLRev 175–​202. 309 The absence of the UK and its traditional support for subsidiarity, and concern to avoid undue burdens on the wholesale markets, might be expected to shape Council preferences. Alongside, the CMU agenda has, since 2015, underlined the importance of the single rulebook and effective supervision in containing any Brexit-​related arbitrage and also in strengthening the ability of EU financial markets to support EU firms’ competitive position internationally. eg, 2020 CMU Action Plan, n 41, 5–​6. 310 See Ch X. 311 SWD(2020) 120. Albeit that some Member States expressed concern that investor protection not be compromised. See, eg, as regards the product governance reforms, Ch IX section 4.11.3.

I.7  Looking to the Future  57 reforms.312 The prevailing trend towards uniformity and specification is, accordingly, being moderated, in some respects, at the legislative level, a trend that can also be associated with a concern to ensure the competitiveness of EU financial markets, a concern that also infuses the Commission’s agenda. The Commission’s 2021 ‘Open Strategic Autonomy’ agenda, for example, emphasizes the need to strengthen the EU’s financial market capacity after the UK’s withdrawal, but also that EU financial markets must remain competitive and attractive for international market participants.313 In addition, and similarly moderating the trend towards uniformity and specification, there are some indications of a growing concern to preserve some degree of Member State (and NCA) autonomy. Brexit, which led to some UK firms relocating some business to the EU-​27, prior to the withdrawal of the UK, to ensure access to the single market,314 exposed competitive dynamics as Member States sought advantage and, alongside these, some Member State (and NCA) appetite for protecting NCA autonomy from ESMA oversight in the authorization and supervision of relocating UK firms.315 Relatedly, the Council’s support for CMU is framed by its concern that a ‘polycentric CMU’ develops which would support local and regional capital markets.316 Similarly, NCAs (which can shape political preferences) are increasingly indicating some wariness as to the quality of home NCA supervision of cross-​border activities, which may imply that host NCAs will seek more autonomy.317 In addition, proportionality (which is something of a proxy for greater flexibility) is increasingly a feature of single rulebook design and has become embedded within ESMA’s operating model since the 2019 reforms to its governance. And while ESMA’s technocratic influence is driving a ‘Europeanization’ of how the single rulebook is applied and supervised, it can also be associated with some degree of flexibility and experimentation, as ESMA draws on NCA expertise and experience in developing its supervisory convergence tools.318 After nearly sixty years of EU engagement, the principle of EU control over financial markets regulation has largely been ceded and the related governance system is now largely mature, has significant technocratic capacity to adjust, and can be expected to develop in an incremental manner. The organization of supervision remains the largest open question but there are few indications, absent a major resetting crisis, of material change to the current coordination and convergence trajectory.

312 The innovative 2020 Proposal was presented in September 2020 and achieved political agreement in December 2021 (the regime is noted in section 7.3). 313 COM(2021) 32. See Ch X section 4 on how the ‘strategic autonomy’ agenda frames the EU’s approach to the international financial market. 314 UK-​based business fragmented across the EU, following centres of specialization (eg, fund business to Luxembourg and Ireland). For a review see Donnelly, S, ‘Post-​Brexit Financial Services in the EU’ (2022) 29 JEPP . 315 In particular as regards ESMA oversight of delegation practices in the fund management sector. See Ch III. 316 2020 Council CMU Conclusions, n 83, 3. 317 2019 saw the ESAs raise concerns as to the quality of home NCA supervision of cross-​border retail financial services and the risks to host NCAs, while a 2020 ESMA peer review was similar in tone. See further Ch IV section 7.1. 318 In this regard, ESMA can be characterized as displaying some elements of ‘experimentalist governance’ in that it learns from NCA experience (ie ESMA-​coordinated supervisory reviews by NCAs can shape soft law and ultimately administrative rules). On experimentalist governance in EU financial integration see Zeitlin, J, Uniformity, Differentiation, and Experimentalism in EU Financial Regulation: the Single Supervisory Mechanism in Action, Amsterdam Centre for European Studies Research Paper No 2021/​04 (2021), available via .

58  The Institutional Setting

I.7.2  Sustainable Finance In addition, the EU’s ‘sustainable finance’ agenda,319 initially set out in the 2018 Sustainable Finance Action Plan320 and framed by international climate change commitments321 and by the related 2019 European Green Deal,322 can be expected to shape EU financial markets regulation. Sustainable finance is now the focus of sustained regulatory attention globally.323 While it engages a range of objectives and concerns, the sustainable finance agenda can broadly be associated with addressing the risks to financial stability from climate change (whether as regards physical risks or a disorderly transition to a low-​carbon economy); and with strengthening the capacity of financial markets to raise the capital needed to fund the low-​carbon transition, and with addressing the related risks, including as regards ‘greenwashing’ (or the misleading of investors and clients as regards the sustainability of investments, services, and activities). Thus far, disclosure has been the main regulatory tool deployed, being used to support the pricing of sustainability risks, the signalling of sustainable investments, and, thereby, the allocation of capital; to address investor protection risks; and to inform supervisory practices. Sustainable finance is a new field for financial markets regulation and has fast become the subject of a burgeoning literature. This literature canvasses, inter alia, and as regards financial markets, debates ranging from whether the objectives of financial markets regulation can support sustainable finance measures (as such measures typically engage a judgment as to the ‘quality’ of certain investments); to the regulatory design challenges associated with developing effective disclosures which appropriately capture, in a standardized and comparable manner, sustainability-​related risks, with retooling conduct regulation to, inter alia, address the investor protection risks associated with greenwashing, and with adjusting prudential regulation to reflecting sustainability risks; to the specific technical challenges engaged in the construction of an appropriate taxonomy to capture the nature of sustainability risks and of sustainable investments; and to, and relatedly, the legitimation challenges posed 319 The interaction between EU financial markets regulation and sustainable finance engages the regulatory treatment of environmental-​, social-​, and governance-​related (ESG) objectives, and particularly environmentally sustainable objectives. The Commission characterizes sustainable finance as the process of taking due account of environmental and social considerations in investment decision-​making, leading to increased investment in longer-​term and sustainable activities: Commission, Action Plan: Financing Sustainable Growth (COM(2018) 97) 1. The scale, reach, and immense technical complexity of the sustainable finance agenda means that it can only be covered in brief outline in a work of this nature. This section outlines in brief the main elements of the EU’s sustainable finance agenda. Subsequent chapters note the agenda as regards specific market segments. 320 n 319. The Action Plan was based on the technical advice of the Commission’s High Level Expert Group on Sustainable Finance: Financing a Sustainable European Economy (2018). It was updated and expanded in 2021: COM(2021) 390. 321 Primarily the 2015 Paris Agreement to keep the increase in global average temperatures to well below 2° above pre-​industrial levels and to aim to limit the increase to 1.5°. 322 The 2019 European Green Deal is a multi-​stranded agenda that sets out a roadmap of policies for addressing climate and environmental-​related changes and is framed by the commitment to ensure no net emissions of greenhouse gases (‘net zero’) by 2050, decouple economic growth from resource use, and support the ‘just transition’: COM(2019) 640. A host of related policies, action plans, proposals (including as regards emissions trading), and an investment plan have followed. Alongside, the related 2030 Climate Target Plan commits the EU to reducing greenhouse gases to at least 55 per cent below 1990 levels by 2030 (previously 40 per cent) and the European Climate Law sets a legally binding target of net zero greenhouse gas emissions by 2050 and includes the 2030 target. 323 It is addressed by all the main international standard-​setters. See, eg, FSB, Roadmap for Addressing Climate-​Related Financial Risk (2021) (focused on financial stability and related risk management); and IOSCO, Sustainable Finance and the Role of Securities Regulators and IOSCO (2020) (focused on sustainable investment, disclosure, and investor protection risks).

I.7  Looking to the Future  59 by the dependence of regulation in this area on technocratic (and in particular scientific) capacity given the technicalities engaged in capturing what is meant by ‘sustainability’ and in articulating it in regulatory and supervisory standards.324 The myriad regulatory design challenges in the EU are framed by the agenda-​setting 2018 Sustainable Finance Action Plan which was designed to enrol financial markets in the achievement of the EU’s sustainability objectives and so to orient private capital to more sustainable investments, as well as to support the capital-​raising required to fund the ‘green transition’.325 Relatedly, the 2020 CMU Action Plan was in part designed to strengthen markets to provide the funding required to deliver the European Green Deal and to support sustainable investment.326 Specifically, the 2018 Action Plan was designed to reorient capital flows towards sustainable investments; manage financial risks arising from climate change, resource depletion, environmental degradation, and social issues, including through related risk management processes; and foster transparency and long-​termism in financial and economic activity. Its main elements as regards financial markets regulation (the Action Plan addressed the financial system horizontally, including the banking and insurance systems) included adopting a taxonomy/​classification system for ‘sustainable’ investments; developing standards and labels for ‘green’ financial products; incorporating sustainability factors into investment advice; developing sustainability benchmarks; exploring the integration of sustainability factors into the credit rating process; clarifying the duties of collective investment managers as regards sustainability considerations; integrating sustainability risks into prudential regulation; and strengthening issuer disclosures as regards sustainability considerations. Most of these initiatives have since been adopted. The sustainable finance agenda, while still under development, and expanded by the 2021 Sustainable Finance Action Plan,327 has rapidly become one of the most technically complex and thereby technocratically driven aspects of EU financial regulation generally, but it has also become contested politically, with the taxonomy/​classification system proving to be sensitive to Member State and institutional preferences as regards the coverage of ‘sustainable investments’. The consequent reforms to the single rulebook (and its administrative rules) primarily, but not entirely, take the form of highly detailed specification of the sustainability-​related disclosures now required. The reforms, noted in brief in subsequent chapters, range from the facilitative and operational (including the construction of two climate-​oriented benchmarks under the Benchmark Regulation;328 and the 2021 Green Bonds Proposal329); to 324 See, eg, Busch, D, Ferrarini, G, and Grünewald, S (eds), Sustainable Finance in Europe (2022); the special edition of the EBOLR on sustainable finance: (2022) 23(1) EBOLR; Steuer, S and Tröger, T, ‘The Role of Disclosure in Green Finance’ (2022) 8 J Fin Reg 1 (on the use of disclosure); and de Arriba-​Sellier, N, ‘Turning Gold into Green: Green Finance in the Mandate of European Financial Supervision’ (2021) 58 CMLRev 1097 (on whether and how ‘green finance’ can be integrated into financial supervision in the EU). 325 The investment gap has been identified as being in the region of €350 billion annually, with regard to the emissions-​reduction target: 2021 Sustainable Finance Action Plan, n 320, 2. 326 2020 CMU Action Plan, n 41, 1–​2. 327 The 2021 Action Plan was more diffuse, covering a host of initiatives relating to, inter alia, expanding the taxonomy classification to include other sustainable investments, providing additional ‘labels’ to recognize transition efforts, addressing ratings, ensuring the inclusiveness of sustainable finance, and enhancing financial sector resilience, including through stress testing. 328 Following reforms adopted in 2019 under Regulation (EU) 2019/​2089 [2019] OJ L317/​17. Noted in Ch VIII section 10. 329 COM(2021) 391. A disclosure-​oriented reform, the Green Bonds Proposal is designed to provide an EU-​ label for bonds that pursue ‘environmentally sustainable’ objectives (within the meaning of the 2020 Taxonomy Regulation, as noted below). Noted in Ch II section 10.

60  The Institutional Setting issuer-​disclosure-​related reforms, including the new corporate sustainability reporting regime, agreed in 2022, which reforms the Non-​Financial Reporting Directive to require sustainability reporting and which will be supported by new sustainability reporting standards;330 to reforms that require that sustainability considerations, and the management of related risks, be embedded in investment firms’ operating procedures (through the refinement of the organizational and risk management administrative rules adopted under MiFID II/​MiFIR; the revision of the MiFID II ‘know-​your-​client’ administrative rules to reflect clients’ sustainability preferences; and the adjustment of the MiFID II product governance regime to reflect sustainability risks331) and in collective investment management.332 The pillar measures of this fast-​evolving regime are the intricate 2019 Sustainable Finance Disclosure (SFD) Regulation and the 2020 Taxonomy Regulation. The SFD Regulation is a horizontal disclosure measure that applies to regulated financial market participants.333 It lays down harmonized disclosure requirements for financial market participants and ‘financial advisers’ as regards the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes; and as regards the provision of sustainability‐related information with respect to financial products (Article 1). A widely cast measure, it applies at entity/​firm and at product levels. It is accordingly designed to encourage financial intermediaries to consider ‘adverse sustainability impacts’ (by means of a related disclosure obligation); and also to provide investors with comparable disclosures, presented in a standardized manner, relating to financial products that claim sustainability objectives/​considerations and as regards the sustainability impact of such products (it is calibrated according to the extent to which products integrate sustainability-​related considerations).334 The SFD Regulation also defines, inter alia, ‘sustainable investments’ and 330 Provisional agreement on the proposal for what will be the Corporate Sustainability Reporting Directive (COM(2021) 189) was reached in June 2022. It reforms Directive 2014/​95/​EU [2014] OJ L330/​1 (on non-​financial reporting). Noted in Ch II section 10. 331 Respectively, Delegated Regulation (EU) 2021/​1253 [2021] OJ L277/​1 (organizational and know-​your-​client requirements); and Delegated Regulation (EU) 2021/​1269 [2021] OJ L277/​137 (product governance). Noted in Chs IV and IX. 332 Delegated Regulation (EU) 2021/​1255 [2021] OJ L277/​11 and Delegated Regulation (EU) 2021/​1270 [2021] OJ L277/​141 require the managers of alternative investment funds and of UCITSs to integrate sustainability risks in the management of funds, including as regards conflicts-​of-​interest management procedures and risk management procedures. Noted in Ch III. 333 Regulation (EU) 2019/​2088 [2019] OJ L317/​1. Its obligations apply to a wide range of regulated financial market participants, including investment firms and collective investment scheme managers, but also participants in the financial system generally, including credit institutions and insurance companies (Art 2(1)). 334 It covers inter alia: the publication of firms’ sustainability risk policies; transparency requirements as regards the ‘principal adverse impacts’ of firms’ investment decisions on sustainability factors and related due diligence policies (and as regards where such an impact assessment is not carried out by a firm); transparency requirements relating to the extent to which ‘financial advisers’ (which cover investment firms and collective investment scheme managers providing investment advice) consider principal adverse impacts on sustainability factors in their investment advice (and if they do not, an explanatory statement); and the transparency of remuneration policies as regards sustainability risks. The Regulation also imposes a series of obligations in relation to (and as regards the product-​related and pre-​contractual disclosures required under the relevant sectoral legislation): the manner in which sustainability risks are integrated into investment decisions/​investment advice and the result of any assessment of sustainability risks on the returns of financial products made available/​advised on; whether and how the relevant financial product considers principal adverse impacts on sustainability factors (Art 6); where a financial product promotes environmental or social characteristics, disclosures as to how these characteristics are met (Art 8); and, where a product has a sustainable investment objective and a related index has been designated as a benchmark, disclosures relating to the index and, where no such index is designated, the required disclosures as to how the objective is to be attained (Art 9). It also addresses the required website disclosures regarding the promotion of environmental/​social and of sustainable investments, and the coverage of environmental/​social and of sustainable investments in periodic reports. How these disclosure rules apply in practice requires close consideration of the intricacies of the different classes of product used by the SFD Regulation (all products under Art 6; ‘Art 8 products’

I.7  Looking to the Future  61 related cognate terms used to impose sustainability-​related obligations, including ‘sustainability risks’ and ‘sustainability factors’335. It accordingly provides, along with the 2020 Taxonomy Regulation,336 the classification/​definitional platform on which the sustainable finance reform agenda is based. While the SFD Regulation is supported by extensive administrative rules,337 the ‘environmental’ elements of this disclosure regime are governed by the cornerstone 2020 Taxonomy Regulation. The complex, highly articulated, and deeply technical Taxonomy Regulation, which has come to have totemic status globally as seeking to establish an EU ‘gold standard’ for classifying environmentally sustainable investments, and thereby to reduce the risk of market distortion, sets out a framework for establishing whether an economic activity qualifies as ‘environmentally sustainable’ for the purposes of establishing the degree to which an investment is environmentally sustainable (Article 1). In essence, it provides that for an investment to be environmentally sustainable it must contribute substantially to one or more of the specified environmental objectives, not significantly harm those environmental objectives, and comply with the ‘technical screening criteria’ amplified by administrative rules (Article 3).338 In addition, the Regulation supplements the disclosures required under the SFD Regulation for those actors subject to the SFD Regulation and as regards environmental sustainability; and also imposes disclosure obligation on those large firms that are subject to the NFR Directive. It is amplified by administrative rules of immense granularity and intricate technical specification.339 It remains to be seen how the sustainable finance agenda will shape EU financial markets and EU financial markets regulation. At the very least, and as regards regulatory design, it has injected additional and immense technical specification into the single rulebook, and that promote environmental or social characteristics; and ‘Art 9 products’ that have as an objective an environmental or social Impact). 335 Under Art 2(17) a ‘sustainable investment’ means an investment in an economic activity that contributes to an environmental objective, as measured, eg, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance. A ‘sustainability risk’ is an environmental, social, or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of an investment (Art 2(22)). ‘Sustainability factors’ mean environmental, social, and employee matters, respect for human rights, anti-​corruption, and anti-​bribery matters: Art 2(24). 336 Regulation (EU) 2020/​852 [2020] OJ L198/​13. 337 Set out in RTS 2022/​1288 [2022] OJ L196/​1. The immensely detailed rules were developed by all three ESAs and with reference to the work of the Technical Expert Group on Sustainable Finance. 338 Climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems: Art 9. The nature of a substantial contribution is specified by Arts 10–​16, and the nature of significant harm by Art 17. 339 The first set of rules (Delegated Regulation (EU) 2021/​2139 [2021] OJ L442/​1), extending across some 350 pages of the OJ, address the technical screening criteria governing when an economic activity contributes substantially to climate change mitigation/​adaptation, and where an activity causes no significant harm to the other environmental objectives. A second set of rules will address the remaining objectives. Alongside, and in accordance with its 2021 Action Plan, the Commission proposed that specified nuclear and gas energy activities be included in the taxonomy as environmentally sustainable (C(2022)631), a reform which met with material resistance from Member States opposed to nuclear power but which was adopted in 2022: Delegated Regulation 2022/​1214 [2022] OJ L188/​1.

62  The Institutional Setting so tilted it ever more towards relying on technocratic capacity,340 including by means of the express mandate ESMA now has as regards sustainability.341 It has also placed very considerable weight on disclosure as a means for supporting the political commitment towards sustainable finance.

I.7.3  Technological Innovation and Digital Finance The future development of EU financial markets regulation will also be shaped by the ongoing and burgeoning technological innovation in how financial market intermediaries provide services and in how infrastructures are designed, including as regards the impact of artificial intelligence (AI).342 The single rulebook is designed to be ‘technologically neutral’ (often expressed as ‘same risks, same rules’343) and, in many respects, is accustomed to grappling with the risks posed by technological innovation. Typically, the single rulebook deals with technological innovation by means of the foundational organizational/​operational requirements that, regardless of the relevant delivery mode or related innovation, require regulated actors to have in place robust internal procedures and risk management processes to ensure compliance with EU requirements. EU financial markets regulation is, however, increasingly grappling with the distinct pressure that technological innovation can place on regulation. The retail market regime, to take only one example, is addressing the digitalization of disclosure and of distribution, in particular through trading apps and social media means, with the 2021 ‘Gamestop’ episode sharpening regulatory focus on the risks that digitalization can pose.344 Crowdfunding platforms, to take an example from the capital-​raising sphere, have recently been drawn into the single rulebook through the 2020 Crowdfunding Regulation.345 Technological innovation is also shaping supervision, with ESMA supporting the use by NCAs of ‘RegTech’ and ‘SupTech’ tools, which use technology to support regulatory compliance by regulated actors (RegTech), and to facilitate supervision (SupTech), often based on AI-​led construction and interrogation of the massive data-​sets now produced under the single rulebook.346 Similarly, NCAs are experimenting

340 Alongside the ESAs, different technical bodies have been engaged in developing the agenda and supporting the development of its administrative rules, in particular as regards the taxonomy, including the Platform on Sustainable Finance (established under the Taxonomy Regulation) and the Member State Expert Group on Sustainable Finance and, earlier, the Technical Expert Group and High Level Group on Sustainable Finance. 341 The 2019 ESA Reform Regulation revised ESMA’s founding Regulation to require that ESMA take account of sustainable business models, and the integration of environmental, social, and governance-​related objectives, in carrying out its tasks: Art 8(1a). ESMA has adopted a related Sustainable Finance Roadmap (2022–​2024) based on tackling greenwashing and promoting transparency, building NCAs’ and ESMA’s capacities, and monitoring, assessing, and analyzing ESG markets and risks. 342 An extensive, jurisprudentially oriented literature considers the impact of AI on the design of regulation. For leading examples see Deakin, S and Markou, C (eds), Is Law Computable? (2020) and Hildebrandt, M, Smart Technologies and the End(s) of Law (2016). For financial-​markets-​oriented discussion see Omarova, S, ‘New Tech v New Deal: Fintech as a Systemic Phenomenon’ (2019) 36 Yale J of Reg 735, arguing that technological change is driving a major systemic reorganization of how markets work; and, similarly, calling for more adaptive regulation and greater enrolment of technology in regulation, see Lo, A, Moore’s Law vs. Murphy’s Law in the Financial System: Who’s Winning? BIS WP No 564 (2016). 343 eg, as expressed in the 2020 Digital Finance Strategy (COM(2020) 591) 5. 344 Ch IX. 345 Ch II section 11.2. 346 For an example see ESMA’s ‘meta examination’ of fund disclosures by means of Suptech tools: Amzallag, A, ‘54,000 PRIIPs KIDs—​how to read them (all)’ ESMA TRV No 1 (2021) 93.

I.7  Looking to the Future  63 with means for facilitating innovation, including through ‘sandboxes’ and innovation hubs.347 The reform agenda is now framed by the EU’s wide-​ranging 2020 Digital Finance Strategy, which is based on the earlier 2018 FinTech Action Plan.348 The Strategy, which has a wide sweep across the financial system,349 sets out a host of different actions (many with a 2024 timeline), extending from enabling use of interoperable digital identities for accessing financial services; to enhancing passporting for digital financial services and, relatedly, strengthening the European Forum of Innovation Facilitators350 ; to developing a common financial data space; to providing guidance on how the single rulebook applies to new technologies; and to reviewing financial services legislation to ensure it is ‘future proof ’.351 The adoption of the Strategy was accompanied by a horizontal measure designed to address digital operational resilience and impose related requirements on regulated firms as regards their ability to withstand disruption: the 2020 Digital Operational Resilience Act (DORA) Proposal, on which provisional agreement was reached in May 2022.352 This agenda may lead to specific single rulebook reforms, but the direction of travel has, until now, been to deploy a primarily technocratic and specifically supervisory response, including through ESMA’s supervisory convergence measures.353 Nuanced and agile NCA supervision, particularly where it is iterative, responds to market developments, and is coordinated through ESMA, has the benefit of supporting an adaptive response and of accommodating some degree of experimentation. Legislative or administrative rule reform, by contrast, is less flexible and prone to obsolescence. Supervision is, however, exposed to information asymmetry risks, while technocratic ‘gap-​filling’, including through ESMA supervisory convergence 347 These facilities, hosted by NCAs, allow firms to explore, in coordination with NCAs, how technologically innovative delivery means can operate in a regulated environment. They have been the subject of extensive discussion in the literature as a form of innovative governance but also of some risk. See, eg, as regards financial markets regulation, Aherne, D, ‘Regulatory Lag, Regulatory Friction and Regulatory Transition as Fintech Disenablers’ (2021) 22 EBOLR 395; and, from a regulatory governance perspective, Ranchordás, S, Experimental Lawmaking in the EU: Regulatory Sandboxes, University of Groningen Faculty of Law Research Paper No 12/​2021, available via . 348 n 343 and COM(2018) 109, respectively. Alongside, the 2021 AI Act Proposal is designed to establish a risk-​ based framework for the regulation of the use of AI systems generally, with the most stringent standards applying to the most high risk contexts (COM(2021) 206). 349 It has four priorities: removing fragmentation in the digital single market, allowing consumers to access cross-​border services and firms to scale up their digital operations; adapting the EU regulatory framework to facilitate digital innovation (including AI and distributed ledger technology); creating a European financial data space; and addressing the challenges and risks of digital transformation, including as regards digital operational resilience. 350 The Forum provides a platform for NCAs to share experiences with ‘innovation facilitators’, such as regulatory sandboxes and innovation hubs, and forms part of the EU Digital Finance Platform which supports dialogue between industry and public authorities. 351 The treatment of digital disclosure and distribution, eg, is a recurring theme of the Commission’s parallel development of a Retail Investment Strategy: Commission, Consultation on a Retail Investment Strategy for Europe (2021). See Ch IX. 352 COM(2020) 595. The DORA regime has a wide reach across the financial sector generally, addressing inter alia collective investment managers, investment firms, rating agencies, crowdfunding service providers, data reporting services providers, CCPs, CSDs, credit institutions, insurance firms, and statutory auditors. It is designed to establish uniform requirements concerning the security of network and information systems in order to achieve a high common level of digital operational resilience (Art 1). Its requirements relate to the governance of risk management; risk management processes; incident reporting; digital resilience stress-​testing; monitoring of third party risk; and information sharing. 353 The ESAs, eg, jointly developed best practices for NCAs as regards ‘innovation facilitators’ such as regulatory sandboxes (Joint ESA Committee, FinTech: Regulatory Sandboxes and Innovation Hibs (2018)) and maintain a list of such facilitators. Alongside, ESMA has adopted financial-​market-​specific measures, including its Guidelines on ‘robo-​advice’: ESMA, Guidelines on Certain Aspects of the MiFID II Suitability Requirements (2018).

64  The Institutional Setting measures, can raise legitimation challenges, particularly where technological innovation raises foundational challenges, such as the questions the Gamestop episode generated as regards the appropriate level of retail investor engagement and also protection in financial markets.354 Finally, technological innovation has led to the massive expansion in the market for digital or crypto-​assets, assets that are based on some form of distributed ledger technology (DLT).355 This book is concerned with the ‘financial instruments’ which dictate the scope of the single rulebook. It does not accordingly address crypto-​assets and their intermediaries and venues, as these fall outside the perimeter of the single rulebook (as ESMA and the EU’s NCAs have repeatedly warned356), unless the relevant assets can be characterized as financial instruments, in which case the single rulebook applies.357 Reflecting the commitment in the 2020 Digital Finance Strategy to enable EU markets in crypto-​assets, a tailored, wide-​ranging (if heavily contested) regulatory regime, with bespoke disclosure, intermediation and venue regulation, and market abuse prohibition elements, is being put in place for crypto-​assets, issuers of crypto-​assets (including ‘stablecoins’), and crypto-​asset service providers (including trading venues) (the Regulation on Markets in Crypto-​Assets (MiCAR)).358 In addition, the 2022 DLT Market Infrastructure Pilot Regime Regulation359 puts in place (from March 2023) a pilot regime (in effect, a form of sandbox) for the trading and settlement of those crypto-​assets that qualify as financial instruments (‘tokenized financial instruments’ or ‘digital financial instruments’), by providing significant exemptions from the rules that otherwise govern trading and settlement infrastructures. The single rulebook measures that govern trading and settlement infrastructures (MiFID II/​MiFIR for trading venues and the CSD Regulation for settlement systems) do not accommodate the use of DLT (which is used to ‘tokenize’ financial instruments). The Regulation is accordingly designed to facilitate access to and allow experimentation with these infrastructures, as well as experimentation with DLT as a means for bringing efficiencies to the trading and settling of financial instruments.360 The Pilot is only available for crypto-​assets that represent financial instruments; infrastructures for other crypto-​assets are addressed by the MiCAR regime.

354 Ch VI section 2.2 and Ch IX section 4.9.2. 355 A crypto-​asset is, in effect, a digital representation of value that uses some form of distributed ledger technology (DLT). DLT is, in essence, an electronic transaction recording system that is maintained by a shared (distributed) network of participants (that may or may not require permission to access the network) that validates transactions, and that is accordingly not in the form of a centralized validation system. It is also associated with related computer-​based encryption techniques to store assets and validate transactions. Originally associated with public ledgers (such as bitcoin), it has been developed to take the form of permission-​based systems which can be used in financial market systems more generally and to deliver operational efficiencies. For an early EU policy perspective see ESMA, The Distributed Ledger Technology Applied to Securities Markets (2016). 356 eg, ESMA, EBA, EIOPA, EU Financial Regulators Warn Consumers on the Risks of Crypto-​Assets (2022). 357 See Ch II section 10.1 in the context of the capital-​raising regime. 358 Based on Commission Proposal COM(2020) 593, provisional agreement was reached on the sprawling and specialist regime in June 2022. For reviews of the proposal on which it is based see, eg, the discussions in Avgouleas, E and Marjosola, H (eds), ECFR Special Volume 5. Digital Finance in Europe: Law, Regulation, and Governance (2022). ESMA will be charged with specific competences under MiCAR as regards crypto-​asset service providers, primarily of a supervisory convergence orientation although it will also have intervention powers (akin to its MiFIR product intervention powers) to prohibit or restrict services in exceptional circumstances. 359 Regulation (EU) 2022/​858 [2022] OJ L151/​1. 360 The 2020 Proposal characterized the reform as being ‘innovation friendly’ and as allowing the EU to gather evidence which could inform future regulatory action while securing investor protection, market efficiency, and financial stability: COM(2020) 594, 1–​2.

I.7  Looking to the Future  65 The Regulation addresses market infrastructures for ‘DLT financial instruments’361 in the form of multilateral trading facilities (MTFs, the main form of trading venue under the EU’s trading venue regime, authorized and regulated under MiFID II/​MiFIR), settlement systems (for settling transactions, authorized and regulated under the CSD Regulation), and mixed trading and settlement systems (‘DLT market infrastructures’). It establishes a framework under which these infrastructures can be granted special permission to operate as ‘DLT market infrastructures,’ subject to the Regulation’s conditions, which include organizational requirements as regards the use of DLT. The permission, which lasts for six years and is passportable across the EU, allows the DLT market infrastructure to request exemptions from the MiFID II/​MiFIR and CSD Regulations, subject to compliance with the Regulation’s conditions and also with any additional compensatory requirements imposed by the relevant NCA.362 ESMA, as is now common across the single rulebook, is embedded in the regime, being charged with reviewing NCAs’ exemption decisions. The regime will be supported by RTSs to be developed by ESMA and will be reviewed by ESMA and the Commission within three years of its coming into force. It constitutes a major innovation by the law-​making process, representing the first time a pilot regime has been used to address technological innovation. Hitherto, experimentation in the single rulebook has been mainly a function of providing opt-​in/​labelling regimes (such as the different fund regimes that operate within the fund rulebook generally and as outlined in Chapter III). The Regulation accordingly represents an epochal development by providing for large-​scale but controlled exemptions from the relevant rules to allow for market and regulatory experimentation. It remains to be seen how the single rulebook and these bespoke regimes will interact over time and whether this parallel approach is sustainable, not least as the crypto-​asset market remains, at the time of writing, unstable.363 Whatever the outcome, the DLT Pilot Regime Regulation has left a significant legacy by embedding experimentation in the single rulebook.

361 Defined as financial instruments issued, recorded, transferred, and stored using DLT. The DLT financial instruments that can be admitted to trading on/​settled by these infrastructures are limited to less liquid instruments: shares of issuers with a market capitalization below €500 million, bonds with issuance size below €1 billion, and UCITS funds with assets under management of below €500 million. 362 eg, where an authorized investment firm has been granted permission to operate a DLT MTF, the MiFID II/​ MiFIR rulebook applies, subject to specified exemptions, chief among these an exemption from the transaction reporting requirements, but also the facility to allow direct access to the system by natural persons (otherwise prohibited): Arts 4 and 8. 363 After a period of intense growth (by early 2021, crypto-​asset prices had surged to an all-​time high with the total market capitalization of crypto-​assets at over €500bn: ESMA, TRV Report No 1 (2021) 54), 2022 saw gyrations in the crypto-​asset market, steep losses in value, and the failure of a major crypto-​exchange, amidst increasing regulatory concern. From the extensive coverage in the financial press see Foroohar, R, ‘Crypto: New Asset, Old Problem’, Financial Times, 20 November 2022; and Oliver, J, Chipolina, S, and Shubber, K, ‘Digital Asset Industry Feels Shockwaves from Its Very Own ‘Credit Crisis’, Financial Times, 25–​26 June 2022.

II

CAPITAL-​RAISING II.1 Introduction II.1.1  Introduction This chapter addresses the EU rules which govern capital-​raising by firms through the markets (or firms’ recourse to market finance by selling their securities in the financial markets).1 The regulation of capital-​raising through the markets by firms (issuers of securities), which is one of the most longstanding elements of financial markets regulation,2 engages several objectives (section 2). Its primary objective is to ensure that the markets efficiently allocate capital to the most productive firms.3 In service of this objective, regulation in this area, as regards issuers,4 is typically based on the imposition of issuer disclosure requirements,5 being largely concerned with ‘truth-​telling’ by issuers and with the related removal of ‘lemons’, or poorly performing issuers, from the market:6 issuers are typically required to make comprehensive disclosures to the public on the initial raising of capital, on a regular basis thereafter, and at particular points, usually linked to the occurrence of material events. Regulation in this field also addresses the ‘secondary market’ trading venues on which issuers’ securities are traded, once sold in the ‘primary markets’ by issuers, 7 in particular to ensure there is sufficient liquidity in the securities traded.8 The nature and incidence of these disclosures (which are typically reserved for the ‘public markets’, a setting which can be defined in different ways)9 reflect multiple 1 On the distinction between market finance and bank finance see Ch I section 3.2. 2 And so has generated a massive literature over time, primarily US in orientation, and that has been strongly influenced by financial economics. This literature is noted across the chapter but cannot be fully canvassed. Rr 3 Choi, S, ‘Law, Finance and Path Dependence. Developing Strong Securities Markets’ (2002) 80 Texas LR 1657. 4 The different elements of the capital-​raising process, and the other actors engaged, are subject to other forms of EU financial markets regulation. The underwriting process, eg, is subject to the general and underwriting-​ specific conduct and prudential requirements that apply to investment firms (Ch IV), while issuers and the market intermediaries that support capital-​raising are subject to the market abuse regime (Ch VIII). 5 Black, B, ‘The Legal and Institutional Preconditions for Strong Securities Markets’ (2001) 48 UCLA LR 781, relating the ‘magical’ process whereby intangible securities can be used to raise capital to issuer disclosure requirements and to the different institutions (such as auditors, investment analysts, rating agencies, and trading venues) which support effective disclosure. 6 Langevoort, D, ‘Global Securities Regulation after the Financial Crisis’ (2011) 13 JIEL 799. 7 On the primary and secondary markets see section 2. 8 Reflecting the fact that ‘[t]‌he economic function of the trading markets is to create liquidity—​a market characteristic that enables investors to dispose of or purchase securities at a price reasonably related to the preceding price’: Poser, N, ‘Restructuring the Stock Markets: A Critical Look at the SEC’s National Market System’ (1981) 56 NYULR 884, 886. 9 As discussed across this chapter, issuer disclosure regulation typically distinguishes between the public markets, which are subject to the highest levels of regulation; and the private markets, in which issuers raise capital from, usually, professional/​wholesale investors (although the rise of digital distribution channels has seen a private retail market emerge), which are less intensively regulated, given the substitutes for regulation in these markets.

68 Capital-raising jurisdiction-​specific influences, including the extent to which market finance is embedded in the relevant economy, levels of internationalization and related competitiveness risks,10 the extent to which recourse by small and medium-​sized enterprises (SMEs) to market finance is supported, the relative importance of the retail investor constituency, and, increasingly, the level of engagement by the regulatory system with digitalized distribution and disclosure.11 As outlined across this chapter, all of these influences are at play in the EU’s regulation of issuer disclosure. But, and while the related rulebook now forms a dense, multi-​layered, and intricate regulatory system, it continues to serve the longstanding and foundational imperatives of EU financial markets regulation as regards the embedding of market finance and the supporting of market integration: the harmonized rules of the issuer disclosure rulebook are, at bedrock, designed to facilitate access to market finance, in particular by supporting cross-​border ‘passporting’ by issuers. The market finance/​ market integration imperatives ground the single rulebook generally, as noted in Chapter I and across this book, but they are totemic in this area, given the foundational importance of the extent to which EU firms raise finance through the markets to the embedding of market finance and to market integration, as is underlined by the Capital Markets Union (CMU) agenda.12 These imperatives are accordingly highlighted in this chapter.

II.1.2  The EU Issuer Disclosure Rulebook The EU issuer disclosure regime has a long history, stretching back past the pivotal Financial Services Action Plan (FSAP)-​era reforms,13 but has most recently been shaped by the financial-​crisis era and the CMU agenda. At its heart is the foundational 2017 Prospectus Regulation,14 a CMU measure which came into force in 2019 and replaced the precursor 2003 Prospectus Directive.15 Amplified by a dense administrative rulebook constructed by the 2019 Prospectus Delegated Regulation and the 2019 Prospectus RTS,16 and supported by a thicket of European 10 As is reflected in the post-​Brexit overhaul the UK is engaging in of its prospectus rules. eg, HM Treasury, UK Prospectus Regime Review. Review Outcome (2022) (and the earlier consultation: UK Prospectus Regime Review (2021)). 11 Requirements such as machine-​readability, designed to support meta data-​analyses of issuer disclosures, eg, are now common. 12 The 2015 and 2020 Action Plans (Commission, Action Plan on Building a Capital Markets Union (COM(2015) 468) and Commission, A Capital Markets Union for People and Businesses. New Action Plan (COM(2020) 590)) highlight the importance of strengthening the capacity of the EU capital market to support firms, particularly SMEs. The 2020 Action Plan, eg, in the context of the recovery from the Covid-​19 pandemic, noted that: ‘Market financing will be the lifeblood that sustains the recovery and future growth over the long-​term’; and that ‘CMU is also essential for mobilising private investment in companies and complementing public support. It brings a variety of funding alternatives, reduces dependence on a single source or single provider of financing and reduces the funding gap. Companies of all sizes—​and in particular SMEs—​need solid market-​based funding sources’: at 2 and 3. The CMU reform agenda includes adjusting the issuer disclosure regime to support SMEs through a ‘Listing Act’ reform, as outlined in Commission, Targeted Consultation on the Listing Act (2021). As this book went to press, the related Listing Act reform agenda was adopted by the Commission in December 2022 (n 144). 13 Commission, Communication on Implementing the Framework for Financial Markets: Action Plan (COM(1999) 232). 14 Regulation (EU) 2017/​1129 [2017] OJ L168/​12. 15 Directive 2003/​71/​EC [2003] OJ L345/​64. 16 Regulation (EU) 2019/​980 [2019] OJ L166/​26 and RTS 2019/​979 [2019] OJ L66/​1. These measures replace but are based on the earlier and frequently revised Delegated Regulation (EC) No 809/​2004 [2004] OJ L149/​1.

II.1 Introduction  69 Securities and Markets Authority (ESMA) soft law, the Regulation imposes a prospectus requirement on issuers offering securities to the public and on issuers admitting their securities to trading on a ‘regulated market’.17 The related ongoing disclosure regime imposes periodic disclosure obligations on issuers with securities admitted to a regulated market, by means of the 2004 Transparency Directive as amended by the 2013 Amending Transparency Directive18 and by means of the related 2013 Accounting Directive which addresses financial reporting and financial statements.19 Financial reporting is also governed by the 2002 International Accounting Standards (IAS) Regulation20 which requires that the consolidated accounts of issuers admitted to trading on a regulated market be presented in accordance with International Financial Reporting Standards (IFRS). The 2014 Market Abuse Regulation (MAR) imposes ad hoc disclosure obligations on issuers as regards the disclosure of material information.21 The admission of securities to trading on a regulated market is governed by the 2014 Markets in Financial Instruments Directive II (MiFID II)/​Markets in Financial Instruments Regulation (MiFIR) regime which also addresses the specific admission requirements applicable to ‘SME Growth Markets’.22 A subset of rules continues to govern ‘official listing’ under the 2001 Consolidated Admission Requirements Directive 2001 (or Listing Directive),23 although the ‘admission to official listing’ concept has been largely overtaken by the regulated market regime. A dense administrative rulebook, and supporting ESMA soft law, amplifies these measures. The scope of each of the prospectus, transparency, market abuse, and admission regimes is not identical but is similarly designed in each case. The issuer disclosure regulatory perimeter, broadly conceived, is cast around issuers of ‘transferable securities’24 who make a public offer of their securities or who seek the admission of their securities to a regulated market in the EU and, thereafter, whose securities trade on a regulated market in the EU. The regulatory perimeter is accordingly a ‘public’ one, albeit that the marking out of the non-​regulated ‘private market’ space within which the issuer disclosure requirements do not apply is one of the key achievements of the issuer disclosure regime.25 Other offers and markets fall within the regulatory scheme to different degrees, particularly as regards the MAR ad hoc disclosure requirements and the specialist prospectus regimes available under the 2017 Prospectus Regulation. The public/​private border has over time and continues to shift, as outlined across this chapter; the pressure that the rise of digital assets is placing on the issuer disclosure perimeter is only one of a series of disruptive forces that have shaped the issuer disclosure perimeter over time. Reflecting the operation of these forces, while the

17 See section 4.3 on ‘regulated market’. 18 Directive 2004/​109/​EC [2004] OJ L390/​38, as amended by Directive 2013/​50/​EU [2013] OJ L294/​13. 19 Directive 2013/​34/​EU [2013] OJ L182/​19. 20 Regulation (EC) No 1606/​2002 [2002] OJ L243/​1. 21 Regulation (EU) No 596/​2014 [2014] OJ L173/​1. 22 Markets in Financial Instruments Directive 2014/​65/​EU [2014] OJ L173/​349 (MiFID II) and Markets in Financial Instruments Regulation (EU) No 600/​2014 OJ [2014] L173/​84 (MiFIR). 23 Directive 2001/​34/​EC [2001] OJ L184/​1. 24 See section 4.3 on ‘transferable securities’. 25 The regulatory environment for private placements (particularly of bonds) is, by and large, not considered to be problematic: BCG and Linklaters, Study for the Commission on Identifying Market and Regulatory Obstacles to the Development of Private Placement Debt in the EU (2017). The two major private placement markets in the EU are in France (the French Euro-​PP market) and Germany (the German Schuldschein Market).

70 Capital-raising issuer disclosure regime is one of the most longstanding elements of EU financial markets regulation, it has recently become highly dynamic, as outlined across the chapter. In addition, the EU issuer disclosure regime interacts with cognate legislative measures which impose additional disclosure requirements on issuers to greater and lesser degrees. The 2016 Benchmark Regulation, for example, interacts lightly with the regime, requiring certain benchmark-​related disclosures where the securities in question reference a benchmark, and the rating agency regime operates in a similar way.26 To take another example, the 2014 Packaged Retail and Insurance-​based Investment Products (PRIIPs) Regulation, which requires that a summary Key Information Document (KID) be provided for investment products, interacts with the Prospectus Regulation’s ‘summary prospectus’.27 The issuer disclosure regime also sits within an expanding ecosystem of related measures and policies that are designed to support firms’ access to funding and that have developed strongly since the adoption of the first CMU action plan in 2015. Chief among these measures are the 2019 Securitization Regulation and the 2019 Covered Bonds regime, which are designed to support capital-​raising by freeing up bank capital for lending, and the 2020 Crowdfunding Regulation, which is designed to support smaller issuers (sections 12 and 11).28 Further, the EU’s sustainable finance agenda is shaping how issuers address sustainable-​finance-​related disclosures (section 10), while the EU’s digital finance agenda, although not directly concerned with capital-​raising by issuers, is leading to the development of a parallel regime for digital assets (section 11).

II.2  Capital Markets, Issuer Disclosure, and the EU II.2.1  Capital Markets and Issuer Disclosure II.2.1.1 The Market Setting and Regulation The efficiency of the public capital markets, and the related efficacy of relevant regulation particularly mandatory issuer disclosure requirements, has been the subject of repeating cycles of debate and reform. The financial-​crisis era, for example, saw a questioning of the efficiency of the public markets in supporting funding. It did not, however, presage a retreat from policy or regulatory support of the market finance model generally as an effective means of financing firm and economic growth generally,29 notwithstanding the crystallization over the crisis-​ era of the risks that excessive intermediation, innovation, and financialization can pose to the efficiency of markets as funding mechanisms.30 Since then, the public markets have been shaped by a series of developments which have roiled markets, policy, and regulation, 26 Regulation (EU) 2016/​1011 [2016] OJ L171/​1 Art 29(2). The rating agency regime requires that a prospectus contain clear and prominent information stating whether any ratings referenced are issued by rating agencies established and registered in the EU: Regulation (EC) No 1060/​2009 [2009] OJ L302/​1 Art 4(1). 27 Regulation (EU) No 1286/​2014 [2014] OJ L352/​1. On the PRIIPs interaction see section 4.9.8. 28 Regulation (EU) 2017/​2402 [2017] OJ L347/​35; Directive (EU) 2019/​2162 [2019] OJ L328/​29 and Regulation (EU) 2019/​2160 [2019] OJ L328/​1; and Regulation (EU) 2020/​1503 [2020] OJ L347/​1, respectively. 29 eg Zingales, L, A Capitalism for the People. Recapturing the Lost Genius of American Prosperity (2012). 30 For a crisis-​era review see Moloney, N, ‘The Legal Effects of the Financial Crisis on Regulatory Design in the EU’ in Ferran, E, Moloney, N, Hill, J, and Coffee, J, The Regulatory Aftermath of the Global Financial Crisis (2012) 111.

II.2  Capital Markets, Issuer Disclosure, and the EU  71 including the massive growth in private markets and, relatedly, in the private equity funding model in the decade or so since the financial crisis, fueled by low interest rates and central bank quantitative easing measures, and the associated growth in ‘de-​listings’ from public trading venues;31 the related and explosive emergence of special purpose acquisition companies (SPACs) as vehicles for supporting public offers;32 and the impact of mass, digitally enabled retail engagement with the public markets.33 The dynamic quality of the market setting for issuer disclosure (and admission) regulation is well-​reflected in the change in market conditions across 2022, as the long-​running period of accommodative monetary policy ended, markets experienced volatility in consequence and in reaction to the outbreak of war in Ukraine, funding conditions tightened, SPAC issuances reduced,34 and funding levels dropped.35 The efficiency of the public equity markets, in particular, has shaped the debate on issuer disclosure (and admission) regulation since the financial-​crisis era. Over the financial-​ crisis period, although equity markets experienced significant losses of value,36 they did not experience particular difficulties, global contagion was limited,37 diversification proved effective,38 the equity trading market infrastructure proved resilient,39 and global equity markets began to recover in 2010.40 From 2012 to 2020, fund-​raising globally on public equity markets continued to increase, supported by accommodative monetary policy.41 The immediate aftermath of the Covid-​19 pandemic in 2021 saw public equity markets experience 31 From the extensive recent literature see Witney, S, Corporate Governance and Responsible Investment in Private Equity (2021) and Paterson, S, Corporate Reorganization Law and the Forces of Change (2020). By 2021, private equity funds were injecting significantly greater volumes of capital into public companies (and taking them private) than fund managers were, reflecting ‘a widening gap between cash-​rich buyout groups and public market investors’: Wiggins, K, ‘Private Equity Pays Record Premiums for Public Companies’, Financial Times, 6 October 2021. 32 SPACs are not trading businesses but shell companies, with a short lifespan, that raise capital through public offers in order to carry out mergers with privately held businesses; these businesses are thereby offered a cheaper route to market. Over 2020–​2021 in particular, SPAC public offerings experienced a period of almost exponential growth, although they were, at the same time, coming under closer regulatory scrutiny. See, eg, Klausner, M, Ohlrogge, M, and Ruan, E, ‘A Sober Look at SPACs’ (2020) 39 Yale J on Reg 228. See generally D’Alvia, D, Mergers, Acquisitions and International Financial Regulation. Analyzing Special Purpose Acquisition Companies (2022). 33 As the totemic Gamestop episode (considered in Chs VI section 2.2 and IX 4.9.2) made clear. For a positive analysis of the market impact of intensifying retail engagement see Pagano, M, Sedunov, J, and Velthuis, R, How Did Retail Investors Respond to the Covid-​19 Pandemic? (2021), available at . 34 2022 saw a significant reduction in SPAC activity, tied to rising interest rates, market volatility, and pending US regulatory change: Aliaj, A et al, ‘Spac Boom Dies as Wary Investors Retreat’, Financial Times, 9 June 2022. As at Q1 2022, SPACs raised $10 billion in the Americas, down from $96 billion for Q1 2021: PWC, Global IPO Watch Q1 2022 (2022). 35 Funding raised globally through the capital markets (regarded in this data-​set as equity, bond, but also loan markets) in Q1 2022 ($2.3 trillion) was significantly lower than in Q1 2021 ($3.2 trillion), a drop linked to US Federal Reserve interest rate rises and market volatility: Rennison, J, Megaw, N, and Platt, N, ‘Global Fund Raising in Capital Markets Shrinks by $900 Billion in First Quarter’, Financial Times, 1 April 2022. 36 eg Bartram, S and Bodner, G, ‘No Place to Hide: The Global Crisis in Equity Markets’ (2009) 28 J of International Money and Finance 1246. 37 Bekaert, G, Ehrmann, M, Fratzcher, M, and Mehl, A, ‘Global Crises and Equity Market Contagion’ (2014) 69 J Fin 2597. 38 Vermeulen, R, ‘International Diversification During the Financial Crisis: A Blessing for Equity Investors’ (2013) 35 J of International Money and Finance 104. 39 Financial Services Authority (FSA), The FSA’s Markets Regulatory Agenda (2010) 4 and 19 and Securities and Exchange Commission (SEC), Release No 34-​61358, Concept Release on Equity Market Structure (2010) 64. 40 In 2010, global stock market capitalization amounted to $54 trillion, up from $34 trillion in 2008, although down from $65 trillion in 2007: McKinsey, Mapping Global Financial Markets (2011) 2. 41 In 2012 $142 billion (728 initial public offerings (IPOs) and subsequent offers) was raised in the public markets. This had grown to $209 billion (1,523 offers) by 2017 and to $331.3 billion (1,415 offers) by 2020: PWC, Global IPO Watch Q1 2021 (2021) (the data covers offerings in excess of $5 million).

72 Capital-raising historic highs, driven by deep liquidity as monetary policy accommodations continued, growth in the ‘tech’ sector and the explosion in SPAC offerings, and easier access to household capital through online platforms,42 although 2022 saw a reduction in funding levels, associated with higher volatility.43 Despite the strength of the public equity markets since the financial crisis, they have nonetheless drawn policy concern as capital-​raising has, in tandem, been moving to the private markets,44 notwithstanding the advantages of the public equity markets, including as regards risk management and diversification and for mobilizing household savings.45 In the UK, for example, the 2012 Kay Review and the 2021 Hill/​Listing Review, each of which addressed the public equity markets, bookended an almost decade-​long period over which private markets expanded and public offers and related admissions to trading weakened.46 In the EU, the CMU agenda, in its 2015 and 2020 iterations, has underlined the persistent weaknesses in the EU’s public equity markets.47 Issuer disclosure regulation is only one of the many variables that drive public capital-​raising, but it has come to the forefront in the EU and the UK debates. While situated in different institutional contexts, the 2021 Hill/​ Listing Review and the 2015 and 2020 CMU Action Plans share a concern that the regulation of the public markets is not sufficiently agile or flexible. Similarly in the US, despite recent strong growth in public equity markets following a period of decline prior to the financial crisis in particular,48 concerns persist as to the efficacy of the public markets.49 Regulatory reform in this sphere is not straightforward, particularly as the relationship between market development and regulation is not clear, as noted in Chapter I. It is, however, clear that regulation of the public markets, and by means of issuer disclosure requirements, requires multiple and intricate design decisions. In particular, it requires decisions as to the appropriate design of the regulatory perimeter and as to how public and private markets are to be differentiated. The ‘public offer’, however defined, is typically the main perimeter for issuer disclosure regulation, along with the major trading venues which admit securities to trading. Private markets—​which can encompass, for example, private placements and private equity transactions—​typically operate outside the main regulatory perimeter, given the substitutes in these markets for mandatory issuer disclosures

42 eg early 2021 saw the number of IPOs globally running at the highest level in two decades (excluding SPACs): EY, Global IPO Market Summary Q1 (2021). 43 Q1 2022 saw $56.1 billion raised in IPOs in the public markets, down on the historic high of $212.4 billion recorded for Q1 2021, but still ahead of the pre-​pandemic five-​year average ($32.3 billion): PWC, Global IPO Watch Q1 2022 (2022). 44 For an initial post-​crisis perspective in the EU see European IPO Task Force, Rebuilding IPOs in Europe (2015). 45 eg Zingales, L, ‘The Future of Securities Regulation’ (2009) 47 J of Accounting Research 391 and Thomson, R, ‘The SEC after the Financial Meltdown: Social Control over Finance’ (2009) 71 University of Pittsburgh LR 567. 46 The UK Listing Review (2021) (also known as the Hill Review); and the Kay Review of UK Equity Markets and Long-​Term Decision Making (2012). 47 One CMU-​related report suggested that the ongoing decline in EU public equity markets implied a ‘partial eclipse of the public corporation’: Oxera, Primary and Secondary Equity Markets (2020), reporting on a 12 per cent decline in share listings (admissions to trading venues) over 2010–​2018, alongside a 24 per cent growth in GDP (at 12). Similarly, the Commission’s 2021 assessment of market finance reported that while reliance on market-​finance-​based funding sources (listed shares and bonds) had increased (if slowly) over 2015–​2019, this was a function of increased reliance on bonds, given ongoing contraction in the public equity markets: Commission, Monitoring Progress Towards CMU: a tool-​kit of indicators (SWD(2021) 544) 15–​18. See also section 13. 48 eg Weild, D and Kim, E, Market Structure is Causing the IPO Crisis. Grant Thornton Paper (2010). 49 Committee on Capital Market Regulation, Reforming US Capital Markets to Promote Economic Growth (2021).

II.2  Capital Markets, Issuer Disclosure, and the EU  73 and the dominance of sophisticated investors.50 This perimeter can, however, be difficult to fix,51 and, if not fixed correctly, can weaken the efficacy of the public markets in supporting market finance by imposing disproportionate regulatory costs, as illustrated by the 2017 Prospectus Regulation’s ‘EU Growth Prospectus’ reform which is designed to facilitate SMEs, and by the 2022 Listing Act reform agenda.52 A range of factors are now placing increasing pressure on the traditional public market perimeter within which full-​scale issuer disclosure is required. These include the longstanding but ongoing institutionalization of public equity markets and, in particular, the growth of exchange-​traded funds (ETFs), which may reduce the need for full-​scale disclosure;53 and, conversely, the digitalization of the channels through which private markets can reach household capital, which may call for enhanced disclosure in the private markets.54 Ultimately, concentric perimeters may come to characterize how issuer disclosure rules apply, particularly given current concerns to ensure issuer disclosure regimes are agile and flexible and supportive of SMEs. While very different measures and initiatives, the US 2012 JOBS Act (which brought the most radical deregulation of US disclosure regulation since the 1930s),55 the UK’s 2021 Listing Review and related Prospectus Regime Review,56 and the EU’s 2017 Prospectus Regulation and 2022 Listing Act reform agenda, form a continuum, being concerned, albeit in different ways, with facilitating issuers, with modernizing and calibrating disclosures to the features of different markets and issuers, and, thereby, with supporting the public equity markets. In addition, the emergence of digital finance is exerting further pressure on the perimeter for issuer disclosure, engaging debate as to how or if new instruments should be brought within the regulated space (section 11). Beyond perimeter design, issuer disclosure continues to grapple with foundational questions as to the processability of disclosure, as well as with the ever-​changing challenges that wider socio-​economic change and related market innovations bring, including as regards the green transition (section 10). The regulatory design challenges are therefore considerable.

II.2.1.2 The Issuer Disclosure Debate While its market setting is dynamic, mandatory issuer disclosure has, however, long been the linch pin of the regulation of the public fund-​raising markets. Very broadly, two related rationales can be associated with mandatory issuer disclosure. In the primary markets, in

50 eg Langevoort, D and Thompson, R, ‘Publicness in Contemporary Securities Regulation after the JOBS Act’ (2013) 101 Georgetown LJ 337. 51 In the context of the growth of private markets in the US see de Fontenay, E and Rauterberg, G, ‘The New Public/​Private Equilibrium and the Regulation of Public Companies’ (2021) Co Bus LR 1199. 52 See n 144. 53 For a US perspective see Hu, H and Morley, J, ‘A Regulatory Framework for Exchange-​Traded Funds’ (2018) 91 So Cal LR 839 and Langevoort, D, ‘The SEC, Retail Investors, and the Institutionalization of the Securities Markets’ (2009) 95 Va LR 1025. 54 Such as the growth, particularly since the financial-​crisis era, of crowdfunding platforms. For an assessment of crowdfunding from 2012–​2019 see Rossi, A, Vanacker, T, and Vismara, S, Equity Crowdfunding: New Evidence from US and UK Markets (2021), available via . 55 The Act was designed to reduce the regulatory costs of emerging growth companies by, eg, facilitating IPOs for companies with under $1 billion in revenue, allowing smaller companies to benefit from lighter regulation for the first five years following their public offering (the ‘on ramp’ provisions), and addressing crowdfunding. See Langevoort and Thompson, n 50. Some ten years on, there is some doubt that it has succeeded (see, eg, Even-​Tov, O, Patatoukas, P, and Yoon, Y, The JOBs Act did not raise IPO Underpricing (2021), available via . 56 nn 46 and 10.

74 Capital-raising which the issuer sells securities to investors, issuer disclosure serves to address the information asymmetry between the issuer (and its advisers) and the investor, reduce the risk of fraudulent sales of over-​valued securities, and support the issuer in signalling its quality.57 In the secondary markets, where securities subsequently trade between investors, issuer disclosure is primarily associated with reducing the information costs associated with the market mechanisms that drive efficient pricing of securities, although it is also associated with the support of efficient corporate governance and with remedying the agency problems of dispersed (and of block-​holding) firms.58 Policymakers and regulators have rarely shown any weakening of their commitment to mandatory issuer disclosure (albeit that regulatory perimeter changes and processability-​ related reforms are frequent).59 Nonetheless, a lively debate continues to consider the optimality of mandatory issuer disclosure.60 This debate was initially most strongly associated with the US Securities and Exchange Commission’s (SEC’s) issuer-​disclosure regime (adopted in the wake of the 1929 Wall Street Crash and the inspiration for many regimes globally), in relation to which the debate—​initially framed in terms of the costs which the foundational 1933 Securities Act and 1934 Securities Exchange Act imposed on issuers—​ first took root over the 1960s and 1970s.61 Through the 1980s, scholarship was framed by the then-​ascendant market efficiency theory and grappled with the question of whether mandatory issuer disclosure supported market efficiency mechanisms and led to stronger resource allocation.62 The debate still rages and continues to widen, engaging with, inter alia, the challenge which the evidence from behavioural finance as to the prevalence of biases and heuristics poses to market efficiency and so to mandatory issuer disclosure;63 the risks 57 Investors in the public primary markets do not benefit from the price-​setting mechanisms provided by liquid secondary securities markets, as primary-​market prices are established by the issuer and the underwriters who sell the securities on the issuer’s behalf: Scott, H, ‘Internationalization of Primary Public Securities Markets’ (2000) 63 Law and Contemporary Problems 71. 58 Mahoney, P, ‘Mandatory Disclosure as a Solution to Agency Problems’ (1995) 62 University of Chicago LR 1047. 59 eg large-​scale reforms are likely in the UK as it adjusts its regulatory regime post-​Brexit, particularly as regards removing the prospectus requirements for public offers generally (the new regime will, however, prohibit public offers unless an appropriate exemption, such as admission to a regulated market (which may require a prospectus), is available); and allowing the UK regulator (the FCA) discretion as to the extent to which a prospectus is required for admissions to regulated markets, particularly as regards repeat issuers where disclosure is already available: 2022 Prospectus Regime Review, n 10. 60 This debate is noted only in broad outline here. For review and reconsideration see, eg, Enriques, L and Gilotta, S, ‘Disclosure and Financial Market Regulation’ in Moloney, N, Ferran, E, and Payne, J (eds), The Oxford Handbook of Financial Regulation (2015) 511; Ben-​Shahar, O and Schneider, C, ‘The Failure of Mandated Disclosure’ (2011) 159 U Pa LR 647; and Goshen, Z and Parchomovsky, G, ‘The Essential Role of Securities Regulation’ (2006) 55 Duke LJ 711. For a recent review, in light of market demand for ‘safe assets’ (such as securitized debt) which can be regarded as ‘information insensitive’ as regards the underlying issuer see Judge, K, ‘The New Mechanisms of Market Efficiency’ (2020) 45 J of Corp Law 915. 61 For two seminal empirical challenges see Bentson, G, ‘Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act 1934’ (1973) 63 Amer Econ Rev 132 and Stigler, G, ‘Public Regulation of the Securities Markets’ (1964) 37 J of Business 117. 62 For a major contribution in support of mandatory disclosure and based on the role mandatory disclosure plays in economizing the information costs of market-​efficiency mechanisms such as investment analysts see Coffee, J, ‘Market Failure and the Economic Case for a Mandatory Disclosure System’ (1984) 70 Va LR 717. 63 From the ‘first generation’ legal literature see, eg, Gilson, R and Kraakmann, R, ‘The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias’ (2003) 28 J Corp L 715; Stout, L, ‘The Mechanisms of Market Efficiency: An Introduction to the New Finance’ (2003) 28 J Corp L 635; and Langevoort, D, ‘Taming the Animal Spirits of the Stock Markets: A Behavioural Approach to Securities Regulation’ (2002) 97 NorthWestern University LR 135. A vast literature, extending from finance to psychology and beyond, now examines the nature of rationality in the capital markets. For a recent review from a policy perspective see IOSCO, The Application of Behavioural Insights to Retail Investor Protection (2019).

II.2  Capital Markets, Issuer Disclosure, and the EU  75 associated with the supporting institutional structure for mandatory issuer disclosure, including informational intermediaries such as auditors and investment analysts;64 the ability of mandatory issuer disclosure to deal with innovation and complexity;65 and, as noted earlier in this section, the appropriate perimeter design for mandatory issuer disclosure given, inter alia, the growth in private markets, the dynamics of ‘start up’ tech funding,66 the rise of digital assets,67 and the green finance agenda.68 A very brief overview of the debate follows to contextualize the EU regime, although the EU’s commitment to mandatory issuer disclosure has always had distinct drivers, chief among them the market-​integration imperative and the related commitment to harmonization. With respect to mandatory issuer disclosure in the primary markets, while mandatory issuer disclosure (prospectus) requirements for public offers/​admissions to trading venues (both primary market activities) are a longstanding feature of financial markets regulation, an extensive scholarship has queried their purpose. The supporting argument for such mandatory requirements relates to the need to address market failures in the form of information asymmetries. Securities are intangible assets whose value is contingent on the future performance of the issuer; they are ‘credence goods’, in that their quality cannot be assessed easily in advance and their ex-​post effects can take some time to emerge. Information is accordingly essential to an informed investment decision,69 but there are severe information asymmetries between the issuer (and its underwriter(s)) and the investor, which place the investor at risk of fraud but also of poor resource allocation. Mandatory disclosure is claimed to expose the risks of fraud and to support efficient resource allocation by requiring extensive disclosures relating to the issuer as, in the absence of such mandatory requirements, issuers (and more specifically their managers) may have incentives to suppress unfavourable information, manipulate information, or under-​disclose (particularly as the ‘public good’ quality of information is likely to obstruct information flows).70 Relatedly, the costs and complexities of privately contracting for disclosure, and of associated private 64 eg Leyens, P, ‘Intermediary Independence: Auditors, Financial Analysts and Rating Agencies’ (2011) 11 JCLS 33. 65 Hu, T, ‘Too Complex to Depict? Innovation, “Pure Information,” and the SEC Disclosure Paradigm’ (2012) 90 Texas LR 1601, examining the impact on disclosure regulation of financial and technological innovation and the challenges they pose to the classic ‘intermediary (issuer) depiction model’ of corporate disclosure. For a defence of issuer disclosure against charges of obsolescence in the face of complexity see Gerding, E, ‘Disclosure 2.0: Can Technology Solve Overload, Complexity, and Other Information Failures?’ (2016) 90 Tulane LR 1143. 66 eg Langevoort, D and Sale, H, ‘Corporate Adolescence: Why did “We” not Work’?’ (2021) Georgetown Law Faculty Publications and Other Works 2343, using the ‘WeWork’ case study to explore the rent-​seeking behaviours that can arise where regulatory (disclosure) and governance systems are not sufficiently attuned to the risks of start-​up funding; and Fox, M, ‘Regulating Public Offers of Truly New Securities: First Principles’ (2016) 66 Duke LJ 673, querying whether exemptions from disclosure requirements are the optimal means for addressing, eg, the costs faced by smaller firms. 67 eg, challenging the carry-​over of the issuer disclosure model to digital/​crypto-​assets under the EU’s ‘MiCAR’ (Markets in Crypto-​Assets Regulation) regime, given the power of incentives in digital asset markets, see Ferrarini, G and Giudici P, ‘Digital Offerings and Mandatory Disclosure: A Market-​Based Critique of MiCA’ (2022) Special Edition 5 ECFR 87. As outlined in Ch I section 7.3, this book does not address crypto-​assets which will be subject to a discrete EU rulebook under MiCAR (on which provisional agreement was reached in June 2022). 68 eg, for a sceptical view on whether mandatory issuer disclosure can, given its challenges, support the development of green finance, and supporting instead direct interventions such as carbon taxes, see Tröger, T and Steuer, S, ‘The Role of Disclosure in Green Finance’ (2022) 8 J Fin Reg 1. See further section 10. 69 Ogus, A, Regulation. Legal Forms and Economic Theory (1994) 138–​41. 70 The ‘public good’ nature of information—​the fact that it becomes public once disseminated, that use of information by one person does not lower its value to others, and that suppliers of information cannot easily control free-​riding on information or restrict its dissemination to those who will directly or indirectly pay for it—​means that suppliers of information are not given adequate incentives to supply it. See Ogus, n 69, 33–​5, and 40.

76 Capital-raising enforcement, are significant. Mandatory disclosure also, goes the supporting argument, facilitates issuers. In the absence of mandatory disclosure requirements, even where an issuer produces optimal disclosures for investors and sells high-​quality securities, it remains exposed to risks: rational investors should discount an investment where they cannot clearly identify the issuer as a high-​quality issuer; and this risk can arise where the market contains poor-​quality issuers, the standard and quality of information across the market is variable, and it is difficult for high-​quality issuers to signal their quality.71 One response to this difficulty is a merit or substantive assessment of the securities by a trusted entity but merit regulation has never been mainstream in this sphere.72 Criticism of mandatory disclosure in the primary markets flows from the significant transaction costs it imposes on issuers and doubts as to its value.73 Rational investors, goes the counter-​argument, should discount securities where less disclosure is available. Issuers should, accordingly, have strong incentives to provide disclosures, to reduce their cost of capital;74 and in so doing, issuers are supported by informational intermediaries, such as auditors, analysts, and rating agencies, which can lend their reputational capital to issuers by certifying or branding the issuer’s disclosures or securities.75 Further, legally mandated rules, such as issuer disclosure requirements, run the efficiency, capture, and other risks attendant on law-​making generally In the secondary markets, the imperative to protect investors against opportunistic issuers (and their management) which drives primary market disclosure also shapes mandatory issuer disclosure requirements. But secondary market issuer disclosure is additionally, and strongly, associated with the support of an efficient securities pricing mechanism and with market efficiency generally. Where the secondary markets price securities efficiently, they should also allocate scarce capital, and so support the achievement of returns and optimal risk management/​diversification, efficiently. But efficient securities pricing is dependent on efficient information transmission. Mandatory issuer disclosure, however, is argued to support securities pricing efficiency by working in tandem with the informational efficiency dynamics which markets display, as explained by the Efficient Capital Markets Hypothesis (ECMH).76 Under the ECMH, securities prices are assumed to efficiently reflect all publicly available information,77 and where distorting irrationalities arise as to how information is processed, they are assumed to be corrected by arbitrage mechanisms. Mandatory issuer disclosure economizes the information costs associated with the 71 As predicted by the famous ‘lemons’ hypothesis: Akerlof, G, ‘Market for Lemons: Quantitative Uncertainty and the Market Mechanism’ (1970) 222 Q J Econ 488. 72 For a foundational analysis see Douglas, W, ‘Protecting the Investor’ (1934) 23 Yale LJ 521. 73 eg Macey, J, ‘A Pox on Both Your Houses: Enron, Sarbanes-​Oxley and the Debate Concerning the Relative Efficiency of Mandatory Versus Enabling Rules’ (2003) 81 Washington University LQ 329; Romano, R, ‘Empowering Investors: A Market Approach to Securities Regulation’ (1998) 107 Yale LJ 2359; and Easterbrook, F and Fischel, D, ‘Mandatory Disclosure and the Protection of Investors’ (1984) 70 Va LR 1335. 74 eg Romano, n 73. 75 eg Goshen and Parchomovsky, n 60. 76 The seminal discussion is in Fama, E, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ (1970) 25 J Fin 1575. 77 Under the ECMH, the market price of securities in active, liquid markets, which are well followed by analysts, should reflect all publicly available information about that security. It predicts quick (informationally efficient) and accurate (allocatively efficient) pricing responses to information. ‘The power of this statement [Fama’s ECMH] is dazzling . . . In plain English, an average investor cannot hope to consistently beat the market, and the vast resources that such investors dedicate to analysing, picking and trading securities are wasted. Better to passively hold the market portfolio, and to forget active money management altogether. If the EMH holds, the market truly knows best’: Shleifer, A, Inefficient Markets (2000) 1.

II.2  Capital Markets, Issuer Disclosure, and the EU  77 institutional mechanisms that support such market efficiency,78 notably analysis by investment analysts,79 by requiring and standardizing issuer disclosures, and supports, thereby, the securities pricing mechanism. The extent to which mandatory issuer disclosure supports price formation and market efficiency is contested. In particular, the ECMH, which supports the case for mandatory issuer disclosure, has faced sustained challenge given well-​documented evidence of failures in arbitrage mechanisms and of pervasive and systemic biases which distort rational investor decision-​making and, accordingly, the efficiency of the price-​formation process.80 The case against the ECMH received a considerable fillip in the wake of the early 2000s/​ dotcom-​era totemic Enron collapse and the evidence that disclosures on Enron’s impending and massive bankruptcy were publicly available but had not been processed through the mechanisms thought to drive price formation and market efficiency, particularly information intermediaries such as analysts.81 The financial crisis placed the ECMH, market efficiency, and associated rationality assumptions under further pressure.82 Certainly, mandatory disclosures—​issuer-​facing and otherwise—​failed to extend to the range of markets and securities implicated in the crisis,83 market-​driven disclosures did not support market discipline,84 and pricing mechanisms did not predict the scale of the crisis which was to unfold. Nonetheless, notwithstanding its flaws, the ECMH remains regarded as a reasonably robust explanation for pricing dynamics in the secondary markets, and a justifiable support for mandatory issuer disclosure requirements,85 particularly given empirical evidence supporting a link between mandatory issuer disclosure and lower costs of capital for issuers.86 Mandatory issuer disclosure is generally assumed to be primarily concerned with market efficiency and with addressing information-​related market failures. But it is also associated, if primarily in regulatory and policy discussions, with retail investor protection,87 and with the related promotion of the elusive notion of investor confidence:88 the EU’s prospectus 78 The relationship between mandatory issuer disclosure and market efficiency dynamics was subject to a famous critique in 1984 by Gilson and Kraakmann: Gilson, R and Kraakmann, R, ‘The Mechanisms of Market Efficiency’ (1984) 70 Va LR 549. 79 Coffee, n 62. 80 See, eg, the references at n 63 and Barr, M, Mullainathan, S, and Shafir, E, ‘The Case for Behaviorally Informed Regulation’ in Moss, D and Cistrenino, J (eds), New Perspectives on Regulation (2009) 25. 81 See, eg, Prentice, R, ‘Whither Securities Regulation? Some Behavioural Observations Regarding Proposals for the Future’ (2002) 51 Duke LJ 1397. 82 See, eg, Hu, H, ‘Efficient Markets and the Law: A Predictable Past and an Uncertain Future’ (2012) 2 Ann Rev of Financial Economics 179; Lo, A, ‘Adaptive Markets and the New World Order’ (2012) 68 Financial Analysts J 18; and Avougleas, E, ‘The Global Financial Crisis, Behavioural Finance and Financial Regulation in Search of a New Orthodoxy’ (2009) 9 JCLS 23. 83 See, eg, Fisch, J, ‘Top Cop or Regulatory Flop—​the SEC at 75’ (2009) 95 Va LR 785. 84 Generally, Schwarcz, S, ‘Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown’ (2008) 93 Minnesota LR 373 and Schwarcz, S, ‘Regulating Complexity in Financial Markets’ (2009) 87 Washington University LR 211. 85 For a call for the ECMH to be given a more modest (but still important) role in policy formation, rooted in informational efficiency (rather than fundamental market efficiency) see Gilson, R and Kraakman, R, ‘Market Efficiency After the Financial Crisis: It’s Still a Matter of Information Costs’ (2014) 100 Va LR 313 and, similarly, North, G and Buckley, R ‘A Fundamental Re-​Examination of Efficiency in Capital Markets in Light of the Global Financial Crisis’ (2010) 33 UNSW LJ, suggesting the ECMH remained sound after the financial crisis, but calling for a refocusing and for the impact of regulation on the real economy to be assessed. 86 eg Hail, L and Leuz, C, ‘International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?’ (2006) 44 J of Accounting Research 485. 87 Although famously, Easterbrook and Fischel castigated the notion that securities market rules are necessary to protect investors as unsophisticated as the investors they are supposed to protect (n 73). 88 The link between investor confidence and the federal US mandatory disclosure system has long reflected a deep-​rooted SEC policy concern to protect household investors. See Langevoort, D, Selling Hope, Selling Risk.

78 Capital-raising regime has long linked harmonization in this area with retail investor protection and related investor confidence.89 This troublesome rationale for intervention assumes retail investors read and understand mandatory issuer disclosures, although the mandatory disclosures issuers are required to publish are generally accepted to exceed retail investors’ well-​documented limited capacity to absorb information.90 Retail-​market-​oriented justifications are also vulnerable to significant law-​making risks as they carry considerable political weight once a tipping point is reached91 and, in particular, can entrench costly assumptions as to the role and design of mandatory disclosure.92 This risk has been a perennial feature of EU regulatory design in this area.

II.2.2  Issuer Disclosure and the EU: Market Finance and Market Integration The EU issuer disclosure regime reflects the major objectives that shape issuer disclosure regimes internationally, although its animating imperatives of embedding market finance and of supporting market integration can obscure the extent to which the traditional objectives of issuer disclosure regulation are articulated. As regards the market finance imperative, and as noted in Chapter I, capital-​raising by firms in the EU is typically associated with bank finance, rather than with market finance, reflecting the interplay across EU economies of the institutional forces that shape different varieties of capitalism. Given these forces and the gravitational pull of their institutional settings, caution is needed in ascribing significant transformative effects to EU issuer disclosure regulation. A similar need for caution can be inferred from the law and finance literature which underlines the complex and dynamic relationship between law and markets; law is clearly a determinative variable in how markets develop, but it is only one of many.93 The limits of regulatory reform are being more openly acknowledged in the EU policy debate, with the 2020 CMU Action Plan accepting that building CMU will take time and noting that history, customs, and culture have shaped longstanding barriers to market finance in the EU.94 Nonetheless, the promotion and support of market-​based financing by firms, recently expressed in the call in the 2020 CMU Action Plan for a more stable equity-​based funding Corporations, Wall Street and the Dilemmas of Investor Protection (2016) and Choi, S, ‘Regulating Investors not Issuers: A Market-​Based Proposal’ (2000) 88 Cal LR 279. 89 The promotion of investor confidence through disclosure, and the consequent benefits in terms of market integration and investor protection, were key drivers of the Commission’s approach to what would become the foundational 2003 Prospectus Directive: Revised 2003 Directive Prospectus Proposal (COM(2003) 460) 6. 90 From an extensive literature see, eg, Paredes, T, ‘Blinded by the Light: Information Overload and its Consequences for Securities Regulation’ (2003) 81 Washington University LQ 417 and Langevoort, D, ‘Towards More Effective Risk Disclosure for Technology-​Enhanced Investing’ (1997) 75 Washington University LQ 753. 91 See Kastner, L, ‘Much Ado About Nothing?’ Transnational Civil Society, Consumer Protection and Financial Regulatory Reform’ (2014) 21 Rev of IPE 1313 and Langevoort, D, ‘Structuring Securities Regulation in the European Union: Lessons from the US Experience’ in Ferrarini, G and Wymeersch, E (eds), Investor Protection in Europe: Corporate Law Making, the MiFID and Beyond (2006) 485. 92 eg, Langevoort, n 91. 93 See, eg, Deakin, S et al, ‘Legal Institutionalism: Capitalism and the Constitutive Role of Law’ (2017) 45 J Comp Econ 188. 94 2020 CMU Action Plan, n 12, 2.

II.2  Capital Markets, Issuer Disclosure, and the EU  79 structure for the EU as it emerges from the Covid-​19 pandemic and for a fully functioning and integrated market for capital,95 has been entrenched in EU regulatory policy for some sixty years. The 2020 CMU Action Plan forms a continuum with the seminal 1966 Segré Report,96 which found that the financing of economic growth was dependent on the capital markets; reported that there was a shortage of equity capital, that action was needed to increase investment by institutional investors, and that establishing a wider capital market would offer new and varied sources of funding and ultimately increase the supply of capital; and supported harmonization of issuer disclosure requirements accordingly. The 2020 CMU Action Plan also finds echoes in what is, in some ways, the ‘creation document’ of the now behemoth single rulebook: the 1977 Code of Conduct on Transactions in Transferable Securities,97 which called for sufficient and diversified sources of capital to enable investment and recommended mandatory disclosures for publicly offered and ‘listed’ securities.98 The synergies between these early measures and the 2020 CMU Action Plan are remarkable: the Action Plan’s focus on the post-​pandemic recovery and on supporting a digital and sustainable economy could hardly have been predicted in 1966 or in 1977, but the Action Plan nonetheless shares with the Segré Report and the Code of Conduct a concern to wean the EU economy from bank lending, to build well-​functioning, deep, and integrated capital markets, and to deploy regulatory levers to do so. Similarly, the liberalization-​oriented focus of the subsequent 1999–​2004 FSAP reform period, which led to the adoption of the foundational 2003 Prospectus Directive which established prospectus passporting, gave way to the precautionary and stability-​oriented financial-​crisis era (2008–​2014) which was primarily concerned with intermediation, but funding capacity remained a concern. The Commission’s crisis-​era 2013 Green Paper on the Long-​Term Financing of the Economy addressed the crisis-​era contraction in bank-​based funding and concerns as to the capacity of EU capital markets to provide effective alternative source of funding, and laid the foundations for what would become the first (2015) CMU Action Plan.99 Since the adoption of that Action Plan, which led to the 2017 Prospectus Regulation, the policy focus has remained sharply trained on the capacity of EU capital markets to support funding, particularly for SMEs, and on related regulatory reform, as evident from the 2020 CMU Action Plan and the 2022 Listing Act reform agenda. The EU issuer disclosure regime is also, and relatedly, designed to support cross-​ border capital-​raising and thereby market integration. It is axiomatic that mandatory issuer disclosure requirements impose costs on issuers. This cost burden intensifies in the cross-​border context given the costs of compliance with multiple disclosure regimes and

95 2020 CMU Action Plan, n 12, 2. 96 Report by a Group of Experts Appointed by the EEC Commission, The Development of a European Capital Market (1966). 97 Commission Recommendation 77/​534/​EEC concerning a European Code of Conduct relating to transactions in transferable securities [1977] OJ L212/​37, para 1. Advocate General Jacobs read the Code as supporting the construction of a regulatory framework to ‘encourage investment, and so enable the securities markets to perform their economic function, namely the efficient allocation of resources’: Case C-​384/​93 Alpine Investments v Minister van Financiën (ECLI:EU:C:1995:126), Opinion of the AG, para 76. 98 The ‘listing’ process relates to admission to trading venues, typically to the most heavily regulated segment of a trading venue. See section 8. 99 Commission, Green Paper. Long-​Term Financing of the European Economy (COM(2013) 150/​2), which was followed by Commission, Communication on Long-​Term Financing of the European Economy (COM(2014) 168). 2015 saw the launch of the CMU agenda.

80 Capital-raising related liability and litigation risks. Accordingly, and given the benefits of cross-​border capital-​raising,100 regulators worldwide have long grappled with the treatment of multi-​ jurisdictional offers. The techniques used range from mutual recognition,101 to convergence of standards (notably to those standards which the International Organization of Securities Commissions (IOSCO) has adopted),102 to ‘substitute compliance’.103 The management of cross-​border issuer disclosure reaches its apotheosis, however, in the EU’s sophisticated passport-​based mutual recognition regime for prospectuses, which is based on dense rule harmonization which supports home Member State/​national competent authority (NCA) control. As with the commitment to supporting market finance, the promotion of market integration has long been a touchstone of EU issuer disclosure regulation. The 1966 Segré Report presciently set out a proposed ‘model prospectus’ for public issues and stock exchange admission which, foreshadowing by over twenty years the mutual-​recognition device originally trialled in the late 1980s for prospectuses, was based on the adoption of minimum standards which would allow Member States discretion to adopt additional requirements.104 By 1977, however, the position was that ‘there cannot be said to be any wide, unified securities market: lack of transparency, unfamiliarity with other markets or pure absence of interest contribute to this fragmentation’.105 Progress remained slow over the 1980s, notwithstanding, inter alia, technological enhancements to trading and to information dissemination, the growth of the investment fund industry, issuance innovations such as the development of depositary receipts which represent an issuer’s shares and facilitate foreign offerings, the dismantling of exchange controls, and early efforts to harmonize issuer disclosure.106 The empirical case for integration was not made out in any detail until the FSAP-​era, in particular by the 2002 London Economics Report107 which found that debt and equity market integration should result in a 40 basis points decrease in the cost of equity capital and debt financing driven by, inter alia, larger markets for high-​risk capital, lower required rates of return (following from increased diversification opportunities), access to a wider pool of investors, and better information flows. Following the FSAP-​prompted adoption of the 2003 Prospectus Directive and its related passport, a facilitative regulatory system was finally put in place. In addition, the regulatory competition debate, which 100 An extensive literature considers the regulatory treatment of multi-​jurisdictional offerings and the value of admissions to trading venues internationally. For an early review see Jackson, H, ‘Centralization, Competition, and Privatization in Financial Regulation’ (2001) 2 Theoretical Inquiries in Law 649. 101 Examples include the Asean Disclosure Standards which support mutual recognition across Singapore, Malaysia, and Thailand; the Trans-​Tasman Issuer Disclosure System (New Zealand/​Australia); and the US/​Canada Multi-​Jurisdictional Disclosure System. 102 Namely, IOSCO, International Disclosure Standards for Cross-​Border Offerings and Initial Listings by Foreign Issuers (1998); International Disclosure Principles for Cross-​Border Offerings and Listings of Debt Securities by Foreign Issuers (2007); and Principles for Periodic Disclosure by Listed Entities (2010). 103 Substitute compliance was trialled by the SEC prior to the financial crisis and was based on allowing third country actors access to the US market following a determination that the third country regulatory, supervisory, and enforcement regime was broadly equivalent to the US regime in practice: Jackson, H, ‘Substituted Compliance: the Emergence Challenges and Evolution of a New Regulatory Paradigm’ (2015) 1 J of Fin Reg 169. 104 n 96, 231. 105 Wymeersch, E, Control of Securities Markets in the European Economic Community. Collection Studies. Competition—​Approximation of Legislation Series No 31 (1977) 117. 106 From the earlier literature see, eg, Warren, G, ‘The Common Market Prospectus’ (1989) 26 CMLR 687 and Merloe, P, ‘Internationalization of Securities Markets: A Critical Survey of US and EEC Disclosure Requirements’ (1986) 8 J Com Bus and Capital Markets L 249. 107 London Economics, Quantification of the Macro-​Economic Impact of Integration of EU Financial Markets. Final Report to the EU Commission (2002).

II.2  Capital Markets, Issuer Disclosure, and the EU  81 animated the early evolution of the EU issuer disclosure regime and which, drawing inspiration from the US issuer disclosure debate,108 placed the merits of a competition between jurisdictions for issuer business as a means for reducing the transaction costs of diverging regimes in contrast with the costs of harmonization, began to recede.109 Subsequently, the sharp turn the EU took towards uniformity and the construction of a single rulebook after the financial crisis, the further entrenchment of political and market support for the single rulebook as the CMU agenda rolled out, and the institutional technology now available to the EU through the European Securities and Markets Authority (ESMA) to amplify and finesse the rulebook through administrative law and soft law, all rendered the regulatory competition model largely irrelevant in the issuer disclosure context, as well as more generally. The move under the 2017 Prospectus Regulation towards operationalizing the issuer disclosure regime and its passporting arrangements through harmonization of the supervisory process underlines the extent to which the issuer disclosure regime sits within an EU framework. The market finance/​market integration project remains, however, incomplete, with the 2020 CMU Action Plan warning of persistent barriers to a well-​functioning, integrated capital market, including as regards supervision, taxation, and insolvency rules. Nonetheless, progress has been made.110 Levels of market finance (regarded in terms of listed shares and bonds) drawn on by non-​financial corporations (NFCs) are increasing, from 38 per cent of funding in 2011 to 42.8 per cent in 2019, albeit that growth since the launch of the first CMU Action Plan in 2015 has been slow (from 42.1 per cent in 2015 to 42.8 per cent in 2019).111 This growth has primarily driven by bond funding, which has developed from being a substitute for bank funding over the financial-​crisis period, to becoming a ‘fully-​fledged’ component of market funding for NFCs.112 Reflecting global trends, and particularly in the US and UK, reliance on public equity markets has not developed as strongly. Notwithstanding higher valuations over 2015-​2019, de-​listings and share buybacks increased over this period, with private equity a significant source of funding.113 Integration levels have, however, strengthened, with the home bias in investments reducing, if slowly.114

108 See, eg, Romano, n 73; Cox, J, ‘Regulatory Duopoly in US Securities Markets’ (1999) 99 Col LR 1200; and Fox, M, ‘Securities Disclosure in a Globalizing Market: Who Should Regulate Whom’ (1997) 95 Mich LR 2498. 109 On regulatory competition in the EU context see, eg, see Schammo, EU Prospectus Law (2011) and Jackson, H and Pan, E, ‘Regulatory Competition in International Securities Markets: Evidence from Europe in 1999—​Part I’ (2001) 56 The Business Lawyer 653. For an early endorsement of the harmonization model see Buxbaum, R and Hopt, K, Legal Harmonization and the Business Enterprise (1988) finding that, by comparison with the company law harmonization programme, ‘legal harmonization measures that open up national capital markets or pave the way to a European capital market make a much clearer contribution to European integration’ (at 2). 110 2020 CMU Action Plan, n 12, 2. 111 2021 Commission CMU Indicators Report, n 47, 15–​17 and 57–​60. The subsequent 2022 CMU Indicators Update also reported on strengthening recourse to market finance, reporting, inter alia, on a significant increase in IPOs in 2021 (reflecting global trends): Commission, Overview of CMU Indicators –​July 2022 Update (2022). 112 2021 Commission CMU Indicators Report, n 47, 34 and 54. 113 2021 Commission CMU Indicators Report, n 47, 18, noting ‘no positive contribution through listed shares’ to the growth in market funding over 2015–​2019. 114 2021 Commission CMU Indicators Report, n 47, 48–​49 (noting the average bias in holding domestic equity and bonds relative to EU equity and bonds declining from 80 per cent in 2015 to 76 per cent in 2019, albeit ‘far below the theoretical optimum of zero in a fully integrated financial area’). Similarly, the Commission’s 2022 European Financial Stability and Integration Review reported on growth in cross-​border holdings of equity and debt instruments in 2021 (which have been (broadly) increasing since 2010) and also on a substantially faster recovery in financial integration following the outbreak of the Covid-​19 pandemic as compared to other periods of crisis: SWD(2022) 93, 19–​21.

82 Capital-raising The extent to which EU issuer disclosure regulation has been determinative is unclear, as outlined in section 13.115 Whatever the scale of its transformative effects, however, the issuer disclosure regime is now a key component of the institutional structure that supports fund-​raising in the EU and, in that regard, follows the well-​established practice internationally of associating efficient outcomes for issuers, investors, and markets with mandatory issuer disclosure.

II.3  The Evolution of the Issuer Disclosure Regime II.3.1  A Dynamic History The issuer disclosure regime is the most longstanding component of the single rulebook. It has developed over four major phases. In the first phase (late 1970s-​1980s), detailed but incomplete harmonization through directives was deployed and mutual recognition had yet to develop. In the second phase (late 1980s), mutual-​recognition devices (largely ineffective) were attached to the earlier directives. The third phase, which can be strongly associated with the FSAP period (1999–​2004) and with the crisis-​era reforms (2008–​2014), saw a material reduction in Member State regulatory autonomy, detailed harmonization, and a decisive move towards home Member State/​NCA control/​mutual recognition and thereby ‘passporting’. This phase was initially shaped by the intensification of harmonization which followed the adoption of the liberalizing FSAP reform agenda and the related adoption of the Lamfalussy model for financial market rulemaking and its emphasis on administrative rule-​making; and, subsequently, by the decisive shift of regulatory power from the Member States to the EU in the wake of the financial crisis. The current phase, strongly associated with CMU (2015-​present), has seen the issuer disclosure regime bend further towards uniformity, with the transformation of the 2003 Prospectus Directive into the 2017 Prospectus Regulation, the accretion of extensive administrative rules and soft law over the regime as a whole, an increasing tilt toward proceduralization (in the form of greater harmonization of supervisory practices), and the operationalization and centralization of issuer disclosure dissemination, including through the prospectus hub now maintained at ESMA and the 2021 proposal for a European Single Access Point (ESAP) for issuer disclosures (as well other required public disclosures).116 At the same time, the issuer disclosure regime is becoming more calibrated and flexible, with the Prospectus Regulation heralding a significantly more agile and tailored approach, providing a ‘menu’ of different prospectus formats. The regime is also becoming increasingly muscular and responsive in its support of funding: the 2021 Covid-​19 Recovery Prospectus represents a landmark in the evolution of EU issuer disclosure in this regard.117 A brief history follows. 115 Since the financial crisis, more systematic efforts have been made to monitor financial market development in the EU, including ESMA’s regular Trends, Risks, and Vulnerabilities (TRV) reports (TRVs); the Commission’s annual European Financial Stability and Integration Reviews (EFSIRs); and the extensive data that has accompanied the CMU agenda, including the 2021 Commission CMU Indicators Report, n 47, Commission, Economic Analysis Accompanying the Commission Communication on the Mid-​Term Review of the Capital Markets Union Action Plan (SWD(2017) 224), and Commission, Initial Reflections on the Obstacles to the Development of Deep and Integrated EU Capital Markets (SWD(2015) 13). 116 COM(2021) 723. See section 7.3. 117 Regulation (EU) 2021/​337 [2021] OJ L68/​1. See section 4.9.5. Relatedly, the 2022 Listing Act reform agenda seeks to further refine the issuer disclosure regime (n 144).

II.3  The Evolution of the Issuer Disclosure Regime  83

II.3.2  Early Efforts By the early 1970s, proposals were in train for directives designed to harmonize ‘admission-​ to-​listing’ (in effect, admission to a stock exchange) and disclosure requirements for ‘officially listed’ securities.118 By the early 1980s, harmonizing directives covered admission-​ to-​ official-​ listing requirements (now the Consolidated Admissions Requirement Directive);119 the contents of the ‘listing particulars’ to be published as a condition of admission to official listing (the 1980 Listing Particulars Directive120—​since repealed); and the ongoing publication of interim reports by issuers whose shares were admitted to official listing (the 1982 Interim Reports Directive121).122 These early directives were designed to set out exhaustively the minutiae applicable in the areas harmonized, and so to operate as a ‘common code’ which could be applied by the Member States without significant further elaboration at national level, and which would thereby support market integration.123 But this approach failed to remove the regulatory burdens on issuers. The heavy reliance on directives meant that implementation was left to the discretion of the Member States and accordingly rendered vulnerable to misinterpretations, delays, and wilful misconstructions, and the directives also contained substantial escape opportunities for Member States in the form of exemptions, derogations, and generally worded obligations. Particular problems arose, for example, with the loose but pivotal definition of a ‘public offer’ of securities.124 This problem was implicitly acknowledged in the early directives in that they were all monitored by a Contact Committee, the functions of which included facilitating consultation between Member States on the extent to which additional or more stringent conditions were being imposed. Market integration was also hindered by a degree of mutual suspicion between EU NCAs; the paradigm shift in supervisory dialogue and cooperation which would follow under, initially, the Lamfalussy process and with the 2001 establishment of the committee of European Securities Regulators (CESR), and, subsequently, with the 2011 arrival of ESMA, was some way off. The detailed approach also led to a fossilization of the negotiation process because of the level of detail on which agreement was needed. The Commission’s 1985 White Paper on the Internal Market provided the policy impetus for the next phase.125 Although its main focus in the financial sphere was on intermediation and financial services, the White Paper highlighted the need to achieve a ‘single securities market’ and promoted integration via liberalization and mutual recognition, rather than by detailed harmonization. The White Paper did not present a significant reform agenda for issuers,126 but its endorsement of the mutual-​recognition device

118 On ‘official listing’ see section 8. 119 Directive 2001/​34/​EC [2001] OJ L184/​1. The consolidation included the first measure of the issuer disclosure rulebook: the now-​repealed 1979 Admissions Directive 79/​279/​EEC [1979] OJ L66/​21. 120 Directive 80/​390/​EEC [1980] OJ L100/​1. Since repealed. 121 Directive 82/​121/​EEC [1982] OJ L48/​26. Since repealed. 122 The 1977 soft law Code of Conduct (n 97) sat alongside these measures and recommended disclosure requirements for publicly offered and listed securities. 123 See generally Wymeersch, E, ‘The EU Directives on Financial Disclosure’ (1996) 3EFSL 34. 124 See generally ECOSOC, Opinion on the Commission’s Communication on European Capital Markets for Small and Medium-​Sized Issuers—​Prospects and Potential Obstacles to Progress [1998] OJ C235/​13 para 3.4.1.2.2. 125 Completing the Internal Market (COM(85) 310). 126 The now repealed Substantial Shareholdings Directive (Directive 88/​627/​EEC [1988] OJ L348/​62) was the only capital market measure proposed by the White Paper.

84 Capital-raising led to the mutual recognition and home-​country control techniques being applied, and to related revisions to the earlier directives: once a prospectus or listing particulars were approved in accordance with the relevant directive’s requirements by one Member State (the home State), other Member States (host States) were required to accept the document, although they could impose certain additional information and translation requirements. In addition, revisions of the (then) Treaty by the Single European Act facilitated legislative reform by their introduction of qualified majority voting in the Council, and the 1988 Substantial Shareholdings Directive and the 1989 Public Offers Directive (both issuer disclosure measures) were adopted soon after.127 The White-​Paper-​era articulation of mutual recognition was not, however, a success, largely due to the degree to which host Member States could legitimately continue to impose requirements on cross-​border issuers.

II.3.3  The FSAP and Reform The poor state of integration became of acute concern towards the end of the 1990s. The pre-​ FSAP 1998 Communication highlighted the urgent need to complete the establishment of ‘deep and liquid European capital markets which serve both issuers and investors better’,128 expressing concern that the issuer disclosure regime had failed to address the costs still generated by duplicating and diverging disclosure requirements.129 In response, the 1999 FSAP contained a proposal for a single prospectus passport for issuers130 and also sought to improve the financial reporting system. Political support came from the 2000 Lisbon ‘dotcom’ European Council which highlighted the widest possible access to investment capital on an EU-​wide basis, by means of a single passport for issuers, as a matter of critical importance,131 while the Council-​mandated Lamfalussy Report identified, inter alia, the adoption of a single prospectus scheme as a priority.132 Following the FSAP reforms, a radically upgraded issuer disclosure regime—​in the form of the 2003 Prospectus Directive, the 2004 Transparency Directive, the 2003 Market Abuse Directive, and the 2002 IAS Regulation—​all of which, in some form, continue to shape the current issuer disclosure rulebook, was adopted. This period was also characterized by the 2001 establishment of CESR and by its deepening and intensification of the issuer disclosure regime through its support of related Commission administrative rule-​making and its adoption of soft law.

127 Respectively, n 126 and Directive 89/​298/​EEC [1989] OJ L124/​6. Both since repealed. 128 Commission, Financial Services. Building a Framework for Action (COM(1998) 625). 129 n 128, 6. 130 n 13, 4. 131 Lisbon European Council 23 and 24 March 2000, Presidency Conclusions. 132 The initial Lamfalussy Report noted that the cost of raising capital in the EU was higher than in the US as a result of the complexity of cross-​border capital-​raising and diverging Member State rules which impaired liquidity and efficient pricing: Initial Report of the Committee of Wise Men on the Regulation of European Securities Markets (2000) 7. The final 2001 Lamfalussy Report reinforced the importance of reforming the rules governing capital-​raising: Final Report of the Committee of Wise Men on the Regulation of European Securities Markets (2001).

II.3  The Evolution of the Issuer Disclosure Regime  85

II.3.4  The Global Financial Crisis Era Pre-​financial-​crisis, and following the adoption of the FSAP issuer disclosure regime, little EU policy attention was directed to the relative efficiency of the public funding markets in the EU and the effectiveness of the supporting issuer disclosure regime. Private equity funding, for example, grew significantly in the lead-​up to the financial crisis, raising some concern that the efficiency and transparency of the public equity markets might be compromised, but the EU policy response was sanguine.133 This is not to claim that the growth of the private equity funding model called for EU regulatory intervention, but only to highlight the relative lack of attention given to the efficiency of the public funding markets, once the supporting passport regime for pan-​EU offers had been adopted under the Prospectus Directive in 2003. While issuer disclosure reforms were adopted over the financial-​crisis period, chiefly to finesse the prospectus regime and as regards periodic and financial reporting (sections 4 and 5), the main legacy of the crisis era as regards issuer disclosure was the 2011 establishment of ESMA and the technocratic capacity it brought to amplifying the issuer disclosure rulebook. Its establishment led to a finessing of the issuer disclosure regime and to an intensification of harmonization, particularly through new administrative rules and soft law of significantly greater regulatory and operational sophistication. The waning of the crisis era saw the policy frame expand to include consideration of how the capital markets could facilitate the diversification of funding sources, following the severe contraction in bank lending, and support the economic recovery:134 the ill-​fated proposal for a Financial Transaction Tax (FTT), for example, excluded primary market issuances to avoid incentives to shift capital allocation from securities to deposits.135

II.3.5  In the Wake of the Global Financial Crisis: Capital Markets Union and the Covid-​19 Pandemic The adoption of the first CMU Action Plan in September 2015 saw the funding capacity of the EU capital markets come centre-​stage in EU financial markets policy, and with it the issuer disclosure regime. As outlined in Chapter I, the CMU agenda has framed the development of EU financial markets regulation since 2015. While wide-​ranging, it from the outset identified the issuer disclosure regime, and specifically the prospectus rules, as needing reform. The pathfinding 2015 CMU Green Paper warned that the EU economy was still overly dependent on bank funding and that capital markets were underdeveloped, despite their importance in diversifying funding sources (particularly for SMEs), in reducing the cost of capital, and in enhancing the shock absorption capacity of the financial system:136 while the

133 Then Commissioner McCreevy was reluctant to address the relative efficiencies of the public and private markets: eg Speech, 22 March 2007. On the regulation of private equity see further Ch III. 134 An inflection point can be identified in 2013 with the Commission’s Long-​Term Financing Green Paper which queried whether reforms could be adopted to promote the efficiency of bond markets in channeling long-​ term funds and to address the slowdown in the EU IPO market and the related ‘equity gap’: n 99, 11–​12. 135 The FTT is noted in Ch VI section 1. 136 Commission, Green Paper. Building a Capital Markets Union (COM(2015) 63).

86 Capital-raising EU capital market had been strengthening, particularly the bond markets,137 it was under-​ developed, particularly in relation to the US.138 Reform of the prospectus regime was identified as being necessary to make it easier for firms, particularly SMEs, to raise capital. The subsequent 2015 CMU Action Plan placed public equity and debt markets at the centre of the reform agenda, arguing that while they were a principal funding source for mid-​size and large firms, including as exit mechanisms for private equity funders, their development had lagged (against other developed economies) and was patchy across the EU, and regulatory reform was needed.139 One of its six themes accordingly focused on making it easier for companies to enter and raise capital on public markets and three actions followed: reform of the Prospectus Directive; review of regulatory barriers to SME access to the public markets; and review of the EU corporate bond market. Follow up action was swift. The 2015 Prospectus Proposal was published alongside the 2015 CMU Action Plan, adopted as the Prospectus Regulation in June 2017, came into force in July 2019,140 and contains a series of enhancements to support issuers, including new prospectus formats; a range of SME-​ related measures were undertaken, including adoption of the 2019 SME Regulation;141 and a series of studies were undertaken into the functioning of the EU corporate bond market, from which further reforms followed.142 Enhancing the effectiveness of the public debt and equity markets remained at the core of the CMU agenda, however, with the 2017 CMU mid-​term review underlining the importance of public capital markets, but warning as to the persistently low levels of equity share capital across EU firms and a shrinkage in the initial public offer (IPO) market.143 The rebooted 2020 CMU Action Plan, which was designed to inject fresh impetus into the CMU agenda and to support the ‘re-​equitization’ of the EU financial system in order to put EU firms on a structurally sound footing after the pandemic and to avoid over reliance on debt, returned to issuer disclosure. It included among its measures the establishment of a European Single Access Point for issuer disclosure; and a review of how SME access to the public markets could be supported, which led to the subsequent 2022 Listing Act reform agenda.144 137 The Green Paper noted that EU stock market size as a proportion of GDP grew from 22 per cent in 1991 to 65 per cent in 2013, and that outstanding debt securities represented 74 per cent of GDP in 1992 and 171 per cent in 2013: n 136, 7. 138 Reporting that public equity markets represented 138 per cent of GDP in the US and 65 per cent in the EU and that corporate bond markets were significantly larger in the US (at 40.7 per cent of GDP v 12.9 per cent in the EU): Staff Working Document Accompanying the Green Paper (SWD(2015) 13) 11. Similarly, corporates accounted for only 7.5 per cent of EU debt securities, with bond markets largely driven by financial institution issuance and trading: 11–​12. 139 2015 CMU Action Plan, n 12, 12. 140 Save for the Regulation’s new thresholds for exempting small offers which came into force in July 2018 and certain of the exemptions governing admission to trading on a regulated market which came into force in July 2017. 141 Regulation (EU) 2019/​2115 [2019] OJ L320/​1. 142 See, eg, Commission Expert Group on Corporate Bonds, Improving European Corporate Bond Markets (2017) and 2017 BCG Report, n 25. Reforms have followed, albeit in a piece-​meal manner, including the revisions to the market abuse ‘market soundings’ regime to accommodate private placements (Ch VIII section 6.3.4), but overall the reviews indicated broad satisfaction with the regulatory environment (national and EU) for private placements. 143 Listed shares represented only 20.9 per cent of the funding of NFCs in 2015, while the IPO market was shrinking (€57.2 billion in 2006 v €27.9 billion in 2016): 2017 CMU Economic Analysis, n 115, 37 and 39. 144 The Action Plan warned that the strength of the post-​Covid-​19 recovery would depend on the availability of sufficient funding sources, that access to public equity remained limited (although access to bond markets and to private equity was strengthening). and that further action was needed to increase companies’ visibility and to ease SME access to the public markets: n 12, 7–​8.

II.3  The Evolution of the Issuer Disclosure Regime  87 In addition, the series of deregulatory reforms adopted under the pandemic-​related 2020 Capital Markets Recovery Plan saw the adoption of a novel prospectus format, the Covid-​ 19 Recovery Prospectus, to support the recapitalization of SME issuers in particular, in an indication of the extent to which the issuer disclosure regime has become a platform for reform.145 Whether or not the reforms will lead to the achievement of CMU’s ambitious aims remains to be seen, as outlined in the last section of this chapter, but it is certainly clear that issuer disclosure, notwithstanding its long history, is not losing traction with EU policy makers.

II.3.6  The SME Agenda The evolution of the issuer disclosure regime has been shaped by the particular challenges faced by EU SMEs, who rely heavily on bank finance for external funding, in accessing funding through the public markets:146 among the headline figures are that EU SMEs receive five time less funding from the markets than their US counterparts and receive more than 75 per cent of their funding from bank credit.147 While SMEs drew attention over the FSAP period,148 the financial crisis significantly sharpened the EU policy focus on the SME sector as funding pressures increased: the

As this book went to press, the Commission adopted, in December 2022, three ‘Listing Act’ Proposals: the Listing Act Directive Proposal I (COM(2022) 760) (official listing; investment research); the Listing Act Directive Proposal II (COM(2022) 761) (multiple vote structures and SME Growth Markets); and the Listing Act Regulation Proposal (COM(2022) 762) (prospectus and market abuse regime disclosures). The main reforms proposed by the Listing Act Directive Proposal I were to remove the current ‘stub’ rules relating to ‘official listing’ and to incorporate revised versions of the official listing requirements relating to minimum free float and minimum capitalization in the MiFID II admission to trading regime (the admission regime is discussed in section 8); and to further liberalize the ‘unbundling’ rule that applies to investment research, to support SME research in particular (the investment research regime is discussed in section 9). The main reforms proposed by the Listing Act Regulation Proposal were to refine the prospectus formats for frequent issuers (by replacing the ‘simplified prospectus’ with a lighter ‘EU Follow-​on Prospectus’) and for SME issuers (by replacing the optional ‘EU Growth Prospectus’ with a lighter but mandatory ‘EU Growth Issuance Document’); to reduce the costs of the ‘standard’ prospectus (including by applying standardized format and sequence requirements, reducing the disclosures required, and imposing a 300 page limit on share IPO prospectuses); and to extend the exemptions from the prospectus requirement, including for small offers. The prospectus regime is discussed in section 4. Finally, the Listing Act Directive Proposal II proposed a minimum harmonized regime for the use of multiple vote structures by issuers seeking admission to SME Growth Markets. The reforms, as a package, do not disrupt the structure and core content of the issuer disclosure regime but propose a series of targeted and finessing adjustments to reduce issuer costs. The fate of the reforms remains to be seen, particularly given the closure of the current Commission and Parliament terms in 2024. They indicate, however, the persistently deregulatory orientation of issuer disclosure policy since the adoption of the 2015 CMU agenda, as well as the related dynamism of the issuer disclosure regime. 145 On the rationale see Commission, EU Capital Markets Recovery Package (SWD(2020) 120). On the Covid Recovery Prospectus, adopted in 2021, see section 4.9.5. 146 Adding to the myriad complexities faced by SMEs in accessing the public markets, different definitions apply under the single rulebook. Broadly, SMEs are defined as either companies that employ fewer than 250 people, have a turnover not exceeding €50 million, and/​or have a balance sheet not exceeding €43 million (as defined under Commission Recommendation 2003/​61 [2003] L124/​36); and/​or as companies of market capitalization of less than €200 million on the basis of end-​year quotes for the previous three years (as defined under MiFID II/​MiFIR Art 4(1)(13) and for the purposes of the composition of the ‘SME Growth Market’ trading venue). 147 2015 CMU Action Plan, n 12, 4 and 7. 148 The initial policy agenda was set out in Commission, Risk Capital: A Key to Job Creation in the EU (SEC(1998)552).

88 Capital-raising proportion of small bank loans (to SMEs) as a proportion of total EU lending dropped, reflecting de-​leveraging pressures, reduced bank risk appetite, and regulatory effects relating to increased capital charges; funding from venture capital contracted; and SMEs did not, in comparison with larger firms, turn to bond financing but instead tended to rely on internal capital or trade finance.149 Support for SME access to finance therefore became a central pillar of crisis-​era economic policy and of the now overtaken ‘Europe 2020’ economic strategy; but it also shaped the single rulebook, in particular the establishment of the MiFID II/​MiFIR ‘SME Growth Market’ trading venue, a ‘second tier’ trading venue, outside the ‘regulated market’ segment, designed to support SMEs in raising funding through the public markets (section 8). As the crisis era receded, the policy focus remained trained on SMEs, with the 2013 Long-​Term Financing Green Paper highlighting a range of potential alleviating reforms, including with respect to SME networks, securitization networks, tailored ‘scoring’ measures for SMEs (designed to address the difficulties SMEs face in ensuring the availability of verifiable public disclosures on their performance), and non-​traditional funding methods, notably crowdfunding. While many of these measures have yet to come to fruition, supporting SMEs remains one of the EU’s major policy objectives and is being managed through a series of policies, including the 2020 SME Strategy for a Sustainable and Digital Future,150 but also the CMU agenda and related issuer disclosure reform. Enhancing SMEs’ ability to access funding, in particular equity funding, through the public markets was a recurring theme of the 2015 and 2020 CMU Action Plans, and had Council and European Parliament support.151 The related reform agenda is designed to widen SMEs’ access to funding, in particular by facilitating their access to the ‘funding escalator’ across which SMEs can move from bank funding, to private capital, to second-​ tier trading venues, and on to the major public markets. The 2015 CMU Action Plan accordingly proposed a series of reforms, from investment fund/​venture capital fund/​ loan-​originating funds reforms,152 to developing advisory networks for SMEs, to making public funds available,153 to putting in place a supportive regulatory regime for crowdfunding (section 11), and, as regards issuer disclosure, to what became the 2017 Prospectus Regulation reforms which include the tailored ‘EU Growth Prospectus’, designed to support SME issuers (section 4.9.7). A further series of reforms followed under the 2019 SME Regulation. The Commission’s prior 2018 SME Proposal noted the series of SME-​oriented reforms underway, but warned that EU public markets were still struggling to attract new issuers,154 and proposed a series of what were described as technical revisions, in particular

149 2017 CMU Economic Analysis, n 115, 41. 150 COM(2020) 103. 151 eg Council Conclusions on CMU, 5 December 2019 (Council Document14815/​19) and ECON Committee, Report on the Future Development of CMU (A9_​155/​2020). 152 See Ch III. 153 Through the Commission’s VentureEU fund, a pan-​EU venture capital fund of funds programme, making investments in excess of €2 billion: European Commission Press Release, 10 April 2018. 154 It reported that the EU was producing only half the number of SME IPOs than before the financial crisis (478 (raising €13.8 billion) on average annually in 2006-​2007 v 218 (raising € 2.55 billion) between 2009 and 2017 on EU second-​tier markets): 2018 SME Regulation Proposal (COM(2018) 331) 1. Bond issuance was also weak, despite the growth of a number of specialized venues for SME bond trading: Commission, Building a Proportionate Regulatory Environment to support SME Listing (2017) 3. The weak public market for SMEs was also reported to be deterring venture capital funding, given exit risks.

II.3  The Evolution of the Issuer Disclosure Regime  89 to make the rules governing SME Growth Markets more proportionate (section 8);155 and to finesse the 2017 Prospectus Regulation, including by expanding the range of issuers that can benefit from the ‘EU Growth Prospectus’. The 2020 CMU Action Plan returned to this theme, seeking to support SMEs in accessing equity funding to recover from the pandemic shock and to widen their access to ‘solid market-​based funding sources’; and warning that a lack of equity funding weakened companies.156 The related suite of reforms was multi-​faceted, ranging from the development of an SME IPO fund, to review of how stock market indices can support liquidity in SME equity, to the easing of capital and prudential rules for insurers and credit institutions to facilitate SME lending and investment, to requiring banks to direct SMEs to alternative funding sources. As regards issuer disclosure (and admission to trading), the Action Plan included a commitment to review the issuer disclosure regime/​admission to trading process to reduce the compliance costs faced by SMEs;157 this led to the subsequent 2022 Listing Act reform agenda,158 and was also supported by ESMA’s 2021 review of the SME Growth Market as part of the MiFID II/​MiFIR Review.159 The SME reform agenda now extends well beyond issuer disclosure and admission to trading to include a range of non-​regulatory reforms and is being supported by a series of reviews. This holistic and empirically informed approach augurs well, given the range of challenges and the continued dominance of bank funding as external finance for SMEs. Nonetheless, the policy focus remains trained on the issuer disclosure/​admission to trading rulebook, as evidenced by the 2022 Listing Act reform agenda, and there appears to be little sign of the current appetite to use deregulation to support SMEs diminishing. The deregulation of issuer disclosure and admission to trading requirements in service of SME funding is a troublesome reform instrument, however, not least as some 74 per cent of all issuers traded on EU trading venues are SMEs.160 Further, its benefits may not outweigh the risks. The difficulties associated with public market access for SMEs are many, including SMEs’ more limited experience with market-​based funding; SMEs favouring relationship-​based funding channels (whether banks, venture capital funders, angel investors or others);161 financial track-​record weaknesses; difficulties with verifying issuer disclosures; the high fixed costs of market access; thin liquidity (which puts additional pressure on the fractures in the supporting ecosystem of market-​makers, brokers, and investment analysts); the increasing presence in equity markets of exchange-​traded funds which trade in large capitalization shares; limited investor appetite; and weaknesses in the private capital platforms (including 155 The Regulation introduced alleviations for issuers admitted to SME Growth Markets (whether or not SMEs: up to 50 per cent of issuers on an SME Growth Market can be non-​SMEs), particularly as regards MAR’s requirements relating to disclosure of ‘inside information’ and when it can be delayed; ‘insider lists’; and MAR’s treatment of the ‘liquidity contracts’ that can support SME liquidity. See further Ch VIII. 156 2020 CMU Action Plan, n 12, 3. SME are carrying an overhang of debt in the wake of the Covid-​19 pandemic: 2021 Commission CMU Indicators Report, n 47, 27. 157 2020 CMU Action Plan, n 12, 7–​8. The related reviews included an extensive stakeholder review of SME access to the public markets: Technical Expert Group on SMEs (TESG), Empowering EU Capital Markets for SMEs (2021). 158 n 144. The main SME reforms included replacement of the optional EU Growth Prospectus with a mandatory, short-​form EU Growth Issuance Document; the expansion of the exemption for small offers to offers of below €12 million; and a new minimum harmonized regime for multiple vote share structures on SME Growth Markets. 159 ESMA, MiFID II Review Report on the Functioning of the Regime for SME Growth Markets (2021). 160 2021 ESMA SME Growth Market Review, n 159, 15. 161 The regular ‘SAFE’ survey on SME financing conditions repeatedly reports on low SME interest in public equity markets: 2021 Commission CMU Indicators Report, n 47, 27.

90 Capital-raising venture capital and angel investors) from which SMEs can graduate to public markets.162 Not all of these are amenable to disclosure-​related reform. More generally, the SME population is wide and diverse and is populated by firms of varying size, growth rate, business model, ownership structure, capital need, and financial sophistication. The development of strong market-​based funding channels for SMEs depends, therefore, on the development of a wider ecosystem with multiple components, including favourable institutional conditions for seed and venture capital providers and their exit mechanisms; SME-​sensitive accounting standards; specialist investment research; reputational gatekeepers (including ‘sponsors’ or similar on second-​tier trading venues); supportive market microstructure (such as the trading venue auction structures which are more favourable to SMEs than continuous trading); stronger information-​sharing mechanisms; and government support.163 The jigsaw of measures proposed across the 2015 and 2020 Action Plans and the 2022 Listing Act reform agenda may facilitate access to market finance by SMEs, but it is likely to take time and the risks of issuer disclosure deregulation may, in the meantime, not outweigh the benefits.164 Given the scale of the challenge, the significance of the resilience of the EU’s commitment to facilitating SME access to the public equity and debt markets, from the financial crisis and past the Covid-​19 crisis, perhaps lies more in its signalling of the depth of the commitment to market finance more generally, than in what it promises as to real structural change in this area.

II.4  The Prospectus Regulation II.4.1  The Evolution of the Prospectus Regime II.4.1.1 Initial Efforts As one of the pillars of the single rulebook, the long evolution of the Prospectus Regulation (from the initial patchwork disclosure measures over the 1970s and 1980s; to the 2003/​2010 Directive; to the 2017 Regulation) and the changes in its institutional setting (from pre-​ FSAP skeletal legislative measures adopted by the institutions; to the FSAP-​era Directive and administrative rules adopted by the institutions, supported by CESR; to the current highly articulated Regulation and related administrative rulebook adopted by the institutions, supported by ESMA) and market context (from the 1970s bank-​dominated embryonic capital market, to the post-​financial-​crisis, CMU-​framed strengthening capital market) warrants some attention. 162 From the many reviews see, eg, 2020 Oxera Report, n 47, ch 5; Schammo, P, ‘Market Building and the Capital Markets Union’: Addressing Information Barriers in the SME Funding Market’ (2017) 14 ECFR 271; and, from a Commission perspective, 2017 CMU Economic Analysis, n 115, 24–​7. 163 Schammo, n 162; Perrone, A, ‘Light Disclosures Regimes: SMEs; Problems of Financing in the EU’ in Busch D, Ferrarini, G, and Franx, JP (eds), Prospectus Regulation and Prospectus Liability (2020); Perrone, A, ‘Small and Medium Sized Enterprises Growth Markets’ in Busch, D, Avgouleas, E, and Ferrarini, G (ed), Capital Markets Union in Europe (2018) 252; and Ferrarini, G and Ottolia, A, ‘Corporate Disclosure as a Transaction Cost: The Case of SMEs’ (2013) 9 Eur Rev of Contract L 363. 164 In response to the 2021 Listing Act Consultation, ESMA warned as to the risks of deregulation, particularly as regards the Prospectus Regulation and the ongoing disclosure requirements imposed by MAR, and underlined the importance of disclosure requirements in supporting investor protection and trust in the financial system: ESMA, Letter to Commission (Listing Act Consultation), 15 February 2022.

II.4  The Prospectus Regulation  91 At the time of the Commission’s first major issuer disclosure initiative in 1972 (the proposal for what would become the 1980 Listing Particulars Directive), Member States’ disclosure standards varied widely,165 resulting in patchy standards of investor protection and high transaction costs for issuers engaging in cross-​border offers or listings.166 The 1972 Listing Particulars Proposal languished for some time and was overtaken by the 1977 Code of Conduct.167 The Explanatory Memorandum to the Code of Conduct noted that ‘the lack of full information on the securities themselves and ignorance or misunderstanding of the rules governing the various markets have certainly helped to confine the investment of a great majority of savers to the markets of the countries in which they live or to a few well-​known major international securities’ (paragraph 1). Accordingly, Principle 2 of the Code provided that ‘[i]‌nformation should be available to the public which is fair, accurate, clear, adequate and which is given in good time’ and went on to require that ‘the information should be provided in such a way that its significance and intent can be easily understood’. Mandatory EU disclosure requirements were first imposed on issuers in 1979, by the now repealed Admission Directive which was designed to facilitate access to ‘official listing’ (in effect, admission to a stock exchange) by harmonizing the applicable conditions, and which also addressed the ongoing disclosure obligations of officially listed issuers. The now repealed Listing Particulars Directive followed in 1980 and harmonized the disclosure requirements for the document required on admission to official listing (the ‘listing particulars’). In 1989 the gap in the disclosure regime was somewhat haphazardly filled when, after a tortured genesis (its negotiation took more than eight years), the now repealed Public Offers Directive (the POD) introduced a prospectus regime governing offers of securities to the public generally. This framework was subsequently built out by a complex and fragmented mutual recognition system designed to allow issuers to prepare a single disclosure document which, once approved by the relevant Member State’s NCA, could be used for admission applications and public offers across the EU without the need for further modification or approval, bar the inclusion of certain local market-​specific information and subject to translation requirements. Mutual recognition was initially addressed for listing particulars (1987) and then for public offer prospectuses (1990). The Eurolist Directive, which followed in 1994, attempted to remove the need for mutual recognition by giving Member States the option to exempt issuers from the listing particulars requirements where they sought admission to official listing on an exchange but their securities had been officially listed in another Member State exchange for at least three years. This unwieldy issuer disclosure regime failed to support mutual recognition and facilitate cross-​border capital-​raising; fewer than two or three issuers a year attempted to use the complex regime,168 with its weaknesses most pronounced for public

165 Despite the existence of issuer disclosure regimes (of varying degrees of sophistication) in most of the Member States in the early 1970s, the EU had to combat an anti-​disclosure bias (in continental Europe at least) in European corporate culture: Buxbaum and Hopt, n 109, 169. 166 eg, Suckow, S, ‘The European Prospectus’ (1975) 23 A J Comp L 50. 167 The EU was not the first international body to acknowledge the importance of adequate disclosure. In 1974, in its Recommendation concerning Disclosure Requirements and Procedures to be Applicable to all Publicly Offered Securities, the OECD recognized the principle that the investor is entitled to the highest practical degree of protection in respect of standards of securities and that the ultimate responsibility in this area lies with government. 168 See, eg, Gros, D and Lannoo, K, The Euro Capital Market (2000) and Jackson and Pan, n 109.

92 Capital-raising offers.169 The open-​textured nature of the disclosure regime and its multitude of exemptions, derogations, and options resulted in widely varying interpretations of its requirements across the Member States. The insistence of many NCAs on full translation of the entire approved prospectus or listing particulars was particularly burdensome, while the requirement to include local information represented a significant obstacle. The brunt of these difficulties fell on smaller issuers, who were often forced for cost reasons to limit their offers to one Member State. In practice, most cross-​border offers were carried out through private placements,170 but even here difficulties could arise from the failure to harmonize the pivotal definition of ‘public offer’: the same offering could be treated as a private placement and so as exempt from the requirement to produce a prospectus in one Member State, and as a public offer subject to prospectus requirements in another, thereby increasing issuer costs and investor protection risks.171 Further, the basis of much of the disclosure regime in ‘official listing’ under the Listing Particulars Directive became outdated, with capital-​raising occurring outside ‘official’ stock exchange segments, and with high-​tech and innovative-​ growth companies, in particular, being traded on second-​tier trading venues. It also became apparent that the disclosure provided under the regime was inadequate as compared to international best practice;172 that the regime was unwieldy, not being sensitive to the needs of issuers who made repeated calls on the capital markets; and that it did not sufficiently address format, prejudicing comparability. While a host of factors, including the nascent state of market finance and the home bias of investors, impeded cross-​border capital-​raising,173 the regulatory supports were inadequate.

II.4.1.2 The FSAP Period and the 2003 Prospectus Directive The FSAP period led to a step-​change. In response to the difficulties, the FSAP contained proposals to provide for a single prospectus passport for issuers and to facilitate repeat issuers.174 Political support came from the 2000 Lisbon ‘dotcom’ European Council which prioritized the issuer disclosure reforms, while the need for reform was also highlighted by the Lamfalussy Report.175 The momentum for reform was sustained by the activities of the Federation of European Securities Commissions (FESCO, which would subsequently become CESR), which placed the weight of the NCA community behind the prospectus reform process.176 Notwithstanding the consensus from the market and the supervisory community that reform was required, and political support, the genesis of the 2003 Prospectus Directive was

169 The 1999 and 2000 Deutsche Telekom pan-​EU public offering represented the exception rather than the rule, but also faced considerable difficulties from the multiple translation requirements: Pietrancosta, A, ‘The “Public Offering of Securities” Concept in the New Prospectus Directive’ in Ferrarini and Wymeersch, n 91, 339, 341–​2. 170 The cross-​border wholesale market was described as ‘relatively straightforward and seamless’: Burn, L and Wells, B, ‘The Pan-​European Retail Market—​Are We There Yet?’ (2007) 2 CMLJ 263. 171 eg FESCO, A ‘European Passport’ for Issuers, A Report for the EU Commission (2000). 172 Becht, M, ‘European Disclosure for the New Millennium’ in Hopt, K and Wymeersch, E (eds), Capital Markets and Company Law (2003) 87. 173 See further Ferran, E, ‘Cross-​border Offers of Securities in the EU: The Standard Life Flotation’ (2007) 4 ECFLR 462 and Ferran, E, Building an EU Capital Market (2004). 174 FSAP, n 13, 4. The priority given to the reform can be seen in the Commission’s Progress Report on the FSAP (COM(2000) 336), which highlighted the tendency of host NCAs to demand additional disclosures, and the multiple operational weaknesses, including as regards repeat issuers. 175 2000 Initial Lamfalussy Report, n 132, 16. 176 FESCO, n 171.

II.4  The Prospectus Regulation  93 troublesome.177 The rather economically reasoned 2001 Proposal was designed to overhaul the pre-​FSAP prospectus disclosure regime completely in order to facilitate the widest possible access to investment capital for all issuers, including, in a familiar refrain, SMEs. The Commission was largely the architect of its own misfortunes in the subsequent troubled negotiations, as it did not engage in any public consultations prior to the publication of the Proposal; and as it adopted a retail-​investor-​based model, based on extensive prospectus publication requirements, which threatened to disrupt the long-​established wholesale bond markets which had previously operated free of retail-​standard prospectus requirements. This approach, the removal of issuer choice of NCA for all offerings, and the initially limited scope of the exemption regime—​all of which exposed the wholesale bond markets to significant regulatory costs—​generated a deluge of adverse comment, as well as criticism of the Commission’s failure to consult adequately.178 The Commission, unusually, presented a revised Proposal in 2003, following the extensive revisions tabled by the European Parliament and concern expressed in the Council. As the 2003 Proposal reflected most of the Parliament’s revisions, adoption followed reasonably quickly in November 2003; the Directive came into force in July 2005. The 2003 Directive represented, at the time, a sea change from the earlier regime and illustrates the more sophisticated approach to financial markets regulation which emerged over the FSAP period. It grappled with, for example, perimeter design, by means of an extensive exemptions system, including for ‘qualified investors’ and for specified exempted offers, including private placements in the wholesale bond markets (specified, inter alia, by reference to large bond denominations); operational design, through the ‘shelf registration’ system for repeat issuers and the ‘incorporation by reference’ device; disclosure design, by addressing different formats and requirements for specified offerings and instruments (including the ‘base prospectus’ and ‘final terms’ for bond programmes); and the dissemination of prospectus disclosure. It also, and notwithstanding doubts as to the efficacy of prospectus disclosure in the retail markets, embedded retail market protection at its core by requiring a summary retail market prospectus, thereby launching a 20-​year long struggle to refine this troublesome document in light of retail investor needs and capacities and issuer costs and risks. Structurally, the 2003 Directive was the first FSAP measure to adopt a quasi-​maximum harmonization/​home Member State/​NCA control model, which limited the host State/​ NCA to, largely, precautionary intervention. Relatedly, the prospectus passport was highly articulated by the Directive, including by means of a bespoke language regime which, in effect, removed translation requirements from prospectuses written in a language ‘customary in the field of international finance’. In addition, the Directive contained delegations for Commission administrative rule-​making, in one of the first applications of then then-​novel Lamfalussy model for financial market regulatory governance,179 and was subsequently 177 Directive 2003/​71/​EC [2003] OJ L345/​64, as amended by Directive 2010/​73/​EU [2010] OJ L327/​1. The main elements of the legislative history are: Original Commission Proposal (COM(2001) 280); ECOSOC Opinion [2002] OJ C80/​52; ECB Opinion [2001] OJ C344/​4; First Reading by the European Parliament [2003] OJ C47/​417) (ECON Report at A5–​0072/​2002); Revised Commission Proposal (COM(2003) 460); Council Common Position [2003] OJ C125/​21; and Second Parliament Reading [2004] OJ C74/​98 (the second report by ECON is at A5–​0218/​ 2003). On the legislative history of the 2010 Amending Prospectus Directive see n 182. 178 Boland, V, ‘Battle Looms Over Brussels Plan for Capital Markets Regulation’, Financial Times, 11 June 2001. The Commission later acknowledged that it had made a ‘serious error’ in not formally consulting the public and industry participants: Commission, FSAP Evaluation. Part I: Process and Implementation (2005) 12–​13. 179 On the Lamfalussy model see in outline Ch I.

94 Capital-raising amplified by detailed administrative rules, particularly on the specific disclosures required, segmented by reference to types of instrument and issuer. In effect, with the Prospectus Directive, an issuer disclosure ‘rulebook’ began to emerge, supported by CESR’s advice on the administrative rule-​making process and its soft law.

II.4.1.3 The 2010 Reforms and the Global Financial Crisis The 2003 Directive, which initially drew positive assessments180 but which subsequently experienced difficulties,181 was reformed and finessed by the 2010 Amending Prospectus Directive.182 The revisions followed the review of the Directive required by its ‘review clause’ (an FSAP-​era innovation that has since become standard) and, in what was also a new departure for EU financial markets regulation but which has since become standard, a series of studies, including from CESR, foreshadowing ESMA’s now pivotal technocratic role in supporting the single rulebook.183 While the Directive was in many respects regarded as a success, particularly as regards the passport mechanism and the related detailed harmonization of disclosure requirements and also as regards its exemptions, practical difficulties emerged, including in relation to diverging NCA supervisory practices, but also as regards the Directive’s regulatory design, including its treatment, for example, of specific offerings (such as rights issues) and of specific prospectus formats (in particular the ‘base programme’ format for bond programmes).184 Overall, however, the Commission concluded that Directive had been effective, making it easier to offer securities and admit securities to trading.185 The main concern of the subsequent reform exercise was, reflecting the wider pre-​crisis regulatory zeitgeist, to simplify the Directive, enhance administrative efficiency, and reduce inefficiencies in fund-​raising. The related Commission consultation was broadly deregulatory in nature, suggesting, for example, some liberalization of the rules governing the ‘qualified investor’ exemption, employee share offerings, and rights issues, and alleviating the application of the regime to SME issuers. The September 2009 Proposal followed this approach, highlighting the administrative cost reductions that would follow,186 albeit that it also proposed significant reforms to the retail market summary prospectus and that it located the reforms in the need to respond effectively to the financial crisis and investor 180 eg, the first two UK IPOs under the Directive proved easy to manage: Rice, J, ‘Equity Markets Take Prospectus Directive in Their Stride’ (2005) 24 (August) IFLR 6. For an analysis of the 2006 Standard Life equity offering, which included cross-​border offers in Ireland, Germany, and Austria and a considerable retail segment, and which concluded that the prospectus regime came through the major test represented by the offering well, see Ferran, n 173. 181 See, eg, Revell, S and Cole, E, ‘Practical Issues Arising from the Implementation of the Prospectus Directive—​ What Are the Equity Capital Markets Worrying About?’ (2006) 1 CMLJ 77. 182 The main elements of the legislative history are: Commission Proposal (COM(2009) 491) and Impact Assessment (IA) (SEC(2009)1223); ECON Committee Report, 27 March 2010 (A7-​010/​2010), on which the Parliament’s Negotiating Position was based; and Council General Approach, 17 December 2009 (Council Document 17541/​09). 183 Including: European Securities and Markets Expert Group (ESME), Report on Directive 2003/​71/​EC (2007); CESR, CESR’s Report on the Supervisory Functioning of the Prospectus Directive and Regulation (2007); CESR, An Evaluation of Equivalence of Supervisory Powers in the EU under the Market Abuse Directive and the Prospectus Directive. A Report to the Financial Services Committee (2007); Centre for Strategy & Evaluation Services, Study on the Impact of the Prospectus Regime on EU Financial Markets (2008); and CRA, Evaluation of the Economic Impact of the FSAP (2009) ch 5. 184 2007 CESR Report, n 183 and 2008 ESME Report, n 183. 185 Commission, Background Document. Review of Directive 2003/​71 (2009) 2–​3. 186 The Proposal noted, eg, the annual savings of €173 million projected for companies with a ‘reduced market capitalization’ and annual savings of €30 million relating to the new employee share scheme regime: n 182, 4.

II.4  The Prospectus Regulation  95 protection risks.187 During the negotiations, the European Parliament adopted a more ambitious agenda than the Commission’s, introducing, for example, revisions to support SME financing,188 which were largely accepted by the Council. The 2010 Amending Prospectus Directive was adopted in October 2010 and was to be implemented by July 2012. The range of issues addressed by the 2010 Amending Prospectus Directive reflects the increasing technical sophistication, at the time, of the EU prospectus regime. The main reforms included alleviations for the bond markets, in particular as regards the disclosures provided in ‘base prospectuses’ and related ‘final term’ documents, and also as regards the scope of the private placement exemptions; refinements directed to the retail markets, in particular a new short-​form summary document to replace the by-​then discredited summary prospectus; and supports for SME financing, including the adoption of a proportionate disclosure regime. Overall, the reform had, and by contrast with the crisis-​era reform programme generally, a deregulatory quality, although this also reflected the crisis-​ era concern to promote growth and access to market finance. The Directive, as amended, would subsequently be repealed and replaced by the 2017 Prospectus Regulation. While this suggests a major reform, and the Regulation is certainly a different and more highly segmented instrument, most of the Directive’s core features have carried over into the Regulation. Both regimes are also connected by their animating concern to support the capital-​raising process and to respond to market practice, and by their concern accordingly to support market finance and market integration, alongside the objectives traditionally associated with issuer disclosure regulation. They are also connected by the extent to which have they been shaped by the EU’s expanding technocratic capacity, first by CESR and subsequently by ESMA.

II.4.1.4 Capital Markets Union and the Prospectus Regulation The 2017 Prospectus Regulation, which came into force in 2019,189 is one of CMU’s flagship reforms.190 It was the first major measure proposed under the CMU agenda and as such enjoyed a smooth legislative passage.191 The Commission launched its initial consultation on 18 February 2015,192 the same day as the CMU Green Paper was published: the Prospectus Directive had originally been scheduled for review, under the 2010 Amending Directive, by January 2016, but this was brought forward to progress the CMU agenda;193 throughout its development, the Regulation was intertwined with the CMU agenda.194 The Commission 187 2009 Amending Prospectus Directive Proposal IA, n 182, 3. 188 Including raising the exemption thresholds for small offers and adding companies with a ‘reduced market capitalization’ as beneficiaries of a proportionate disclosure regime: ECON Report, n 182, Amendments 19 and 24. 189 Although some elements came into force earlier: n 140. 190 For discussion see Busch et al (2020) n 163; Alvaro, S, Lener, R, and Lucantoni, P, ‘The Prospectus Regulation. The Long and Winding Road’ (2020) 22 Quaderni Giuridici; and Gortsos, C and Terzi, M, the Prospectus Regulation and the Recent Proposal for an EU Recovery Prospectus, EBI WP No 2020/​79 (2020), available at . 191 The main elements of the legislative history are: Commission Proposal (COM(2015) 583) and IA (SWD(2015) 255); European Parliament Negotiating Position, 15 September 2016 (T8-​0353/​2016); and Council General Approach, 17 June 2016 (Council Document 9801/​16). The ECB and EECS also provided Opinions: [2016] OJ C195/​1 and CES5834/​2015, respectively. 192 Commission, Review of the Prospectus Directive (2015). 193 2015 Consultation, n 192, 3. 194 Reform of the Prospectus Directive to facilitate capital-​raising, particularly for SMEs, was identified as an early priority by the 2015 CMU Green Paper (n 136, 2), while the 2015 CMU Action Plan called for the Directive to be modernized to reduce costs and lower barriers to fund raising (n 12, 4). Relatedly, the Proposal’s IA referenced the importance of the capital market funding channel in diversifying funding sources, mitigating the risks of

96 Capital-raising highlighted a series of difficulties which had persisted, despite the 2010 reforms, and called for reforms which would make it easier to raise capital while maintaining an ‘effective’ level of investor protection.195 These reforms included deregulatory reforms to raise the thresholds governing the prospectus regime’s exemptions, alleviate prospectus requirements for secondary issuances given the availability of regulated ongoing disclosures on such issuers, and adopt a new proportionate disclosure regime for SMEs, all of which were ultimately adopted. The consultation was not entirely deregulatory, covering also measures designed to enhance disclosure to investors, chief among them further reforms to the retail summary and to the treatment of risk factor disclosures, reforms which were also adopted. The Commission trailed a series of other reforms, however, which were not adopted, including, notably, removing the wholesale-​market-​oriented exemption for bonds issued in denominations of €100,000 or more (the 2010 Directive had widened the original 2003 Directive exemption for bonds in denomination of €50,000 or more to extend it to bonds in denominations of €100,000 or more), and thereby significantly expanding the regime’s reach into the wholesale markets. The Commission’s Proposal followed in November 2015, shortly after the September 2015 CMU Action Plan. The Proposal broadly followed the earlier consultation, noting that while the prospectus regime was overall functioning well, and had not experienced difficulties over the financial crisis, it was burdensome, particularly for SMEs.196 The goals of the reforms accordingly were to provide issuers with more tailored and cost-​effective prospectus models197 and to ensure that prospectuses was more relevant to investors. The subsequent legislative passage was smooth, with the Council reaching a general approach within six months in June 2016, the Parliament negotiating text following in September 2016, and political agreement being reached by the Parliament and Council in December 2016.198 The Commission’s Proposal was not subject to major change, but was significantly finessed, primarily (but not entirely) to allow issuers more flexibility. Among the most material changes were the Council’s reinstating of the exemption for offers to the public of bonds of denominations of at least €100,000, which had been removed by the Commission; changes by both institutions to the thresholds governing the exemptions; both institutions tightening the over-​arching materiality standard for prospectus disclosures; a lightening by both institutions of the Commission’s more prescriptive approach to risk factor disclosures; and the reinstating by the Council of the host NCA as having

impairment to credit channels, reducing capital costs, and allowing investors greater opportunities to diversify and optimize returns, and identified the prospectus regime as a ‘gateway’ measure in this regard: n 191, 13–​14. 195 The Commission’s approach was broadly supported by ESMA which argued that the 2010 reforms had not worked and that a ‘back to basics’ approach was called for, particularly as regards the treatment of the secondary markets where ongoing disclosures were available: ESMA, Response to Public Consultation (Review of the Prospectus Directive) (2015). 196 2015 Proposal, n 191, 5. 197 The IA was trenchant on the difficulties reporting, inter alia, that the average equity prospectus cost in the region of €1 million and that listing costs amounted to 5-​8 per cent of the proceeds of offers over €50 million, which was onerous for SMEs; that the preparation process was ‘expensive, complex and time-​consuming’; that market sentiment was that the 2010 reforms had not succeeded, particularly the proportionate disclosure regimes which were regarded as very limited and not widely used (only 1.8 per cent of all prospectuses used the proportionate regime for SME disclosures); and that national divergences remained significant and costly, particularly around prospectus approval. It concluded that the difficulties were leading to less investment, fewer jobs, and less growth: n 191, 8–​11 and 13. 198 Council of the EU Press Release (799/​16), 20 December 2016.

II.4  The Prospectus Regulation  97 oversight of advertisements (the Commission had shifted oversight to the home NCA). As is now usual, the Council and Parliament also added greater specification to the mandates for administrative rules. There was not, however, significant political contestation, with the negotiations mainly focused on technical matters, despite the absence of the UK, traditionally a strong supporter of regulatory calibration and liberalization.199 The Regulation, which came into force in 2019, was subsequently amplified by administrative rules and soft law, as noted in section 4.2. While a significant reform, the Regulation has proved dynamic. The 2019 SME Regulation, also a creature of CMU, led to a series of refinements being made to the Regulation to further support SMEs, while the 2021 Covid-​19 Recovery Regulation introduced the innovative and time-​bound ‘EU Recovery Prospectus’, as discussed below in this chapter. Two sets of legislative reform, one in the year of the Regulation’s coming into force200 and one within two years, do not augur well for durability, but they do at least indicate a capacity to adjust and refine in response to market conditions. The Commission’s appetite for dynamic revision remains considerable, as borne out by the subsequent 2022 Listing Act reform agenda which, in practice, also constitutes the Commission’s required review of the Regulation (which was, under Article 48, due for July 2022). The main features of the Listing Act reform agenda include expansion of the exemptions from the prospectus requirement; as regards the standard prospectus, a reduction of the disclosures required, the application of standardized disclosure format and sequence requirements, and the imposition of a 300-​page limit for share IPO prospectuses; and a further liberalization of the disclosure formats and requirements for frequent issuers (by a replacement of the simplified prospectus with a lighter ‘EU Follow-​on Prospectus’) and for SME issuers (by a replacement of the optional EU Growth Prospectus with a mandatory but lighter ‘EU Growth Issuance Document’).

II.4.1.5 The Prospectus Regulation Albeit heavily based on the precursor 2003/​2010 regime, the Prospectus Regulation regime has distinct characteristics. The prospectus regime now takes the form of a Regulation, bringing its legal design into line with much of the single rulebook and minimizing the risk of regulatory divergence by Member States and NCAs.201 It has, however, a deregulatory colour.202 In particular, it is significantly more calibrated than the previous regime, containing a suite of optional and lighter prospectus models designed to support different issuers: for example, the sharp distinction now drawn between secondary issuances and primary issuances, and the lighter prospectus requirements for secondary issuances given the availability of ongoing disclosures on such issuers, illustrates the more nuanced approach being taken to the prospectus obligation. Whether or not the deregulation these optional regimes have brought will, in practice, lead to lower costs for issuers and lighter disclosures for investors remains to be seen, as any prospectus must pass the ‘market test’: where market expectations (including 199 The UK was supportive of the reforms: HM Treasury, Letter to the House of Lords EU Select Committee, 11 February 2016. 200 The Commission underlined, however, that the 2019 SME Regulation was ‘not an overhaul’ and brought only technical amendments: 2018 SME Regulation Proposal, n 154, 3. 201 This significant change of form was justified as representing a ‘modern way of legal drafting’ and reducing the costs associated with the accretion of minor divergences over time: 2015 Prospectus Proposal IA, n 191, 47. 202 ESMA interpreted the Regulation as having as a main goal to simplify the structure of the Prospectus Regulation and minimize the cost of capital: ESMA, Technical Advice under the Prospectus Regulation (2018) 15.

98 Capital-raising in international markets such as the US ‘Rule 144A’ wholesale market)203 are for higher disclosures, this can be expected to trump lighter EU requirements.204 Nonetheless, the reforms represent the first significant deregulation of the prospectus regime. The related optionality, and the consequent atomization of the prospectus requirement, has, however, made the regime significantly more complex than previously, albeit that the administrative rulebook and ESMA’s extensive soft law provide pathways through. While deregulatory to some extent, the Regulation has also expanded and refined the disclosures required, notably as regards risk factor disclosures and as regards the retail summary. It has also expanded the reach of the prospectus regime beyond regulated markets: the Regulation’s EU Growth Prospectus is designed to be used in ‘second tier’, non-​regulated-​ markets. Conversely, however, it has shrunk the regulated market perimeter which otherwise dictates the prospectus obligation, recognizing that regulated markets may operate distinct segments within which full prospectus disclosures are not required: the now expanded exemption for wholesale market bond offers includes an exemption for debt securities of any denomination (and not only the large denominations which have long been exempted), as long as those securities are traded on a regulated market, or segment thereof, that is open only to ‘qualified investors’.205 The Regulation also suggests that support of the SME issuer may be coming to sit alongside support of the retail investor as a totemic but elusive objective of EU prospectus law: the legislative negotiations focused closely on the treatment of SME issuers;206 as regards the Regulation’s administrative rules, the Commission’s most intense engagement with ESMA’s advice related to the SME-​oriented EU Growth Prospectus;207 the 2019 SME Regulation subsequently finessed the operation of the EU Growth Prospectus; and the Regulation’s review clause addressed whether further alleviations for SMEs were required and can be associated with the 2022 Listing Act reform agenda. But whether or not the Regulation can break through the many challenges that direct capital market access poses for SMEs remains to be seen. The Regulation further has a distinctly operational hue, as is reflected in its streamlining of the passporting process. It is also more heavily proceduralized than its precursor, particularly as regards the prospectus approval process, in relation to which NCA discretion has been corralled by a series of requirements governing the standard of review to be applied. Whether or not this more standardized, but also more segmented and calibrated, regime will ease issuer access to the capital markets remains to be seen, particular as the alleviations the Regulation has brought need to be balanced against the increase in supervisory and liability risks for issuers implied in, for example, the more prescriptive approach to risk 203 In the US ‘144A’ private placement market, offers can be made by non-​US issuers to qualified institutional investors without the prospectus/​registration document otherwise required by the US SEC, but standard documentation has become expected by the market. 204 The proportionate SME regime introduced by the 2010 Amending Directive, eg, was eschewed by SME issuers given in part the ‘potential stigma’ associated with lighter disclosures: 2015 Prospectus Proposal IA, n 191, 35. 205 The Luxembourg Stock Exchange launched two professional-​only segments following the adoption of the Regulation: Hogan Lovells, Global Insights, The Prospectus Regulation is coming: getting your debt prospectuses ready (2019). On ‘qualified investors’ see section 4.3. 206 The co-​legislators made a series of refinements and specifications to the Commission’s original model for the EU Growth Prospectus, including to scope and content. 207 The Commission introduced further alleviations to ESMA’s approach, reflecting its concern in its mandate to ESMA that a bespoke, ‘bottom up’ approach be taken in designing the new regime: Commission Request to ESMA for Technical Advice (2018) (Ref Ares(2018)3282605).

II.4  The Prospectus Regulation  99 factor disclosure and to the retail summary. Ultimately, and even with all its refinements, the Regulation does not radically overhaul the regulatory design that has shaped prospectus regulation since 2003. But given the risk of disruption to well-​established market practices which could have followed a more radical reform, evolution rather than revolution appears a reasonable approach to reform.

II.4.2  The Prospectus Rulebook: Legislation, Administrative Rules, and Soft Law The 2017 Prospectus Regulation is amplified by an extensive administrative rulebook and related soft law. The prospectus administrative rulebook is composed of three measures: the 2019 Prospectus Delegated Regulation,208 the 2019 Prospectus RTS,209 and the 2021 Mergers and Takeovers Delegated Regulation.210 The adoption of these rules was relatively uncontested, reflecting the generally non-​contentious nature of the prospectus regime, the basis of much of the new administrative regime in the previous, long-​established administrative rules, and the now well-​settled and mature quality of the administrative rule-​making process. As is the case across the financial market administrative rulebook generally, ESMA was a determinative influence on these rules. A degree of agility can also be observed, as evidenced by the nuances made in 2020 to the Prospectus RTS.211 The 2019 Prospectus Delegated Regulation is the core administrative measure, addressing the content, format, scrutiny, and approval of the prospectus. Supported by 29 detailed Annexes, its content ranges from principles-​based directions to NCAs as regards the prospectus approval process, to the highly granular, line-​item disclosures required in the prospectus. It is heavily based on ESMA’s detailed technical advice to the Commission,212 which reflected extensive market consultation213 as well as the Commission’s detailed mandate to ESMA.214 The relatively smooth adoption of what is a pivotal administrative measure reflects, as noted above, the well-​tested nature of the rules it carries over from the precursor (and frequently revised) 2004 Commission Regulation,215 but also ESMA’s generally responsive and proportionate approach in designing the rules216 and in managing market feedback.217 The passage of the 2019 Prospectus RTS, a largely technical measure, 208 Delegated Regulation (EU) 2019/​980 [2019] OJ L166/​26. 209 RTS 2019/​979 [2019] OJ L166/​1. 210 Delegated Regulation (EU) 2021/​528 [2021] OJ L106/​32. 211 RTS 2020/​1272 [2020] OJ L300/​1 made a series of relatively minor revisions. 212 2018 ESMA Prospectus Technical Advice, n 202. The Commission’s revisions to ESMA’s advice were largely directed to the organization of and terminology used in the measure. The main point of difference related to the SME-​oriented EU Growth Prospectus, as regards which the Commission lightened ESMA’s approach, reflecting the emphasis it had earlier placed in its mandate to ESMA (n 207) that the EU Growth Prospectus be as streamlined as possible: Commission, Explanatory Memorandum to Delegated Regulation Proposal (C(2019) 2020) 2. 213 ESMA’s advice was based on three consultations papers (format and content; EU Growth Prospectus; and prospectus scrutiny and approval) and was subject to a cost benefit analysis. 214 2018 Commission Prospectus Mandate, n 207. ESMA was advised, eg, that there should be a ‘tangible difference’ between the new EU Growth Prospectus and the standard prospectus and so ESMA should devise this new prospectus ‘from scratch’ (at 6 and 9–​10). 215 Commission Regulation 809/​2004 [2004] OJ L149/​1 (now repealed). 216 ESMA, eg, took as a design principle that the 2017 Prospectus Regulation was designed to simplify and minimize costs: 2018 ESMA Prospectus Technical Advice, n 202, 15. 217 ESMA proved willing to change course, while adopting a purposeful approach. eg, it did not agree with the view that there be greater flexibility in how risk factors were to be presented (given risks to investor protection

100 Capital-raising heavily based on earlier administrative rules,218 was similarly smooth. It covers more technical matters and addresses the publication of prospectuses, advertisements, prospectus supplements, and the financial information requirement in the retail summary. The final element of the administrative rulebook, the Mergers and Takeovers Delegated Regulation was adopted in 2021. Further rule-​making is likely as ESMA has been given mandates empowering it to, either on its own volition or on a mandatory basis where the Commission so requests, prepare additional RTSs.219 ITSs are not a major feature of the regime although ESMA has a series of mandates to propose ITSs for related templates and forms. At the core of ESMA’s extensive soft law measures are its 2021 Guidelines on the Prospectus Regulation’s disclosure requirements.220 Designed to ensure the ‘common, uniform and consistent application’ of the details of 2019 Prospectus Delegated Regulation, the Guidelines delve deep into how prospectus disclosure is to be presented, including as regards financial information (such as pro forma information, working capital statements, and profit forecasts) and narrative information (such as the required ‘operating and financial review’ (OFR)). Attesting to the maturity of the prospectus regime, these operationally critical Guidelines carry over much of the previous ‘ESMA Recommendation’ on the presentation of disclosure, reflecting wide market support for that measure.221 Largely uncontested over their development, the 2021 Guidelines are accompanied by the significantly more controversial 2019 Risk Factor Guidelines, which amplify the risk factors regime and which address the related NCA supervisory process, somewhat notoriously directing NCAs to ‘challenge’ risk factor disclosures;222 and by the less combustible, but still operationally significant for issuers and investors, 2015 Guidelines on Alternative Performance Measures (APMs) (adopted under the 2004 Transparency Directive, they amplify how such measures, commonly used in issuer disclosures, are to be used in prospectuses and other regulated disclosures).223 Together, the three sets of Guidelines form a granular manual on how the legislative and administrative prospectus regime applies in practice. They also indicate the extent of ESMA’s technocratic reach over the prospectus regime. The 2021 Prospectus Guidelines have a long lineage, with roots in the CESR-​era,224 but the 2019 Risk Factor Guidelines, which derive from a specific co-​legislators’ mandate to ESMA in the Prospectus Regulation, illustrate the extent to which ESMA’s soft law function has become embedded in the legislative process: that ESMA was mandated to provide Guidelines in what was then a and comparability), but it provided for greater flexibility for the Universal Registration Document (URD), to encourage its use, and withdrew its proposal for a cover note to be included in the base prospectus. 218 Primarily as regards advertisements (RTS 2016/​301 [2016] OJ L58/​13); prospectus supplements (RTS 382/​ 2014 [2014] OJ L111/​36); and prospectus publication (RTS 2016/​301 [2016] OJ L58/​13)—​all since repealed. 219 Covering the omission of information from prospectuses, expanding the documents that can be incorporated by reference, and the publication process (Prospectus Regulation Arts 18(4), 19(4), and 22(12)). 220 ESMA, Guidelines on Disclosure Requirements under the Prospectus Regulation (2021). 221 ESMA, Final Report on the Prospectus Guidelines (2020). The Guidelines are based on CESR’s original 2005 Recommendation on prospectus disclosures, which was reissued in the form of ESMA Recommendations in 2011 and 2013. 222 ESMA, Guidelines on Risk Factors under the Prospectus Regulation (2019). This key element of the new regime was contested during the related consultation, but ESMA did not change its approach, underlining that the Regulation was designed to bring a step-​change to how risk factors were disclosed: ESMA, Final Report on the Risk Factors Guidelines (2019) 8. 223 APMs are informal financial measures that are not defined or specified in the EU’s financial reporting framework, such as ‘operating earnings’, ‘cash earnings’, and ‘net debt’. ESMA, Guidelines on Alternative Performance Measures (2015). 224 n 221.

II.4  The Prospectus Regulation  101 contested area suggests considerable political and institutional comfort with ESMA’s ability to deliver outcomes from legislative directions. These sets of Guidelines, like all ESMA Guidelines, are relatively static, have a quasi-​ binding quality with NCAs being subject to a ‘comply or explain’ obligation,225 and are governed by distinct formalities as regards their adoption and revision under Article 16 of the ESMA Regulation.226 The ESMA Prospectus Q&A, a key resource for the market, and a legacy from the CESR-​era, is a more informal and dynamic measure. Designed to promote common, uniform, and consistent supervisory approaches and practices in the day-​to-​day application of the Prospectus Regulation, and regularly updated in response to questions from stakeholders,227 it has evolved over time228 to become an agile and iterative means for addressing practical market concerns and novel issues in a timely manner.229 The Prospectus Q&A has also served as a short-​term fix for difficulties created by legislative or administrative rules, although here its soft status becomes troublesome as regards legitimation.230 The Prospectus Regulation is now supported by a dense administrative rulebook and a thicket of soft law that amplifies its requirements in detail, but that also provides a wealth of practical examples, guidance, and templates. As a whole, the prospectus regime can be regarded as a sophisticated and mature system that has benefited from ESMA’s experience in rule design since 2011, not least as much of the Regulation’s administrative rulebook incorporates earlier administrative rules (adopted under the 2003/​2010 Directive) that have proved durable.

II.4.3  Setting the Perimeter: Public and Private Markets II.4.3.1 The Core Prospectus Publication Obligation The Prospectus Regulation follows the same regulatory design as regards its scope as the Prospectus Directive. Article 1 accordingly describes the purpose of the Regulation as laying down requirements for the drawing up, approval, and distribution of the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market situated or operating within a Member State. The ‘issuer’ who is the subject of this regime is defined as a legal entity which issues or proposes to issue securities, while the ‘offeror’ (the Regulation also applies to offers of securities by offerors other than the issuer) is defined as a legal entity or individual which offers securities to the public (Article 2(h) and (i)). Article 3 establishes the regime’s regulatory perimeter, which, like that of the precursor Directive, is fixed by two points: offer to the public; and admission to trading on a regulated 225 Unusually, market participants, including those responsible for a prospectus, are also subject directly to the 2021 Prospectus Guidelines. 226 As outlined in Ch I. 227 Which, as for all Q&As, are uploaded through an ESMA portal. 228 From the outset, the Prospectus Q&A was regarded by the markets as a quick, flexible, and efficient means of reducing diverging practices across the Member States: 2007 CESR Prospectus Report, n 183, 8 and 42. For an early assessment see Franx, J-​P, ‘Disclosure Practices under the EU Prospectus Directive and the Role of CESR’ (2007) 2 CMLJ 295. 229 The new URD format, eg, has prompted Q&As, as has Brexit. 230 Q&As were, eg, used to provide guidance on prospectus obligations relating to ‘retail cascades’ (a form of distribution) before legislative change followed under the 2010 Amending Directive.

102 Capital-raising market. Under Article 3(1), securities shall only be offered to the public in the Union after prior publication of a prospectus in accordance with the Regulation; while under Article 3(3) securities shall only be admitted to trading on a regulated market situated or operating in the Union after prior publication of such a prospectus.231 An equality of access principle also applies under Article 22: where material information is disclosed by an issuer or an offeror and addressed to one or more selected investors (whether orally or in writing), this information must either be disclosed to all investors (where the prospectus obligation does not apply) or be included in the prospectus or a supplement thereto (Article 22(5)). The Regulation, like the precursor Directive, contains several devices to set, and then provide exemptions from the application of, this regulatory perimeter, which are noted in the following sections. The net effect of these is, first, to situate the Prospectus Regulation in the ‘public’ market, broadly conceived, and so to give it a retail flavour (which is accentuated by the retail summary); and, second, to facilitate the legally secure operation of a wide ‘private’ market, broadly conceived (this market includes trading venues that are not regulated markets), where the prospectus requirement does not apply. In this regard, the design of the Regulation tracks that of the Directive. While the development of the Regulation saw some discussion of the appropriateness of the longstanding public offer/​admission-​to-​a-​ regulated market ‘public’ perimeter,232 the perimeter debate quickly coalesced around how best to tailor the operation of the prospectus requirement within the public offer/​regulated market ‘public’ perimeter, particularly as regards its application to secondary issuances/​repeat issuers and SMEs.233 One of the distinctive features of the Regulation, accordingly, is its provision of different prospectus formats, and related alleviated disclosure models, which can be used within the Regulation’s ‘public’ regulatory perimeter, and which bring some degree of deregulation within a regulatory perimeter which has otherwise not been materially redrawn since 2003. The outcome has been that while the prospectus regime perimeter remains more or less familiar from that in place since 2003, how the prospectus requirement applies within this perimeter is significantly more atomized. While the Regulation’s ‘public’ regulatory perimeter is widely cast, a series of exemptions operate to limit its reach and so to define the ‘private’ space where a prospectus is not required, particularly as regards small offers, repeat issuers, and the wholesale markets, as noted below. Separate exemptions apply for offers to the public (Article 1(4)) and admissions to trading on a regulated market (Article 1(5), but they can be combined (Article 1(6)). Offers can therefore be structured so that they benefit from a public offer exemption and also that the securities can be admitted to trading on a regulated market without a prospectus (albeit that such transactions will most likely take the form of a secondary offering of some type and a cap will often apply, as discussed below). These exemptions have expanded over time and were added to by the Regulation. The Regulation also confirms that where an offer or admission is outside the scope of the Regulation or subject to an exemption, the issuer can elect to voluntarily draw up a prospectus in accordance with

231 The Regulation, as a directly applicable instrument, is crafted in imperative terms. The precursor Directive version of Art 3, by contrast, directed Member States not to allow offers without prior publication of a prospectus and to ensure admissions to a regulated market were subject to the prospectus publication requirement. 232 2015 Commission Prospectus Consultation, n 192. 233 See, eg, 2015 ESMA Prospectus Consultation Response, n 195, 4, noting that the public offer/​admission to regulated market design model remained valid, but calling for better differentiation between primary and secondary issuances.

II.4  The Prospectus Regulation  103 the Regulation which, once approved by the home NCA, can benefit from the Regulation’s passporting rights (Article 4).

II.4.3.2 Public Offers The reach of the Regulation is governed in large part by whether the securities are ‘offered to the public’ (Article 1). The pivotal concept of ‘an offer of securities to the public’, largely unchanged since 2003,234 is broadly defined by Article 2(1)(d) as a communication to persons, in any form and by any means, presenting ‘sufficient information’ on the terms of the offer and the securities to be offered, so as to enable an investor to decide to purchase or subscribe to the securities in question (the definition also applies to the placing of securities through a financial intermediary). The longevity of this open-​textured definition235 (despite initial concerns that it could generate divergence risks as its interpretation is a function of national law and practice236 albeit subject to definitive interpretation by the Court of Justice) and the limited evidence of significant market concern (there is, for example, only one Q&A on the scope of ‘offer to the public’ in ESMA’s lengthy Prospectus Q&A237 and only one material Court of Justice ruling)238 speak to its resilience. It has also proved effective in defining the scope of the prospectus regime and in generating related deterrent effects: the need for care in designing and distributing pre-​offer communications, particularly by investment analysts connected to the issuer, to avoid triggering the prospectus requirement, has often been highlighted.239 ESMA’s intensifying supervisory convergence activities, which include peer review, suggest that any emerging difficulties would likely prompt convergence action,240 but with close to twenty years of experience, the risks of divergence now seem more apparent than real. The totemic ‘offer to the public’ definition remains nonetheless a relatively rare example of a principles-​based definition in an otherwise dense single rulebook.

234 During the development of the 2010 Amending Prospectus Directive, the Commission acknowledged some implementation difficulties, but highlighted the dangers in changing the definition given its benchmark effects and suggested that guidance would be the most appropriate tool for addressing any legal certainty issues: 2009 Background Document, n 185, 15. 235 The adoption of this definition by the 2003 Prospectus Directive was regarded as a material success given the forlorn admission in the earlier Public Offers Directive that ‘so far, it has proved impossible to furnish a common definition of the term “public offer” ’: 2003 Revised Prospectus Directive Proposal, n 89, 12. 236 Some early market concerns were expressed as to the consistent application of this definition in CESR’s 2007 Prospectus Report, n 183, 19. 237 The question concerns whether a ‘simple indication of secondary market prices’ can be considered to be an offer to the public: ESMA Prospectus Q&A, Q4.5. Answering that it would not, the Commission (which provided the answer) referred to recital 14 of the Prospectus Regulation which states that the publication of bid and offer prices is not in itself to be regarded as an offer of securities to the public. 238 In a preliminary ruling sought by the Hoge Raad of the Netherlands, the Court of Justice found that an enforced sale of securities by a creditor seeking recovery of the proceeds for a claim against the debtor did not amount to a public offer and was not subject to the prospectus requirement: Case C-​441/​12 Almer Beheer BV and Daedalus Holding BV v Van den Dungen Vastgoed BV and Oosterhout II BVBA (ECLI:EU:C:2014:2226). The Court noted the broad nature of the definition, but found that the nature of the transaction was ‘significantly different’ in nature to those contemplated by the (then) Prospectus Directive, and that an obligation to publish a prospectus in such circumstances would impede the objectives of the related enforcement proceedings. 239 eg Teerink, H, ‘The IPO and Listing Process in Practice’ in Busch et al (2020), n 163, 27. 240 ESMA supported greater specification of the definition over the development of the 2017 Regulation, reflecting its concern to support supervisory convergence, suggesting that remedial convergence action could follow: 2015 ESMA Prospectus Consultation Response, n 195, 15.

104 Capital-raising

II.4.3.3 Regulated Markets Similarly, the ‘regulated market’ perimeter, fixed by Article 3(3), has not changed materially over time, although it has shifted slightly as the definition of a regulated market has been refined, most recently by MiFID II Article 4(1)(21) which, in accordance with Article 2(j) of the Prospectus Regulation, defines ‘regulated market’. In effect, the regulated market designation is an opt-​in designation which a trading venue can chose to adopt and which brings with it the highest level of venue regulation.241 The reliance on the MiFID II ‘regulated market’ concept to set the perimeter of the prospectus regime reflects the wider reliance on the MiFID II ‘regulated market’ concept across the single rulebook as a means for marking the boundary between large, public, liquid trading venues which, in part because of the branding associated with these venues, should attract the highest levels of regulation, whether with respect to issuers, intermediaries, trading or the venues themselves, and other venues. The regulated market boundary effect is, however, weakening, with the market abuse regime applying to a wide range of trading venues, while much of MiFID II/​ MiFIR applies to trading venues generally. The regulated market perimeter in the issuer-​ disclosure/​prospectus context also reflects the central role played by trading venues and related admission-​to-​trading rules in the capital-​raising process and in particular the dynamics of competition and differentiation between venues. EU trading venues choosing to operate as regulated markets can brand themselves as venues subject to the most stringent disclosure requirements, under the Prospectus Regulation, and so position themselves on the ‘funding escalator’ on which issuers move from private funding, through to second-​ tier trading venues, and on to regulated markets. Admission to non-​regulated-​markets, termed multilateral trading facilities (MTFs) under the MiFID II classification system, is not subject to the prospectus requirement, unless an offer to the public is carried out.242 As discussed in section 8, MTFs are thereby free to compete as regards admission disclosure requirements, although minimum requirements apply under MiFID II to the ‘SME Growth Market’, a specific form of MiFID-​regulated MTF designed to promote SME capital-​raising. The regulated market concept carries out more heavy lifting under the Prospectus Regulation, however, than previously under the 2003/​2010 Directive, as it is now also used to support lighter prospectus formats for certain repeat issuers on regulated markets, given that issuers admitted to a regulated market are subject to the highest levels of ongoing disclosure imposed by the single rulebook, through the Transparency Directive (these issuers are also required to make the ongoing disclosures relating to ‘inside information’ which apply to issuers admitted to a wide range of trading venues under the Market Abuse Regulation). The Article 14 simplified prospectus regime for secondary issuances, in particular, is predicated on high quality ongoing disclosures already being available to the market on issuers admitted to regulated markets (through the operation of the Transparency Directive), thereby obviating the need to provide the same level of prospectus disclosures as are required in relation to primary issuances by issuers not previously admitted to a regulated market. In its integration, thereby, of the ongoing Transparency Directive disclosures for regulated market issuers into the prospectus system, the Prospectus Regulation is

241 On the ‘regulated market’ definition see Ch V section 5.2. 242 As is highlighted by recital 14 which notes that mere admission of securities to trading on an MTF is not to be regarded in itself as an offer to the public.

II.4  The Prospectus Regulation  105 significantly more streamlined and cost-​sensitive than the precursor Directive. It remains to be seen how far this integration of disclosure will be taken.243 The bifurcation between regulated markets and MTFs which has characterized the prospectus regime since 2003, is, however, somewhat blurred by the Regulation, with some early indications of a more trading-​venue-​neutral approach emerging. The lighter EU Growth Prospectus (Article 15) is designed for offers to the public by smaller issuers, including those traded on MTFs in form of a MiFID II SME Growth Market. As discussed in section 4.9.7, the EU Growth Prospectus is not available for such smaller issuers where they are admitted to trading on a regulated market, given the risk of investor confusion between prospectus formats; and it is an option for MTF issuers, it is not a mandatory requirement. Nonetheless, the EU Growth Prospectus represents an incursion into a previously monolithic distinction between public offer/​regulated market prospectuses subject to the prospectus regime, and the other admission documents subject to MTF rules (in the absence of a public offer). Other indications of a tentative move towards a more trading-​venue-​ neutral approach are peppered across the Regulation, including as regards the Universal Registration Document (URD) (Article 9). This new form of disclosure, designed to support frequent issuers, can also be prepared by an issuer admitted to an MTF and, should the issuer transfer to a regulated market, can be used for the purposes of meeting ongoing disclosure and prospectus requirements. It remains to be seen whether the prospectus regime will evolve into prescribing the minimum content of MTF admission documents more generally. The risks to competition, innovation, and experimentation, combined with a dearth of evidence as to difficulties with MTF admission documents,244 suggest this is unlikely, particularly as the Commission raised but dismissed the prospect of requiring a mandatory prospectus for all MTF admissions during the development of the Regulation.245 A reconfiguration of the regulated market perimeter cannot, however, be entirely discounted.246

II.4.3.4  Securities Further perimeter control comes via the definition of the ‘securities’ subject to the Article 3(1) and (3) prospectus publication requirements. These are defined as ‘transferable securities’ under the MiFID II/​MiFIR regime,247 with the exception of money-​market instruments having a maturity of less than twelve months (Article 2(a)). The foundational MiFID II definition is broad, covering classes of securities negotiable on the capital market, 243 The UK looks set, post-​Brexit, to remove the mandatory prospectus requirement for admission to regulated markets, given the availability of ongoing disclosures, and to confer discretion on the regulator to decide when a prospectus is needed in such circumstances (n 10). Similarly, the 2022 Listing Act reform agenda (n 144) suggests intensifying reliance on this strategy given its proposed lightening of the disclosures required of frequent issuers through the ‘EU Follow-​on Prospectus’. 244 Which are often in practice similar to prospectuses: Driessen, M, ‘The Prospectus Regulation and other EU Legislation—​the wider context for prospectuses’ in Busch et al (2020) n 163. 245 2015 Commission Prospectus Consultation, n 192. ESMA’s review of the SME Growth Market also suggested little ESMA or market appetite for harmonization: 2021 ESMA SME Growth Market Review, n 159. 246 ESMA has reported that 74 per cent of issuers traded on EU trading venues fall within the MiFID II definition of an SME (capitalization of €200 million or less), prompting one analysis to query whether the regulated market should remain the perimeter for much of EU regulation: Annunziata, F, ‘The Best of All Possible Worlds?’ The Access of SMEs to Trading Venues: Freedom, Conditioning and Gold-​plating, EBI WP 2021-​96 (2021), available at . The 2022 Listing Act reform agenda (n 144) has, however, proposed a mandatory, short-​form ‘EU Growth Issuance Document’ for SME Growth Markets. 247 MiFID II Art 4(1)(44). See further Ch IV section 5.3.

106 Capital-raising including shares and bonds (and any related depositary receipts) and any other securities giving the right to acquire or sell any such securities. Equity and non-​equity securities are further defined, given their differential treatment under the Regulation, with non-​equity wholesale market debt securities in particular eligible (since 2003) for an alleviated disclosure regime. Equity securities (Article 2(b)) are defined as shares and other transferable securities equivalent to shares in companies, as well as any other type of transferable securities giving the right to acquire any of these securities as a consequence of their being converted or the rights conferred on them being exercised. Convertible securities must, however, be issued by the issuer of the underlying shares or by an entity belonging to the issuer’s group. Non-​equity securities are simply defined under Article 2(c) as all securities that are not equity securities Article 1(2) sets out several classes of securities which are excluded from the Regulation and which, for the most part, date back to 2003. Under Article 1(2)(a), units issued by collective investment undertakings other than the closed-​end type248 are excluded, as particular disclosure requirements typically apply to these open-​ended funds.249 Government debt and other quasi-​ sovereign securities are also exempt via Article 1(2)(b)-​ (d)). Notwithstanding support in some quarters, as the EU sovereign debt crisis deepened over the financial-​crisis era, for more extensive disclosure with respect to the risks which sovereign debt carries, there has been little enthusiasm for reform in this area, reflecting the extensive disclosure already available with respect to sovereign issuers. The reach of the crisis is, however, evident in the exemption from the prospectus requirement for the admission to a regulated market of securities resulting from the conversion or exchange of other (in effect, bail-​in-​able) securities, own funds, or eligible liabilities by a resolution authority on foot of its resolution powers under the EU’s recovery and resolution regime (Article 1(5) (c)).250

II.4.3.5 Narrowing the Perimeter and Offers to the Public: Private Markets and Placements The Regulation, building on earlier reforms, carves out, through a series of exemptions, a ‘private’ market space which operates without mandatory prospectus requirements. The related exemptions reflect long-​established policy rationales for disapplying public market disclosure standards (i.e. disclosures being unnecessary in the professional/​wholesale private markets; or imposing too high a cost on small offers with limited public reach), but they also reflect the Regulation’s more muscular, CMU-​framed approach to supporting capital-​ raising, and in particular its concern to facilitate smaller issuers. The Regulation provides for two major classes of exemption as regards the prospectus requirement for offers to the public: for wholesale-​market-​oriented private placements; and for SMEs and similar issuers. Where the securities are admitted to a regulated market, these exemptions lift.

248 The defining characteristics of these entities is the collective investment of capital provided by a number of investors in accordance with a defined investment policy and that units are, at the holder’s request, repurchased or redeemed, directly or indirectly, out of the undertaking’s assets (Art 2(p)). Units are securities issued by a collective investment undertaking as representing the rights of the participants in such an undertaking over its assets (Art 2(q)). 249 Open-​ended funds in the form of a ‘UCITS’ are subject to the extensive UCITS regime discussed in Ch III. 250 Distinct disclosure requirements apply under the 2014 Bank Recovery and Resolution Directive 2014/​59/​EU [2014] OJ L173/​190.

II.4  The Prospectus Regulation  107 The wholesale market private placement regime remains based on the system originally adopted by the 2003 Prospectus Directive, which was then regarded as a significant advance on earlier attempts to accommodate the wholesale markets,251 and which was extended by the 2010 Amending Directive. Something of a sea-​change was signalled at the outset of the development of the Prospectus Regulation as regards a central feature of this private placement regime: the exemption from the public offer prospectus requirement of offers of securities of denomination of at least €100,000 (€50,000 under the 2003 Directive but increased in 2010). The Commission sought to remove this exemption on the grounds that it had created a strong disincentive to issue smaller denomination debt, with adverse consequences for liquidity in EU bond markets and also for retail access to debt securities.252 While this reform, which would have had significant implications for the operation of the EU wholesale debt market, garnered some support from the buy-​side253 and from the European Central Bank (ECB),254 it was rejected by the Council255 and did not survive the negotiating process. In a compromise solution designed to support liquidity and encourage the issuance of smaller denominations, the alleviated prospectus regime which applies to admissions to regulated markets of debt securities of at least €100,000 denomination has been extended by the Regulation to cover debt of any denomination, listed on a regulated market (or segment thereof) to which only qualified investors can have access for the purpose of trading such securities (section 4.9.6). The private placement regime flows from Article 1(4) which exempts a series of offers to the public from the prospectus obligation. The first Article 1(4) exemption covers an offer of securities addressed solely to ‘qualified investors’ (Article 1(4)(a)) but, and like all the Article 1(4) exemptions, only as long as the securities are not also admitted to trading on a regulated market. The definition of a qualified investor is aligned to the MiFID II definition of a professional client (Article 2(e)). Accordingly, the following four classes of entity are deemed to be qualified investors: entities required to be authorized or regulated to operate in the financial markets (including credit institutions, investment firms, insurance companies, collective investment schemes, pension funds and other institutional investors); large undertakings;256 national and regional governments and similar public bodies, including international and supranational organizations; and other institutional investors whose main activity is to invest in financial instruments. A second category of investors can, in accordance with the MiFID II professional client system, be deemed to be qualified upon request and provided they meet two of the following criteria: the investor has carried out transactions, in significant size, on the relevant market at an average frequency of ten per

251 eg Ferran, n 173, 200–​1. 252 The Commission argued that the exemption was creating a regulatory disincentive to issue in the retail markets which was prejudicial to households’ capacity to save for the long-​term and could also be associated with thin liquidity in the corporate bond market, citing an OECD study that reported that some 70 per cent of listed bonds in the EU were in denominations of €100,000 and above: 2015 Commission Proposal IA, n 191, 29-​30. 253 There was some support from the asset management sector and from trading venues who sought removal of the exemption as it would make the operation of venues’ central limit order books (on which see Ch V) easier and thereby enhance liquidity: 2015 Commission Proposal IA, n 191, 32. 254 The ECB was supportive of removal given the technical difficulties large denominations posed for clearing and settlement: ECB Opinion, n 191. 255 Reflecting Member State concern that removal would disrupt bond markets and that the link between large denominations and thin liquidity was not made out. 256 Firms must meet two of the following criteria: balance sheet of €20 million or more, or net turnover of €40 million or more, or own funds of €2 million or more.

108 Capital-raising quarter over the previous four quarters; the investor’s financial instrument portfolio must exceed €500,000; or the investor must have worked in the financial sector for at least one year in a professional position. Investment firms and credit institutions must follow a range of procedural requirements in classifying their client base,257 reflected in the Prospectus Regulation providing that investment firms and credit institutions must, on request of the issuer, inform the issuer of their client classifications (Article 2(e)). The alignment to the MiFID II professional client definition is operationally important as it allows advisers and underwriters to rely on their client-​base classifications when they design private placements. In addition, offers designed in practice to be sold to professional or sophisticated investors are also exempted, in that offers of securities whose denomination per unit amounts to at least €100,000 (Article 1(4)(c)) are exempted, as are offers addressed to investors who acquire securities for a total consideration of at least €100,000 per investor for each separate offer (Article 1(4)(d)). The €100,000 exemptions have been contested, primarily as regards their effects in the retail markets, being extended in 2010 to €100,000 from €50,000, on retail investor protection grounds;258 and, over the Prospectus Regulation negotiations, being, as noted above, the subject of a failed Commission attempt at removal, this time in part on the grounds that retail market access to small denomination bonds was being obstructed. Offers of securities addressed to fewer than 150 natural or legal persons per Member State (other than qualified investors) are also excluded (Article 4(2)(b)). Any subsequent resale of such exempt securities is to be considered a separate offer and, if it comes within the definition of an offer to the public, is subject to the prospectus requirement; similarly, a placement of securities through financial intermediaries requires a prospectus unless an exemption applies to the final placement (Article 5(1)). An additional prospectus is not, however, required as long as a valid prospectus is available and the issuer (or person responsible for its drawing up) consents to its use (Article 5(2)). While these exemptions can be called in aid by SMEs, smaller offers are the subject of two specific alleviations designed to facilitate SME access to the capital markets. These date back to the 2003 Directive, although the thresholds have increased over time. First, offers of securities to the public with a total consideration in the EU of less than €1 million (calculated over a twelve-​month period) fall outside the scope of the Regulation entirely (Article 1(3)). In an unusually extended reach into Member States’ regimes, but indicative of the priority now being given to SMEs, Article 1(3) also provides that while Member States may not apply the prospectus requirement to such offers to the public, they may impose other disclosure requirements, but only as long as these do not constitute an unnecessary or disproportionate burden. Second, Member States have discretion to exempt offers of securities to the public, as long as such offers are not cross-​border and the total consideration of each offer (calculated over a twelve-​month period) does not exceed a threshold no higher than €8 million (Article 3(2)). The Regulation negotiations saw some contestation on these thresholds (the Commission and Council sought a €500,000 threshold for offers outside the scope of the Regulation and a €10 million threshold for the optional exemption; the Parliament sought €1 million and €5 million, respectively). As such, the thresholds

257 See further Ch IV section 6.2. 258. Market practice suggested that €50,000 was not sufficiently high to ensure that a predominantly wholesale market operated under the exemptions, given evidence that retail investors were purchasing investments of that denomination, and they were amended in 2010.

II.4  The Prospectus Regulation  109 represent a compromise position,259 designed to reduce costs for smaller issuers. Member States have taken different approaches to the optional exemption, with most Member States exempting offers up to €8 million, a significant minority applying a €5 million threshold, and a small minority applying lower thresholds, including of €1 million.260 In practice, national divergences are unlikely to represent a significant cost, given that SME funding is usually local in orientation. The practical benefit of these alleviations, which are, in different forms, of longstanding, remains questionable. While they may support crowdfunding and while they may be extended,261 offers on such a small scale are most likely to benefit from the private placement system and are unlikely to engage with public capital-​raising. Given the dependence of SMEs on bank rather than market funding, the more material benefits may follow from a final Article 1(4) exemption: for debt securities issued by credit institutions, designed to facilitate the issuance of bonds by smaller credit institutions, given that credit institutions are subject to prudential supervision and that facilitating bond issuance ultimately supports bank financing, particularly for SMEs. Article 1(4)(j) accordingly exempts non-​equity securities issued in a continuous or repeated manner by credit institutions, as long as the total consideration for the offer is less than €75 million (calculated over a twelve-​month period); the securities must not be subordinated, convertible, or exchangeable, not give a right to subscribe to or acquire other types of securities, and not be linked to a derivative instrument.262 The €75 million cap was raised (on a time limited basis to 31 December 2022) to €150 million as part of the EU’s Covid-​19 Recovery Package (Article 1(4)(l)).263

II.4.3.6 Narrowing the Perimeter and Offers to the Public: Exempted Transactions An additional series of exemptions, directed to facilitating particular funding and share-​ capital transactions which do not involve a material change for an issuer and/​or where disclosure is generally already available, applies under Article 1(4). The prospectus obligation does not apply to shares issued in substitution for shares of the same class already issued, where the issuing of the new shares does not involve any increase in the issued share capital (Article 1(4)(e)). Securities offered in connection with a takeover by means of an exchange offer are also exempt, but only as long as a document is available to the public which describes the transaction and its impact on the issuer (Article 1(4)(f)).264 A similar exemption applies to securities offered, allotted, or to be allotted in connection

259 Only the Commission’s position was subject to an impact assessment, which suggested that, while the pre-​ existing thresholds were already balanced, increasing the optional exemption from (under the 2010 Directive) €5 million to €10 million might support more issuers, although only to the extent of an additional 3 per cent of approved prospectuses falling outside the regime: 2015 Prospectus Proposal IA, n 191, 17–​22. 260 ESMA, National Thresholds Below which the Obligation to Publish a Prospectus does not Apply (2020). 261 As was highlighted by the Commission in its IA which noted that even a small increase of the mandatory exemption from €100,000 (the 2003/​2010 threshold) to €500,000 would provide a safe harbour for the ‘vast majority’ of crowdfunding initiatives, with the average fund-​raising on crowdfunding platforms then amounting to €250,000: n 191, 20. The 2022 Listing Act reform agenda (n 144) proposed an expansion of the exemptions in the form of a single, mandatory exemption of €12 million. 262 An exemption also applies where such securities are admitted to trading on a regulated market (Art 1(5)(i)). 263 The threshold increase was designed to ‘foster fundraising for credit institutions and give them breathing space to support their clients in the real economy’: 2021 EU Covid Recovery Regulation recital 4. The cap increase also applied where such securities were admitted to trading on a regulated market (Art 1(5)(k)). The 2022 Listing Act reform agenda (n 144) proposed that this alleviation be made permanent. 264 The previous iteration of this exemption was more restrictive, requiring that the document contain information which the relevant NCA regarded as equivalent to the prospectus disclosures.

110 Capital-raising with a merger or division as long as, again, an equivalent document is made available (Article 4(1)(g)).265 Dividends paid out to existing shareholders in the form of shares of the same class as the shares in respect of which such dividends are paid are exempted, provided a document is available setting out information on the number and nature of the shares, and the reasons for and details of the offer (Article 1(4)(h)). An offer of securities to the public from a crowdfunding service provider authorized under the 2020 Crowdfunding Regulation (section 11.2) is also exempted, as long as it falls under the €5 million threshold applicable under the Crowdfunding Regulation (Article 1(4)(k)). A longstanding exemption is available for occupational share schemes. It has been relaxed over time, in particular by the removal of the significant restrictions which originally applied to third country companies (the exemption initially applied only where the company had securities admitted to trading on an EU regulated market; while it was extended in 2010 to cover third country companies admitted to third country regulated markets, restrictive equivalence requirements were imposed).266 Reflecting the CMU concern to promote wider household saving through the capital markets, the exemption has now been materially loosened by the Prospectus Regulation to provide for an exemption for securities offered, allotted, or to be allotted to existing or former employees or directors, by their employer or an affiliated undertaking (with no restriction as to EU incorporation or admission to trading), as long as a document is made available containing information on the number and nature of the securities and the reason for and details of the offer or allotment (Article 1(4)(i)).

II.4.3.7 Narrowing the Perimeter and Admissions to a Regulated Market: Frequent Issuers and Exempted Transactions The exemptions in Article 1(4) lift where the securities are admitted to trading on a regulated market. A discrete set of exemptions apply, however, to such admissions. While most are of relatively longstanding, they have been expanded by the Prospectus Regulation to facilitate frequent and secondary issuers (who also benefit from the Article 14 simplified disclosure regime where an exemption is not available). Chief among the reforms, and welcomed by the market, is Article 1(5)(a) which (proposed by the Commission and not contested over the negotiations) exempts admissions of securities fungible with securities already admitted to trading on the same regulated market, as long as they represent, over twelve months, less than 20 per cent of the number of securities already admitted to trading on the same regulated market; the cap is designed to ensure that the exemption applies only where the capital-​raising is not a material transaction for the company. The precursor form of this exemption was limited to shares only and applied a 10 per cent cap. This deregulatory reform is balanced, however, by Article 1(5)(b) which applies a new cap of 20 per cent to admissions of shares resulting from the conversion or exchange of other securities (or from the exercise of rights conferred by other securities), where the resulting shares are of the same class as the shares already admitted to trading on the same regulated market; previously such shares were exempt from the prospectus

265 The Mergers and Takeovers Delegated Regulation 2021/​528 [2021] OJ L106/​32 prescribes the minimum information to be covered by such documents. 266 The restrictive nature of the exemption, and the adverse impact it had, with some international firms cancelling their occupational share schemes, was raised from an early stage. See, eg, 2008 CSES Report, n 183, 41–​2.

II.4  The Prospectus Regulation  111 requirement.267 While these two exemptions can be combined, a restriction applies in that they cannot, together, lead to the immediate or deferred admission to trading on a regulated market, over twelve months, of more than 20 per cent of the number of shares of the same class already admitted to trading on the same regulated market, without a prospectus being published (Article 1(6)). Otherwise, a similar series of transaction-​related exemptions as are available for offers to the public applies, including as regards shares issued in substitution for shares of the same class already admitted to trading on the same regulated market, as long as the issuance does not involve an increase in the share capital; takeovers and mergers; and occupational share schemes. An exemption is also available for securities already admitted to trading on another regulated market, subject to a series of conditions, including as to the availability of regulated disclosures (Article 1(5)(j)).

II.4.4  The Prospectus: Disclosure II.4.4.1 The Core Obligation The prospectus regime is now strongly characterized by the granular administrative rules which dictate the content and format of prospectus disclosure. Nonetheless, at its core sits the over-​arching materiality standard for prospectus disclosure, set out in Article 6. The Article 6 standard frames the administrative rules. It also serves as the backstop prospectus disclosure obligation: accordingly, it supports prospectus supervision and enforcement and, depending on how national private liability systems are organized, can act as the standard against which the issuer’s private liability for negligent/​fraudulent prospectus disclosures is assessed. It is accordingly of pivotal importance to the prospectus regime. It is, however, restricted: it applies without prejudice to the alleviated prospectus regime for frequent issuers (Article 14) and that applicable under the now lapsed Covid-​19 Recovery Prospectus (Article 14a), both of which prospectuses are/​were governed by attenuated materiality standards; and to the omission of information regime (Article 18). Under Article 6(1) a prospectus must contain the ‘necessary information’ which is ‘material’ to an investor for making an informed assessment of: the assets and liabilities, profit and losses, financial position, and prospects of the issuer (and any guarantor); the rights attaching to the securities; and the reasons for the issuance and its impact on the issuer. ‘Necessary’ and ‘material’ are not defined by the Regulation or amplified by administrative rules; this design feature supports deterrent effects as well as the integration of the prospectus regime with national private liability regimes. The Article 6 standard reflects the original 2003 Prospectus Directive standard, which prevailed until the Regulation was adopted, but, and although the original standard was regarded as being well-​understood by the market,268 it has been tightened by the Regulation. 267 The cap does not apply in specified cases, including where a prospectus was drawn up in accordance with the Regulation (or the earlier Directive) on the offer to the public or admission to a regulated market of the relevant securities or where the shares qualify as credit institution own funds/​capital in accordance with the conditions set by Art 1(5). The 2022 Listing Act reform agenda (n 144) proposed further liberalization, including that the 20 per cent cap be expanded to 40 per cent. 268 It continues to enjoy market support, as noted by a recent UK report which characterized the standard as ‘robust, clear and comprehensible’: 2021 Treasury Review, n 10, para 4.5.

112 Capital-raising The precursor standard did not impose an express materiality test, being cast in terms of the prospectus containing all information which, according to the particular nature of the issuer and of the securities, was necessary to enable investors to make an informed assessment of the assets and liabilities, financial position, profit and losses, and prospects of the issuer (and of any guarantor) and of the rights attaching to the securities. The Commission’s 2015 Prospectus Proposal followed this formula, but the Council and Parliament toughened the standard by adding the express reference to materiality269 and by specifying that the ‘informed assessment’ relate also to the reasons for the issuance and its impact on the issuer.270 Article 6 provides, however (at the behest of the Parliament) that the required information ‘may vary’, depending on the nature of the issuer, the type of securities, the circumstances of the issuer, and whether the issuer is a wholesale debt market issuer (the issuer is issuing non-​equity securities of denomination of at least €100,000 or that are to be traded only on a regulated market/​specialized segment thereof to which only qualified investors have access). The need for a degree of proportionality in how the Article 6 test is applied is therefore acknowledged. In addition, the retail orientation of much of the prospectus regime is underlined by the Article 6 requirement that the information be written and presented in an ‘easily analysable, concise and comprehensible form’.

II.4.4.2 Risk Factors The Regulation does not otherwise specify how discrete prospectus disclosures are to be addressed (these are governed by the administrative rulebook),271 save as regards risk factors. In one of the Regulation’s most contested provisions,272 Article 16 seeks to ensure that risk factors, which must be disclosed in a prospectus,273 are limited to material and specific risks, and that uninformative ‘boiler plate’ disclosures, which operate like disclaimers, are avoided.274 Article 16(1) provides that the risk factors featured in a prospectus must be limited to risks specific to the issuer and/​or the securities and which are material for taking an informed investment decision, as corroborated by the content of the prospectus (they must therefore be related to prospectus disclosures). Issuers are also required to assess the materiality of the risk factors, based on the probability of their occurrence and the expected magnitude of their negative impact (materiality may be disclosed by reference to a qualitative ‘low, medium, high’ scale). Each individual risk factor disclosed must be adequately described, explaining how it affects the issuer or the securities. Risk factors must also be

269 The Parliament also sought references to the related disclosures being ‘relevant’ and being ‘reasonably required’ by the investor, but these proposals did not survive the negotiations: European Parliament Negotiating Position, n 191. 270 Inserted by the Council: n 191. 271 Although the Regulation sets out in brief in its Annexes the indicative disclosures required. 272 eg the Commission had proposed that all risk factors disclosed be placed within three materiality-​based categories, but this was removed by the Parliament and Council to allow issuers more flexibility, although industry concern remained considerable as to the potential liability risks of these disclosures. 273 Risk factor disclosure was required under the prospectus regime from the outset, under the 2003 Prospectus Directive’s administrative rules: eg 2004 Commission Regulation Art 25, requiring risk factors linked to the issuer and the securities to be disclosed. 274 The provision was designed to ‘curb the tendency of overloading the prospectus with generic risk factors which obscure the more specific risk factors that investors should be aware of ’: 2015 Commission Proposal, n 191, 17.

II.4  The Prospectus Regulation  113 presented in a limited number of categories, according to their nature, and the most material risk factor in each category must be presented first.275 Issuers are therefore required to quantify and rank risks. Article 16 is designed to bring about significant change in how issuers approach risk factors.276 It proved controversial as it constrains issuers in how they approach risk factors (which are useful to issuers as a means for mitigating liability risks, particularly in IPOs where an issuer typically has not previously made risk disclosures), in particular by requiring issuers to assess and rank the materiality of risk factors.277 It has also led to a step-​change in how NCAs engage with risk factor disclosures, particularly as the related and detailed 2019 ESMA Guidelines adopt a robust approach:278 the Guidelines envisage an iterative discussion on risk factors between the NCA and the persons responsible for the prospectus, and direct NCAs to challenge those persons, including where the disclosure of a risk factor does not establish a clear and direct link between the risk factor and the issuer/​ securities, as regards the inclusion of risk factors as disclaimers, and where the materiality of a risk factor appears to be compromised by mitigating language. Article 16 accordingly increases issuers’ enforcement risks, including as regards their appropriate categorization and prioritization of risk factors as well as in relation to the effectiveness of their internal processes for assessing the materiality of risks, as well as liability risks. Article 16 reflects an undercutting concern of the Regulation to ensure that disclosures are meaningful. It also, by requiring issuers to consider (and, implicitly, document) their choice of risk factors, forms part of the wider move across the single rulebook to proceduralize regulation and thereby to shape internal firm processes. This can be seen, for example, in the MiFID II product governance regime, which also shapes the issuance process.279

II.4.4.3 The Disclosure Rulebook The Article 6 materiality standard is the foundation stone for the vast administrative rulebook which operationalizes Article 6 by specifying the line-​item content of prospectuses, whether in standard form, or in the form of base, simplified, wholesale debt, or EU Growth prospectuses (the different prospectus formats are outlined in section 4.9). The five Annexes to the 2017 Prospectus Regulation set out the general categories of disclosures required, but in practice the disclosure rulebook is contained in the behemoth 2019 Prospectus Delegated Regulation. It sets out, in a series of Annexes, the detailed disclosures required, according to the type of securities offered and also the format of the prospectus

275 Risk factors are to include those arising from the subordination of a security and the impact of bankruptcy or action under the BRRD, and those arising from any guarantees: Art 16(2) and (3). 276 Art 16 has been described as requiring the quantification of risk factors in a manner novel to capital market regulation: Norton Rose, Prospectus Regulation (2019). In developing the related Guidelines, ESMA was unequivocal as to the need for change, noting that, under the Prospectus Directive, risk factors had often been used to mitigate liability and were often difficult for retail investors to understand, and that the Regulation was ‘seeking to influence a change of course’ and designed to prevent a recurrence of risk factors operating as disclaimers: 2019 Risk Factors Guidelines Final Report, n 222, 6. 277 ESMA noted market concern, but also general acceptance of ESMA’s attempt to balance flexibility and robustness in its related Guidelines: 2019 Risk Factors Guidelines Final Report, n 222, 8. Extensive market commentary has attended Art 16, including as regards the need for issuers to be alert to liability risks. See, eg, Hogan Lovells, Global Insights, The Prospectus Regulation is coming: getting your debt prospectuses ready (2019). 278 n 222. 279 See Ch IX section 4.11.

114 Capital-raising (the Delegated Regulation essentially organizes disclosures according to whether they relate to the prospectus registration document (which covers the issuer, as outlined below) or the prospectus securities note (which covers the securities, as outlined below),280 and whether the registration document/​securities note sit within a distinct prospectus format). Containing 29 detailed Annexes, the Delegated Regulation sets out the specific disclosures required for the registration document, according to the securities offered and the prospectus format;281 the securities note, according to the securities offered and the prospectus format;282 additional information for specific circumstances;283 the requirements for the EU Growth Prospectus;284 and other information required, including as regards the ‘final terms’ which is used with the base prospectus, and also in relation to specialist issuers.285 The Delegated Regulation accordingly follows the well-​established ‘building block’ format of the precursor administrative 2004 Commission Regulation, which distinguished between the disclosures required for registration documents and for securities notes, and according to the type of offer. The Delegated Regulation also establishes core principles, including as regards financial reporting and the use of IFRS. In substance, the 2019 Prospectus Delegated Regulation is very close to the precursor 2004 Commission Regulation, reflecting the Commission’s mandate to ESMA that the new administrative rules, under the 2017 Prospectus Regulation, should follow the approach of the 2004 Commission Regulation, as well as market concern that well-​established disclosure practices not be disrupted.286 Nonetheless, and given the concern to reduce costs and streamline disclosure that animates the 2017 Prospectus Regulation, the Commission also mandated ESMA to streamline where possible, ‘in a spirit of simplification’, and to carry forward disclosure items only where it had verified that they represented an appropriate balance between investor protection and cost. Similarly, while the Commission for the most part followed ESMA’s technical advice on the new rules (ESMA sought to simplify disclosures and to enable the issuer ‘to draw up a comprehensive, yet short and digestible prospectus which investors will read’),287 it streamlined some of ESMA’s recommendations.288 The Delegated Regulation is accordingly lighter than the 2004 administrative rules in some respects: for example, the previous (costly) requirement for an auditor’s report where forecasts and estimates are included in a prospectus has been removed, and forecasts and estimates are only required for equity offerings and then only where they are still outstanding and valid.289 Similarly, in order to enhance the ‘incorporation by reference’ system 280 Issuers can also choose to organise the prospectus as a unitary document which combines the registration document and securities note (Art 6(3)). 281 It covers the registration document for equity securities (Annex 1); secondary issuances of equity (3); units of closed-​end investment undertakings (4); depositary receipts over shares (5); retail non-​equity securities (6); wholesale non-​equity securities (7); secondary issuances of non-​equity securities; asset-​backed securities (9); non-​ equity securities issued by third country issuers. It also covers URD disclosures (Annex 2). 282 Equity and units of collective investment undertakings and secondary issuances of such securities (Annex 11 and 12); depositary receipts over shares (13); retail non-​equity securities (14); wholesale non-​equity securities (15); and secondary issuances of non-​equity securities (16). 283 Securities giving rise to payment or delivery obligations linked to an underlying asset (Annex 17); underlying shares (18); asset-​backed securities (19); pro forma information (20); guarantees (21); and consent (22). 284 Annexes 23–​27, covering the EU Growth Prospectus’ summary, registration document (equity and non-​ equity), and securities note (equity and non-​equity). 285 Annexes 28 and 29. 286 2018 Commission Prospectus Mandate, n 207. 287 2018 ESMA Prospectus Technical Advice, n 202, 14–​15. 288 Commission, Explanatory Memorandum to Delegated Regulation Proposal (C(2019) 2020) 2–​3. 289 Although the over-​arching Art 6 materiality/​necessity test applies as regards the inclusion of any outstanding forecasts and estimates for non-​equity offerings.

II.4  The Prospectus Regulation  115 (which allows issuers to incorporate public disclosures, previously made, in their prospectuses), ESMA was charged with ensuring consistency and adequate alignment between the prospectus requirements and other EU disclosure requirements, notably the ongoing requirements imposed by the Transparency Directive:290 the narrative operating and financial review (OFR) disclosure has accordingly been revised to align with the management report required in financial statements (under the Transparency Directive), although the minimum harmonization approach adopted by the Transparency Directive means that significant difficulties remain in incorporating its regulated disclosures into prospectuses. The 2019 Prospectus Delegated Regulation operates in tandem with ESMA’s detailed and practical 2021 Prospectus Disclosure Guidelines291 which cover a wealth of technical material, including the content of the OFR,292 the working capital statement, financial information, remuneration, and profit forecasts and estimates. Based on and updating the precursor CESR/​ESMA Recommendations on the application of the 2004 Commission Regulation, like the 2019 Delegated Regulation they provide continuity with well-​established disclosure practices, while reflecting the changes wrought by the Regulation.293 The ‘disclosure rulebook’ constituted by the 2019 Prospectus Delegated Regulation and the related 2021 Guidelines accordingly reflects the 2017 Prospectus Regulation reforms, but also the earlier 2004 Commission Regulation, which had been repeatedly revised, extended, and upgraded. This rulebook can therefore now be regarded as constituting a mature disclosure regime, albeit one that is continually being refined and amplified, notably through the frequently revised Prospectus Q&A. Notwithstanding the scale of this rulebook it is not, and cannot be, exhaustive, particularly given the speed with which the market develops new products and given the specificities which issuers can have. NCAs remain, as a result, the ultimate arbiters on the evolution of the disclosure rulebook as they exercise their prospectus approval powers,294 albeit within a supervisory operating framework framed by ESMA’s supervisory convergence powers and related ESMA soft law as well as by ESMA peer review and other supervisory convergence measures (outlined in section 12). Further reforms may follow from the 2022 Listing Act reform agenda, including, as regards the ‘standard’ prospectus format, a reduction in the range of disclosures required, standardization of disclosure format and order, and a 300-​page limit on share IPO prospectuses.

II.4.4.4 Omission of Information and the Final Price Articles 17 and 18 of the 2017 Prospectus Regulation set out the limited conditions under which information can be omitted from the prospectus. Article 17(1) addresses the final offer price and amount, and requires that where this disclosure cannot be included in the prospectus, either the acceptances of the purchase or 290 2018 Commission Prospectus Mandate, n 207, 15–​16. 291 n 220. 292 eg, the Guidelines provide that the OFR should be balanced, comprehensive, and consistent with the size and complexity of an issuer’s business; and establish over-​arching principles for the preparation of the OFR, its content, and how the related management report can be used: n 220, 11–​13. 293 The Guidelines for the most part carry over the earlier CESR/​ESMA Recommendations (2020 ESMA Final Report Prospectus Disclosure Guidelines, n 221, 11). Not all of the CESR/​ESMA Recommendations were carried into the new Guidelines, however. The recommendations relating to specialist issuers still apply and are contained in ESMA, Update of the CESR Recommendations (2013). 294 As is acknowledged by the 2019 Prospectus Delegated Regulation which recognizes that NCAs can require additional disclosures of ‘specific and adapted’ information, and that NCAs, in discussion with issuers, should determine any additional disclosures required for new securities not covered by the Regulation: recitals 23 and 24.

116 Capital-raising subscription of the securities may be withdrawn for not less than two working days after the final offer price and/​or amount of securities have been filed; or specified disclosures are made in the prospectus covering the maximum price and/​or the maximum amount of securities, as far as available, or covering the valuation methods and criteria, and/​or conditions, in accordance with which the final offer price is to be determined and an explanation of any valuation methods used. The final offer price must also be filed with the home NCA and published in accordance with Article 21 (section 4.6). More generally, under Article 18, the home NCA may authorize the omission of required information from the prospectus where the stringent conditions set out in Article 18(1) are met. The first condition provides that information may be omitted where it is contrary to the public interest. The second condition permits the omission of information where disclosure would be seriously detrimental to the issuer (or guarantor), but only where the omission would not be likely to mislead the public with regard to facts and circumstances essential for an informed assessment of the issuer, the offer, the guarantor (where relevant), and the rights attached to the securities in question—​a condition which is likely to be very difficult to meet. The third condition relates to immaterial omissions and permits omission where the information is of minor importance only, for a specific offer or admission to trading on a regulated market, and is not such as will influence the assessment of the financial position and prospects of the issuer, offeror, or guarantor. The concern to avoid excessive or divergent reliance on this provision is clear from the requirement for NCAs to report annually to ESMA on any omissions authorized and from the delegation to ESMA to draft related RTSs to specify cases where information may be omitted (Article 18(1) and (4)). ESMA has yet to exercise this delegation in an indication that the omission regime does not generate convergence risks. More usefully, where, exceptionally and assuming adequate information is provided to investors, required information is inappropriate to the sphere of activity of the issuer, guarantor, or securities, equivalent information is to be provided, assuming it exists (Article 18(2)).

II.4.4.5 Incorporation by Reference The 2017 Prospectus Regulation, in a reflection of its concern to streamline the prospectus regime and to support frequent issuers, has significantly expanded the precursor ‘incorporation by reference’ system. Incorporation by reference is a well-​established disclosure technique internationally (particularly associated with the sophisticated US integrated disclosure system)295 which allows issuers to integrate disclosures already in the public domain given that market efficiency mechanisms should incorporate publicly available disclosures in securities prices. While incorporation by reference has formed part of the prospectus regime since 2003, the system has been significantly modernized and expanded by the Prospectus Regulation.

295 In an early explanation of the rationale for its integrated disclosure system, the SEC stated that it ‘recognizes that, for companies in the top tier, there is a steady stream of high quality corporate information continually furnished to the market and broadly digested, synthesized and disseminated . . . the widespread market following of such companies and the due diligence procedures being developed serve to address the concerns about the adequacy of disclosure and due diligence and, thus, ensure the protection of investors’: SEC Release No 33–​6499 (1983) para I.

II.4  The Prospectus Regulation  117 Under Article 19(1), information may be incorporated by reference in a prospectus where it has been previously or simultaneously published electronically, is drawn up in a language fulfilling the Regulation’s language requirements, and is contained in one of an expanded list of documents, including periodic reports by issuers admitted to MTFs and not subject to the requirements of the Transparency Directive.296 That a facilitative approach is intended is clear from the delegation to ESMA to (if it wishes or if the Commission so requests) develop RTSs to be adopted by the Commission in order to update the list of documents with others that are, under EU law, required to be filed with or approved by a public authority (Article 19(4)). Any information incorporated must be the latest available to the issuer, and the issuer must also ensure the accessibility of this information, including by means of a cross-​referenced list in the prospectus which must also contain links to the relevant documents (Article 19(1) and (2)). The expansion of the regime has been balanced by a strengthening of supervisory oversight: a new obligation is placed on issuers to submit, either with the first draft of the prospectus or over the review process and in searchable electronic format, any information incorporated by reference, unless that information has already been filed or approved with the NCA approving the prospectus (Article 19(3)).

II.4.5  Prospectus Format: The Standard Form The most significant reforms wrought by the 2017 Prospectus Regulation relate to the format of prospectus disclosure. The standard prospectus format, in place since 2003, has been atomized, with prospectus disclosure now potentially taking the form of, or being based on, one of a series of different models beyond the standard format: the base prospectus (Article 8); the simplified prospectus (Article 14); the EU Growth Prospectus (Article 15); the wholesale debt securities prospectus (2019 Prospectus Delegated Regulation); and the Universal Registration Document (URD) (Article 9). These different formats are designed to calibrate the prospectus system more finely to the needs of different issuers, and thereby to reduce costs and facilitate offerings. As applications of the standard prospectus format, they are discussed further in section 9. The standard prospectus format, which has been in place since 2003, takes two forms: the unitary prospectus; or the prospectus based on a registration document and securities note. The prospectus may be drawn up as a single document (the unitary prospectus); or as separate documents which divide the required information between a registration document, which contains the information relating to the issuer, and a securities note, which contains the information relating to the securities (Article 6(3)). The registration document/​securities note format is an embryonic form of ‘shelf registration system’, designed to allow the issuer to move nimbly once market conditions are suitable: the registration document is approved in advance by the NCA,297 so that only the securities note is subject to approval when the issuer seeks to access the markets (Article 10). The alleviated disclosures which the 296 These include documents approved or filed under the 2017 Prospectus Regulation, regulated information, annual and interim financial statements, audit reports and financial statements, management reports, corporate governance statements, remuneration reports, and memorandum and articles of association. 297 Once approved, the registration document must be made available to the public without delay in accordance with the Regulation’s Art 21 publication requirements (Art 10(2)).

118 Capital-raising specialized formats allow can also be presented in the registration/​securities note format. An innovation in 2003, reflecting demand from international issuers who were familiar with shelf-​based systems, and regarded as one of the successes of the 2003 Directive,298 it is now supported by a number of other devices, including the simplified prospectus for frequent issuers, the URD, and the enhanced incorporation by reference system, which facilitate easier access to the capital markets. In practice, and although the disclosure regime is organized around this format, the registration document/​securities note format has been little used, with most issuers using the standard unitary form.299 All prospectuses, whatever their format, apart from the wholesale debt securities prospectus, must also be accompanied by the retail market prospectus summary, discussed further in section 4.9.8. Where the prospectus takes the form of separate documents, the summary is subject to separate approval.

II.4.6  Publication and Dissemination Article 21 addresses the prospectus publication process and is largely directed to online publication and the related modalities to be followed. The core obligation is that the prospectus must be made ‘available to the public’ by the issuer (or offeror or person asking for the admission of the securities) at a reasonable time in advance of, and at the latest at the beginning of, the offer to the public or the admission to trading. Where the offer concerns an initial public offer of a class of shares that is admitted to trading on a regulated market for the first time, the prospectus must be available to the public at least six working days before the end of the offer. A prospectus is deemed to be ‘available to the public’ when it is published through one of the different websites specified in Article 21.300 It must remain available for at least ten years,301 but a copy of the prospectus in a ‘durable medium’302 must be delivered to any potential investor on request. In support of publication and accessibility, the home NCA must also publish on its website, at its choice, either all the prospectuses approved, or a list of prospectuses approved and relevant links (again for a period of ten years). Similarly, ESMA must publish on its website all approved prospectuses notified to it by NCAs and make them available through a publicly accessible storage mechanism. This mechanism is now in place through the ESMA Prospectus Register which provides

298 eg, 2007 ESME Report, n 183. 299 Fischer-​Appelt, D, ‘Prospectus Formats and Shelf Registration’ in Busch et al (2020), n 163, 299. 300 Those of the issuer, offeror, or person seeking the admission; the financial intermediary placing the offer; and the relevant regulated market. Conditions apply under Art 21, including as to the accessibility of the site; the format of the prospectus; that access must not be subject to a fee, a registration process, or acceptance of a disclaimer as to legal liability; the maintenance of links to documents incorporated by reference; the inclusion of warnings as to the expiry of the prospectus’ validity; and the maintenance of the integrity of all published documents, which must be identical to the original versions approved by the NCA. The publication requirement extends to all components of the prospectus, including supplements. 301 Warnings as to expiry of the validity of the prospectus must be provided, and to the effect the prospectus is not subject to an obligation to be updated once it has expired. 302 A ‘durable medium’ (a concept that recurs across the single rulebook) is any instrument which enables a customer to store information addressed personally to that customer in a way that is accessible for future reference and for a period of time adequate for the purposes of the information; and which allows the unchanged reproduction of the information stored: Art 2(z).

II.4  The Prospectus Regulation  119 centralized access to a wealth of easily searchable prospectus material; this regime will be upgraded by the proposed European Single Access Point (section 7.3). While subject to detailed legislative specification under Article 21, the publication regime is further amplified by the 2019 Prospectus RTS.303

II.4.7  Prospectus Supplements An updating regime applies to protect prospectuses once they are approved. Under Article 23, in a long-​established but periodically finessed formula, every significant new factor, material mistake, or material inaccuracy relating to the information included in the prospectus and which may affect the assessment of the securities and which arises or is noted between the time when the prospectus is approved and the closing of the offer period or the time when trading on a regulated market begins (whichever is later) must be mentioned in a supplement to the prospectus without delay; the supplement must be approved by the NCA and published in accordance with the arrangements which applied to the prospectus.304 The retail summary (and any translations) must also be supplemented, where necessary, to reflect the relevant information. The serious consequences of such material changes to the prospectus disclosure (the 2019 Prospectus RTS sets out non-​exhaustive circumstances when the supplement obligation arises)305 extend beyond the additional approval process and any adverse market reaction. Where the prospectus relates to an offer to the public, acceptance withdrawal rights (exercisable within two days of the publication of the supplement) are generated for investors who have already agreed to purchase the securities; and the conditions governing such rights, which are set out in Article 23(2), must be prominently stated in the supplement (Article 23(2)). In addition, investor notification obligations are imposed on the financial intermediary responsible for placing the offer (or on the issuer where the securities are purchased or subscribed directly from the issuer) (Article 23(3)). In an indication of the complexity the injection by the 2017 Prospectus Regulation of several different formats into the prospectus regime has generated, Article 23 calibrates the supplement obligation, and the related generation of withdrawal rights, to the base prospectus and to the URD (Article 23(4) and (5)). The supplement obligation (but not withdrawal rights) also applies to the registration document (in this case the supplement obligation must be discharged at the latest by the time the securities note and summary are submitted for approval) (Article 10(1)).

303 In a good example of the density of the administrative rulebook, the RTS addresses how issuers should manage access by investors not targeted by the relevant public offer to the website on which the prospectus is published, and the measures required to ensure that any websites referenced in a prospectus are not assumed by investors to be approved by the NCA in question: Art 10. 304 A five-​day limit applies to the approval process. 305 2019 Prospectus RTS Art 18 (including the publication of new audited annual statements; the publication of a profit forecast or estimate; a change in control; the working capital statement is no longer valid; a takeover bid; and the admission of the securities to an additional regulated market). Recital 14 underlines that only the minimum situations where a supplement is needed are specified.

120 Capital-raising

II.4.8  Prospectus Validity A prospectus (whether in unitary or registration document/​securities note form) is valid for twelve months after its approval for offers to the public or admissions to trading on a regulated market, as long as it is completed by any necessary supplements (Article 12(1)),306 although, as noted above, once published the prospectus must be available online for ten years. A registration document, previously filed and approved, is also valid for up to twelve months.

II.4.9  Calibration and Differentiation: Multiple Prospectus Formats II.4.9.1 Calibration and Differentiation Better calibration of the prospectus regime to the needs of different issuers is one of the key animating themes of the 2017 Prospectus Regulation. The finer calibration achieved by the Regulation is in part a function of its expanded exemptions, but it is primarily a function of the expanded suite of optional prospectus formats, outlined in the following sections. These represent a significant evolution from the failed proportionate disclosure regime introduced by the 2010 Amending Directive. While that regime was limited and hedged about with conditions, the new suite of prospectus formats is significantly more facilitative. Calibration is also supported by the change to the over-​arching materiality standard to specify that the nature of the disclosure required to meet the prospectus obligation may vary depending on any of the nature of the issuer and securities, and the circumstances of the issuer (Article 6(3)). A significantly more nuanced and sophisticated approach now obtains to calibrating prospectus requirements to issuers’ circumstances, particularly to those of frequent and also SME issuers, with further refinements likely under the 2022 Listing Act reform agenda. II.4.9.2 Frequent Issuers: The Base Prospectus Since the adoption of the 2003 Directive, the prospectus regime has given particular attention to the dynamics of bond market fund-​raising, including through the ‘base prospectus’ mechanism which provides for a form of shelf registration. The re-​tooled base prospectus regime is now contained in Article 8 of the 2017 Prospectus Regulation. Given earlier reforms to the regime, including under the 2010 Amending Directive and related administrative rules adopted in 2012, the Prospectus Regulation did not adopt major changes, although a series of adjustments, largely concerned with reducing costs and with enhancing the regime’s flexibility,307 and which were largely based on the 2015 Prospectus Proposal and were not heavily contested by the co-​legislators, have been made. The base prospectus is an optional prospectus format designed to facilitate frequent issuances of debt securities. Following the Regulation’s expansion of the precursor regime, which was only available for ‘offering programmes’308 or for non-​equity securities issued in 306 Where the prospectus is in registration document/​securities note form, the validity period runs from the approval of the securities note. 307 2015 Commission Proposal, n 191, 15. 308 As defined under the 2003 Directive and relating to a plan for issuing securities of a similar type in a continuous/​repeated manner during a specified issuing period: Art 2(k).

II.4  The Prospectus Regulation  121 a continuous or repeated manner by credit institutions, it is now available for all non-​equity securities, including warrants (Article 8(1)). A full base prospectus is composed of the base prospectus document (which can take the form of a registration document (which can be in URD format) and securities note, which together contain the necessary base prospectus information concerning the issuer and the securities offered);309 and a ‘final terms’ updating document,310 which contains the relevant information relating to the individual issue of securities offered under the base prospectus (the template for the final terms document must be included in the base prospectus). This format supports fast and streamlined access to the bond markets as the final terms document is filed with the home NCA, but is not subject to NCA approval (unless it is, at the choice of the issuer, contained in the base prospectus or in a supplement to it). Given the incentives the final terms device creates to elude supervisory review, as it is not approved by the NCA, and in order to protect the integrity of the prospectus, the content of the final terms is specified in some detail. It must contain only information related to the securities note disclosures, and which is specific to the individual issue in question, such as the issue, maturity date, coupon, exercise date and price, and any other information not known at the time the base prospectus was drawn up.311 Any material new information cannot be in the final terms, but must be disclosed in a base prospectus supplement that is approved, in accordance with Article 17, by the NCA (Article 8(4)). The final terms must also comply with the other conditions imposed by the Regulation, including that it is easily analyzable and comprehensible, contains the different legends required (including that it must be read in conjunction with the base prospectus), and is published, in accordance with the Regulation’s publication requirements (Article 21), as soon as practicable upon the offering of the securities to the public and, where possible, before the beginning of the public offer or the admission to a regulated market (Article 8(5)). The filing of the final terms also triggers the retail summary obligation. In an alleviation of the precursor regime, a retail summary is required only when the final terms is filed,312 and so is specific to the individual issue, although this summary must comply with the Article 7 requirements governing the retail summary (section 4.9.8) and contain key information relating to the base prospectus and the final terms (Article 8(8) and (9)). Article 8 also address the intricate interaction between the base prospectus, the final terms, the retail summary, and the issuer’s registration document or URD (where these are already in place), as well as how the related approval and updating processes apply. The specific disclosures required in the base prospectus, and the allocation of disclosures between the base and the final terms, are covered by the 2019 Prospectus Delegated Regulation.313 309 The availability of the registration document/​securities note format for base prospectuses is a flexibility-​ oriented enhancement of the precursor regime which prohibited their use. 310 The final terms must be presented as a separate document, included in the base prospectus, or, where relevant, presented as a supplement thereto: Art 8(4). 311 Art 8(4) and recital 36 (reflecting the reforms adopted by the 2010 Amending Directive). Further specification is contained in the 2019 Prospectus Delegated Regulation (Art 26 and related Annex disclosures) in provisions carried over from the 2004 Commission Regulation, as revised in 2012 to address concerns about final terms coverage. A category-​based system is used, with category A and B information to be included in the base prospectus and category C information in the final terms. In an indication of the operational sensitivity and importance of this issue, the Prospectus Q&A also addresses final terms’ disclosures. 312 Or when the final terms is included in the base prospectus or a supplement, if this is the case. 313 Prospectus Delegated Regulation Art 25 (the format of the base prospectus) and Art 26 (the information required in the base prospectus and in the final terms).

122 Capital-raising The base prospectus regime is one of the more well-​tested, less controversial, and more operational aspects of the 2017 Prospectus Regulation, but it nonetheless illustrates the complexity of the ecosystem of interacting disclosure documents that the Prospectus Regulation now supports in its effort to enhance flexibility: the relationship between the base prospectus and the other prospectus formats and components which can shape and constitute the base prospectus is carefully worked through in Article 8. The base prospectus regime also reflects the increasing maturity and agility of the EU prospectus regime and its ability to use legislative, administrative, and soft law levers to adapt to market and supervisory concerns. This is particularly marked as regards the evolution of the approach to the final terms. The 2003 Directive did not address the base prospectus/​final terms relationship in any detail, leading to NCA and market concern that the final terms was being used to circumvent the supplement approval process, divergent supervisory practices were emerging, and the integrity of the base prospectus was being compromised.314 Following an initial attempt at reform through a 2007 CESR Q&A, legislative reforms followed in the 2010 Amending Directive which were amplified by detailed administrative rules in 2012 and subsequently refined by the 2017 Regulation and its rules. The Prospectus Q&A continues to support the Regulation’s requirements for the final terms document. Threaded through these different reforms to how the final terms is used is ESMA’s technocratic influence. It provided the technical capacity to deliver the necessary reforms to a troublesome issue,315 but it also displayed a purposeful approach to dealing with what it regarded as industry ‘excesses’ in how the final terms was being used.316

II.4.9.3 Frequent Issuers: The Universal Registration Document One of the most significant reforms introduced by the 2017 Prospectus Regulation concerns the new Universal Registration Document (URD). The URD is designed to significantly enhance the embryonic shelf registration model implied in the longstanding but in practice little used registration document/​securities note system.317 Based on the French ‘document de réference’, despite its novelty the URD was not significantly contested over the negotiations. In essence, under Article 9 an issuer whose securities are admitted to a regulated market or to an MTF may every year draw up a registration document in the form of a URD. The URD is either approved annually by the home NCA, or simply ‘filed’ annually with the NCA (whether the URD is approved or filed is governed by the Article 9 timing rules). The URD may then be used by the issuer as the basis of a prospectus, and the issuer can accordingly benefit from a faster prospectus approval process: a five-​day initial approval limit applies rather than the usual ten-​day limit that applies to prospectuses. The URD can also be used 314 eg, Commission, Prospectus Delegated Regulation Proposal 486/​2012 IA (SWD(2012) 77) 9. 315 In an indication of its thorny nature, one of the rare Court of Justice rulings on the prospectus regime relates to final terms disclosure. In a 2014 ruling, the facts of which pre-​date the reforms originally adopted in 2012, the Court highlighted that final terms documents must not contain information extraneous to that required by the prospectus regime, and that any supplement to the base prospectus must only relate to a significant new factor, material mistake, or inaccuracy, in accordance with the Prospectus Directive: Case C-​359/​12 Michael Timmel v Aviso Zeta AG (ECLI:EU:C:2014:325). 316 During the development of the 2012 administrative rules (now incorporated in the 2019 Delegated Prospectus Regulation), ESMA rejected industry calls for a more flexible approach to the final terms, warning that the new regime was designed to prevent ‘further excesses’, particularly as structured securities were increasingly being sold through base prospectus/​final terms structures: ESMA Technical Advice (2011). 317 Fischer-​Appelt, n 299.

II.4  The Prospectus Regulation  123 as an ongoing disclosure document and to meet Transparency Directive requirements. The Article 9 regime is relatively complex as it accordingly grapples with two separate but complementary processes: it introduces a regime whereby the URD, regarded in its first, prospectus capacity, can, as a component part of the prospectus, be used to support faster prospectus approval; and a regime whereby the URD, regarded in its second, ongoing disclosure capacity, as an ongoing disclosure document which can meet ongoing obligations under the Transparency Directive, is subject to an updating process. Accordingly, Article 9 injects an entirely new ongoing disclosure document into EU disclosure law (the URD) and, at the same time, finesses the prospectus regime so that it can draw on the URD. The animating principle governing the URD regime in this regard is the leveraging of publicly available ongoing disclosure: as market mechanisms should feed the ongoing URD disclosures through to pricing and inform market sentiment on the issuer, these ongoing URD disclosures, familiar to the market, can be incorporated by reference into the prospectus and, when supplemented by a securities note and the retail summary (Article 10(3)), can support the use of a shorter prospectus and an abbreviated approval process. Issuers can accordingly ‘swiftly react to market windows’.318 A short overview of its operation follows. Like the base prospectus regime, the URD regime is optional but, unlike the base prospectus, it is available for all securities. Under Article 9(1) and (2), a qualifying issuer (admitted to a regulated market or MTF) may annually draw up a URD which describes the company’s organization, business, financial position, earnings and prospects, governance, and shareholding structure (the URD can incorporate disclosures by reference, in accordance with Article 19). For the first two consecutive years, the URD must be approved by the home NCA, but thereafter, on the assumption that the issuer is then well-​known to the NCA, the URD may be ‘filed’ with the NCA without prior approval, although an ex-​post discretionary review process is available to the NCA, as noted below. The facility to file the URD without approval is, however, lost if the issuer fails to the file the URD annually; in this case, the two-​year approval requirement is then reinstated. The approved or filed URD (and any amendments thereto) is subject to the Regulation’s language regime, and it must also be made available to the public without undue delay, in accordance with the Regulation’s publication rules (Article 9(4) and (5)). The content of the URD, specified in the 2019 Prospectus Delegated Regulation,319 is designed to ensure maximum flexibility so that the URD can be used in the prospectus for offers to the public and for admissions to trading on a regulated market, for equity and non-​ equity securities;320 and also to meet the Transparency Directive’s annual report and six-​ monthly report requirements. The equity disclosure standard accordingly applies, to ensure such maximum flexibility,321 and the required disclosures are also aligned to those applicable to annual and half-​yearly reports. The prospectus capacity of the URD engages when the issuer qualifies as a ‘frequent issuer’ (Article 9(11)). This designation arises where the issuer (who has either had a URD 318 2017 Prospectus Regulation recital 39. 319 2019 Prospectus Delegated Regulation Art 3 and Annex 2. 320 The URD can also be used as a constituent part of a base prospectus, an EU Growth Prospectus, or a prospectus based on the simplified disclosures which can be used by frequent issuers or by wholesale debt market issuers, in each case in place of a registration document. 321 Although it is calibrated to reflect the multi-​purpose character of the URD, including as regards the greater degree of flexibility given to issuers as regards how they present the disclosures: 2019 Delegated Prospectus Regulation recital 15.

124 Capital-raising approved or who has qualified to file the URD), on the filing or submission for approval of each URD, provides written confirmation to the NCA that, to the best of its knowledge, all ‘regulated information’ required under the Transparency Directive and the Market Abuse Regulation322 has been filed and published over the last eighteen months (or over the period since the obligation to disclose regulated information triggered, if shorter); and, if the NCA has earlier undertaken a discretionary review of the URD (noted below), the issuer has made any required revisions to the URD. As a frequent issuer, the issuer then, as regards prospectus approval, needs only to prepare a securities note and summary (the URD being incorporated by reference) and also benefits from an abbreviated five-​day deadline for the initial scrutiny of the prospectus (Article 20(6)). Once the URD is in use as a constituent part of an approved prospectus, it can only by updated by means of an Article 23 prospectus supplement (Article 9(10)). As regards the ongoing disclosure capacity of the URD, Article 9 in effect establishes the URD as a new reporting format in the EU’s ongoing disclosure regime. Under Article 9(12), as long as the relevant timelines and disclosure content requirements are met, the URD can serve to meet an issuer’s annual report obligations and half-​yearly report obligations under the Transparency Directive. Relatedly, Article 9 puts in place a discrete updating regime for the URD, reflecting its capacity as a new disclosure document in the EU’s ongoing disclosure regime. The updating process has two elements: issuer updates (Article 9(7)); and NCA-​required updates (Article 9(8)–​(9)). Once the URD is filed or approved, the issuer may at any time update it by filing an amendment with the NCA (this does not require approval). In addition, the NCA may at any time review the content of an unapproved (filed) URD and any amendments made thereto as regards completeness, consistency, and comprehensibility.323 Where it finds these standards are not met or that amendments are needed, the NCA must notify the issuer and any related requests made to the issuer must be addressed by the issuer for the next URD (for the next financial year): immediate changes are not required, unless the issuer wishes to use the URD as a part of a prospectus, in which case the changes must be made prior to the submission of the relevant prospectus to the NCA; or unless the request relates to a material omission, material mistake, or material inaccuracy, in which case an amendment to the URD must be filed without undue delay. The URD system is a major innovation. It is, however, a complex regime with multiple risks. For example, where an NCA requests changes to an issuer’s unapproved URD, while these need not be made (unless the changes are material) until the next URD is filed, there are liability risks to the issuer from failing to make such changes. The issuer’s updating responsibilities as regards approved and filed URDs are cast in opaque terms: the updating obligation is characterized as a voluntary one, but the Regulation implies that the URD should be updated whenever a material change occurs in the issuer’s organization or financial position (recital 41); and prudent liability management also suggests that any material changes should always be published as soon as possible. The nature of and relationship between the URD approval process and the prospectus approval process is byzantine, with the nature of the approval required from the NCA depending on the interaction between a series of

322 Essentially, all information required to be disclosed under the Transparency Directive and MAR and any additional information required by relevant national rules: Art 2(l). 323 The NCA is subject to the same review standards as apply to prospectus approval, including those applicable under the 2019 Delegated Prospectus Regulation.

II.4  The Prospectus Regulation  125 variables relating to, inter alia, the status of amendments previously made to the URD and whether or not the prospectus or the URD are to be passported.324 The benefits of faster prospectus approval may be more apparent than real: a ‘frequent issuer’ must notify the home NCA five days in advance of its intention to submit a URD-​based prospectus (Article 20(6)), a requirement which leads, in effect, to a ten-​day approval window, the standard time horizon. And while the application of an equity disclosure standard (the highest level of disclosure) to the URD is designed to ensure maximum efficiency benefits as well as flexibility for the issuer, it renders the URD less useful for issuers of debt securities who may find the base prospectus regime less onerous and more accommodating. Nonetheless, the URD evidences increasing sophistication in how the EU prospectus regime integrates ongoing disclosure requirements, and it marks a decisive step on the path towards a more fully integrated disclosure system. It has, however, been little used by the market,325 and the 2021 Listing Act Consultation queried its effectiveness and how it might be enhanced.326

II.4.9.4 Frequent Issuers: The Simplified Disclosure Regime Article 14 provides an additional prospectus format for frequent issuers, based on simplified disclosures, to facilitate secondary issuances.327 The 2010 Amending Directive had earlier established a proportionate disclosure regime for secondary share issuance prospectuses, but as this was restricted to rights issues where pre-​emption rights had not been disapplied, and did not cover debt securities, it was of limited value.328 Less complex than the URD regime, the simplified disclosure regime for secondary issuance prospectuses is less closely integrated than the URD regime into the ongoing disclosure regime, but, like the URD regime, is based on the premise that, where disclosures are already available to the market, prospectus disclosures can be lighter. The simplified prospectus regime is available for issuers admitted to regulated markets, but it is also available for issuers admitted to SME Growth Markets (who seek to make a public offer or to admit securities to a regulated market). Accordingly, it integrates the ongoing disclosures required, as a matter of contract, by SME Growth Markets, of their admitted issuers, as well as the ongoing disclosures required, under the Transparency Directive, of issuers on regulated markets. It thereby assumes something of an identity between regulated markets and SME Growth Markets as regards ongoing disclosure, on the grounds that both venues are subject to the Market Abuse Regulation as regards disclosure of ‘inside information’ and that MiFID II imposes an obligation on SME Growth Markets to adopt rules requiring appropriate ongoing disclosure.329 In practice the disclosures may be 324 The interactions have necessitated a lengthy flow-​chart explanation in the ESMA Prospectus Q&A, which also provides a vivid illustration of the dependence of the Prospectus Regulation on technocratic support from ESMA: Q3.2 325 See section 13. 326 2021 Listing Consultation, n 12, 31–​3. Some finessing reforms were proposed under the 2022 Listing Act reform agenda (n 144), including the reduction of the two-​year NCA approval requirement (prior to filing being possible) to a one-​year requirement. 327 In proposing this reform, the Commission suggested that it would be available for some 70 per cent of approved prospectuses and reduce prospectus costs by 20 per cent: 2015 Prospectus Proposal IA, n 191, 24–​6. 328 The difficulties posed by, inter alia, identification of all shareholders holding pre-​emption rights, meant it was rarely used: Horsten, P, ‘Light Disclosure Regimes: Secondary Issuance’ in Busch et al (2020), n 163, 244. 329 MiFID II Art 33(d) requires that SME Growth Markets ensure that there is appropriate ongoing periodic financial reporting, eg audited reports. Delegated Regulation (EU) 2017/​565 [2017] OJ L87/​1 amplifies this obligation by requiring that registration as an SME Growth Market is dependent on the relevant NCA being satisfied that the trading venue requires issuers whose securities are traded on the venue to publish annual financial reports within six months of the end of the financial year, and half-​yearly reports within four months of the end of the first

126 Capital-raising similar, and an SME Growth market issuer who admits a secondary issuance to a regulated market then becomes subject to the full range of mandatory disclosure rules. Nonetheless, the simplified prospectus marks something of a weakening in the regulated market perimeter around the prospectus regime. The simplified prospectus regime should reduce the costs of rights issues, in particular, and is also available for debt securities (the simplified prospectus can take the form of a base prospectus) but whether or not the simplified prospectus becomes a major feature of the EU disclosure landscape will depend in large part on whether it passes the EU/​international wholesale market test as to the completeness of the disclosure it provides. Under Article 14, a series of issuers can draw up a ‘simplified prospectus’ for secondary issuances, whether in the form of a public offer or an admission to trading on a regulated market. The qualifying issuers fall into four categories, following revisions made to Article 14 by the 2019 SME Regulation which sought to expand the coverage of Article 14 to facilitate smaller issuers. Article 14 is available for: issuers whose securities have been admitted to trading on a regulated market or an SME Growth Market continuously for at least eighteen months and who issue securities fungible with existing, previously issued securities; issuers whose equity securities have been admitted to trading on a regulated market or SME Growth Market for at least eighteen months and who issue non-​equity securities or securities giving access to equity securities fungible with the existing equity securities admitted to trading (added in 2019); offerors of securities admitted to trading on a regulated market or an SME Growth Market continuously for at least the last eighteen months; and finally issuers who seek to transfer from an SME Growth Market (on which they have been admitted for at least two years) to a regulated market (added in 2019).330 These issuers qualify for a simplified prospectus (which must include a retail summary), the reduced content of which is set out in the 2019 Prospectus Delegated Regulation.331 In a significant alleviation, such prospectuses are subject to a discrete materiality standard which is lower than Article 6 and more closely focused on the issuer’s prospects. Under Article 14(2), the simplified prospectus must contain the ‘relevant reduced information’ necessary to enable the investor to understand: the prospects of the issuer and any significant changes in the business and financial position of the issuer (and guarantor) since the end of the last financial year; the rights attaching to the securities; and the reasons for the issuance and its impact on the issuer (and its overall capital structure) and the use of the proceeds. The simplified prospectus must also, as under Article 6, be presented in an easily analyzable, concise, and comprehensible form. Reflecting the dependence of the simplified prospectus regime on prior disclosure to the market, it must also, in a somewhat Delphic formula, which has the potential to expose the issuer to supervisory and liability risks, ‘take into six months of the financial year; and also ensures dissemination to the public of these reports and any disclosures required under the Market Abuse Regulation (Art 78). 330 This category is available for issuers whose securities have been offered to the public and admitted to trading on an SME Growth Market continuously for at least two years, and who have fully complied with reporting and disclosure obligations over this period, and where the admission to a regulated market relates to securities fungible with existing securities which have been previously issued. 331 Articles 4 and 9 and Annexes 3 and 8 covers the registration document for secondary equity and non-​equity issuances, respectively; and Arts 13 and 17 and Annexes 12 and 16 cover the securities note disclosures. Among the significant alleviations are the removal of the OFR requirement as well as of disclosure relating to corporate governance, remuneration, share capital, and group funding arrangements, while the business activity disclosures required are significantly lighter.

II.4  The Prospectus Regulation  127 account’ the regulated information previously disclosed under the Transparency Directive and Market Abuse Regulation. This regime may, however, be further refined. The 2022 Listing Act reform agenda proposed the replacement of the simplified prospectus by a new, shorter ‘EU Follow-​on Prospectus’ (subject to a fifty-​page limit for share prospectuses).

II.4.9.5 Frequent Issuers: The Covid-​19 Recovery Prospectus Reflecting a long history of crises provoking innovation in EU financial markets regulation, the Covid-​19 pandemic led to the Commission presenting a suite of deregulatory reforms in its 2020 Capital Markets Recovery Package.332 Designed to support a ‘sustained investment-​based recovery’ and to ensure that firms could easily issue new capital and have smooth access to an increased investor base,333 one of its major reforms, the EU Recovery Prospectus,334 represented, on its adoption, a significant reform for frequent issuers and a watershed in EU prospectus regulation given its singular focus on removing rules and liberalizing process. The Recovery Prospectus reform was designed to support the Covid-​19 recovery by facilitating a rapid recapitalization of firms, particularly SMEs, and thereby to support a ‘better market ecosystem for the issuance of new equity’.335 The short-​form EU Recovery Prospectus (Article 14a) used similar legal technology to the simplified prospectus in that it was only available to issuers that had shares admitted to trading on a regulated market or on an SME Growth Market336 continuously for at least eighteen months.337 It was designed to facilitate recapitalizations: the Recovery Prospectus was limited to offers of/​admissions to a regulated market of shares that were fungible with existing shares that had been previously issued.338 The EU Recovery Prospectus was available for offers to the public or admissions to trading on a regulated market, but it could not be used by SME Growth Market issuers to transfer to a regulated market (it could only be used for a public offer).339 Reflecting concern in the Council that a short form prospectus would not be an appropriate disclosure document for a highly dilutive share issue,340 the EU Recovery Prospectus was only available where the number of shares offered (together with those already offered under an EU Recovery Prospectus over twelve months, where relevant) represented no more than 150 per cent of the shares already admitted to trading on a regulated market or SME Growth Market. The EU Recovery Prospectus was short; it was to be of maximum length of no more than thirty pages.341 It was not subject to the Article 6 materiality standard and was not, given the need for the new regime to be adopted speedily, amplified by administrative rules: the 332 A summary of the reforms is set out in Commission, EU Capital Markets Recovery Package (SWD(2020) 120). 333 Commission 2020 Recovery Package SWD, n 332, 5. 334 Regulation (EU) 2021/​337 [2021] OJ L68/​1, which inserts a new Art 14a on the EU Recovery Prospectus into the Prospectus Regulation. 335 2020 Commission Recovery Package SWD, n 333 5; and Commission, Covid Recovery Prospectus Proposal (COM(2020) 281). 336 Provided, in the case of an SME Growth Market issuer, that a prospectus has been published for the offer of those shares. 337 See section 4.9.4 on the simplified prospectus. 338 It is also available to offerors of such shares. 339 Underlined by 2021 EU Covid Recovery Regulation recital 8. 340 eg, Council Press Release, 21 October 2020.The Council’s original position was that the Recovery Prospectus could only be available for offers equivalent to no more than 90 per cent of outstanding share capital but this was adjusted over the negotiations. See also n 344 341 The required retail summary and any disclosures incorporated by reference are not taken account of for the page count: Art 14(4).

128 Capital-raising detailed specification of content was provided in a new Annex Va, incorporated in the Regulation. Under Article 14a(2), a bespoke materiality standard applied: the over-​arching disclosure obligation imposed was that the prospectus contain the ‘relevant reduced information’ necessary to enable investors to understand: the prospects and financial performance of the issuer and the significant changes in its financial and business position since the end of the last financial year, as well as its financial and non-​financial long-​term business strategy and objectives;342 and the essential information on the shares, including the rights attached to those shares and any limitations on those rights, the reasons for the issuance and its impact on the issuer, including on the overall capital structure of the issuer, as well as disclosures as to capitalization and indebtedness, working capital, and the use of proceeds. The disclosures were to be written and presented in an easily analyzable, concise, and comprehensible form; and to enable investors (and in particular retail investors) to make an informed decision, taking account of the regulated disclosures already available to the public, including under the Transparency Directive and Market Abuse Regulation (Article 14a(3)). A specific retail summary obligation was imposed by means of a revision to Article 7 (which governs the retail summary) which provided for a truncated (two-​page) summary which covered introductory material, key information on the issuer, including no less than 200 words on the impact of the pandemic, and key information on the shares and the offer. The prospectus approval process was shortened to seven days, although the issuer was to give the NCA five days’ notice of submission.343 The reform is notable on several grounds.344 It was sharply focused: it was available for secondary share issuances only and so was directed to recapitalizations by seasoned (repeat) issuers. It represented an evolution from the simplified prospectus in that while, like the simplified prospectus, it relied heavily on publicly available disclosures, it also, in order to ease investor understanding, limited the level of disclosure provided. It re-​tooled the materiality standard significantly. It was overtly experimental and crisis-​driven: the reform was to expire after eighteen months and has now lapsed.345 But it also vividly illustrates the enduring attachment of the EU to the assumption that retail investors are (and should be) direct investors in the equity market (clear from the specific retail summary and the warning to issuers to ensure a ‘high degree of diligence’ in drafting the summary),346 and that SMEs can be encouraged, through law, to access equity finance through the markets, despite the fragility of both these assumptions.

342 Including reference to, in not less than 400 words, the impact of the pandemic on the issuer and its anticipated future impact. 343 The withdrawal rights that follow on approval of a supplementary prospectus are also revised, in order to support investor protection; a three-​day (rather than two-​day) withdrawal period applies. The Regulation also adopted ameliorations to assist financial intermediaries in the management of the withdrawal right process: Art 23(2a). 344 Its novelty was reflected in some Council unease, with the adoption of its negotiating general approach seeing a number of Member States issue statements (Council Document 11861/​20, 21 October 2020). Italy expressed reservations that the Council’s proposed 90 per cent cap on outstanding shares (the cap was increased to 150 per cent over the negotiations with the Parliament) would limit the value of the reform, but conversely Belgium, Spain, France, Hungary, and Poland strongly supported the 90 per cent cap, given the impact of highly dilutive issuances on firms and investors, and called for the cap to be maintained at a level ‘close to the one enshrined in the Council’s general approach’. Poland was additionally concerned that the NCAs would not have sufficient time to review the prospectus and emphasized the seven-​day limit (which was retained following the negotiations). 345 By 31 December 2022: 2021 EU Covid Recovery Regulation Art 47a. 346 2021 EU Covid Recovery Regulation recital 10.

II.4  The Prospectus Regulation  129 From a regulatory design perspective, the reform is a watershed and evidences a turn in EU prospectus regulation towards an increasingly nimble, dynamic, and experimental approach. While it lapsed at the end of 2022, it may also have legacy effects in that the 2022 Listing Act reform agenda proposed that it act as a design template for the proposed new EU Follow-​on Prospectus for frequent issuers and EU Growth Issuance Document for SMEs.

II.4.9.6 Wholesale Markets: The Wholesale Debt Markets Disclosure Regime Calibrations are also available for wholesale debt market issuers who can, in addition, rely on the formats designed for frequent issuers: the base prospectus, the URD, and the simplified prospectus. The application of the 2017 Prospectus Regulation to the wholesale debt markets is tailored across three vectors: exemptions from the obligation to publish a prospectus; issuer choice of NCA; and disclosure requirements/​disclosure formats (these calibrations date back to the 2003 Directive). This tailoring reflects the dominance in the wholesale debt markets of sophisticated/​professional investors who do not require the disclosures and protections provided by the Regulation, as well as the influence of a well-​organized lobby during the original 2003 Directive negotiations.347 It also reflects a concern to ensure the efficiency of the cross-​border private placement market, a concern which is now all the stronger given growth in the EU corporate bond market in the wake of the financial crisis and the related CMU focus on supporting bond markets and the private placements through which they operate. The first set of calibrations relates to the exemptions from the prospectus requirement that are of particular importance to the wholesale debt markets, chief among them the exemption for offers of securities issued in denominations of at least €100,000 (Article 1(4)). Wholesale debt market offers can, accordingly, be structured to avoid the prospectus requirement. But where an issuer either chooses to publish an approved prospectus or is in practice compelled to do so (admission to a regulated market, for example, might be necessary given the investment mandates of certain professional investors), an alleviated prospectus regime is available. There are three dimensions to this regime: choice of NCA for prospectus approval; alleviated disclosure; and retail summary/​language calibrations. The first alleviation is available for issuers of non-​equity securities with denominations of at least €1,000; the others are available for specified wholesale non-​equity issuances (the securities issued have denominations of at least €100,000; or are admitted only to a regulated market restricted to qualified investors or admitted only to a segment thereof restricted to qualified investors). As regards the first alleviation, the ability of qualifying non-​equity issuers to choose their home NCA (in effect, that of the Member State where the securities are first admitted 347 The Commission’s original retail-​market-​oriented approach to the 2003 Prospectus Directive Proposal resulted in a ‘one-​size-​fits-​all’ model which severely limited the exemptions available for wholesale market debt issuance, and, by removing issuer choice of NCA from the wholesale debt markets, threatened to disrupt the operation of the eurobond market in particular by moving prospectus approval from the London and Luxembourg marketplaces where it had concentrated. eg, Preston, A, ‘Home Country Rule Threat to Eurobond Market’, Euromoney, July 2001, 33. The strength of the opposition can be tracked through the Financial Times’ discussion, including Letters, Financial Times, 16 November 2001 (a letter from a group of 56 chairpersons, chief executives, and directors of smaller UK companies). An effective lobbying effort, combined with strikingly cohesive institutional support from the Parliament and Council (in an echo of the reaction to the Commission’s 2015 attempt to remove the exemption for securities with denominations of at least €100,000), led to the considerably altered regime which has applied since 2003.

130 Capital-raising to trading on a regulated market) has long been a cornerstone of the prospectus regime (Article 2(m)(ii)) (section 4.10). As regards the second, an alleviated prospectus disclosure regime has always been available to wholesale issuances of non-​equity securities in denominations of at least €100,000 (€50,000 prior to the 2010 Amending Directive), but this regime was finessed by the 2017 Prospectus Regulation: the Regulation expanded the regime to include non-​equity securities (of any denomination) traded only on a regulated market, or specific segment thereof, to which only qualified investors have access.348 The disclosure alleviation is achieved in two ways: the over-​arching Article 6 materiality standard provides that the ‘necessary information’ required to make an informed assessment of the issuer, the securities, and the reasons for the issuance and its impact on the issuer can vary to reflect where the securities are issued in a denomination of not less than €100,000 or admitted to a qualified-​investor-​ restricted regulated market or segment thereof (Article 6(1)); and Article 13(1) provides a delegation for administrative rules governing the specific disclosures required for such issuances. The details of the alleviated regime are set out in the 2019 Prospectus Delegated Regulation which reflects the earlier 2004 Commission Regulation in this regard.349 Finally, such non-​equity securities prospectuses are exempt from the requirement to produce a retail summary (Article 7(1)) and also benefit from a discrete language/​translation regime (Article 27(5)).

II.4.9.7 SMEs: The EU Growth Prospectus The CMU concern to enhance SME funding sources has exerted significant influence on the design of the Prospectus Regulation, most evident in the Regulation’s introduction of a proportionate disclosure regime for SMEs in the form of the EU Growth Prospectus. The calibration of prospectus requirements to ease burdens on the SME segment is not a straightforward exercise.350 In favour of calibration, the costs represented by prospectus (and other) disclosures can be disproportionate for SMEs, particularly given the lower levels of funding SMEs typically seek to raise. But any segmentation between large and smaller issuers on EU regulated markets with respect to prospectus (and other) obligations could generate investor confusion and damage to the regulated market ‘brand’. SME investment also poses risks, particularly liquidity risks,351 which caution against a deregulatory approach, particularly as the risks may not be counter-​weighed by funding benefits given

348 This expansion was designed to facilitate issuances of lower denomination bond securities so as to respond to the Commission’s concern that the regulatory incentive to issue in denominations of €100,000 and above was thinning liquidity: section 4.3. 349 2019 Prospectus Delegated Regulation Art 8 and Annex 7 (registration document for wholesale non-​equity securities) and Art 16 and Annex 15 (securities note). Where the registration document/​securities note are drawn up under the base prospectus, simplified prospectus, or EU Growth formats, which are all alleviated regimes, these requirements do not apply. 350 For a challenge to the deregulatory reforms introduced by the 2012 JOBS Act, eg, see Fox, n 66. The difficulties are well-​illustrated by the different positions adopted by the Commission and ESMA with respect to the initial deregulation of SME prospectus disclosure by means of the proportionate disclosure regime adopted under the 2010 Amending Directive. The Commission was supportive, but ESMA advised against a differentiated prospectus regime for smaller issuers, given the risks to investor protection and to regulatory consistency: ESMA, Final Prospectus Advice (2011). The EU Growth Prospectus partly reflects ESMA’s position as it cannot be used for admissions to a regulated market, although it can be used for a public offer. 351 The risks inherent in crowdfunding, including liquidity risks, underline the difficulties in deregulating public markets on the basis of issuer size. See, eg, Verstein, A, ‘The Misregulation of Person-​to-​Person Lending’ (2011) 47 UC Davis LR 447.

II.4  The Prospectus Regulation  131 the structural challenges market-​based capital-​raising generates for SME, as noted in section 3.6. Nonetheless, the deregulation of the prospectus regime to support SMEs, and the building of a more mobile ‘funding escalator’, taking SMEs from private funding to second-​ tier trading venue, to regulated market, was a pillar of the 2015 CMU Action Plan and also of the Commission’s 2015 Prospectus Proposal. The outcome has been the EU Growth Prospectus. By contrast with the proportionate disclosure regime for SMEs introduced by the 2010 Amending Directive, it is only available for public offers and cannot be used for admission to a regulated market. It thereby side-​steps some of the investor confusion and perimeter-​weakening risks associated with differentiated disclosure for SMEs. Although a pivotal reform, the EU Growth Prospectus is only one of the means the Prospectus Regulation employs to support smaller issuers. The Regulation expands the gateway definition of an SME to cover not only companies which meet two of the three threshold criteria (an average number of employees during the financial year of at least 250; total balance sheet not exceeding €43 million; and an annual net turnover not exceeding €50 million),352 (the precursor definition) but also, in line with the MiFID II definition of an SME, companies with an average market capitalization of less than €200 million over the previous three years (Article 2(f)). In addition, the mandatory and optional thresholds for offers below which the prospectus requirement does not apply have increased to €1 million and €8 million respectively (Articles 1(3) and 3(2)), while the longstanding exemption available for offers to less than 150 persons continues to support small offers (Article 1(4)). The revisions made earlier by the 2010 Amending Directive, and since by the Prospectus Regulation, to the employee and director share-​offer regime are also designed to support smaller issuers.353 So too, given the dependence of SMEs on bank finance, is the prospectus exemption for credit institutions that issue up to €75 million in non-​equity securities over a twelve-​month period (Article 1(4) and (5)). Further, where SME offers come within the scope of the prospectus regime, the disclosure rulebook can be somewhat adjusted in that the Article 6 materiality standard provides that disclosures can vary given the nature and circumstances of the issuer, thereby allowing some room to tailor disclosures to the specifics of SMEs. The prospectus regime has, however, struggled for some time with how to calibrate the detailed prospectus rulebook. The 2003 Prospectus Directive required that its administrative rules take into account the features of SMEs, but this injunction was not followed under the 2004 Commission Regulation.354 Following the 2010 Amending Directive (which also finessed the definition of an SME), the Commission activated the Directive’s new delegation for proportionate disclosure for SMEs, leading to revisions to the 2004 Commission Regulation which included in-​scope SMEs being able to disclose two, rather than three, years of audited historical financial information, amongst other alleviations.355 In practice, these reforms proved ineffective, in part as issuers were wary of a negative market reaction to the reduced disclosures.356 With facilitating access to market finance by SMEs a core

352 In each case by reference to the last set of financial statements. 353 2017 Prospectus Regulation recital 17 notes the importance of employee share ownership schemes for SMEs. 354 In part given a lack of support for the key distinguishing requirement that two, rather than three, years’ financial information be required for smaller issuers: Ferran (2004), n 173, 181. 355 The refinements included, eg, alleviated disclosure concerning capital resources, borrowing requirements, and funding structure. 356 n 204.

132 Capital-raising tenet of the 2015 CMU Action Plan, the Commission’s 2015 Prospectus Proposal contained a proposal for a bespoke prospectus regime which would reduce the costs of prospectus preparation for SMEs. The Commission proposed a lighter, proportionate regime, which engaged novel prospectus format techniques, including the use of a Q&A document rather than the traditional prospectus. Over the negotiations, while the principle of alleviated disclosure was not contested, the co-​legislators finessed this regime, including by expanding its scope to include larger SMEs, removing the Q&A model, requiring a retail summary (albeit one shorter than the standard Article 7 retail summary), introducing clarity and simplicity requirements, and specifying the disclosure requirements. The EU Growth Prospectus regime which emerged from the negotiations is set out in Article 15. It is designed to facilitate access to market finance by SMEs and to reduce their costs, but also to ensure sufficient disclosure is available to reflect the specific investment risks generated by SMEs.357 By contrast with the precursor proportionate disclosure regime, and in order to avoid any risk of a two-​tier disclosure system existing on regulated markets, and of related investor confusion, the EU Growth Prospectus is not available for admissions to a regulated market: it is available only for an offer of securities to the public where the issuer has not securities admitted to trading on a regulated market (Article 15(1)). The EU Growth Prospectus can, however, be passported for public offers. The EU Growth Prospectus is optional, but it can only be chosen by identified categories of issuer, originally: SMEs (and offerors of securities issued by SMEs); issuers, other than SMEs, whose securities are traded (or to be traded) on an SME Growth Market, as long as the issuer’s market capitalization is less than €500 million, on the basis of end-​year quotes, over the last three years (and offerors of such securities); and issuers, other than these classes of issuer, where the relevant offer of securities to the public is of total consideration in the EU of not more than €20 million over twelve months, as long as such issuers do not have securities traded on an MTF and their average number of employees during the previous financial year is less than 500. In a good example of the dynamism of the prospectus regime (and the scale of the commitment to priming market finance for SMEs), the 2019 SME Regulation added to the list of qualifying issuers those who were larger than traditional SMEs, but who did not qualify as regards the ‘below €200 million capitalization’ threshold which brings ‘larger’ SMEs into Article 15. The reach of Article 15 was thereby expanded to cover issuers seeking an initial public offer of their shares (at the same time as admission of the shares to an SME Growth Market) with a tentative market capitalization of below €200 million.358 The regime is directed to smaller companies, but it also has a venue orientation, supporting the SME Growth Market, set up under MiFID II, as a ‘promising tool’ for supporting smaller companies,359 and developing fast in practice (section 8). The EU Growth Prospectus available to these issuers is designed as an entirely new prospectus; it is not a ‘cut down’ version of the standard prospectus.360 Article 15 provides that the prospectus is to be in a standardized format, written in a simple language, and easy for issuers to complete, and to be based on a specific registration document, securities note, 357 2017 Prospectus Regulation recital 51. 358 See 2019 SME Regulation recital 17. 2017 Prospectus Regulation Art 15(1)(ca) applies a final offer price and number of shares outstanding formula to determine the size of offer eligible. 359 2017 Prospectus Regulation recital 51. 360 As underlined by the Commission in its mandate to ESMA for technical advice on the related administrative rules: n 207.

II.4  The Prospectus Regulation  133 and retail summary; notably, notwithstanding the retail market risks, an abbreviated summary, designed to be shorter than the standard Article 7 retail summary and not to impose any additional burdens or costs on issuers, is required (Article 15(2)). The coverage of the EU Growth Prospectus, including its retail summary, is amplified by the 2019 Prospectus Delegated Regulation.361 Like the URD, the EU Growth Prospectus is a significant but potentially troublesome innovation. As with many of the Prospectus Regulation reforms, it is a deregulatory measure, privileging SME support and designed to minimize the costs of prospectus approval. Certainly, the requirements imposed by the 2019 Prospectus Delegated Regulation are, while alleviated, highly specified, and specialist SME Growth Markets are developing, supported by this bespoke disclosure system, and so acting as ‘commitment devices’, binding SME issuers to the disclosures made.362 Nonetheless, the reform creates a second-​tier prospectus, which is not supported by the ongoing disclosure flows provided by regulated market admission, and further atomizes a prospectus regime already characterized by multiple formats. Given the relatively small number of issuers projected to use the format, it remains to be seen whether the balance of risks and benefits has been correctly calibrated.363 The regime, for example, reduces the ability of SME Growth Markets and other second-​tier venues to experiment with the format of admission/​‘prospectus’ documents, a facility that the Regulation otherwise seeks to protect.364 While in practice this risk may be limited, as the EU Growth Prospectus is optional and is based on admission standards already imposed by MTFs,365 the reform narrows the space within which second-​tier/​MTF venues can experiment with disclosure documents and tailor disclosures to local market conditions. The current priority being given to SME funding, however, suggests that this aspect of the prospectus regime is likely to remain on the reform radar.366

II.4.9.8 The Retail Markets: The Summary In addition, the Prospectus Regulation expressly addresses retail market disclosure through the requirement for a ‘prospectus summary’ to be included in the prospectus (Article 7).367 The Article 7 summary represents the most recent iteration in the prospectus regime of mandatory short-​form retail disclosure, the optimal design of which has troubled the prospectus regime since its adoption in 2003.

361 2019 Prospectus Delegated Regulation Arts 28–​34 and Annexes 23–​7. The requirements cover the registration document and securities note (for equity and non-​equity securities), format and order of disclosures, and the retail summary. Among the major alleviations are the requirement for two (rather than three) years of financial statements and the lighter requirements governing, eg, investments, R&D, corporate governance, and organizational structure, and the limitation of the OFR and working capital statement requirement to equity issuers with a market capitalization of over €200 million. 362 Perrone, n 163 (2020) 239, noting that this may have the effect of deterring ‘bad issuers’. 363 The reform was projected to be available for 320 SME prospectuses and to yield annual savings in the region of €45 million: 2015 Prospectus Proposal, n 191. 364 2017 Prospectus Regulation recital 15 notes that nothing in the Regulation is designed to prevent Member States from introducing local rules that allow MTFs to determine the content of admission documents or the modalities of their review. 365 2018 ESMA Prospectus Technical Advice n 202, 148, although a variety of different approaches still obtain across the EU: Perrone (2018), n 163, 258. 366 Evident in the 2022 Listing Act reform agenda (n 144) proposing that the optional EU Growth Prospectus be replaced by a mandatory EU Growth Issuance Document. It would be governed by lighter disclosure requirements which would reflect the Recovery Prospectus as well as the approach adopted by SME Growth Markets. 367 Art 7 provides that the prospectus must include the summary.

134 Capital-raising The summary can be associated with the wider concern to protect retail investors that animates the prospectus regime. The 2003 Prospectus Directive was the first FSAP measure to engage closely with the retail markets and with retail investor protection,368 as was clear from the strongly retail orientation of the original Prospectus Proposal which threatened to derail the negotiations. The 2017 Prospectus Regulation, while a significantly more nuanced and wholesale-​oriented measure, forms a continuum with the 2003 Directive in having a retail orientation. A key architectural principle running through the Regulation is that the disclosures made must be digestible by retail investors. This is implied in the approach taken to presentation: Article 6 provides that the prospectus must be written and presented in an easily analyzable, concise, and comprehensible form. The Regulation’s retail orientation is also a function of the exemptions to the regime and the nature of the different alleviating formats: these are for the most part directed to the wholesale markets, with the standard, ‘full’ prospectus operating in the public market/​regulated market sphere, both of which are proxies for markets with widespread retail participation. Similarly, line-​item disclosure requirements, particularly as regards non-​equity securities, are tailored, under the 2019 Prospectus Delegated Regulation, to whether the offering is retail or wholesale. The Prospectus Regulation also contains, in the Article 7 prospectus summary, the zenith of the efforts since 2003 to produce an optimum short-​form disclosure document for retail investors. The Regulation accordingly reflects a longstanding association in EU prospectus regulation and policy between prospectus regulation and the promotion of cross-​border investment by retail investors as well as the promotion of stronger household engagement with market-​based saving generally.369 The 2010 Amending Directive reforms, for example, were designed to promote greater share ownership among employees, and to encourage retail investors to compare securities offerings, aided by the new summary prospectus introduced by the 2010 reforms. The risks of using issuer/​prospectus disclosure to promote retail investment have, however, been well-​documented, given in particular the weight of evidence that retail investors struggle to process prospectus disclosures.370 Further, the ‘signalling’ effects associated with mandatory issuer/​prospectus disclosure have been criticized for implicitly encouraging retail investors into the market, and for imbuing them with a false sense of security (leading them to believe they can generate equal returns to market professionals), by impliedly emphasizing the protections provided by disclosure without highlighting the impact of trading costs and diversification.371 EU retail market policy has, however, become increasingly more nuanced since the financial-​crisis era. As outlined in Chapter IX, it has taken a precautionary turn, becoming more closely oriented towards the intermediation process and towards the regulation of investment product governance and distribution. The CMU agenda reflects this turn. While 368 See Morris, T and Machin, J, ‘The Pan-​European Capital Market—​Is the Prospectus Directive a Success or Failure?’ (2006) 1 CMLJ 205. 369 For an analysis linked to the 2003/​2010 Directive see Moloney, N, How to Protect Investors. Lessons from the EC and the UK (2010) 363–​73 370 See, in the EU context, Schammo, P, ‘The Prospectus Approval System’ (2006) 7 EBLR 501. 371 This theme is a feature of US scholarship in particular, See, eg, Jackson, H, ‘To What Extent Should Individual Investors Rely on the Mechanisms of Market Efficiency? A Preliminary Investigation of Dispersion in Investor Returns’ (2003) 28 J Corp L 671; Hu, T, ‘Faith and Magic: Investor Beliefs and Government Neutrality’ (2000) 78 Texas LR 777; and Langevoort, D, ‘Theories, Assumptions, and Securities Regulation: Market Efficiency Revisited’ (1992) 140 U Pa LR 851.

II.4  The Prospectus Regulation  135 it is designed to channel household savings towards productive capital allocation, its retail agenda is directed towards investment product distribution and does not privilege direct investment in securities.372 And while the Prospectus Regulation retains a strong retail orientation, this is more a consequence of it seeking to ensure that the highest standards of disclosure and investor protection apply within the public/​regulated market sphere, than of a privileging of the prospectus as a means for actively promoting direct retail investment. Certainly, there is little evidence to suggest that the prospectus regime has had transformative effects on retail investor behaviour; EU households have long relied heavily on intermediated distribution of investments, and their preference for insurance-​based and pension products as long-​term investments has proved sticky.373 Notwithstanding the wider shift in EU retail market policy towards intermediation, the prospectus regime continues to grapple with how best to ensure issuer disclosures are directly accessible to retail investors, in particular by means of summary disclosures. In some respects, these efforts might be regarded as misdirected. Given that intermediated/​ advised sales of investments are the main vector across which much of EU household investment is mediated, distribution regulation, rather than issuer disclosure regulation, is the key pressure point, and there is little evidence of value from the repeated efforts at summary prospectus disclosure reform. Similarly, the recent growth in the gamification and digitalization of direct investment, brought into sharp relief by the 2021 Gamestop episode, suggests a need to focus regulatory resources on the resilience of distribution and order execution regulation, as well as on the digitalization of disclosures.374 Further, full-​scale retail public offers are rare, with the September 2022 Porsche IPO, which included retail offers in Germany, France, Italy, Spain, and Austria, an exception; and there are specific obstructions in the retail bond markets, where regulatory incentives have led to a contraction in their size as issuers have offered debt in denominations of at least €100,000.375 Certainly, it is not contested that prospectuses are dense, lengthy, and complex documents and challenging for retail investors.376 But density, length, and technical obscurity are unavoidable given, inter alia, the demands of the disclosure rulebook; the need to support passporting and the removal of the host NCA which necessitates dense harmonization; the need to manage litigation risk, which leads to prospectuses operating as liability shields; and the information expectations of the wholesale market, including internationally (most notably the US, as EU public offers will often be accompanied by a wholesale (Rule 144a) offering). The standard prospectus will, accordingly, always struggle in terms of retail market ‘processability’.377 The 372 See, eg, 2015 CMU Action Plan, n 12, 18. 373 Ch IX section 1.2.1 374 See further Ch IX. 375 As noted in section 4.3. 376 ESMA has recently noted the ‘size inflation’ of prospectuses, which it has linked to excessive coverage of risk factors: 2019 Risk Factor Guidelines, n 222, 14. For an early perspective see the 2008 CSES Report which found that many market participants regarded prospectuses primarily as liability shields and that retail investors did not use them (n 183, 51) and the 2007 CESR Report which found that the prospectus was burdensome to produce and difficult to read (n 183, 16). The 2021 Listing Consultation returned to the size debate, querying the length and complexity of prospectuses, albeit mainly from the issuer perspective: 2021 Listing Consultation, n 12, 11–​16. The 2022 Listing Act reform agenda (n 144) subsequently proposed a series of page-​limit reforms, including that the ‘standard’ format prospectus for a share IPO be limited to 300 pages. 377 In the US, the SEC’s failure to address the processability of issuer disclosures has long been a cause of concern in US scholarship. The 2010 Dodd-​Frank Act, however, required the SEC to focus more closely on how disclosures are designed and on related literacy strategies and led to the publication of a major study (SEC, Study Regarding Financial Literacy Among Investors (2012)). An SEC advisory committee (set up under the Dodd Frank Act) has recently commended the SEC’s ‘good faith’ efforts in this area but has called for more extensive research and

136 Capital-raising EU’s efforts to design short-​form disclosures that support some level of retail accessibility can, however, be regarded as a reasonable compromise between disregarding retail investor processability needs and re-​engineering how prospectus disclosures operate. The Prospectus Regulation’s reformed prospectus summary certainly represents a high point in the EU’s long struggle to address short-​form prospectus disclosure. The 2003 Prospectus Directive required issuers to produce a short-​form summary (2,500 words) which, in non-​technical language, conveyed the essential characteristics and risks associated with the issuer and offer. Not subject to further amplification, this non-​standardized document was widely regarded a failure, doing little to support retail investors (being largely a ‘cut and paste’ from the main prospectus) and adding to issuers’ costs and liability risks, particularly as over-​zealous NCA supervision of the 2,500 word-​limit risked that material information was not presented. The second round of prospectus reform, under the 2010 Amending Directive, saw the 2003 summary replaced by a materially more articulated and nuanced version which was subject, for the first time, to format and presentation requirements to support comparability, and which was designed to deliver ‘key investor information’ in concise and non-​technical language. In another departure, administrative rules (in the revised 2004 Commission Regulation) set out detailed content requirements, including as to length (seven per cent of the prospectus or fifteen pages, whichever was the shorter). While an improvement, the 2010 revisions did not grapple with the underlying accessibility challenges: the summary was not tested on retail investors, did not address presentation in any detail, did not require warnings as to the risks posed by investment generally, and was based on traditional line-​item presentation of specific disclosures. The new summary (Article 7), which was not heavily contested over the negotiations,378 is based on the ‘key investor information’ concept from 2010, but is materially more standardized. It is designed to provide key information with a view to helping investors (all investors, but particularly retail investors) to decide which offers they wish to review more fully by examining the full prospectus (recital 28): it is, in effect, a sort of ‘taster’ device, albeit a regulated one. The level of legislative prescription is striking; most of the detail is contained in Article 7, with the administrative amplification limited to the EU Growth Prospectus summary (2019 Prospectus Delegated Regulation),379 and to the treatment of financial information (2019 Prospectus RTS).380 The over-​arching obligation has two aspects. First, the summary is to provide key information that investors need to understand the nature and risks of the issuer, the guarantor, and the securities in question; it is designed as a self-​contained document, but to be read together with other parts of the prospectus to aid investors when considering whether to invest in the relevant securities (Article 7(1) and recital 28). Second, the content must be accurate, fair, clear and not misleading and, testing: Investor as Purchaser Subcommittee, Recommendation on Disclosure Effectiveness, March 2020. The SEC has recently proposed major reforms designed to tailor disclosures to retail investor needs, but primarily as regards mutual fund and exchange-​traded fund disclosures: SEC, Press Release 2020-​172, August 2020. 378 The regime as adopted closely follows the Commission’s model, save for some alleviations as regards risk factors. The Council, however, extended the summary requirement to the Article 14 simplified prospectus and to the Article 15 EU Growth Prospectus. 379 2019 Prospectus Delegated Regulation Arts 33–​4 and Annex 23. It is similar to the Art 7 summary, but limited to six pages, given the truncated nature of the EU Growth Prospectus. 380 2019 Prospectus RTS Arts 1–​9 cover financial information and are tailored to reflect the type of securities issued and the issuer (credit institutions, insurance companies, SPVs issuing asset-​backed securities, and closed-​end funds).

II.4  The Prospectus Regulation  137 while the summary is to be read as an introduction to the prospectus, it must be consistent with other parts of the prospectus (Article 7(2)). Detailed format and content requirements apply to ensure standardization and accessibility, chief among them that the summary document must be short and written in a concise manner and cannot extend beyond seven pages;381 must be written in a language and style that facilitates understanding (and that is clear, non-​technical, concise, and comprehensible); and must follow the four ‘blocks’ of disclosure required relating to the introduction, the issuer, the securities, and the offer (Article 7(3) and (4)). The ordering and content of these blocks of disclosures is highly prescribed by Article 7. Among the features designed to support accessibility by retail investors is the organization of the blocks around a series of questions: the blocks include ‘who is the issuer’; ‘what is the key financial information regarding the issuer’; ‘what are the key risks that are specific to the issuer’; ‘what are the securities’; ‘what are the key risks that are specific to the securities’; and ‘why is this prospectus being produced’? Other retail-​oriented features include the mandatory warnings (including as to the risk of the investor losing all the invested capital); the emphasis on the potential risks of bail-​in-​able securities;382 and the limits on the number of risk factors which can be included to avoid generalities and the obscuring of key risks (the total number of risk factors across the different blocks where risk disclosures are required (issuer, guarantor, and securities) cannot exceed fifteen). This approach builds on the novel Key Information Document (KID) format developed under the 2014 PRIIPs Regulation, which came into force into 2018 and which was subject to extensive research and testing.383 The Article 7 summary is a watershed in many respects. It is organized in an intuitive manner around key questions. The seven-​page limit is not unduly restrictive for issuers (who were previously concerned that breaching earlier limits in order to provide sufficient material disclosures would lead to the publication of an unapproved prospectus). It builds on the KID format developed by the PRIIPs regime, at the time a major step forward in retail short-​form disclosures. The level of specification is immensely granular, from content, to ordering, to format, to style, to presentation; the potential for greater retail investor understanding of investment risk and potential returns is accordingly high. Yet difficulties remain. The summary does not, by contrast with the PRIIPs KID, contain visual indicators or standardized risk metrics, although account must be taken of the summary not being designed to support comparability across a range of investments, being issuer-​specific. The limit on the number of risk factors that can be disclosed reduces the danger of material risks being obscured, but it may lead to sub-​optimally abbreviated risk disclosures. The injection of the PRIIP KID into the summary may cause confusion: where the issuer has been required to prepare a KID where the issuance qualifies as a PRIIP (see Chapter IX section 5), it may substitute the PRIIP KID for the relevant securities-​related content required in the summary (or the home NCA may require such substitution), in which case the length of the summary can be extended by three pages and the KID element of the summary must be clearly labelled as such.384 Civil liability remains an intractable difficulty. Civil liability 381 The limit is designed to ensure that retail investors are not deterred from reading the summary and issuers are incentivized to disclose essential information: 2017 Prospectus Regulation recital 30. 382 Expressly noted in Art 7(7)(a)(iv). 383 Regulation (EU) No 1286/​2014 [2014] OJ L352/​1. See Ch IX section 5. 384 An alleviation is made available to issuers in that where the KID is incorporated within the summary in this way, the publication of the prospectus summary is deemed to meet the obligation to provide a KID under the PRIIPs Regulation (Art 7(12)). The PRIIPs KID is designed to catch products with some degree of ‘packaging’ and

138 Capital-raising attaches to those who have ‘tabled’ the summary, but only where the summary is misleading, inaccurate, or inconsistent when read together with other parts of the prospectus, or where it does not provide, when read together with the prospectus, key information to aid the investor when considering to invest in the securities (Article 7(5)). But while the summary is translated for each host State in which the prospectus is passported (section 4.10), the prospectus is not, meaning that the conundrum which has long bedevilled the prospectus summary remains: how can the summary be effective where liability is a function of its relationship with the prospectus, but the prospectus will likely not be translated into the language of the host State (and the investor must bear the cost of any translation for legal proceedings)? Further, the prospectus remains a potentially daunting prospect for retail investors, although Article 6 imposes comprehensibility requirements, and ESMA soft law is increasingly engaging with how these are to be met.385 Ultimately, there are limits to short-​form prospectus disclosures. While clearly a significant step forward, it remains unclear whether the new prospectus summary is worth the regulatory design and issuer costs or whether the commitment to short-​form prospectus disclosure remains somewhat quixotic, particularly in light of EU household investment patterns.

II.4.10  Market Integration: Prospectus Approval and the Passport Mechanism II.4.10.1 Approving the Prospectus: Designating the Home NCA The prospectus regime requires the publication of a prospectus (Article 3). Prior to publication, the prospectus must be approved by the relevant NCA (Article 20), a requirement that brings supervisory oversight to bear on the prospectus’ content. The prospectus is approved by the ‘relevant’ NCA (Article 20), which is the home NCA (Article 24). The home NCA is the NCA of the home Member State which is governed by Article 2(m). Article 2(m) is based on a two-​pronged default and issuer choice model originally adopted by the 2003 Directive and now a longstanding feature of the prospectus regime. Under the default model (Article 2(m)(i)), the home Member State for all EU issuers of securities not covered by Article 2(m)(ii) is the Member State where the issuer has its registered office: given the operation of Article 2(m)(ii), the Member State of the issuer’s registered office is the home Member State for all equity issuers and also issuers of debt with denomination of less than €1,000. By contrast, under Article 2(m)(ii), which is designed to accommodate bond market practices, for issues of non-​equity securities whose denomination per unit amounts to at least €1,000, the home Member State is the Member State where the issuer has its registered office, or, and bringing issuer choice to bear, the Member State where the securities were or are to be admitted to trading on a regulated market or where the securities are offered to the public, as chosen by the issuer or the offeror of securities.

so is unlikely to apply to ‘plain vanilla’ issuances by corporate issuers of shares and bonds, albeit that its coverage remains contestedl: Ch IX section 5.4.

385

Comprehensibility is a recurring theme of the 2021 Prospectus Disclosure Guidelines.

II.4  The Prospectus Regulation  139 The assumption underlying the removal of issuer choice for equity/​small denomination debt issuers is that the NCA of the Member State in which the issuer has its registered office is best placed to supervise prospectus disclosure, has the strongest incentives to do, particularly as regards the domestic retail market implications, and that arbitrage risks are reduced; reasoning of this form underlines the single rulebook’s jurisdiction allocation scheme generally. the removal of issuer choice as regards prospectus approval was, however, criticized at the time of the 2003 Directive’s adoption on the grounds that monopoly supervisors (the NCAs) would be thereby constructed that would make little effort to deliver efficiency benefits and innovation; and, relatedly, that NCAs would have insufficient incentives to review a prospectus appropriately where the offer took place in another Member State. Most contestation, however, concerned the bond markets, reflecting the concentration of bond markets in certain markets (at the time in Luxembourg and London). The Commission’s original proposal that the Member State of issuer registration also govern bond issues prompted an intense industry backlash at the prospect of well-​established market practices being disrupted by the replacement of these seasoned NCAs (chosen by issuers) with those inexperienced with bond market practices,386 as well as institutional disquiet.387 Issuer choice was accordingly maintained for non-​equity offerings of denominations of €1,000 and above.388 While now well-​established, the home NCA designation system was, during the initial phase of the prospectus regime’s application, questioned and has been associated with, inter alia, some regulatory incoherence (in that the bond market calibrations otherwise apply to large denomination debt (€50,000 initially and subsequently €100,000), although a higher threshold for issuer choice could embed further incentives not to issue retail-​market-​ oriented debt). The Commission, in the 2010 review of the Directive, and reflecting some stakeholder concern, proposed the removal of the €1,000 threshold and so freer investor choice,389 the European Parliament favoured its retention on investor protection and regulatory arbitrage avoidance grounds,390 while NCAs' views differed.391 The compromise was to direct the Commission to review the €1,000 threshold and to consider whether it should be removed,392 but it has remained a feature of the 2017 Prospectus Regulation. The clamour that initially attended the system for allocating the home NCA was associated with the debate on the extent to which issuers should be able to choose NCAs, and, relatedly, on the degree to which NCA specialization and/​or competition should be 386 The London Stock Exchange, eg, raised concerns with respect to the implications for NCA resources and expertise, monopoly risks, the lack of incentives for NCAs to provide more efficient services, and the costs imposed on intermediaries: London Stock Exchange, Comments on the Proposed Prospectus Directive, August 2001, paras 4.4–​4.5. 387 The European Parliament, eg, raised concerns with respect to monopoly risks and a loss of concentrated expertise: First ECON Report, n 177, Amendments 2 and 16. 388 Consistency with the original wholesale bond market regime might have suggested a €50,000 threshold as a starting point and the Commission proposed such a €50,000 threshold in its revised 2003 Prospectus Proposal, on the grounds that this would distinguish retail and professional markets. The Council, however, adopted a rather arbitrary €5,000 threshold, while the Parliament called for a €1,000 threshold on the grounds that investment funds frequently invested in small-​denomination bonds for ease of handling and diversification and (presciently) that a higher threshold would limit cross-​border access by retail investors to bond investments. This was the approach that prevailed: Second ECON Report, n 177, Amendment 10. 389 The Commission noted some practical difficulties faced by issuers as well as the absence of ‘concrete risks’ to investor protection: 2010 Amending Prospectus Directive Proposal, n 182, 6. 390 ECON Report, n 182, Amendment 3. 391 Schammo, n 109, 27 (noting the difficulties CESR faced in presenting a common position in response to the Commission’s consultation on what would become the 2010 Amending Directive). 392 2010 Amending Prospectus Directive recital 8.

140 Capital-raising facilitated. While issuer choice remains a feature of the prospectus regime, developments in the intervening twenty-​plus years since the prospectus regime was adopted in 2003 have rendered this debate largely otiose. The transformation of the prospectus regime into a Regulation, and the density of the administrative rulebook and related soft law, means that there is no room for regulatory competition (and arguably no appetite, given the multiplicity of channels through which market and national interests regarding prospectus rules can be fed through to administrative rules and soft law, in particular via ESMA’s activities; and the transaction cost benefits of what is now a uniform regime), save as regards matters cognate to the prospectus regime, such as admission/​listing rules. Similarly, as ESMA’s reach over operational supervisory practices by NCAs expands through the exercise of its wide range of supervisory convergence powers (section 4.12), the scope for supervisory competition, while still real, is becoming increasingly limited, not least given the greater prescription imposed on the prospectus approval process by Article 20 (as noted in this section below). Finally, the Article 20 prospectus approval regime now permits issuers to request the transfer of a prospectus, allowing issuers to request the home NCA to transfer the prospectus to another NCA (who, if it agrees, then becomes the home NCA); this right replaces the previous regime which was based on the home NCA’s power to delegate prospectus approval to another NCA. While the transfer process can be regarded as subverting the restrictions on issuer choice, it also ensures that specialization and expertise can, where relevant, be accessed, and underlines the driving concern of the Prospectus Regulation to facilitate issuers. In the absence of the emergence of serious difficulties, the current system, which accommodates, through issuer choice, long-​established bond market practices, but which has not prompted difficulties as regards its default system for equity and small denomination debt, can be expected to remain in place.

II.4.10.2 Prospectus Approval In one of the 2017 Prospectus Regulation’s major reforms, the prospectus approval process, which previously was largely left to the discretion of NCAs, subject to ESMA’s supervisory convergence efforts, has been significantly more operationalized and standardized under Article 20, reflecting concerns as to divergences in how NCAs approached the approval process. Article 20 imposes a series of procedural requirements, many of which are based on the precursor regime, but it also addresses the substantive nature of the review to be carried out by NCAs. The governing principle of the regime is clear: to ‘eliminate’ different approaches to prospectus approval.393 Procedure-​wise, time limits apply to prospectus approval, albeit that failure by an NCA to comply does not constitute an approval by default, although the legislative specification of these limits imposes a degree of discipline on NCAs. Under the standard model, an NCA is to notify the issuer or relevant person of its decision within ten working days of submission of the draft prospectus, but this is extended to 20 days in the case of an IPO, and reduced to five and seven days, respectively, in the case of a prospectus based on a URD or following the (now lapsed) EU Recovery Prospectus format.394 Article 20 also specifies that 393 The Regulation notes that not all issuers have access to adequate guidance on the approval process, as NCAs take different approaches; states that the Regulation should eliminate those differences by harmonizing the criteria for scrutiny and the process for approval; and calls for NCAs to take a convergent approach: 2017 Prospectus Regulation recital 60. 394 Art 20(2), (3), (6), and (6a).

II.4  The Prospectus Regulation  141 the NCA can terminate a review process where the issuer or relevant person is unable or unwilling to meet the NCA’s requests. In practice, as a request by the NCA, following the initial submission of the draft prospectus, for clarification/​additional disclosures re-​sets the ‘clock’ (Article 20(4)), the prospectus approval process takes in the region of two to three months.395 The fees which NCAs charge are also addressed and subject to a ‘reasonable and proportionate’ standard. In addition, and in a material change from the precursor regime, the standard of review applicable to prospectus approval (approval is ‘the positive act’ which follows supervisory scrutiny of the ‘completeness, consistency, and comprehensibility’ of the prospectus information (Article 2(r)) has been amplified and proceduralized.396 NCAs are to assess prospectuses for completeness, consistency, and comprehensibility (the ‘3Cs’) and in accordance with the requirements of the 2019 Prospectus Delegated Regulation which, inter alia, amplifies the 3Cs, including the comprehensibility criteria which seems to have limited traction on prospectuses in practice.397 The new approach also renders the approval process more transparent, with NCAs required to publish guidance on their processes (Article 20(7)). A form of operational manual for prospectus approval has, in effect, been put in place,398 although NCAs retain a degree of operational discretion,399 and NCA liability remains a function of national law. Further, ESMA is charged with promoting supervisory convergence as regards the approval process, including by means of Guidelines and peer review. As outlined in section 4.12, ESMA’s reach over the operational business of prospectus review is now considerable.

II.4.10.3 The Prospectus Passport and Notification The Prospectus Regulation and its administrative rules and soft law constitutes a dense prospectus rulebook that applies whether or not an in-​scope offer/​admission to a regulated market has cross-​border elements. This rulebook also accommodates the conferral of a ‘prospectus passport’ for cross-​border offers/​admissions under the Regulation’s mutual recognition system. Facilitating cross-​border capital-​raising by means of a regulatory passport has been one of the animating principles of the prospectus regime since 2003. Article 24 is the operative provision for the passport. It provides that where an offer to the public or admission to trading on a regulated market is carried out in one or more Member States, or in a Member State other than the home Member State, the prospectus approved by the home Member State (and any supplements thereto) is valid for the public offer or the admission to trading 395 Teerink, H, ‘The IPO and Listing Process in Practice’ in Busch et al (2020), n 163. 396 RTS 2016/​301 [2016] OJ L58/​13 previously amplified the approval process but was limited to procedural matters (including the receipt and processing of documents) and did not address the review standard. 397 Prospectus Delegated Regulation Arts 36–​8. Under Art 37, NCAs are to consider a series of criteria in assessing comprehensibility, including whether the draft prospectus is free from unnecessary iterations, is written in plain language, explains industry terminology, and has a structure that enables investors to understand its contents. 398 ESMA noted the novelty of the new rules and predicted that they ‘would undoubtedly harmonize the scrutiny process’: 2018 Prospectus Technical Advice, n 202, 206 and 208. The regime continues to evolve. The war in Ukraine led the Commission to warn that infringements of EU sanctions against Russia constituted a sufficient legal basis to refuse prospectus approval: Commission, Sale of Securities, FAQ, 14 June 2022 (the Commission’s warning was underlined in ESMA, Public Statement (Prospectus Supervision and EU Sanctions relating to Russia’s Invasion of Ukraine), 7 July 2022). 399 ESMA noted that the rules were designed to be proportionate and allowed a level of NCA discretion: 2018 Prospectus Technical Advice, n 202, 207.

142 Capital-raising in any number of host Member States.400 Host NCAs may not undertake any approval or administrative procedure relating to prospectuses and their supplements or final terms. This remains the case even where there are flaws in the prospectus; the home NCA remains in control of the prospectus. Article 24(2) provides that where a significant new factor, material mistake, or inaccuracy arises within the timeframe for prospectus supplements, the home NCA is to require that a prospectus supplement be approved. The host NCA and ESMA may, however, draw the attention of the home NCA to the need for new information. As is typical across the single rulebook generally, the passporting system depends on prior notification (Article 24(1) and 25). Reflecting the Regulation’s concern to minimize frictions to passporting, notification is NCA-​led and NCAs (whether home or host) cannot impose any fees as regards the notification process or any related supervisory activity. Under the Article 25 notification system, the home NCA must, at the request of the issuer (or the offeror, person asking for admission to trading, or person responsible for drawing up the prospectus), notify the host NCA within the specified time-​limit401 with a ‘certificate of approval’ (a template has been developed by ESMA), which attests that the prospectus has been drawn up in accordance with the Regulation and states whether any required information has been omitted, with an electronic copy of the prospectus and, where applicable, a translation of the prospectus and of any summary. The issuer (or other person) must be notified of the certificate of approval at the same time as the host NCA. ESMA must also be notified by the home NCA of the certificate of approval. In practice, and as required by Article 25, ESMA operates a notification portal402 through which NCAs upload the certificates of approval and prospectuses. This portal supports the extensive ESMA Prospectus Register: a searchable database of prospectuses, registration documents, URDs, securities notes, summaries, supplements, amendments, and final terms approved by NCAs, which are filed in accordance with classification and machine-​readability requirements to facilitate searching.403 This procedure, and the uploading through the ESMA portal, must also be followed for any prospectus supplements and, where relevant, for final terms.404 A separate notification regime applies under Article 26 to address the distinct issues raised where a bond issuer eligible to choose the home NCA under Article 2(m)(ii) has chosen a home NCA for prospectus approval which is different to the NCA which has approved the registration document or URD on which its prospectus is based. Article 26 is similar in design to Article 25 but sets out the interaction between the NCA responsible for the registration document/​URD and the home NCA responsible for prospectus approval. The passport mechanism has, by and large, worked well, although host State administrative obstructions and frictions have long been a feature of the passporting process,405 400 Defined as the State where an offer to the public is made or admission to trading on a regulated market is sought where that State is different from the home Member State (Art 2(n)). 401 The notification must be sent within one working day following receipt of the request or one working day following the prospectus approval, if the request accompanies the draft prospectus. 402 The technical arrangements for the functioning of the notification portal are set out in the 2019 Prospectus RTS Arts 11–​12 and 19–​21. 403 Accessible through: . 404 Where the final terms to a base prospectus (where the base has previously been notified) is not included in the base or in a supplement, the home NCA must communicate it to the host NCA (and to ESMA) as soon as practicable after it is filed. 405 Including as regards the imposition by host NCAs of translation requirements, additional filing requirements, and additional publication requirements (including requirements to publish a notice of publication of a prospectus): 2007 ESME Report, n 183, 5.

II.4  The Prospectus Regulation  143 and their reduction was a concern of the 2017 Regulation.406 The move to the Regulation format, the more detailed specification of rules, including as regards advertising, the operational hue of much of the Regulation, including as regards the prospectus approval process, and ESMA’s burgeoning supervisory convergence presence can be expected to further ease its operation in practice.

II.4.10.4 The Language Regime The language (or translation) system (Article 27) is one of the most successful and celebrated elements of the prospectus regime. It is largely unchanged since 2003, save for clarification of how it applies to the base prospectus and final terms documents. Broadly based on issuer choice, the language regime prohibits host NCAs from imposing translation requirements, and offers issuers a menu of language options depending on the type of offer (home/​ cross-​border) envisaged. Where an offer to the public is made or admission to trading on a regulated market is sought only in the home Member State, the prospectus must be drawn up in a language accepted by the home NCA (Article 27(1)). Where the offer to the public is made or the admission to trading is sought in one or more Member States, but not in the home Member State, the prospectus must be drawn up either in a language accepted by the NCAs of those Member States or in a ‘language customary in the sphere of international finance’407 (Article 27(2)). The choice of language is for the issuer, offeror, or person seeking admission. Accordingly, while the host NCAs must require that the prospectus summary is translated into their official languages or another language accepted by the NCAs408 (in practice, however, retail offers tend to be limited to the home State and are not usually passported, although the September 2022 Porsche IPO was an exception in this regard),409 they cannot require translation of the prospectus (Article 27(2)). Host NCAs are also prevented from assessing the quality of any translation.410 Similarly, the home NCA cannot dictate the language choice, although the prospectus must be approved by the home NCA, whose official language may be different from the language chosen: for the purposes of prospectus scrutiny by the home NCA, the prospectus must be drawn up either in a language accepted by the home NCA or in a ‘language customary in the sphere of international finance’, and this language at the choice of the issuer, offeror, or person asking for admission (Article 27(2)). Where the offer to the public is made or the admission to trading is sought in one or more Member States including the home Member State, a third regime applies (Article 27(3)). The prospectus must be drawn up in a language accepted by the home NCA, but it must 406 While the review undertaken in advance of the adoption of the 2017 Prospectus Regulation indicated that the passport had worked well and provided ‘real benefits’ for issuers, it reported that the passport notification process could be obstructed by, eg, host NCA reviews of marketing materials, requests for additional information, and imposition of notification requirements: 2015 Prospectus Proposal IA, n 191 10 and 25–​6. 407 In practice, this formula typically leads to use of English, although the Commission at an early stage emphasized that other languages can be used as long as they are customary in the sphere of international finance: Prospectus Transposition Meeting Minutes 26 January 2005. 408 The mandatory translation requirement reflects the priority given to the summary under the Regulation. The precursor regime gave NCAs discretion in this regard. 409 Teerink, n 239, 37. 410 ESMA Prospectus Q&A, Q9.1a-​c. ESMA provides an ‘information note’ (2020) which sets out the languages accepted in each Member State for the purposes of NCA scrutiny, passporting, and summary translation requirements. English is the dominant non-​official language accepted by host NCAs.

144 Capital-raising also be made available either in a language accepted by the NCAs of each host Member State or in a ‘language customary in the sphere of international finance’—​at the choice of the issuer, offeror, or person asking for admission. As with host-​State-​only offers, the host NCAs must require that the summary is translated into their official languages, but cannot require translation of the prospectus. Two further language regimes apply. One (Article 27(5)) relates to cross-​border wholesale bond market admissions: the admission to trading on a regulated market of non-​equity securities whose denomination per unit amounts to at least €100,000, or of non-​equity securities of any denomination which are to be traded on a regulated market or segment thereof to which only qualified investors have access; and where admission is sought in one or more Member States. The prospectus must be drawn up either in a language accepted by the home and host NCAs or in a ‘language customary in the sphere of international finance’—​at the choice of the issuer, offeror, or person asking for admission to trading. The other (Article 27(4)) addresses the base prospectus regime and addresses the language requirements where the base, final terms, and summary are passported.

II.4.10.5 Precautionary Powers As across the single rulebook, the home Member State/​NCA control principle dominates, but provision is made for exceptional powers to be exercised by the host NCA under the Regulation’s precautionary regime (Article 37). Where the host NCA has clear and demonstrable grounds411 for finding that irregularities have been committed by the issuer (or the offeror, the person asking for admission, or the financial intermediaries in charge of the public offer), or that those persons have infringed their Regulation obligations, it must refer those findings to the home NCA and to ESMA. The host NCA may act only where, despite measures taken by the home NCA, the infringements persist. In these circumstances, the host NCA may, but only after informing the home NCA and ESMA, take ‘all appropriate measures’ to protect investors. In a provision designed to deter abuse of this power, the Commission and ESMA must be informed of the measures taken without undue delay. As is the case across the single rulebook, ESMA’s mediation powers are injected into the precautionary system, with ESMA empowered to mediate between NCAs where disagreements arise.

II.4.11  Advertising In one of the more material changes wrought by the 2017 Prospectus Regulation, and in an illustration of the Regulation’s retail orientation, the previously limited advertising regime has been significantly expanded (Article 22).412 In an exception to the Regulation’s home control organizing principle, oversight of this regime is the purview of the host NCA (that of the Member State in which advertisements are disseminated). Host control

411 This threshold condition was added by the 2017 Prospectus Regulation in order to minimize frictions in the home/​host NCA relationship and issuer costs. 412 The new regime is designed to avoid the undermining of public confidence and prejudice to the proper functioning of markets: 2017 Prospectus Regulation recital 64.

II.4  The Prospectus Regulation  145 of advertisements has been a feature of the prospectus regime since the adoption of the Prospectus Directive in 2003. The first expansion relates to the foundational definition of an ‘advertisement’, previously defined as an ‘announcement’ relating to a specific offer of securities to the public or to an admission to trading on a regulated market, aiming to specifically promote the potential subscription or acquisition of securities.413 The same definition now applies, but with the replacement of the specific term ‘announcement’ with the more widely drawn ‘communication’ (Article 2(k)). A wider range of marketing communicationsis likely to captured as a result. The second expansion relates to the more extended series of conditions that Article 22 applies to advertisements. Advertisements must, inter alia, state that a prospectus has been or will be published and where it can be obtained, the information therein must be consistent with the prospectus and not inaccurate or misleading, and they must be clearly recognizable as advertisements. These requirements have been amplified in some detail by the 2019 Prospectus RTS. The RTS requirements have, overall, a strong retail colour, including as regards the requirement for risk warnings and to avoid presenting prospectus information in a ‘materially unbalanced way’.414 Article 22 also specifies, to a greater extent than previously, the role of the host NCA and the home/​host NCA interaction, providing that the NCA of the Member State where the advertisements are disseminated has jurisdiction over Article 22 compliance as regards advertising activity, but that, where necessary, the home NCA is to assist this host NCA as regards any assessments of consistency with the prospectus; that, where the host NCA takes any supervisory or enforcement action under Article 22, this must be communicated to the home NCA without delay; and that the host NCA can agree with the home NCA that the home NCA retains control over Article 22 compliance as regards advertising activity. Reflecting the undercutting concern of the Regulation’s passport-​related provisions to minimize administrative frictions, any scrutiny by the host NCA of advertisements cannot constitute a precondition for offering or admitting to trading the relevant securities in the Member State in question; the host NCA can only charge fees that are linked to supervisory tasks relating to advertisements and that are non-​discriminatory, reasonable, and proportionate; and the host NCA must not impose any requirements or administrative provisions additional to those relating to supervision of Article 22. In a similar vein, ESMA is mandated to develop Guidelines which address the need to ensure that supervision of advertisements does not hamper the passport notification procedure and to minimize the administrative burdens on cross-​border issuers. Some degree of unease as regards this level of host NCA control can be traced through Article 22, which seeks to balance the need to ensure minimum investor protection for retail investors, who are vulnerable to misleading advertisements, with the countervailing need to avoid host NCA disruption to cross-​border offerings. The prospectus advertising

413 2004 Commission Regulation Art 1(9). 414 The RTS covers how the prospectus is to be identified in the advertisement; the content of advertisements (including as regards clear presentation, the inclusion of a recommendation that potential investors read the prospectus before making an investment decision to fully understand the potential risks and rewards, and the need to ensure written advertisements cannot be confused with the prospectus); dissemination and the amending of advertisements where a prospectus supplement is published; and the relationship between advertisement and prospectus disclosures as regards ensuring consistency and balance: 2019 Prospectus RTS Arts 13–​16.

146 Capital-raising regime is bolstered by the extensive marketing communications rules which apply under the EU investment product distribution regime (Chapter IX).

II.4.12  Supervision and Enforcement II.4.12.1  NCAs The Prospectus Directive, when originally adopted in 2003, marked a break with pre-​FSAP financial markets regulation in that it rationalized and reinforced the institutional structure for prospectus supervision and enforcement. In particular, it addressed the controversies then swirling around the extent to which commercially driven, demutualized stock exchanges should be responsible for the review of issuer disclosure by introducing an independence requirement for NCAs (still in force) which, in effect, removed prospectus approval from stock exchanges. It also put in place the minimum powers NCAs were to have at their disposal. As such, it adopted the template regarding NCAs’ structure and powers which has since come, in more sophisticated form, to characterize most of the single rulebook. The 2017 Regulation builds on this well-​established architecture, strengthening the powers of NCAs. Although the Prospectus Directive was, in 2003, at the vanguard of the movement to enhance the supervisory powers of NCAs, it had by the time of the 2015 Prospectus Proposal slipped back: the raft of crisis-​era reforms which strengthened the supervisory and enforcement powers of NCAs, across a range of legislative measures, came after the 2010 Amending Prospectus Directive, leaving the prospectus regime an outlier as regards NCAs’ powers, particularly as regards sanctions and enforcement. This anomaly was corrected by the Regulation, with NCAs now required to be equipped with an extensive suite of supervisory, investigatory, and enforcement tools. The right of appeal which has long been a feature of the prospectus regime is accordingly of increasing importance.415 Under Article 31(1), each Member State is to designate a ‘single competent administrative authority’416 responsible for carrying out the duties resulting from the Regulation and for ensuring that the Regulation is applied, and independent from market participants. Delegation is permitted, but only as regards the electronic publication of approved prospectuses and related documents and subject to conditions designed to address conflict of interests and clarify responsibilities (Article 31(2)).417 The NCA remains remain responsible for approving the prospectus and for ensuring compliance with the Regulation. The foundation obligation imposed on Member States as regards NCAs’ powers is to, in a formula familiar across the single rulebook, ensure that appropriate measures are in place so that NCAs have all the necessary supervisory and enforcement powers to fulfill their duties (Article 32(3)). The extensive suite of specific minimum powers which must be conferred on NCAs is specified in Article 32(1). These range from information-​gathering powers to more interventionist powers, including as regards the suspension and prohibition 415 Under Art 40 Member States are to ensure that decisions taken under the Regulation are properly reasoned and subject to a right of appeal. 416 This requirement was originally designed to eliminate the practice, prior to the adoption of the 2003 Directive, of multiple authorities within a Member State having different powers over the approval of prospectuses. 417 Previously, and reflecting practice in some Member States, delegation of a wider range of powers to stock exchanges and regulated markets was permitted until 31 December 2011, subject to a range of conditions designed to address conflict-​of-​interest risks.

II.4  The Prospectus Regulation  147 of offers/​admissions and of subsequent trading. The information-​gathering powers418 include the power to require issuers, offerors, and persons asking for admission to trading on regulated markets to include supplementary information in the prospectus, where this is necessary for investor protection; to require those persons and the persons that control them (or are controlled by them) to provide information and documents; and to require auditors and managers of those persons, as well as financial intermediaries commissioned to carry out the offer or ask for admission to trading on a regulated market, to provide information. The suspension/​prohibition powers include the power to suspend a public offer or admission to trading on a regulated market, or an advertisement (for a maximum of ten consecutive working days on a single occasion), where the NCA has reasonable grounds for suspecting an infringement of the Regulation; to prohibit a public offer where the NCA finds that the Regulation has been infringed (or has reasonable grounds for suspecting an infringement); to suspend (or ask the relevant trading venue to suspend) trading on a regulated market or other trading venue (for a maximum of ten consecutive working days on a single occasion) where the NCA has reasonable grounds for believing the Regulation has been infringed; and to prohibit trading on a regulated market or other trading venue where the NCA finds that the Regulation has been infringed. More generally, the NCA must also be empowered to carry out on-​site inspections (where these are carried out jointly by NCAs ESMA must is entitled to participate); make public that an issuer has failed to comply with its obligations; suspend scrutiny of a prospectus, or suspend the offer/​admission to trading on a regulated market, in each case where the NCA is imposing a prohibition or restriction under the market abuse regime; refuse approval of any prospectus drawn up by a specified issuer (offeror or person asking for admission) for a maximum of five years, where that issuer or person has ‘repeatedly and severely’ infringed the Regulation; disclose, or require the issuer to disclose all material information which may have an impact on the assessment of the securities offered to the public or admitted to trading on a regulated market, to ensure investor protection or the smooth operation of the market; and suspend or require the suspension of the securities from trading where the NCA considers the issuer’s situation is such that trading would be detrimental to investors’ interests. These powers can be exercised directly, in collaboration with (and by delegation to) other authorities, and by application to the judicial authorities. These powers amount to an extensive tool-​kit of supervisory powers and are exercised within the wider supervisory cooperation/​supervisory convergence arrangements established by the Regulation.

II.4.12.2 Supervisory Cooperation The prospectus regime is anchored to the home NCA. Efficient home/​host NCA supervisory cooperation is therefore essential to support the passport and is supported by NCA/​ ESMA cooperation obligations (Articles 33 and 34). These obligations follow a design now familiar across the single rulebook. The foundation obligation imposed on NCAs by Article 33(1) is to cooperate with each other and with ESMA for the purposes of the Regulation and to exchange information without undue delay and to cooperate in investigation, supervision, and enforcement



418

Professional secrecy obligations and data protection obligations apply (Arts 35 and 36).

148 Capital-raising activities. NCAs are relatedly charged with immediately supplying any information requested (Article 33(3)). Specific attention is given to the sensitive context of on-​site inspections and investigations. NCAs are empowered to request the assistance of another NCA in such an inspection or investigation (impliedly in another Member State), and the requested NCA must then carry-​out the inspection or investigation itself, allow the requesting NCA to participate or carry it out itself, appoint auditors or other experts to carry it out, or share specific tasks related to supervisory activities with the other NCAs (Article 33(4)). The expectation of swift cooperation is clear, with Article 33(2) specifying the limited circumstances in which an NCA may refuse to act on a request for information or cooperation in an investigation,419 and Article 33(5) engaging ESMA’s binding mediation powers where a request for cooperation is refused or not acted on in a reasonable time. ESMA is also embedded into the inspection process, with the requesting NCA required to inform ESMA where it makes a request of another NCA, and ESMA empowered to coordinate the inspection where so asked by one of the relevant NCAs (Article 33(4)). Reflecting ESMA’s now pivotal role in supporting supervisory convergence, NCAs are also charged with cooperating with ESMA for the purposes of the Regulation and must without delay provide ESMA with all information necessary for ESMA to carry out its duties in accordance with the ESMA Regulation (Article 34).

II.4.12.3 Supervisory Convergence and ESMA By and large, supervisory weaknesses have not been a marked feature of the prospectus regime,420 perhaps reflecting the long lineage of prospectus/​issuer disclosure oversight in many NCAs. Relatedly, supervisory arbitrage risks have not, for the most part, been realized. Levels of NCA coordination have also been relatively strong, dating back to the CESR era,421 although there have been persistent frictions in the passporting process.422 While supervisory consistency is supported by the now granular prospectus rulebook in place under the Prospectus Regulation, and by its specification of how prospectus review is to be carried out, ESMA is, as it does across the single rulebook, shaping supervisory practices through its supervisory convergence powers. ESMA’s engagement with NCA supervision of the prospectus regime, through its supervisory convergence powers, is of longstanding (having its roots in the CESR years)423 and of wide reach. ESMA’s general powers under the ESMA Regulation aside, the Prospectus Regulation embeds supervisory convergence as a tool of the prospectus regime, inter alia requiring that ESMA adopt Guidelines on NCA supervision and enforcement (Article 20(12))424 and specifying that ESMA engage in at least one peer review of the prospectus approval process (by 2022; this has been carried out, as noted below) and that this focus 419 Where compliance would adversely affect its own investigation and enforcement activities; where judicial proceedings have already been initiated as regards the matter and person; and where a final judgment has been delivered in relation to the relevant person. 420 As was evident from an early stage: 2007 CESR Prospectus Supervisory Functioning Report, n 183, 3 and 5. 421 Including with respect to the treatment of new securities, complex products, multiple offerings, and requests for the suspension or prohibition of trading in securities in different markets across the Member States: 2007 CESR Prospectus Supervisory Functioning Report, n 183, 14. 422 See n 406. 423 CESR’s innovations included the Prospectus Q&A and also principles on good practices for prospectus approval (which was subsequently subject to an ESMA peer review (ESMA/​2012/​300)). 424 This has been achieved through the 2021 Prospectus Guidelines which support NCA review of prospectuses by specifying further the different disclosure items and how they are to be addressed by issuers.

II.4  The Prospectus Regulation  149 on the passport notification process as well as on the impact on capital-​raising of NCAs’ supervisory approaches (Article 20(13)). The Regulation also enhances ESMA’s data capacity, requiring it to host a publicly accessible prospectus repository (Article 25) (the ESMA Prospectus Register) and requiring it to report annually on prospectus activity (Article 47) and on NCA sanctioning activity (Article 43); peer review also typically yields large volumes of data for ESMA on local market structures and operation.425 ESMA’s sight-​line over NCAs is further sharpened by the wide range of ESMA reporting obligations placed on NCAs, including as regards their approval of omissions of prospectus disclosure, transfers of prospectus approvals, and agreements that home NCAs supervise advertisements’ compliance with the Regulation. The net effect is that ESMA has access to a repository of data which strengthens its capacity to drive supervisory convergence. In practice, ESMA has long used its general ESMA Regulation supervisory convergence powers to shape NCA supervision in this area and to address obstructive practices.426 That ESMA’s supervisory convergence powers can be used in an agile manner in crisis conditions, and to minimize any supervisory divergences, became clear over the Covid-​19 pandemic. Along with its guidance on how issuers were to address the pandemic in their periodic disclosures (section 5.3), ESMA used soft law to address issuer use of ‘alternative performance measures’ (APMs),427 including in prospectuses, given the instability caused by the pandemic.428 While a technical intervention, it supported NCA convergence on a live supervisory issue in a highly dynamic situation. In an example of it responding to market developments of a less acute nature, 2021 saw ESMA address the increased issuance activity by SPACs by adopting a Public Statement regarding NCA review of SPAC prospectuses; detailed and specific, the Statement acts as a template for the required issuer disclosures and also for NCAs’ review of such disclosures.429 More generally, while ESMA’s 2021 Prospectus Guidelines act as a handbook for issuers on prospectus disclosure, they are also designed to ‘establish consistent, efficient and effective supervisory practices’ across NCAs when reviewing prospectuses, and so are designed to meet the Prospectus Regulation Article 20(12) direction to ESMA to produce Guidelines on the prospectus approval process.430 Similarly, the 2019 Risk Factor Guidelines have an operational quality and support supervision.431 Both sets of Guidelines are (as is usual) complied with by all NCAs,432 and thereby constitute something of a supervisory handbook as regards the Prospectus Regulation.

425 The 2022 peer review report on NCA prospectus approval, eg, contains extensive data on market practices and structure: ESMA, Peer Review of the Scrutiny and Approval Procedures of Prospectuses by Competent Authorities (2022). 426 eg, a 2013 ESMA Opinion on the application of the prospectus regime’s base prospectus rules was designed to address obstructions arising from how certain host NCAs were applying the regime’s notification rules, and contained the warning that, if non-​compliance persisted, ESMA could pursue non-​compliant NCAs under its ESMA Regulation Art 17 breach of EU law powers (ESMA/​2013/​1944). 427 See n 223 on APMs. 428 ESMA eg warned that it might not be appropriate to use new/​adjusted APMs where Covid-​19 had a pervasive effect on the overall financial performance, position, and/​or cashflow of an issuer, as the outcome could be that users were misled in their understanding of a ‘true and fair view’ of the issuer’s position: ESMA, Q&A. ESMA Guidelines on APMs (2022), Q18. 429 ESMA, Public Statement (SPACs: prospectus disclosure and investor protection), 15 July 2021. 430 2021 Prospectus Guidelines, n 220, 9. 431 eg, NCAs are called to challenge the inclusion of risk factors that serve as disclaimers: 2019 Risk Factor Guidelines, n 222, 9-​10. 432 As is reported in ESMA’s related compliance tables.

150 Capital-raising In addition, ESMA uses peer review to address supervisory frictions and support best practices. ESMA’s second peer review (2016)433 on the prospectus approval process, for example, was positive for the most part, but it identified operational weaknesses relating to NCA resource allocation, wide varieties in NCA risk-​based assessments, and, notably, persistent difficulties across NCAs as regards their addressing of comprehensibility defects in prospectuses, and made a series of remedial recommendations. Its third peer review (2022) was similarly mixed, underlining that convergence remains a work-​in-​progress.434 While the peer reviews suggest that operational convergence is still developing, ESMA’s supervisory convergence activities are increasingly placing NCAs’ operational practices within an EU framework. Nonetheless, whether or not prospectus approval will become centralized within ESMA or otherwise remains a longstanding and perennial question.435 The ongoing ‘‘Europeanization’’ of NCAs’ supervisory practices by means of ESMA supervisory convergence measures, which can be expected to intensify given the divergences peer reviews are identifying, suggests that the risks of any such institutional centralization within ESMA, including as regards the loss of local market expertise and as regards the efficiency and incentive risks associated with centralization (and aside from the political and legal risks associated with direct ESMA powers)436 may outweigh the benefits, which are most likely to relate to offers that are directed towards host Member States and do not have a home component. Certainly, there is little political appetite. The 2017 Proposal for what became the 2019 European Supervisory Authority (ESA) Reform Regulation contained a proposal to confer on ESMA exclusive approval power as regards specified classes of prospectuses which, given their cross-​border dimension, technical complexity, and risks of exposure to supervisory arbitrage, would be most efficiently supervised at EU level:437 prospectuses relating to non-​equity securities to be traded on a regulated market or segment thereto limited to qualified investors; those relating to asset-​backed securities; those relating to property, mineral, scientific-​research-​based, or shipping issuers; and third country prospectuses. There was also some leakage of the proposed reforms beyond prospectus approval responsibilities: ESMA would have been empowered to assess compliance by the relevant issuer with advertising rules in the relevant host Member State in which the prospectus was distributed and related advertisements were disseminated. The failure of the reform to garner political support438 underlines the extent to which the prospectus approval 433 ESMA, Peer Review on the Prospectus Approval Process (2016). Its first peer review was in 2012 and reviewed NCAs’ application of CESR’s earlier principles for prospectus approval. Foreshadowing developments to come, the review was operationally oriented and focused on NCAs’ practices: (ESMA/​2012/​300). 434 ESMA was generally positive, finding that NCAs typically scrutinized prospectuses in a satisfactory manner and had sufficient and proportionate resources. But it reported on a wide variety of approaches being taken by NCAs, including as regards communications with issuers, the flexibility of approval processes, and NCAs’ attitudes towards liability, which could impact on issuers’ ability to raise capital. ESMA also identified minor differences relating to timelines and procedures which could, through their cumulative effect, result in it being easier to have a prospectus approved by some NCAs than others: n 425. 435 For an early assessment see, eg, Wymeersch, E, ‘From Harmonisation to Centralisation to Integration in European Securities Markets’ (1981) 3 J of Comp Corp L and Sec Reg 1 and, in the later CMU context, Avgouleas, E and Ferrarini, G, ‘The Future of ESMA and a Single Listing Authority and Securities Regulator for CMU: costs, benefits and impediments’ in Busch et al (2020) n 163. 436 See in outline Ch I. 437 2019 ESA Reform Proposal (COM(2017) 536) 8. 438 The proposed prospectus powers were removed in the Council’s general approach (Council Document 5934/​ 19, February 2019). The extent of the political resistance can be seen in the opinion from the Swedish parliament (Reasoned Opinion on Subsidiarity, 12 March 2019) which referenced, inter alia, the operational and efficiency risks associated with ESMA approval. Certain significant NCAs were also wary. eg, Statement by Central Bank Director of Policy and Risk G Cross Before the Irish Parliament, Committee on Finance, Public Expenditure and

II.4  The Prospectus Regulation  151 process is a foundational supervisory competence for many NCAs. While the 2019 ESA Reform Regulation conferred new direct supervisory competences on ESMA, these all relate to either EU actors of limited population, some novelty, and clear cross-​border reach (in particular data reporting services providers and administrators of EU critical benchmarks), or to third country actors, and do not relate to long-​established areas of national supervisory competence.439 There are currently few indications of prospectus approval being moved from its NCA-​based and supervisory-​convergence-​framed setting.

II.4.12.4 Enforcement and Civil Liability As regards enforcement, the Prospectus Regulation, like the single rulebook generally, is based on an NCA-​situated public enforcement model which is subject to harmonized standards. Reflecting the single rulebook generally, the availability and design of private enforcement/​civil liability mechanisms as regards breach of the Regulation’s requirements, however, is a matter of national law.440 This has the effect of artificially sealing off the Regulation, to some extent, from the full range of enforcement mechanisms. The Article 6 materiality standard, for example, is the fulcrum around which the NCA prospectus approval process and related NCA enforcement action pivots. Article 6 can also, however, ground national private causes of action relating to prospectus disclosures. But while there may be a degree of identity in practice between relevant national civil liability standards as regards prospectus liability and the Regulation,441 and while EU regulatory standards can, generally, shape national private causes of action,442 both systems (public enforcement by NCAs under the Regulation and national civil liability regimes) operate in parallel. The Regulation does not require that its provisions are supported by national civil liability mechanisms and, as the Court of Justice has repeatedly confirmed, it is for the Member States to determine the private law consequences of breaches of EU financial regulation.443 Accordingly, and despite the regulatory-​style deterrent effects associated with civil liability in this area,444 the Prospectus Regulation, like most single rulebook legislative measures,

Reform, 28 November 2017, expressing concern and noting that the Irish NCA was the second-​largest approver of prospectuses in the EU. 439 See Ch V section 12.3 (data reporting services providers), Ch VIII section 10.3 (EU critical benchmarks), and Ch X (third country powers). 440 There are exceptions across the single rulebook, with harmonized civil liability regimes provided for in relation to rating agencies (Ch VII section 15) and the PRIIPs Regulation (Ch IX section 5.3), but even here these regimes are closely tied to national liability regimes. 441 Albeit that there is considerable uncertainty as to the extent to which EU prospectus rules shape national liability regimes: Busch, D, ‘The Influence of the EU Prospectus Rules on Private Law’ (2021) 16 CMLJ 3. 442 A rich literature now considers the relationship between EU financial regulation and civil liability and how regulatory standards can shape private causes of action and related national law. For recent treatments see Cherednychenko, O, ‘Two Sides of the Same Coin: EU Financial Regulation and Private Law’ (2021) 22 EBOLR 147 and Cherednychenko, O and Andenas, M, Financial Regulation and Civil Liability in European Law (2020). 443 eg Case C-​174/​12 Alfred Hirmann v Immofinanz AG (ECLI:EU:C:2013:856) and Case C-​604/​11 Genil 48 SL and Comercial Hostelera de Grandes Vinos SL v Bankinter SA and Banco Bilbao Vizcaya Argentaria SA (ECLI:EU:C:2013:344). 444 Cherednychenko, O, ‘Financial Regulation and Civil Liability in European Law: Towards a More Coordinated Approach’ in Cherednychenko and Andenas, n 442, 2, calling for civil liability measures to be more closely integrated in EU financial regulation. Issuer liability actions can, however, lead to any damages costs being incurred by the issuer’s shareholders and to a reduction, potentially, in deterrent effects. See, eg, Gelter, M, Issuer Liability: Ownership Structure and the Circularity Debate, ECGI Law WP No 647/​2022, available via https://​ssrn. com/​abstr​act=​4120​570.

152 Capital-raising operates in the public sphere, with enforcement a function of NCA enforcement and based on administrative sanctions (Articles 38-​43). As regards NCA/​public enforcement, the 2017 Prospectus Regulation modernized the precursor, thinly harmonized, administrative sanctions regime under the Prospectus Directive to bring it into line with the reforms made earlier, over the financial crisis era, to pillar financial market measures, as exemplified by the MiFID II/​MiFIR administrative sanctions regime. The administrative sanctions regime is now accordingly specified in detail, both as regards the type of sanctions which must be available to NCAs, and how these sanctions are to be applied. Following the MiFID II/​MiFIR template, the core obligation imposed on Member States is (without prejudice to their right to impose criminal sanctions; or to the supervisory and investigatory powers of NCAs) to provide that NCAs have the power to impose administrative sanctions, and take appropriate other administrative measures, which are, in the standard formula, ‘effective, proportionate, and dissuasive’ (Article 38(1)). Article 38(1) also specifies the particular infractions of the Regulation which must, at the least, be subject to administrative sanctions, including breaches of pivotal provisions such as Article 3 (the prospectus requirement) and Article 6 (the materiality standard), as well as any failure to comply with an NCA investigation, inspection, or request.445 The suite of (minimum)446 sanctions which must be available to NCAs is familiar from other single rulebook legislation, but oriented to the prospectus context and to the potential gravity of the infractions. It covers: public statements; injunctions; and maximum pecuniary sanctions of at least twice the profits gained or losses avoided (where these can be determined) and, specifically, pecuniary sanctions for legal persons, subject to a minimum upper limit of at least €5 million or 3 per cent of turnover (according to the last available financial statements), and pecuniary sanctions for natural persons, subject to a minimum upper limit of at least €700,000.447 Reflecting the now standard single rulebook template for administrative sanctions, the Regulation also addresses how NCAs are to assess the type and level of administrative sanction to be imposed (Article 39). NCAs are to take into account all relevant circumstances including, where appropriate: the gravity and degree of the infringement; the degree of responsibility of the relevant person responsible; the financial strength of the relevant person, whether by turnover (legal persons) or net assets (natural persons); in an indication of the retail orientation of the Regulation, the impact on retail investors; the importance of the profits gains and losses avoided for third parties, where they can be determined; the level of cooperation of the relevant person with the NCA; previous infringements by the relevant person; and any measures taken by the relevant person to prevent a repetition. The enforcement regime also addresses reporting by and protection of whistleblowers, following the template now in use across the single rulebook and which requires NCAs to establish effective mechanisms to encourage and enable the reporting of actual or potential infringements, including as regards the protection of whistleblowers and the use of financial incentives (Article 41). As is usual with the single rulebook’s administrative sanctions regimes, transparency and publication obligations apply to related NCA 445 Member States may decide not to adopt administrative sanctions as regards the specified infractions, however, where criminal sanctions apply and these are notified to the Commission and ESMA. 446 Art 38(3) specifies that Member States can provide for additional sanctions and higher levels of pecuniary sanction. 447 MiFID II, reflecting the wider potential impact of infractions, requires higher minimum thresholds of 10 per cent of turnover for legal persons and of €5 million for natural persons.

II.4  The Prospectus Regulation  153 decisions including as regards when, exceptionally, publication can be deferred or anonymized or not required (Article 42). Early indications of how the Regulation is applying in practice suggest varying approaches to the imposition of administrative sanctions by NCAs,448 reflecting longstanding trends.449 The Regulation’s harmonization of sanctions, and how they are to be applied, can, however, be expected to lead to greater convergence in this area, particularly in light of the obligation on NCAs to cooperate to ensure their exercise of supervisory, investigatory, and sanctioning powers is ‘effective and appropriate’ and that duplication and overlaps are avoided in cross-​border cases (Article 39(2)); and to report annually on administrative sanctions to ESMA, which must maintain a related database for NCA use (Article 43). Nonetheless, the range of factors that drive shape and drive effective enforcement,450 suggest that diverging approaches will long be a feature of NCA enforcement, but this is not to imply that enforcement should be further harmonized. While the Regulation’s enforcement model is therefore a public one, it brushes against national civil liability regimes, very loosely enrolling them into the Regulation.451 The tentative approach originally adopted by the 2003 Prospectus Directive452 continues to frame how the prospectus regime engages with civil liability. Article 11 addresses prospectus responsibility statements and requires Member States to ensure that responsibility for the information given in a prospectus (and any supplement thereto) attaches, at least, to the issuer (or its administrative, management, or supervisory bodies), the offeror, the person asking for the admission to trading on a regulated market, or the guarantor (where relevant). These persons must be clearly identified in the prospectus by their names and functions (or registered offices). The prospectus must also include declarations by these persons that, to the best of their knowledge, the information contained in the prospectus is in accordance with the facts and that the prospectus makes no omission likely to affect its import. Article 11 does not address how Member States approach civil liability, but simply provides that their laws, regulation, and administrative provisions on civil liability (however designed and applied as regards prospectuses) apply, where they apply to prospectuses, to those persons responsible for the information given in a prospectus (Article 11(2)). Member States must also ensure that civil liability does not attach to any person solely on the basis of the summary (including any translations), unless it is misleading, inaccurate, or inconsistent when read together with other parts of the prospectus. Similarly, responsibility for the registration 448 ESMA first annual report on sanctioning practices (required by Art 43), noted 57 sanctions imposed by the Belgian NCA (public statements), one (in the European Economic Area) by the Norwegian NCA (public statement), and none elsewhere: ESMA, Report on Prospectus Activity and Sanctions in 2020 (2021) 22–​3. For a critique of the sanctioning regime, suggesting that monetary penalties do not provide deterrent effects see Tountopoulos, V, ‘Pecuniary Sanctions against Issuers in European Capital Markets Law: Harming the Protected Investors’ (2019) 20 EBOLR 695. 449 Experience with the 2003 Directive suggested that convergence in sanctioning powers was weak, with the same infraction subject to different types of administrative measures or sanctions across the Member States: 2007 CESR Prospectus Supervisory Functioning Report, n 183, 13. 450 As noted in brief in Ch I section 5.2. 451 The Regulation steps closer to private law than MiFID II, eg, which make no reference to the interaction between the regime’s rules and private law. For an analysis of the extent to which different EU financial regulation measures engage with private law see Tridimas, T, ‘Financial regulation and private law remedies: an EU perspective’ in Cherednychenko and Andenas, n 442, 47. 452 Which was introduced following representations by the German government: Hopt, K, ‘Modern Company and Capital Market Problems: Improving European Corporate Governance After Enron’ in Armour, J and McCahery, J (eds), After Enron. Improving Corporate Law and Modernising Securities Regulation in the EU and the US (2004) 445, 475.

154 Capital-raising document or URD attaches only to the persons specified under Article 11(1) where the document is in use a constituent part of an approved prospectus (Article 11(3)). Approaches to prospectus civil liability regimes vary considerably across the EU in terms of, inter alia, the basis for liability (for example, breach of contract, fraud, or negligence), causation, standard of review, those persons able to take a cause of action, and the availability of class actions.453 Further complexities are raised by private international law as regards the allocation of the applicable law and jurisdiction. This complexity and diversity, long a feature and risk of the EU prospectus regime,454 continues to generate risks and costs for pan-​EU issuers, particularly as regards litigation risk, as liability risk can be mitigated by due diligence in the preparation of the prospectus.455 While the Court of Justice has brought some limited clarity as regards jurisdiction, and also as regards the potential scope of liability claims,456 divergence and uncertainty continues to characterize the pan-​EU civil liability landscape, and related litigation risk is repeatedly identified as a disincentive to access the public markets.457 The Prospectus Regulation may, depending on its interaction with national civil liability regimes, increase these risks, particularly if class actions become more widespread.458 While the Regulation has brought greater regulatory and supervisory clarity, it has also increased litigation risks given, for example, the higher degree of prescription regarding risk factors and the uncertainties relating to the updating of the URD, which may both expose the issuer to greater litigation risks depending on the design of national civil liability regimes. Since 2003, there have been periodic calls for a closer policy focus 453 For a review of the different approaches to prospectus liability across the EU see Busch et al (2020), n 163 and Alvaro et al, n 190. 454 Ferran (2007), n 173. 455 Ferran has distinguished between liability risk, which can be managed by complete and candid disclosure, and litigation risk, which is much less easy to manage and dependent in part on the robustness of courts in dismissing frivilous actions: (2007) n 173, 21. 456 In Case C-​375/​13 Harald Kolossa v Barclays Bank (ECLI:EU:C:2015:37), the Court of Justice, in the context of the Brussels I Regulation, ruled that, in cases involving tort/​negligence actions relating to prospectuses, and where jurisdiction is linked to the identification of the place where loss is suffered by investor, the courts of the investor’s domicile have jurisdiction, as long as the financial institution that manages the securities account in which the relevant securities are held, is in the same jurisdiction. For a critical perspective on the uncertainties the ruling creates see Lehmann, M, ‘Prospectus Liability and Private International Law—​Assessing the Landscape after the CJEU Kolossa Ruling’ (2016) 11 J of Private International L 318. An extensive private international law literature considers how the applicable law and jurisdiction for prospectus liability actions are identified. The Court of Justice further addressed prospectus liability, as regards the scope of private causes of action (under Prospectus Directive Art 6), in Case C-​910/​19 Bankia v UMAS (ECLI:EU:C:2021:433). In the context of the extensive litigation in the wake of the failed 2011 IPO of Spanish bank Bankia (following the insolvency and restructuring of Bankia after the post-​IPO restatement and reduction of its profits), a question arose in the Spanish courts as to whether those qualified investors who were not the addressees of the related Bankia prospectus (the share offer had separate retail and qualified investor tranches, with the prospectus directed to the retail tranche) could bring an action on foot of the defective prospectus. The Court, underlining the investor protection objective of the prospectus, and that investors should legitimately be able to rely on prospectus disclosures, ruled that, in a mixed retail/​qualified investor offer, qualified investors should not be denied the opportunity to bring a damages claim: the principle of civil liability established by Art 6 meant that, irrespective of the type of investor engaged, it must be possible to bring an action on foot of a defective prospectus. The Court also ruled that while the Spanish courts could take into account that qualified investors were, or should have been, aware of Bankia’s economic situation (irrespective of the prospectus disclosures), and while Member States had ‘broad discretion’ in designing causes of action, any consideration of qualified investor expertise should not make it impossible or excessively difficult for an action to be brought. While the Bankia ruling is based on the earlier Prospectus Directive, and while it underlines the breadth of Member State discretion, the ruling nonetheless subjects Member State discretion in this area to minimum standards, designed to support the investor protection function of the prospectus. 457 A recent survey of stakeholder opinion reported that litigation risk was a major concern: 2020 Oxera Report, n 47, 68. 458 A harmonized class action (representative action) system, which comes into force in 2023, has recently been adopted for EU consumers and covers the prospectus regime: Directive 2020/​1828 [2020] OJ L409/​1.

II.5  Ongoing and Periodic Disclosure  155 on how the prospectus regime interacts with national civil liability regimes.459 The 2010 Amending Directive contained a direction, reflecting a European Parliament amendment, for a review of Member States’ civil liability regimes, which led to ESMA’s 2013 report on national liability regimes.460 Informative as to the wide variety of approaches taken, it did not contain recommendations as to future action. The absence of a harmonized approach to civil liability, and the related costs and risks for issuers, sits uneasily with the priority given to the prospectus regime as a means for driving CMU.461 For now, however, the complexities associated with private law harmonization, and the uncertainties as to how and whether the Regulation can shape national causes of action, suggest that the prospectus regime will continue to sit alongside but not integrated with the civil liability mechanisms that are operating in service of similar investor protection and market efficiency goals.

II.5  Ongoing and Periodic Disclosure: The Transparency Directive and the Market Abuse Regime II.5.1  The Transparency Directive The 2004 Transparency Directive, as amended by the 2013 Amending Transparency Directive462 and as amplified by administrative rules, is at the heart of the EU’s regulatory framework governing the ongoing disclosures to be provided by issuers admitted to regulated markets in the EU. In addition to addressing substantive disclosure requirements, it governs the dissemination of disclosure. Unlike the prospectus regime, the transparency regime is not event-​specific: it addresses ongoing disclosures by issuers within the perimeter of the transparency regime and so is of central importance to the price-​formation process and, relatedly, to market-​based monitoring of issuers. In addition, an extensive legislative and administrative rulebook applies to such issuers under the financial reporting system, discussed in section 6, which is composed of the 2013 Accounting Directive (which sets out the general financial reporting requirements that apply to all companies in the EU); the 2002 IAS Regulation (which requires that the consolidated financial reports of issuers admitted to a regulated market be prepared in accordance with IFRS); and the 2014 Non Financial Reporting (NFR) Directive (which requires a non-​financial statement, geared to environmental, social, and governance (ESG) disclosures, of ‘public interest companies’ (those admitted to a regulated market and with more than 500 employees)).463 Issuers whose securities are admitted to second-​tier trading venues do not come within the Transparency Directive. Their ongoing disclosures (financial reports) are governed by the 2013 Accounting Directive and by national accounting standards (national Generally Accepted Accounting Principles (GAAP)), as well as by any requirements imposed by

459 For an early perspective see 2007 ESME Report, n 183, 19, calling for harmonization of liability standards. 460 ESMA, Comparison of Liability Regimes in Member States in relation to the Prospectus Directive (2013). 461 For a CMU-​related call for a single EU framework for prospectus liability see Alvaro et al, n 190. 462 Directive 2004/​109/​EC [2004] OJ L390/​38, as amended by Directive 2013/​50/​EU [2013] OJ L294/​13. References to the Transparency Directive are to the 2004 Directive as amended by the 2013 reforms. 463 Respectively, Directive 2013/​34/​EU [2013] OJ L182/​19; Regulation (EC) No 1606/​2002 [2002] OJ L243/​1; and Directive 2014/​95/​EU [2014] OJ L330/​1.

156 Capital-raising the relevant trading venue. For a subset of issuers admitted to trading on a MiFID II SME Growth Market, the ongoing disclosures required under this regime apply (section 8). Taken as a whole (and including financial reporting), the ongoing issuer disclosure regime has become increasingly dynamic since the financial-​crisis era. It has expanded in scope (notably as regards sustainability-​related disclosures (section 10)); become increasingly more harmonized (the 2013 reforms to the Transparency Directive tilted it somewhat away from its minimum harmonization model); and adopted an operational and procedural posture (notably as regards digital reporting and dissemination). It has also come to embrace a wider set of governing objectives. While always concerned with market efficiency and market integration, since the financial-​crisis era it has become more closely associated with financial stability. It has also become more associated with the information needs of constituencies beyond shareholders and investors, as regards sustainability in particular.464 This development can be associated with the notion of ‘double materiality’ (‘inside-​out/​ outside-​in’) which frames sustainability-​related disclosures as regards their utility for shareholders and investors (outside-​in), but also as regards their utility for the wider set of stakeholders impacted by companies’ activities (inside-​out). Dynamism is also a defining characteristic of the recent evolution of the prospectus regime, but the nature of the evolution of the ongoing issuer disclosure regime is distinct to that of the prospectus regime. In particular, the Transparency Directive has been shaped more markedly than the prospectus regime by the different approaches to market finance across the EU: early attempts to introduce share ownership notification rules, for example, led to opposition in Germany arising from concern that such rules favoured the speculative investor,465 which slowed the development of the regime.466 Reflecting such national divergences, the Transparency Directive has, also by contrast with the prospectus regime, long been based on a minimum-​harmonization model (although the allied financial reporting system is densely harmonized). This model, with some modifications in 2013, remains in place. A brief account of the evolution of the Transparency Directive follows.

II.5.2  The Transparency Directive: Evolution II.5.2.1 Initial Efforts: Limited and Fragmented Transparency Prior to the adoption of the 2004 Transparency Directive,467 ongoing issuer disclosure was addressed through a patchwork regime which was limited in scope and did not support

464 The 2021 ‘fitness check’ on the EU’s public reporting framework for companies is indicative in that it related the objective of the related disclosures to financial stability and sustainable growth, as well as to capital market development and integration. It also noted that corporate reporting had evolved to make companies more accountable on broader economic and societal issues: Commission, Fitness Check on the EU Framework for Public Reporting by Companies (SWD(2021) 81) 4. Similarly, the IFRS ‘endorsement process’ through which IFRS are incorporated into EU law relates its governing notion of ‘EU public good’ to not endangering financial stability and is increasingly engaging with sustainability concerns (section 6). 465 The German stock exchange was ‘adamantly opposed’: Committee on the European Communities, Report on the Disclosure of Significant Shareholders, HL (1985–​86), 16th Report, para 27. 466 Gros and Lannoo, n 168, 127. 467 The main elements of the legislative history of the 2004 Directive are: Commission Proposal COM(2003) 138; ECOSOC Report [2004] OJ C80/​128; ECB Opinion [2003] OJ C242/​6; and First Parliament Reading T5–​0220/​ 2004 (ECON Report at A5–​0079/​2004). The legislative history of the 2013 Amending Transparency Directive is at n 475.

II.5  Ongoing and Periodic Disclosure  157 mutual recognition. The 1979 Admission Directive introduced the principle of ongoing disclosure for issuers whose securities were admitted to ‘official listing’ (including with respect to annual reports), and put in place a framework for ad hoc (material events) disclosure. Otherwise, the general annual reporting regime for all companies, contained in the (since repealed) Fourth and Seventh Company Law Directives imposed annual reporting obligations on all companies, private and public, with some exceptions for smaller companies. This limited regime was first supplemented by the 1982 Interim Reports Directive (since repealed) which imposed a very limited half-​yearly reporting obligation based on minimal financial information and an explanatory statement on company activities on issuers of shares admitted to official listing.468 Member States were empowered to impose obligations additional to or more stringent than those set out in the Directive and host control was not restricted; the prospect therefore arose of divergent reporting obligations for companies with multiple listings. Subsequently, the 1988 Substantial Shareholdings Directive (since repealed) addressed changes in the capital structure of issuers and built on the very limited requirements imposed by the 1979 Admission Directive in order to address the significant divergences in this area. It required notification of the company concerned by holders of voting rights in a company whose shares were officially listed when a disposition or acquisition of voting rights by such holders resulted in their holdings of voting rights achieving, exceeding, or falling below certain thresholds; and the onward dissemination of this information to the public by the company. The Directive was more a creature of company law than of capital market transparency. Although reporting obligations of this nature form a central element of ongoing issuer-​disclosure regulation (section 5.8), the relevant thresholds were a function of company law thresholds and did not fully capture the nature of control and influence in an issuer (the first threshold started at 10 per cent and then jumped to 20 per cent). Implementation of the Directive was slow, which further impeded its effectiveness.

II.5.2.2 The FSAP The ongoing issuer-​disclosure regime came under scrutiny as part of the FSAP’s drive to promote integration and more efficient capital formation through an upgraded issuer-​ disclosure regime, and following concerns as to the inadequacy of ongoing issuer-​disclosure (and potential prejudice to the reputation of the EU market internationally), notably by comparison with the US regime which, in practice, produced more ongoing disclosure regarding EU issuers than the EU regime. The reform agenda became subsumed within, and benefited from the political priority afforded to, the FSAP’s ‘disclosure and transparency’ agenda for all securities admitted to trading on a regulated market. This agenda included the Commission’s 2000 programme for reform of the accounting and financial reporting regime469 (which would ultimately lead to the adoption of the 2002 IAS Regulation), the 2003 Market Abuse Directive (as regards disclosure of ‘inside information’), and the 2003 Prospectus Directive. It also included the 2004 Transparency Directive, now the centre-​ piece of the ongoing issuer-​disclosure regime, which would lead to a reorientation of the

468 Debt securities were excluded on the assumption that holders were protected by the rights bestowed by the securities. 469 Commission, Communication on the EU Financial Reporting Strategy: the Way Forward (COM(2000) 359).

158 Capital-raising previous ongoing issuer-​disclosure regime from one largely based in the requirements of company law, to a capital markets, transparency-​oriented regime,

II.5.2.3 The 2004 Directive Negotiations The 2004 adoption of the Transparency Directive benefited from widespread agreement on the limitations of the ongoing issuer-​disclosure regime then in place, but it was not free from contestation: the Commission’s initial reform orientations included a quarterly reporting requirement which generated significant market concern and was not included in the Commission’s March 2003 proposal for the new regime. The 2003 Proposal argued that transparency was ‘essential for the functioning of capital markets, enhancing their overall efficiency and liquidity’, but also made the traditional connection between harmonization and market integration.470 Four major reforms were proposed: the imposition of deadlines on annual reporting; the enhancement of half-​yearly disclosure and a new interim management-​reporting requirement (the interim requirement was subsequently removed by the 2013 reforms); the extension of half-​yearly reporting to issuers of only debt securities; and an upgrading of the share ownership/​major holdings notification regime to change its orientation from company law to capital markets. The Directive was adopted in December 2004 and came into force in January 2007. It was amplified by the 2007 Commission Directive, one of the earlier examples of post-​FSAP/​CESR-​shaped administrative rule-​making, which remains in force.471 II.5.2.4 Global Financial Crisis Era Reform and the 2013 Amending Directive The Directive’s review clause, then a novel element of the FSAP-​era reforms but now standard, required that it be reviewed by 2009. As with the prospectus regime review which took place around the same time, and has now become standard practice but was innovative then, the review was informed by a number of reports.472 While these typically reported on broad satisfaction with the Directive,473 a number of weaknesses were identified, including the costs associated with the minimum-​harmonization model on which the Directive was based, high SME costs in particular, difficulties with the share ownership/​major holdings notification regime in practice and its failure to address market innovation, notably with respect to contracts for difference (CfDs), and weaknesses in the disclosure dissemination system.474 The interim management statement also proved problematic, particularly for SMEs. The Commission’s subsequent reforming 2011 Proposal475 accordingly suggested 470 It argued that the Proposal would ‘help further integrate Europe’s securities markets by reducing or eliminating information asymmetries, which may hamper comparability and market liquidity, by enhancing investor confidence in the financial position of issuers, and by reducing the cost of accessing capital’: n 467, 2. 471 Commission Directive 2007/​14/​EC [2007] OJ L69/​27. 472 Chief among them: CESR’s 2010 review of whether the share ownership notification regime should be extended to interests ‘economically equivalent’ to shares (CESR/​09-​1215b), CESR’s mapping exercise of NCAs supervisory powers (CESR/​09-​058), and CESR’s mapping exercise on the Directive’s implementation (CESR/​08-​514b); Mazars, Transparency Directive Assessment Report (2009); ESME, First Report of ESME on the Transparency Directive (2007). 473 The 2009 Mazars Report, eg, found that 82 per cent of stakeholders canvassed found the disclosures useful: n 472, xiii. 474 Commission, Report to the Council, European Parliament, ECOSOC, and Committee of the Regions on the Operation of the Transparency Directive (COM(2010) 243). 475 The main elements of the legislative history are: Commission Proposal (COM(2011) 683) and IA (COM(2011) 683); European Parliament Negotiating Position (27 September 2012, A7-​0292/​2012); and Council General Approach, 29 May 2012 (Council Document 10384/​12).

II.5  Ongoing and Periodic Disclosure  159 that while the Directive was widely regarded as supporting market effectiveness, a series of clarifications and enhancements were required. Like the cognate 2010 prospectus regime reforms, the proposed reforms, which included removing the interim reporting requirement, were broadly concerned with fine-​tuning the Directive and reducing its costs, in particular for SMEs. The reforms were also designed to respond to market change, particularly as regards the major holdings notification regime. In addition, the reforms sought to align the Directive’s administrative sanctions regime with the more harmonized approach to sanctions adopted across the crisis-​era reform programme generally. The crisis-​era preoccupation with financial stability was another theme of the reforms, particularly as regards the inclusion of CfDs in the major holdings notification system.476 Negotiations were relatively uncontroversial;477 political agreement on what would become the 2013 Amending Transparency Directive was reached by the European Parliament and Council in May 2013.

II.5.2.5 The Transparency Directive and Capital Markets Union Since the adoption of the 2013 reforms, which came into force in 2015, the Transparency Directive has, at least as regards legislative reform, been one of the quieter corners of the single rulebook. By contrast with the prospectus regime, substantive reform of the Transparency Directive has not been a major preoccupation of CMU, save as regards the dissemination of issuer disclosure: the 2020 CMU Action Plan identified the enhancement of dissemination through the establishment of a European Single Access Point (ESAP) as a priority (section 7.3). Nonetheless, and regarded as a whole with the related financial reporting system, the ongoing issuer-​disclosure regime has experienced significant change which is expanding its reach. This has happened through several channels. The expansion and evolution of the IFRS financial reporting system has injected considerable dynamism into the parallel financial reporting regime, while the 2014 NFR Directive marked an important initial step towards an EU sustainability-​related ongoing issuer-​disclosure framework, albeit that it has since been enhanced by the regime agreed in 2022 on corporate sustainability reporting.478 In addition, ESMA’s supervisory convergence activities have significantly expanded, leading to the emergence of a now mature system for NCA coordination as regards the enforcement of financial reporting requirements (section 6.4). The Transparency Directive itself has been less dynamic, but its supporting supervisory/​ enforcement arrangements and also its disclosure dissemination systems have come under strain. As was underlined by the Commission’s wide-​ranging 2021 ‘Fitness Check’ on public reporting by companies, the 2020 Wirecard scandal exposed weaknesses in the supervision and enforcement of the Directive’s requirements, while enhancements to the Directive’s ability to support the digitalization of disclosures were needed.479 The parallel 2021 review of the Transparency Directive was, overall, positive, albeit that, in addition to highlighting the supervisory/​enforcement and digitalization challenges, it reported on the transaction 476 2011 Amending Transparency Directive Proposal, n 475, 3. 477 The most significant change to the Commission’s Proposal concerned the Commission’s original proposal that the interim management statement requirement be removed, and for a related prohibition on Member States adopting additional national requirements. Council and European Parliament support for a degree of Member State discretion prevailed. 478 Proposed in COM(2021) 189 (see section 10). 479 n 464. The fitness check did not find major difficulties with the Transparency Directive, but identified enforcement and supervision, and digitalization, as potential avenues for reform.

160 Capital-raising costs that national divergences in the major holdings notification regime were imposing on cross-​border investment.480 Further reforms, particularly as regards supervision and enforcement, are likely, albeit that much depends on ESMA’s ability to address supervisory weaknesses and regulatory divergences through convergence measures. It is clear from the prospectus regime’s recent trajectory, however, that there is considerable appetite for focused legislative reforms in this area.

II.5.3  The Transparency Rulebook: Legislation, Administrative Rules, and Soft Law Given the extent of national variation as regards ongoing issuer-​disclosure requirements, the Transparency Directive was originally (in 2004) based on minimum harmonization, unlike the parallel 2003 Prospectus Directive. Its key legislative provisions were cast in broad terms which invited diverging implementation. Member States also enjoyed significant discretion to ‘goldplate’ the regime (or impose ‘super-​equivalent’ additional provisions):481 the home Member State was expressly permitted to subject an issuer to super-​equivalent requirements more stringent than those laid down in the Directive, and empowered to subject shareholders and other relevant persons to more stringent obligations than those that applied under the major holdings notification regime. While the current regime retains this quality, and so stands in contrast with the prospectus regime, the level of harmonization is now more significant, with the 2013 reforms reflecting widespread market concern as to the costs of divergence (particularly with respect to the major holdings notification regime) and support for greater harmonization.482 The home Member State is still permitted to subject an issuer to requirements more stringent than those laid down in the Directive, but it may not require issuers to publish periodic financial information on a more frequent basis than the required annual financial reports and half-​yearly financial reports (Article 3(1)). By way of derogation, however, Member States may require issuers to publish additional periodic financial information on a more frequent basis, but only where the relevant conditions are met (Article 3(1a)) (section 5.7.3). The 2013 reforms also reduced Member State discretion by prohibiting Member States from applying more stringent requirements under the major holdings notification regime, unless the conditions set by Article 3(1a) are met. The main substantive components of the Directive’s administrative rulebook are the now longstanding 2007 Commission Directive (which, inter alia, amplifies the Directive’s requirements relating to major holdings notifications and the dissemination of disclosure) and the 2015 RTS on Major Holdings Notifications.483 Otherwise, the administrative rulebook is largely operational in design, being concerned with dissemination and reporting. A 2016 RTS provided for, in accordance with the Directive, ESMA’s establishment of a 480 Commission, Report to the European Parliament and Council on the Review Clauses in the Accounting Directives and Transparency Directive (COM(2021) 199). 481 Which led to significant variation: ESMA, Mapping the Transparency Directive—​Options, Discretions, and Goldplating (2011). 482 2009 Mazars Report, n 472, xi–​xii. 483 Commission Directive 20017/​14/​EC [2007] OJ L69/​27 and RTS 2015/​761 [2015] OJ L120/​2.

II.5  Ongoing and Periodic Disclosure  161 European Electronic Access Point (EEAP) for regulated disclosures,484 but ESMA action on this was suspended in 2016 and has since been overtaken by the CMU project for a European Single Access Point (ESAP) for issuer disclosures, a much larger project (section 7.3); and a series of RTSs address the ‘European Single Electronic Format’ reporting standard that now applies to annual reports.485 In addition, an extensive legislative and administrative rulebook applies under the financial reporting system (section 6). In practice, the IFRS reporting system carries much of the regulatory weight with respect to ongoing reporting for issuers subject to IFRS. ESMA’s imprints on the Transparency Directive regime are clear through its extensive soft law and supervisory convergence measures. ESMA maintains a regularly updated Transparency Directive Q&A486 and has adopted a series of operationally oriented templates and forms, including a standard notification form for major holdings.487 ESMA has also proved nimble in the face of disruption, coordinating NCAs’ response to the challenges the Covid-​19 pandemic generated for issuer disclosure. ESMA underlined that issuers should disclose as soon as possible any relevant significant information on the actual and potential impacts of Covid-​19 on their ‘fundamentals, prospects or financial situation’, in accordance with the market abuse regime; advised that issuers provide transparency on the actual and potential impacts of Covid-​19, to the extent possible, in their periodic disclosures;488 and provided guidance on how issuers should approach their half-​yearly reports.489 ESMA also coordinated NCAs to allow a degree of supervisory forbearance as regards issuer reporting in the early months of the pandemic: while acknowledging the importance of timely and transparent issuer disclosure, ESMA recognized the burdens being carried by issuers, including as regards the auditing of reports, and called for NCA forbearance as regards the publication of annual and half-​yearly periodic reports, recommending two months leeway for annual reports and one month for half-​yearly reports.490 Similarly, it addressed the implications of the war in Ukraine for issuers’ half-​yearly reports.491 It has accordingly stewarded the regime through two periods of market disruption that required comprehensive and material issuer disclosures and consistent NCA practices. ESMA’s measures as regards the Transparency Directive are, however, primarily operational in nature, with its 2015 Guidelines on the Enforcement of Financial Information (GLEFI), in combination with institutional innovation in the form of ESMA’s European Enforcers’ Co-​ordination Sessions (EECS), constructing an NCA coordination framework, particularly as regards ongoing financial reporting (section 6.4). While supervision of the prospectus regime is increasingly being operationalized through ESMA since the adoption

484 RTS 2016/​1437 [2016] L234/​1. 485 The main measure is the ESEF RTS (RTS 2018/​815 [2019] OJ L143/​1) which requires annual reports to be produced in XHTML format. The Covid-​19 pandemic alleviations adopted in 2020 under the Capital Markets Recovery Package extended the deadline for reporting in ESEF from financial statements covering 2020 to financial statements covering 2021. 486 At the time of writing, the Q&A runs to some 26 questions, many of which related to the major holdings notification rules: ESMA Transparency Directive Q&A. 487 The notification regime is also supported by ESMA’s 2021 ‘practical guide’ for issuers on the national rules that apply to notifications. 488 ESMA, Public Statement (Covid-​19 Impact), 11 March 2020. On supervisory forbearance see further Ch I section 6. 489 ESMA, Public Statement (Covid-​19 and Half-​Yearly Reports), 20 May 2020. 490 ESMA, Public Statement (Covid-​19 Mitigating Action Transparency Directive), 27 March 2020. 491 ESMA, Public Statement (Russian Invasion of Ukraine and Half-​Yearly Reports), 13 May 2022.

162 Capital-raising of the 2017 Prospectus Regulation, the transparency regime has, at least as regards financial reporting, been in the vanguard of ESMA’s operational innovations.

II.5.4  The Transparency and Prospectus Rules: An Integrated Regime? As outlined in section 4, the reforms to the prospectus regime under the 2017 Prospectus Regulation are designed to reduce costs for repeat issuers by facilitating the incorporation by reference in prospectuses of ongoing issuer disclosures requirements, including by means of the new Universal Registration Document (URD) (section 4.9.3). Full integration of ongoing issuer disclosure, however, requires closer alignment between the prospectus and transparency regimes. The two measures do not currently form a fully integrated issuer-​disclosure regime, albeit that the 2017 Prospectus Regulation has delivered enhancements in this regard, including as regards the relationship between the narrative disclosures required in the prospectus Operating and Financial Review (OFR) and the annual report’s annual management statement.

II.5.5  Transparency Directive: Scope Perimeter control under the Transparency Directive is broadly similar to perimeter control under the 2017 Prospectus Regulation. The regime applies to ‘issuers’ whose ‘securities’ (both concepts are broadly the same as under the Prospectus Regulation)492 are already admitted to trading on a regulated market (as defined under MiFID II) situated or operating within a Member State. As with the prospectus regime, the regulated market is a proxy for perimeter control.

II.5.6  Transparency Directive: Differentiation, Exemptions, and SMEs Like the prospectus regime, the Transparency Directive regime is differentiated to reflect different issuers’ specificities. In particular, sovereign and public debt issuers493 are exempt from the annual and half-​yearly reporting obligations (Article 8(1)(a)). The half-​yearly reporting requirement may also, at the discretion of the home Member State, be disapplied for credit institutions whose shares are not admitted to trading on a regulated market and which have, in a continuous or repeated manner, issued only debt securities (Article 8(2)).494 492 The definition of ‘issuer’ is more nuanced than that under the 2017 Prospectus Regulation and refers to a natural person, or legal entity governed by private or public law, including a State, whose securities are admitted to trading on a regulated market. The definition also specifies that the issuer in the case of depositary receipts representing securities is the issuer of the securities represented by the depositary receipts: Art 2(1)(d). ‘Securities’ covers transferable securities within the scope of the MiFID II regime, with the exception of money-​market instruments with a maturity of less than twelve months: Art 2(1)(a). Units issued by collective investment undertakings other than the closed-​end type are also excluded (Art 1(2)). 493 A State, a regional or local authority of a State, a public international body of which at least one Member State is a member, the ECB, and the European Stability Mechanism or similar mechanism: Art 8(1)(a). 494 This exemption is available only where the total nominal amount of debt securities issued remains below €100 million and as long as a prospectus has not been published.

II.5  Ongoing and Periodic Disclosure  163 Also like the prospectus regime, the Transparency Directive is calibrated to the wholesale bond markets, given their sophisticated participants and the substitutes available for mandatory disclosures. An exemption from the annual and half-​yearly reporting obligations is available for issuers exclusively of debt securities admitted to trading on a regulated market, with a denomination per unit of at least €100,000 (Article 8(1)(b)).495 The exemption also applies where the denomination is of at least €50,000 (reflecting the regime prior to its alignment with the prospectus regime under the 2010 Amending Prospectus Directive), as long as the securities were admitted to trading before 31 December 2010.496 SME issuers were, originally, not directly addressed by the 2004 Directive, although the calibrations which apply in the related financial reporting regime applied. SME interests were, however, to the fore in the 2011 review of the Transparency Directive,497 with concerns raised as to the costs of the transparency regime, the visibility and ‘bottleneck’ problems faced by SME issuers (when the market is processing extensive disclosures and focused on the largest issuers as a result, particularly between annual and half-​year reports), a related reduction in the value of regulated markets to SME issuers, and the disproportionate impact on the SME segment of the absence of a system supporting pan-​EU disclosure dissemination.498 The major SME-​related reform which followed under the 2013 Amending Transparency Directive related to the abolition of the interim reporting regime (noted below); while general in application it was driven by SME concerns. Since then, EU issuer disclosure policy for SMEs has tilted away from regulated markets, with most efforts focusing on facilitating SME access to second-​tier trading venues, including through the EU Growth Prospectus (section 4.9.7).

II.5.7  Transparency Directive: The Issuer Disclosure Regime II.5.7.1 Periodic Annual Financial Reports Prior to the adoption of the Transparency Directive in 2004, annual reporting obligations applied to issuers under the pre-​existing company law financial reporting regime. The Transparency Directive clarified the contents of the annual report, with reference in particular to the IFRS financial reporting regime, and thereby oriented the company-​law-​ based reporting regime to the disclosure and comparability requirements of capital market disclosure. An issuer subject to the Transparency Directive must make public its annual financial report at the latest four months499 after the end of the financial year, and ensure that it remains publicly available for at least ten years500 (Article 4(1)). As the heavy lifting on annual report disclosure is carried by the financial reporting regime, the Transparency Directive simply 495 Reflecting aligning reforms by the 2010 Amending Prospectus Directive and the 2013 Amending Transparency Directive. 496 Article 8(4). 497 2011 Amending Transparency Directive Proposal IA, n 475, 9–​10. 498 eg 2009 Mazars Report, n 472, xi and xiii–​xiv, and 44 and 57. 499 This deadline caused considerable difficulties during the 2004 Directive negotiations. The Commission initially proposed a sixty-​day deadline, but revised this to three months following market concerns. The four-​month deadline was introduced during the institutional negotiations. 500 Reports were originally to be available for five years, but this was extended to ten under the 2013 Amending Transparency Directive.

164 Capital-raising specifies the content of the annual report as including (i) the audited financial statements, (ii) the management report, and (iii) responsibility statements. Article 4 specifies alongside that, as regards the financial statements, where the issuer is required to prepare consolidated accounts, the audited financial statements must include the consolidated accounts (drawn up in accordance with IFRS) as well as the individual annual accounts of the parent company (drawn up in accordance with the national law of the Member State in which the parent company is incorporated (including accordingly national GAAP)). Where consolidated accounts are not required, the audited financial statements must comprise the individual accounts prepared in accordance with the national law of the Member State in which the company is incorporated. The financial statements must be audited in accordance with the requirements of the 2013 Accounting Directive, and the audit report must be disclosed in full to the public, along with the annual financial report. The management report must also be drawn up in accordance with the 2013 Accounting Directive. The responsibility statements are designed to align issuer responsibility for the disclosures with the ‘true and fair view’ model which governs the 2013 Accounting Directive and the IFRS reporting regime. Statements must accordingly be made by the persons responsible within the issuer to the effect that, to the best of their knowledge, the financial statements prepared in accordance with the applicable set of accounting standards give a true and fair view of the assets, liabilities, financial position, and profits or loss of the issuer and the undertakings included in the consolidation taken as a whole. The statements must also refer to the management report and state that the report includes a fair review of the development and performance of the business and position of the issuer and the undertakings included in the consolidation taken as a whole. In order to facilitate dissemination and machine readability, annual financial reports must follow the new European Single Electronic Format (XHTML), in accordance with the related 2019 RTS which was adopted following the required positive cost-​benefit assessment by ESMA (Article 4(7)).501

II.5.7.2 Periodic Half-​yearly Financial Reports Half-​yearly reporting requirements are imposed under Article 5. They apply to issuers of shares or debt securities (issuers of other securities (such as covered warrants) only are not subject to the half-​yearly reporting obligation). Price-​formation mechanisms in the debt markets are less dependent on issuer disclosure than such mechanisms are in the equity markets, but the regime also has an investor protection dimension in that it is designed to ensure sufficient disclosure is available on the insolvency risk posed by debt securities, and reflects a policy concern to ensure consistent levels of transparency across debt and equity asset classes.502 Issuers within the scope of Article 5 must make public a half-​yearly financial report which covers the first six months of the financial year, as soon as possible after the end of the relevant period but at the latest three months thereafter;503 like the annual report, the six-​ monthly report must remain available to the public for at least ten years. It must include the

501 As noted above (n 485) the requirement originally applied to financial statements from 2020 on but, to reflect pandemic-​related disruption, Member States had the option of extending this to 2021. 502 As noted in the 2011 Amending Transparency Directive Proposal, n 475, 17. 503 The 2013 Amending Transparency Directive extended the deadline from two to three months to ease bottleneck problems for SMEs, with respect to analyst coverage in particular.

II.5  Ongoing and Periodic Disclosure  165 condensed set of financial statements, the interim management report, and responsibility statements (reflecting those required for the annual report). Where the issuer is not required to prepare consolidated accounts under the 2013 Accounting Directive, the condensed set of financial statements must include a condensed balance sheet, a condensed profit-​and-​loss account, and explanatory notes.504 Where the accounts must be consolidated, the issuer must follow the IFRS regime applicable to interim financial reporting in producing the condensed accounts. The interim management report must include at least an indication of important events that have occurred during the first six months of the financial year and of their impact on the condensed financial statements. It must also include a description of the principal risks and uncertainties for the remaining six months of the financial year. Issuers of shares must report on major related party transactions.505 The Directive does not require that the half-​yearly report is audited, but where it has been the subject of an auditor’s review, the report must be reproduced in full. Where the report has not been audited or reviewed by auditors, a statement to that effect must be made in the report.

II.5.7.3 Quarterly Reporting and the Interim Management Statement Interim management statements or quarterly reporting are not required under the EU issuer disclosure regime, by contrast with the US regime. The 2013 Amending Transparency Directive abolished the previous and controversial requirement for an interim management statement.506 This reform, a major change at the time, reflected widespread concern with the requirement, including as regards the costs it imposed on SMEs.507 The Commission had initially adopted a maximalist approach to the reform, proposing that Member States be prevented from adopting any such requirement for domestic issuers but, following European Parliament and Council revisions over the negotiating process, home Member States can require issuers to publish additional periodic financial information on a more frequent basis than the annual and half-​yearly reports (Article 3(1a)). Two conditions apply: the additional reporting requirement must not constitute a disproportionate financial burden in the Member State concerned, in particular for SMEs; and the content of the additional reporting requirement must be proportionate to what contributes to investment decisions by investors in the Member State concerned. Member States are also to assess whether the additional requirement may lead to an excessive focus on short-​term results and performance and impact negatively on SME access to regulated markets. Issuers are 504 The issuer must follow the same recognition and measurement principles as apply when preparing the annual financial report. Non-​consolidated half-​yearly financial statements are governed by the 2013 Accounting Directive and the 2007 Commission Directive. 505 This related party disclosure requirement is specified by the 2013 Accounting Directive. 506 The interim management statement requirement was introduced by the 2004 Directive following difficult negotiations. Quarterly reporting requirements were not common across the EU at the time (being imposed in eight Member States), but a requirement was proposed by the Commission in part to align the EU with the US approach. The fraught negotiations reflected strong market resistance (given costs, particularly for SMEs, and volatility risks), opposition from some Member States, and outright opposition in the European Parliament which associated quarterly/​interim reporting with increased short-​termism. The result was an attenuated, narrative-​ based, historically oriented interim management statement requirement which was cast in high-​level terms and not amplified. 507 Concerns were widespread as to the lack of standardization and auditing, which reduced the comparability benefits of the statements, and as to their costs and relevance, given the availability of other periodic and ad hoc material disclosures: 2011 Amending Transparency Directive Proposal IA, n 475, 11 and 13.

166 Capital-raising free to make discretionary quarterly or other disclosures; the ability of the market to drive the appropriate level of interim disclosure is assumed by the reform. This reform was at the time designed to reduce prejudicial short-​termism, reflecting wider crisis-​era concerns as to excessive market volatility.508 It also responded to concerns as to the regulatory costs borne by regulated-​market-​admitted SMEs and as to the visibility problems for SMEs which arise from ‘bottlenecks’ of regulated disclosure publication. The interim management statement requirement was, however, removed for all issuers given the dangers as to potential confusion over the regulated market brand were different rules to apply to issuers admitted to regulated markets according to their size.509 The 2021 review of the Transparency Directive suggested that the reform has been effective; the abolition has been regarded as being beneficial for SME issuers in particular.510 In practice, however, many issuers continue to report on a quarterly basis, either voluntarily and reflecting market expectations and peer practices, or because quarterly reports are required at national level or in the admission requirements of certain regulated markets.511 This tolerance of varying levels of disclosure, in practice, on regulated markets is unusual for the EU issuer disclosure regime, but it suggests confidence in the ability of the markets to drive the appropriate level of disclosure and manage transaction costs.

II.5.7.4 Ongoing Disclosure on Rights Attached to Securities Issuers of shares admitted to trading on a regulated market must also make public without delay any change in the rights attaching to various classes of shares, including changes in the rights attaching to derivative securities issued by the issuer which give access to the shares of the issuer (Article 16(1)). Issuers of securities other than shares admitted to trading on a regulated market must make public without delay any changes in the rights of holders of such securities, including changes in the terms and conditions of these securities which could indirectly affect those rights (particularly changes with respect to loan terms or interest rates) (Article 16(2)). II.5.7.5 Access to Information for Holders of Securities Admitted to Trading on a Regulated Market The Transparency Directive imposes requirements on shareholder communications generally,512 and particularly with respect to shareholder meetings, reflecting the governing

508 2011 Amending Transparency Directive Proposal IA, n 475, 14–​16. 509 In its 2010 pathfinder Consultation, the Commission queried whether a differentiated ongoing disclosure regime for ‘small listed companies’ on regulated markets would ease regulatory burdens. Stakeholder reaction was hostile, with concern raised that the regulated market brand could be damaged: Commission, Feedback Statement to Transparency Directive Proposal (2010). 510 2021 Commission Accounting and Transparency Directives Review, n 480, 21–​2. 511 Issuers voluntarily report in at least 15 Member States, on a mandatory basis by operation of national law in five Member States, and by operation of regulated market admission requirements in eight Member States: 2021 Commission Accounting and Transparency Directives Review, n 480, 21. 512 In this regard, the Transparency Directive forms part of the wider corporate governance regime which addresses shareholders’ rights, including the Shareholder Rights Directive II (Directive 2017/​828 [2017 OJ L132/​1) which amended the Shareholder Rights Directive (Directive 2007/​36/​EC [2007] OJ L184/​17) to require institutional investors to disclose their engagement policies regarding how they monitor investee companies, including on social and environmental impacts as well as on financial and strategic matters. Shareholder engagement is also the subject of CMU-​related reforms, including as regards the use of digital technologies to support shareholder engagement. See generally Katelouzou, D and Sergakis, K, ‘When Harmonization Is not Enough: Shareholder Stewardship in the EU’ (2021) 22 EBOLR 203.

II.5  Ongoing and Periodic Disclosure  167 principle that equal treatment must be ensured by the issuer for all holders of shares who are in the same position (Article 17(1)). In support of this principle, the issuer must ensure that all the facilities and information necessary to enable holders of shares to exercise their rights are available in the home Member State, and that the integrity of data is preserved (Article 17(2)). A similar regime applies to debt securities (Article 18).

II.5.8  Transparency Directive: Ongoing Disclosure on Major Holdings The Transparency Directive also addresses disclosure (in the form of reporting/​notification obligations) of ‘major holdings’ in issuers as regards holdings of shares and share-​like instruments. Reporting/​notification obligations relating to ownership levels in publicly traded firms are common internationally, reflecting the importance of these disclosures to firm monitoring. These disclosures are particularly associated with the monitoring dynamics of the market for corporate control, as they shed light on potential takeover activity as well as on the structure of corporate control generally.513 Notwithstanding that ownership notifications are in large part a creature of company law/​takeover regulation—​which has had a very troubled history in the EU, reflecting significantly divergent Member State positions on the role of the market for corporate control514—​notification requirements regarding ‘major holdings’ have long been a feature of EU financial markets regulation, initially under the 1988 Substantial Shareholders Directive (since repealed) and subsequently under the Transparency Directive. The original 2004 Transparency Directive regime was largely concerned with upgrading and reorienting the 1988 regime from its company law-​oriented model to a capital market-​oriented model. In particular, the reporting thresholds for notifications of holdings, which under the 1988 Directive were a function of company law voting thresholds, were readjusted and reduced, reflecting market demand for more effective disclosure on the nature of control in an issuer. While much of this regime remains in place, and is amplified by the 2007 Commission Directive, the 2013 reform of the Transparency Directive led to two major revisions which, first, extended the reach of the notification obligation as regards holdings, and, second, reduced Member States’ discretion. As regards the first, the reach and effectiveness of the notification regime as regards holdings had come under scrutiny given increasing reliance on cash-​settled equity derivatives (typically CfDs), which do not carry rights to the underlying shares, but which can be used to acquire economic exposure to those shares and to exert control, and which were not notified under the 2004 Directive. Transparency risks to efficient price formation were accordingly generated, as were market abuse risks. The governance risks engaged by the potential these instruments held for ‘empty voting’ were also considerable, given the possibility for influence without the financial risks of share ownership, and the resulting disconnect between influence and consequences.515 The 2004 Directive did cover notification obligations 513 See, eg, Kershaw, D, Principles of Takeover Regulation (2016). 514 eg Clift, B, ‘The Second Time as Farce? The EU Takeover Directive, the Clash of Capitalisms and the Hamstrung Harmonization of European (and French) Corporate Governance’ (2009) 27 JCMS 55. 515 See, eg, Conac, P-​H, ‘Cash Settled Derivatives as a Takeover Instrument and the Reform of the EU Transparency Directive’ in Birkmose, H, Neville, M, and Sorensen, K (eds), The European Financial Market in

168 Capital-raising as regards holdings of financial instruments carrying rights to acquire shares, alongside the notification obligations for share holdings, but it was limited in its reach and did not cover CfDs. Reflecting widespread market concern516 and a series of high-​profile control acquisitions through cash-​settled derivatives,517 the 2013 Amending Transparency Directive significantly extended the notification obligation.518 Notwithstanding the risks thereby addressed, the logic for including such cash-​settled instruments in the Transparency Directive is not entirely compelling, in particular as these notifications support the market for corporate control but the Directive is not primarily a takeover market measure; further, takeover regulation in the EU is highly contested and operates under minimum-​harmonization disciplines.519 The reforms were, however, pragmatic, responding to widespread market concern at the time as to the costs of divergence in this area. They also support the price-​ formation efficiencies which are at the heart of the Directive’s objectives by ensuring more accurate information is conveyed to the market regarding the structure of control in an issuer. The 2013 revisions also reduced Member State discretion. The minimum harmonization model adopted for the major holdings notification regime had led to significant divergences, including as regards the thresholds which governed notification, the identification of holdings, and the mechanics of notification, which all imposed significant costs on investors.520 In response, the 2013 Amending Transparency Directive reshaped the notification regime as a maximum harmonization obligation, prohibiting Member States from imposing more stringent notification requirements (Article 3(1a));521 the Article 12 procedures which govern notification fall outside this restriction. Lower or additional notification thresholds can be set, however, in order to allow Member States to reflect distinctive market conditions.522 Subsequent amplification has followed with the 2015 Major Holdings Notification RTS which addresses, inter alia, how holdings are to be aggregated. The major holdings notification regime as currently configured applies to shares (Article 9) and ‘share-​like’ instruments (Article 13). The core obligation as regards holdings of shares is set out in Article 9(1), which imposes a notification obligation on shareholders.523 Article Transition (2012) 49 and Schouten, M, ‘The Case for Mandatory Ownership Disclosure’ (2009) 15 Stanford J of Law, Business & Finance 127. 516 eg ESME, Views on the Issue of Transparency of Holdings of Cash Settled Derivatives (2009). 517 Including the high-​profile 2008 72 per cent position built by Porsche in Volkswagen through cash-​settled derivatives (representing around 30 per cent of the total position) which led to significant volatility in the Volkswagen share price once the position was suddenly disclosed in October 2008, revealing that the Volkswagen free float was potentially reduced to only 6 per cent: 2010 CESR Major Shareholdings Report n 472, 7. 518 CESR, and lately ESMA, were in the vanguard of these developments at EU level. CESR was an early supporter of extended reporting requirements, proposing a principles-​based regime in 2010 (2010 CESR Major Shareholdings Report, n 472), while ESMA considered the empty voting question more generally (ESMA/​2011/​ 288). 519 Conac, n 515, 61–​2, but noting the efficiency gains from extending the regime to include these instruments. 520 ESMA’s 2011 review identified a series of material divergences across the Member States: 2011 ESMA Mapping Report, n 481, 12–​15. 521 This reshaping, reflecting strong market demand, was designed to create a uniform approach, reduce legal uncertainty, enhance transparency, simplify cross-​border investments, and reduce costs: 2011 Amending Transparency Directive Proposal, n 475, 6. 522 Particularly in those Member States where widely dispersed share ownership is common. 523 A shareholder is defined as any natural person or legal entity governed by private or public law who holds, directly or indirectly, shares of the issuer in its own name and on its own account, shares of the issuer in its own name but on behalf of another natural person or legal entity, and depository receipts, in which case the holder of the depositary receipts is considered to be the holder of the underlying shares represented by the depositary receipts: Art 2(1)(e).

II.5  Ongoing and Periodic Disclosure  169 12 covers the related notification procedures and is supported by the 2007 Commission Directive524 as well as by ESMA soft law, including an ESMA template notification form. Under Article 9, the home Member State must ensure that where a shareholder acquires or disposes of shares of an issuer whose shares525 are admitted to trading on a regulated market (and to which voting rights are attached), the shareholder notifies the issuer of the proportion of voting rights526 in the issuer held by the shareholder as a result of the acquisition or disposal where the proportion reaches, exceeds, or falls below the following thresholds: 5 per cent, 10 per cent, 15 per cent, 20 per cent, 25 per cent, 30 per cent,527 50 per cent, and 75 per cent.528 The notification system is therefore relatively sensitive to the nature of corporate influence, as it starts at the lower threshold of 5 per cent and proceeds in 5 per cent increments until 30 per cent. Passive crossing of the relevant thresholds is also covered: notification must be made where the proportion of voting rights reaches, exceeds, or falls below the thresholds as a result of events which change the breakdown of voting rights, and on the basis of the information which must be disclosed by the issuer concerning its share capital under Article 15 (Article 9(2)).529 The Directive expressly permits Member States to retain lower or additional reporting thresholds, although they may not otherwise impose more stringent requirements (Article 3(1a)); Member States are also free to ‘gold plate’ the Article 12 notification procedures. Notification obligations of this nature represent a considerable burden for dealers in securities who hold proprietary positions and are of doubtful value where they do not shed light on those who control the issuer. An exemption is accordingly available for market-​ makers.530 A market-​maker is not subject to the notification requirements where its holdings reach or cross the 5 per cent threshold, as long as the market-​maker is authorized by its home NCA under MiFID II/​MiFIR and does not intervene in the management of the issuer concerned or exert any influence on the issuer to buy the shares or back the share price (Article 9(5)). A similar exemption is available for voting rights held in the ‘trading book’ (an own funds/​capital concept which covers short-​term investments of credit institutions and investment firms (Article 9(6)); for voting rights attached to shares acquired for stabilization purposes (Article 9(6a)); and for shares provided to or by members of the European System of Central Banks in carrying out their monetary functions (Article 11). Issuers are also subject to the share notification obligation in that an issuer must, where it acquires or disposes of its own shares (either itself or through a person acting on its behalf), make public the proportion of shares (as soon as possible but not later than four trading

524 Which amplifies, inter alia, when the notification obligation arises and the scope of the Art 12 exemptions, including for asset management. 525 The notification obligation does not apply to shares acquired for the sole purpose of clearing and settling within the usual short settlement cycle or to custodians holding shares in their custodian capacity, as long as such custodians can exercise the voting rights attached to such shares only under instructions given in writing or by electronic means: Art 9(4). 526 Voting rights are calculated on the basis of all the shares to which voting rights are attached, even if their exercise is suspended. 527 Member States have the option of applying a one-​third threshold. 528 Member States have the option of applying a two-​thirds threshold. 529 Art 15 requires the issuer to disclose to the public the total number of voting rights and capital at the end of each calendar month during which an increase or decrease occurs. 530 A market-​maker is defined as a person holding itself out on the financial markets on a continuous basis as being willing to deal on own account by buying and selling financial instruments against its proprietary capital at prices defined by it: Art 2(1)(n). The conditions applicable are amplified by the 2007 Commission Directive.

170 Capital-raising days following the acquisition or disposal) where the proportion reaches, exceeds, or falls below 5 per cent or 10 per cent of the voting rights (Article 14). Article 13 addresses ‘share-​ like’ instruments including, since the 2013 Amending Transparency Directive reforms, cash-​settled instruments such as CfDs; it applies the Article 9 notification obligation to the financial instruments covered by Article 13. These are financial instruments531 that, on maturity, give the holder, under a formal agreement, either the unconditional right to acquire, or the discretion as to the right to acquire, shares to which voting rights are attached, already issued, of an issuer whose shares are admitted to trading on a regulated market (Article 13(1)(a)). In addition, financial instruments which do not come within this classification, but which are referenced to shares and which have ‘economic effects similar to’ Article 13(1)(a) financial instruments, whether or not they give a right to physical share settlement, are covered (Article 13(1)(b)). The related notification must include a breakdown by type of the financial instruments held under each classification, distinguishing between instruments which give right to a physical settlement, and those which give right to a cash settlement. Capturing CfDs and related interests for the purpose of the notification obligation is a complex exercise, particularly with respect to how these interests are identified and calculated for the purposes of the different Article 9 voting right thresholds, and how exemptions apply, given the multiplicity of instruments engaged and the different structures possible (including, for example, instruments referenced to a basket of shares or index).532 The Directive engages with some of the related complexities, clarifying, for example, how voting rights are to be calculated and aggregated (Article 13a), but it is also amplified by the 2015 Major Holdings Notification RTS, including as regards the calculation of voting rights in relation to financial instruments where instruments are referenced to a basket or index. The objective of enhancing market transparency on the nature of corporate control requires that the scope of the share notification obligation extend considerably beyond shareholders to cover a wide range of indirect control relationships. Article 10, a longstanding element of the Transparency Directive, accordingly provides that the Article 9 notification requirements are also applied to a natural person or legal entity to the extent that it is entitled to acquire, dispose of, or exercise voting rights in the circumstances identified in Article 10 (or in any combination of these circumstances). A major reform at the time, the 2021 Transparency Directive review found that the ‘share like’ notification regime was regarded as working well in practice, albeit that some concerns were raised about the complexity of the supporting calculation rules. Given that it takes time for investors and shareholders to adapt, and as the resilience of the regime in the face of a new generation of financial instruments is yet to be tested, future reviews are likely to be more informative.533 The more longstanding share notification regime has, however,

531 Defined as transferable securities, options, futures, swaps, forward rate agreements, CfDs, and other contracts or agreements with similar economic effects which can be settled physically or in cash: Art 13(1b). In accordance with Art 13, ESMA maintains an indicative list of financial instruments subject to the Art 13 notification requirement: ESMA, Indicative List of Financial Instruments (2015). 532 As regards CfDs, eg, notification rules can be based on aggregating CfD disclosure with share ownership disclosure, and can also be calibrated (or delta-​adjusted) to reflect the exact relationship between the CfD and the related share. 533 2021 Commission Accounting and Transparency Directives Review, n 480, 24–​5.

II.5  Ongoing and Periodic Disclosure  171 experienced difficulties. Although the 2013 reforms were designed to limit Member State discretion and reduce transaction costs, the 2021 Transparency Directive review found that divergence and related transaction costs remained a feature of the regime.534 For example, eight Member States set a lower notification threshold than 5 per cent, most Member States applied additional higher thresholds, and Member States also differed in their approach to the Article 12 procedures governing notification and the formats in which issuers are required to make the related notifications. Given the EU’s now considerable technocratic capacity as regards technical rule-​making, additional administrative rules may follow, assuming the cross-​border transaction costs are sufficiently material.

II.5.9  Transparency Directive: Market Integration and Home Member State Control II.5.9.1 Home Member State Control The Transparency Directive does not apply an NCA approval requirement to its required ongoing issuer disclosures, reflecting longstanding practice and the central role played by information intermediaries (notably auditors) in policing these disclosures; this approach has recently been articulated in the 2017 Prospectus Regulation’s URD which is not subject to NCA approval once the relevant time-​period has passed (section 4.9.3). The Directive does, however, require an anchor home Member State/​NCA with respect to the determination of the substantive content of the disclosure rules which apply (given in particular the Directive’s minimum harmonization approach, albeit subject to the Article 3(1a) conditions), and with respect to related disclosure filing rules (section 7). As under the prospectus regime, the home Member State definition is segmented as regards the retail and wholesale markets. Accordingly, issuer choice does not govern the identification of the home Member State in the case of issuers of shares and of debt securities with a denomination of less than €1,000: the home Member State for these issuers is, reflecting the prospectus regime, where the issuer is incorporated in the EU, the Member State in which it has its registered office (Article 2(1)(i)(i)). For other issuers, the home Member State is chosen by the issuer from among the issuer’s State of registration and those Member States in which its securities are admitted to trading on a regulated market (Article 2(1)(i)(ii)). The powers of the host Member State (the Member State in which securities are admitted to trading on a regulated market where this State is different from the home Member State) are confined by Article 3(2). The host State may not impose disclosure requirements on the admission of securities to trading on a regulated market in its territory which are more stringent than those set out in the Directive or under the market abuse regime, or impose more stringent requirements concerning notification of major holdings on shareholders and other relevant persons. The precautionary principle applies, however, and allows the host NCA to intervene in exceptional circumstances to protect investors once the home NCA’s response has proved inadequate (Article 26).



534

2021 Commission Accounting and Transparency Directives Review, n 480, 25–​6.

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II.5.9.2 Language Regime A language regime (Article 20) applies in support of the notional ‘passport’ extended to ongoing issuer disclosure. It is closely based on the prospectus language regime, although with some variations, and supports issuer choice of publication in a ‘language customary in the sphere of international finance’. As under the 2017 Prospectus Regulation, where securities are admitted to trading on a regulated market in the home Member State only, ‘regulated information’ (which includes Transparency Directive requirements—​see section 7) must be disclosed in a language accepted by the home NCA. But unlike the regime which applies under the Prospectus Regulation, where securities are admitted to trading on a regulated market both in the home Member State and in one or more host States, information must be disclosed in a language accepted by the home NCA and, at the issuer’s choice, either in a language accepted by the host NCA or a ‘language customary in the sphere of international finance’. Translation requirements may, therefore, be imposed where the language required by the home NCA differs from the issuer’s choice. Where the securities are not admitted to trading on a regulated market in the home Member State but are admitted in one or more host-​State-​regulated markets, the issuer may choose either a language accepted by the host NCA or a ‘language customary in the sphere of international finance’. The home Member State may also require that the disclosure is, depending on the choice by the issuer, made in a language which it accepts or is ‘customary in the sphere of international finance’. A discrete regime applies to wholesale offers (or securities with a denomination of at least €100,000); issuers may choose either a language accepted by the home and host NCAs or one customary in the sphere of international finance.

II.5.10  Transparency Directive: Supervision and Enforcement II.5.10.1 Supervision: NCAs, Cooperation, and Convergence In its essentials, the Transparency Directive supervisory regime is similar to that which operates under the prospectus regime, albeit that a thinner and more lightly harmonized approach applies, reflecting that its disclosures are not approved. Article 24 requires Member States to designate the central authority required under the prospectus regime (the NCA) as the ‘central competent administrative authority’ responsible for carrying out the Transparency Directive’s obligations; identity between the prospectus regime and the transparency regime NCA is therefore required. However, and a cause of some coordination and enforcement difficulties as the 2020 Wirecard scandal exemplified (noted below), enforcement of financial reporting requirements can be allocated to a separate authority (reflecting the approach adopted in many Member States) (Article 24(1)). Article 24 also specifies the powers which must be conferred on NCAs and which are calibrated to relate to the ongoing issuer disclosure context (Article 24(4)). The NCA must be empowered to: require auditors, issuers, holders of securities, those required to provide major holdings notifications, and relevant controlling or controlled persons to provide information and documents; require the issuer to disclose information to the public (an NCA may publish the information on its own initiative where the issuer fails to do so); require major holdings notifications to be made; suspend (or request the relevant regulated market to suspend) trading in securities (for a maximum of ten days at a time) where it has reasonable grounds for suspecting that

II.5  Ongoing and Periodic Disclosure  173 the provisions of the Directive have been breached by the issuer; prohibit trading on a regulated market; monitor that the issuer discloses timely information, with the objective of ensuring effective and equal access to the public in all Member States where the securities are traded and take appropriate action where this is not the case; make public any failures to comply with the major holdings notification regime; examine whether information is drawn up in accordance with the relevant reporting framework and take appropriate action in the case of infringements (these powers can be exercised by a separate authority); and carry out on-​site inspections. More generally, NCAs are also to be given all investigative powers necessary for the exercise of their functions (Article 24(4a)). In addition, cooperation obligations are imposed between NCAs (Article 25(2)) and between NCAs and ESMA (Article 25(2b)), and ESMA is empowered to mediate between NCAs where cooperation requests have been rejected or not acted on within a reasonable time (Article 25(2a)). Professional secrecy obligations apply (Article 25(1)), but they must not prevent the exchange of confidential information between NCAs or with ESMA and the ESRB (Article 25(3)). NCAs must also provide ESMA without delay with all information necessary to carry out its duties under the ESMA Regulation (Article 25(2c)). Initially, and despite the institutional divergence that characterizes organization of the supervision of the Transparency Directive nationally, particularly as regards enforcement of the related financial reporting requirements, supervisory convergence difficulties were not associated with the Transparency Directive.535 More recently, supervisory convergence has been significantly strengthened by the bespoke coordination arrangement that ESMA established for financial reporting and which, for some time, represented the most advanced form of ESMA-​led supervisory coordination across the single rulebook. As outlined in section 6, NCAs follow ESMA’s Guidelines on the Enforcement of Financial Information (GLEFI, adopted in 2014 and since revised) with respect to how issuer financial reporting should be reviewed and when enforcement action should be taken; and coordination is supported through a discrete institutional innovation, ESMA’s European Enforcers Co-​ ordination Sessions (EECS). While the GLEFI and EECS system supports NCA coordination, it has also identified weaknesses in NCAs’ supervisory and enforcement approaches as regards financial reporting.536 The scale of these weaknesses emerged with the 2020 Wirecard scandal which exposed gaps in the Transparency Directive’s coverage of NCAs’ supervisory and enforcement powers, and as regards its treatment of NCA coordination with enforcement authorities. The exposure of a €1.9 billion gap in Wirecard’s escrow accounts and associated allegations of fraud led to a sharp focus on, inter alia, Wirecard’s disclosures and, relatedly, the supervisory and enforcement approach of the German NCA (BaFIN) and of the German financial reporting enforcement authority (the Financial Reporting Enforcement Panel, FREP), but also on the quality of the supervision of, and enforcement related to, ongoing issuer disclosures generally.537 The subsequent November 2020 ‘fast track’ ESMA peer review of the two authorities, which followed a June 2020 request from the Commission, identified difficulties with, inter alia, the independence of the German NCA (BaFIN); a failure to supervise

535 eg 2009 Mazars Report, n 472, xxi. 536 A 2017 peer review identified a series of weaknesses (section 6). 537 On the nature and implications of the scandal see, eg, Langenbucher, K, et al, What Are the Wider Supervisory Implications of the Wirecard Case? Study for the European Parliament ECON Committee (2020).

174 Capital-raising and examine Wirecard’s financial reporting fully, despite the emergence of specific risks; and a lack of coordination and information exchange between the two German authorities, exacerbated by the operation of confidentiality obligations.538 ESMA linked these failures to structural weaknesses in the supervisory architecture supporting the ongoing issuer disclosure regime, warning that while a ‘one size fits all’ approach to local institutional design was not appropriate, different institutional approaches to the supervision and enforcement of ongoing disclosure obligations should not deter effective enforcement or collaboration.539 It also and relatedly identified a series of weaknesses in the Transparency Directive which required remediation, including by means of stronger NCA cooperation obligations, including as regards cooperation with enforcement authorities; independence requirements for NCAs as regards enforcement; and an enhancement of NCAs’ powers, including in relation to corrections to financial reports, requiring second audits/​forensic examinations, and on-​site inspections.540 The supervisory and enforcement weaknesses which Wirecard exposed were also a feature of the Commission’s 2021 review of ongoing issuer disclosure/​the Transparency Directive, which noted the diversity of national supervisory and enforcement practices and institutional structures and identified supervision and enforcement as an area for potential reform.541 The management of the institutional/​operational risks to supervision that the Wirecard scandal exposed requires, given the delicate political setting of the organization of the supervision of the single rulebook, deft balancing between EU central steering and local NCA/​supervisory discretion. As outlined in Chapter I, supervisory convergence action is the EU’s preferred lever for the heavy-​lifting required to support NCA best practice nationally and effective coordination cross-​border. ESMA’s development of the GLEFI/​EECS system supporting financial reporting shows that supervisory convergence can be a multi-​ faceted and agile tool. But the Wirecard saga underlines that deficiencies in the legislative regime, here as regards NCAs’ powers, independence, and coordination capacity, can defeat soft measures and lead to major failures with systemic effects on price-​setting.

II.5.10.2 Enforcement: Administrative Sanctions and Civil Liability The Directive’s approach to enforcement reflects that of the prospectus regime (and of the single rulebook generally) and so is based on public enforcement. The original lightly harmonized administrative sanctions regime was revised by the 2013 Amending Transparency Directive to align the Directive’s requirements with the more intensely harmonized approach to administrative sanctions adopted over the crisis era. Accordingly, Member States must lay down rules on administrative measures and sanctions and take all necessary measures to ensure they are implemented; these sanctions must be effective, proportionate, and dissuasive (Article 28(1)). The Directive, unlike the 2017 Prospectus Regulation, also specifies that sanctions must apply to members

538 ESMA, Fasttrack Peer Review of Enforcement of Financial Information Guidelines by BaFIN and FREP in the context of Wirecard (2020). 539 ESMA, Letter to Commissioner McGuinness, 26 February 2021. 540 Prior to the Wirecard scandal, ESMA had earlier raised concerns as to the diversity of powers, resources, and review and enforcement practices across NCAs, warned as to the limits of the soft law EECS/​GLEFI framework, and called for a legislative response: ESMA, Response to the Fitness Check Consultation (2018). 541 2021 Fitness Check, n 464, 54–​5 and 2021 Commission Accounting and Transparency Directives Review, n 480, 23–​4.

II.5  Ongoing and Periodic Disclosure  175 of the administrative, management, or supervisory boards of the issuer and to any other person responsible under national law for a breach, where obligations under the Directive apply to legal entities and subject to national law (Article 28(2)). As is now standard, the sanctions regime specifies the particular breaches of the Directive to which sanctions must apply (Article 28a), the minimum suite of administrative sanctions which must be available (Article 28b),542 and the framework governing how sanctions are to be applied (Article 28c).543 NCAs are also required to publish every decision on sanctions without undue delay (including information on the type and nature of the relevant breach and the identity of the person); publication may be delayed or on an anonymous basis in certain situations (Article 29). NCAs are not, however, required to report to ESMA which does not, relatedly, report on sanctions, by contrast with the prospectus regime. Sanctioning powers may be exercised directly, in collaboration with other authorities, by delegation to other authorities, and by application to the competent judicial authorities (Article 24(4b)). Cross-​border cooperation with respect to sanctions is expressly addressed: NCAs must cooperate to ensure that sanctions (or other measures) produce the desired results and coordinate their action when dealing with cross-​border cases (Article 25(2)). Like the prospectus regime, the Transparency Directive touches lightly on civil liability through responsibility requirements.544 Responsibility for the annual and six-​monthly reports must lie at least with the issuer or its administrative, management, or supervisory bodies (Article 7); and Member States must ensure that their civil liability rules apply to issuers, their administrative, management, or supervisory bodies, or the persons responsible within the issuer (Article 7). Civil liability is not harmonized and, as with the prospectus regime, the possibility of multiple actions across the Member States arises, along with the attendant costs.545

II.5.11  Ad Hoc Disclosure and the Market Abuse Regime The market abuse regime, by addressing the disclosure of material, price-​ sensitive events which arise outside the periodic reporting cycle (‘inside information’), constitutes a key component of the EU’s ongoing issuer-​disclosure rulebook. As the regime is deeply embedded in the concepts deployed by the market abuse regime, it is discussed in Chapter VIII.

542 Public statements, injunctions, suspension of voting rights, and pecuniary sanctions (the higher of up to €10 million or up to 5 per cent of total annual turnover in the preceding year for legal persons and €2 million for natural persons, or, in each case, of up to twice the amount of the profits gained or losses avoided because of the breach, where those can be determined). 543 The regime requires NCAs, in assessing the type and level of sanction, to take into account: the gravity and duration of the breach; the degree of responsibility of the responsible person; the financial strength of the responsible person; the importance of the profits gained or losses avoided; the losses to third parties; the level of cooperation with the NCA provided by the responsible person; and previous breaches by the responsible person. 544 The Directive’s approach is modelled on that adopted earlier by the 2003 Prospectus Directive, but the Commission also related it to the post-​Enron scandal certification requirements introduced by the US SEC and which require directors and financial officers to certify quarterly and annual reports. Transparency Directive Proposal, n 467, 8–​9. 545 Attempts were made over the course of the development of the 2004 Transparency Directive to dilute the risks of liability across different legal regimes by anchoring liability to the home Member State of the issuer, but this approach was not adopted in the Directive.

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II.6  Financial Reporting and International Financial Reporting Standards (IFRS) II.6.1  The EU Financial Reporting Framework The EU’s issuer disclosure requirements (ongoing and prospectus requirements) are supported by the parallel financial reporting system.546 This system, which carries much of the regulatory weight of the Transparency Directive’s ongoing issuer-​disclosure requirements in that it addresses how financial information in annual and half-​yearly reports is presented, and which also supports the prospectus regime as regards its financial reporting requirements, has a number of components. The 2013 Accounting Directive, a principles-​based measure, governs financial reporting generally and applies to all EU companies (it is amplified by national reporting frameworks (national Generally Accepted Accounting Principles or nGAAP)). Harmonized rules also address the related statutory audit of financial reports, required under the Accounting Directive and the Transparency Directive.547 In addition, issuers admitted to a regulated market and with more than 500 employees are subject to the 2014 NFR Directive which addresses non-​financial reporting but which will be overtaken by the corporate sustainability reporting regime agreed in 2022; specific reporting obligations also apply as regards environmental sustainability under the ‘taxonomy’ regime (section 10). Finally, and the concern of this section, under the Transparency Directive and the IAS Regulation, issuers admitted to trading on a regulated market must, as regards their consolidated accounts (yearly and half-​yearly), follow the IFRS reporting system.548 IFRS are a global financial reporting standard, adopted by the International Accounting Standards Board (IASB), which is overseen by the IFRS Foundation.549 Issuers admitted to a regulated

546 For FSAP-​era discussions of the financial reporting regime, at a time when it was fast developing and drawing attention, see Schön, W, ‘Corporate Disclosure in a Competitive Environment: The Quest for a European Framework on Mandatory Disclosure’ (2006) 6 JCLS 259 and Van Hulle, K, ‘Financial Disclosure and Accounting’ in Hopt and Wymeersch, n 172. 547 The EU statutory audit regime has two components. Directive 2014/​56/​EU [2014] EU L158/​196, a financial-​ crisis-​era reform, amended the original statutory audit regime (Directive 2006/​43/​EC [2006] OJ L157/​87) to, inter alia, strengthen the independence of the statutory audit, strengthen the content of the audit report, and enhance the oversight of auditors and sanctioning regimes. Regulation (EU) No 537/​2014 [2014] OJ L158/​77, which was adopted in parallel with the 2014 Directive, imposes more stringent requirements on ‘public interest entities’, which include issuers admitted to trading on a regulated market. These rules include mandatory auditor rotation requirements, a prohibition on certain non-​audit services being carried out by the auditors of public interest entities, and additional requirements for the audit report as regards the audit process. The Regulation also enhances the role and competence of a firm’s audit committee and provides a framework for dialogue between the relevant firm’s NCA and the statutory auditor. The Directive and Regulation also require Member States to require statutory auditors to carry out audits in accordance with International Auditing Standards (IASs) adopted by the International Auditing and Assurance Standards Board (IAASB). The Commission has been empowered to adopt IAS as EU standards, but it has yet to do so. National oversight bodies coordinate their activities, and cooperate with ESMA, through the Committee of European Auditing Oversight Bodies (CEAOB). As the audit is most usually examined as a function of issuer/​shareholder relations and as a function of corporate governance it is not addressed by this book 548 Transparency Directive Arts 4(3) (annual reports) and 5(3) (half-​yearly reports). 549 The IASB is composed of 14 technical experts (geographical distribution requirements apply), and is appointed and overseen by the IFRS Foundation Trustees (geographical representation requirements also apply to Trustees to ensure global balance) who are accountable to the IFRS Monitoring Board. The Monitoring Board is composed of capital market authorities but includes the Commission. The EU is also represented on the IFRS Advisory Council which is designed to support stakeholder engagement and on which the Commission but also the ECB and ESMA sit.

II.6  Financial Reporting and IFRS  177 market are not subject to the IFRS obligation as regards their non-​consolidated accounts.550 Issuers admitted to a seco nd-​tier trading venue/​MTF in the EU are also not subject to IFRS, unless the Member State in question has made IFRS application mandatory (a Member State may also make IFRS available as an option which issuers can choose to use). These issuers are subject to the principles-​based reporting requirements of the 2013 Accounting Directive and relevant nGAAP. Prospectus disclosures within the scope of the Prospectus Regulation must, however, be prepared in accordance with IFRS.551 The IFRS financial reporting system is accordingly of defining importance in shaping regulated-​market-​issuers’ mandatory financial disclosures. The practical scope of IFRS application in the EU, however, is wider than its legal/​regulated market scope.552 This multi-​layered financial reporting system is, by and large, regarded as effective. The Commission’s 2021 ‘Fitness Check’ review of the EU framework for public reporting by companies assessed whether it had been effective in enabling stakeholders to make informed decisions by ensuring the timely reporting of sufficient, relevant, comparable, and reliable financial and non-​financial information. Based on a wide-​ranging consultation, it found that the framework was working well, with the IFRS system the most effective component of the framework in ensuring high-​quality and comparable public information across the EU.553 This finding reflects the scale and sophistication of the IFRS system, which is one of the two major global financial reporting systems, with US GAAP.554 While it is not straightforward to assess the merits of financial reporting standards,555 the EU’s initial transition to IFRS (all regulated market issuers were subject to IFRS from financial year 2005) was associated with greater transparency, higher quality reporting which is more value-​relevant (in that share prices better reflect financial disclosures) and which supports more accurate forecasting of future earnings, and greater comparability.556 IFRS reporting since then has also been regarded as successful, as reported by the Commission’s 2021 ‘Fitness Check’ review.557 Embedded within a dense matrix of soft measures and interpretative guidance, and with bespoke international and EU governance arrangements, IFRS are continually developed and existing standards refined, and so are relatively agile in responding to economic

550 These financial statements must be prepared in accordance with the national law of the Member State in which the company is incorporated: Arts 4(3) and 5(3). 551 See, eg, 2019 Prospectus Delegated Regulation Annex I (Registration Document for Equity Securities) 18.1.3. 552 In 2021, some 4,200 issuers preparing IFRS financial statements were admitted to trading on a regulated market of which some 3,500 prepared IFRS consolidated financial statements and some 700 prepared IFRS non-​ consolidated financial statements: ESMA, 2021 Corporate Reporting Enforcement and Regulatory Activities (2022) 12. Some 11 Member States require the use of IFRS for the non-​consolidated accounts of issuers subject to the IFRS obligation, while 11 allow this as an option: 2021 Fitness Check, n 464, 46. 553 2021 Fitness Check, n 464, 4–​5. 554 Some 132 jurisdictions either permit or require IFRS for their domestic issuers: Deloitte, IAS Plus, Use of IFRS by Jurisdictions (as at June 2022). 555 The quality of reporting standards is difficult to assess, given the range of factors, including firm incentives and the wider economic environment, which shape how firms report their performance. See, eg, Barth, M, Landsman, W, and Lang, M, ‘International Accounting Standards and Accounting Quality’ (2008) 46 J of Acc Research 467. 556 As was found by the Commission’s first major review of the impact of IFRS: Commission, Evaluation of the 2002 IAS Regulation (COM(2015) 301). For an early positive review, see Armstrong, C, Barth, M, Jagolinzer, A, and Riedl, E, ‘Market Reaction to the Adoption of IFRS in Europe’ (2010) 85 Accounting Rev 31. 557 This reflects international experience with the IFRS system (n 567).

178 Capital-raising and business model change and to financial innovation.558 An outline of the IFRS system in the EU follows.

II.6.2  IFRS and the IAS Regulation II.6.2.1 The Road to the 2002 IAS Regulation While now a core component of the EU’s issuer disclosure regime, the original transition to IFRS reporting (through the 2002 IAS Regulation) represented at the time a major change to the EU’s financial reporting system. Prior to the 2002 adoption of the IFRS regime, large divergences existed across the Member States with respect to how the financial information required in prospectuses and in ongoing disclosures for issuers admitted to regulated markets was presented. This reflected the open-​textured nature of the original suite of framework accounting directives (Fourth and Seventh Company Law Directives; since repealed) which allowed significant discretion to the Member States. Financial reports in the EU were, as a result, presented in a range of different ways, including under the standards adopted by the International Accounting Standards Committee (now the IASB) in the form of International Accounting Standards (IAS, now IFRS); US GAAP (where required for EU issuers accessing the US market and, in some cases, permitted by Member States for domestic reporting); and nGAAP. The variations in nGAAP in particular, which reflected longstanding path dependencies relating to institutional structures, financing models, and cultural influences,559 exacerbated the risks to comparability already generated by the framework accounting directives and thereby risked increasing the cost of capital.560 As the EU’s efforts to develop and integrate its capital markets intensified, and as the financial reporting regime became more strongly associated with the support of market finance, rather than with the reporting requirements of company law, resolution of the difficulties became a central FSAP concern. In 2000, the Commission produced its EU Financial Reporting Strategy, which asserted a link between reporting standards harmonization and the depth and efficiency of the EU capital market, and proposed that all companies admitted to a regulated market prepare their consolidated accounts in accordance with IFRS by 2005.561 The choice of IFRS reflected a multiplicity of influences, extending from the inability of the EU to influence US GAAP (the other major international option), to market preferences, to the strengthening international influence of IFRS which was intensified by the 2000 recommendation by IOSCO that its members permit the use of IAS (now IFRS) for financial statements.562

558 As noted in the 2021 Fitness Check, n 464, 50. 559 Generally, Leuz, C, ‘Different Approaches to Corporate Reporting Regulation: How Jurisdictions Differ and Why’ (2010) 40 Accounting and Business Research 229. 560 On the costs of a lack of comparability in reporting standards generally see, eg, De George E, Li, X, and Shivakumar, L, ‘A Review of the IFRS Adoption Literature’ (2016) 21 Rev of Accounting Studies 898 and Cunningham, L, ‘The SEC’s Global Vision: A Realistic Appraisal of a Quixotic Quest’ (2008) 87 North Carolina LR 1. 561 2000 Financial Reporting Strategy, n 469. 562 See Ferran (2004), n 173, 28–​31 and Karmel, R, ‘The EU Challenge to the SEC’ (2007) 31 Fordham International LJ 1692.

II.6  Financial Reporting and IFRS  179

II.6.2.2 The IAS Regulation and IFRS The 2002 IAS Regulation was the legislative vehicle for the adoption of the IFRS system. Enjoying strong political support over the negotiations on its adoption,563 the Regulation is designed to provide the EU with a ‘comprehensive and conceptually robust set of standards specifically intended to serve the needs of the international business community’.564 The Regulation’s objective accordingly is the adoption and use of ‘international accounting standards’ (defined as including IAS, IFRS, their related interpretive documents and subsequent revisions, and future standards (Article 2)) in the EU, with a view to harmonizing the financial information presented by the companies covered and in order to ensure a high degree of transparency and comparability of financial statements and the efficient functioning of the Community capital market and the internal market (Article 1). For each financial year (starting on or after 1 January 2005) companies governed by the law of a Member State must prepare their consolidated accounts in conformity with IFRS if, at the balance sheet date, their securities are admitted to trading on a regulated market (Article 4).565 Under Article 5, Member States have the option of extending the IFRS reporting regime to (i) listed companies in respect of their annual accounts (not just the consolidated accounts) (Article 5(a)), and (ii) other companies with respect to their consolidated and/​or their annual accounts (Article 5(b)). The adoption of IFRS has, by and large, been regarded as a success in the EU, as reported in the Commission’s 2021 ‘Fitness Check’ review,566 reflecting the comparability and value-​ enhancing benefits associated with IFRS internationally.567 Relatedly, the Commission’s 2021 recommendation, following a wide-​ranging review, that IFRS application be extended, suggests significant political, market, and stakeholder support: the Commission’s 2021 ‘Fitness Check’ recommended that IFRS apply to all reporting by issuers admitted to regulated markets (not just consolidated reporting); and that the IFRS system be made available as an optional standard for SMEs planning to admit securities to trading and for larger non-​traded companies.568 So too does the application of IFRS, in practice, beyond the consolidated accounts of regulated-​market-​issuers (by Member States and by issuers).569 Reliance on IFRS as the EU financial reporting standard brings, however, distinct challenges. IFRS are adopted outside the EU institutional structure by the IASB.570 The incorporation of IFRS, which are designed as a global standard, within the EU’s distinct legal, market, and economic environment, is not always, accordingly, straightforward. Neither is the operation of the EU’s related governance arrangements for the ‘endorsement’ of IFRS, which has led to the construction of two vectors across which related institutional and market interests and tensions coalesce: the internal EU administrative process for endorsing IFRS, which can experience inter-​institutional tensions; and the external EU/​IASB/​IFRS 563 Commission, FSAP Evaluation. Part I: Process and Implementation (2005) 22. 564 2001 IAS Proposal ([2001] OJ C154/​285) 3. 565 A transitional period until financial year 2007 was available for issuers of debt securities (Art 9). 566 n 464. 567 Basseimir, M, ‘Why Do Private Firms Adopt IFRS’ (2018) 48 Accounting and Business Research 237 and Ball, R, ‘IFRS Ten Years Later’ (2016) 46 Accounting and Business Research 545. 568 2021 Fitness Check, n 464, 8, 84–​5, and 99. An IFRS for SMEs has been adopted by the IASB but it has not been endorsed by the EU. 569 n 552. 570 For an early assessment of the IASB’s place in international financial governance see Pan, E, ‘The Challenge of International Co-​operation and Institutional Design in Financial Supervision: Beyond Transgovernmental Networks’ (2010) 11 CJIL 243.

180 Capital-raising Foundation relationship, which can be riven by periodic contestation between the EU and the IASB. Finally, US GAAP remains a major global standard and, despite the efforts at convergence in this area,571 US GAAP and IFRS continue to diverge,572 complicating the IFRS institutional setting. The IFRS endorsement process is, however, now well-​established and, for the most part, institutionally stable, as considered in the following section.

II.6.3  Incorporating IFRS in the EU: The Endorsement Mechanism As the EU cannot devolve standard-​setting to a private third party, the adoption of IFRS as the EU financial reporting standard for regulated markets (and prospectuses) necessitated some form of EU review and incorporation process. The solution adopted by the IAS Regulation is the ‘endorsement mechanism’ which applies to IFRS, amendments and revisions thereto, and related interpretive documents. The endorsement process, set out under Articles 3 and 6 of the Regulation, is designed to incorporate IFRS effectively and speedily, while respecting the EU’s constitutional imperatives. Under the endorsement process, the Commission, in accordance with the Regulation’s endorsement principles (Article 3, noted below) adopts IFRS as administrative Commission regulations, subject to veto by the European Parliament and Council. This delegation of rule-​making power from the co-​ legislators (the Commission endorsement power) is overseen by the Accounting Regulatory Committee (ARC), which represents Member State interests and which votes on the adoption of the draft regulations. The European Financial Reporting Advisory Group (EFRAG), a technical advisory body, is charged by the Commission with providing advice on any proposed regulation’s compliance with the IAS Regulation’s endorsement criteria (noted below) and on the cost/​benefit impact.573 Three principles apply under the IAS Regulation to the endorsement of IFRS (Article 3(2)). The first reflects an underpinning principle of the EU’s accounting regime (set out in the 2013 Accounting Directive): IFRS may be adopted only if they are not contrary to the ‘true and fair view’ principle; this principle does not, however, require that IFRS are tested against the rules of the EU accounting regime (recital 9). Second, IFRS must meet the criteria of understandability, relevance, reliability, and comparability required of the financial information needed for making economic decisions and for assessing the stewardship of management. Investor, creditor, and shareholder perspectives are therefore included. Finally, IFRS must be conducive to the European ‘public good’. The nature of the public good is not amplified further and it has proved to be a dynamic concept. Following the 2013 Maystadt Review into the adoption of IFRS,574 the European public good is typically 571 Since the 2002 ‘Norwalk Agreement’ the IASB and the US Financial Accounting Standards Board (FASB) have sought greater convergence between the two systems. Aside from the IASB/​US FASB workstreams, over 2010-​ 2012, the US SEC considered the potential incorporation of IFRS within the US financial reporting system but did not come to a firm conclusion (for the final study see SEC, Work Plan for the Consideration of Incorporating IFRS into the Financial Reporting System for US Issuers (2012)). 572 Gelter, M, Accounting and Convergence in Corporate Governance: Doctrinal or Economic Path Dependence?, ECGI Law WP No 524 (2020), available via . 573 EFRAG is a private sector body with a remit wider than advice to the Commission. Its working arrangements with the Commission were established in 2016: Commission, Working Arrangements between the European Commission and EFRAG (2016). 574 Maystadt, P, Should IFRS Standards Be More European? Mission to Reinforce the EU’s Contribution to the Development of International Accounting Standards. Report for the Commission (2013) 10–​12.

II.6  Financial Reporting and IFRS  181 cast in terms of the IFRS in question not endangering financial stability, not hindering the economic development of the EU, and not being detrimental to the competitiveness of European undertakings. More recently, the public good standard has come to be associated with the EU’s sustainability objectives.575 Over the endorsement process, the IFRS in question is reviewed against the endorsement principles/​criteria. Although a private sector body, EFRAG, as the technical adviser to the Commission, plays a pivotal role. While superficial parallels could be made between EFRAG’s role and ESMA’s role in the adoption of administrative rules, EFRAG is a much less institutionally sophisticated actor. It is not set up under EU law and is a private sector body, albeit one with a mixed status: EFRAG is an independent, private sector body with a public service mission; it describes its role as to serve the European public interest by developing and promoting European views in the field of financial reporting.576 For the purposes of the IFRS endorsement process, it can be characterized as a body independent of the Commission and the IASB that is appointed as the technical advisor to the Commission in the context of the development and adoption of international accounting standards in the EU.577 EFRAG carries out the initial technical review of the proposed IFRS, including against the endorsement criteria, and undertakes a cost/​benefit and impact assessment as well as related consultations. The incorporation within the endorsement process of EFRAG as the primary location of technical expertise (albeit that ESMA also provides technical input, as noted below) was initially contested, given its private sector roots and related difficulties as to the extent of its independence which were identified by the 2013 Maystadt Review. Reflecting the Review’s recommendations and the Commission’s assessment, its governance, accountability arrangements, and independence were strengthened,578 including by the establishment of an oversight board.579 EFRAG’s role remains, however, somewhat insecure. Although the Maystadt Review had recommended that the three ESAs and the ECB sit on its oversight board, they declined to do so, as EFRAG is not constituted as a fully independent public body, and instead participate as observers.580 Further complicating the institutional setting, technical advice is also provided separately by ESMA. EU institutional complexities aside, the endorsement process is an inherently delicate one. It is geared to the adoption (or not) of a standard. The Commission cannot, accordingly, modify the content of IFRS, reflecting the global application of IFRS and the risks to the integrity of the IFRS system were an EU-​IFRS system to develop in parallel. But the Commission can give qualified approval to a standard by ‘carving out’ from the full extent of its scope, or it can expand the scope of application of a standard (by ‘topping up’ the standard). Either action, however, potentially undermines the global integrity of IFRS, with related risks and costs to EU issuers operating internationally. Nonetheless, endorsement

575 2021 Fitness Check, n 464, 90. 576 As stated in its Mission Statement: https://​www.efrag.org/​About/​Facts. 577 2016 Commission/​EFRAG Working Arrangements, n 573, 2. 578 Commission, Report on the Review of EFRAG (COM(2014) 396). 579 Composed in equal numbers of private sector stakeholders (eight) and of national standard setters (eight). 580 The ESAs had raised ‘serious concerns’ as to whether the proposed governance reforms would allow the accurate reflection of their views as the concerned public interest bodies, and as to the absence of a mechanism to allow the ESAs to veto EFRAG advice which they deemed to run counter to the public interest. Their position was that, within EFRAG, only the ESAs should decide on endorsement advice. Accordingly, they refrained from accepting membership in the newly constituted EFRAG and requested, instead, observer status: ESAs, Letter to Commissioner Barnier (Maystadt Report), 20 January 2014.

182 Capital-raising can raise EU-​specific difficulties, particularly in crisis conditions for the EU or where EU-​ specific competitiveness risks arise from IFRS application. The effectiveness of the endorsement mechanism depends in large part on the quality of EU (through the Commission) and IASB/​IFRS Foundation relations, but these have proved tense on occasion; the IASB/​IFRS Foundation’s interests as a private standard-​setting actor, with a global agenda, have at times conflicted with the particular interests pursued by the EU, leading to tensions with respect to IASB/​IFRS Foundation governance and operation generally, as well as with respect to particular IFRS. The importance of effective liaison is formalized under Article 7 of the IAS Regulation, which provides that the Commission is to liaise on a regular basis with the IASB. In practice, EU relations with the IFRS Foundation and the IASB are mediated across a number of relationships: the Commission sits, with voting rights, on the IFRS Foundation’s Monitoring Board (its oversight body); technical engagement with the IASB on specific IFRS takes places through EFRAG,581 albeit that, in an indication of the institutional sensitivities, the Commission claims overall stewardship of the IASB relationship;582 and, as noted below, ESMA also engages with the IASB. In practice, what could be a fractious relationship is generally workmanlike and is supported by tested governance arrangements. Across the dense IFRS rulebook, there have been only two instances where the EU has adjusted or ‘carved out from/​topped up’ a standard.583 The first relates to the 2004 carve-​out from IAS 39 (on the measurement and recognition of financial instruments); adopted just before the application of IFRS in the EU, the carve-​out led to something of a fracas.584 The other adjustment relates to a ‘top up’ (a widening of the scope of) of an optional deferral as regards the application of IFRS 9 (financial instruments) to certain insurance entities.585 The financial-​crisis era, however, saw acute tensions between the EU and the IASB as regards the IFRS fair value/​mark-​to-​ market reporting model and its implications for financial instrument measurement and reporting.586 While the difficulties were ultimately resolved by the adoption of IFRS 9, the impact of the earlier standard (IAS 39) on EU financial institutions, in the teeth of the financial crisis, saw the EU threaten a carve-​out from the standard.587 581 EU influence on IFRS is, in practice, largely a function of EFRAG engagement: 2021 Fitness Check, n 464, 93. 582 2016 Commission/​EFRAG Working Arrangements, n 573, 1 and 2, noting that while EFRAG is ‘entitled to interact’ with the IASB, the Commission, the official EU representative, is to be informed of any interactions with the IASB (or other EU and international bodies). 583 Leading the Commission to suggest that it has ‘only needed to do so [carve-​out] sparingly on only two occasions since 2003 to cover very limited elements of two standards’: 2021 Fitness Check, n 464, 90. 584 See generally Whittington, G, ‘The Adoption of International Financial Reporting Standards in the European Union’ (2005) 14 European Accounting Rev 127. The Commission stressed that the carve-​out was ‘exceptional and temporary’ and ‘not the preferred solution . . . the Commission prefers full endorsement of any international accounting standard’: Commission, IAS 39 Financial Instruments: Recognition and Measurement—​Frequently Asked Questions (2004). The acknowledgement in the IASC Annual Report that it ‘has, of course, been disappointing that the European Union has carved out of our main financial instruments standards’ (International Accounting Standards Committee Foundation, Annual Report (2004) 12) hid a frequently ill-​tempered debate. A second IAS 39 carve out relating to derivatives was overtaken by the adoption of IFRS 9. 585 2021 Fitness Check, n 464, 90. This top-​up, in support of the insurance sector, was criticized by the ESAs as generating risks relating to complexity, arbitrage, and creating an uneven playing field with the banking sector, which was already subject to IFRS 9: ESAs, Statement (Concerns Regarding Enlarging the Temporary Exemption from Applying IFRS 9), 21 June 2017. 586 On the association between fair value reporting, procyclicality, and the financial crisis see, eg, Ojo, M, ‘The Role of the IASB and Auditing Standards in the Aftermath of the 2008/​2009 Financial Crisis’ (2010) 16 ELJ 604, and Laux, C and Leuz, C, ‘Did Fair-​Value Accounting Contribute to the Financial Crisis?’ (2010) 24 J of Economic Perspectives 93. 587 On the EU/​IASB relationship over this period see House of Commons Treasury Select Committee, 9th Report 2008–​2009, The Banking Crisis, Reforming Corporate Governance and Pay in the City (2009) paras

II.6  Financial Reporting and IFRS  183 Since then, relations have stabilized considerably. But while the EU remains a strong supporter of IFRS as the global reporting standard,588 the EU/​IASB-​IFRS Foundation relationship remains delicate and prone to outbreaks of tension, reflecting the potential for misalignment between the EU’s expectations as the major international consumer of IFRS and the IASB’s position as the supplier of IFRS globally. The 2013 Maystadt Review counselled caution as regards adjusting the endorsement process, given the risk of weakening the global integrity of IFRS. The Commission’s 2018 consultation on what would become the 2021 ‘Fitness Check’, however, raised the possibility of introducing a new ‘carve-​in’ power into the endorsement mechanism which would allow the EU to adjust IFRS more easily.589 While this suggestion did not garner support from EU stakeholders,590 it prompted a robust response from the IFRS Foundation which warned that it would damage IFRS as a global standard and add ‘accounting friction’ to European capital markets.591 The 2021 ‘Fitness Check’ ultimately concluded that there was sufficiently flexibility in the endorsement process to address ‘deadlock situations’, although it warned that, as the ‘Conceptual Framework’ (2018) that governs IFRS has a capital-​provider focus and as the IASB’s impact assessments are, as a result, narrower than those carried out by the EU, the sustainability impacts of IFRS would be addressed over the endorsement process;592 some instability may yet follow as a result. IASB governance, and what the EU perceives as insufficient engagement with EU specificities, has also long been a concern of the EU,593 albeit that, following a series of governance reforms, this concern has abated somewhat. The 2021 ‘Fitness Check’ noted, however, that, while the IASB ‘has a very transparent due process’, EU influence on IASB standard-​setting and governance was ‘fairly limited’.594 Ultimately, while headline skirmishes can be expected where EU interests are strongly engaged, the workmanlike relationship which otherwise characterizes EU/​IASB-​IFRS Foundation engagement is likely to continue to prevail.

258–​67. Subsequently the EU’s major review on the crisis, the de Larosière Report, underlined the extent of the tensions, calling for the IASB to review the fair value principle and in so doing to ‘open itself up more to the views of the regulatory, supervisory and business communities’: The High-​Level Group on Financial Supervision in the EU, Report (2009) 21. 588 The EU is currently the largest funder of the IFRS Foundation (ahead of the major accounting firms that are the second largest funding source), providing some 23.7 per cent of its funding in 2020: Report from the Commission to the European Parliament and Council on the activities of the IFRS Foundation, EFRAG and PIOB in 2020 (COM(2022) 104) 6. 589 Commission, Consultation on Fitness Check on the EU Framework for Public Reporting by Companies (2018) Q 19. 590 Commission, Summary Report of the Public Consultation on the Fitness Check In (2018) 8–​9. Respondents noted the potential detriment to EU issuers seeking capital internationally as well as the potential for undermining IFRS as a global standard. 591 Press Release, IFRS Foundation and IASB Chairs, 27 March 2018, warning of the danger of opening a ‘Pandora’s Box of carve-​ins’ with significant consequences for EU companies, investors, and regulators. 592 2021 Fitness Check, n 464, 90–​2. 593 The European Parliament and Council have long sought stronger engagement with the IFRS process and are annually presented with a report from the Commission which includes details of IFRS Foundation interaction. See recently 2020 IFRS Foundation Report, n 588. 594 2021 Fitness Check, n 464, 91.

184 Capital-raising

II.6.4  IFRS, ESMA, and Supervisory Convergence The adoption of the IFRS regime does not, in itself, assure the consistency and integrity of financial reporting standards in the EU across IFRS-​scope issuers or secure the related benefits as regards capital-​raising and market integration. NCAs play a pivotal role, as the supervision and enforcement of IFRS compliance is a national competence: the Transparency Directive requires the NCAs appointed under that Directive to police compliance with the financial reporting regime (although oversight can also be carried out by other authorities, as noted in section 5.10.1 as regards the Wirecard scandal).595 Any divergences and/​or weaknesses as regards how IFRS compliance is supervised and enforced by NCAs have, accordingly, the potential to disrupt the application of IFRS in the EU and, internationally, to undermine the integrity of the IFRS regime.596 As the IFRS system began to bed in, CESR initially provided an institutional capacity to support consistency in IFRS supervision and enforcement and, since 2011, ESMA has come to exert significant influence on how IFRS are applied, and on how supervision and enforcement is carried out.597 ESMA’s activities span two main areas—​the consistent application of IFRS and the enforcement of IFRS compliance—​although these overlap. ESMA, which has an express supervisory convergence mandate as regards financial reporting,598 has proved increasingly entrepreneurial in claiming the IFRS/​financial reporting agenda, albeit in a somewhat crowded institutional space given the Commission’s pre-​eminence as the endorser of IFRS and EFRAG’s role as technical adviser.599 Over the financial-​crisis era, for example, and as it was finding its feet institutionally, ESMA produced a series of consultations and statements on IFRS, related to crisis-​era issuer disclosures on credit risk and instrument risk, including as regards the treatment of lenders’ loan forbearance practices600 and the treatment of sovereign debt disclosures.601 While these were technical interventions, they were also of material market significance and allowed ESMA to sculpt how IFRS applied to issuer disclosures over a period of acute volatility. Since then, ESMA has continued to shape how IFRS are applied, including by adopting soft interpretative statements which are often designed to follow up on evidenced weaknesses in financial reporting,602 although ESMA’s main focus tends to be on responding to IASB/​ EFRAG consultations; its 2021 response to the IASB on SPACs provides a good example of 595 Art 24(4)(h) requires that NCAs have the powers to examine whether the disclosure required under the Directive is drawn up in accordance with the relevant reporting framework; under Art 24(1) these functions can be carried out be a separate authority. 596 Schipper, K, ‘The Introduction of International Accounting Standards in Europe: Implications for International Convergence’ (2005) 14 European Accounting Rev 101. 597 Early in ESMA’s development, ESMA Chair Maijoor highlighted that pan-​EU coordination of IFRS was one of ESMA’s primary objectives: Speech, 12 November 2012. 598 ESMA Regulation Art 29(1)(c). 599 Its claiming of a stewardship role over IFRS can be seen in its response to the Commission’s 2018 consultation on what would become the 2021 ‘Fitness Check’. ESMA ‘strongly disagreed’ with the proposition that IFRS be adjusted to EU circumstances, as this would defy a key objective of the IAS Regulation by undermining the global nature of IFRS, and also cautioned against incorporating sustainability into the notion of ‘European public good’ (an endorsement principle) given that accounting standards ‘should be neutral’ as regards public policy objectives: ESMA, Response to Fitness Check Consultation (2018). 600 ESMA, Public Statement (Treatment of Forbearance Practices in IFRS Financial Statements), 20 December 2012. 601 ESMA, Public Statement (Treatment of Sovereign Debt in IFRS Financial Statements), 20 December 2012. 602 eg ESMA, Public Statement (Deferred Tax Assets), 15 July 2019, which reflected reporting weaknesses identified by NCAs.

II.6  Financial Reporting and IFRS  185 its concern to police IFRS in the EU.603 The Covid-​19 pandemic, however, saw it, in coordination with the European Banking Authority (EBA) and the ECB, develop a soft solution to the difficulties the IFRS 9 standard threatened to pose to the offering by banks of ‘payment breaks’ to creditors in response to the economic turmoil unleashed by the pandemic; the coordinated action had the effect of allowing EU lenders to provide payment breaks without being required at the same time to make significant additional provisions against these loans or to increase their supervisory capital requirements.604 It is in relation to supervision and enforcement, however, that ESMA’s influence has been most marked, through its European Enforcers Co-​ ordination Sessions (EECS) (through which NCAs coordinate, supported by ESMA),605 and its related Guidelines on the Enforcement of Financial Information (GLEFI) (which support NCA enforcement of financial reporting requirements).606 The EECS carries out a wide range of coordination and convergence activities relating to financial reporting supervision and enforcement which include:607 providing a forum for discussion of emerging issues; coordinating and sharing best practices; advising on enforcement; maintaining an enforcement data-​base;608 and, foreshadowing the 2019 ESA Reform Regulation which now requires ESMA to adopt European Supervisory Priorities for NCAs, adopting common enforcement priorities. While an informal forum, the EECS has developed over time to provide an institutional capacity for supporting IFRS in capturing current and emerging risks, and for following up on weaknesses identified in issuers’ financial reporting.609 In addition, ESMA has sought to embed the related GLEFI, including through a peer review of NCA compliance in 2017.610 Nonetheless, difficulties remain. The 2017 ESMA peer review of the GLEFI underlined the convergence risks, finding inefficient resourcing or insufficient allocation of resources

603 In October 2021, ESMA raised its concern that different views were emerging as to the appropriate treatment of SPAC shares as regards IAS 32 (on financial instrument presentation): ESMA, Letter to IFRS Interpretation Committee, 26 October 2021. 604 The difficulties related to how such payment breaks were treated under IFRS 9 (which inter alia governs how banks measure loan losses) and whether additional capital would be required by banks as a result (which would have impaired their ability to support creditors). ESMA, in coordination with EBA and the ECB (in its SSM capacity) indicated its view that IFRS 9 did not require such provisioning: ESMA, Public Statement (Accounting Implications of Covid-​19), 25 March 2020. The IASB noted ESMA’s action and encouraged issuers to consider that guidance: IFRS Foundation, IFRS 9 and Covid-​19 (2020). 605 ESMA also informally reviews issuer compliance on a thematic basis, using NCA data. eg, ESMA, Review of Fair Value Measurement in the IFRS Financial Statements (2017). ESMA examined the financial statements of sampled issuers for 2015, as well as NCAs’ enforcement practices over the period from 2013 to 2015. 606 Adopted in 2014, the Guidelines were revised in 2020 to reflect the main findings of ESMA’s 2017 peer review of the Guidelines: ESMA, Guidelines on Enforcement of Financial Information (2020). The Guidelines cover the enforcement of the financial information required under the Transparency Directive (and so cover IFRS) but do not extend to the non-​financial statements required under the 2014 NFR Directive. The Guidelines are principles-​ based and inter alia, set out what characteristics ‘enforcers’ should possess, describe selection techniques that should be followed and other aspects of enforcement methodology, describe the types of enforcement actions that should be made use of by enforcers, and explain how enforcement activities are coordinated within ESMA. 607 ESMA, Terms of Reference, EECS, January 2016. 608 Extracts from the database are made publicly available to support supervisory convergence. 609 The 2022 enforcement priorities, eg, covered climate-​related disclosures, treatment of the impact of Russia’s invasion of Ukraine, and treatment of the macroeconomic environment (ESMA, Public Statement (Common Enforcement Priorities for 2022 Annual Financial Reports), 28 October 2022), while the 2021 priorities covered treatment of the impact of the Covid-​19 pandemic, including as regards expected credit losses, as well as climate-​ related disclosures (ESMA, Public Statement (Common Enforcement Priorities for 2021 Annual Financial Reports), 29 October 2021).Earlier, the 2016 priorities, eg, focused on persistent weaknesses in financial reporting, including as regards the presentation of financial performance and the distinction between equity and financial liabilities, as well as on the impact of Brexit (ESMA, Public Statement, 28 October 2016). 610 ESMA, Peer Review on Guidelines on Enforcement of Financial Information (2017).

186 Capital-raising in four NCAs; weaknesses in the risk models used for selecting financial reporting enforcement cases in five NCAs; and a general NCA tendency to not carry out in-​depth inquiries. In response, ESMA made several practical recommendations, including in relation to risk model design and resource allocation. These institutional fragilities, and the persistence of recurring weaknesses in financial reporting by issuers (notably as regards financial statement presentation, impairment of non-​financial assets, and accounting for financial instruments), underline the convergence challenges, albeit that there is also some evidence of an increase in NCA enforcement activity.611 The Wirecard scandal relatedly exposed weaknesses in NCAs’ powers and cooperation/​coordination competences which are likely to require legislative remediation and which cannot easily be addressed through soft law action.612 The IFRS institutional space is a crowded one with the Commission, EFRAG, and ESMA all shaping how IFRS are applied, and NCAs responsible for supervision and enforcement. In practice, the different institutional wheels seem to interact smoothly. The Commission oversees the financial reporting system as a whole and manages the reform process, as can be seen in the 2021 ‘Fitness Check’; is the institutional lead on IFRS Foundation relations; and is the institutional location of rule-​making power, endorsing IFRS. EFRAG provides technical support to IFRS endorsement and, with ESMA, ensures open channels with the IASB. ESMA’s role sits between the Commission and EFRAG. It has used its supervisory convergence powers to craft an operational role which has allowed it to exert considerable influence on how IFRS are applied in practice, albeit that the soft law nature of its powers, and its wide reach, raises potential legitimation risks.613 NCA supervisory and enforcement practices, coordinated through ESMA’s EECS and shaped by ESMA’s GLEFI, are converging, albeit that the Wirecard scandal exposed significant institutional risks. Overall, while it is characterized by some inter-​institutional tension and dissonance, some legitimation grey zones, and NCA weaknesses, taken as a whole, this interlocking system allows the EU to react with some agility to emerging difficulties (as over the pandemic and in relation to IFRS 9) and gives it a considerable capacity to support the consistent application of IFRS.

II.7  Filing and Dissemination of Issuer Disclosures II.7.1  Substantive and Operational Harmonization The efficient filing and public dissemination of mandated issuer disclosures has long been the Achilles heel of the EU issuer-​disclosure regime; the intensity of substantive harmonization has not been matched by related operational dissemination initiatives. And as has 611 The annual reports of the EECS over financial years 2016-​2021 report on similar weaknesses in financial reports but also on increasing enforcement. 612 See section 5.10.1. Relatedly, four NCAs do not fully comply with the GLEFI given conflicts with national law or limited resources: ESMA, Guidelines Compliance Table, Guidelines on the Enforcement of Financial Information, January 2021 (Austria, Bulgaria, Germany, and Slovenia). 613 Some nervousness as to ESMA’s burgeoning influence over financial reporting and related legitimation risks can be seen from the 2017 consultation on reform of the ESAs. The Commission’s suggestion that ESMA be given additional empowerments over financial reporting, including direct enforcement powers, generated material hostility and was not included in the 2017 ESA Proposal, indicating the sensitivity of financial reporting for the market and NCAs. See, eg, Commission, Feedback Statement (ESA Reform Consultation) (2017) 11–​12.

II.7  Filing and Dissemination of Issuer Disclosures  187 been frequently observed, the fragmentation of issuer disclosure across different dissemination channels not only increases transaction costs for investors and obstructs issuers in signalling their quality (SMEs in particular), it also has the potential to weaken the effectiveness of the disclosure regime and so to threaten investor protection and efficient price formation.614 The disclosure regime has, however, long sought to enhance filing and dissemination. As noted in section 4.6, the 2017 Prospectus Regulation governs the filing and publication of approved prospectuses and provides for a nascent dissemination system based on NCA-​ based filing, ESMA acting as a digital repository, and public (primarily digital) publication. Ongoing issuer disclosures represent a significantly greater challenge, given the weight and range of this material, its multiple dissemination channels, and its central importance to price formation. The original 2004 Transparency Directive was designed to enhance public access to, and pan-​EU dissemination of, ongoing issuer disclosures. But while it established a basic framework for dissemination, and applied minimum standards to national filing and access systems, it was not successful in building a system for distributing disclosures. The 2013 Amending Transparency Directive envisaged a step-​change, with ESMA set to play a central role in a new operational phase of EU issuer-​disclosure regulation, based on the construction of an ESMA-​based European Electronic Access Point (EEAP). While this development foundered, the priority the 2020 CMU Action Plan has given to the construction of a European Single Access Point (ESAP) for issuer (and other) disclosures, and the related 2021 ESAP Proposal, augur well for a step-​change in the EU’s approach.

II.7.2  Filing Ongoing Issuer Disclosures A framework filing regime as regards ongoing issuer disclosures applies to ‘regulated information’ under the Transparency Directive. This concept covers the ongoing disclosure required of issuers under the Transparency Directive, the ad hoc disclosures required under the market abuse regime, and any super-​equivalent disclosure required by Member States where they exercise the Article 3(1) power to impose additional requirements to the Transparency Directive.615 All such regulated information must be ‘filed’ in the issuer’s home Member State: Article 19(1) provides that whenever an issuer discloses regulated information to the market it must, at the same time, file that information with the home NCA (Article 19(1)); that NCA may decide to publish the filed information on its website. The filing obligation extends to the information notified to the issuer under the major holdings notification regime (Article 19(3)). The filing of regulated information is not characterized as the distribution of disclosures, but simply as the deposit of information with the NCA; dissemination to the public is a distinct function and is based on the Officially Appointed Mechanism system, as discussed in the next section.

614 The High Level Forum on CMU, eg, warned that the lack of easily accessible, reliable, understandable, and comparable information was one of the reasons why EU firms, and particularly SMEs, struggled to attract investors: High Level Forum on the Capital Markets Union, A New Vision for Europe’s Capital Markets (2020) 11–​12. 615 Art 2(1)(k).

188 Capital-raising

II.7.3  Dissemination of Ongoing Issuer Disclosure Under the Transparency Directive, the home Member State must ensure that the issuer (or the person who has applied for admission to trading on a regulated market without the issuer’s consent) discloses ‘regulated information’ in a manner which ensures fast access to such information on a non-​discriminatory basis (Article 21(1)). The home Member State must require the issuer to use such media as may reasonably be relied on for the effective dissemination of information to the public throughout the EU, but may not require that issuers only use media whose operators are established on its territory. Although this regime is governed by the home Member State, an exception applies where the securities are admitted to trading on a regulated market in only one Member State where this is not the home State; in this case that State is responsible for ensuring dissemination in accordance with Article 21. The delegated 2007 Commission Directive imposes minimum standards on the dissemination of information in accordance with Article 21. This regime based on the principle that mere availability of information, which means that it must be actively sought out by investors, is not sufficient for the purposes of Article 21 and that dissemination should involve the active distribution of information from issuers, to the relevant media, and with a view to reaching investors (2007 Commission Directive recital 15). ‘Regulated information’ must also be made available to (and stored in) an ‘Officially Appointed Mechanism’ (OAM) (Article 21(2)). The home Member State must ensure that there is at least one OAM for the central storage of information which must meet minimum quality standards as to security, certainty as to information source, time recording, and easy access by end-​users (Article 21(2)). The national OAMs (typically NCAs but in some Member States market operators have been designated) were originally designed to, first, support the construction of national electronic networks (between, inter alia, NCAs, company registries, and regulated market operators); but also, second, to support the subsequent development of a pan-​EU single electronic disclosure network or a platform of related networks. But progress was slow. The Transparency Directive review underlined the costs and difficulties associated with information being held across the EU in different OAMs with a poor level of interconnection,616 and the related visibility difficulties for SMEs in particular.617 Although all Member States had OAMs in place, often closely integrated with local trading venues and regulated information services, dissemination across the EU occurred through multiple channels and integration levels were poor.618 A new model was accordingly adopted by the 2013 Amending Transparency Directive which sought to build on the technical capacity that ESMA provided. It provided that an ESMA-​based web portal serving as a ‘European Electronic Access Point’ (EEAP) was to be established by January 2018; the EEAP was to link Member States’ central storage mechanisms (or OAMs) and to provide an EU platform for access to all regulated issuer disclosures (Article 21a). While an RTS supporting the EEAP was adopted, ESMA paused work on it in 2018.619 More progress was made, however, with the related requirement, also imposed by the 2013 Amending Transparency Directive, for all annual financial reports to be prepared 616 Actica, Feasibility Study for a pan-​EU storage system for information disclosed by issuers of securities (2011). 617 2009 Mazars Report, n 472, xix. 618 2011 Actica Report, n 616. 619 Given budgetary restrictions: ESMA, Management Board Minutes, 13 December 2017.

II.7  Filing and Dissemination of Issuer Disclosures  189 in a ‘European Single Electronic Format’ (the ESEF) for financial years 2020 on (Article 4(7)); this reform was designed to support the standardization of disclosure formats and, thereby, centralized storage and dissemination. Following the required cost-​benefit assessment by ESMA, the relevant administrative rules were adopted in 2018,620 and the ESEF requirement, after a discretionary, pandemic-​related extension until 2021,621 came into force for all annual reports from 2021. While there have been some initial difficulties with the ESEF,622 it has, for the most part, been welcomed by stakeholders.623 A step-​change looks set to follow with the ambitious 2021 Proposal for the European Single Access Point (ESAP),624 a 2020 CMU Action Plan commitment, but which also forms part of the 2020 Digital Finance Strategy.625 The ESAP initiative is a large-​scale infrastructure project: reflecting stakeholder support for the ESAP to have a broad reach, it is designed to provide EU-​wide access, through a single access point which supports easy ‘searchability’, to all the regulated disclosures/​reports/​documents specified by the ESAP Proposal (not only issuer disclosures), and thereby to enhance market functioning.626 The Proposal, the development of which was supported by a series of technical reports,627 charges ESMA with the construction and governance of the ESAP: by 31 December 2024, ESMA is to establish and operate an ESAP providing ‘centralized electronic access’ to the information required to be made public under the measures specified in the Proposal’s Annex (including the Prospectus Regulation, the Transparency Directive, the IAS Regulation and the Market Abuse Regulation, and also MiFID II//​MiFIR, the UCITS/​AIFMD regimes, and the PRIIPs Regulation; but also financial services legislative measures generally, including under the banking and insurance regimes) and any future such measures.628 The ESAP also has a voluntary dimension: it is to provide access to other information of relevance to financial services provided in the EU or to capital markets of the EU or concerning sustainability that entities wish to make available on a voluntary basis about their economic activities (Article 1). In this regard the ESAP is designed to support voluntary dissemination by SMEs who sit outside the regulated-​market-​oriented issuer disclosure system.629 The design of the ESAP is based on relevant entities (those subject to the specified disclosure obligations 620 Delegated Regulation 2019/​815 [2019] OJ L143/​1. The Regulation specifies the XHTML language to be used for all annual financial reports, supporting machine-​readability. 621 The discretionary extension could be exercised by Member States to the financial year beginning 2021 and was achieved by the 2021 EU Covid Recovery Regulation. 622 Including in relation to the audit process, and relevant audit standards, for ESEF-​compliant financial statements. The Committee of European Auditing Oversight Bodies and Commission adopted related recommendations in 2019 and 2020, respectively. 623 2021 Fitness Check, n 464, 80–​1 (noting a reduction of up to 75 per cent in data access costs over time). 624 COM(2021) 723. The Proposal is accompanied by a proposal for an Omnibus Directive (COM(2021) 724) and Omnibus Regulation (COM(2021) 725), each of which make consequential amendments to relevant financial services measures to support the ESAP, including as regards the format in which disclosures are to be provided and how they are to be collected. 625 COM(2020) 591 (see Ch I section 7.3). The ESAP supports the Strategy’s ‘European financial data spaces’ agenda, which is based on all publicly disclosed financial information being disclosed in standardized and machine-​readable formats. 626 The ESAP is designed to support decision-​making and thereby to contribute to capital market integration, more efficient capital allocation, and the promotion of smaller national markets: 2021 Proposal, n 624, 1. 627 The Proposal’s IA examined the supporting studies and the required infrastructure/​ protocol reforms: SWD(2021) 344. 628 The operation of the ESAP (if adopted) is to be phased in over 2024–​2026, reflecting stakeholder support for a prioritized approach, but the Prospectus Regulation and Transparency Directive disclosures are to be prioritized: 2021 ESAP Proposal, n 624, 8. 629 2021 ESAP Proposal, n 624, 1.

190 Capital-raising or volunteering to provide disclosures) submitting the disclosures to a ‘collection body’ (in effect, either the relevant NCA or ESMA)630 and in accordance with specified requirements relating to the disclosures, including their format (as regards machine-​readability, for example); the collection bodies, inter alia, collecting, storing, and validating the disclosures and implementing the protocols for their automated transmission; and these disclosures then being transmitted by the collection bodies to the ESMA-​hosted ESAP, the functionalities of which, including as regards ‘searchability’, are specified in the Proposal, as are ESMA’s tasks as regards the ESAP, including as regards ESAP monitoring (in coordination with EBA and the European Insurance and Occupational Pensions Authority (EIOPA)). Access to the ESAP is to be free of charge (save for more specialist searches) and on a non-​ discriminatory basis. While the Proposal specifies certain minimum technical specifications, the ESAP will be supported by extensive administrative rules to be developed by the ESAs jointly. The ESAP Proposal is a significant landmark in the development of the single rulebook and forms a continuum with the similar consolidated tape proposal for trading transparency data under the 2021 MiFID III/​MiFIR 2 reforms (Chapter V). If adopted, the ESAP initiative will bring a marked operational tilt to EU financial markets governance, as well to issuer disclosure regulation, and has, relatedly, significant capacity to enhance the efficiency with which the market processes issuer and other disclosures.631 It also indicates how the development of EU financial markets governance is increasingly being shaped by the now extensive technocratic capacity provided by ESMA. ESMA, already charged with the operational supervision of data management, in particular through its supervision of trade repositories (Chapter VI), and recently conferred with direct supervisory powers over data reporting services provides (Chapter V), is well placed to construct and host the ESAP, and has been pivotal to its development, in particular through its construction of the ESEF reporting format. By embedding ESMA deeper into EU financial markets governance, the ESAP reform also, however, underlines the importance of ESMA’s underpinning legitimation arrangements.

II.8  Admission to Trading and to Official Listing II.8.1  Trading Venues and Capital-​raising Trading venues632 play a central role in the capital-​raising process given their capacity to support the signalling of issuer quality, and also to support the exchange/​transfer of 630 The accompanying Omnibus Regulation and Omnibus Directive reforms revise the relevant legislation to specify the collection body (ESMA in the case of the Prospectus Regulation; NCAs in the case of the Transparency Directive). 631 The IA reported on the host of difficulties, including that most company disclosures were accessed, in a fragmented manner, through company websites (79 per cent of responders to the Commission’s survey) (and so not OAMs) and disclosure formats were not standardized, adapted to digitalization, or easily searchable: 2021 ESAP Proposal IA, n 627 12–​13. The ESAP initiative enjoys strong support, with the Commission’s related 2021 consultation process reporting that 67 per cent of responders saw the benefits outweighing the costs: Summary Report, Targeted Consultation on the Establishment of an ESAP (2021). 632 Trading venue regulation is considered in Ch V and is addressed here only with respect to issuers and admission to trading (ie the primary market function of trading venues). This section uses the term ‘venue’ given the array of trading platforms beyond traditional stock exchanges on which organized trading can take place and which can come within the regulatory net, as discussed further in Ch V.

II.8  Admission to Trading and to Official Listing  191 securities, liquidity, price formation/​the management of information asymmetries, and contract conclusion and, thereby, investor exit (including by early stage investors such as venture capital funds through an IPO), which lowers issuers’ cost of capital. The admission of securities to trading is also associated with, inter alia, lowering issuers’ cost of capital for subsequent issuances, the funding by issuers of acquisitions, facilitating issuer access to debt finance, and, more generally, increasing issuer visibility and prestige, through the ‘bonding’ dynamic associated with adherence to trading venue admission rules (which also supports initial capital-​raising by issuers).633 Trading venues’ admission-​to-​trading rules, which are designed, relatedly, to support transferability, liquidity, and price formation, accordingly form part of the institutional structure that supports capital-​raising.634 In effect, the initial admission-​to-​trading process acts as a ‘filter’ mechanism, which supports issuers in signalling their quality; and the related ongoing requirements which subsequently apply, including with respect to ongoing disclosure, the minimum size of the issuer’s ‘free float’ (or shares in public issue), and corporate governance, serve to ‘bond’ issuers with a venue and thereby allow them to continue to signal quality.635 The admission-​to-​trading process also supports capital-​raising by serving as an instrument of trading venue competition, innovation, and specialization. Trading venues often operate a range of market segments which reflect different issuer and investor needs across the ‘funding escalator’. Admission to the ‘main’ segment (or venue) typically implies that the securities have been issued by a well-​established issuer which meets certain size and trading-​record requirements and which is subject to the highest admission standards. ‘Second’-​and ‘lower’-​tier segments (or venues) typically admit securities to trading on the basis of less onerous and more flexible issuer requirements, particularly with respect to size and trading record, and are designed to support more early stage, SME, or specialist issuers. Trading venues can accordingly innovate and compete with respect to their admission products and thereby meet different investor and issuer needs.636 Given its support of capital-​raising, the admission-​to-​trading process has long been of concern to regulators. Most regulatory attention has focused on the large, long-​established equity trading venues, which have long been regarded as a key element of the institutional structure supporting capital allocation and price formation. These venues typically act as a proxy for regulatory perimeter control with respect to mandatory issuer disclosure requirements in the ‘public’ markets and are, additionally, often subject to other mandatory admission standards. The central position of such trading venues in regulation and policy has, however, been questioned since the financial-​crisis era in particular. As private capital-​raising volumes soared in the aftermath of the financial crisis, doubts were cast on whether admission to trading on a public trading venue remained primarily capital-​raising in nature: the major equity trading venues became characterized less as capital-​raising 633 See, eg, Naes, R, Skjeltorp, J, and Ødegaard, B, ‘Stock Market Liquidity and the Business Cycle’ (2011) 66 J Fin 139 and Poser, N, ‘Restructuring the Stock Markets: A Critical Look at the SEC’s National Market System’ (1981) 56 NYULR 884. 634 An extensive literature addresses admission to trading rules and their type and function, particularly as monitoring mechanisms for firm governance. See, eg, Fleckner, A, ‘Stock Exchanges at the Crossroads’ (2006) Fordham LR 2541. 635 See, eg, Cheffins, B, ‘The Undermining of UK Corporate Governance (?)’ (2013) 33 OJLS 503 and Levine, R, ‘Financial Development and Economic Growth: Views and Agenda’ (1997) 35 J of Econ Lit 688. 636 Macey, J and O’Hara, M, ‘The Economics of Stock Exchange Listing Fees and Listing Requirements’ (2002) 11 J of Fin Intermed 297.

192 Capital-raising mechanisms and more as mechanisms for ensuring good stewardship in firms, for pooling liquidity and supporting efficient secondary market trading, and for, relatedly, supporting strong returns for savers.637 Since then, the continued growth in private capital-​raising and the increase in de-​listings from venues (as outlined in section 2), have kept concerns as to the effectiveness of the major public trading venues as capital-​raising mechanisms to the fore. In the UK, one of the major global centres for admission to trading, the 2021 Listing Review reported on a drop in admissions, a loss of trading venue competitiveness and a failure to attract international issuers, and an over weighting of ‘old economy’ issuers on trading venues, and called for a series of reforms to the admission process;638 it forms a continuum with the earlier 2012 Kay Review which had reported on a weakening of UK trading venues.639 In the EU, the CMU agenda is animated by similar concerns, with volumes of capital raised on major EU trading venues declining and de-​listings increasing.640 The weakening of EU trading venues as capital-​raising platforms can be associated with a host of factors, including de-​listings arising from private-​equity-​led acquisitions and also increased volumes of merger and acquisition activity, both fuelled by the accommodative monetary policy which prevailed until 2022.641 The regulatory costs associated with admission to trading, while not determinative, have, however, been associated with disincentives to admit securities to trading, particularly as regards SMEs.642 Regulatory reforms have been canvassed,643 including initially through the 2021 Listing Act consultation644 which led to the 2022 Listing Act reform agenda.645

637 See, eg, 2012 Kay Review, n 46, 10 and 14 and Commission Staff Working Document Accompanying the Green Paper on Long-​Term Financing of the European Economy (SWD(2013) 76) 22–​3, suggesting that major equity trading venues might act as providers of liquidity rather than as sources of issuer capital, and highlighting the decrease in the number of listed companies in the EU. 638 2021 Listing Review, n 46, reporting on, inter alia, a drop of 40 per cent in the number of listed companies from a 2008 peak, and on the UK hosting only 5 per cent of IPOs globally over 2015–​2020. The proposed reforms relevant to the admission process included allowing dual class share structures, reducing minimum ‘free float’ (shares in public issue) requirements, and rebranding the different ‘official listing’ segments. These reforms are being pursued under the wider reform to UK financial markets regulation being undertaken post Brexit. 639 2012 Kay Review, n 46. 640 This trend has been tracked in a series of CMU-​era reports. See, eg, 2020 Oxera Report, n 47, European IPO Task Force, European IPO Report (2020), and CEPS-​ECMI, Rebranding Capital Markets Union. A Market Finance Action Plan (2019). 641 eg, 2020 Oxera Report, n 47, reporting also on the ‘listing gap’ represented by some 8,000-​14,000 companies being appropriately placed for admission to trading, but choosing not to, primarily due to other and cheaper sources of debt financing (at 114). 642 eg 2020 European IPO Report, n 640, 11–​12 and 2020 CMU High Level Forum Report, n 614, 66 and 70, suggesting admission costs were a disincentive for SMEs in particular. References to the costs of admission are increasingly appearing across the rulebook. See eg Delegated Regulation 2019/​1011 [2019] OJ L165/​1 (on the SME Growth Market), recital 1, noting that companies that seeks to raise capital on trading venues face ‘high one-​off and ongoing disclosure and compliance costs’ which can act as a disincentive. 643 The CMU High Level Forum, eg, called for all issuers to be permitted to issue dual class shares (n 614, 66), while the 2020 Oxera Report recommended, as well as dual class share reform, a review of the disclosure regime, changes to the prudential regime to ease pension fund and insurance company investment, and retail-​oriented enhancements, including greater allocations to retail investors during the book-​building phase of a public offer. 644 It invited feedback on, eg, admission rules relating to the free float, multiple classes of voting rights, and corporate governance: n 12, 59–​70. 645 The 2020 CMU Action Plan argued that the admissions process was too cumbersome and costly, particularly for SMEs, and proposed a targeted simplification of admission requirements: 2020 CMU Action Plan, n 12. The 2022 Listing Act reform agenda (n 144) subsequently proposed, inter alia, the removal of the official listing regime and the adoption of harmonized minimum standards for multiple vote share structures on SME Growth Markets.

II.8  Admission to Trading and to Official Listing  193

II.8.2  Regulated Markets and Perimeter Control The ‘regulated market’ concept acts as a proxy for large public trading venues in the single rulebook and, as outlined in earlier sections, is one of the key perimeter controls on the EU issuer disclosure regime. It also sets the perimeter for the EU’s admission-​to-​trading rules. As previously noted, ‘regulated markets’ are those trading venues governed by the MiFID II/​MiFIR requirements for regulated markets, which include authorization, membership, access, and operating requirements, and which ‘opt-​in’ to this status (Chapter V).646 Trading venues choose regulated market status; it does not apply by regulatory fiat (the default status for most trading venues is that of ‘multilateral trading facility’ (MTF) (or ‘second-​tier venue’/​exchange-​regulated market)). Regulated markets are distinguished most clearly from MTFs by the mandatory admission standards which apply under MiFID II to regulated market issuers and which include the Prospectus Regulation’s prospectus requirements and the Transparency Directive’s ongoing issuer-​disclosure requirements, alongside other MiFID II admission-​to-​trading requirements. Trading venues accordingly ‘opt-​in’ to regulated market status where they seek the branding effects associated with this status as regards issuer access (or as regards their ‘primary market’ function). The EU’s reliance on the ‘regulated market’ as a form of perimeter control for issuer disclosure and also for admission-​to-​trading regulation generally is rooted in pragmatism and is shaped by legacy effects. Pre-​FSAP, the EU’s admission-​to-​trading rules were governed by the ‘official listing’ concept. The 1979 Admission Directive imposed harmonized admission requirements in respect of the admission of securities to ‘official listing’ on stock exchanges. Although this Directive did not define ‘official listing’, the regime was designed to cover that segment of an exchange’s market which offered the maximum guarantees for investors and in respect of which access was the most difficult. By imposing requirements on the official listing process, the Admission Directive thereby impliedly characterized trading venues as monopoly providers of admission or ‘listing’ services, which would, in the absence of controls, abuse their monopoly position.647 This regulatory model became outmoded as trading venues demutualized and became subject to competitive pressures, developed multiple trading segments, and competed in different ‘admission products’, and as increasingly large segments of major trading venues accordingly operated outside the official listing perimeter.648 The limitations of the official listing concept were a recurring theme of the subsequent FSAP reform period,649 and led to the adoption of the ‘regulated market’ model, initially based on the MiFID I (now MiFID II) regulated market definition, although the ‘official list’ concept still persists with respect to a subset of admission rules (as outlined in this 646 A ‘regulated market’ is a multilateral system which is operated and/​or managed by a market operator, and which brings together, or facilitates the bringing together, of multiple third party buying-​and-​selling interests in financial instruments (in the system and in accordance with its non-​discretionary rules) in a way that results in a contract, in respect of the financial instruments admitted to trade under its rules and/​or systems, and which is authorized and functions regularly in accordance with the MiFID II/​MiFIR rules for regulated markets: MiFID II Art 4(1)(21). 647 For this key analysis see Ferrarini, G, ‘The European Regulation of Stock Exchanges: New Perspectives’ (1999) 36 CMLR 569 and Ferrarini, G, ‘Securities Regulation and the Rise of Pan-​European Securities Markets: An Overview’ in Ferrarini, G, Hopt, K, and Wymeersch, E (eds), Capital Markets in the Age of the Euro (2002) 272. 648 Ferrarini, G, ‘Pan-​ European Securities Markets: Policy Issues and Regulatory Responses’ (2002) 3 EBOLR 249. 649 The 2001 Lamfalussy Report, eg, expressed concern at the failure of EU regulation to distinguish between admission to trading and admission to official listing: n 132, 13.

194 Capital-raising section below). The MiFID II definition of a ‘regulated market’ certainly reflects a policy concern to capture the importance to the public capital-​raising process of certain trading venues. But it is more deeply rooted in the fiercely contested negotiations on the liberalization of share trading in the EU, and on how different classes of equity trading venue should be regulated, including as regards trade transparency, which shaped the regulated market and other trading venue concepts (Chapter V). Accordingly, and while only regulated markets are subject to harmonized admission-​to-​trading requirements, the regulated market perimeter control does not represent a clear policy position on which trading venues should be subject to mandatory EU admission rules. This ambiguity has become more apparent as the EU has moved to address the treatment of MTFs/​second-​tier venues as regards admission requirements, and how admission rules can support SME access to capital, in particular (as outlined in this section below).

II.8.3  The Admission of Securities to Trading II.8.3.1 Regulated Markets MiFID II (Articles 51–​52) imposes minimum standards on securities admitted to trading on a regulated market in order to support transferability, liquidity, and price formation; these standards are designed as minimum, principles-​based standards to accommodate regulated market flexibility and ability to compete on ‘admission products’.650 The issuer disclosure regime is incorporated within the admission-​to-​trading framework in that regulated markets must, under Article 51(3), establish and maintain effective arrangements to verify that issuers of transferable securities admitted to trading comply with their disclosure obligations under EU law in relation to initial (prospectus), ongoing, or ad hoc (including Market Abuse Regulation) disclosure obligations. The regulated market must also establish arrangements which facilitate its members or participants in obtaining access to information which has been made public under EU law. Regulated markets are accordingly thereby enrolled in the institutional structure which supports oversight of the issuer disclosure regime. The admission regime otherwise focuses on free negotiability and on fair and orderly trading. Under Article 51(1), regulated markets must have clear and transparent rules governing the admission of financial instruments to trading which ensure that any financial instruments admitted to trading on a regulated market are capable of being traded in a fair, orderly, and efficient manner, and, in the case of transferable securities, are ‘freely negotiable’ (these rules must also ensure that the design of derivatives allows for orderly pricing and effective settlement (Article 51(2)). Compliance with these rules must be regularly monitored (Article 51(4)). Article 51(5) clarifies that where a transferable security has been admitted to trading on a regulated market, it can be subsequently admitted to other regulated markets, even without the consent of the issuer (who must, however, be informed by the regulated market where its securities are admitted).651 650 These requirements apply without prejudice to the other admission requirements of the parallel ‘official listing’ regime. 651 The issuer is not subject to any related disclosure obligations where it has not consented to the admission of the securities (the prospectus regime reflects this, applying the prospectus obligations, as relevant, to the person seeking admission to trading on a regulated market).

II.8  Admission to Trading and to Official Listing  195 These conditions governing the admission of financial instruments are amplified by RTS 2017/​568.652 It adopts a similar approach to the precursor 2006 Commission MiFID I Regulation,653 following a principles-​based model designed to allow regulated markets flexibility in designing admission requirements, although regulated markets are, reflecting MiFID II, subject to an over-​arching obligation to have in place procedures for verifying issuer compliance with their EU law obligations generally, including issuer disclosure obligations (RTS 2017/​568 Article 7). The RTS 2017/​568 admission regime is largely concerned with the conditions which govern whether a transferable security is ‘freely negotiable’ (only transferable securities are subject to the freely negotiable condition) and whether financial instruments generally can be traded in a fair, orderly, and efficient manner. As regards transferable securities (the class most relevant to issuers raising capital), high-​level principles, linked to transferability, apply to the notion of freely negotiable (Article 1).654 The Regulation also specifies how the assessment of whether a transferable security is capable of being traded in a fair, orderly, and efficient manner is to be carried out (Article 2). These requirements are primarily concerned with the assessment process, providing that the regulated market take into account, in the assessment, prospectus disclosures or other information publicly available (such as historical financial information, information about the issuer, and information providing a business overview); additionally, as regards shares, the distribution of the shares to the public (minimum distribution/​free float requirements are not imposed); and additionally, as regards specified and more complex securities (other than shares and bonds), whether a series of criteria are satisfied. ‘Officially listed’ securities (‘official listing’ is discussed below in this section) are automatically deemed to be freely negotiable and capable of being traded in a fair, orderly, and efficient manner (Article 3). While not directly relevant to capital-​raising, Article 4 addresses units and shares in collective investment schemes (see generally Chapter III) and requires that the regulated market ensure that the units or shares are permitted to be marketed in the Member State of the regulated market. Article 4 also requires that, in assessing whether the units in open-​ended collective investment undertakings are capable of being traded in a fair, orderly, and efficient manner, the regulated market take into account the distribution of the units or shares to the public, whether there are appropriate market-​making arrangements (or whether the scheme’s management company provides alternative redemption arrangements), and whether the value of the units or shares are sufficiently transparent to investors by means of the periodic publication of net asset value.655 Derivatives are addressed by Article 5 which, as regards the assessment of fair, orderly, and efficient trading, covers the terms of the contract establishing the derivative, the reliability and public availability of the price of the underlying, the sufficiency and public availability of the information required to value the derivative, and settlement arrangements. 652 RTS 2017/​568 [2017] OJ L87/​117. 653 Commission Regulation 1287/​2006 [2006] OJ L241/​1. 654 Under Art 1, securities are freely negotiable if they can be traded between the parties to a transaction and subsequently transferred without restriction, and where all securities of the same class are fungible. Transferable securities that are subject to a restriction on transfer are not to be considered as freely negotiable unless that restriction is not likely to disturb the market (this alleviation recognizes that some Member States allow certain types of issuer to approve a transfer of securities). Transferable securities that are not fully paid can be considered as freely negotiable where arrangements are made to ensure that negotiability is not restricted and adequate information concerning their partly paid status and the implications is publicly available. 655 On net asset value see Ch III.

196 Capital-raising MiFID II also addresses the procedures governing the suspension and removal of financial instruments from regulated markets (Article 52)656 in order to ensure that any such action is coordinated across the range of regulated markets (and other venues) on which an instrument may be trading, and that any related market abuse or disorderly trading risks are thereby avoided. Where the suspension or removal is due to suspected market abuse, a takeover bid, or non-​disclosure of ‘inside information’ about the issuer or financial instrument in breach of the market abuse regime, distinct procedures apply, designed to protect the efficiency and integrity of pan-​EU trading in the instrument. MiFID II and RTS 2017/​568 do not, therefore, dictate particular conditions, such as the minimum free float necessary, or specify minimum trading record/​financial history requirements (by contrast with the official listing regime), but allow regulated markets significant discretion. While the result has been significant diversity in admission rules and products across the EU there is little evidence that this diversity is associated with obstructive costs to issuers or risks to investors.657

II.8.3.2 Official Listing A parallel regime applies to admission to ‘official listing’ under the 1979 Admission Directive, which remains in force under the 2001 Consolidated Admission Requirements Directive (CARD; also termed the ‘Listing Directive’).658 The MiFID II admission-​to-​trading regime is designed to support trading in securities, primarily by ensuring orderly trading in the admitted securities and by, relatedly, supporting price formation. The persistence of the ‘official listing’ system in parallel carries with it the assumption that officially listed securities are of a higher quality than those simply admitted to trading on a regulated market. But it is not clear what official listing is, additionally, designed to achieve, particularly as regulated markets, through their admission requirements, can signal quality. The oversight of official listing by a public authority rather than a regulated market might mark a clearer distinction between both systems, but the official listing regime does not require that official listing is supervised by a public authority. Similarly, extensive derogations are available from the official listing requirements, so official listing status does not imply the application of a standard set of rules. The regime was originally designed in part to support multiple official listings and related mutual recognition, but this objective has become something of an anachronism given the ease with which securities admitted to one regulated market can be traded pan-​EU. It was also designed to control monopolistic exchanges’ abuse of their position—​an objective which has had a similar fate. Nonetheless, and even allowing for the departure from the EU of the UK, one of the main adherents to the official listing concept,659 official listing remains relevant 656 Art 52 is amplified by Implementing Regulation 2017/​1005 [2017] OJ L153/​1. 657 For a recent analysis of stakeholder opinion see 2020 Oxera Report, n 47, chs 3 and 4. 658 Directive 2001/​34/​EC [2001] OJ L184/​1. The admission to official listing regime is covered in Arts 1 (definitions), 2 (scope), 5–​7 (general admission conditions), 8–​9 (ability of Member States to impose more stringent conditions and derogation regime), 11–​15 (powers of the NCA relating to official listing), 16 (information requirements), 17–​19 (action where an issuer fails to comply with official listing conditions), 42–​64 (the core of the regime: specific obligations in respect of particular securities, including shares, debt securities, and sovereign debt securities), 64 (treatment of newly issued shares of the same class as those officially listed), and 105–​7 (general rules applicable to NCAs). 659 The ‘official listing’ concept operates in the UK through the ‘Official List’ maintained by the UK Financial Conduct Authority. Prior to Brexit, the Official List regime stood independently of, albeit closely connected to, the minimum-​standards regime which UK regulated markets applied to the admission of securities under MiFID II. The design of Official Listing is under review as part of the UK Listing Review, with Official Listing likely to be

II.8  Admission to Trading and to Official Listing  197 and in use in some Member States. Its removal may also be hazardous in the absence of careful analysis, including of the impact on investment mandates, particularly as there is little evidence that the regime is disruptive, the ambiguities are more a matter of conceptual untidiness than substantive difficulty, and regulated markets retain wide discretion under MiFID II to operate distinct market segments. The 2022 Listing Act reform agenda, however, proposed its abolition.660 The official listing regime applies to securities which are ‘admitted to official listing or are the subject of an application for admission to official listing on a stock exchange situated or operating within a Member State’ (CARD Article 2(1)). The Directive does not define ‘official listing’ or ‘stock exchange’. The standards are pegged at a minimum level with Member States enjoying a general power to adopt additional and more stringent conditions (Articles 8(1) and (2)), subject to a non-​discrimination principle. Article 12 also allows Member States, ‘solely in the interests of protecting the investors’, to permit NCAs to subject the listing of a particular security to such ‘special conditions’ as they deem appropriate and which have been notified to the applicant issuer. Member States may also authorize derogations from any additional or more stringent obligations which they impose, although only where they ‘apply generally for all issuers where the conditions justifying them are similar’ (Article 8(3)). Similarly, the Directive’s admission conditions can be subject to derogations, as long as the non-​discrimination principle is met.661 The admission conditions for shares and debt securities are set out in Article 6(1), Articles 42–​51 (shares), and Articles 52–​63 (debt securities) and include: minimum capitalization requirements,662 operating history requirements (shares only),663 free transferability and negotiability requirements,664 and minimum distribution or ‘free float’ requirements.665 The disclosure requirements for officially listed securities are subsumed within the prospectus and transparency regimes. Oversight of the official listing regime is carried out by NCAs (Article 11), but reflecting the dominance of exchange self-​regulation when the official listing regime was adopted in 1979, the Directive does not stipulate that the NCA take a particular legal form or be a public authority. The official listing function can therefore be carried out by trading venues.

simplified and subject to minimum standards (the current regime is ‘super equivalent’ to the CARD). The review has also led to a liberalization of the regime’s free float rules and its restrictions on dual class voting shares. See, eg, FCA, Primary Markets Effectiveness Review (2021) and FCA, Feedback to the Discussion of the Purpose of the Listing Regime and Further Discussion (2022). 660 The Commission argued, inter alia, that the official listing regime was not used in many Member States, gave significant discretion to Member States to deviate from its requirements, and led to confusion with the MiFID II admission to trading process. It also proposed, however, that its requirements relating to free float and minimum capitalization be incorporated in the MiFID II admission regime and liberalized (including by means of a reduction of the current free float requirement for shares from 25 per cent to 10 per cent). 661 The 2021 Listing Act Consultation noted the ‘rather broad discretion’ given to Member States: n 12, 61. 662 A €1 million requirement is imposed for shares, although derogation is permitted where an ‘adequate market’ will be created in the shares (Art 43). A €200,000 requirement is imposed on debt securities (Art 58). 663 A total of three years of financial accounts are required for shares although, again, derogation is permitted where investors have the information necessary to make an informed judgement on the issuer and the shares (Art 44). 664 Article 46 (shares) and Art 54 (debt securities). 665 The distribution requirement is met for shares when the shares in respect of which the application is made are in the hands of the public to the extent of at least 25 per cent of the subscribed capital represented by the class of shares concerned. A lower percentage will fulfil the sufficiency requirement when, in view of the large number of shares of the same class and the extent of their distribution to the public, the market will operate properly with a lower percentage: Art 48(5). In practice, free float requirements in the EU vary from 5 per cent to 45 per cent: 2021 Listing Act Consultation, n 12, 63.

198 Capital-raising

II.8.3.3 SME Admission to Trading and SME Growth Markets The CMU concern to support SMEs has brought their access to trading venues on to the regulatory reform agenda, including as regards regulated market admission.666 The trading venue regime is, however, already differentiated between regulated markets, subject to mandatory issuer disclosure and admission requirements, and other trading venues (MTFs or ‘second-​tier’ venues/​exchange-​regulated markets)). These other trading venues operate outside the perimeter of the EU issuer disclosure/​admission-​to-​trading regime and, accordingly, where these trading venues apply lighter rules, are more accommodating to SME issuers. The recent growth of these venues is a function of a series of factors, but regulatory reform, and in particular the MiFID II SME Growth Market reform, has been a key variable. Although second-​tier trading venues had been developing in the EU since the mid-​ 1990s in particular,667 the adoption of the FSAP issuer-​disclosure regime, and the related application of the regulated market perimeter, prompted strong growth in the second-​tier/​ MTF trading venue segment. Leading examples included the London Stock Exchange’s Alternative Investment Market (AIM), Euronext-​NYSE’s Alternext, and Deutsche Börse’s Entry Standard. By 2011, some twenty trading venues operated second-​tier/​MTF venue segments outside the regulated market perimeter.668 The second-​tier/​MTF trading venue sector came under increased scrutiny as the financial crisis period receded and EU (and international) attention turned to market efficiency and the role of trading venues in supporting SME finance.669 A specialist second-​tier/​MTF trading venue classification and regulatory regime followed under MiFID II, which established the ‘SME Growth Market’ as a discrete form of second-​tier/​MTF trading venue (MiFID II Article 33). The reform, which was broadly uncontroversial over the MiFID II/​ MiFIR negotiations,670 was designed to address the visibility and branding difficulties then associated with second-​tier/​MTF trading venues, as well as the related liquidity and volatility risks and issuer costs,671 and thereby to facilitate the development of such venues and their capacity to support smaller and more specialist issuers. The regime and the related SME Growth Market label is available to second-​tier/​MTF trading venues on an opt-​in basis (Article 33(1)). In force since January 2018, the regime experienced early reform, underlining the centrality of SMEs to the CMU agenda and the EU’s appetite for related regulatory reform, but also the ‘stickiness’ of the frictions SME issuers face as regards trading venue admission. The

666 The High Level CMU Forum, eg, called for the establishment of a new class of issuer, the ‘Small and Medium Capitalization Company’ which, with a market capitalization of below €1 billion, would benefit from a five-​year transition period as regards the application of relevant rules when it was admitted to a regulated market: n 614, 66. 667 See Röell, A, ‘Competition among European Exchanges’ in Ferrarini, G (ed), European Securities Markets. The Investment Services Directive and Beyond (1998) 220–​2. 668 Commission, 2011 MiFID II/​MiFIR Proposals Impact Assessment (SEC(2011)1226) 98. 669 eg Schwartz, J, ‘The Twilight of Equity Liquidity’ (2012) 34 Cardozo LR 531 and Högborn, C and Wagenius, H, ‘Growing Necessity for Innovative SME Exchanges in Europe’ (2011) 226 World Federation of Exchanges Focus 7. 670 The Council was broadly supportive of the Commission’s proposal (Cyprus Presidency Progress Report on MiFID II/​MiFIR, 13 December 2012 (Council Document 16523/​12)). The Commission earlier reported that the Member States with the most active SME markets (Germany, France, and the UK) were supportive, and that a lack of support from some stakeholders could be related to the Commission’s failure to clarify that the new regime was designed to operate as an opt-​in ‘quality label’ and not to restrict the then-​current range of second-​tier trading venues: 2011 MiFID II/​MiFIR Proposal IA, n 668, 36–​7. 671 2011 MiFID II/​MiFIR Proposal IA, n 668, 11 and 34.

II.8  Admission to Trading and to Official Listing  199 2017 CMU review highlighted the persistent difficulties672 and paved the way for the 2019 SME Regulation reforms to the SME Growth Market, only a year after the regime had come into force.673 The Regulation signalled concern as to the ‘low uptake’ of the new regime,674 adopted a series of alleviations from the Market Abuse Regulation for SME Growth Market issuers,675 and expanded the alleviations the Prospectus Regulation had already introduced for SME issuers (chief among them the EU Growth Prospectus), including by making available a simplified prospectus for issuers seeking to transfer from an SME Growth Market to a regulated market (section 4.9.4). Since then, the priority given to the SME Growth Market as a means for supporting SMEs has been underlined by the further 2019 adjustments to its operation (through administrative rule reform) which have, inter alia, alleviated how its admission requirements apply to SME bond issuers.676 Registration as a MiFID II SME Growth Market (which is carried out by the relevant trading venue’s home NCA) requires that the venue comply with the MiFID II Article 33 criteria, as amplified by Delegated Regulation 2017/​565.677 Under Article 33, the trading venue must be primarily designed to support SME trading, in that at least 50 per cent of the issuers admitted to trading are qualifying SMEs at the time the venue is registered as an SME Growth Market and in any calendar year thereafter: the 50 per cent headroom given for non-​SME issuers is designed to support the liquidity and profitability of SME Growth Markets generally, as well as to allow SME issuers to grow while on the market. A capitalization criterion is used to capture the qualifying SMEs that the SME Growth Market reform is designed to support: SMEs for this purpose are defined as companies that had an average market capitalization of less than €200 million on the basis of end-​year quotes for the previous three calendar years.678 The eligibility of SMEs issuing debt securities only was originally tied to a more specified definition (tied to firm size indicators, not capitalization).679 Given weaknesses in the SME bond markets,680 this definition was revised and expanded in 2019 (by administrative rules) to cover any issuer (regardless of size) of debt securities 672 Among its headline findings were the existence of a ‘clear IPO gap’ and ‘marginal at best’ reliance on market finance: n 115, 38–​48. Relatedy, the difficulties caused by thin liquidity in SME securities were a major theme of the Commission’s 2017 review of SME trading venue admission: Commission, Building a Proportionate Regulatory Environment to Support SME Listing (2017). On SME access to market finance difficulties generally see section 3.6. 673 COM(2018)331 and Regulation (EU) 2019/​2115 [2019] OJ L320/​1. 674 The 2018 Proposal had noted the need to ‘promote’ the SME Growth Market and to strike the right balance between investor protection and market integrity, on the one hand, and cost reduction on the other: at 1. Similarly, the Regulation noted the need to ensure the SME Growth Market was differentiated from other MTFs and benefited from distinct regulatory alleviations in order to ensure sufficient incentives to adopt the new model (recital 3). 675 As regards the obligation to maintain ‘insider lists’, delays to the publication of ‘inside information’, the use of liquidity contracts to support share trading, and the application of the market soundings regime: see Ch VIII. 676 Delegated Regulation 2019/​1011 [2019] OJ L165/​1. These adjustments include an expansion of the scope of the bond issuers eligible for qualifying SME status, as noted in this section below. Bond issuance on SME Growth Markets is low, reflecting issuance costs, the availability of alternative bank loans and credit lines, the dominance in the bond markets of institutional investors who do not typically invest in SME issuances (given, inter alia, liquidity risks), regulatory costs, and a limited number of arranging banks: 2021 ESMA SME Growth Market Review, n 159, 10–​11. 677 [2017] OJ L87/​1. 678 MiFID II Art 4(1)(13). Delegated Regulation 2017/​565 clarifies how the market capitalization is to be calculated: Art 77(1). On the definition of SMEs more generally, including under the prospectus regime see n 146. 679 Delegated Regulation 2017/​565 originally provided that a non-​equity issuer was a qualifying SME where, reflecting the Prospectus Regulation SME definition, as at its last annual or consolidated accounts, it met two of three criteria: average number of employees less than 250, total balance sheet not exceeding €43 million, and net turnover not exceeding €50 million: Art 77(2). 680 See n 676.

200 Capital-raising only, where the nominal value of the issuer’s debt instruments over the previous calendar year, on all EU trading venues, does not exceed €50 million.681 As ‘SME-​type’ firms issuing debt securities tend to be larger firms,682 the original definition, tied to smaller firms, was preventing trading venues specializing in SME debt issuances (or in debt and equity issuances) from registering as SME Growth Markets and thereby limiting the reach of the SME Growth Market regime.683 Specific admission criteria do not apply to the SME Growth Market under Article 33, but ‘appropriate’ criteria must be set by the venue.684 The quality of issuer disclosure is, however, addressed by Article 33, as amplified by Delegated Regulation 2017/​565. On initial admission to trading of the issuer’s financial instruments, there must be sufficient information published to enable investors to make an informed judgement about investing in the instruments (either through an ‘appropriate admission document’ or a prospectus under the prospectus regime). The SME Growth Market must also have in place rules governing the minimum content of the ‘appropriate admission document’ and that are designed to ensure that, in an echo of the prospectus regime, ‘sufficient information is provided to investors to enable them to make an informed assessment of the financial position and prospects of the issuer, and the rights attaching to its securities’.685 While NCA approval is not required for these admission documents, the SME Growth Market must make arrangements for them to be subject to an ‘appropriate review’ of their ‘completeness, consistency, and comprehensibility’, again in an echo of the ‘3Cs’ against which NCAs review prospectuses.686 The admission document requirement accordingly places some guardrails around the disclosure provided, albeit at a highly principles-​based level and without any of the specificities, such as summary and risk factor disclosure requirements, that apply under the prospectus regime.687 ‘Appropriate ongoing periodic financial reporting’ is also required, in the form of a requirement for the publication of annual financial reports within six months of the financial year end and half-​yearly reports within four months of the financial year end.688 In another alleviation for the SME bond markets, the venue may exempt issuers of debt securities only from the half-​yearly requirement.689 The SME Growth Market admission regime is therefore principles-​based and allows venues very significant latitude in how they design their ‘admission products’. The 2019 administrative rule revisions tightened the regime 681 Delegated Regulation 2017/​565 Art 77(2), as revised by Delegated Regulation 2019/​1011. 682 Such issuers issuing debt only were reported, during the development of the 2019 SME Regulation, as having turnover of up to €400 million, well in excess of the €50 million threshold applicable under Delegated Regulation 2017/​565. 683 Delegated Regulation 2019/​1011 recital 3. 684 Amplified by the requirement that admission rules must provide for ‘objective and transparent criteria’ for initial and ongoing admission: Delegated Regulation 2017/​565 Art 78(2)(a). 685 Delegated Regulation 2017/​565 Art 78(2)(d). The Regulation further specifies that the document must state whether it has been approved and reviewed (and by whom); and whether the issuer’s working capital is sufficient for its present requirements and, if not, how the additional capital will be provided: Art 78(2)(c) and (e). 686 Delegated Regulation 2017/​565 Art 78(2)(f). 687 In practice, extensive disclosure requirements are required by SME Growth Markets, as is reflected in the EU Growth Prospectus being modelled on MTF practice: see section 4.9.7. SME issuers (as defined under the broader Prospectus Regulation definition) can avail of the lighter EU Growth Prospectus in admitting their securities, where this is accepted by the SME Growth Market, and to support any related public offer. 688 Delegated Regulation 2017/​565 Art 78(2)(g). 689 This alleviation (which, if exercised, prevents the relevant NCA from imposing such a requirement) was introduced in 2019, removing the original requirement imposed by Delegated Regulation 2017/​565 on the grounds that it was disproportionate, given that many SME-​oriented MTFs do not require half-​yearly reporting and that its imposition was discouraging venues from registering as SME Growth Markets: Delegated Regulation 2019/​1011 recital 4.

II.8  Admission to Trading and to Official Listing  201 somewhat, however, by requiring SME Growth Markets, in order to support liquidity, to impose a ‘free float’ requirement, the nature of which is to be established by the venue.690 Organizationally, the SME Growth Market must have in place systems and procedures for the storage and public dissemination of regulatory information relating to issuers. Market abuse controls apply: admitted issuers (and persons discharging managerial responsibilities within the issuer (and persons closely associated with them)) must comply with the Market Abuse Regulation; and effective controls and systems aimed at preventing market abuse must be in place. The Market Abuse Regulation regime dovetails with Article 33, however, providing that a lighter ad hoc issuer-​disclosure regime (as regards the disclosure of ‘inside information’) applies to SME Growth Market issuers.691 A venue may be de-​registered as an SME Growth Market where it no longer complies with these conditions. The SME Growth Market regime is still in its infancy, applying only since 2018 and revised in 2019 by the 2019 SME Regulation and by related administrative rule reforms. Not all trading venues specializing in SMEs have opted for the designation,692 and the segment is fragmented,693 although there are signs of growth,694 with specialist SME Growth Markets developing.695 An example of how the single rulebook can construct facilitative vehicles,696 there is much that augurs well for the regime’s development, including the agility with which it has been refined and, relatedly, its calibration to the distinct issues raised by the SME bond markets. Further, the regulatory ecosystem within which the SME Growth Market sits is becoming increasingly SME-​oriented, by means of the SME-​related reforms introduced by the 2017 Prospectus Regulation and by means of the Market Abuse Regulation regime facilitating venues’ liquidity-​supporting measures.697 The first major review of the SME Growth Market regime (by ESMA) was broadly positive and, reflecting strong stakeholder support for SME Growth Market flexibility, did not propose any major reforms.698 Nonetheless, SME access to market finance remains limited, as outlined in section 3.6, regulatory reform can address only some of the ecosystem difficulties, and the deregulatory priority currently animating SME regulatory policy must be balanced with market integrity and efficiency and investor protection, particular retail investor protection, imperatives. Further, any material expansion of the SME Growth Market sector may not be an unalloyed success,699 while the related fragmentation in the trading venue landscape has 690 Delegated Regulation 2019/​1011, adding a new Art 78(2)(j) to Delegated Regulation 2017/​565. 691 See further Ch VIII. 692 As at 2021, some 15 MTFs oriented to SME issuers had not registered as SME Growth Markets: 2021 ESMA SME Growth Market Review, n 159, 9. 693 Sweden is the largest SME market by trading volume, followed by Italy and France: 2021 ESMA SME Growth Market Review, n 159, 9. 694 2019 saw a high-​profile addition, with the adoption by Euronext Growth of the SME Growth Market designation. 17 MTFs had registered as SME Growth Markets in early 2021: 2021 ESMA SME Growth Market Review, n 159, 9. 695 Such as Borsa Italiana’s ExtraMOT Pro3 segment which launched in September 2019 and is designed to support bond issuances by SMEs with high growth potential: Allen & Overy, ExtraMOT PRO3: the new features of the Borsa Italiana segment (2020). 696 The collective investment scheme regime adopts a similar approach, constructing particular forms of fund to support capital-​raising. See Ch III. 697 See Ch VIII section 8.2 on ‘accepted market practices’ as regards liquidity provision and the related Market Abuse Regulation requirements. 698 ESMA’s 2021 review reported on strong market support for allowing venues discretion and flexibility in their admission requirements and to design proprietary admission requirements that best supported liquidity. While ESMA indicated its support for some harmonization of disclosure requirements in the medium term, it accordingly did not propose any immediate reforms: 2021 ESMA SME Growth Market Report, n 159, 16–​20. 699 eg, ESMA has cautioned against raising the €200 million capitalization qualifying threshold for SME designation, for the purposes of the SME Growth Market, including on the ground that any incentives created thereby

202 Capital-raising been associated with the challenges SMEs face.700 Given that the SME Growth Market has become something of a laboratory for how the rulebook supports SMEs, its regulation is, however, likely to remain dynamic for some time.

II.9  Capital-​raising and Investment Research II.9.1  Investment Research, Gatekeeping, and Regulation Issuer disclosure is the primary focus of this chapter but a brief excursus into the EU’s regulation of the provision of investment research, and its relationship with the capital-​raising process and issuer disclosure, is warranted. Investment analysts form part of the institutional apparatus that supports market efficiency in that they assess issuer disclosure and produce related investment research/​recommendations (typically ‘buy’, ‘sell’, ‘hold’, and variations thereof) and, through this monitoring of issuers, support price formation and, relatedly, liquidity. They have, accordingly, long been associated with mitigating the difficulties and costs that issuers face in signalling the credibility of their disclosures and the quality of their securities, and with minimizing the related risk that their securities are discounted (and the cost of capital increased).701 Weak analyst coverage is, relatedly, counted among the institutional difficulties faced by SMEs in the EU as they typically attract less analyst coverage than larger firms and so face related price formation and liquidity risks. Given the importance of investment research in supporting market efficiency, one of the driving rationale for mandatory issuer disclosure is that it reduces the information costs of investment analysts.702 The embedding of investment analysts within the mechanisms of market efficiency, and the related privileging of mandatory issuer disclosure as a regulatory tool, is a function of analysts’ associated ‘gatekeeper’ function. As discussed further in Chapter VII in relation to credit rating agencies, gatekeepers are typically characterized as independent market actors who provide verification or certification services to investors and to the market, and whose credibility in so doing relies on their ‘reputational capital’.703 Built up over time, and derived from the gatekeeper’s independence and competence, this asset drives the ability of the gatekeeper to act as a credible market monitor. Accordingly, gatekeepers, before the defining Enron-​era and global-​financial-​crisis-​era shocks, were typically subject to little or no regulation. Given the importance of reputational capital to the gatekeeper business model, any distorting incentives to, for example, collude with the relevant issuer and to move from regulated markets would not be desirable in light of the high standards applicable to regulated markets: 2021 ESMA SME Growth Market Review, n 159, 15. 700 Annunziata, n 246, querying whether the strong but ‘random’ growth in SME Growth Market/​second-​tier segments supports SME financing. See also Peronne (2020), n 163, 252, calling for a central pan-​EU SME trading venue, which would benefit from strong labelling effects, and which would be subject to mandatory rules to support robust screening, investor protection, and deep liquidity. 701 Black, n 5. 702 Coffee’s seminal work on the role of analysts justified the imposition of mandatory issuer-​disclosure requirements in part by the informational efficiencies and cost reductions mandatory requirements would generate for analysts, who would accordingly be able to cover a wider range of issuers: Coffee, n 62. 703 For a review of the gatekeeping function and its regulation see Payne, J, ‘The Role of Gatekeepers’ in Moloney et al, n 60, 254.

II.9  Capital-raising and Investment Research  203 extract related rents, were assumed to be counter-​balanced by the likely subsequent erosion of reputational capital and damage to the gatekeeper’s business model. As outlined in Chapter VII, the global financial crisis exposed the weaknesses in this approach as regards credit rating agencies. But previously, the massive 2001 Enron bankruptcy, which marked the end of the ‘dotcom’ equity market boom (1995–​2001), had provided the paradigmatic case of how investment analyst reputational capital could be eroded and laid the foundations of the current regulatory approach towards investment research/​analysts in the EU and internationally.704 The Enron collapse exposed systemic failures by investment analysts who had continued to rate Enron as a ‘buy’ immediately prior to its collapse, notwithstanding the evidence publicly available as to its precarious financial position.705 The structural conflict-​of-​interest risks to which ‘sell side’706 investment research in the multi-​service investment firm is exposed were heavily implicated. In the multi-​service firm, proprietary investment research which presents a positive view of an issuer’s financial position and prospects and so a strong ‘equity story’ can potentially, and as was the case with Enron and a number of other high profile failures at the time, be used to, inter alia, attract corporate finance business, including underwriting business; to ‘pump’ IPOs; to, where positive research is ‘front run’ or leaked in advance to trading desks, generate profits for proprietary dealing; to inflate firms’ investments in IPOs; and, where research is passed across information barriers, to privilege leading clients.707 The incentives to produce research which presents a positive view of an issuer but which is either partial, distorted, misrepresented or, in the most serious cases, fraudulent, and to breach related market abuse rules (and firm information barriers)708 are therefore high-​powered and deep. Prior to the Enron-​era series of bankruptcies, and over the ‘dotcom’ equity market boom, these conflict-​of-​interest risks crystallized and were exacerbated by a series of interrelated factors which degraded the capacity of reputational capital to manage these conflicts, including the market exuberance associated with the ‘dotcom’ equity market boom which disabled investor caution and devalued the gatekeeper function. The ‘dotcom’ era came to an abrupt end with a series of equity market scandals, chief among them the Enron bankruptcy, which led to a collapse in the US equity market following the unravelling of biased positive ‘buy’ recommendations as financial failures were exposed. A series of reforms followed in the US709 and internationally.710 704 The role of investment analysts but also auditors in the Enron-​era equity market scandals and the nature of the subsequent regulatory reform movement generated a vast scholarship, particularly on the US experience. See, eg, Coffee, J, The Role of the Professions in Corporate Governance (2006); Choi, S, ‘A Framework for the Regulation of Securities Markets Intermediaries’ (2004) 1 Berkeley Business LJ; and Macey, J, ‘Efficient Capital Markets, Corporate Disclosure and Enron’ (2004) 89 Cornell LR 394. 705 In October 2001, shortly before the Enron bankruptcy, sixteen of the seventeen analysts covering Enron maintained ‘buy’ recommendations in respect Enron shares: Coffee, J, ‘Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms’ in Ferrarini, G, Hopt, K, Winter, J, and Wymeersch, E (eds), Reforming Company and Takeover Law in Europe (2004) 455, 466. 706 The sell side of the market concerns the origination, marketing, and sale of securities. The buy side concerns the trading/​dealing and investment activities of major institutional investors. 707 The failures of investment research over this period were exacerbated by linkages between analyst remuneration and the performance of business divisions and the related emergence of the ‘cult’ of the ‘star analyst’ with the power to drive mass retail investor sentiment. See references at n 704. 708 Prior to publication, investment recommendations are typically regarded as ‘inside information’. 709 The Enron scandal led, inter alia, to the adoption of the 2002 Sarbanes-​Oxley Act which introduced a range of corporate governance reforms, including SEC rules requiring the certification of analyst reports. 710 See, eg UK Financial Services Authority (FSA), Conflicts of Interest: Investment Research and Issues of Securities (2003), highlighting international developments. The reforms included IOSCO’s adoption of principles: IOSCO, Statement of Principles for Addressing Sell-​Side Securities Analyst Conflicts of Interest (2003).

204 Capital-raising Regulatory reform poses challenges, however, given the importance of investment research to effective price formation and, accordingly, the risks of under-​production.711 Investment research, particularly where it is not subject to fees and is subsidized by other businesses within the multi-​service firm, is a costly process712 and the imposition of excessive regulatory costs can prejudice the effectiveness of price formation where investment research is, in consequence, underproduced, particularly research on SMEs.713 While the related EU regime is now well-​established, it continues to grapple with the problem of under-​production of SME investment research, as the ‘unbundling’ saga, outlined in this section below, suggests.

II.9.2  The Evolution of the EU’s Response The EU’s investment research ‘rulebook’ has developed over time. The US Enron-​era scandals might have been expected to trigger a ‘copycat’ regulatory reform in the EU, particularly given the regulatory orientation of the FSAP agenda which then framed regulatory policy. That they did not can be related to the structure then of EU financial markets (including as regards the relative thin-​ness of EU equity markets, the much less developed household equity culture as compared to the US,714 and the dominance of block-​holding investors with the capacity to monitor issuers and a lesser dependence on analysts),715 and the comparatively more limited set of gatekeeper conflict-​of-​interest scandals,716 which blunted appetite for reform. The Commission’s initial response to the Enron-​era scandals took the form of a review717 and the establishment of the Forum Group on Financial Analysts which recommended a self-​governance approach.718 Subsequently, the administrative rule-​ making processes for the FSAP-​era 2003 Market Abuse Directive and 2004 MiFID I led to the adoption of administrative rules on the presentation of investment research, under the market abuse regime, and on the management of conflict of interests, under MiFID I. This development, which laid the foundations of the current regime, can be strongly associated with the FSAP-​era turn to deploying administrative rules. Investment research was only tangentially referred to in the Market Abuse Directive and in MiFID I, but their mandates for ‘fair presentation’ investment research administrative rules (in the case of the market abuse regime), and for general investment firm conflict-​of-​interest rules (in the case of 711 For criticism of the US response see Romano, R, ‘The Sarbanes-​Oxley Act and the Making of Quack Corporate Governance’ (2005) Yale LJ 1521. 712 Choi, n 3, noting that public-​good dynamics prevent analysts from capturing fully the costs of their work from the investment community. 713 For an FSAP-​era analysis see Cervone, E, ‘EU Conduct of Business Rules and the Liberalization Ethos: The Challenging Case of Investment Research’ (2005) EBLR 421. 714 See Langevoort, n 91. 715 Coffee, J, ‘A Theory of Corporate Scandals: Why the US and Europe Differ’ in Armour and McCahery, n 452, 215. 716 The cognate 2003 Parmalat scandal, however, ensured that gatekeeper conflict-​of-​interest management remained on the EU reform agenda. Although weaknesses in Parmalat’s governance structure were apparent, it enjoyed an investment-​grade credit rating which allowed it to borrow ever increasing funds from the market immediately prior to its massive 2003 bankruptcy. See Ferrarini, G and Giudici, P, ‘Financial Scandals and the Role of Private Enforcement: the Parmalat Case’ in Armour and McCahery, n 452, 159 and Commission, Preventing and Combating Financial Malpractice (COM(2004) 611). 717 Commission, Note for the Informal ECOFIN Council Oviedo, 12 and 13 April. A First Response to Enron-​ related Policy Issues (2004). 718 Forum Group, Financial Analysts: Best Practices in an Integrated Market (2003).

II.9  Capital-raising and Investment Research  205 MiFID I), led to the first set of EU investment-​research-​related rules: the 2003 Commission Investment Recommendations Directive (under the Market Abuse Directive); and the 2006 Commission MiFID I Directive (under MiFID I).719 While these rules attracted some contestation,720 they remain the basis of the current rules. The investment research regime now sits within the Market Abuse Regulation (investment research presentation) and MiFID II (conflict-​of-​interest management) and their administrative rules. Both regimes adopt slightly different definitions of ‘investment research’ but, regarded as a whole, and given the level of granularity and procedural detail of the administrative rules, take the form of a detailed, operating rulebook for sell-​side investment research which is designed to minimize conflict-​of-​interest risk and thereby support the process through which analysis of issuer disclosure shapes price formation.

II.9.3  Presentation Requirements and Conflict of Interest Management The Market Abuse Regulation (MAR) addresses the presentation of investment research. Under MAR Article 20 persons who produce or disseminate ‘investment recommendations’, or other ‘information recommending or suggesting an investment strategy’, must take reasonable care to ensure that such information is objectively presented, and to disclose their interests or indicate conflicts of interest concerning the financial instruments to which that information relates. It also provides a mandate for administrative rules, which have been adopted under RTS 2016/​598721 which amplifies the disclosure requirements that apply to ‘investment recommendations’722 and ‘information recommending or suggesting an investment strategy’.723 It requires, inter alia, that facts are distinguished from interpretation; sources are indicated and reliable; and projections, forecasts, and price targets are clearly labelled as such (Article 3). Specialist firms providing such investment research724 are subject to additional presentation requirements, including that disclosure is made regarding where a recommendation has been changed, and as regards the nature of the methodologies used; that the meaning of recommendations (such as ‘buy’, ‘sell’, ‘hold’) is 719 Commission Directive 2003/​125/​EC [2003] OJ L339/​73; and Commission Directive 2006/​73/​EC [2006] OJ L241/​26. 720 The investment recommendations/​analyst provisions of the MiFID I administrative rules in particular had a troublesome gestation. CESR, after two 2004 rounds of consultation (it noted the ‘very difficult’ discussions in its April 2005 Feedback Statement on its technical advice for the Commission (CESR/​05-​291b, 17)), delayed its technical advice to the Commission until April 2005 (CESR 05-​290b) in order to assess the hostile market response to its proposals. Its technical advice was then subject to considerable revision by the Commission which adopted a principles-​based approach, recasting CESR’s detailed investment-​research-​specific proposals into a regime based on the application of general conflict-​of-​interest rules and the imposition of only a limited number of investment recommendations/​analyst-​specific rules. A similar approach obtains in the current MiFID II-​based regime. 721 RTS 2016/​958 [2016] OJ L160/​15. 722 Defined under MAR as ‘information recommending or suggesting an investment strategy, explicitly or implicitly, concerning one or several financial instruments or the issuers, including any opinion as to the present or future value or price of such instruments, intended for distribution channels or for the public’ (Art 3(1)(35)). 723 Defined under MAR as, in essence, information produced by an independent analyst, investment firm or credit institution, or any person whose main business is to produce investment recommendations, which, directly or indirectly, expresses a particular investment proposal in respect of a financial instrument or issuer (and also information produced by persons other than these persons, which directly proposes a particular investment decision in respect of a financial instrument): Art 3(1)(34). 724 The wide-​ranging MAR definition captures, in essence, investment firms, credit institutions, independent analysts, and other persons whose main business is to produce investment recommendations (or those working for them): Art 3(1)(34).

206 Capital-raising explained; and that a list is disclosed of all recommendations on any financial instrument or issuer disseminated in the previous year and containing the required specified disclosures for each recommendation (including price targets and the direction of the recommendation) (Article 4). Conflict-​of-​interest disclosure requirements are also imposed. All persons producing investment recommendations must disclose all relationships and circumstances that could reasonably be expected to impair the objectivity of a recommendation (Article 5). More stringent disclosure requirements apply to specialist firms who are required to make a series of prescribed disclosures, including where the firm has a 5 per cent or more holding in the issuer, acts as a market-​maker or underwriter for the issuer, or provides investment services to the issuer (Article 6).725 In addition, the MiFID II investment research rules are primarily directed to conflict-​of-​ interest management in the provision of investment research by investment firms. As is discussed in Chapter IV, the behemoth MiFID II regime governing investment services applies to in-​scope investment firms providing ‘investment services’. ‘Investment services’ as defined under MiFID II include the provision of investment research, but MiFID II treats investment research as an ‘ancillary service’. This has the effect of excluding investment research from MiFID II where it is the sole service provided by a firm; in practice, however, boutique investment research houses are rare in the EU, with investment research typically being provided within multi-​service investment firms as part of a portfolio of investment services. Where investment research is provided alongside other investment services, the full range of MiFID II operational, organizational, and conduct rules apply, of which the conflict-​of-​ interest rules have most traction for investment research. MiFID II Articles 23 and 16(3) together require investment firms to identify and to prevent or manage conflicts of interest; have and maintain effective organizational and administrative arrangements which take all reasonable steps to prevent conflicts from adversely affecting the interests of clients; and, where such arrangements are not sufficient to ensure with reasonable confidence that risk of damage to client interests will be prevented, clearly disclose the general nature and source of the conflict and the steps taken in mitigation. The application of these general principles to the specific conflicts raised by investment research is amplified by one of MiFID II’s many administrative rules, Delegated Regulation 2017/​565, which addresses the operational and organizational regulation of investment firms.726 Its detailed rules which apply to conflict-​of-​ interest management generally (Articles 33–​35), and which cover, inter alia, the identification of conflicts of interests, the contents of the required conflicts of interest policy including relevant conflicts management procedures, the ‘last resort’ disclosures required where the risk of detriment cannot be prevented, the review of the conflicts policy, and related record-​ keeping, apply to investment research. A firm providing investment research must, accordingly, and reflecting the specific requirements of Articles 33–​35, have in place appropriate procedures to manage conflicts of interests, including as regards information exchange and barriers (particularly relevant to manage the risk of conflicts between dealing desks and investment research business); separate supervision lines; remuneration policies (including as regards removing any link between analyst remuneration and business divisions); rules governing the exercise of inappropriate influence; and rules governing the prevention or control of simultaneous or sequential involvement of persons in firm activities where conflicts 725 A discrete set of lighter requirements apply to persons disseminating investment recommendations produced by third parties (Arts 8–​10). 726 Delegated Regulation 2017/​565 [2017] OJ L87/​1.

II.9  Capital-raising and Investment Research  207 arise (such as the use of analysts in ‘roadshows’ to promote IPOs).727 In addition, Delegated Regulation 2017/​565 applies discrete conflict-​of-​interest management rules to ‘investment research’ (Article 37).728 These include trading restrictions for investment analysts; physical separation requirements between analysts and those whose responsibilities may generate conflicts (or, where proportionate, information barriers); prohibitions on inducements to analysts and on analysts promising favourable coverage; and a prohibition on issuers reviewing draft recommendations where the recommendation includes a price target.

II.9.4  Unbundling the Cost of Investment Research The MAR presentation and MiFID II conflict-​of-​interest management rules are, broadly, uncontested. This is not the case as regards the MiFID II rules which apply an ‘unbundling’ requirement to investment research. Under Delegated Directive 2017/​593,729 and in an administrative amplification of the MiFID II Article 24 prohibition on investment firms receiving inducements, asset managers are prohibited from receiving ‘research’730 from their investment firm brokers where its costs are, as has long been market practice in the EU (and the US), ‘bundled’ into the wider execution charges paid by asset managers to their brokers. Article 13 of the Delegated Directive provides, in essence, that, in the context of the asset manager/​broker relationship, investment research provided by the broker to the asset manager must either be paid for by the asset manager or paid for through research payment accounts which levy the investment research charge on clients.731 This ‘unbundling’ requirement is designed to tackle the market failures and risks associated with the bundling by brokers of investment research costs with brokerage costs.732 These include the consequent lack of a clear price signal as to the real cost of investment research, the production of poor-​quality research, and the over-​consumption of research; and also the conflict-​of-​interest risks to which asset 727 These general requirements are applicable to all investment services but, under Art 37(1), must all be implemented in relation to financial analysts involved in the production of investment research. 728 The Art 37 requirements apply to investment firms that produce, or arrange the production of, ‘investment research’ that is intended or likely to be subsequently disseminated to clients or to the public, under their own responsibility or that of a group member (Art 37(1)). ‘Investment research’ is defined as research or other information recommending or suggesting an investment strategy, explicitly or implicitly, concerning one or several financial instruments or issuers of financial instruments, including any opinion as to the present or future value or price of such instruments, intended for distribution channels or the public (Art 36(1)). Further, the research or information must be labelled or described as investment research or in similar terms, or otherwise be presented as an objective or independent explanation of the recommendation; and must not take the form of MiFID II ‘investment advice’ (see further Ch IX). Where a communication falls outside this definition, but within the MAR definition, it is to be treated as a marketing communication for the purposes of MiFID II and identified as such (Art 36(2)). 729 Delegated Directive 2017/​593 [2017] OJ L87/​500. 730 Adding to the complexity of the unbundling regime, this term is not defined by Directive 2017/​593. ESMA has, however, adopted in its Q&A on the unbundling rule the very broad description of ‘research’ used in recital 28 to Directive 2017/​593: ESMA, Q&A on MiFID II and MiFIR Investor Protection and Intermediaries Topics (2021), section 7, Q&A 8. Recital 28, in very broad terms, relates investment research to research material that informs views on the relevant instruments/​issuers/​sectors, and presents a related lengthy narrative as what is covered. 731 The design of the unbundling rule is linked to the structure of the MiFID II prohibition on investment firms receiving inducements. This prohibition applies unless the inducement meets the qualifying tests that lift the prohibition (Art 24(8)). Accordingly, under Art 13 of the Delegated Directive, research provided by third parties to asset managers is exempt from characterization as an inducement (and so from being prohibited) if the research is paid for by the asset manager or paid for through the research payment account processes set out in Art 13. The research payment account procedures are set out in detail in Art 13 and further amplified by an ESMA Q&A. 732 For a regulatory perspective see UK FCA, Discussion Paper DP 14/​3 on the Use of Dealing Commission Regime (2014). At NCA-​level, the FCA was the standard-​bearer for unbundling reform in the EU, having initially

208 Capital-raising manager clients are exposed to by bundling, including as regards the risk of clients being over-​charged through inflated execution costs and the related ‘churning’ of portfolios in the form of unnecessary trades. The unbundling of investment research, accordingly, is associated with a stronger demand-​side signal as to the type of investment research that is valued and required, the production of better targeted and higher-​quality investment research which supports price formation, and stronger research governance practices which minimize conflict-​of-​interest risk for asset manager clients.733 The unbundling requirement represented a major change to the structure of the investment research industry and was highly contested. MiFID II did not contain an express legislative reference to, or a delegation for administrative rules relating to, unbundling. The rule is technocratic in origin, being developed by ESMA as part of its technical advice for the Commission on the administrative amplification of the MiFID II conflict-​of-​interest rules, in particular the MiFID II Article 24 prohibition on inducements. ESMA relatedly proposed that the provision of investment research by third parties to asset managers could be exempted from characterization, under MiFID II Article 24, as a prohibited inducement, as long as payment arrangements were in place to address the conflict-​of-​interest risk, whether by means of the research being paid for by the asset manager or, alternatively, being paid for through a ringfenced firm research account, funded by means of a specific charge to clients (i.e. the research payment was ‘unbundled’).734 ESMA’s decision to address unbundling as a specific application of MiFID II Article 24 was accepted by the Commission which supported an unbundling rule as a means for addressing conflict-​of-​interest risk and, inter alia, driving stronger asset manager accountability and generating efficiencies in the investment research market.735 Industry resistance was fierce, with the concerns raised including the cost of producing investment research and the potential reduction, in consequence of unbundling, in the quality and diversity of the research produced, particularly SME research; and the redundancy of the unbundling rule given the general MiFID II conflict-​of-​ interest rules.736 Subsequent to its coming into force in 2018, the unbundling reform led to structural change in the investment research industry,737 with most asset managers now paying for research.738 Criticism but also support has followed.739 raised concerns in a 2006 review which were reiterated in supervisory and policy reviews in 2008, 2012, and over 2013–​2014. Its concerns related in particular to the conflict-​of-​interest risks to clients and to price opacity in the investment research market. 733 The risks and benefits of bundling/​unbundling investment research are, however, highly contested and have produced a considerable scholarly and policy literature. For a recent review of US orientation see SEC, Staff Report on the Issues Affecting the Provision of and Reliance Upon Investment Research into Small Issuers (2022). 734 ESMA, Technical Advice on MiFID II/​MiFIR (December 2014) 130–​4. On its earlier, more restrictive approach, which did not provide for payment accounts, see ESMA, Consultation Paper on MiFID II/​MiFIR (May 2014) 120–​2. 735 For discussion of the Commission’s position see its IA for what would become Delegated Directive 2017/​ 593: SWD (2016) 157) 20–​5. 736 The debate can be traced through ESMA’s related consultations (n 734). 737 Major global investment banks also implemented the reforms, responding to investor demands for greater transparency: Flood, C, ‘MiFID II leads to global demands for transparency’, Financial Times, 10 December 2018. 738 On the demand side, while most asset managers now carry the cost of investment research, the evidence suggests that they are also cutting the volume of research purchased. On the supply side, price cuts by larger (global investment bank) research providers have followed, smaller research providers and brokers have faced viability risks as related execution commissions dropped, and innovations in the production of investment research have emerged. See, eg, Murphy, H, Morris, S, and Mooney, A, ‘MiFID II Has Thrown Up Several Unintended Consequences’, Financial Times, 2 January 2019 and Murphy, H, ‘Gloomy City Stockbrokers Struggle with MiFID II Fallout’, Financial Times, 13 October 2018. 739 The unbundling reform attracted considerable attention, particularly but not entirely of a finance orientation, including in the US. For a review see Jackson, H and Zhang, J, The Economics of Soft Dollars: A Review of the

II.9  Capital-raising and Investment Research  209 Reform came early to the unbundling rule. It became regarded as creating disincentives for investment research providers to cover SMEs, given the costs of SME research and also changing demand patterns for such research, with the growth of exchange-​traded funds and their focus on large capitalization securities, in particular, reducing already limited demand. In addition, the departure of the UK, a supporter of the unbundling rule, changed the political environment, as did the outbreak of the Covid-​19 pandemic which generated political and institutional concern to facilitate firms’ access to the capital markets and particularly to equity capital. The 2021 MiFID II ‘Quick Fix’ reform accordingly refined the unbundling rule to limit its application as regards SMEs.740 In effect, the unbundling requirement no longer applies to investment research relating to issuers whose capitalization in the three years prior to the provision of the research does not exceed €1 billion.741 Some evidence suggests, however, that the unbundling reform had not prejudiced SME research coverage742 and was supporting investor protection.743 The unbundling saga has many implications, not least as regards the importance of the prevailing political context to rule development,744 ESMA’s technocratic influence, and the Literature and New Evidence from the Implementation of MiFID II (2022), available via , examining the long history of research bundling in the US through an EU lens, and finding that the MiFID II reforms can be associated with stronger market efficiency. Industry comment has also been significant. For contrasting industry perspectives, published as part of the Financial Times’ 2019 review of MiFID II, see Vismara, A, ‘Why MiFID II Is a Menace to Investment Banking in Europe’, Financial Times, 31 May 2019, linking the unbundling reform to reduced SME research coverage, and Lannoo, K, ‘MiFID II Critics Are Not Seeing the Big Picture’, Financial Times, 17 May 2019, highlighting the role of the unbundling rule in addressing conflicts of interests and lowering fees for investors. 740 The Commission argued (reflecting the review it had earlier commissioned which suggested that SME coverage was decreasing and that research budgets were declining: Risk Control Ltd, The Impact of MiFID II on SME and Fixed-​Income Research (2020)) that SME research coverage had been decreasing and that the unbundling rule had led to higher costs for covering SMEs and, relatedly, to less SME coverage: SWD(120) 120 para 4.1.8. The related consultation was brief in its justification, with the Commission noting a decline in investment research coverage generally, and particularly for SMEs (Ref.Ares(2020) 3914669). The consultation additionally proposed that the unbundling requirement be lifted for fixed income/​debt research, but this proposal was not ultimately adopted. 741 Directive (EU) 2021/​338 [2021] OJ L68/​14, inserting a new Art 24(9a) into MiFID II. The rationale for the €1 billion threshold was not explained in the Commission’s analysis, save by reference to it capturing SMEs: n 740. The reform also requires that an agreement be entered into in advance between the asset manager and the research provider (broker) which documents how the investment research is paid for; and that clients are informed by the firm as to how the research is paid for. The definition of ‘research’ maps that used by ESMA as regards the unbundling rule and so is based on Delegated 2017/​593 recital 28 (n 730). 742 A 2021 ESMA review found that the quantity of research per SME had not declined relative to larger firms, that the probability of an SME completely losing coverage had not increased relative to larger firms, and that the quality of SME research had not worsened relative to larger firms. Overall, while SMEs continued to receive less investment research coverage than other firms, the review reported that this situation had neither been improved nor worsened by the unbundling reforms: Amzallag, A, Guagliano, C, and Lo Passo, V, MiFID II Research Unbundling: assessing the impact on SMEs, ESMA WP No 3 (2021). The data picture is complex. One study on the pre-​Brexit impact on the UK, eg, found that the unbundling reforms had led to a drop in analyst coverage on the London Stock Exchange Main Market, but that the second tier Alternative Investment Market had experienced higher coverage, a finding the study related to the AIM requirement that all issuers have a ‘Nominated Advisor’ to facilitate the disseminate of firm information: Fu A, et al, Research Unbundling and Market Liquidity: Evidence from MiFID II (2021), available via . 743 In a 2019 review, the UK FCA reported that the unbundling reform had led to better accountability and scrutiny as regards execution costs, and that investors in UK-​regulated equity portfolios had saved in the region of £70 million in the first six months of MiFID II coming into force in 2018: FCA, Implementing MiFID II. Multi-​ Firm Review of Research Unbundling Reforms (2019). 744 The importance of context is underlined by the UK FCA also revising the UK’s post-​Brexit/​‘on-​shored’ MiFID II unbundling rule, but, in this case, to provide a more restricted SME carve-​out (for issuers of market capitalization of £200 million and below). The FCA did not agree to aligning its alleviation with the EU’s €1 billion alleviation, notwithstanding market demand, given that its £200 million threshold was based on analysis of where the lack of investment research was most acute: FCA, Changes to UK MiFID’s Conduct and Organisational Requirements, PS21/​20 (2021).

210 Capital-raising increasing agility of the legislative process in managing reforms. As regards capital-​raising, however, it underlines the complexity of the regulatory environment relating to SMEs and the related challenges faced by regulation.745

II.10  Issuer Disclosure and Sustainable Finance Public disclosure of high quality, consistent, and comparable sustainability-​related information is a key plank of the ‘European Green Deal’ and the related Sustainable Finance Action Plan,746 being associated with sustainable investment practices, funding the transition to a green economy, stronger corporate accountability as regards sustainability impacts, and reliable risk disclosures as regards sustainability risks to businesses and, relatedly, potential build-​ups of financial stability risks. As regards issuer disclosure, the value of the recent explosive growth in sustainability-​related issuer disclosures (in part driven by regulatory fiat and in part by market demands) has, however, been contested, including as regards the appropriateness of enrolling issuer disclosure (and its regulation) in service of wider societal goals regarding sustainability and climate change, given that the primary role of markets, supported by issuer disclosure, is to allocate capital; and also as regards regulatory design, given challenges including as to the lack of reliable sustainability-​related metrics, what can be the idiosyncratic nature of these disclosures, and related comprehensibility, comparability, and reliability risks.747 The proliferation of different standards internationally has further complicated the disclosure setting.748 These challenges are reflected in the dynamic nature of the EU’s agenda here, which has been evolving since the early post-​ financial-​crisis period.

745 The 2021 Listing Act consultation returned to the unbundling debate, calling for feedback on the impact of the 2021 reforms, including as regards whether the unbundling requirement should be alleviated further, but also as regards whether ‘sponsored research’ (research paid for by a trading venue or issuer) could be supported by legislative/​non-​legislative action: n 12, 53–​5. The trade-​offs and uncertainties were highlighted by ESMA. It did not support further alleviations, suggesting that the unbundling rule had addressed a ‘fundamental problem of conflict of interest’, and that there was not clear evidence of any detrimental effects on the availability and quality of research on EU companies including SMEs, but identified ‘sponsored research’ as potentially benefiting from reform: 2022 ESMA Listing Act Letter, n 164. The 2022 Listing Act reform agenda (n 144), however, proposed that the SME alleviation be raised to €1.5 billion and the introduction of a framework for ‘sponsored research.’ 746 The Sustainable Finance Action Plan is at COM(2018) 97. On the Plan and the framing European Green Deal see further Ch I section 7.2. Relatedly, ESMA in October 2022 adopted ESG disclosures as a ‘Union Strategic Supervisory Priority’ (USSP; ESMA adopts two USSPs at any given time to frame its and NCAs’ supervisory activities), in order to foster transparency and comprehensibility across the ‘sustainable finance value chain’, including as regards issuers (as well as investment firm and collective investment managers): ESMA, Press Release, 27 October 2022. 747 For analyses broadly supportive of enrolling issuer disclosure see, eg, Steuer and Tröger, n 68 and Armour, J, Enriques, L, and Wetzer, T, ‘Mandatory Corporate Climate Disclosures: Now, But How? (2021) Co Bus LR 1085. For a more sceptical analysis, from a US perspective, see, eg, Mahoney, P and Mahoney, J, ‘The New Separation of Ownership and Control: Institutional Investors and ESG’ (2021) Co Bus LR 840. For a policy-​oriented review see the SEC’s 2022 consultation: SEC, The Enhancement and Standardization of Climate-​Related Disclosures for Investors (2022). 748 See, eg, IOSCO, Report on Sustainability-​Related Issuer Disclosures (2021), reporting on asset management sector concerns as to the lack of globally accepted standards and related concerns as to poor quality reporting. A series of different standards are used globally, chief among the UN’s Sustainable Development Goals, the Global Reporting Initiative (GRI) standards, the recommendations issued by the Financial Stability Board’s Task Force on Climate-​related Financial Disclosures, and the standards issued by the Sustainability

II.10  Issuer Disclosure and Sustainable Finance  211 Sustainability-​related issuer disclosures interact with all aspects of the EU issuer disclosure regime. As regards the Prospectus Regulation, they could be required under, inter alia, the Regulation’s Article 6 materiality obligation, the risk factor regime, and as part of the required Operating and Financial Review (OFR) disclosures. The prospectus rulebook does not, however, specifically address sustainability-​related disclosures, but they are increasingly being addressed by ESMA soft law, underlining ESMA’s importance in calibrating the prospectus regime,749 and legislative reform is likely.750 Further, the extent to which NCAs expect sustainability-​related disclosures, and review any questionable claims in this regard, can also be expected to shape how the prospectus regime develops.751 More specifically, while the 2021 Proposal for a Regulation on European Green Bonds does not address prospectus disclosure directly, it is likely to lead to additional offer disclosures relating to the offer of ‘green bonds’ or bonds issued for environmentally sustainable purposes.752 Designed to facilitate issuers in raising sustainable finance and to support investors in assessing the merits of green bonds, the Proposal sets out a series of standards with which issuers must comply if they are to avail of the ‘European Green Bond’ label. Its use is conditional on issuers, inter alia, allocating the funds to ‘green’ purposes (in accordance with the foundational 2020 Taxonomy Regulation),753 but also on their complying with disclosure-​ related obligations, including as regards publishing a ‘European Green Bond Fact Sheet’, annual reports on use of proceeds, and a final impact report once the proceeds are allocated.754 In addition, the Proposal provides for the compliance of the issuance with the standards to be reviewed by an external reviewer (a new ESMA authorization and related light-​touch regulatory and supervisory regime would apply to reviewers). While reflecting developing market practice, the Proposal also represents a significant innovation as regards issuer disclosure regulation as it combines voluntary elements (the regime is ‘opt-​in’), merit-​style regulation (deploying a regulatory ‘label’ the use of which is reviewed by an external reviewer), and more traditional mandatory disclosure elements (the requirement for a ‘Fact Sheet’ to be published and the required related ongoing reports).

Accounting Standards Board and the Climate Disclosure Standards Board. Greater international standardization will follow for IFRS-​reporting firms given the November 2021 establishment by the IFRS Foundation of the International Sustainability Standards Board (ISSB) to set IFRS Sustainability Disclosure Standards, in response to global demand. 2022 saw the ISSB consult on two major draft standards: IFRS S1 (General Requirements for Disclosure of Sustainability-​Related Financial Information); and IFRS S2 (Climate-​Related Disclosures). 749 The 2021 Prospectus Guidelines require coverage in the OFR of sustainability risks (Guideline 3), while the 2021 ESMA guidance for SPAC issuers warns that commitments must not be made as to investments in ‘green targets’ where other targets might be considered: 2021 ESMA SPAC Public Statement, n 429, 3. 750 The 2021 EU Covid Recovery Regulation called on the Commission to consider whether sustainability-​ related disclosures should be integrated within the Prospectus Regulation: recital 7. ESMA also called for an additional prospectus ‘building block’ for ‘green bonds’ issued to support sustainability-​related purposes: ESMA, Response to the Commission Consultation on a Renewed Sustainable Finance Strategy (2020) 22. 751 The sustainability claims being made by issuers are increasingly being tested by regulators, with the US SEC reportedly requiring one offeror to remove a prospectus claim that the offer was the first sustainable IPO: Megaw, N, Palma, S, and Mann, J, ‘Allbirds dropped ‘sustainable’ claim from IPO after SEC objection’, Financial Times, 7 November 2021. 752 COM(2021) 391. 753 The 2020 Taxonomy Regulation sets out the classification system governing environmentally sustainable investments: Regulation (EU) 2020/​852 [2020] OJ L198/​13. See in outline Ch I section 7.2. 754 The Proposal does not, accordingly address prospectus disclosures, although it requires that the prospectus for bonds using the new label must identify the issuance as an EU Green Bond.

212 Capital-raising The standards that apply to annual financial reporting, however, are the main lever currently deployed by the EU to address sustainability-​related disclosures by EU corporate issuers, although these disclosures can also engage the Market Abuse Regulation regime, when sustainability-​related developments can be characterized as disclosable ‘inside information’.755 Since 2014 in particular, with the adoption of the Non-​Financial Reporting (NFR) Directive,756 the EU’s financial reporting regime for annual reports has come to focus more closely on sustainability-​related disclosures. The NFR Directive amended the 2013 Accounting Directive to require large ‘public interest entities’ (issuers admitted to trading on a regulated market, as well as banks, insurance companies, and any firms that may be so designated by Member States) with more than 500 employees to include a non-​ financial statement in their annual management reports covering environmental, social, and employee matters, respect for human rights, and bribery-​related matters; and adopting a ‘double materiality’ approach (in that the relevant disclosures cover the sustainability impact of such entities as well as address how sustainability issues might generate financial risks for such entities).757 The content of this statement was amplified by two sets of Commission Guidelines, one general (2017); and one, reflecting a commitment in the 2018 Sustainable Finance Action Plan, specific to climate-​related reporting and reflecting the recommendations of the Commission’s Technical Expert Group on Sustainable Finance (2019).758 While the EU’s sustainability-​related disclosure requirements generally (including for investment firms and investment products) are regarded as being in the vanguard of developments globally (particularly as regards their supporting taxonomy, as regards environmental sustainability, which is set out in the 2020 Taxonomy Regulation),759 this suite of annual reporting requirements, nested within the principles-​based NFR Directive, came to be regarded as inadequate to the task of improving the quality of sustainability-​related disclosures and of narrowing the substantial information asymmetry that had emerged as regards these disclosures.760 Although the first set of NFR Directive reports were required only from financial year 2018, and despite oversight through ESMA’s EECS (see section 6.4), a weight of evidence quickly built up as to the inadequacy of the Directive.761 Among the many difficulties, it was reported that issuers were not disclosing material non-​financial information and were presenting volumes of non-​material information; reliability was limited

755 See Mülbert, P and Sajnovits, A, ‘The Inside Information Regime of the MAR and the Rise of the ESG Era’ (2021) 18 ECFR 256, highlighting the complex interaction between sustainability-​related issuer developments and the imposition of MAR disclosure requirements, particularly as regards the application of the ‘reasonable investor’ test that governs disclosable ‘inside information’, and calling for the MAR to be revised to specify the treatment of sustainability-​related information. 756 Directive 2014/​95/​EU [2014] OJ L330/​1. 757 The statement must include a brief description of the entity’s business model, policies pursued in relation to these matters and related due diligence processes, the outcome of these policies, principal risks relating to these matters, and non-​financial key performance indicators: 2013 Accounting Directive Art 19a. 758 Respectively, Guidelines on Non-​Financial Reporting (2017) [2017] OJ C215/​1 and Guidelines on Non-​ Financial Reporting: Supplement on Reporting Climate-​related Information (2019) OJ [2019] OJ C209/​1. 759 FSB, Task Force on Climate-​related Financial Disclosures 2021 Status Report (2021). On the EU agenda see in outline Ch I section 7.2 760 eg, ESMA, Letter to the IFRS Foundation (Response to Consultation Paper on Sustainability Reporting), 16 December 2020. 761 For review of the critical market, stakeholder, and policy reaction see ESMA, Undue Short-​Term Pressure on Corporations (2019) 23–​37.

II.10  Issuer Disclosure and Sustainable Finance  213 given the absence of audit assurance;762 comparability was poor given the lack of consistent reporting standards and formats; and there was limited market and issuer understanding of the nature of the disclosures required.763 For example, issuers were not consistent in reporting on how their businesses were impacted by environmental matters and used different reporting standards.764 In 2021, the Commission presented a proposal to reform the NFR Directive (the Corporate Sustainability Reporting Proposal),765 acknowledging that the related Guidelines had not sufficiently improved the quality of disclosures; that the disclosures were not sufficiently reliable or comparable; that they were difficult to access, partial, and particularly weak as regards the sustainability impact of intangibles (including brands, intellectual property, and R&D); and were ill-​suited to allow financial market participants to meet their obligations under the 2019 Sustainable Finance Disclosure Regulation (which imposes sustainability-​related disclosure obligations on financial market intermediaries, including as regards their financial products766).767 The Proposal was accordingly designed to improve the reliability, consistency, comparability, and availability of sustainability-​related disclosures, and thereby to bring these non-​financial disclosures into alignment with European Green Deal objectives. Among its key reforms, the Proposal clarified the application of the NFR Directive’s ‘double materiality’ principle; specified in significantly greater detail the sustainability-​related disclosures required, requiring qualitative and quantitative disclosures and over the short-​, medium-​and long-​term; and, at the core of the reform, provided for the adoption of EU sustainability reporting standards (European Sustainability Reporting Standards (ESRS)) and for discrete, proportionate standards for SMEs. The Proposal also expanded the reach of the NFR Directive, extending the new sustainability reporting requirements to all companies admitted to a regulated market, regardless of size, albeit, reflecting the CMU concern to reduce transaction costs for SMEs, that it extended the proposed implementation date for SMEs. Provisional agreement on the Proposal, and on the related development and subsequent adoption of ESRS (as administrative rules), was reached in summer 2022 (the Corporate Sustainability Reporting Directive (CSRD)); and the regime will start to apply from January 2024 (its application is to be phased-​in, with entities already subject to the NFR Directive the first to become subject to the new regime)768

762 The statutory audit only has to assess whether the statement is published, not whether it complies with relevant requirements. 763 2021 Fitness Check, n 464, 57–​60. 764 Reporting on 2020, ESMA found that, of a sample of issuers reviewed, while 59 per cent included information on their environmental impacts, only 41 per cent reported on how climate change and environmental risks were shaping their businesses; and that different standards were used, although the GRI standards were used most commonly (68 per cent of reviewed issuers): ESMA, Enforcement and Regulatory Activities of European Enforcers 2020 (2021) 31. 765 2021 Corporate Sustainability Reporting Proposal (COM(2021) 189) 1. 766 Regulation (EU) 2019/​2088 [2019] OJ L317/​1. See Ch I section 7.2. 767 2021 Corporate Sustainability Reporting Proposal, n 765, 1–​3. 768 Provisional agreement was reached in the trilogue negotiations in June 2022: ECOFIN Council Press Release, 21 June 2022. The Commission described the agreement as a ‘game changer’ in that sustainability reporting would be placed on an equal footing with financial reporting: Press Release (Sustainable Finance), 26 July 2022. The major changes from the 2021 Proposal included the expansion of the scope of the regime to cover non-​EU companies with substantial business in the EU (more than €150 million in net turnover generated in the EU in the last financial year); and a transitional opt-​out for regulated-​market-​admitted SMEs until 2028. EFRAG is charged with developing the draft ESRS at the core of the CSRD and has accordingly established a new Sustainability Reporting Board. On the new regime see Conac, P-​H, ‘Sustainable Corporate Governance in the EU: Reasonable Global Ambitions’ (2022) Revue Europeénne du Droit, Special Ed on Responsible Capitalism, 111.

214 Capital-raising In addition, the 2020 Taxonomy Regulation, as regards environmental sustainability specifically, requires larger issuers (those subject to the NFR Directive) to provide disclosures regarding how and to what extent their activities are associated with economic activities that qualify as being ‘environmentally sustainable’ in accordance with the Regulation’s taxonomy.769 Disclosure aside, the 2022 Proposal on Corporate Sustainability Due Diligence is designed to impose due diligence duties regarding sustainability impact, illustrating the widening reach of the EU’s sustainable finance agenda.770 The significant change which the new CSRD regime (in combination with the specific 2020 Taxonomy Regulation requirements regarding environmental sustainability) will bring to issuer disclosure, as regards sustainability-​related reporting, exemplifies how the single rulebook is being deployed in service of the EU’s sustainability objectives. The CSRD regime will expand the issuer disclosure regime materially, in particular by means of the ESRS, a novel set of reporting standards the development and adoption of which represents a significant technical but also political challenge for the EU’s processes (including as regards the interaction between the ESRS regime and the IFRS Sustainability Disclosure Standards being developed by the International Sustainability Standards Board (ISSB), particularly as the EU’s standards relating to sustainability disclosures generally (under the Sustainable Finance Disclosure Regulation and the Taxonomy Regulation) are currently the highest and also the most wide-​ranging internationally), and will likely increase costs,771 albeit that a proportionate regime will apply to SMEs. But the CSRD regime should enhance and standardize issuers’ sustainability-​related disclosures, thereby facilitating investors in pricing risks and in allocating capital, including to the green transition. It should, relatedly, reduce the information costs of financial market participants subject to the 2019 Sustainable Finance Disclosure Regulation, as the CSRD regime will expand and standardize relevant issuer disclosures regarding sustainability and thereby facilitate financial market participants in reporting on their investments and related activities. The CSRD reform also illustrates the EU’s intensifying capacity to finesse the issuer disclosure rulebook and the related and continuing expansion of technocratic influence: EFRAG but also ESMA are charged with advising the Commission on the new ESRS which, forming the centrepiece of the new regime, will standardize and impose technical specification on corporate sustainability disclosures, thereby marking a major change to how sustainability disclosures are made by issuers.

769 Article 8. The disclosures must include the proportion of companies’ turnover derived from products or services associated with economic activities that qualify as ‘environmentally sustainable’, and the proportion of companies’ capital expenditures and operating expenditures related to such activities. Extensive administrative rules, in accordance with the Regulation’s taxonomy, specify these disclosures and the methodologies to be used: Delegated Regulation (EU) 2021/​2178 [2021] OJ L443/​9. 770 COM(2022) 71. The Proposal addresses the obligations of companies (with more than 500 employees and more than €150 million in net worldwide turnover in the last financial year, whether or not admitted to trading) regarding actual and potential human rights adverse impacts and environmental adverse impacts, with respect to their own operations, the operations of their subsidiaries, and the value chain operations carried out by entities with whom the relevant company has an established business relationship and as regards liability for violations of these obligations (Art 1). It includes related requirements as to due diligence, identification of adverse impact, prevention/​mitigation actions (including related contractual termination rights), complaints procedures, and disclosure obligations. 771 While the consultations suggested some issuer disquiet as to the costs likely to follow, the need for reform was generally accepted: 2021 Corporate Sustainability Reporting Proposal, n 765, 8. On the ISSB see n 748.

II.11  Capital-raising and Digital Finance  215

II.11  Capital-​raising and Digital Finance II.11.1  The Issuer Disclosure Regime and Digital Assets The burgeoning asset class of digital (or crypto-​) assets ranges from crypto-​currencies, such as bitcoin; to utility and payment tokens which give access to products or services or act as alternative payment forms; to, with most relevance for financial markets regulation, ‘security tokens’ which grant the holder rights or claims on assets that are comparable to the rights and claims exercised by share-​or bond-​holders.772 Whether or not an offering of digital assets falls within the scope of the issuer disclosure regime773 depends on whether or not such assets qualify as ‘transferable securities’.774 Where they do, the issuer disclosure regime will apply. NCAs and ESMA have been in the vanguard of efforts to stabilize the issuer disclosure/​admission perimeter as regards the coverage of transferable securities in this regard. ESMA’s related 2019 review underlined the uncertainty attending the treatment of the vast range of different digital assets775 and the varying approaches adopted by NCAs.776 It concluded that the issuer disclosure rules would apply where an NCA determined that a digital asset was a transferable security, but that the EU issuer disclosure regime was not adapted to the specificities of such digital assets and that the prospectus requirements, in particular, should be amplified by NCAs to address the specific risks posed by digital assets.777 In addition, the sprawling Markets in Crypto-​Assets Regulation (MiCAR) regime, which falls outside the scope of this book, puts in place a comprehensive framework for

772 As noted in Ch I section 7.3, a crypto-​asset is, in effect, a digital representation of value that uses some form of distributed ledger technology (DLT). For a wide-​ranging review see Brummer, C (ed), Cryptoassets: Legal, Regulatory, and Monetary Perspectives (2019) and, from an EU perspective, see the special edition of the ECFR (Avgouleas, E and Marjosola, H (eds), ECFR Special Volume 5. Digital Finance in Europe: Law, Regulation, and Governance (2022)). The EU’s agenda in this sphere also includes the development of a ‘digital euro’, being spearheaded by the ECB. 773 As noted in Ch I section 7.3, the focus of this book is on the financial instruments that set the perimeter of EU financial markets regulation and it does not address the specificities associated with digital/​crypto-​assets and their related regulation. 774 From the extensive literature see, eg, Zetsche, D, Annunziata, F, Arner, D, and Buckley, R, ‘The Markets in Crypto-​Assets Regulation and the EU Digital Finance Strategy’ (2021) 16 CMLJ 203, warning as to classification risks; Zetsche, D, Buckley, R, Arner, D, and L, Föhr, ‘The ICO Gold Rush’ (2019) 63 Harv Int LJ 267, warning of the investor protection risks of security tokens but identifying the fund-​raising benefits; Ferrarini, G and Giuidici, P, ‘Transferable Securities and the Scope of the Prospectus Regulation—​the Case of ICOs’ in Busch et al (2020), n 163, calling for a risk-​based approach to the classification of digital assets, based on negotiability and financial risk; and Hacker, P and Thomale, C, ‘Crypto-​Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law’ (2018) 15 ECFR 645, calling for tailored disclosure regulation and stronger international coordination. For an extended treatment of digital assets and their interaction with financial regulation, including as to classification risks, see Chiu, I, Regulating the Crypto Economy (2021). 775 ESMA, Advice on Initial Coin Offerings and Crypto-​Assets (2019). Its review was in response to the Commission’s 2018 Fintech Action Plan (COM(2018) 109). 776 It reported that while NCAs agreed that where a digital asset qualified as a MiFID II financial instrument or transferable security (most usually ‘security tokens’ of some form) it fell within the EU rulebook, the extent to which different assets qualified varied, as NCAs operated within different local legal frameworks and took a case-​by-​case approach to assessing digital assets. The German NCA (BaFIN), eg, has issued guidance on whether a prospectus is needed for offerings of crypto-​tokens (BaFIN, Secondary Letter on Prospectus and Authorisation Requirements in Connection with the Issuance of Crypto Tokens, November 2019). In essence, an assessment is made on a case-​by-​case basis, and enforcement action can follow. BaFIN warned in April 2021 of a potential infringement of prospectus rules by the Binance trading platform as regards the offer of certain share tokens which had not been accompanied by an approved prospectus: BaFIN, Press Release 82 April 2021. 777 2019 ESMA Advice, n 775, 21–​3.

216 Capital-raising enabling the use of, and managing the risks raised by, crypto-​assets in the financial sector,778 including by establishing a taxonomy of crypto-​assets, and by applying a bespoke regulatory regime to their offering which includes ‘white paper’ disclosure requirements. It also clarifies that crypto-​assets that qualify as financial instruments under MiFID II (including transferable securities) do not come within the MiCAR regime.779

II.11.2  The 2020 Crowdfunding Regulation While the EU’s digital finance strategy (or strategy for dealing with the impact of new technologies on finance) generally is fast expanding,780 the first sustained attempt to grapple with the interaction between technological innovation and the regulation of fund-​raising concerned ‘crowdfunding’,781 and the adoption of the 2020 Crowdfunding Regulation.782 Crowdfunding, while still a small segment of the EU funding ecosystem, has grown strongly in the EU since its initial development in 2012/​2013.783 The regulatory challenge has been well documented: how best to manage the investor protection risks to retail investors in particular,784 including fraud, conduct, illiquidity, and disclosure risks, but to avoid imposing disproportionate regulation on a nascent funding source. The EU’s approach evolved in this regard, initially suggesting some reticence towards regulatory intervention and privileging the support of innovation, and later pivoting to a mandatory regulatory regime. As crowdfunding began to develop in the aftermath of the financial crisis, the Commission made tentative moves towards an EU response, primarily in the form of soft measures.785 Subsequently, the 2015 CMU Action Plan was cautious as to the merits of a regulatory approach: it noted the then-​rapid expansion in crowdfunding in some Member States and the benefits for start-​up and small companies, warned that ‘premature regulation’ 778 COM(2020) 593. Provisional agreement on MiCAR was reached in June 2022. From the extensive and expanding MiCAR-​related literature see, eg, Zetsche et al, n 774. 779 Securitizations, structured deposits, deposits, and electronic money, each as defined under relevant EU law, are also excluded. 780 See in outline Ch I section 7.3. 781 Crowdfunding concerns the raising of capital, in small increments, from large numbers of investors, usually under the regulatory thresholds for public offers and typically through an online platform, usually in the form of a specialist website, or through social media. Fund raising can be non-​financial in nature (in that a donation is made, or the return is in the form of a reward or product; globally, most crowdfunding activity takes this form) or financial (equity or debt). Targets for the funding are usually set and funds are returned if the target is not met. From the now extensive literature see, for a legal perspective, Armour, J and Enriques, L, ‘The Promise and Perils of Crowdfunding: Between Corporate Finance and Consumer Contracts’ (2018) 81 MLR 51 and Macchiavello, E, ‘Financial-​return Crowdfunding and Regulatory Approaches in the Shadow Banking, FinTech and Collaborative Finance Era’ (2018)14 ECFR 662. For a finance-​oriented view see Mollick, E, ‘The Dynamics of Crowdfunding: Determinants of Success and Failure’ (2014) 29 J of Bus Venturing (2013) 1. 782 Regulation (EU) 2020/​1503 [2020] OJ L347/​1. The Crowdfunding Regulation is of tangential relevance to this chapter as, while designed to widen funding opportunities for small issuers, it is primarily concerned with intermediary regulation. It is covered in outline only. 783 Volumes of investment-​based crowdfunding grew from €69 million in 2013 to €1,606 million by 2018: PWC Study for the European Commission, Unlocking the Crowdfunding Potential for the European Structural and Investment Funds (2021) 35. 784 The investor base in the EU is predominantly retail: 2021 PWC Crowdfunding Report, n 783, 35. 785 In 2013 the Commission issued its first major consultation (Crowdfunding in the EU—​Exploring the Added Value of Potential EU Action) and highlighted the potential of crowdfunding as source of long-​term financing (2013 LongTerm Financing Green Paper: n 99). A supportive Commission Communication, designed to facilitate crowdfunding by means of a series of soft measures (including investigation of ‘labelling’ devices, the mapping of regulatory developments, and the raising of awareness), followed in March 2014: Communication on Unleashing the Potential of Crowdfunding in the EU (COM(2014) 172).

II.11  Capital-raising and Digital Finance  217 could hamper the growth of this sector, and committed to reviewing the sector.786 A series of Commission reviews and stakeholder consultations followed,787 accompanied by a swathe of ESMA initiatives;788 the Crowdfunding Regulation, despite the modest size of the market it regulates, emerged from one of the more expansive and detailed reviews undertaken in recent years. These reviews led to a change in the Commission’s position, given the evidence suggesting that diverging national approaches to regulating crowdfunding789 were constructing barriers to the cross-​border market, hindering scaling, generating market fragmentation (with a persistent concentration of crowdfunding activity in only a few Member States), and limiting investors’ capacity to diversify.790 The 2018 Proposal for a Regulation on European Crowdfunding Service Providers, focused on crowdfunding services/​platforms and on intermediary regulation rather than issuer regulation, followed.791 Notwithstanding the extensive preparatory reviews, the negotiations proved complex,792 and led to major changes to the Commission’s initial regulatory design, in two respects in particular. First, the Commission had proposed a voluntary model under which crowdfunding service providers could choose to be regulated under the new regime and thereby benefit from a ‘European Crowdfunding Service Provider (ECSP)’ label. Coming in the wake of the financial-​crisis era shift to intensive harmonization, this voluntary model was a novelty,793 but it reflected the Commission’s concern to adopt a limited and proportionate approach which would accommodate the national crowdfunding regimes that had developed.794 The European Parliament was supportive of a voluntary approach, but the Council revised the Proposal to take the form of a mandatory regulation. Over the negotiations, the regime also became more prescriptive and its scope expanded.795 Second, the 786 2015 CMU Action Plan, n 12, 7. 787 Including: Assessing the Potential for Crowdfunding and other forms of Alternative Finance to support Research and Innovation (2017); Identifying Market and Regulatory Obstacles to Cross-​border Development of Crowdfunding in the EU (2017); Crowdfunding in the EU Capital Markets Union (SWD(2016) 154); and Crowdfunding: Mapping EU Markets and Events Study (2015). 788 eg, ESMA’s review of national approaches (Investment-​based Crowdfunding, Insights from Regulators in the EU (2020); examination of the regulatory implications for money laundering and terrorist financing rules (Q & A, 1 July 2015); and opinion on the regulatory challenges (Opinion, (Investment-​based Crowdfunding), 18 December 2014). 789 The different national models ranged from the application of financial services regulation, to the exemption of crowdfunding services from regulation, to the imposition of bespoke crowdfunding rules: 2018 Crowdfunding Proposal (COM(2018) 113) 3. For an analysis of the German model, eg, see Klöhn, L, Hornuf, L, and Schilling, T, ‘The Regulation of Crowdfunding in the German Small Investor Protection Act’ (2016) 13 European Co L 56. 790 2018 Crowdfunding Proposal, n 789, 1–​2 and 3. 791 2018 Crowdfunding Proposal, n 789. 792 The Proposal straddled the closure of the 2014–​2018 Parliament term and was carried over into the subsequent term. The Parliament reached a negotiating position in March 2019 (T8-​0301/​2019) and the Council adopted its general approach in June 2019 (Council Document 10557/​19). Trilogue negotiations commenced in September 2019 and informal agreement was reached in December 2019, followed by the final Council agreement and Parliament first reading vote in July and October 2020. The Regulation as adopted most closely resembles the Council text. The lengthy negotiations can be associated with different perspectives on crowdfunding, strong national interests, and Brexit-​related uncertainties: Macchiavello, E, ‘The European Crowdfunding Service Providers Regulation: The Future of Marketplace Lending and Investment in Europe and the “Crowdfunding Nature” Dilemma’ (2021) 32 EBLRev 557. 793 While there were voluntary models in use elsewhere (primarily the different voluntary investment fund labels available; see Ch III) these applied as ‘add-​ons’ to pre-​existing regulatory schemes. 794 2018 Crowdfunding Proposal, n 789, 2 and 5. The optional model was designed so as not to interfere with national bespoke regimes or existing licenses, but to provide the crowdfunding industry with the possibility to apply for an EU ‘label’ that could facilitate scaling up. In the region of twenty-​five applications for the new label were expected in the first year (at 8). 795 Among the many revisions, the Council and Parliament introduced own funds/​capital requirements, while the Parliament enhanced the investor protection requirements. As regards scope, the Commission had limited the regime to offers of €1 million or less. While the Parliament and Council raised the threshold to €8 million, to

218 Capital-raising Commission had proposed that ESMA be the sole supervisor of in-​scope providers, but the Parliament and Council both revised the text to revert to the traditional NCA supervision/​ ESMA coordination model. Given the acute sensitivity that attends any conferrals of direct supervisory power on ESMA, this outcome was not unexpected and reflected the parallel negotiations on the 2017 ESA Reform Proposal.796 The Regulation was finally adopted in October 2020 and came into force in November 2021.797 The regime that has emerged adopts a muscular approach to investor protection, fusing intermediary authorization and related ongoing conduct and prudential requirements to disclosure and suitability-​related requirements which are tailored to the particular risks associated with crowdfunding. The Crowdfunding Regulation is designed to provide a regulatory framework for ‘an increasingly important type of intermediation where a crowdfunding service provider, without taking on own risk, operates a digital platform open to the public in order to match or facilitate the matching of prospective investors or lenders with businesses that seek funding’ (recital 1). It lays down uniform requirements for the provision of crowdfunding services, for the organization, authorization, and supervision of crowdfunding service providers, for the operation of crowdfunding platforms, and as regards transparency and marketing communication in relation to crowdfunding services (Article 1). It does not apply, however, to crowdfunding offers with a total consideration of more than €5 million (which would likely come within the Prospectus Regulation in many Member States).798 The gateway definition of ‘crowdfunding service’ is widely defined as: the ‘matching’ of business funding interests of investors and ‘project owners’ (the person seeking funding through a crowdfunding platform:799 Article 2(1)(h)) through the use of a crowdfunding platform and which ‘matching’ consists of any of the facilitation of granting of loans, or the placing, without a firm commitment, of transferable securities800 and admitted instruments for crowdfunding purposes801 issued by a project owner or a special purpose align with the maximum exemption threshold for discretionary Member State exemptions of small offers from the Prospectus Regulation, €5 million was adopted as a compromise, given that many Member States applied a €5 million ceiling to the Prospectus Regulation exemption. 796 Which saw proposals to confer ESMA with additional competences, including as regards prospectus approval, scaled back. See section 4.12. 797 A transitional arrangement permitted crowdfunding service providers authorized under national law to continue to offer such services in accordance with national law until 10 November 2022, in order to facilitate the transition to the new regime. Following a subsequent Commission review, the transition period was extended by a year to avoid market disruption, given the evidence that certain NCAs would not have completed the required authorization processes under the Regulation in time, and the inability of crowdfunding platforms to adapt to the Regulation in time: Delegated Regulation (EU) 2022/​1988 [2022] OJ L273/​3. A series of administrative rules (proposed in ESMA, Draft Technical Standards under the European crowdfunding service providers for business Regulation (2021)), primarily in the form of RTSs, were adopted by the Commission in July 2022 and amplify the Regulation, including with respect to conflict-​of-​interest management, business continuity, disclosure requirements, complaints handling, and the specific requirements (noted below) applicable to ‘non-​sophisticated investors’: [2022] OJ L287. 798 Article 1(2). This upper limit is designed to support investor protection by limiting the reach of offers under the Regulation and also to reflect the use by the majority of Member States of a €5 million upper limit to exempt small offers from the Prospectus Regulation (recital 16), although in practice most Member States now apply an upper limit of €8 million (n 260). 799 A publicly accessible, internet-​based information system operated or managed by a crowdfunding service provider: Art 2(1)(d). 800 As defined under MiFID II: Art 2(1)(m). See section 4.3 and Ch IV section 5.3 on MiFID II transferable securities. 801 ‘Admitted instruments’ are shares of a private limited liability company that are not subject to restrictions that would effectively prevent them from being transferred (Art 2(1)(n)). Accordingly, transferability, which supports exit, is the key qualifying criteria for these instruments, and a material investor protection safeguard. The

II.11  Capital-raising and Digital Finance  219 vehicle802 and the reception and transmission of client orders in relation to these securities and instruments for crowdfunding purposes (Article 2(1)(1)).803 The ‘provider’ of these crowdfunding services (the legal person providing crowdfunding services (Article 2(1)(e)) is the main target of the Regulation. Its regulatory scheme is therefore oriented towards intermediary regulation and it thereby enrolls the crowdfunding service provider as the monitor of the project owner seeking funding. The Regulation has accordingly a different regulatory design to the issuer disclosure regime: the project owner (the parallel to the issuer under the issuer disclosure regime) is not its primary concern. Restrictions apply to the range of services which can be offered by a crowdfunding service provider. In particular, while a provider can propose specific crowdfunding projects to an investor (within investment parameters/​mandates set by the investor), the investor is to review and expressly take an investment decision in relation to each such offer (Article 3(4)). The Regulation does not therefore support discretionary-​management-​type services. The Regulation, which covers loan and investment-​based crowdfunding,804 is based on the regulation and supervision of crowdfunding service providers who must be legal persons, established in the EU, and authorized, by the home NCA (of the Member State where the provider is established (Article 12)), in accordance with the Regulation (Article 3). Authorization brings with it passporting rights, as long as the related notification requirements are followed (Article 18). In common with the approach to intermediary regulation adopted across the single rulebook, the conditions governing provider authorization and the authorization process are specified in detail (Article 12)805 and a requirement for inclusion on an ESMA register applies (Article 14). A series of ongoing conduct and prudential requirements, which reflect, in a highly attenuated form, those applicable under MiFID II to investment firms, also apply to providers. The conduct regime is based on the foundational principle that providers must act honestly, fairly, and professionally in accordance with the best interests of clients (Article 3(2)) and is closely focused on conflict-​of-​interest management (Articles 3, 4, and 8). Providers must, for example, maintain and operate effective internal rules to prevent conflicts of interest and take all appropriate steps to prevent, identify, manage, and disclose conflicts of interests (Articles 4 and 8). Providers are also subject to specific conflict-​of-​interest management obligations, including that they cannot participate in any crowdfunding offer on their platforms or accept their 20 per cent (or more) shareholders, or their managers or employees, as project owners on their platforms (Article 8);806 and that that they must inclusion of ‘admitted instruments’ is designed to ensure that shares in private companies, which might otherwise not be regarded as transferable securities under the MiFID II definition, are in scope. 802 The hosting of a crowdfunding offer through an SPV (a feature of the crowdfunding market) is restricted by Art 3(6), which provides that an SPV can give exposure to only one illiquid or indivisible asset. This restriction is designed to avoid regulatory arbitrage by other regulated financial intermediaries, particularly asset managers, and to ensure the Regulation applies to direct investments. An SPV should accordingly only be used where it enables investor access to assets which would not otherwise be easily offered. This aspect of the Regulation has prompted some market discussion and was the first subject of ESMA’s Crowdfunding Q&A (issued initially in February 2021) which considers, inter alia, the factors governing when an asset is illiquid 803 The joint provision of placing (without a firm commitment) and order reception/​transmission therefore characterizes crowdfunding service provision: recital 10. 804 Specific rules apply to loans under the Regulation. This discussion addresses the investment aspect of the Regulation. 805 Authorization can be withdrawn in accordance with the Art 17 grounds which include lack of activity as well as serious infringement of the Regulation and anti-​money laundering requirements infringements. 806 They may accept such persons as investors, but subject to full public disclosure.

220 Capital-raising not accept any payment for routing investors’ orders to a particular crowdfunding offer on their platforms or to a third-​party platform (Article 3). A series of operational rules apply to providers, including as regards the foundational requirement to establish, and oversee the implementation of, adequate policies and procedures to ensure effective and prudent management, including as regards conflict-​of-​interest management, segregation of duties, and business continuity (Article 4); due diligence in respect of project owners (Article 5);807 complaints handling (Article 7); outsourcing (Article 9); and safekeeping of assets (Article 10). A form of capital/​own funds regime also applies, through a requirement for a prudential safeguard equal to the higher of €25,000 or one-​quarter of fixed overheads of the previous year; this must the form of Common Equity Tier 1 instruments or an insurance policy, or a combination of both (Article 11).808 Supervisory reporting obligations (to the home NCA) are also imposed as regards the funding activity on the provider’s platform (Article 16).809 The Regulation also sets out the supervisory and enforcement architecture, which is based on home NCA supervision, NCA cooperation, and ESMA coordination, and follows the approach in place across the single rulebook.810 In addition, the Regulation constructs a bespoke investor protection system, based on a combination of disclosure and more interventionist suitability/​know-​your-​client rules.811 There are faint echoes of the Prospectus Regulation (as regards disclosure) and MiFID II (as regards suitability/​know-​your-​client requirements) in this system, but it is materially lighter than both, and distinct to the crowdfunding context. The disclosure regime has a number of elements, including, as under MiFID II, the foundational requirement that all information, including marketing communications, from the provider to clients, is fair, clear, and not misleading (Article 19). At its core is the requirement imposed on providers to provide prospective investors (whether retail or institutional) with a ‘key investment information sheet’ (KIIS),812 drawn up by the project owner for each offer, verified by the provider, but not subject to NCA approval813 (Article 23).814 The substantive content of the KIIS is specified,815 and it must also include a disclaimer as regards it not being NCA-​approved, a series of risk warnings,816 and a responsibility 807 The provider must undertake ‘at least a minimum level’ of due diligence regards project owners, including confirming that they have no previous criminal record in the field of commercial and financial law generally. 808 Article 11 sets out how the prudential safeguard is to be calculated and constituted, including where an insurance policy is used. 809 An annual confidential report is required that specifies for each project the project owner and amount raised; the instrument issued; and aggregated information about the investor, and invested amount, by investor fiscal residency, distinguishing between sophisticated and non-​sophisticated investors. 810 The related set of NCA supervisory powers covers inter alia the suspension and prohibition of crowdfunding offers and crowdfunding services and the power to transfer existing contracts to another provider when an authorization is withdrawn, as well as sanctioning powers. 811 Marketing communications by providers are also regulated (Art 27). 812 The KIIS meets the PRIIPs Regulation Key Information Document (KID) obligation for packaged investment products (see Ch IX section 5) where it would otherwise apply (Art 23(15)). 813 Article 23(14) prevents NCAs from approving these information sheets, although they may request to be notified of a sheet at least seven days before it is made available to potential investors. 814 Under the Art 23 language regime, the KIIS must be drawn up in one of the official languages of the Member State whose NCA authorized the provider (or another language accepted by the relevant NCA), but the provider may translate the KIIS (Art 23(2) and (4)). 815 In Annex I to the Regulation, and as regards the project owner and the investment (including principal activities of the project owner and a link to the most recent financial statements, where available); main features of the crowdfunding process; risk factors; securities; the SPV, where relevant; and investor rights. 816 Article 23(6)(c) contains the text of the risk warnings that must be included and as regards the risk of partial or entire loss of the money invested, that a return on the investment may not be received, that the investment is not

II.11  Capital-raising and Digital Finance  221 statement.817 KIIS updating requirements apply to the provider (who must request the project owner to provide it with any necessary changes of information), as does an obligation to promptly notify the project owner where the provider identifies an omission, mistake, or inaccuracy that could have a material impact on the expected return of the investment; the project owner must then promptly complete or correct the information (Article 23(8) and (12)). In an echo of the prospectus regime, Member States must ensure their civil liability provisions apply to those responsible for the KIIS, but the regime is more specified as it requires that these provisions must apply at least where the information is misleading or inaccurate or where the KIIS omits key information needed to aid investors when considering whether to finance the crowdfunding project (Article 23(10)). While there are some resonances, accordingly, between the KIIS and the prospectus regime, the Crowdfunding Regulation takes a significantly lighter if more targeted approach to disclosure, focusing in particular on the design of the crowdfunding offer, risk factors, and the rights attaching to the securities, requiring risk warnings, and requiring relatively pared-​back disclosures on the project owner.818 It is also focused on the service provider as a form of gatekeeper, rather than on the project owner seeking funding. This light-​touch disclosure regime is accompanied by a significantly more precautionary, suitability/​know-​your-​client obligation, again imposed on the provider, but only as regards prospective ‘non-​sophisticated investors’.819 Under Article 21, providers are required to assess in advance whether and which crowdfunding services are appropriate for these investors; and, for the purposes of this assessment, to request information from these investors as regards experience, investment objectives, financial situation, and basic undertaking of the risks involved in investment in general and in the platform’s investments (and including as to past investments (including crowdfunding investments) and understanding of the risks associated with crowdfunding). Where the information is not provided, or where the provider considers that the investor has, based on the information provided, insufficient knowledge, skills, or experience, the provider is to issue a risk warning, which must be acknowledged by the investor. By contrast with the MiFID II suitability assessment, accordingly, the provider is not prohibited from offering the relevant services.820 This assessment must be undergone every two years. The Regulation also requires providers, as part of the suitability assessment, to advise non-​sophisticated investors to simulate their ability to bear losses (calculated as 10 per cent of net worth) and to repeat the exercise annually; a savings product and the investor is advised not to invest more than 10 per cent of net worth, and that it may not be possible to sell the investment when wished. 817 Those responsible (the project owner or its administrative, management or supervisory bodies) must be identified and make declarations to the effect that the information in the KIIS is in accordance with the facts and the KIIS makes no omission likely to affect its import (Art 23(9)). 818 For a supportive analysis, suggesting that the KIIS disclosures are better aligned to investor behaviour, see Serdaris, K, ‘Behavioural Economic Influences on Primary Market Disclosure: The Case of the EU Regulation on European Crowdfunding Services Providers’ (2021) 18 ECFR 428. 819 A non-​sophisticated investor (Art 2(1)(k)) is one who is not a ‘sophisticated investor’ as defined by the Regulation (Art 2(1)(j)). The ‘sophisticated investor’ definition is based on the MiFID II criteria for professional clients (Ch IV section 6.2), covering investors who are professional clients within the MiFID II framework or any natural or legal person who has the approval of the provider to be treated as a sophisticated investor. The approval process is set out in Annex II to the Regulation and is broadly similar to, but finesses, the MiFID II approach to approving persons not otherwise specified as professional as professional clients. 820 On the MiFID II suitability regime, which applies to investment advice and discretionary asset management, see Ch IX section 4.8.

222 Capital-raising and, where a proposed investment by a non-​sophisticated investor exceeds the higher of €1,000 or 5 per cent of net worth, and in an attenuated form of exposure limit, risk warning and investor consent requirements are imposed. Non-​sophisticated investors benefit from a four-​day pre-​contractual reflection period, from the point at which the investment offer is made, during which the investor can revoke the offer without reason or penalty (Article 22). It remains to be seen whether the Regulation will have sustained effects on the crowdfunding market and whether it has successfully balanced the costs associated with managing the investor protection risks of crowdfunding, with the benefits of allowing crowdfunding platforms an accommodating regulatory space.821 While its authorization and regulation regime for providers is among the lightest in the single rulebook (certainly as compared to the intermediary regimes governing rating agencies and even the smallest of MiFID II firms), it nonetheless imposes an extensive suite of conduct and operational rules, with the alleviations largely as regards prudential regulation. It cannot, accordingly, easily be described as a light-​touch measure and the risks of intervention are thereby amplified, although an early review is to follow by November 2023 (Article 45). It can, however, reasonably be characterized as an innovative measure, adopting an intermediary-​based approach to capital-​raising regulation that is tailored to the crowdfunding context, and experimenting with a new approach to ‘issuer’ (project owner) disclosure (via the KIIS and reliance on the provider as a disclosure gatekeeper) and also with suitability/​know-​your-​client regulation. It may, accordingly, come to have wider influence on the retail market regime in particular.

II.12  The Wider Regulatory Ecosystem Supporting Capital-​raising The EU’s issuer-​disclosure regime sits within the wider institutional ecosystem that intermediates capital and that is governed by the single rulebook, including the rules governing trading venues, the prudential and conduct rulebook that applies to investment firms, the market abuse regime, and the investment fund rules, all discussed elsewhere in this book. As regards the role of investment funds in intermediating capital, for example, much attention has focused on the massive post-​financial-​crisis growth of the private equity funding model globally and on the related partial eclipsing of public equity markets.822 Private-​ equity-​based funding has also grown in the EU, if at a less dramatic rate823 and is supported by the CMU agenda as a means for strengthening market finance.824 In addition, loan origination through investment funds is being supported under the CMU agenda, as is access to venture capital (Chapter III).

821 Some evidence augurs well, suggesting that the introduction of regulation increases crowdfunding volumes: Raghavendra Rau, P, Law, Trust, and the Development of Crowdfunding (2020), available via . In support of harmonization in this area as a means for supporting cross-​border activity see Zetsche, D and Preiner, C, ‘Cross-​border Crowdfunding: Towards a Single Crowdfunding Market in Europe’ (2018) EBOLR 217 822 Noted in outline in section 2. 823 The increase over 2015–​2019 has been in the region of 0.3 per cent to just below 0.5 per cent of GDP, as compared to 0.5 per cent to 0.8 per cent in the UK: 2021 Commission CMU Indicators Report, n 47, 23 and 62–​3. 824 eg 2020 CMU Action Plan, n 12, 7 and 12. Reforms are, eg, in train to the prudential treatment of long-​term equity investments by insurance companies, under the Solvency II regime. These would facilitate the holding of private equity exposures: COM(2021) 581. This contrasts with the more sceptical approach which prevailed, particularly in the European Parliament, over the financial-​crisis era. See Ch III.

II.12  The Wider Regulatory Ecosystem Supporting Capital-raising  223 The CMU agenda has also seen the adoption of reforms directed to the banking system, and of a prudential orientation, but designed to support the market intermediation of credit risk more generally, and thereby to release bank capital for lending.825 These measures accordingly have ancillary relevance for issuers who additionally seek funding through bank lending. Chief among these reforms are those relating to the securitization process and to covered bonds. The EU’s new regime for securitizations,826 set out in the 2017 Securitization Regulation,827 is designed to free up credit institutions’ balance sheets for new lending, to create broader investment opportunities for long-​term investors, and, ultimately, to increase the supply of capital and reduce its cost.828 Securitization is regarded as an efficient means for strengthening and widening fund-​raising opportunities as it allows banks to free up their capital for lending, and affords investors, particularly long-​term investors, a wide range of investment opportunities tailored to different risk appetites. Rebooting the securitization market, which had collapsed in the wake of the global financial crisis, quickly emerged as one of CMU’s main priorities, in a clear example of the EU’s pivot from financial-​crisis era stabilization measures to measures designed to drive growth and deepen market finance.829 The complex financial engineering associated with the securitization process, and which was particularly a feature of ‘originate to distribute’ loan practices in the US subprime mortgage market, came to be closely implicated in the financial crisis. Highly complex and poorly understood forms of securitization had led to the transmission of high levels of credit risk into financial markets and across the financial system, which risk crystallized to catastrophic effect.830 While securitization levels recovered relatively quickly in France after the financial crisis, they decreased sharply in Germany where the Landesbanks had suffered from their exposure to asset-​backed securities (securitizations) over the crisis,831 and remained generally fragmented across the EU.832 The safe revival of the EU securitization market (and as regards funding-​oriented securitizations and not the highly complex and opaque securitizations associated with destructive risk transmission over the financial crisis) to pre-​crisis levels, however, was projected to have the potential 825 eg 2015 CMU Action Plan, n 12, 21–​3. These measures, as primarily banking measures, are noted here in outline only. 826 Securitization refers to the process whereby loan assets (such as mortgages and loans to SMEs) are pooled together and moved from the balance sheet of a bank. This is achieved by means of structures which issue securities which generate returns from the underlying loan assets according to the risk/​return profile of the securities; these securities are typically marketed to institutional investors. Risk is accordingly diffused across market actors and bank balance sheets can sustain more lending activity. 827 The regime has two components: the Regulation governing the requirements for ‘STS’ (simple, transparent, and standardized) securitizations and for securitizations generally (Regulation 2017/​2402 [2017] OJ L347/​35) and the accompanying Regulation 2017/​2401 ([2017] OJ L347/​1) which addresses the related capital regime. This discussion addresses the STS or Securitization Regulation. 828 The securitization regime has been characterized as a cornerstone of the CMU project and as designed to support a safe, deep, liquid, and robust market for securitization: 2020 Commission Securitization Covid Proposal (COM(2020) 282) 1. 829 Recital 2 to the Regulation notes the Commission’s intention to ‘restart high quality securitization’. 830 Risker securitizations were not strongly associated with the financial crisis in the EU. The residential-​ mortgage-​backed securitizations (RMBS) which, by securitizing US subprime mortgages (packaged as AAA-​ rated bonds), fuelled the massive risk bubble in the US, never exceeded 0.1 per cent of securitizations in the EU: Kastelein, G, ‘Securitisation in the Capital Markets Union: One Step Forward, Two Steps Back’ in Busch et al (2018), n 163, 468. 831 Howarth, D, ‘State Intervention and Market-​based Banking in France’ in Hardie, I and Howarth, D (eds), Market-​Based Banking and the International Financial Crisis (2013) 128. 832 2017 CMU Economic Analysys, n 115, 52.

224 Capital-raising for unlocking over €100 billion of bank credit (and some €20 billion of SME credit).833 The related reforms were proposed in 2015834 and were designed to stream-​line the patchwork of EU rules governing securitization (notably with respect to due diligence, risk retention, and transparency); to make the capital treatment of securitizations more risk sensitive to facilitate investment; and, in the most eye-​catching reform, to introduce a new harmonized regime for the identification and regulation/​supervision of ‘simple, transparent, and standardized’ (STS) securitizations (including a specific, risk-​sensitive capital treatment for investments in such securitizations) in order to promote such securitizations and thereby to increase bank lending capacity. The negotiations were relatively straightforward although, given the extent of the financial-​crisis-​era losses from securitization, contestation might have been expected, particularly in the Council. The reforms were, however, not deregulatory, reflected international reform trends,835 and their objectives with respect to facilitating the bank lending process and risk diversification were widely supported by the central banking sector as well as by the industry.836 The reforms proceeded unusually quickly through the Council, being agreed some three months or so after the Commission’s proposals were adopted,837 although progress subsequently slowed over 2016 and 2017 as the proposals progressed through the Parliament and through the trilogues, in part given Brexit-​associated dynamics.838 Since then, and like the 2017 Prospectus Regulation, the 2017 Securitization Regulation is proving dynamic. It was adjusted under the Capital Markets Recovery Package to support the EU’s economic recovery from the pandemic, albeit that these reforms, reflecting the intensifying influence of technocracy on the EU rulebook, followed earlier pre-​pandemic EBA reviews which had called for reforms.839 The revisions, adopted in 2021,840 reform the Securitization Regulation to allow certain on-​balance-​sheet securitizations (where the exposures are retained by the relevant lender rather than sold on) to be designed as STS

833 2015 CMU Action Plan, n 12, 4. 834 COM(2015) 472 (the general and the ‘simple, transparent, and standardized’ (STS) frameworks for securitization) and COM(2015) 473 (the capital reforms). The reforms drew on Commission, An EU Framework for Simple, Transparent, and Standardized Securitization (2015) and also closely followed EBA’s technical recommendations in relation to the identification of STSs and their capital treatment (see, eg, EBA, Report on Synthetic Securitisation (2015); Discussion on Simple, Standard, and Transparent Securitisations; (2014) and Report on Qualifying Securitisations (2014)). 835 Basel Committee, Basel III Document. Revisions to the Securitisation Framework (2014) and Basel Committee and IOSCO, Criteria for Identifying Simple, Transparent, and Comparable Securitisations (2015). 836 A 2014 intervention by the ECB and the Bank of England was influential in driving the reforms: Bank of England and ECB, Discussion Paper, The Case for a Better Functioning Securitisation Market in the EU (2014). Among the many industry reports urging reform see AFME, High-​quality Securitisation for Europe (2014). 837 The Council reached a general approach in December 2015: Council Press Release 887/​15, 2 December 2015. The Commission highlighted the ‘record speed’ of the Council agreement: Statement, 2 December 2015. In a historical footnote, the influence of the UK was marked, reflecting the importance of the UK securitization market. See Quaglia, L, ‘It Takes Two to Tango: The European Union and the International Governance of Securitization in Finance’ (2021) 59 JCMS 1364. 838 France and Germany in particular were concerned as to the Parliament’s proposals for the third country (in effect, UK) application of the regime: Brunsden, J and Hale, T, ‘Brexit Risks EU Plans to Fast Track Securitisation’, Financial Times, 7 February 2017. Commission concern at the impasse was forcefully expressed: Commission Vice-​President Dombrovskis, Remarks, Public Hearing on CMU Mid-​Term Review, 11 April 2017. 839 EBA, Report on STS Framework for Synthetic Securitisation (2020) and Opinion to the European Commission on the Regulatory Treatment of Non-​Performing Exposure Securitisations (2019). Similarly, a major report from the three ESAs on reform of the regime (which was required by the Securitization Regulation) can be expected to shape the reform process: Joint Committee Report on the Implementation and Functioning of the Securitisation Regulation (2021). 840 Regulation (EU) 2021/​557 [2021] OJ L116/​1.

II.12  The Wider Regulatory Ecosystem Supporting Capital-raising  225 securitizations, and also remove restrictions on the securitization of non-​performing exposures (these restrictions were limiting banks’ ability to reduce non-​performing loans), in particular to provide additional capacity for SME lending. Further reform can be expected,841 amid ongoing concerns that the EU securitization market is under-​developed.842 The 2017 Securitization Regulation (which is accompanied by the partner Regulation on capital treatment and which is amplified by a dense administrative rulebook) lays down a general framework for securitizations, including by defining an in-​scope securitization as a transaction or scheme whereby the credit risk associated with an exposure or pool of exposures is tranched.843 The Regulation has a wide reach, covering the different entities engaged in the securitization process (including originators (who generate the assets to be securitized (whether as original lenders or as purchasers of the assets), sponsors (who manage the securitization process), original lenders, and special purpose vehicles engaged in the securitization process, as well as institutional investors). It imposes, inter alia, requirements governing due diligence for investors (Article 5),844 risk retention for the originator, sponsor, or original lender (Article 6),845 and the transparency obligations of the originator, sponsor, and securitization vehicle (securitization special purpose entities (SSPEs)) (Article 7); imposes rules governing the selling of securitizations to retail clients (Article 3);846 prohibits resecuritizations (Article 8); and requires the establishment, and the ESMA authorization and supervision of, ‘securitization repositories’ that hold data on securitizations (Article 10–​17).847 In addition, it puts in place a new regime for STS securitizations which is designed to facilitate their use: under Articles 18–​22 and 27–​8 a

841 The Commission’s 2022 review (required by the Regulation’s review clause), published in October 2022, was relatively sanguine. It found that the regime was overall fit-​for-​purpose, albeit that it proposed that changes be made to the Regulation’s transparency regime to mitigate its costs. The Commission acknowledged, however, that securitization still suffered from a ‘perceived stigma’ and that, while it was difficult to establish a reliable estimate of the size of the EU securitization market, the evidence suggested that securitization issuance was muted, with a decline in the market since 2015 (by comparison with the growing US market): (COM(2022) 517). Earlier, the 2020 CMU Action Plan, while regarding the regime as a success, called for SME-​oriented reforms (n 12, 9–​10). 842 The High Level CMU Forum, eg, called for a greater expansion of securitization, noting that it represented only 3 per cent of GDP in the EU, as compared to 12.5 per cent and 12 per cent in the US and UK, respectively: n 614, 57. Similarly a 2021 review by the European Stability Mechanism noted that the crisis-​era ‘stigma persists’, with securitization volumes a small fraction of what they were a decade ago (the European securitization market (including the UK) was 75 per cent of the US market in 2008, but 6 per cent in 2020): Janse, K and Strauch, R, Reviving Securitization in Europe for CMU, ESM Report, July 2021. 843 Securitization Regulation Art 2(1). Three further criteria apply: payments in the transaction or scheme are dependent on the performance of the exposure or pool; the subordination of the tranches determines the distribution of losses during the life of the transaction or scheme; and the transaction or scheme does not have the features of certain specialized lending exposures under the terms of the CRD IV/​CRR prudential regulation regime (Directive 2013/​36/​EU [2013] OJ L176/​338 (CRD IV)) and Regulation (EU) No 575/​2013 [2013] OJ L176/​1 (CRR)): CRR Art 147(8)). 844 Article 5 specifies the nature of the due diligence review that must be carried out by institutional investors in respect of all securitization investments and the process and stress tests to be followed. 845 The originator, sponsor, or original lender must retain on an ongoing basis a material net economic interest in the securitization of not less than 5 per cent. 846 Sales are prohibited unless a MiFID II suitability assessment has been performed (see Ch IX section 4.8), the seller of the securitization is satisfied that the position is suitable for the client, and the client is informed in writing of the outcome of the suitability test. Where the client’s financial instrument portfolio does not exceed €500,000, further restrictions apply in that: the seller must ensure, on the basis of information provided by the retail client, that the retail client does not invest an aggregate amount in excess of 10 per cent of its financial instrument portfolio in securitization positions; and the minimum amount invested in one or more positions must be €10,000. 847 Securitization repositories were established by the Regulation as new EU data banks, authorized and supervised by ESMA, and designed to hold and disseminate data on securitizations. They are based on, and their functions in practice carried out by, the trade repositories that hold derivatives market data under EMIR (Ch VI section 5).

226 Capital-raising series of detailed substantive requirements govern when a securitization can be designated as ‘simple, transparent and standardized’848 and can thereby benefit from alleviated capital treatment as well as signalling effects. The Securitization Regulation is not directly concerned with fund-​raising through the markets by issuers, and is oriented towards prudential regulation and risk management, but there are points of connection. It has ancillary effects on capital-​raising as it is designed to free up bank capital for lending. Further, its design has some resonances with the issuer disclosure regime, in that it imposes specific and detailed transparency requirements on originators, sponsors, and SSPEs.849 There is a direct cross-​over between the Regulation and the issuer disclosure regime, however, in that where a securitization is offered to the public or admitted to a regulated market, the Prospectus Regulation applies and the ongoing issuer disclosure requirements apply as regards any admission to a regulated market. Otherwise, where a prospectus is not required to be drawn up under the prospectus regime, a ‘transaction summary’ must be drawn up which covers the main features of the transaction (Article 7(1)(c)).850 Alongside the securitization regime, the harmonized regime for covered bonds, adopted in 2019,851 is similarly designed to free up bank capital for lending and to provide investment opportunities for long-​term investors. Covered bonds take the form of debt securities issued by credit institutions which allow double recourse in that they are backed by a ringfenced ‘cover pool’ of assets (usually high-​quality assets such as public debt or residential mortgages) to which investors (typically institutional investors) have direct recourse in the event of default. Regarded as a key long-​term funding tool,852 covered bonds constitute an important source of funding for EU credit institutions (and provided a reliable funding source over the crisis era when other funding channels for credit institutions’ lending activities contracted).853 Given their capacity to provide a stable funding source for credit institutions, the adoption of a harmonized, facilitative rulebook,854 which would remove legal frictions and support the development of covered bond markets and thereby support real 848 Including that the underlying exposures (loans) are originated in the ordinary course of business by the originator or lender (simple); that data is made available to potential investors covering at least five-​year historical data on default and loss performance for substantially similar exposures to those being securitized (transparent); and that interest rate and currency risks are mitigated (standardized). 849 A series of transparency requirements apply under Art 7 to the originator, sponsor, and SSPE (who are to decide who among them is designated as providing the disclosures and making them available to a securitization repository) as regards the disclosures to be made available to holders of securitization positions, relevant NCAs, and, on request, potential investors, including quarterly information on the underlying exposures; all underlying documentation necessary to understand the transaction, including the final offering document or prospectus and the related transaction documentation, including the asset sale agreement; quarterly investor reports; and disclosures required under the MAR market abuse regime (or if not so required, on similarly material events). Specific requirements apply to STS securitizations. 850 Including details on the structure of the transaction; on the exposure characteristics, cash flows, credit enhancement, and liquidity support features; the voting rights of securitization position holders; and a list of all triggers or events that could have a material impact on the performance of the position. 851 The covered bond regime has two components: Directive 2019/​2162 [2019] OJ L328/​29 (which sets out a harmonized regulatory framework for covered bonds) and Regulation 2019/​2160 [2019] OJ L328/​1 (as regards the capital treatment of covered bonds). 852 EBA, Report on Covered Bonds (2016) 6. 853 The global covered bond market grew steadily over 2003-​2012, with a temporary dip at the height of the financial crisis, and was dominated by EU issuers, with 80 per cent of the global market represented by six EU Member States. Over the financial crisis, this market provided the main, and sometimes only, source of funding for many banks, apart from central bank funding. Commission, Covered Bonds in the EU (2016) 6–​10. 854 EBA reported on a diversity of legal and supervisory frameworks (particularly as regards liquidity, stress testing, and transparency and supervisory approaches): n 852.

II.13  Reform and the Market  227 economy funding, was folded into the CMU agenda.855 A proposal for an ‘enabling’ regime, following a principles-​based approach which would allow Member States to apply domestic requirements within a harmonized but facilitative framework,856 was presented in March 2018857 and speedily agreed in February 2019. Unusually for post-​financial-​crisis/​CMU-​era regulatory design, its main measure takes the form of a directive. This design choice reflects the structure of the EU covered bond market which is based on well-​established national markets; a regulation would have had disruptive effects accordingly. The 2019 Covered Bonds Directive accordingly specifies minimum requirements for covered bonds marketed in the EU (dual recourse; bankruptcy remoteness; and cover pool/​eligible assets and related transparency and liquidity requirements); establishes the ‘European Covered Bonds’ label for bonds meeting the Directive’s requirements; and puts in place a supervisory regime. Alongside the securitization and covered bonds regimes, a European Secured Notes instrument, which would use the covered bonds ‘technology’ to develop a new asset class that would provide additional bank lending capacity for SMEs and for infrastructure loans is under development.858

II.13  Issuer Disclosure, Admission to Trading Venues, Reform, and the Market The issuer disclosure (and admission-​to-​trading) regime has experienced repeated cycles of reforms since the early 1970s. It has evolved to take the form of a dense rulebook, supported by the increasingly sophisticated convergence tools deployed by ESMA, and shaped by the extensive IFRS financial reporting system. It has become more calibrated and atomized and more operational and procedural. It has also become dynamic; reform and adjustment are now embedded features of the regime, whether as regards legislative, administrative, or soft law measures, and whether as regards large-​scale legislative reform or targeted ESMA guidance to reflect market conditions. Whether or not this rulebook has had a transformative impact on market finance in the EU is difficult to unpack. The scale of the CMU agenda underlines the policy realization that support of market finance generally, and of issuer capital-​raising specifically, calls for an ecosystem of interlocking regulatory and non-​regulatory measures. Data is a particular challenge, with the Commission only recently adopting metrics for assessing whether the CMU reform programme is driving change.859 It is reasonable, however, to suggest that the disclosure/​admission rulebook can be associated with higher quality, more comparable market disclosures and that it thereby supports capital-​raising, not least given the canonical association between mandatory disclosure and market efficiency and between admission requirements and liquidity. But the wide range of factors that shape capital market growth 855 2015 CMU Action plan, n 12, 22. 856 2018 Covered Bond Directive Proposal (COM(2018) 94) 1. 857 As with much of the CMU agenda, technocratic influence was strong, in the form of EBA’s 2014 report on how Member States addressed covered bonds and which recommended best practices: EBA, Report on EU Covered Bond Frameworks and Capital Treatment (2014). 858 The 2019 Covered Bond Directive requires the Commission to report on a European Secured Note instrument by 2024. Preparatory work is underway as to market appetite and potential structure (see, eg, Richard Kemmish Consulting, Feasibility Study on European Secured Notes for European Commission (2018)). 859 2021 Commission CMU Indicators Report, n 47.

228 Capital-raising and depth, as well as the different forces that shape the relative scale of public and private markets, caution against assertions as to specific transformative effects for the issuer disclosure/​admission rulebook. Similarly, while the issuer disclosure/​admission regime has removed many of the frictions associated with diverging national rulebooks, whether or not this can be associated with cross-​border activity is unclear. As outlined in Chapter I, a wealth of data is now available as to levels of market finance in the EU economy. There is little data, however, on the impact of the different elements of the issuer disclosure/​admission regime. Among the few longstanding sources are ESMA’s annual reports on approved prospectuses860 which report on one of the headline features of EU financial markets since the financial crisis: the downward trend in the number of prospectuses approved, which have dropped from 8,875 (2007) to 2,612 (2020); some 29 per cent of the 2007 peak.861 This trend has been persistent since 2007, with CESR initially and then ESMA repeatedly reporting on this downturn.862 Prospectuses are predominantly approved for non-​equity offerings,863 reflecting the thinness of equity capital markets in the EU. The passporting of prospectuses, something of a proxy for cross-​border activity, has not increased significantly.864 Certainly, the development of the issuer disclosure/​admission regime has not been accompanied by a marked increase in capital market depth and strength. The ratio of non-​financial corporations (NFCs) use of market funding (listed shares and bonds) has, after an initial marked increase over 2011 (38 per cent of NFC funding) to 2015 (42.1 per cent),865 increased only slowly in recent years, from 42.1 per cent in 2015 to 42.8 per cent in 2019; and there are significant divergences across the Member States, with the ratio ranging from 7 per cent in Cyprus through to 85 per cent in Ireland.866 The increase has been driven almost entirely by greater reliance on bond issuances, with little change in the low levels of recourse to listed equity capital.867 The value of capital raised through IPOs, for example, has declined from 0.9 per cent of GDP in 2015 to 0.2 per cent in 2019.868 860 These reports were initiated by CESR in 2007 and have become considerably more extensive and informative over time. 861 Excluding the UK (with the UK (prior to its departure from the EU) the drop is from 10,390 (2007) to 3,113 (2019)): ESMA, EEA Prospectus Activity in 2020 (2021) 7–​8. More generally, the growth of EU equity markets has been volatile, reflecting, inter alia, a series of crises, from the Enron-​era equity market crisis, to the global financial crisis, to the Covid-​19 crisis. EU stock market capitalization as a proportion of GDP has ranged from a high of 83 per cent in 1999, to 67 per cent in 2001 (reflecting the Enron-​era volatility), to a low of 37 per cent in 2008 during the financial crisis, to 81 per cent in 2021: CEPS/​ECMI Roundtable on the EU’s Capital Markets, Time to Re-​energize the EU’s Capital Markets (2022). The number of companies listed on public trading venues, however, has increased, from 3,237 in 1993 to 5,902 in 2021: ibid. 862 The sharpest decline (from 8,875 approved prospectuses to 5,701) was from 2007 to 2008, in the teeth of the financial crisis, but year-​on-​year since then approvals have decreased (bar a marginal increase of 50 from 2012–​2013). 863 Prospectuses for non-​equity offerings have typically been in the region of 75 per cent of all prospectuses in recent years (eg, 75 per cent in 2014 (2014 ESMA Prospectus Report) and 2015 (2015 ESMA Prospectus Report); 76 per cent in 2019 (2019 ESMA Prospectus Report); and 78 per cent in 2020 (2020 ESMA Prospectus Report)). 864 2020 ESMA Prospectus Report, n 861, 16 and 18, reporting on a more or less static trend from 2013 to 2019 but some upward momentum in the period from 2019 to 2020. 865 2021 Commission CMU Indicators Report, n 47, 15–​17. The ratio relates to the sum of listed shares and bonds issued by NFCs relative to the sum of shares/​bonds and bank loans to NFCs. The increase reflects a structural change from corporate bonds acting as a substitute for bank lending at the height of the crisis-​era contraction in lending, to forming a complementary source of finance. 866 2021 Commission CMU Indicators Report, n 47, 16. While the range reflects the relative size of economies there are still marked divergences between economies of similar size, with market funding of NFCs in Austria at much lower levels than in Spain (ibid). 867 2020 Oxera Report, n 47. 868 2021 Commission CMU Indicators Report, n 47, 20. By 2021, however, the value had increased to 0.9 per cent of GDP (from 0.3 per cent in 2020): 2022 Commission CMU Indicators Update, n 111.

II.13  Reform and the Market  229 More generally, the longstanding differentiation between broadly bank-​based and broadly market-​based funding systems remains, with public equity markets, for example, significantly deeper in Denmark and Sweden than in Germany and in Austria.869 More recently, there have been signs of market finance gaining greater traction. 2021 saw strong growth in market-​finance-​based funding for NFCs, with total equity issuance (IPOs and secondary offerings) at €165 billion, 65 per cent higher than 2020 and just 10 per cent below the record levels recorded in 2014; IPOs saw particularly strong growth, exceeding by one per cent the record level (2007, before the global finance crisis).870 But these headline figures shed little light on the effectiveness or otherwise of the issuer-​disclosure/​admission regime in driving market change, given the wide range of factors that have shaped the contraction in EU public equity markets, and increases in de-​listings, since the financial crisis, from wider economic conditions, to the impact of previously accommodative monetary policy on the easier availability of debt and the related explosion in private equity funding, to the impact of the debt bias in taxation.871 Similarly, the sharp 2021 increase in market-​based funding activity has been related to the impact of SPACs and of accommodative pandemic-​related monetary policy,872 while early 2022 saw a contraction of funding conditions as monetary policy took a decisive turn towards a more restrictive approach and the war in Ukraine increased market volatility (albeit that September 2022 saw the largest cross-​border IPO in the EU in decades with the Porsche offering).873 Perhaps the better question is the extent to which issuers use the different choices and formats made available in the prospectus regime, as this sheds some light on its effectiveness. Over time, there has been very limited use of the ‘shelf registration’ (registration document/​securities note) system, with the vast majority of prospectuses (that are not in the form of a base prospectus) being prepared as a single document.874 Whether or not the availability of the URD will change issuer behaviour remains to be seen, but the initial indications show some evidence of it being a useful reform.875 There are also some early indications that the EU Growth and simplified prospectuses are responding to issuer needs, representing together 13 per cent of total approved prospectuses in 2020, up from 8 per cent in their first year of availability in 2019.876 Both formats were more heavily used for shares. The regime does therefore seem to be responding, at least to some extent, to issuer needs.

869 2021 CMU Indicators Report, n 47, 21. Generally, equity capital markets are strongest in Denmark, Finland, and Sweden, reflecting a host of domestic factors, including tax incentives: 2022 CEPS/​ECMI Report, n 861. 870 ESMA TRV (No 1) (2022) 22. There were 485 IPOs (191 in 2020): EY, Strong Third Quarter for IPOs—​ especially in Europe, 14 December 2021. Similarly, the Commission’s 2022 update on its CMU indicators ‘tool-​kit’ reported on a sharp increase in the value of IPOs (and on a drop in the value of corporate bond issuances): 2022 Commission CMU Indicators Update, n 111. 871 For an extended analysis see the 2020 Oxera Report, n 47, finding that regulation has not been a driver of the contraction in public markets. 872 As well as growing share valuations and increased corporate earnings: ESMA TRV (No 1) (2022) 22. 873 n 35. On the Porsche offering and its significance as the largest European IPO by market capitalization on record see Clifford Chance, Porsche: A Model for the Pan-​European Retail IPO, October 2022. 874 Over the years, in the region of 90 per cent of issuers have prepared the prospectus as a single document. ESMA has reported that the single format has ‘consistently remained overwhelmingly more popular’ than the tripartite form: 2020 Prospectus Report, n 861, 12. 875 From a slow start in 2019 (15), approved URDs rose to 56 in 2020. In practice, use of the URD is likely to be more widespread than the numbers suggest, as ESMA only collects data for approved URDs, whereas URDs can, after two years, be filed and then used for prospectus preparation. France is far and away the highest user of URDs (at 73 per cent of the total in 2019 and 2020), reflecting the longstanding use of a similar document in the French market. 2020 ESMA Prospectus Report, n 861, 21. 876 2020 ESMA Prospectus Report, n 861, 19.

230 Capital-raising Regarded in terms of regulatory design, however, there is a positive tale to tell. While the issuer disclosure regime has certainly expanded and intensified, it has also become significantly more differentiated and calibrated, primarily, but not only, as regards SMEs. It has become more operationally oriented, with the recent expansion in the prospectus formats available to issuers an indicator of a concern to respond to issuer needs. It is also increasingly responsive, with legislative review clauses setting up a semi-​permanent reform cycle. The 2021 Covid-​19 Recovery Prospectus, for example, suggests a willingness to experiment as well as some legislative agility, as do the frequent reforms to support SMEs. The rulebook has, however, in consequence, become somewhat unstable, as well as highly atomized, but this may be the price for a more responsive regime. Difficulties remain, however, with the supervisory architecture, as the Wirecard scandal indicates, with much depending on ESMA’s soft supervisory convergence capacity.

III

COLLECTIVE INVESTMENT MANAGEMENT III.1  Introduction: Collective Investment Management This chapter is concerned with the regulation of collective investment management. The investment or asset management sector sits at the heart of the EU financial market as a critical channel for the pooling and intermediation of capital and its allocation to the real economy, for the diversification of risk, and, accordingly, for the achievement of Capital Markets Union (CMU).1 Reflecting global trends, the EU investment management sector recovered strongly after the global financial crisis, with assets under management (AUM) growing from €13.6 trillion in 2010 to over €28 trillion in 2020.2 AUM in the EU are more or less evenly split between assets managed collectively through collective investment schemes and assets managed under discretionary mandates, although collective asset management currently dominates.3 Discretionary investment or asset management involves the agency management of a client’s portfolio (whether retail or professional), on an individual basis and in accordance with the mandate agreed between the agent investment manager and the principal client. An ‘investment service’ under the 2014 MiFID II/​MiFIR regime,4 it is governed by the extensive MiFID II authorization and operating requirements for investment services and the related administrative rulebook, discussed in Chapters IV, VI, and IX.5 In addition, the EU’s prudential regulation regime imposes a series of prudential requirements, including capital, liquidity, and governance requirements, on discretionary asset management (Chapter IV). This chapter is concerned with collective investment management, or the management of investment funds (in EU parlance, collective investment schemes (CIS)).6 A CIS is a form of investment vehicle which pools investors’ funds to make investments and delivers returns related to pre-​set asset-​selection and risk-​management criteria and in proportion to the investor’s ownership stake in the CIS.7 Given its capacity to pool and intermediate capital (the EU CIS sector currently represents in the region of €16 trillion AUM),8 a deep and 1 CMU is supported by its 2015 and 2020 Action Plans: Commission, Action Plan on Building a Capital Markets Union (COM(2015) 468) and Commission, A Capital Markets Union for People and Businesses. New Action Plan (COM(2020) 590). 2 Assets under management (AUM) rose continuously between 2012 and 2017, declined in 2018 in line with a decline in stock markets globally, rebounded in 2019, suffered a major reversal in Q1 2020 as the Covid-​19 pandemic deepened, but have recovered strongly since: EFAMA, Asset Management in Europe (2021) 6. 3 AUM subject to discretionary mandates represented 45.9 per cent (€13,052 billion) of total EU AUM at the end of 2020, while AUM subject to collective asset management represented 54.1 per cent (€15,371 billion): 2021 EFAMA Asset Management Report n 2, 7. 4 Directive 2014/​65/​EU [2014] OJ L173/​349 (MiFID II) and Regulation (EU) No 600/​2014 [2014] OJ L173/​84. 5 See generally on discretionary investment management regulation Busch, D and De Mott, D (eds), Liability of Asset Managers (2012). 6 The terms ‘fund’ and ‘CIS’ are used interchangeably in this chapter. 7 By contrast, packaged investment products, which often act as functional substitutes for retail-​market-​ oriented CIS investments, deliver a return related to the structure of the product. 8 ESMA, Performance and Costs of EU Retail Investment Products (2022).

232  Collective investment Management liquid CIS market is regarded as a key institutional component of a strong financial market.9 While CISs can take myriad forms, three predominant types can be identified: scheme assets can be owned by a company in which investors are given a share representing their investment; scheme assets can be held within a structure without separate legal personality and held by a trustee on behalf of investors;10 and schemes can similarly be held in a structure without separate legal personality but in contractual form. A CIS share or unit gives the investor the right to participate in the profits or income which arise from the CIS’ investment activities and which form the return on the CIS. Whatever the form of legal vehicle used, the CIS is run by the CIS manager and depositary, two different legal entities who must be structurally separate. The CIS manager carries out the investment and risk management functions; custody of the assets is the responsibility of the CIS depositary which also monitors the manager. The CIS manager and depositary are regulated under the EU regime; the extent to which the CIS itself is regulated depends on the type of CIS, with the EU rulebook segmented in this regard. As discussed across this chapter, EU collective investment management regulation serves a number of objectives, primarily, and reflecting the regulatory treatment of CISs internationally, in relation to investor protection but also, and reflecting the increasingly intricate interdependencies between CISs and the financial system (exposed most recently in March 2020 as the Covid-​19 pandemic deepened, markets roiled, and CISs came under severe outflow pressure), financial stability.11 But its foundational and longstanding purpose, in common with that of the single rulebook generally, is to support the embedding of market finance and market integration: CISs are a critical institutional support to the embedding of market finance, while the harmonized rules of the CIS rulebook are, at bedrock, in service of passporting by CISs and their managers (depositaries do not have passporting rights). The CIS rulebook has a long lineage, stretching back to 1985, and now forms a dense, multi-​layered, and mature regulatory system, but these imperatives remain pivotal: the 2015 and 2020 Capital Market Union (CMU) agendas, for example, identified CISs as a critical institutional support to market finance and to market integration, and proposed a series of finessing reforms.12

III.2  The EU Collective Investment Management Rulebook The EU collective investment management regime has developed from a single 1985 source to become, by 2022, a multi-​layered, technically intricate, and dense ‘rulebook’.13 9 eg, Black, B, ‘The Legal and Institutional Preconditions for Strong Securities Markets’ (2001) 48 University of California LR 781 and Levine, R, ‘Financial Development and Economic Growth: Views and Agenda’ (1997) 35 J of Econ Lit 688. 10 For an examination of the ‘delicate interface’ between private trust law and freedom of contract and CIS regulation, and how private law supports the ordering of fund sector, see Kulms, R, ‘Trusts as Vehicles for Investment’ (2016) 24 ERPL 1091. 11 Well exemplified also by the enhanced monitoring by ESMA of the investment fund sector for liquidity risks following the outbreak of the war in Ukraine and the market volatility which followed: ESMA, Public Statement (Ukraine), 14 March 2022. 12 n 1. As outlined across this chapter, the reforms include removing frictions to cross-​border CIS distribution, accommodating loan origination by CIS, and facilitating CISs in supporting venture capital. 13 For a review of the entire regime see Zetsche, D, The Anatomy of European Investment Fund Law (2017), available via .

III.2  The EU Collective Investment Management Rulebook  233 Collective investment management was first addressed by the 1985 UCITS Directive.14 The foundation of the EU collective investment rulebook, it addressed the collective investment management of the now totemic ‘Undertaking for Collective Investment in Transferable Securities’ (UCITS), a retail-​oriented CIS which, being subject to an authorization requirement which was dependent on compliance with extensive asset allocation rules, was constructed by the 1985 Directive. From then until the global financial crisis and the epochal adoption of the 2011 Alternative Investment Fund Managers Directive (2011 AIFMD), which governs the collective investment management of all non-​UCITS funds (termed ‘alternative investment funds’ (AIFs)),15 the UCITS regulatory regime acted as a proxy for EU collective investment regulation and policy generally. The 1985 Directive was repeatedly refined prior to the financial-​crisis era, most significantly by the two 2003 ‘UCITS III’ reforms,16 and has been reformed since. The UCITS regime is currently based on the 2009 UCITS IV Directive (or UCITS Directive), which replaced the 1985 Directive, consolidated the earlier reforms, and imposed new requirements. Still in force, the UCITS IV Directive has been revised by a series of subsequent reforms, chief among them the 2014 UCITS V Directive and the 2019 ‘Refit’ reforms. While repeatedly refined, the core UCITS regulatory design and the UCITS ‘label’ it constructs have shown remarkable longevity. The UCITS fund is regularly lauded internationally as a major achievement in regulatory design17 and, supporting over €11 trillion of net asset value (NAV),18 remains one of the success stories of the EU capital markets project.19 Since the 2011 adoption of the AIFMD, the management of CISs in the EU can be regarded as being governed by the AIFMD, with the UCITS Directive addressing a subset (if the largest subset) of CISs. The AIFMD addresses the collective investment management of all CISs, apart from those authorized under the UCITS Directive. It regulates the managers of ‘alternative investment funds’ (AIFMs), but it does not require the authorization of alternative investment funds (AIFs) (non-​UCITS funds). Although the UCITS sector is larger than the AIF sector,20 because the UCITS Directive is an opt-​in regime (it applies where 14 Directive 85/​611/​EC [1985] OJ L375/​3 (since repealed). Following a series of reforms, now Directive 2009/​ 65/​EU [2009] OJ L302/​32, as amended subsequently, most significantly by the 2014 ‘UCITS V’ reforms (Directive 2014/​91/​EU [2014] OJ L257/​186). 15 Directive 2011/​61/​EU [2011] OJ L174/​1 (the 2011 AIFMD). 16 Directive 2001/​107/​EC [2002] OJ L41/​20 and Directive 2001/​108/​EC [2002] OJ L141/​35. 17 For a recent example see Investment Company Institute, 2021 Investment Company Factbook (2021), describing the UCITS structure as a global success story and noting that from its initial 1985 adoption it had developed to support some €11 trillion in assets in the EU and globally: at 27. 18 UCITS funds are the most common form of CIS in the EU, representing some €11.6 trillion in net asset value (NAV): ESMA, EU Alternative Investment Funds (2022) 9 (reporting on 2020 data). Net asset value is the current market value of a fund’s portfolio (assets minus liabilities) and is widely used (including by ESMA) as a proxy for the size of a fund. The per share/​per unit NAV, which acts a proxy for the return the investor will receive on redemption, is the NAV divided by the number of shares/​units outstanding 19 The CMU agenda has seen it described as one of the major successes of the EU capital market integration project and a powerful driver of growth in the financial sector: High Level Forum on the Capital Markets Union, A New Vision for Europe’s Capital Markets (2020) 9. Prior to the financial crisis, it was noted that ‘almost by accident, Brussels appeared to have engineered a rip-​roaring success in the world of investment funds’: Johnson, S, ‘How UCITS Became a Runaway Success’, Financial Times Fund Management Supplement, 27 November 2006. A critical 2022 review of the funds regime generally by the European Court of Auditors (as regards market integration, investor protection, and financial stability: European Court of Auditors, Special Report: Investment Funds (2022)) drew a robust response from the Commission which found the regime to be ‘suitable and effective,’ underlined the repeated reforms since the global financial crisis, and emphasized that regulatory reforms needed time to take effect: Commission, Response to the European Court of Auditors Report (2022). 20 ESMA’s 2022 report on the AIF industry reported that AIFs accounted for some 1/​3 of the EEA investment fund industry at end 2020 (€5.9 trillion NAV): 2022 ESMA AIF Report, n 18. In the three years since the first

234  Collective investment Management a CIS is constructed as a UCITS in accordance with the Directive), the AIFMD is the default, horizontal regime for collective investment management in the EU, other than UCITS management. The AIFMD and its supporting rules and soft law constitutes a horizontal, management-​ focused regulatory regime that is associated in particular with the professional markets,21 and with the management of financial stability risks, including, unusually, through macroprudential tools.22 The UCITS Directive and its supporting rules and soft law constitutes a fund-​specific, product-​focused regulatory system, that is associated in particular with the retail markets,23 and that is less associated with the management of financial stability risks, given in part the extensive liquidity and leverage conditions imposed on UCITS funds. Together, these two measures form the twin pillars of the EU’s collective investment rulebook. Attached to these two pillar measures are the specialist regimes that apply to four different forms of CIS in the EU. Since the financial crisis, the EU has used collective investment fund regulation to promote capital-​raising by constructing three different forms of AIF vehicle which are regulated (to different extents) under the horizontal AIFMD regime. The European Venture Capital Fund (EuVECA), the European Social Entrepreneurship Fund (EuSEF), and the European Long-​term Investment Fund (ELTIF) are all constructed under their respective regulations (the 2013 EuVECA Regulation, the 2013 EuSEF Regulation, and the 2015 ELTIF Regulation)24 (which are oriented to product regulation as they address how these funds are constructed) but are nested within the AIFMD regime as regards their management. A fourth regime applies to money-​market funds (MMFs) under the 2017 (2019) publication of this annual report, the AIF sector has grown from €4.9 trillion. (The 2022 data showed a drop from 2021 as a result of Brexit and the exclusion of UK data.) 21 Some 14 per cent of investment in AIFs represents retail investment: 2022 ESMA AIF Report, n 18, 6. 22 Macroprudential regulation is a form of prudential regulation directed to system-​wide stability, rather than to firm-​level stability. It is typically associated with capital requirements and bank lending and relies on tools such as: higher capital charges for systemically significant institutions, capital buffers designed to prevent procyclicality in banks’ lending activities, and restrictions on banks’ lending/​mortgage policies. For a financial-​crisis-​era perspective see Lastra, R, ‘Systemic Risk and Macro-​Prudential Supervision’ in Moloney, N, Ferran, E, and Payne, J (eds), The Oxford Handbook of Financial Regulation (2015) 309. In the financial markets area, macroprudential regulation is increasingly becoming associated with the management of the growth in non-​bank financial intermediation risks and, in particular, with fund leverage and liquidity risks and related regulatory requirements, such as leverage limits. The macroprudential regulation of funds, and the related management of non-​bank financial intermediation risks, is still in its infancy and is contested. In the EU, the AIFMD empowers national competent authorities (NCAs) to impose macroprudential leverage limits on AIFs, but macroprudential regulation is otherwise not a feature of EU fund regulation. Fund macroprudential regulation is increasingly being debated internationally, however, with the Financial Stability Board (FSB) coordinating the debate, given the increasing focus on fund stability risks, particularly in the wake of stability risks generated by money-​market funds (MMFs) as the Covid-​19 pandemic expanded in early 2020 (sections 3.2.1 and 7.3), although the extent to which, and in what form, macroprudential tools should be used in the fund sector is contested. For an EU policy perspective see ECB, Developing Macroprudential Policy for Alternative Investment Funds, Occasional Paper No 202 (2017) and, for an NCA perspective, see Central Bank of Ireland, Macroprudential Measures for the Property Fund Sector, Consultation Paper 145 (2021). For an international perspective see International Monetary Fund (IMF), Investment Funds and Financial Stability (2021). 23 Of the some €7 trillion of UCITS NAV assessed by ESMA for its 2022 review of retail investment products, it regarded €4.1 trillion as representing funds marketed to retail investors: 2022 ESMA Retail Investment Products Report, n 8, 8. Similarly, some 74 per cent of NAV held in long-​term UCITSs (excluding MMFs and Exchange Traded Funds (ETFs)) are held through retail share classes: Investment Company institute, Experiences of European Markets, UCITS, and European ETFs during the Covid-​19 Crisis (2020) 16. 24 Respectively, Regulation (EU) No 345/​2013 [2013] OJ L115/​1; Regulation (EU) No 346/​2013 [2013] OJ L115/​ 18; and Regulation (EU) 2015/​760 [2015] OJ L123/​98. The EuVECA and EuSEF Regulations have been revised and liberalized under the CMU agenda, while a proposal for ELTIF reform has been presented (section 6).

III.3 Evolution  235 MMF Regulation.25 This Regulation is supported by the UCITS and the AIFMD regimes in that an MMF can be constructed as a UCITS or as an AIF and so can be regulated under either regime. But given the distinct financial stability risks posed by MMFs, the MMF Regulation imposes tailored risk management rules on MMFs; these rules have a product-​ oriented dimension as they impose intricate portfolio construction rules on MMFs. Taken as a whole, the collective investment management rulebook now takes the form of a matrix of interlocking legislative measures (supported by cognate legislative measures, including the DORA regime on digital operational resilience, as well as specific measures relating to sustainable finance (section 3.3.4))26 which deploys product-​related and management-​related regulatory techniques to different extents, and at the centre of which sit the UCITS and AIFMD regimes.27 The legislative rulebook is amplified by an administrative rulebook of immense technical complexity and operational intricacy and by related European Securities and Markets Authority (ESMA) soft law and supervisory convergence measures.

III.3  The Evolution of the Collective Investment Management Regime III.3.1  From the UCITS Regime to the Global Financial Crisis From the adoption of the UCITS Directive in 1985 to the eve of the global financial crisis, market integration and the effectiveness of the UCITS passport were the main drivers of EU regulatory intervention, although the harmonized rules designed to support the UCITS passport (particularly with respect to risk management and the UCITS manager and depositary) became increasingly dense over the pre-​crisis period (as outlined in section 4.2). The financial-​crisis era saw major reform. The UCITS regime was expanded, with ever more specific rules, particularly risk management requirements, applying to a range of different UCITSs. The crisis period also saw the adoption of the 2011 AIFMD which, while associated with hedge fund regulation, brought all non-​UCITS funds (AIFs) within the regulatory net. In effect, it bifurcated the CIS rulebook into two segments: the UCITS rulebook and the AIFMD rulebook. In addition, the 2011 establishment of ESMA injected technocracy into the regulation of collective investment management and heralded the

25 Regulation (EU) 2017/​1131 [2017] OJ L169/​8. 26 AIFMD and UCITS managers will be subject to the Digital Operational Resilience Act (DORA) which addresses the security of financial firms’ network and information systems and the ability of financial firms to withstand threats and disruptions. Provisional agreement on DORA was reached in May 2022 (the Commission Proposal is at COM(2020) 595). See in outline Ch I section 7.3. They are also subject to the disclosure and operational/​risk managements requirements imposed through the EU’s sustainable finance agenda (section 3.3.4). Alongside, the financial-​crisis-​era/​post-​crisis thickening of the single rulebook generally has led to the imposition of additional rules on collective investment management generally, most notably the reporting rules that apply as regards securities financing transactions under the 2015 Securities Financing Transactions Regulation (EU) 2015/​ 2365 [2015] OJ L337/​1) and the compliance rules that apply to the holding of securitization positions under the 2017 Securitization Regulation (EU) 2017/​2402 [2017] OJ L347/​35. 27 Where discretionary asset management services (and identified investment services, including investment advice) are provided by UCITS or AIFMD collective investment managers, the 2014 MiFID II regime and its allied prudential rules apply in respect of those services. Both the 2009 UCITS and 2011 AIFMD regimes provide that identified investment services can be provided by the collective investment managers within the scope of each measure and that the MiFID II regime applies to these services (eg, 2011 AIFMD Art 6(4) and 7(6); and 2009 UCITS Directive Art 6).

236  Collective investment Management subsequent dense amplification of the UCITS and AIFMD rulebooks through administrative rules, soft law, and supervisory convergence measures. The reforms to the rulebook, while responding to EU-​specific drivers as discussed later in this chapter, were also a response to the crisis-​era global financial stability agenda which captured CISs through their association with ‘shadow banking’ activities (now typically termed ‘non-​bank financial intermediation’), as outlined in section 3.2.1. The crisis era also saw CISs become folded into the EU’s wider growth agenda,28 particularly with respect to the funding of small and medium-​sized enterprises (SMEs). Given the impairment of banks’ ability to provide long-​term funding, CISs were identified as providing a functional substitute for bank financing and as potentially contributing to a more stable and diversified funding base.29 As discussed in section 6, discrete CIS vehicles for Social Entrepreneurship Funds (the EuSEF) and for Venture Capital Funds (the EuVECA) followed in 2013. Also, while retail investors have long been associated with the UCITS regime, an increasingly muscular approach took root as regards household capital, culminating in the adoption of the 2015 ELTIF Regulation which is designed to support retail access to long-​term investments, although it also serves as an institutional investment vehicle. CIS regulation accordingly became something of a laboratory for experimentation, with these three new forms of EU CIS, the EuVECA, EuSEF, and ELTIF, being constructed to facilitate capital-​raising, particularly for early-​stage companies, social purpose companies, and long-​term capital projects.

III.3.2  The Post Global Financial Crisis Era: Stability Risks and Non-​Bank Financial Intermediation, Capital Markets Union, and Technocracy Since then, a series of forces have combined to shape the collective investment management regime: the management of financial stability risks; CMU; and the intensifying influence of technocracy, primarily in the shape of ESMA but also of the European Systemic Risk Board (ESRB). Related legislative reform is in the offing with the November 2021 AIFMD/​ UCITS Proposal.30 This Proposal is primarily concerned with supporting financial stability through targeted reforms but, by proposing a framework for loan origination by AIFs, also seeks to support capital-​raising and can be strongly associated with CMU. In addition, the sustainable finance agenda, outlined in Chapter I, is also shaping the collective investment management regime (as outlined in brief in section 3.3.4).

III.3.2.1 Non-​Bank Financial Intermediation and Collective Investment Management Regulation One of the major preoccupations of the global regulatory reform agenda as the acute phase of the financial crisis receded, and since, has been the identification and management of the

28 The related Europe 2020 Growth Strategy had several strands, but it included the ‘Innovation Union’ strand which identified the CIS industry, and particularly the venture capital segment, as a means of supporting access to finance for innovative firms. 29 Commission, Green Paper. Long-​Term Financing of the European Economy (COM(2013) 150/​2) 2. 30 2021 UCITS/​AIFMD Proposal (COM(2021) 721).

III.3 Evolution  237 financial stability risks posed by ‘non-​bank financial intermediation’.31 The sector, which is now regularly monitored by the ESRB,32 has grown strongly in the EU: in 2021, the continued expansion of non-​bank financial intermediation, and the related retreat of the traditional banking sector, was identified as one of the biggest and most significant trends in the European economic and financial system.33 The related EU reform agenda has several dimensions, including as regards securities financing transactions,34 but is in particular oriented towards managing the financial stability risks associated with investment funds. Investment funds can amplify financial stability risks through several channels of non-​ bank financial intermediation risk, including credit intermediation (through, inter alia, direct loan origination by funds and funds’ holdings of financial institutions’ debt securities); and liquidity transformation (by, in particular, ‘open-​ended funds’35 which must meet redemption requests from investors on demand but which may hold potentially illiquid assets and so may be exposed to liquidity ‘mismatches’).36 As the investment fund sector burgeoned in the wake of the financial crisis,37 the international and EU regulatory focus on the extent to which funds formed part of the non-​bank financial intermediation sector, and 31 The non-​bank financial intermediation agenda is broadly associated with non-​bank financial entities which undertake activities which involve bank-​like financial stability risks, but which fall outside the perimeter for bank regulation. It is, broadly, associated with credit intermediation outside the banking system and the management of the related financial stability risks, including as regards maturity and liquidity transformation (which relate to the risks associated with providing long-​term lending against short-​term liabilities and with providing liquidity while holding illiquid assets) and the build-​up of leverage. The FSB’s regular monitoring covers the activities of, inter alia, pension funds, insurance companies and ‘other financial institutions’ including investment firms, structured finance vehicles, and investment funds. In the EU, the ESRB’s monitoring of non-​bank financial intermediation has ‘entity components’ (investment funds and ‘other financial institutions’, including securitization vehicles, own account dealers, and specialist entities such as CCPs) and ‘activity components’ (based on derivatives use, securities financing transactions, and securitizations). See, eg, Judge, K, ‘Information Gaps and Shadow Banking’ (2017) 103 Va LR 411, 414, characterizing shadow banking (non-​bank financial intermediation) as ‘an intermediation regime that resides in the capital markets while serving many of the economic functions traditionally fulfilled by banks’. While the reform agenda developed early in the financial crisis period (see, eg, Financial Services Authority (FSA), The Turner Review. A Regulatory Response to the Global Banking Crisis (2009)), the global agenda took root from 2010/​2011, following its spear-​heading by the FSB (FSB, Shadow Banking: Scoping the Issues) and its related recommendations (Recommendations to Strengthen Oversight and Regulation of Shadow Banking (2011)). For a recent review see FSB, Global Monitoring Report on Non-​Bank Financial Intermediaries (2020). For a crisis-​ era perspective see Gerding, E, The Shadow Banking System and its Legal Origins (2012), available at , and, for a post-​crisis examination comparing EU and US market developments and regulatory reform see Nabilou, H and Prum, A, ‘Shadow Banking in Europe: Idiosyncrasies and their Implications for Financial Regulation (2019) 10 European J of Risk Regulation 781. Non-​bank financial intermediation has also drawn the attention of political economists given the relative slowness of the international regulatory response, as compared to other elements of the crisis-​era reform agenda (see, eg, Ban, C and Gabor, D, ‘The Political Economy of Shadow Banking’ (2016) 23 Rev of IPE 901). 32 Through its annual EU Non-​Bank Financial Intermediation (previously Shadow Banking) Risk Monitor. 33 Commission, 2021 AIFMD/​UCITS Proposal Impact Assessment (IA) (SWD(2021) 340) 132. 34 Ch VI section 4. 35 An open-​ended fund is one which is continually open to new investment and which offers redemption on request to investors. While this feature makes such funds highly liquid for investors, it also renders them vulnerable to liquidity mismatch risk where redemption pressure cannot be met by fund assets or asset sales. The UCITS, an open-​ended fund as it must provide redemption on demand, is accordingly subject to extensive asset allocation requirements designed to support liquidity. The AIFMD covers open-​and closed-​ended funds, with open-​ended funds (most exposed to liquidity risk) subject to more stringent requirements (section 5). 36 The ESRB has related the investment fund sector’s capacity to generate bank-​like financial stability risks to a number of channels: financial leverage (particularly in the case of hedge funds and real estate funds); interconnectedness (particularly in the case of MMFs and their connection to the banking system); liquidity transformation risks (particularly through open-​ended bond funds); and credit intermediation (including through direct loan origination as well as through funds’ holdings of financial institutions’ debt securities). On MMF risk specifically see section 7. 37 AUM of investment funds globally rose from $53.6 trillion in 2005 to $76.7 trillion in 2015: FSB, Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities (2017) 1.

238  Collective investment Management posed financial stability risks, sharpened. Initially, most attention focused on funds’ capacity to amplify financial stability risks on a contraction of liquidity, and in particular on the risks posed by open-​ended funds.38 But while over 2015–​2016 the International Monetary Fund (IMF) and the Financial Stability Board (FSB) highlighted the emerging stability risks posed by growth in the investment fund sector,39 international policy action was tentative. Uncertainty as to the extent to which the investment fund sector posed stability risks, as well as differing regulatory perspectives as to the extent to which funds, usually regulated by means of financial-​market-​oriented tools such as conduct, disclosure, and asset allocation requirements, should come within stability-​oriented prudential or macroprudential regulation, led to a cautious response.40 The FSB’s 2017 examination of structural vulnerabilities in the fund sector, for example, was largely concerned with monitoring and review, while other initiatives were similarly tentative.41 In the EU, the monitoring of the potential financial stability risks posed by funds was enhanced by the technocratic capacity provided by the ESRB which began to monitor the risks from non-​bank financial intermediation in related annual reports from 2016, including as regards funds (although the ESRB recognized, from the outset, some doubt as to the extent to which investment funds formed part of the non-​bank financial intermediation system),42 with most attention focusing on AIFs. UCITSs generated less concern, given the limits the UCITS rulebook places on the extent to which UCITSs can be leveraged, as well as the impact of the UCITS asset portfolio rules which are designed to contain liquidity risks.43 Regulatory reform initially focused on the MMF segment, with the adoption of the MMF Regulation in 2017 (section 7). The March 2020 market turmoil, driven by the Covid-​19 pandemic, sharpened the focus on the financial stability risks posed by investment funds. As large segments of the global economy shut down, markets experienced a sharp repricing downwards of credit risk, a related ‘flight’ to safe, highly liquid assets, and large outflows from MMFs and open-​ended funds.44 In the EU, investment funds experienced large valuation losses as well as elevated outflows, particularly bond (UCITS) funds and MMFs, reflecting the increased risk profile of these funds’ underlying debt instruments. Also, the below market-​value asset sales required of these funds, driven by liquidity mismatches as outflows increased, amplified

38 See, eg, FCA, Policy Statement 19/​24, Illiquid Assets and Open-​ended Funds (2019), introducing reforms to the non-​UCITS sector following a series of fund redemption suspensions in 2016 related to Brexit-​referendum​associated liquidity contractions in the property market. 39 eg IMF, Global Financial Stability Report, April (2016) and Global Financial Stability Report, April (2015). 40 The reticence can in part be related to the different frames of reference applied by the markets regulators that dominate in the investment fund sphere, and who are traditionally oriented to disclosure and asset allocation requirements, and by prudential regulators, who are traditionally more focused on stability-​oriented requirements. For a political economy perspective see James, S and Quaglia, L, ‘Epistemic Contestation and Interagency Conflict: The Challenge of Regulating Investment Funds’ (2022) Regulation and Governance. 41 The FSB’s 2017 review noted the scale of growth in the fund sector, called for closer monitoring, and recommended a series of policy actions, including as regards liquidity management, leverage, and operational risks: FSB, Policy Recommendations to Address Structural Vulnerabilities from Asset-​Management Activities (2017). The International Organization of Securities Commissions (IOSCO) followed with related principles and recommendations on liquidity risk management: IOSCO, Open-​ended Fund Liquidity and Risk Management (2018) and IOSCO, Recommendations for Liquidity Risk Management for Collective Investment Schemes (2018). For a call for a cautious response see ICMA and EFAMA, Managing Fund Liquidity Risk in Europe (2016). 42 See, eg, ESRB, Shadow Banking Monitor No 2 May (2017) 17. 43 2017 ESRB Shadow Banking Monitor, n 42, 17–​18. 44 For a review of the global experience see FSB, Holistic Review of the Market Turmoil (2020).

III.3 Evolution  239 bond market volatility, impairing bond financing mechanisms for non-​financial companies.45 Large-​scale central bank asset purchases and liquidity operations and government intervention, globally and in the EU, quickly supported economic activity and stabilized markets by April. While the EU UCITS sector proved relatively resilient (section 4.2.5), the turmoil exposed other regulatory weaknesses, particularly as regards MMFs. A related international reform agenda, focused in particular on MMFs as agents of non-​bank financial intermediation, followed (section 7).46 The extent to which and how fund regulation should include stability-​oriented prudential (and macroprudential) measures remains contested, reflecting the limited experience with stability-​oriented tools in this area, certainly by comparison with the banking sector. The international reform agenda can, however, be expected to remain focused on the financial stability risks associated with investment funds, not least given the changed interest rate environment, lower asset prices, and higher volatility which now shape financial markets globally and which have the potential to expose any stability-​related fragilities in the sector, as was exposed by the October 2022 disruption to liability-​driven investment funds (LDI funds) in the UK. In the EU, related stability-​oriented reform, initially mainly a function of technocracy,47 became framed by the AIFMD Review. While the Review found that the AIFMD was, by and large, operating well, it led to the November 2021 AIFMD/​UCITS Proposal which proposed a series of stability-​oriented reforms, including a new regime for fund liquidity management tools (section 4.4.1) and for loan origination (section 5.10.2). In addition, reforms to the MMF regime are likely (section 7). The Proposal will also likely lead to a closer alignment between the UCITS and AIFMD regimes (to the AIFMD’s more granular requirements as regards risk management) and in support of financial stability.48 For example, the relatively limited supervisory reporting required under the UCITS regime as compared to the extensive reporting required under the AIFMD was identified by ESMA and the ESRB as a gap in the UCITS regime which hindered effective risk monitoring;49 data-​gathering on the UCITS market is primarily dependent on commercial sources and on ad hoc national

45 For an overview of the EU market turmoil and its causes see ESRB, EU Non-​bank Financial Intermediation Risk Monitor October (2020) 5–​8. 46 See, eg, FSB, Policy Proposals to Enhance Money Market Fund Resilience (2021) and Bank of England, Assessing the Risks of Market-​based Finance (2021). The FSB also adopted proposals designed to enhance liquidity management by open-​ended funds, in response to the amplifying impact asset sales by open-​ended bond funds had during the March 2020 period of liquidity stress: FSB, Enhancing the Resilience of Non-​Bank Financial Intermediation. Progress Report (2022). The FSB’s proposals form part of the wider non-​bank financial intermediation reform and review agenda pursued by the international standard-​setting bodies following the March 2020 disruption and which has included reviews of, inter alia, liquidity in bond markets and margining practices. See, eg, IOSCO, Corporate Bond Markets. Drivers of Liquidity During the Covid-​19 Induced Market Stress (2022). 47 Following an ESRB Recommendation (ESRB Recommendation 2017/​6 [2018] OJ C151/​1) and prior to the March 2020 turmoil, ESMA adopted its 2020 Guidelines on liquidity stress testing and subsequently adopted its 2021 Guidelines on AIF leverage limits (noted below in this chapter). ESMA and the ESRB later called for closer supervisory oversight of fund liquidity risks and for harmonized liquidity management tool requirements: ESRB, Use of Liquidity Management Tools by Investment Funds with Exposures to Less Liquid Assets (2020); and ESMA, Report on Recommendations of the ESRB on Liquidity Risks in Investment Funds (2020) and Letter to the Commission (AIFMD Review), 18 August 2020. 48 The UCITS regime has already been shaped by innovations introduced by the AIFMD, including as regards the 2014 UCITS V depositary regulation and executive remuneration reforms. Alongside, ESMA’s supervisory convergence agenda, while usually specific to each fund sector, is increasingly adopting integrated measures, including as regards financial stability, such as its 2020 Guidelines on Liquidity Stress Testing in UCITS and AIFs. 49 2018 ESRB Recommendation, n 47, Recommendation D (calling for quarterly reporting to NCAs, including on liquidity risk and leverage) and 2020 ESMA Liquidity Risk Report, n 47.

240  Collective investment Management competent authority (NCA) data-​bases.50 Also, ESMA called for significantly greater alignment between the UCITS and AIFMD regimes as regards risk management and liquidity risk management, as the AIFMD rules in these areas are more granular.51 The 2021 Proposal proposes a degree of alignment, including as regards the regulation of liquidity risk management, but it does not suggest a wide-​ranging alignment. The direction of travel, however, is increasingly towards convergence between both regimes.

III.3.2.2 Capital Markets Union The development of collective investment management regulation is also being shaped by the CMU agenda, in particular as regards funds’ capacity to support capital-​raising. The 2015 CMU Action Plan identified a series of reforms to enhance the ability of funds to support capital-​raising,52 including reform and liberalization of the EuVECA/​EuSEF and ELTIF regimes (section 6). Relatedly, and reflecting the growth in loan origination by funds (allowed under the AIFMD for AIFs but prohibited for UCITS),53 and the related potential for diversification of sources of credit and of credit risk, the CMU agenda led to a new framework governing loan origination by AIFs being proposed under the 2021 AIFMD/​ UCITS Proposal (section 5.10.2).54 The CMU agenda also focused attention on the market fragmentation that has long characterized the EU funds market and which has been of concern since the pre-​financial-​ crisis UCITS Review.55 A review instituted under the 2015 CMU Action Plan identified persistent obstacles to cross-​border fund distribution, notwithstanding the UCITS/​AIFMD passporting regimes. While some 80 per cent of UCITSs and 40 per cent of AIFs were distributed cross-​border, the fund market remained geographically segmented (with a third of those funds marketed cross-​border sold in only one other Member State (typically the Member State of the investment manager) and a third marketed in no more than four Member States),56 limiting the potential for economies of scale, increasing costs, and reducing investment choice for investors.57 This segmentation can in part be related to national legal complexities58 as well as to varying investment preferences and to the organization 50 As ESMA has repeatedly noted in its annual reports on the ‘Cost and Performance of Retail Investment Products’ which examine the UCITS market in detail but draw on commercial sources. ESMA has also underlined that it did not have access to UCITS supervisory reporting data in its review of UCITS liquidity risk management over the pandemic: 2020 ESMA AIFMD Review Letter, n 47, Annex I, 4. 51 2020 ESMA AIFMD Review Letter, n 47, Annex I, 3. 52 2015 CMU Action Plan, n 1, 8–​10 and 20. 53 UCITS Directive Art 88(1) prohibits UCITS from granting loans or acting as guarantor. The EuVECA, EuSEF, and ELTIF regimes all allow loan origination, subject to conditions, but there is no cross-​sector AIF regulation of loan origination. 54 Progress was slow. A review of loan origination was committed to in the 2015 CMU Action Plan and a supportive ESMA opinion followed (ESMA, Key Principles for a European Framework on Loan Origination by Funds (2016)), but action was not taken until the 2021AIFMD/​UCITS Proposal. 55 A series of UCITS Review (2004–​2009) reports examined market fragmentation, including Oxera, Current Trends in Asset Management (2006), Commission, White Paper on Enhancing the Single Market Framework for Investment Funds (COM(2006) 686), and Commission, Green Paper on the Enhancement of the EU Framework for Investment Funds (COM(2005) 314). 56 Commission, Accelerating the Capital Markets Union: Addressing National Barriers to Capital Flows (COM(2017) 147) 3. 57 The average size of an EU UCITS fund is 1/​8 that of a US fund, a differential that can be linked to the significantly lower cost of US funds: 2022 ESMA Retail Investment Products Report, n 8, 8. 58 eg fund mergers engage intricate national company law and private law rules. For discussion see Annunziata, F, Cross-​Border Mergers between Investment Funds in Europe, Bocconi Legal Studies Research Paper (2019), available via .

III.3 Evolution  241 of fund distribution channels. But the CMU review also identified regulatory barriers, including as regards host Member State marketing rules, a lack of clarity on ‘pre-​marketing’,59 the requirement for local administrative facilities in host Member States,60 and regulatory/​ supervisory fees.61 The subsequent 2018 Refit Package Proposal62 underlined that, despite extensive passporting rules, the funds market remained organized on national lines, with 70 per cent of all AUM held for distribution in the domestic market only and only 37 per cent of UCITSs and 3 per cent of AIFs registered for distribution in more than three Member States,63 and that the costs associated with passporting were material.64 Two sets of reforms were proposed in response. The first set related to largely technical revisions to the UCITS and AIFMD regimes, designed to ease the passporting process (including a prohibition on host Member States from requiring a physical presence for UCITS administrative facilities; and a new ‘de-​notification’ regime for UCITSs and AIFs seeking to cease marketing cross-​border), with the most substantial of these reforms concerning a new ‘pre-​ marketing’ regime for AIFs. The second set related to fund marketing and to supervisory fees and included harmonized requirements for marketing communications, a transparency framework for additional national marketing requirements (designed to enhance legal certainty), procedural constraints on host Member State processes for reviewing marketing communications, and principles governing the setting and publication of supervisory fees. A largely technical reform, albeit projected to generate significant savings,65 this package was adopted as the 2019 Refit Directive (the technical revisions) and 2019 Refit Regulation (marketing and supervisory fees). In some respects, the Refit reform is underpowered, certainly by comparison with other elements of the CMU agenda, being concerned with largely technical matters and not with substantive questions of regulatory design. It indicates, however, the relative maturity of the collective investment management rulebook and the appetite of the EU for refining this rulebook to achieve marginal changes which, in sum, may have material impact. Persistent frictions remain, however, as regards the structure of fund distribution channels and relating to investor appetite and which are much less tractable to reform. The CMU period has also seen largely technical amendments to the UCITS and AIFMD regimes arising from cognate reforms through the Securitization Regulation, Covered Bonds Directive, and Investment Firm Directive.66

59 In the AIF market, managers may seek to ‘test’ the market when developing a fund to assess its likely success. Different rules obtained, however, across the EU as to the extent to which this was permitted. 60 While permitted by the UCITS Directive, the obligation imposed by many host Member States to provide local facilities for redeeming, subscribing, and payment were associated with additional costs: 2017 Commission Barriers Report, n 56, 4. 61 The variety in host Member State fee requirements and a lack of transparency in their calculation was regarded as a disincentive for smaller funds: 2017 Commission Barriers Report, n 56, 5. 62 Composed of the 2018 Refit Directive Proposal (COM(2018) 92), which addressed technical reforms to the UCITS and AIFMD Directives, and the 2018 Refit Regulation Proposal (COM(2018) 110), which addressed marketing rules. 63 2018 Refit Regulation Proposal, n 62, 2. 64 Ranging from 1–​4 per cent of the fund expenses: 2018 Refit Regulation Proposal, n 62, 6. 65 Cost reductions in the region of €395 million-​440 million annually were projected: 2018 Refit Regulation Proposal, n 62, 7. 66 Including as regards fund manager obligations to take action in the interest of investors when a securitization no longer meets the requirements of the Securitization Regulation; the applicable asset allocation rules governing funds’ covered bond investments; and the adjustment of the capital regime for fund management companies to align with the new investment firm prudential regime.

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III.3.2.3 Technocracy The collective investment management rulebook has, accordingly, been dynamic since the financial-​crisis era. This dynamism has also been a function of technocratic action. In particular, the rulebook has been repeatedly thickened by ESMA soft law which, in this area, has a strongly quasi-​regulatory colour. The UCITS rulebook is now amplified by five sets of ESMA UCITS Guidelines, which range from operational guidelines on liquidity stress testing to quasi-​regulatory guidelines on risk measurement and leverage, and which sit alongside legacy CESR guidelines.67 In addition, five sets of Guidelines amplify the AIFMD,68 and two sets of Guidelines address the MMF Regulation,69 with Guidelines likely to follow on the Refit reform package. The AIFMD, UCITS, and EuSEF/​EuVECA regimes are also accompanied by wide-​ranging ESMA Q&As. This soft law ‘rulebook’ is, like its counterparts in other areas of the single rulebook, a construct of immense intricacy and technical complexity that exemplifies the technocratic turn EU financial markets regulation has taken since the financial-​crisis era. ESMA has also used its supervisory convergence tools to build a significant operational capacity in this area, particularly as regards the still novel area of investment fund stress testing, in relation to which ESMA is showing some entrepreneurialism and an appetite for shaping NCA and fund practices. ESMA initially developed this capacity in relation to MMF stress testing, adopting in 2018 detailed Guidelines for MMF stress testing (which are regularly updated to reflect market conditions) under an MMF Regulation mandate.70 It has since adopted the 2020 Guidelines for UCITS and AIF stress testing by fund managers,71 engaged in sector-​level stress tests,72 coordinated (over 2020–​2021) a ‘Common Supervisory Action’ by NCAs which was directed to the stress testing of UCITS liquidity,73 and, following the March 2020 market turmoil, undertook a review of investment fund liquidity generally and of its resilience to future shocks.74 ESMA has also significantly enhanced the EU’s data capacity as regards investment funds. 2019 saw the first iteration of its now annual reports on the AIF sector, which build on the extensive reporting required under the AIFMD and which have brought a wealth of data to light on the EU AIF market; it also saw the first iteration of ESMA’s now annual reports on the fees and performance of retail investment products, including investment funds. These extensive annual reports, alongside the coverage of the investment fund market in ESMA’s bi-​annual Trends, Risks, and Vulnerabilities (TRV) Reports, and also the ESRB’s review of investment fund stability risks in its annual review of non-​bank financial intermediation, form the basis of a now extensive databank on fund market trends and risks, both as regards investor protection and financial stability.

67 See section 4 on the UCITS Guidelines. 68 See section 5 on the AIFMD Guidelines. 69 See section 7 on the MMF Regulation Guidelines. 70 The current iteration was adopted in 2021: ESMA, Guidelines on Stress Test Scenarios (2018, updated 2021). 71 ESMA, Guidelines on Liquidity Stress Testing for UCITS and AIFs (2020). 72 For a review of its approach see ESMA, Stress Simulation for Investment Funds (2019). 73 ESMA, Public Statement (the 2020 Common Supervisory Action on UCITS Liquidity Risk Management), 24 March 2021. 74 See section 4.2.5.

III.3 Evolution  243

III.3.2.4 Sustainable Finance As outlined in Chapter I, the sustainable finance agenda is increasingly shaping EU financial markets regulation, including as regards collective investment management regulation. These specialist rules, noted below, can be expected to be tested soon. ‘Green funds’ are drawing in more capital and supporting thereby the raising of capital to support the green transition as well as sustainable investment practices,75 and are showing signs of strong performance.76 But they also generate related risks, including as to ‘greenwashing’. UCITS/​AIFMD collective investment managers, as in-​scope ‘financial market participants’, are subject to the extensive ‘entity-​level’ disclosure requirements that apply to financial market participants as regards their sustainability-​related activities and impacts and their management of ‘sustainability risks’77 under the 2019 Sustainable Finance Disclosure (SFD) Regulation78 (as specified as regards environmental sustainability by the 2020 Taxonomy Regulation).79 Extensive ‘product-​level’ (fund) disclosure requirements also apply under the SFD Regulation and are specified as regards environmental sustainability by the Taxonomy Regulation.80 In addition, the CIS rulebook has been refined, at the administrative level, to require that UCITS and AIFMD managers integrate ‘sustainability risks’ (as defined under the SFD Regulation) in their management of funds, including as regards risk management, the treatment of the principal adverse impacts of investment decisions on sustainability factors, conflict-​of-​interest management, and having appropriate resources and expertise; and ESMA soft law is developing.81

75 Capital flows into ESG (environmental, social, and governance)-​related equity funds reached €71 billion in the first half of 2021, compared to €69 billion in non-​ESG funds, while ESG-​related ETFs grew at a rate of more than 200 per cent (25 per cent for non-​ESG ETFs): ESMA Director Cazenave, Speech, 19 November 2021. Similarly, in 2020, net flows into ESG UCITSs reached €67 billion and represented some 18 per cent of AUM across equity, bond, and mixed UCITSs: 2022 ESMA Retail Investment Products Report, n 8, 21. 76 ESMA reported that ESG UCITS funds (excluding ETFs) were cheaper and performed better than non-​ESG UCITS funds over 2019 and 2020: 2022 ESMA Retail Investment Products Report, n 8, 21–​5. 77 Alongside the disclosure obligations relating to ‘sustainable investments’ and ‘sustainability risks’, specific requirements apply where a collective investment manager assesses the ‘principal adverse impacts’ of investment decisions on ‘sustainability factors’ (these key terms are defined by the Regulation (as noted briefly in Ch I section 7.2)). 78 Regulation (EU) 2019/​2088 [2019] OJ L317/​1. These obligations apply to a wide range of regulated financial market participants, including investment firms and collective investment scheme managers (Art 2(1)). See Ch I section 7.2. 79 Regulation (EU) 2020/​852 [2020] OJ L198/​13. See Ch I section 7.2. 80 The Sustainable Finance Disclosure (SFD) Regulation requires several disclosures to be made at product (fund) level, including as regards the impact of ‘sustainability risks’ on the returns of financial products; whether and how the relevant financial product considers principal adverse impacts on ‘sustainability factors’ ; where a financial product promotes environmental or social characteristics, disclosures as to how these characteristics are met; and, where a product has a ‘sustainable investment’ objective and a related index has been designated as a benchmark, disclosures relating to the index and, where no such index is designated, disclosures as to how the objective is to be attained. 81 These reforms were achieved by Delegated Regulation (EU) 2021/​1270 [2021] OJ L277/​141 (the UCITS regime) and Delegated Regulation (EU) 2021/​1255 [2021] OJ L277/​11 (the AIFMD regime). Where a manager considers principal adverse impacts on sustainability factors, these are to be taken into account as part of the due diligence required of managers in selecting, monitoring, and implementing their risk management policies in relation to investments. ESMA soft law is also developing: November 2022 saw ESMA consult on Guidelines relating to the naming of funds as ‘ESG funds’ or similar.

244  Collective investment Management

III.4  The UCITS Regime III.4.1  The Regulatory Context III.4.1.1 Retail Market Protection The UCITS regime, while increasingly being shaped by financial stability considerations, has a strongly retail orientation. This reflects the central role CISs generally have long played in intermediating household funds and in thereby institutionalizing the retail/​household investment market.82 Among their benefits, CISs allow for a delegation by retail investors of decision-​making to the fund manager and the related mitigation of behavioural risks;83 bring economies of scale as regards trading costs84 (this is particularly the case with passive CISs, as is reflected in the explosive growth of the retail exchange-​traded fund (ETF) market in the US);85 support diversification;86 and typically display deep liquidity and related ease of redemption, particularly in the case of open-​ended CISs which allow redemption on request by investors at a price related to the scheme’s net asset value (NAV).87 This is not to suggest that open-​ended CISs, such as UCITSs, are a panacea for retail market risks. For example, the diversification rules that apply to asset allocation by UCITSs only limit exposure to single issuers; they are not linked to factors more likely to impact on diversification risk and related returns, such as the degree of concentration of the UCITS’ portfolio in particular industry sectors or in particular asset classes. The UCITS diversification rules did not, for example, protect retail investors from market risk related to over-​exposure to particular asset classes as the financial crisis deepened; the retail sector experienced proportionately heavier losses than the institutional sector over the financial crisis, given the predominance of equity investments in retail funds.88 More recently, the Covid-​19 pandemic saw some underperformance by equity UCITS funds against their market benchmarks.89 Neither do diversification/​asset-​allocation rules protect investors from the herding risks associated with collective investment management generally.90 82 An extensive US literature (reflecting the institutional importance of fund investment in the US retail market) has examined the investor protection risks associated with the massive ‘mutual fund’ (the typical US term for a CIS) industry and its regulation. See, eg, Langevoort, D, ‘The SEC, Retail Investors, and the Institutionalization of the Securities Markets’ (2009) 95 Va LR 1025; Zingales, L, ‘The Future of Securities Regulation’ (2009) 47 J of Accounting Research 391; Choi, S and Kahan, M, ‘The Market Penalty for Mutual Fund Scandals’ (2007) 87 Boston University LR 1021 83 eg Barber, B, Lee, Y-​T, Liu, Y-​J, and Odean, T, ‘Just How Much Do Individual Investors Lose by Trading’ (2009) 22 Rev of Financial Studies 609 and Choi, S and Pritchard, A, ‘Behavioural Economics and the SEC’ (2003) 56 Stanford LR 1. 84 French, K, ‘Presidential Address: The Cost of Active Investing’ (2008) 63 J Fin 1537. 85 Hu, H and Morley, J, ‘A Regulatory Framework for Exchange-​Traded Funds’ 91 So Cal LR (2018) 389. On ETFs, see (in brief) section 4.2.5 below. 86 eg Jackson, H, ‘To what Extent Should Individual Investors Rely on the Mechanisms of Market Efficiency: A Preliminary Investigation of Dispersion in Investor Returns’ (2003) 28 J Corp Law 671 and Freeman, J and Brown, S, ‘Mutual Fund Advisory Fees: The Costs of Conflicts of Interests’ (2001) 26 J Corp Law 609. 87 As noted previously, current net asset value is the current market value of the scheme’s portfolio (assets minus liabilities). The per share/​per unit NAV, which acts a proxy for the return the investor will receive on redemption, is the NAV divided by the number of shares/​units outstanding 88 Retail investor AUM lost 22 per cent in value in 2008, as compared to a loss of 7 per cent in the institutional segment: EFAMA, Asset Management in Europe (2012) 28. 89 An ESMA review found, from a sample of actively managed equity UCITS funds, that more than half underperformed their benchmarks during the period of acute market stress over mid-​February to end-​March 2020: ESMA, Fund Performance during Market Stress—​the Corona Experience (2022). 90 US mutual funds were among the main purchasers of asset backed securities, leading to significant litigation in the US: Ferrell, A, Bethel, J, and Hu, G, Legal and Economic Issues in Litigation after the 2007–​2008 Credit

III.4  The UCITS Regime  245 Regulation does not, however, seek to protect retail investors from market risks generally,91 and CIS investment affords retail investors diversification and liquidity benefits which are difficult to replicate at the individual investor level. CIS regulation, accordingly, typically reflects two investor-​protection-​related rationales, which are reflected in the UCITS regime. The first relates to the mitigation of the distinct investor protection risks generated by CISs and their related agency costs.92 These risks relate to, inter alia, the potential for the extraction of benefits by CIS managers (by means of, for example, excessive costs and abusive trading practices);93 failures in portfolio management which can generate liquidity and redemption risks for investors, particularly where assets become illiquid; and fraudulent diversion of assets from the CIS. These risks are exacerbated by the complexities of CIS disclosures and also by distribution-​related risks, including conflict-​of-​interest and competence risks in CIS sales and advice. In response, CIS regulation typically deploys asset-​allocation rules (or portfolio-​shaping rules) which, by addressing risk management and diversification, asset valuation, and liquidity risks seek to address the agency risks which cannot be efficiently addressed through disclosure or by private contracting.94 The structure of CISs, in particular the separation of fund management (the manager) and custody (the depositary), is also typically regulated, while prudential and conduct-​of-​business regulation of the fund manager and of the depositary, as well as disclosure requirements, are common. Second, CIS regulation has, reflecting the extent to which household investment internationally has become institutionalized through CIS investments, become associated with the promotion of long-​term market-​based saving by households. Most recently, this rationale can be associated with the debate on the appropriate regulation of ETFs, given their dominance in the retail market as primarily passive, low-​cost investment vehicles.95

III.4.1.2 The EU Context The EU’s regulation of the UCITS CIS reflects these investor protection rationales, but, as with EU financial markets regulation generally, must also be placed in the context of the driving market integration imperative. The foundational 1985 UCITS regime was primarily designed as a supply-​side measure and to support cross-​border UCITS marketing; it was crafted long before the retail market and related investor protection regulation had impinged seriously on EU policy and regulation; the drive to support household long-​term savings and private pension provision through CIS/​UCITS investment, and the related concern for investor protection, would not gain traction until and over the Financial Services Crisis, Harvard Law and Economics Discussion Paper No 612 (2008), available via . 91 See Ch IX. 92 eg Frankel, T and Cunningham, L, ‘The Mysterious Ways of Mutual Funds: Market Timing’ (2006) 25 Annual Rev of Banking and Financial L 235 and Mahoney, P, ‘Manager Investor Conflicts in Mutual Funds’ (2004) 18 J of Econ Perspectives 161. From earlier discussions see Jackson, H, ‘Regulation in a Multi-​sectored Financial Services Industry: an Exploration Essay’ (1999) 77 Washington University LQ 319; Clark, R, ‘The Four Stages of Capitalism’ (1981) 94 Harv LR 561; and Clark, R, ‘The Soundness of Financial Intermediaries’ (1976) 86 Yale LJ 1. 93 See generally Frankel and Cunningham, n 92 and McCallum, J, ‘Mutual Fund Market Timing: A Tale of Systemic Abuse and Executive Malfeasance’ (2004) 12 JFRC 170. 94 eg, Palmiter, A, ‘The Mutual Fund Board: A Failed Experiment in Regulatory Outsourcing’ (2006) Brooklyn J of Corporate, Financial, and Commercial L 165. 95 Hu, H and Morley, J, ‘The SEC and Regulation of Exchange-​Traded Funds: A Commendable Start and a Welcome Invitation’ (2019) 92 So Cal LR 1155 and n 85.

246  Collective investment Management Action Plan (FSAP) era.96 The extent to which market integration has long been the dominant concern of the regime is well illustrated by the 2001 UCITS III extensions to the previously restrictive UCITS asset-​allocation regime, which were designed to allow the UCITS industry to expand, but which brought investor protection risks. Similarly, although the 2009 UCITS IV reforms introduced a raft of significant investor protection measures, chief among them the retail-​oriented Key Investor Information Document (KIID), they also sought to support pan-​EU UCITS industry organization and related economies of scale. UCITS regulation has also and relatedly been associated with the support of market finance, given the critical role CISs play in financial intermediation; the promotion of a vibrant cross-​border UCITS market has long been closely associated with the promotion of market finance in the EU.97 The management of the stability risks generated by the UCITS market has also, however, now come to the fore in EU regulation and policy, as part of the non-​bank financial intermediation agenda.

III.4.2  The Evolution of the UCITS Regime III.4.2.1 Early Developments The potential of CISs as agents to stimulate and integrate the European capital market was noted by the seminal 1966 Segré Report. Identifying a shortage of capital, the Report recognized that ‘institutional investors [CISs] are best suited to manage the savings of a large section of the public with no practical experience of direct and judicious investment in securities’, but reported that these institutional investors were hindered in attracting public funds by regulation and needed to be stimulated if the equity markets, in particular, were to attract the savings of the public at large.98 By 1976, CISs were operating in most Member States, albeit that only a few Member States applied discrete regulation.99 The first steps towards regulating this nascent market came in 1976 with a Commission proposal for the harmonization of CIS regulation.100 While the proposal is now of historical interest only, its emphasis on and approach to market integration, in particular, remains striking. In a very early example of mutual recognition, Member States would have been required to permit CISs authorized in another Member State in accordance with the proposal’s requirements to operate within their territory without further regulation, except for local marketing rules, in a forerunner of the current approach. Although there was

96 eg, the 2005 Investment Funds Green Paper argued that an integrated and efficient EU CIS market could contribute significantly to retirement provisioning: n 55, 3 and 16. 97 See, eg, for early FSAP-​era support, the Initial Report of the Committee of Wise Men on the Regulation of European Securities Markets (2000) 5 and Commission, Financial Integration Monitor 2006 (SEC(2006) 1057) 19–​21. 98 Report by a Group of Experts Appointed by the EEC Commission, The Development of a European Capital Market (1966). 99 See further Scott Quinn, B, ‘EC Securities Markets Regulation’ in Steil, B (ed), International Financial Market Regulation (1994) 121. 100 [1976] OJ C171/​1, Explanatory Memorandum at COM(76) 152. The proposal was lightly amended by COM(77) 277. CISs were not covered in the foundational Commission Recommendation 77/​534/​EEC concerning a European Code of Conduct relating to transactions in transferable securities [1977] OJ L212/​37.

III.4  The UCITS Regime  247 some institutional support,101 the proposal languished while the measures which formed the foundations of the prospectus regime (Chapter II) slowly came into force. By 1985, the single market programme, and with it the 1985 Internal Market White Paper, which envisaged a mutual recognition regime for CIS, had intervened.102 In this facilitative political and institutional environment, the first UCITS Directive, using the new mutual recognition technology, and providing a product passport for authorized UCITS CISs, was adopted in December 1985 and was to be implemented by the Member States by October 1989.

III.4.2.2 The FSAP and the UCITS III Reforms Notwithstanding the 1985 introduction of the UCITS CIS passport, integration of the UCITS market was slow.103 This reflected the persistence of different market structures, with the EU market segmented into siloed national markets based, in part, on asset allocation preferences,104 while investor lack of familiarity with the varying structures which could (and can) be adopted by UCITSs further slowed integration. The UCITS vehicle also proved problematic, particularly as regards its restriction of asset allocation to transferable securities only. In a theme which has persisted up to the CMU era and the 2019 Refit reforms, costly national implementation divergences also emerged. A 1994 proposal to reform the 1985 Directive followed.105 It was designed to liberalize asset allocation by UCITSs, including by permitting UCITS investments in deposits with credit institutions and by providing three new UCITS categories: cash funds, investing solely in deposits with credit institutions; funds of funds, investing solely in units of other UCITSs; and master-​feeder funds, investing solely in the units of a single UCITS. Little progress was made in the Council where the provisions on master-​feeder funds and cash funds proved controversial, and the proposal ultimately foundered. The adequacy of the 1985 Directive’s minimal regulation of the management companies entrusted with UCITS asset management also came under scrutiny. With the adoption of the Investment Services Directive (ISD) in 1993 and the related introduction of an (albeit embryonic) discretionary investment management regime, the limited regulation of UCITS managers under the 1985 Directive became out of kilter with the regulation of investment firms generally. Level playing field risks were also thereby generated, as UCITS management companies were ineligible for the ISD passport (as collective asset managers) but were also not conferred with a passport under the UCITS regime. Progress on related reforms stalled until 1998 when the Commission presented two proposals: one focusing on the UCITS scheme and liberalizing asset allocation; and the other addressing the UCITS manager as well as the UCITS prospectus and short-​form disclosure. In the 1999 FSAP, the Commission highlighted progress on the UCITS reforms as an urgent political priority in the interests of maximizing the ability of investors to exploit the benefits 101 [1977] OJ C57/​31 (European Parliament) and [1977] OJ C75/​ 10 (Economic and Social Committee (ECOSOC) (now EESC)), although neither institution gave the proposal a ringing endorsement and both were concerned as to the thin level of harmonization. 102 Completing the Internal Market (COM(85) 310) para 102. 103 Although the adoption of the UCITS Directive had significantly raised expectations, being heralded as ‘the first tangible indication of a single European market in retail financial services’: Poser, N, International Securities Regulation. London’s Big Bang and the European Securities Markets (1991) 364. 104 As to equity/​bond asset mixes in particular: Gros, D and Lannoo, K, The Euro Capital Market (2000) 67. 105 COM(94) 329 (unusually, and following an extensive market consultation process, it replaced an earlier 1993 proposal (COM(93) 37)).

248  Collective investment Management of the single market.106 Both Directives (together, the ‘UCITS III’ reforms)107 were finally adopted in 2003.

III.4.2.3 Post-​FSAP and UCITS IV As the FSAP-​era drew to a close, the UCITS regime was broadly regarded as successful.108A series of risks were, however, emerging and were reflected in the wide-​ranging post-​FSAP review of the UCITS regime which led to the currently governing 2009 UCITS IV Directive. The UCITS Review represented, at the time, a landmark for EU financial markets regulation given its scale. Launched by the 2004 report of the Commission’s Asset Management Expert Group,109 the review process included extensive European Parliament discussion,110 specialist working groups,111 several studies,112 as well as workshops on UCITS disclosure. A 2005 Commission Green Paper113 led to further consultation114 and to the Commission’s agenda-​setting 2006 Investment Funds White Paper115 and the subsequent suite of ‘Initial Orientations’ on specific reforms, which included impact assessments and draft legislative proposals.116 This review revealed several difficulties. As regards market integration, the achievement of pan-​EU UCITS scale efficiencies and cost reductions, for example, was being prejudiced by the proliferation of small UCITS funds and by obstacles to funds merging. The requirement that the UCITS depositary be located in the same Member State as the UCITS fund, and restrictions on the cross-​border activities of UCITS managers, were also hindering efficient pan-​EU organizational structures. Investor protection risks were also intensifying, linked to the liberalization of asset allocation by the UCITS III reforms, arbitrage risks (given that UCITSs were subject to higher levels of regulation than functionally similar investment products such as unit-​linked life insurance contracts and structured products), and ineffective summary disclosures. The Commission was faced with two potential responses: to engage in a radical overhaul of the UCITS regime which would dismantle the UCITS-​based strategy and introduce a horizontal regime for all CISs; or to engage in incremental and targeted reform of specific inefficiencies in the UCITS regime.117 It became clear early on that the Commission did not have the appetite for a radical overhaul of the regime or for the construction of a 106 Commission, Financial Services: Implementing the Framework for Financial Markets: Action Plan (1999) (COM(1999) 232) 3. 107 n 16. 108 It was described as a ‘recognized global label of quality and investor protection’: Asset Management Expert Group Report, Financial Services Action Plan: Progress and Prospects (2004) 8. 109 n 108. 110 eg, European Parliament, Klinz I Report on Asset Management to the Committee on Economic and Monetary Affairs, 26 April 2006 (A6-​0106/​2006). 111 Including: Report of the Expert Group on Investment Fund Market Efficiency (2006); Report of the Alternative Investment Expert Group Report, Managing, Servicing, and Marketing Hedge Funds in Europe (2006), and Report of the Alternative Investment Expert Group, Developing Private Equity (2006). 112 Oxera, Current Trends in Asset Management (2006), ZEW/​OEE, Current Trends in the European Asset Management Industry (2006), and CRA International, Potential Cost Savings in a Fully Integrated European Investment Fund Industry (2006). 113 n 55. 114 Commission, Feedback Statement. Enhancing the European Framework for Investment Funds (2006). 115 n 55 and IA (COM(2006) 686). 116 Commission, Initial Orientations of Possible Adjustments to the UCITS Directive (March 2007). 117 Industry views were also divided: Norman, P, ‘Tweak the Old Banger or Overhaul the Lot’, Financial Times Fund Management Supplement, 14 February 2004.

III.4  The UCITS Regime  249 broad-​based CIS system (this would follow after the financial crisis with the AIFMD),118 perhaps in an exercise of pragmatism as a major overhaul would have taken considerable time and political effort at a time of post-​FSAP strain.119 A targeted reforming Proposal, restructuring the 1985 Directive, was presented in 2008.120 It was primarily supply-​side focused, being designed to deliver efficiencies to UCITS structures and to pan-​EU distribution.121 But it also addressed short-​form retail market disclosures, the epochal KIID which would come to shape a generation of short-​form disclosure reforms, from the 2016 packaged retail and insurance-​based investment product (PRIIP) key information document to the 2017 Prospectus Regulation’s summary prospectus. The complexities associated with providing for a UCITS manager passport led to its original exclusion from the Proposal, although it was reintroduced over the trilogue negotiations. Following a relatively smooth legislative process,122 the end of which coincided with the start of the financial crisis, the 2009 UCITS IV Directive, which continues to govern the UCITS market, was adopted in January 2009 and was to be adopted by July 2011. The reforms were not entirely successful, with administrative barriers and structural obstacles persisting in the UCITS market123 and subsequently becoming a feature of the CMU agenda.

III.4.2.4 The Global Financial Crisis Era The UCITS market, and the UCITS rulebook, performed relatively well over the financial crisis.124 Losses and outflows were, however, significant from the outset,125 retail investors sustained heavy losses, and the MMFs which represented 15 per cent of UCITS assets experienced significant strain. But very few EU UCITSs closed (four),126 and only a few suspended redemptions (twelve, of which four reopened).127 UCITS reform was nonetheless swift and wide-​ranging, underlining the momentum of the crisis-​era reform period. The 2014 UCITS V reforms to the 2009 UCITS IV Directive can be strongly associated with the financial crisis in two respects.128 First, they addressed 118 eg 2005 Investment Funds Green Paper, n 55, 4. 119 This was also the view of the European Parliament’s Klinz I Report (n 110), which supported targeted legislative reform. 120 The main elements of the UCITS IV legislative history are: Commission Proposal, COM(2008) 458/​3 (2008 UCITS IV Proposal), IA at SEC(2008) 264; European Parliament Negotiating Position, 13 January 2009 (T6-​0012/​ 2009); and Council General Approach, 2 December 2008 (Council Document 16241/​08). 121 The Proposal noted that the Directive was excessively constraining, prevented UCITS managers from fully exploiting development opportunities, and that ‘estimated potential annual savings amount to several billion euros’: 2008 UCITS IV Proposal, n 120, 2. 122 The revisions and amendments were largely concerned with clarifying and simplifying the Commission’s proposals for fund mergers and master-​feeder structures and with the reintroduced management company passport. 123 For an initial review see KPMG, The Perfect UCITS (2012) 20–​3. 124 ESMA, TRV No 2 (2013) 50, describing the UCITS segment as being resilient over the crisis, and noting the return of most of the industry to positive returns. Similarly, bar those few UCITSs associated with the Madoff fraud (noted below), ‘the UCITS structure has proved scandal-​free during the severe ructions of the past 18 months’: Johnson, S and Aboulian, B, ‘Convergence Strategy Under Threat’, Financial Times Fund Management Supplement, 16 March 2009. The German NCA (BaFIN) also noted the limited impact of the crisis on retail UCITS schemes (BaFIN, Annual Report 2007–​2008, 164), although the French NCA (the AMF) focused on risk controls and the quality of disclosure (Annual Report 2007, 3). 125 By the third quarter of 2007, net outflows represented one third of total sales from the beginning of the year, with bond schemes most heavily affected: CESR, Annual Report (2007) 19. 126 Johnson, S, ‘UCITS Outflows Soar in Q3’, Financial Times Fund Management Supplement, 1 December 2008 also reporting on some rationalization and cost-​cutting, but that the industry remained broadly robust. 127 EFAMA, Annual Report (2007–​2008) 9. 128 The UCITS V reform (Directive 2014/​91/​EU [2014] OJ L257/​186) was agreed, following trilogue discussions, in February 2014. The main elements of the legislative history are: Commission Proposal COM(2012) 350/​2,

250  Collective investment Management the specific risks associated with the crisis-​era Madoff fraud and so addressed the UCITS depositary (section 4.8). Second, the 2011 AIFMD reforms for non-​UCITS collective investment management, adopted early in the crisis reform period, shaped the reforms to the UCITS regime. The UCITS V process also provided EU legislators with the opportunity to align the UCITS sanctioning and enforcement regime with the new approach to sanctioning which was adopted over the crisis. The non-​bank financial intermediation reform agenda kept the UCITS regime under review as the financial crisis began to recede. A related 2012 Commission consultation129 had earlier laid the foundation for what would become a series of financial-​stability-​oriented reforms relevant to the CIS sector generally, culminating in the 2015 Securities Financing Transactions Regulation and 2017 MMF Regulation. This consultation had also identified a series of potential reforms to the UCITS regime,130 generating some concern as to the ongoing instability in the UCITS rulebook.131 The momentum for legislative reform receded, however, perhaps as the 2011 establishment of ESMA provided a technocratic channel through which the UCITS regime could be amplified and refined. The massive soft law ‘rulebook’ which has followed, and ESMA’s extensive supervisory convergence agenda, are, along with the UCITS V reforms and the sharpened focus on UCITSs as sources of stability risks, the major legacies from the financial-​crisis era.

III.4.2.5 The Post Global Financial Crisis Period a. Financial Stability Since the UCITS V reforms, the UCITS legislative regime has been broadly stable and has not experienced major strain. By way of illustration, the rise in the EU of Exchange-​Traded Funds (ETFs) (funds which (typically) track major benchmarks and so are low cost and which offer enhanced liquidity as they are traded on trading venues),132 and their significant growth,133 was managed without related reforms to the UCITS rulebook.134 By contrast, the

IA SWD(2012) 185; European Parliament Negotiating Position, 3 July 2013 (T7-​0309/​2013), and Council General Approach, 2 December 2013 (Council Document 17095/​13). 129 Commission, UCITS. Product Rules, Liquidity Management, Depositary, Money Market Funds and Long-​ term Investments (2012). 130 The Commission suggested a series of technical enhancements to the master-​feeder, merger, and notification reforms introduced by the UCITS IV reforms: 2012 UCITS VI Consultation, n 129, para 9. 131 Aboulian, B, ‘Brussels May Curb Use of Derivatives’, Financial Times Fund Management Supplement, 30 July 2012. 132 While the ETF sector is primarily based on passive index-​tracking strategies, 2021 saw growth in the actively managed ETF sector in the US: Noblett, J, Debuts in active ETFs surge as US investor appetite grows,’ Financial Times, 31 December 2021. For a review of the EU market see Thomadakis, A, The European ETF Market: What can be done better? ECMI Commentary No 52 (2018). 133 AUM in the EU ETF sector grew from €504 billion in 2017 to €1.2 trillion in 2021 (see ESMA’s TRV Reports No 2 (2021) and No 1 (2017)), reflecting continual growth from 2008. The EU ETF market remains small as compared to the behemoth US market which has experienced massive growth: Flood, C, ‘ETF assets close to $10tn after second year of record growth’ Financial Times, 24 December 2021. 134 ETFs are heavily regulated in the EU as they typically take the form of UCITSs and so come within the UCITS portfolio allocation and risk management regime. They are also addressed by specific ESMA Guidelines which cover, inter alia, disclosure requirements and the redemption rights which secondary market purchasers of ETFs may have: ESMA, Guidelines on ETFs and other UCITS Issues (2014). ETFs are further subject to admission and trading rules under MiFID II/​MiFIR.

III.4  The UCITS Regime  251 ETF sector has been the focus of targeted regulatory attention in the US.135 Relatedly, the UCITS sector has not experienced any major fund failures.136 The resilience of the UCITS rulebook was, however, tested by the intensification of financial stability risks in the UCITS sector as it expanded in the wake of the financial crisis. In particular, as UCITS bond funds held more illiquid, lower-​rated debt securities (as such bond UCITSs went down the risk curve in a search for yield in the prevailing, post-​crisis low interest rate environment),137 they became more exposed to liquidity risk (arising from the core UCITS regime requirement that investors be able to redeem their UCITS investments on demand, as noted in section 4.4.1) and, accordingly, at more risk of exposing the financial system to financial stability risks. The increasing risks were, reflecting the EU’s strengthened technocratic capacity since the financial crisis, identified and monitored by the ESRB which, from 2016 on (in its annual non-​bank financial intermediation reports), reported on an escalation of liquidity risks in open-​ended bond funds (typically in UCITS form), as their asset portfolios became more exposed to lower-​rated debt securities of potentially greater illiquidity risk, and as they became more exposed to liquidity mismatch risks were they to experience redemption pressure.138 Also, ESMA’s bi-​annual Trends, Risks, and Vulnerabilities Reports (TRVs) monitored the investment fund sector, similarly noting potential liquidity mismatch risks in open-​ended bond funds.139 The liquidity mismatch risk to which UCITS bond funds were exposed crystallized in March 2020 when the spread of the Covid-​19 pandemic globally led to a severe economic shock and major market dislocation, with large falls in asset prices. Nonetheless, and by contrast with the turmoil in the MMF market (section 7), while UCITS corporate bond funds experienced large outflows amidst a liquidity squeeze in high-​yield debt markets, they proved able to manage the liquidity risks. Following the dislocation, ESMA, in response to an ESRB recommendation,140 assessed the performance of some 367 UCITSs which had particularly large exposures to corporate bonds141 and found that liquidity risk management systems had overall worked well.142 While some of these UCITSs had experienced significant net outflows and liquidity pressures, only six had suspended redemptions and most other bond UCITSs were either able to manage the liquidity risk through portfolio management or (in the case of some 134 funds) by imposing ‘swing pricing’ restrictions (increases in the price of units or shares, as a cost on investors seeking to redeem). Across the sector as a whole, only 0.2 per cent of all EU investment funds imposed redemption suspensions.143 135 A set of disclosure-​oriented reforms were adopted in 2019. Leveraged ETFs (which use derivatives to amplify the performance of benchmarks) became a particular source of concern, given the complexity of these products and the risk of mis-​selling to retail investors, as well as the wider stability risks they pose (Flood, C, ‘US regulator warns leveraged ETPs pose systemic risks to market’, Financial Times, 6 October 2021), and prompted a US Securities and Exchange Commission (SEC) warning in July 2022. 136 One of the few major failures concerned the 2019 suspension of redemptions in a UK UCITS (Woodford Equity Income Fund). Following significant outflows (which included outflows of 18 per cent of NAV in one day), redemption was suspended to protect investors: ESMA, TRV No 2 (2019) 22. 137 The move to increased holdings of higher-​yielding BBB securities was regularly reported. See ESMA, TRV No 2 (2019) 21. 138 The 2018 review, eg, noted elevated liquidity risk in bond funds: ESRB, EU Shadow Banking Monitor No 3 September (2018) 8. 139 See, eg, ESMA, TRV No 2 (2018) 13, noting a deterioration in the liquidity risk profile of bond funds. 140 ESRB Recommendation 2020/​4 [2020] OJ C200/​1. The ESRB recommended that ESMA review the impact on corporate bonds and on real estate funds (ESMA’s report followed in 2020: n 47). 141 This riskier segment of the UCITS market was small in an overall population of some 30,000 UCITS funds. 142 2020 ESMA Liquidity Risk Report, n 47. 143 ESMA Chair Maijoor, Speech, 13 November 2020. Some 140 funds in total suspended redemptions in March 2020: 2020 ESMA Liquidity Risk Report, n 47, 4.

252  Collective investment Management Fund liquidity profiles recovered quickly in April 2020 and by 2021 the UCITS sector was no longer a source of concern.144 An ESMA-​coordinated ‘Common Supervisory Action’ by NCAs on UCITS liquidity risk similarly found little evidence of significant liquidity risk across the sector.145 ESMA warned, however, that massive central bank and government intervention had minimized the impact of the March 2020 shock, and that concerns remained as to UCITS’ valuation and liquidity risk management processes, and as to varying national rules and practices regarding exceptional liquidity risk management tools. While the UCITS rulebook therefore proved to be relatively resilient to crisis conditions, the episode led to a proposal for legislative reform, in the form of the 2021 AIFMD/​ UCITS Proposal’s liquidity management tools regime (section 4.4.1). It also led to soft law: a 2018 ESRB Recommendation on the need for enhanced monitoring of fund liquidity and leverage146 led to ESMA’s 2020 Guidelines on Liquidity Stress Testing and to its 2021 Guidelines on AIF Leverage. The episode also evidences the now significant technocratic capacity of the EU to manage UCITS financial stability risks. The ESRB provided an EU-​level systemic perspective on the emerging UCITS risk, while ESMA’s more operationally oriented response included the 2020 and 2021 Guidelines; coordinating between NCAs in March 2020, at the height of the liquidity contraction, on supervisory risks and the use of liquidity management tools; data collection; the 2020 Common Supervisory Action; and the identification of recommended legislative reforms.147 b. Capital Markets Union and the UCITS Regime The CMU investment funds agenda has been primarily focused on venture capital funds (section 6), but it identified from the outset the need to address longstanding obstacles to the pan-​EU distribution of UCITSs (and other funds).148 As outlined in section 3.2.2, the 2019 Refit Directive and Regulation adopted a series of related but largely technical reforms to the UCITS (and other fund) regimes. The most extensive CMU reforms are likely to come from the 2021 AIFMD/​UCITS Proposal which, while arising from the AIFMD review process, is also designed to support CMU by enhancing the UCITS regulatory framework. c. The 2021 UCITS/​AIFMD Proposal The 2021 AIFMD/​UCITS Proposal is primarily concerned with AIFMD reform but, and reflecting the increasing alignment between the AIFMD and UCITS regimes, it applies its proposed reforms as regards delegation, liquidity risk management, data reporting, and supervisory cooperation reforms to both sectors. Chief among the UCITS reform proposals is the proposed new framework for UCITS liquidity risk management tools, which is based on ensuring a minimum suite of such tools is available for UCITSs; and tighter regulation 144 ESMA, TRV Report No 2 (2021), reporting on positive fund inflows, albeit noting persistently elevated credit risk and related bond fund liquidity risk (at 22–​3). 145 ESMA, Public Statement (2020 CSA on UCITS Liquidity Risk Management), 24 March 2021. A subsequent ESMA/​NCA review found that the corporate bond and property funds exposed did not pose substantial risks to financial stability, albeit that ESMA called for improvements in stress-​testing and in the valuation of less liquid assets: ESMA, Press Release, 30 March 2022. 146 n 47. 147 Including as regards enhanced UCITS reporting to support supervision and a harmonized framework governing the use of liquidity risk management tools. 148 2015 CMU Action Plan, n 1, 20.

III.4  The UCITS Regime  253 of the delegation by UCITS management companies of their functions. A wide-​ranging review of UCITS reporting requirements, designed to support a future redesign of UCITS reporting and, ultimately, the creation of an integrated supervisory data collection system that would integrate data reporting across the single rulebook, is also proposed.149 Modest in design, the Proposal does not unduly disrupt the UCITS regime. The emphasis on enhancing data reporting, and on facilitating UCITSs in managing liquidity risk, suggests a focus on operational effectiveness, both supervisory and at the UCITS level. It also implies that a level of maturity has been achieved in the legislative scheme such that the reform lens can be focused on more operational adjustments.

III.4.3  The UCITS Rulebook: Legislation, Administrative Rules, and Soft Law The UCITS regime has evolved and thickened very significantly since its initial adoption in 1985. Privately contracted UCITS rules/​instruments of incorporation remain of pivotal importance to UCITS governance, but the UCITS rulebook is now of formidable scale and determines much of how a UCITS operates. The scale of the regime reflects the technical complexity of the regulatory issues (particularly with respect to portfolio regulation/​ asset allocation and as regards liquidity and leverage risk management), the multi-​layered nature of UCITS regulation (which includes the conduct and prudential regulation of management companies and depositaries), the challenges posed by retail investor protection in this area (particularly as regards short-​form disclosures), and the operational and coordination risks which cross-​border activity by UCITSs and their depositaries and management companies pose to pan-​EU supervision. Unusually, the UCITS regime is based on a directive, although regulations have, since the financial-​crisis era, come to frame the single rulebook. This accommodates some degree of Member State discretion, albeit that this flexibility has also been associated with the persistent frictions in cross-​border UCITS distribution. Member State discretion is institutionalized within the UCITS Directive which provides that a Member State may adopt additional or stricter requirements for UCITSs established within its territory, as long as these requirements are of general application and do not conflict with the Directive (Article 1(7)). This provision was of some significance at the outset, when the 1985 Directive imposed only minimum rules. Over time, the harmonized regime has been filled in, to the extent that, following the adoption of the 2009 UCITS IV Directive and its amplification by an extensive suite of administrative rules, soft law, and supervisory convergence measures, the only real gap related to UCITS’ marketing. This gap has now been in part filled by the 2019 Refit Directive and Regulation which have constrained, to some extent, the competences of host Member States as regards UCITS marketing. The UCITS Directive has also been amplified by detailed administrative rules, most of which were adopted prior to the injection of ESMA into the rule-​making process. Seven

149 The review is designed to reduce areas of duplication and inconsistency between the asset management sector and other financial sectors, and to improve data standardization and the efficient use and sharing of data.

254  Collective investment Management sets of administrative rules apply: the 2007 Commission Eligible Assets Directive;150 the 2010 Commission Management Company Directive;151 the 2010 Commission Mergers and Master-​Feeder Directive;152 the 2010 Commission Key Investor Information Document (KIID) Regulation;153 the 2010 Commission Notification and Information Exchange Regulation;154 the 2016 Delegated Depositaries Regulation;155 the 2016 UCITS Forms and Templates ITS;156 and the 2018 Delegated Depositary Safekeeping Regulation.157 Together, these measures form an administrative rulebook of formidable breadth and depth. As regards the extensive UCITS soft law ‘rulebook’, CESR’s legacy to ESMA was significant.158 It included the wide-​ranging 2007 Eligible Assets Guidelines159 and the pivotal 2010 Guidelines on UCITS risk measurement and the calculation of global exposure and counterparty risk.160 These remain in force and amount to a soft but hefty operational manual on UCITS risk management. ESMA has since adopted additional Guidelines, including: Guidelines for UCITSs, including structured UCITSs and ETFs (2012; and 2012, revised 2014);161 Guidelines on remuneration policies (2016);162 Guidelines on performance fees (2020);163 and Guidelines on liquidity stress testing (2020).164 These Guidelines often have a quasi-​regulatory orientation and are not easily distinguished from administrative rules. The structured UCITS Guidelines, for example, are designed to bring technical clarity and greater standardization to risk management procedures, while the ETF Guidelines are designed to address the specific risks associated with the ETF sector. Similarly, the 2016 Remuneration Guidelines provide immensely detailed guidance on how remuneration processes and structures are to be organized. The Guidelines can also have a strongly operational quality, well-​illustrated by the 2020 Liquidity Stress Testing Guidelines which address, inter alia, the design and governance of stress testing models, data sources, frequency of stress testing, and scenario design. In addition, an extensive and frequently updated Q&A165 provides further amplification of ESMA/​NCAs’ expectations regarding the application of the UCITS regime, while ESMA also issues ‘Opinions’ and similar measures 150 Delegated Directive 2007/​16/​EC [2007] OJ L79/​11. This administrative Directive remains in force although the legislative measure on which it is based, the 1985 UCITS Directive, has been repealed. Provision was made for it to remain in force through a legislative measure. 151 Delegated Directive 2010/​43/​EU [2010] OJ L176/​42. 152 Delegated Directive 2010/​42/​EU [2010] OJ L176/​28. 153 Delegated Regulation (EU) No 583/​2010 [2010] OJ L176/​1. 154 Delegated Regulation (EU) No 584/​2010 [2010] OJ L176/​16. 155 Delegated Regulation (EU) 2016/​438 [2016] OJ L78/​11. 156 ITS 2016/​1212 [2016] OJ L199/​6. 157 Delegated Regulation (EU) 2018/​1619 [2018] OJ L271/​6. 158 CESR’s ambition in the funds/​UCITS sphere is well illustrated by it suggesting—​presciently, given the product intervention powers conferred on ESMA under MiFIR (Ch IX)—​a possible role for itself with respect to the EU-​level approval of innovative UCITSs: CESR, Preliminary Progress Report, Which Supervisory Tools for the EU Securities Market? An Analytical Paper by CESR (2004) 13 and 15. 159 CESR/​07-​044 and CESR/​07-​044b (2007 CESR Eligible Assets Guidelines). These Guidelines are supplemented by specific Guidelines relating to the treatment of hedge fund indices (CESR/​07-​437). 160 CESR, Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk (2010). 161 ESMA, Guidelines on Risk Management and Calculation of Global Exposures for Certain Types of Structured UCITS (2012) and ESMA, Guidelines on ETFs and other UCITS Issuers (2014). 162 ESMA, Guidelines on Sound Remuneration Policies under the UCITS Directive (2016). 163 ESMA, Guidelines on Performance Fees in UCITS and certain types of AIFs (2020). 164 ESMA, Guidelines on Liquidity Stress Testing in UCITS and AIFs (2020). 165 ESMA, Questions and Answers. Application of the UCITS Directive. The Q&A is immensely detailed, covering, inter alia, the passport notification process, risk management, and the depositary, and addressing ESMA Guidelines as well as administrative and legislative rules.

III.4  The UCITS Regime  255 to NCAs, typically where divergences are identified in how NCAs apply the rule-​book or where there is a lack of clarity.166

III.4.4  Setting the Perimeter: Scope of the UCITS Regime III.4.4.1 Defining Features and Redemption on Demand a. Redemption on Demand Under Article 1(1), the UCITS Directive applies to UCITSs.167 UCITSs are further defined under Article 1(2) as undertakings the sole object of which is the collective investment in transferrable securities168 and/​or in other ‘liquid financial assets’ (listed in Article 50(1))169 of capital raised from the public, and which operate on the principle of risk-​spreading.170 Diversification is therefore built into the UCITS structure. In addition, the units of the UCITS must, at the request of the unit-​holder, be capable of repurchase or redemption, directly or indirectly, from the UCITS’ assets (Article 1(2)). This defining redemption-​on-​demand feature, which renders a UCITS investment a highly liquid form of investment (and so attractive to retail investors in particular), and which has led to the construction of a related and extensive asset-​allocation and liquidity risk management regime, is at the heart of the UCITS regime and is reflected in Article 84(1), which provides that a UCITS must repurchase or redeem its units at the request of any unit-​holder. Two derogations apply to this rule. First, a UCITS may temporarily suspend the repurchase or redemption of units in the cases and according to the procedures set out by law, the fund rules, or the investment company’s instruments of incorporation (Article 84(2)(a)) (as occurred, albeit only to a limited extent, over the global financial crisis and over the March 2020 pandemic-​related period of market dislocation). Such suspension may be provided for only in exceptional cases and must be justified having regard to the interests of unit-​holders or the public. Second, Member States may allow NCAs to require the suspension of repurchases or redemptions in the interests of unit-​holders or the public (Article 84(2)(b)). Redemption on demand requires that the UCITS’ asset portfolio is sufficiently liquid to manage redemption pressure, particularly in volatile conditions and when liquidity thins, if financial stability risks are to be avoided. The UCITS regime’s asset allocation requirements, risk management rules, and exposure limits all serve, however, to manage the related liquidity risks. Also, UCITSs can, where these are provided for in their constitutive documents, draw on liquidity risk management tools, including ‘redemption gates’ and ‘swing pricing’.171 As outlined in section 4.2.5, this risk management regime proved relatively 166 In January 2017, eg, ESMA used an Opinion to set out a common ESMA view on the different share classes which a UCITS fund can use. 167 Under Art 1(5), an anti-​evasion prohibition, Member States must prohibit UCITSs which are subject to the Directive’s provisions from transforming themselves into CISs which fall outside the Directive’s scope. 168 Defined as shares in companies and other equivalent securities; bonds and other forms of securitized debt; and any other negotiable securities which carry the right to acquire any such transferable securities by subscription or exchange: Art 2(1)(n). 169 The 2007 Eligible Asset Directive amplifies in some detail the nature of the instruments in which a UCITS can invest. 170 A scheme which does not operate on the principle of risk-​spreading is one which, eg, seeks to exercise control over the undertakings in which it invests. 171 ‘Redemption gates’ are used to slow down the rate of redemption by, eg, allowing only partial redemption. ‘Swing pricing’ is a technique used to pass on the costs of redemption. Any such tools (which are more typically

256  Collective investment Management resilient in March 2020 in the face of massive redemption pressure on UCITS bond funds: only six of the 367 UCITSs reviewed by ESMA suspended redemption, although 134 initiated swing pricing restrictions.172 The subsequent ‘Common Supervisory Action’ by NCAs (coordinated by ESMA) similarly found only limited evidence of significant liquidity risks, as well as a high level of convergence across NCAs in how liquidity risk was supervised.173 The episode nonetheless exposed weaknesses in liquidity risk management that led ESMA to call for enhanced supervisory review by NCAs, more comprehensive reporting on UCITS liquidity risks, and a harmonized framework governing liquidity management tools,174 supporting the earlier ESRB recommendation to this effect.175 The 2021 AIFMD/​UCITS Proposal subsequently, and reflecting wide-​spread stakeholder support,176 proposed the adoption of a liquidity management tools regime, based on the UCITS manager being required to choose one from the prescribed set of liquidity management tools177 and to adopt a related policy on its use (Article 18a)); a revision to Article 84 to provide that a UCITS can, as an alternative to suspending redemption, activate any liquidity management tool selected and that the UCITS’ home NCA may require the activation of a liquidity management tool; and strengthened NCA cooperation. This regime is designed to strengthen the UCITS’ capacity to manage redemption in conditions of elevated liquidity risk. It also reflects the extent to which stability risk management has come to shape the UCITS regime as well as the technocratic influence of ESMA and the ESRB. b. Fund Structure Article 1 also provides that a UCITS may be constituted according to the law of contract (as common funds without a separate legal personality and managed by management companies), according to trust law (as unit trusts), or under statute (as investment companies) (Article 1(3)). UCITSs can be relatedly classified as UCITSs in the form of investment companies and UCITSs with a separate management company. The latter form of UCITS (termed a ‘common fund’ in the Directive) consists of three separate entities: the capital raised from unit-​holders (the fund, in effect); the management company178 which manages the assets and markets the UCITS; and the depositary which has custody of the assets.179 associated with AIFs, such as property funds, which have more illiquid asset profiles) must be specified in the UCITS’ documentation, exercised in compliance with the UCITS rulebook, and may require local NCA approval. Liquidity management tools can be categorized as exceptional (such as the activation of gates) or those more commonly used (such as swing pricing). 172 2020 ESMA Liquidity Report, n 47. 173 2021 Liquidity Risk Management Common Supervisory Action, n 73. 174 2020 ESMA Liquidity Risk Report, n 47. 175 2018 ESRB Recommendation, n 47. 176 2021 AIFMD/​UCITS Proposal, n 30, 7. ESMA was also strongly supportive: 2020 ESMA AIFMD Review Letter, n 47, 8. 177 Set out in Annex IV to the Proposal, the proposed tools cover: suspension of redemptions/​subscriptions; ‘redemption gates’ (temporary restrictions on redemption which may be partial, restricting redemption to a portion of an investor’s shares/​units); notice periods for redemption; redemption fees; ‘swing pricing’ (changes to share/​ unit pricing to reflect the cost of fund transactions); anti-​dilution levies (charges payable to the fund to protect remaining investors from the cost of large in or out flows, and not involving an adjustment to unit/​share pricing); redemptions in kind (through securities instead of cash); and ‘side pockets’ (or the separation of illiquid and liquid fund assets). 178 Defined as a company the regular business of which is the collective portfolio management of UCITSs: Art 2(1)(b). 179 The depositary is the institution entrusted with the depositary’s duties as set out under the Directive: Art 2(1) (a).

III.4  The UCITS Regime  257 As regards the former type, the UCITS takes the form of an investment company (in which the UCITS investor holds shares) which is also the management company (or it may designate a separate management company), and the assets are held by a depositary. Crucially, in the common fund form of UCITS, UCITS unit-​holders do not have direct control over the management company as they hold units in the UCITS, not shares in the management company; by contrast, shareholders in an investment company UCITS, as shareholders, exercise control over the investment company and its directors.180 Investment companies, management companies, and depositaries are all regulated by the Directive, with management companies subject to more stringent regulation than investment companies (as regards UCITS management), reflecting their different structure.

III.4.4.2 Exclusions Article 3(1) sets out the exclusions from the Directive’s scope. One of the most significant exclusions, which follows from the Directive’s definition of a UCITS as a scheme in which units can be redeemed or repurchased, relates to UCITSs ‘of the closed-​end type’ (Article 3(a)). In a closed-​end CIS, restrictions apply to redemption: the investor typically buys a share in a company the main activity of which is investment and holds the usual equity risk held by shareholders (as well as the well-​known risk that investment companies typically trade at a discount to their net assets).181 Liquidity is provided by open market sales. By contrast, in an open-​ended scheme of whatever form, units are issued continuously, or at short intervals, at a price related to current NAV and may be redeemed by unit-​holders on demand, again at a price related to current NAV, with liquidity support built into the scheme’s structure. The Directive’s restriction to open-​ended schemes reflects the popularity of open-​ended schemes at the time of the Directive’s adoption. In addition, as open-​ended schemes often lie outside the safeguards of company law, and are subject to the defining redemption obligation which demands careful asset-​selection and portfolio management, they were seen as more susceptible to failure unless specific rules were applied. The other exclusions from the scope of the Directive relate to extra-​territoriality (UCITSs which raise capital without promoting the sale of their units to the public within the EU, or any part of it, and UCITSs whose units may be sold only to the public in third countries) and Member State exclusions (categories of UCITSs, prescribed by the Member States and in respect of which the Directive’s investment and borrowing rules are inappropriate).

III.4.5  Market Integration: Authorization, the Passport, and UCITS Mergers III.4.5.1 Authorization: The UCITS The UCITS passporting system is unusual in that it engages the passporting of two actors: the UCITS; and the management company (where relevant in that the management company is separate from the UCITS (i.e. the UCITS is not in the form of an investment company)). 180 For ease of reference, holders of units in UCITSs, whether in the form of an investment company UCITS or other UCITS, will be collectively referred to as unit-​holders, unless the distinction is material. 181 ‘Few problems in finance are as perplexing as the closed-​end fund puzzle’: Shleifer, A, Inefficient Markets. An Introduction to Behavioural Finance (2000) 53. The discount is often linked to liquidity risks attached to the portfolio, agency costs, and tax liabilities: at 53–​88.

258  Collective investment Management The passporting regime is accordingly more complex than other single rulebook passports, particularly as regards the supporting notification and supervisory arrangements. The passport, as is usual, is dependent on authorization. Authorization of the UCITS by the UCITS home Member State (in effect, the home NCA)182 supports the UCITS passport. Authorization of the management company by that company’s home Member State (in effect, the home NCA)183 supports the management company passport. The depositary is not subject to an authorization regime and does not benefit from a passport (section 4.8). As the management company’s home Member State may be a different State to the UCITS home State, UCITS and management company authorization and supervision can be split across two jurisdictions, which is reflected in the distinct supervisory cooperation regime which applies under the Directive. In practice, the management company (or the investment company where the UCITS is self-​managed), runs the UCITS authorization process.184 As regards UCITS authorization, Article 5(1) provides that no UCITS can pursue activities as such unless it has been authorized in accordance with the Directive. Once authorized, a regulatory passport is conferred in that the UCITS authorization is valid for all Member States (Article 5(1)). The nature of UCITS authorization depends on its structure. In the case of a common fund (a UCITS with a separate management company), authorization is conditional on the UCITS home NCA having also approved the application of the separate management company to manage the UCITS (Article 5(2)). Management company authorization, however, is the responsibility of the management company’s home NCA (Article 6(1)). UCITS authorization reflects this split in that it is conditional on the management company being authorized to manage UCITSs in its home Member State (Article 5(4)(b)). Similarly, authorization of a UCITS in the form of a common fund requires that the UCITS home NCA approve the choice of depositary (Article 5(2)). The UCITS home NCA must also approve the fund’s rules (Article 5(2)). Where the UCITS takes the form of an investment company, the UCITS home NCA must approve the instruments of incorporation and the choice of depositary. Where the investment company appoints a separate manager, the home NCA must approve the application of the relevant management company to manage the investment company (Article 5(2)). UCITS authorization in this case is also subject to the investment company meeting the authorization and operating requirements for investment companies imposed under Articles 27–​31 (Article 5(4)(a)). While depositaries are not subject to authorization as part of the UCITS authorization process (although conditions are imposed on entities that can act as depositaries, as noted below in this chapter), for both common fund and investment company UCITSs, the UCITS may not be authorized by its home NCA if the directors of the depositary are not of sufficiently good repute or are not sufficiently experienced in relation to the type of UCITS to be managed (Article 5(4)). Neither the management company nor the depositary can be replaced (nor the fund rules/​instruments of incorporation amended) without the approval of the UCITS home NCA (Article 5(6)).

182 Defined as the Member State in which the UCITS is authorized (Art 2(1)(e)), thereby allowing significant regulatory competition, albeit within the limitations imposed by the detailed UCITS rulebook. Ireland and Luxembourg are the dominant home Member States for UCITSs. 183 The Member State within which it has its registered office: Art 2(1)(c). 184 And must be informed as to the success of the UCITS authorization application within two months: Art 5(4).

III.4  The UCITS Regime  259 Given the potential split in supervision between the UCITS and the management company, a number of mechanisms specific to the UCITS field are used to support effective supervision and to provide strong home NCA supervisory incentives. The UCITS home NCA may not grant authorization where the UCITS is legally prevented from marketing its units in the home Member State (Article 5(5)), thereby ensuring the home NCA has an incentive to monitor the UCITS. Additionally, where the UCITS home Member State is different to that of the management company, a tailored cooperation regime applies to the relationship between the two home NCAs involved -​nonetheless, strains remain in the supervisory cooperation framework (section 11).

III.4.5.2 Authorization: The Management Company Prior to the 2009 UCITS IV reforms which introduced the current management company passport, significant difficulties attended management company passporting. Although the 2001 UCITS III reforms attempted to liberalize the management company industry, diverging national interpretations and weaknesses in the 1985 Directive limited the extent to which management companies could manage UCITSs cross-​border.185 Most Member States required that the management company be established in the Member State where the UCITS was authorized, thereby ‘landlocking’ management companies within a Member State and eliminating management company passporting.186 The potential for more effective risk management across UCITSs, economies of scale, and cost reduction through the centralization of management functions was therefore severely constrained. The symbiosis between the management company and the UCITS, however, raises delicate questions of supervisory coordination where management company passporting is permitted and supervisory jurisdiction is, accordingly, split between the UCITS and management company NCAs. The scale of the operational and legal difficulties led the Commission to exclude management company reforms from the UCITS IV Proposal187 and instead to charge CESR with developing a solution.188 While CESR failed to reach a unanimous position,189 its technical advice ultimately formed the basis of the current management company passport regime under the UCITS IV Directive.190 It provides for a management company passport, supported by a management company authorization requirement and detailed supervisory cooperation arrangements. The management company must be authorized by the NCA of its home Member State (Article 6(1)).191 Once granted, the authorization supports the management company passport, being valid for all Member States (Article 6(1)).192 Prudential supervision is the 185 See, eg, 2004 Asset Management Expert Group Report, n 108, 18. 186 Similarly, 2008 UCITS IV Proposal IA, n 120, 16. 187 The 2008 UCITS IV Proposal IA proposed that the status quo be maintained, given the significant operational and legal difficulties associated with remote supervision of management companies: n 120, 28–​30. 188 Commission Letter to CESR (Request for Assistance on the UCITS Management Company Passport), 16 July 2008. 189 The advice was adopted by a qualified majority of CESR’s members: five members (including the NCAs of the major fund domiciles of Luxembourg and Ireland) voted against: CESR Advice on the Management Company Passport (2008) 3. Luxembourg and Ireland were concerned as to the potential risks to investor protection were supervision to be split between management company and UCITS NCAs in different Member States. 190 The management company regime was added during the trilogue negotiations between the European Parliament, Commission, and the Council: Summary Document. Text Adopted by Parliament. 1st/​Single Reading, 13 January 2009. Both institutions were supportive of a passport for management companies. 191 The Member State within which it has its registered office: Art 2(1)(c). 192 As is now standard across the single rulebook, ESMA must be notified of every authorization and maintain a list of authorized management companies on its website: Art 6(1).

260  Collective investment Management responsibility of the NCA of the management company’s home Member State, whether or not the management company passports into another Member State (Article 10(2)). As under the MiFID II regime for discretionary investment management, conduct regulation with respect to management company branches is the responsibility of the host Member State (Article 17(4) and (5)) (otherwise the home Member State).193 In order to support the management company passport, the related UCITS authorization regime provides that UCITS authorization cannot be conditional on the UCITS being managed by a management company with its registered office in the UCITS home Member State, or conditional on the management company pursuing or delegating any activities in the UCITS home Member State (Article 5(3)).194 Authorization by the management company’s home Member State NCA is conditional on the management company only engaging in collective UCITS management (Article 6(2)).195 A number of exceptions apply. Management companies may engage in collective investment management for non-​UCITS schemes, as long as the management company is subject to related prudential supervision and the schemes’ units cannot be marketed in other Member States (Article 6(2)). Management companies are also permitted to engage in discretionary investment management, including for pension funds, where the portfolio includes one or more MiFID II-​scope instruments and, as non-​core services only,196 to provide investment advice in relation to MiFID II-​scope instruments and also safekeeping and administration services in relation to CIS units (Article 6(3)).197 The authorization process is broadly similar to, if lighter than, the MiFID II authorization process for investment services, incorporating capital,198 ‘fit and proper’ management, business plan, and ‘close links’ and qualifying shareholder requirements, as well as a requirement for the head office and registered office to be in the same Member State (Articles 7 and 8). A broadly similar but somewhat lighter authorization regime (Articles 27–​9) applies to investment companies which do not appoint a separate management company, reflecting the single focus of these companies as well as the monitoring provided by shareholders.199

III.4.5.3 The Passport and Notification a. The UCITS UCITS authorization is valid for every Member State (Article 5(1)). A Member State may not apply any other provisions in the field covered by the Directive to authorized UCITSs 193 The home NCA remains responsible for conduct regulation carried out on a cross-​border services basis: Art 18(3). 194 Similarly, the ongoing organizational and other prudential rules which apply to the management company and which are supervised by the home NCA can be no stricter than those which apply where the management company conducts activities only within the home Member State: Art 19(1). In addition, the Directive clarifies that management companies may not be subject to additional requirements in the UCITS home Member State, save as specified in the Directive: Art 19(8). 195 The scope of which is set out in Annex II to the Directive. 196 Management companies cannot, accordingly, be authorized to provide only these services. 197 MiFID II’s requirements apply to Art 6(3) services. 198 The capital regime is calibrated to the particular risks posed by collective investment management, focuses on operational risk, and is related to the value of the assets under management: Art 7(1)(a). The rules are tied to the 2019 Investment Firm Directive/​Regulation in that the own funds of a management company cannot be less than the amount set by the IFR: Art 7(1)(a)(iii), referring to the minimum amount set by IFR Art 13 as regards fixed overheads. 199 Authorization is by the investment company’s home NCA (where the company is registered). Where a company appoints a separate management company, the authorization conditions are limited and apply only to restricting the scope of business to collective investment management and to the capital required (Arts 27–​8).

III.4  The UCITS Regime  261 established in another Member State, or to the units issued by such UCITSs, where those UCITSs market their units within the territory of that Member State (Article 1(6)). Similarly, UCITS host Member States200 are prohibited from imposing any additional requirements or administrative procedures on UCITSs in the field governed by the Directive (Article 91(2)). The Directive does not cover marketing. Host marketing rules may, accordingly, apply, albeit they must be in accordance with the 2019 Refit Regulation which has imposed a new framework on host marketing rules to mitigate the passporting frictions long associated with these rules. It includes minimum standards for marketing communications (Refit Regulation Article 4),201 publication by NCAs of local marketing rules (Article 5), a requirement for ESMA to construct a database of relevant rules (Article 6), and a framework governing the notification of marketing communications to the host NCA, designed to prevent host NCAs from making the authorization of marketing communications a precondition for the marketing of UCITS units in the host Member State and to ensure that any host NCA notification requirement is only for the purpose of verifying compliance with national rules (Article 7). The operation of the UCITS passport and the related notification process is governed, in detail, by Articles 91–​6. Once the relevant notification requirements are met,202 which include disclosure requirements,203 the host Member State must ensure that the UCITS can market its units within the host Member State (Article 91(1)).204 Notification is made by the UCITS to its home NCA, which verifies whether the required documentation is complete and then transmits it to the host NCA, together with an attestation that the UCITS fulfils the conditions imposed by the Directive.205 Once this notification has been made by the home NCA and the UCITS informed, the UCITS can access the market of the host Member State. ESMA maintains a database of all passported UCITS.206 By contrast with the management company notification regime, the UCITS home NCA’s powers to block cross-​border notification are limited, and relate only to the UCITS’ compliance with the Directive. The UCITS must, however, ensure that payment and related 200 The Member State, other than the home Member State, in which the UCITS units are marketed: Art 2(1)(f). 201 All marketing communications must be identifiable as such and describe the risks and rewards of purchasing units in an equally prominent manner; in a formula that repeats across the single rulebook, all information in such communications must be ‘fair, clear and not misleading’; and communications must specify where disclosures on investor rights can be accessed: Art 4(1) and (3). While these requirements apply to all in-​scope managers (of AIFs, UCITSs, and EuSEF/​EuVECAs), UCITS marketing communications must additionally align with the UCITS prospectus and Key Investor Information Document (KIID) and indicate the availability of these documents: Art 4(2). The KIID regime changed in January 2023 (see section 9). 202 The 2010 Delegated Notification and Exchange of Information Regulation Arts 1–​5 governs the technical modalities. 203 The notification required of a UCITS (to its home NCA) before marketing its units outside the home Member State must include the prospectus, financial reports, KIID (now the KID), and the fund rules or instruments of incorporation (Art 93(2)). The UCITS must also provide investors in the UCITS’ host State with all documents provided to investors in the UCITS’ home Member State (Art 94(1)). Only the KID must be translated into the official language of the UCITS’ host State (or other language approved by the NCA) (Art 94(1)(b)); all other documents, reflecting the Prospectus Regulation’s translation regime, are to be translated into either the official language(s) of the UCITS’ host State, a language approved by the host NCA, or a language customary in the sphere of international finance, at the choice of the UCITS (Art 94(1)(c)). 204 Host NCAs may not ask for documents or disclosures additional to those specified for the notification: Art 93(6). 205 The notification must be made in a language customary in the sphere of international finance, unless the two NCAs agree to it being in one of their official languages: Art 93(4). 206 Previously, and by contrast with the prospectus regime, ESMA did not maintain data on passporting UCITSs. This requirement was introduced by the 2019 Refit Directive.

262  Collective investment Management subscription and redemption facilities are available in the host State. The governing Article 92 on such facilities was replaced and revised by the 2019 Refit Directive to remove the previous requirement for the UCITS to provide a physical presence in the host Member State, given that investors typically now exercise their UCITS rights through digital means.207 The Refit Directive also introduced a mechanism for a UCITS to ‘de-​notify’, thereby addressing the uncertainties that had bedevilled UCITS withdrawal from a host Member State.208 Article 93a provides a means for a UCITS to withdraw from the marketing of its units in a Member State, subject to compliance with a series of conditions designed to secure investor protection, including as regards the notification of investors and the communication of blanket repurchase/​redemption offers to all impacted investors. The notification process has been further enhanced by the new regime governing NCA fees which is designed to address the uncertainties and costs associated with the imposition of host NCA fees on passporting UCITSs. NCAs are now required to ensure that any fees charged are consistent with the overall costs of the NCA as regards the functions in question and that current fee information is published; ESMA is required to maintain a fee database (Refit Regulation Articles 9–​11). b. The Management Company The management company passport is similar to the MiFID II investment services passport.209 It covers the provision of management company services by way of the freedom to provide services and by way of the freedom to establish (Article 16(1)).210 The host NCA can exercise limited precautionary powers (Article 21). In order to address the potential split of supervision between the UCITS home NCA and the management company home NCA in a passporting context (where the management company is managing a UCITS in another State), a jurisdiction-​allocation regime applies. Where a management company provides collective investment management services on a cross-​border basis, it must comply with the home country regime with respect to organizational matters.211 The management company must, however, comply with the rules of the 207 UCITS are to make available facilities for a series of functions (including the subscription, repurchase, and redemption of units and information publication) but Member States may not require the UCITS to have a physical presence or to appoint a third party: Art 92(1) and (2). 208 The absence of a clear framework for the discontinuation of UCITS marketing had been associated with economic and legal uncertainty for fund managers: 2019 Refit Directive recital 7. 209 It is set out in Arts 17 (branches) and 18 (services). 210 Management companies may pursue authorized activities in another Member State through the freedom to provide services or the freedom to establish (Art 16(1)), and the host Member State may not make these activities subject to any authorization requirement, any additional capital requirements, or any other measure having equivalent effect (Art 16(2)). The notification system for branches (Art 17) and services (Art 18) is based on the investment-​services model and so gives the home NCA the ability to block the establishment of a branch cross-​border where it doubts the adequacy of the administrative structure or the financial situation of the management company (Art 17(3)) (the services notification process is largely automatic). The notification process is adjusted to the particular supervisory and substantive risks posed by collective investment management in that it focuses in particular on risk management and the notification must include information on the nature of the collective investment management services engaged in and any restrictions on the type of UCITSs which the company can manage. The 2019 Refit Directive refined the notification system to provide that, where the required notification of the home NCA of any changes to any notification disclosures previously made identifies non-​compliance with the Directive, the home NCA is to inform the management company that the change cannot be made or, where the change has been implemented, to take all necessary measures and inform the host NCA accordingly. 211 Including delegation arrangements, risk management, prudential rules and procedures, and reporting requirements: Art 19(1) (reflecting Art 10(2), which confers prudential supervision responsibility on the home Member State). This regime is supervised by the home NCA (Art 19(2)).

III.4  The UCITS Regime  263 UCITS home Member State with respect to UCITS-​related matters, which are supervised by the UCITS home NCA.212 To support the UCITS home NCA under this split model, the management company’s home NCA is responsible for supervising the adequacy of the management company’s arrangements and organization such that the company is in a position to comply with these UCITS-​related rules (Article 19(7)). The UCITS authorization process also reflects the risk of split supervision. Where the UCITS is established in a different State to the management company, the UCITS authorization process (which includes approval of the management company’s application to manage the UCITS) must include the provision by the management company of information on delegation arrangements (which may be used by the management company to manage the UCITS) and on the agreements between the depositary and the management company (Article 20(1)). In addition, the UCITS home NCA may ask the management company’s home NCA for clarification regarding the management company’s authorization documentation and also regarding the compliance of the UCITS for which authorization is sought with the scope of the management company’s authorization (Article 20(2)). The UCITS home NCA may only refuse the management company’s application to manage the UCITS in question, however, where it does not comply with the home NCA’s UCITS-​related rules, the company is not authorized in relation to the UCITS in question, or the Article 20(1) documentation has not been provided (Article 20(3)). This jurisdiction allocation regime is supported by distinct supervisory cooperation obligations (Articles 107–​10, section 11).

III.4.5.4 Mergers of UCITSs The UCITS IV Directive introduced a specific regime for UCITS mergers (Articles 37–​48) in order to support integration by facilitating UCITSs in pooling their assets and thereby generating pan-​EU efficiencies. The concerns regarding the sub-​optimal size of UCITS funds, which the merger reform was designed to address,213 remain, however, as has been highlighted by the CMU agenda and the related Refit reforms which are designed to support economies of scale.

III.4.6  Asset Allocation and Investment Limits III.4.6.1 A Dynamic Regime Asset-​allocation and related diversification rules, designed to ensure that a UCITS can meet its core Article 84 obligation to redeem units on request, are at the heart of the Directive’s regulatory design. These rules have, since their initial adoption, been liberalized and refined to expand the scope of permissible UCITS investments. Under the 1985 UCITS Directive, assets eligible for UCITS investment were limited to transferable securities; UCITSs were prohibited from 212 Including in relation to UCITS authorization, issuance, and redemption of units; investment policies and limits; restrictions on borrowing; asset valuation; income distribution; UCITS disclosure and reporting requirements; the merging and restructuring of UCITS; and UCITS winding up and liquidation: Art 19(3). 213 The UCITS Review had earlier highlighted the small size of the average UCITS fund and the legal difficulties associated with constructing fund mergers, which had resulted in a proliferation of funds: 2006 Investment Fund Market Efficiency Group Report, n 111, 10–​16.

264  Collective investment Management investing in other CISs unless those CISs were UCITSs; and restrictive diversification rules applied. The 2001 UCITS III Product Directive liberalized the asset allocation rules to offer more opportunities to the collective investment industry and provide greater choice for investors214 by permitting investment in financial instruments other than transferable securities, including in derivatives. Related risk-​management, diversification, and disclosure rules were introduced. The 2009 UCITS IV Directive further refined the asset-​allocation regime by addressing master-​feeder funds. The UCITS III reforms to the asset-​allocation regime were amplified in detail by the 2007 Commission Eligible Assets Directive.215 Its administrative rules (still in place) were a response to growing uncertainty as to which financial instruments were ‘eligible assets’ as firms pushed at the boundaries of the UCITS III reforms and as divergences arose with respect to NCAs’ treatment of, in particular, structured products, closed-​end funds (units of which can be akin to transferable securities), money-​market instruments, and financial derivatives, particularly those based on indices. In addition, an extensive soft law rulebook has burgeoned which includes the CESR-​era 2007 CESR Eligible Asset Guidelines and the 2007 CESR Hedge Fund Indices Eligible Asset Guidelines (still in place), as well as, more recently, ESMA’s 2014 Guidelines on ETFs and other UCITS Issues and the extensive suite of ESMA Guidelines which address UCITS risk management, including as regarding liquidity and the calculation of global exposures. The different elements of the asset-​allocation regime are considered in the following sections.

III.4.6.2 Strand (1): Eligible Assets a. Transferable Securities and Money-​market Instruments The asset-​allocation regime is based on the assumption that it is for each UCITS to choose its own investment profile and its degree of specialization in particular financial instruments, economic sectors, or geographic areas. The permitted scope of UCITS investment is widely defined, covering collective investment in ‘transferable securities’ and other ‘liquid financial assets’ (Articles 1(2) and 50). Accordingly, an extensive range of ‘eligible assets’ (specified in Article 50) can be invested in by UCITSs, extending from ‘plain vanilla’ securities admitted to trading on regulated markets to complex financial derivatives. Article 50 eligible assets include ‘transferable securities’ and money-​market instruments216 admitted to or dealt in on a MiFID II regulated market,217 as well as these instruments when dealt in on ‘another’ regulated market in a Member State which operates regularly and is recognized and open to the public, and when admitted to official listing on a stock exchange, or dealt in on another regulated market, in a non-​Member State (which operates regularly and is recognized and open to the public), as long as the choice of third 214 Directive 2001/​108/​EC [2002] OJ L41/​35. 215 The Directive, reflecting the pivotal importance of the asset-​allocation regime, emerged from a lengthy preparatory process. Following an extensive and somewhat fraught market consultation process which included two consultation papers, CESR’s advice to the Commission was presented in January 2006. Lengthy European Securities Committee discussions followed and opinions were received from the European Parliament and the European Central Bank (ECB) prior to the Commission’s adoption of the Directive. 216 Money-​market instruments are defined, for the purpose of the UCITS regime, under Art 2(1)(o) as instruments normally dealt in on the money market which are liquid and which have a value that can be accurately determined at any time. See section 7 on money-​market instruments in the context of the MMF Regulation. 217 Under Art 50(1)(h) OTC money-​market instruments (such as treasury and local authority bills, certificates of deposit, commercial paper, and bankers’ acceptances) are permitted as eligible assets, but only if they meet the specified liquidity and valuation standards.

III.4  The UCITS Regime  265 country trading venue has been approved by the NCA or is provided for in law, the fund rules, or the investment company’s instruments of incorporation (Article 50(1)(a)–​(c)). Article 50 extends to recently issued transferable securities (Article 50(1)(d)), subject to a series of restrictions with respect to the issue’s admission to trading. The foundation definition of ‘transferable securities’ (Article 2(1)(n)) is widely cast to cover shares in companies and equivalent securities; bonds and other forms of securitized debt; and any other negotiable securities which carry the right to acquire any such transferable securities by subscription or exchange. In an indication of the increasing sophistication and breadth of the single rulebook, the adoption of the 2017 Securitization Regulation led to the imposition of a related obligation on UCITS management companies and investment companies, where they become exposed to a securitization position that no longer complies with the Regulation, to act in the best interests of the relevant UCITS investors and take corrective action where appropriate (Article 50a). The elastic quality of the transferable securities definition means that it encompasses a potentially wide range of financial instruments which, while legally constituted as shares or bonds, can have different features and different liquidity levels which may, in practice, compromise the requisite liquidity required of UCITS asset portfolios. The 2007 Commission Eligible Assets Directive (Article 2(1)) accordingly employs a range of criteria (chief among them liquidity, valuation, information, and transferability criteria), linked to the underlying objectives of the UCITS regime, against which instruments can be assessed as to whether they can be characterized as eligible ‘transferable securities’. For example, the potential loss to the UCITS with respect to the instrument in question must be limited to the amount paid and the instrument’s liquidity profile must not compromise the Article 84 redemption obligation (compliance is assumed for instruments traded on a regulated market). Reliable valuations must be available, as must ‘appropriate information’ (either in the form of regular, accurate, and comprehensive information to the market, for instruments traded on a regulated market, or regular and accurate information to the UCITS, for other instruments). The instrument must also be negotiable (assumed for instruments traded on a regulated market), its risk must be adequately captured by the UCITS’ risk-​management process, and its acquisition must be consistent with the investment objectives of the UCITS’ investment policy. Although a UCITS may not take the form of a closed-​end fund, many non-​UCITS closed-​end funds are admitted to trading on regulated markets, and their units are akin to transferable securities, particularly shares. Units in such funds can provide exposure to riskier/​higher return investments, such as hedge fund and private equity investments. The approach taken by the 2007 Eligible Assets Directive is to bring investments in such closed-​ end funds within the scope of ‘transferable securities’ (and within the range of UCITS eligible assets) where they are akin to shares in companies and, specifically, where the relevant closed-​end fund is subject to the corporate governance requirements (or equivalent) applied to companies (2007 Commission Eligible Assets Directive Article 2(2)). The eligibility of structured products (which pay a return linked to the performance of embedded assets which may not constitute ‘eligible assets’) is also addressed by the 2007 Directive. Liquidity tests, and restrictions on the investment exposing the UCITS to additional liabilities, govern their qualification as ‘transferable securities’.218 218 Arts 2(2)(c), 2(3), and 10. The aim of the regime is to ensure that embedded derivatives are brought within the UCITS regime where appropriate, that the UCITS Directive’s risk-​management and asset-​allocation regimes apply, and that products are not developed in order to bypass the UCITS regime for derivatives.

266  Collective investment Management Detailed rules also apply under the 2007 Directive to regulated-​market-​traded and over-​ the-​counter (OTC) money-​market instruments (Articles 3–​7). The key criteria governing eligibility include maturity tests (Article 3), risk profile requirements (Article 3), and liquidity and valuation requirements (Article 4). b.  CISs The UCITS asset-​allocation regime recognizes that investments in other CISs can provide liquid investments and reduce transaction costs, including by facilitating diversification. Under Article 50(1)(e), a UCITS may invest in the units of a UCITS authorized under the Directive and also in other CISs within the meaning of Article 1(2),219 whether or not those other CISs are situated in a Member State, as long as those other CISs meet the eligibility conditions of Article 50(1)(e). These conditions are designed to ensure a degree of equivalence between the regulatory treatment of these other CISs and UCITSs.220 c.  Deposits Article 50(1)(f) provides that investments in deposits with credit institutions which are (in order to ensure adequate liquidity) repayable on demand or which have the right to be withdrawn, and maturing in no more than twelve months, are permissible.221 The credit institution with which the deposit is made must have its registered office in a Member State or, where the registered office is in a third country, must alternatively be subject to prudential rules considered by the investing UCITS’ NCA to be equivalent to those applicable under EU law. d. Financial Derivatives The UCITS III reforms, in a significant liberalization, brought financial derivative instruments within the asset-​allocation regime. Previously, financial derivatives could only be used for portfolio management purposes, such as risk reduction and cost reduction. Article 50(1)(g) provides that investments may be made in financial derivative instruments, including equivalent cash-​settled instruments, dealt in on a regulated market and in OTC financial derivative instruments. Derivatives can, accordingly, be used by a UCITS manager to hedge risks but also to gain or reduce exposure to assets (and to generate cost savings relative to the costs of direct investment) and, within the Directive’s limits, to generate leverage. For both types of derivative instrument (regulated-​market-​traded and OTC), the underlying asset must consist of eligible assets covered by Article 50(1), financial indices, interest rates, foreign exchange rates, or currencies, and in which the UCITS may invest according to its investment objectives as stated in its fund rules or instruments of incorporation. Additionally, counterparties to OTC derivatives transactions must be institutions subject to prudential supervision and must belong to the categories approved by the investing UCITS’ home NCA. OTC derivatives must also be subject to reliable and verifiable valuation on a daily basis and must be capable of being sold, liquidated, or closed by an offsetting transaction at any time at their fair value at the UCITS’ initiative.

219 See section 4.4.1. 220 The different elements of the equivalence conditions are specified and relate to adequacy of supervision, level of investor protection (in particular as regards asset protection), and disclosure. 221 Under the 1985 regime, cash could only be held by a UCITS as an ancillary liquid asset.

III.4  The UCITS Regime  267 Detailed administrative rules apply to financial derivatives under the 2007 Commission Eligible Assets Directive, designed to ensure adequate liquidity. Article 8(1) addresses regulated-​market-​traded and OTC financial derivatives and sets out the criteria for assessing whether these financial derivatives are ‘liquid financial assets’ (as required by Article 50(1)). These criteria are based on identifying the permitted eligible underlyings of the derivative in question (which must consist of other assets listed in Article 50(1), financial indices, interest rates, foreign exchange rates, or currencies). OTC financial derivatives are regarded as liquid where they meet the underlying, counterparty, and valuation requirements of Article 50(1)(g). Under Article 8(2) of the 2007 Commission Directive, credit derivatives qualify as eligible financial derivatives, and meet the Article 50(1) ‘liquid financial asset’ requirement, where they allow the transfer of the credit risk of eligible underlyings (independently of the other risks associated with the asset), they do not result in the delivery or transfer of assets other than those covered by the UCITS Directive, they comply with the Article 50(1)(g) criteria for OTC derivatives as well as those set out in the 2007 Commission Directive, and their risks are adequately captured by the UCITS’ risk-​management process and its internal control mechanisms. Risk-​management procedures must be able to manage the risks which arise where an information-​asymmetry risk arises between the UCITS and the derivative counterparty, reflecting the potential access of the counterparty to non-​public information on firms the assets of which are used as underlyings by credit derivatives. Detailed rules also govern financial indices, designed to balance the risk-​diversification benefits of derivatives on financial indices with the danger that retail investors are unable to assess their impact on a UCITS’ risk profile. Under Article 9 of the 2007 Commission Directive, a financial index must be sufficiently diversified, represent an adequate benchmark for the market, and be published in an appropriate manner. Hedge fund indices are the subject of specific guidance under the 2007 CESR Hedge Fund Indices Guideline which address the extent to which they can be regarded as financial indices. Also, a series of specific prohibitions and restrictions apply under Article 50(2) of the UCITS Directive. A UCITS may not invest more than 10 per cent of its assets in transferable securities and money-​market instruments other than those investments covered in Article 50(1); and may not acquire precious metals (or related certificates). Property investments are not permitted, although an investment company may acquire moveable and immoveable property, but only where it is essential for the direct pursuit of its business (Article 50(3)). Pre-​crisis moves to develop a passportable retail market property fund, reflecting the popularity of real estate investment trusts (REITs), were abandoned. Such funds, as AIFs, now come within the 2011 AIFMD. UCITS are also permitted to hold ancillary liquid assets (Article 50(2)), chiefly bank deposits, in order to cover, for example, exceptional payment obligations.222 Significant contestation attended the UCITS III expansion of the eligible assets regime, particularly as regards the treatment of hedge-​fund-​related investments (associated with financial indices and structured products that afforded UCITSs a means of gaining exposure to hedge-​fund-​like risk and returns). The asset-​allocation regime has since become more or less settled. This can be related to the additional protections and risk management requirements introduced by cognate measures relating to, for example, hedge funds and private 222 2009 UCITS IV Directive recital 41. Liquid financial assets may also be held where, eg, because of unfavourable market conditions, investments by the UCITS are suspended.

268  Collective investment Management equity funds (the AIFMD) and to securitization positions (the Securitization Regulation), as well as to the expansion of ESMA’s soft law and supervisory convergence measures relating to UCITS risk management.

III.4.6.3 Strand (2): Investment Limits—​Risk-​spreading Rules UCITS asset portfolios are also subject to risk spreading requirements, designed to avoid excessive concentrations of risk. Article 52(1) is the core investment limits provision. It provides that a UCITS may invest no more than 5 per cent of its assets in transferable securities or money-​market instruments issued by the same body; and it may not invest more than 20 per cent of its assets in deposits with the same body. Article 52(1) also provides that the UCITS’ risk exposure to a counterparty in an OTC derivative transaction may not exceed 10 per cent of its assets, when the counterparty is a credit institution (as referred to in Article 50(1)(f)), or, in all other cases, 5 per cent of its assets. A UCITS may not, overall, have exposure to a single body of more than 20 per cent of its assets (Article 52(2)). For transferable securities and money-​market instruments, the 5 per cent limit may, under Article 52(2), be raised by Member States to 10 per cent, but in this case the total value of the instruments held by the UCITS in the issuing entities in each of which it invests more than 5 per cent of its assets, must not then exceed 40 per cent of the value of its assets. The 5 per cent limit can also, subject to the specified conditions, be raised by Member States to 35 per cent for transferable securities and money-​market instruments issued or guaranteed by public authorities (Member States, local authorities, non-​Member States, or public international bodies to which one or more Member States belong) (Article 52(3)); and to 25 per cent for covered bonds (Article 52(4)).223 These issuances by public entities and covered bonds are not to be taken into account for the purposes of applying the Article 52(2) 40 per cent limit (Article 52(5)). The Article 52(1)–​(4) limits may not be combined. As a result, investments in transferable securities or money-​market instruments issued by the same body or in deposits or derivative instruments made with this body in accordance with Article 52(1)–​(4) may not, in any circumstances, exceed in total 35 per cent of the assets of the UCITS (Article 52(5)).224 Groups are addressed by Article 52(5) which provides that companies included in the same group for the purposes of consolidation are to be regarded as a single body for the purpose of the investment limits. Member States may allow cumulative investment in transferable securities and money-​market instruments within the same group up to a limit of 20 per cent. Article 54 addresses investment in securities issued by public authorities, providing a specific derogation. Member States may authorize UCITSs to invest (in accordance with the principle of risk-​spreading) up to 100 per cent of their assets in different transferable securities and money-​market instruments issued or guaranteed by any Member State, its local authorities, any non-​Member State, or public international bodies of which one or more 223 Issued in accordance with the 2019 Covered Bonds Directive (Ch II section 12) or, where issued prior to that regime being in force, having similar features. 224 The overall limit of 35 per cent generated controversy when the UCITS III reforms were adopted. The ECB noted in its Opinion on the UCITS III Product Proposal that ‘it seems questionable whether the investment of up to 35 per cent of the assets of a fund in instruments of one issuer can be reconciled with the principle of risk spreading’: [1999] OJ L285/​9 para I, 4.

III.4  The UCITS Regime  269 Member States are members (Article 54(1)). The securities must, however, be from at least six different issues, securities from any single issue must not account for more than 30 per cent of the UCITS’ total assets, and the NCA may only grant the derogation to a particular UCITS where it is satisfied that unit-​holders have protection equivalent to those unit-​ holders in UCITSs which comply with the investment limits set out in Article 52. Further protection is given to unit-​holders by a disclosure requirement. Such a UCITS must make express mention in either its fund rules or the instruments of incorporation (which must be approved by the NCA) of any entity in which, where permitted, it intends to invest more than 35 per cent of its assets, and include a ‘prominent statement’ referring to this authorization and the entities concerned in its prospectus and any promotional literature (Article 54(2) and (3)). Finally, in order to encourage appropriate risk-​spreading and to prevent a UCITS from pursuing control over the issuers in which it invests,225 which activity is outside the function of a UCITS under Article 1, restrictions are placed on the voting rights and management control which a UCITS may acquire through its investment activities (Article 56). The central requirement is that the investment company or the UCITS management company (acting in connection with all of the common funds which it manages and which fall within the scope of the Directive) may not acquire any shares carrying voting rights which would enable it to exercise significant influence over the management of an issuing body (Article 56(1)).226

III.4.6.4 Strand (2): Investment Limits–​Particular Investment Policies and UCITS Structures a. Tracker Funds Article 53 is designed to reflect the popularity of passive tracker funds and to encourage greater investment in equities. It permits Member States to adopt a limit of up to 20 per cent of assets for investments in shares or debt securities issued by the same body when, according to the fund rules or instruments of incorporation, the aim of the UCITS’ investment policy is to ‘replicate’ (or track) the composition of a certain stock or debt securities index which is recognized by the Member States’ NCAs according to the criteria set out in Article 53. These criteria, which are designed to ensure that the replication technique is not abused, require that the index is sufficiently diversified, that it represents an adequate benchmark for the market to which it refers, and that it is published in an appropriate manner. The 20 per cent limit may, under Article 53(2), be raised to 35 per cent where this is justified by ‘exceptional market conditions in particular in regulated markets where certain transferable securities or money-​market instruments are highly dominant’. This extension is permitted only for a single issuer. b. Funds of Funds With respect to CIS investments, a limit of 10 per cent of total assets applies to investments in a single UCITS or other CIS, which Member States may raise to 20 per cent (Article 55).

225 The UCITS regime therefore falls outside the debate as to the influence exerted by large funds, particularly hedge funds and private equity funds, on issuers. See, eg, Brav, A, Jiang, W, Partnoy, F, and Thomas, R, ‘Hedge Fund Activism, Corporate Governance and Firm Performance’ (2008) 63 J Fin 1729. 226 The regime is amplified in Arts 56(2) and (3).

270  Collective investment Management Investments made in units of CISs other than UCITSs may not exceed, in aggregate, 30 per cent of the assets of the UCITS; a UCITS may, however, invest 100 per cent of its funds in units of other UCITSs. Article 50(1)(e) is designed to protect investors against cascades of investments in CISs which may result in opaque cross-​investments in other CISs. It provides that a UCITS may not invest in units of another UCITS or CIS which invests itself more than 10 per cent of its assets in units of other UCITSs and/​or CISs. Article 55(3) addresses the conflicts of interest which arise where the UCITS invests in a UCITS or other CIS which is managed by the same management company (or by any other company with which the management company is linked by common management or control or by a substantial direct or indirect holding). That management company or other company may not charge subscription or redemption fees on account of the UCITS’ investment in the units of such other UCITS and/​or CIS. Article 55(3) also provides that a UCITS that invests a ‘substantial proportion’ of its assets in other UCITSs and/​or CISs must disclose in its prospectus and annual report the maximum level of the management fees that may be charged to both the UCITS itself and the other UCITSs or CISs in which it intends to invest. c. Master-​feeder Funds The UCITS III regime prohibited UCITSs from taking the form of feeder funds which invest all their assets exclusively in the units of one UCITS (the master fund). Scale efficiencies can, however, be generated by asset-​pooling techniques through which the assets of different funds are aggregated and managed as a single pool. The UCITS IV Directive (Article 58) accordingly introduced a new regime for master-​feeder UCITSs reflecting market practice in many Member States227 and strong industry demand for easier cross-​border access by these structures. A feeder UCITS is a UCITS (or an investment compartment thereof) which has acquired approval to invest at least 85 per cent of its assets in the units of another UCITS (or an investment compartment of that UCITS) (the ‘master UCITS’) (Article 58); the regime is accordingly limited to structures involving one ‘master’ for each ‘feeder’ UCITS. This structure represents a significant departure from the investment limit rules, although these risks are mitigated by the panoply of UCITS rules which apply to the master UCITS. Accordingly, a discrete regime, designed to ensure supervisory oversight of the decision by the UCITS to invest in the master UCITS and, thereafter, to ensure that the feeder UCITS can appropriately act in the best interests of its unit-​holders, applies (Articles 58–​64) and is amplified by a highly detailed administrative regime.228

III.4.6.5 Strand (2): Investment Limits–​Disclosure of Investment Policies Risk assessment by investors forms part of the asset-​allocation regime. Under Article 70(1), the UCITS prospectus must indicate in which categories of assets a UCITS is authorized to invest. If it is authorized to engage in transactions in financial derivatives, it must include a ‘prominent statement’ indicating whether these transactions may be carried out

227 2009 UCITS IV Directive recital 50. 228 2010 Delegated Mergers and Master-​Feeder Directive Arts 8–​28, covering, inter alia, the master-​feeder agreement, the conduct rules governing the master-​feeder relationship, including with respect to dealing and conflicts of interests, liquidations, merger, and division procedures, and monitoring by the auditor and depositary.

III.4  The UCITS Regime  271 for the purposes of hedging or with the aim of meeting investment goals, and the possible outcome of the use of financial derivatives instruments on the UCITS’ risk profile. Under Article 70(2), when a UCITS invests principally in assets other than transferable securities and money-​market instruments or when it replicates an index, its prospectus and, where necessary, any other marketing literature must include a prominent statement drawing attention to this investment policy. Similarly, when the NAV of a UCITS is likely to have high volatility due to its portfolio composition or the portfolio management techniques that may be used, its prospectus/​marketing literature must include a prominent statement drawing attention to this fact (Article 70(3)). Finally, under Article 70(4), on the request of an investor, the management company must provide supplementary information relating to the quantitative limits which apply to the risk management of the UCITS, to the methods chosen to this end, and to the recent evolution of the risks and yields of the main instrument categories.

III.4.6.6 Strand (3): Risk Management The asset-​ allocation and diversification rules are supported by an extensive risk-​ management regime (which now includes the assessment of sustainability risks (section 3.2.4)). It has been subject to repeated refinements, initially as regards the UCITS III inclusion of financial derivatives as eligible assets, which called for robust risk management practices; and more recently as regards liquidity risk management, reflecting the post-​crisis folding of UCITS regulation into the EU’s financial stability agenda. Technocratic influence on the risk management regime has been decisive, with ESMA’s soft law and supervisory convergence measures constructing an operating manual for UCITS risk management which is being continually refined. By contrast, the AIFMD risk governance system is based to a significantly greater extent on administrative rules. The risk management regime has several components but is built on the risk management requirements adopted under the UCITS Directive which focus in particular on derivatives. Under the foundational Article 51(1), the UCITS management or investment company must have a risk management process in place which enables it, at any time, to monitor and measure the risk of the positions held and their contribution to the overall risk profile of the portfolio229 (the 2010 Commission Management Company Directive similarly requires that management companies ensure, for each UCITS managed, the liquidity profile of the UCITS’ investments is appropriate to the fund’s redemption policy (Article 40(4))). Derivatives are expressly addressed: a process for the accurate and independent assessment of the value of OTC derivative instruments must be in place; and generally, and with respect to each UCITS, the relevant NCA (and ESMA via an NCA reporting obligation (covering aggregated data)) must be informed regularly, and in accordance with the NCA’s rules, of the types of derivative instruments involved, the underlying risks, the quantitative limits, and the methods chosen to estimate risk (Article 51(1)). Article 51(2) addresses portfolio management techniques. It provides that Member States may authorize UCITSs to ‘employ techniques and instruments relating to transferable securities and

229 Reflecting the crisis-​era reforms to rating agencies, Art 51(1) (added by Directive 2013/​14/​EU [2013] OJ L145/​1, which also applies to the AIFMD) also specifies that ratings must not be mechanistically relied on to assess the creditworthiness of UCITS assets. NCAs are to, relatedly, monitor the adequacy of credit assessment policies and assess reliance on ratings, with a view to reducing ‘sole and mechanistic’ reliance (Art 51(3a)).

272  Collective investment Management money-​market instruments’ (such as repurchase transactions) under the conditions and limits they lay down for the purposes of efficient portfolio management but, where derivatives are involved in these operations, the conditions and limits imposed must conform with the Directive and such any such operations must not cause the UCITS to diverge from its investment objective (Article 52(2)). Exposure and leverage through derivatives are addressed by Article 51(3), which requires that a UCITS must ensure that its ‘global exposure’ (see below) relating to derivative instruments (the calculation of which must be carried out in accordance with the Directive’s general guidelines)230 does not exceed the total net value of its portfolio. Exposure to the underlying assets must also be considered: the UCITS’ exposure to underlying assets through derivative investments must not exceed in aggregate the Article 52 investment limits.231 At all times, where a transferable security or money-​ market instrument embeds a derivative, the derivative must be taken into account when complying with Article 51(3). This legislative framework has been subject to extensive administrative amplification under the 2007 Eligible Assets Directive, including as regards portfolio management techniques, and also under the 2010 Management Company Directive, which addresses risk-​ management policies and their review (Articles 38–​9); measuring and managing risk, including through stress tests (Article 40); the calculation of ‘global exposure’ (Article 41 and 42);232 counterparty risk and issuer concentration (Article 43); valuing OTC derivatives (Article 44); and reporting on derivatives (Article 45). The extent to which the risk-​management regime has been further refined and operationalized through detailed supervisory convergence measures underlines the pervasive influence ESMA has come to exert on the UCITS regime. The extensive and granular 2007 CESR Eligible Assets (and related Hedge Fund Indices) Guidelines, 2010 CESR Guidelines on Risk Measurement and Global Exposure (as expanded by ESMA’s 2012 Guidelines on Risk Measurement and Global Exposure for Structured UCITS), 2014 Guidelines on ETFs and other UCITS Issues, and 2020 Guidelines on Liquidity Stress Testing, for example, together form a soft but nonetheless thick and heavily proceduralized risk management manual. This manual is further supported by the ESMA UCITS Q&A and by ESMA’s operational supervisory convergence measures, which include stress testing. Following the March 2020 convulsions in the EU fund market, and although the UCITS segment emerged largely unscathed, additional measures can be expected, particularly as regards liquidity risk management (section 4.4.1)

III.4.6.7 Strand (4): Leverage The extent to which a UCITS is leveraged increases its risk profile and is accordingly subject to discrete regulation. Investment companies, management companies, and depositaries are not permitted to borrow (Article 83). Member States may derogate from this rule by authorizing a UCITS to 230 The exposure must be calculated taking into account the current value of the underlying assets, counterparty risk, future market movements, and the time available to liquidate the positions. 231 The limits are relaxed for index-​based derivatives. 232 The calculation, which must be carried out daily, can be made by reference to either (i) the incremental exposure and leverage generated by the UCITS from financial derivatives and which may not exceed total UCITS NAV; or (ii) the market risk of the UCITS’ portfolio. The calculation can be made under the commitment approach, the Value at Risk (VAR) approach, or under any other advanced risk-​management technique, as appropriate.

III.4  The UCITS Regime  273 borrow up to 10 per cent of its assets (in the case of an investment company) or 10 per cent of the value of the UCITS (in the case of a common fund), but the borrowing may only be on a temporary basis. A Member State may, additionally, authorize an investment company to borrow up to 10 per cent of its assets where the borrowing is for the acquisition of immovable property essential for the direct pursuit of its business. Where any such borrowing is authorized, it may not exceed in total 15 per cent of the investment company’s assets/​ UCITS fund value (Article 83(2)). Very considerable ‘synthetic leverage’ can be sustained by a UCITS, however, through financial derivatives. These leverage risks are primarily managed through the risk management rules and soft law that govern exposures to financial derivatives and that place limits on the associated leverage, either linked to the UCITS NAV or, where sophisticated portfolio management strategies are used, linked to the Value at Risk.233 Leverage can also be sustained through securities financing transactions, in particular repurchase transactions through which funds can, in effect, arrange for short-​term funding by using their asset portfolio as collateral.234 In practice, the UCITS sector tends not to be highly leveraged, given the operation of the UCITS risk management requirements, certainly by comparison with the AIF sector which is not subject to leverage limits under the AIFMD (unless limits are imposed by NCAs).235 The lack of a harmonized UCITS reporting framework on leverage levels (leverage reporting is required by the AIFMD), however, has been highlighted as an obstacle to effective monitoring.236

III.4.6.8 A Resilient Regime? The UCITS asset-​allocation regime, in place since the UCITS III reforms, has had significant transformative effects. In the immediate wake of the liberalizing UCITS III reforms, structured financial instruments, non-​UCITS CISs, and financial derivatives, including those based on hedge fund indices, all became eligible for UCITS investment and led to the adoption of more sophisticated derivatives-​based investment techniques.237 But two risks in particular were associated with the UCITS III liberalization. The first related to the heavy lifting which risk management rules and internal procedures were required to carry out to ensure that the redemption-​on-​demand obligation, the defining feature of the UCITS, could be met where a UCITS became more exposed to more illiquid assets. Here, the regime has proved broadly resilient. Prior to the financial crisis, 233 Leverage limits are primarily addressed by the 2010 CESR Guidelines on Risk Measurement and Global Exposure, as expanded by ESMA’s 2012 Guidelines on Risk Measurement and Global Exposure for Structured UCITSs. 234 See further Ch VI section 4 on the related supervisory reporting and disclosure requirements imposed on funds by the 2015 Securities Financing Transactions Regulation. In addition, the investment company/​management company and depositary are prohibited from carrying out uncovered sales of transferable securities, money-​ market instruments, or the CIS, financial derivative, and OTC money-​market instruments listed in Art 50 as eligible assets (Art 89). 235 As has been repeatedly reported by the ESRB in its annual Non-​Bank Financial Intermediation/​Shadow Banking Monitor. The ESRB has related the lower levels of UCITS leverage to the related regulatory regime: ESRB, Shadow Banking Risk Monitor No 3 September (2018) 9. 236 The ESRB has warned of the difficulties in monitoring overall leverage levels in the EU fund market, given the absence of a reporting regime for UCITSs, and called for reforms: 2018 Shadow Banking Monitor, n 235, 9 and 2018 ESRB Recommendation, n 47. 237 While the market took some time to use the full range of UCITS III investment strategies, 2007 saw the emergence of derivatives-​based UCITS funds: Johnson, S, ‘New Products Make Use of UCITS Power’, Financial Times Fund Management Supplement, 12 March 2007.

274  Collective investment Management there were few signs of a slackening in risk management.238 The financial crisis did not reveal significant weaknesses in risk management, with the UCITS industry performing reasonably well under significant strain. Most recently, the March 2020 pandemic-​related turbulence did not expose significant weaknesses in the risk management rulebook for UCITSs, albeit that UCITS liquidity management tools did come under pressure and some reforms can be expected (section 4.4.1). The second related to the retail market and to the potential, following the UCITS III reforms, for the UCITS vehicle to support complex and high-​risk investments and for a ‘retailization’ of complex UCITSs.239 Over the financial-​crisis era, the risk of detriment to the retail sector from the stretching of the UCITS brand to include funds using complex and high-​risk portfolio management techniques, in particular hedge fund-​like strategies,240 and the distribution by banks of complex UCITS products to generate balance-​sheet-​repairing revenues,241 came into sharp policy focus and led to allied reforms. These included the exclusion of structured UCITSs from the MiFID II execution-​only regime (Chapter IX). In practice, however, UCITS mis-​selling, or the retailization of complex UCITS funds, has not emerged as a major risk to the retail market, with the retail UCITS market dominated by equity and bond funds.242 Overall, the asset-​allocation regime has proved to be relatively durable. Nonetheless, the scale of the supporting ESMA soft law ‘rulebook’ underlines the heavy lifting required of technocracy to support this central element of the UCITS regime.

III.4.7  The Management Company: Ongoing Regulation III.4.7.1 Organizational and Conduct Regulation UCITS management companies are subject to operating rules (of organizational and conduct orientation) which are designed to respond to the agency risks in the UCITS/​investor relationship, mitigate financial stability risks, and support the passport. These requirements reflect the major principles which govern the investment services regime generally (Chapter IV) but are tailored to the particular risks posed by collective investment management. Management companies must comply at all times with the authorization conditions (Article 10(1)) and a qualifying shareholders regime (Article 11), and follow the

238 A 2008 PriceWaterhouseCoopers Report found that while reliance on derivatives had increased, UCITS III investment powers were being used effectively and market risk levels were not significantly higher as compared to those of other CISs: PriceWaterhouseCoopers, Investment Funds in the European Union (2008). 239 The international distribution of UCITSs faced some related early difficulties following the UCITS III stretching of the asset-​allocation regime. UCITS funds came under closer scrutiny in Hong Kong and Singapore, eg, where before they had enjoyed a relatively straightforward authorization process. 240 This development was extensively reported, following the move by hedge funds into UCITS III structures in early 2009, driven by investor demand for higher standards of investor protection, liquidity, and transparency: eg, Kelleher, E, ‘Listed Funds of Hedge Funds Lose Out to UCITS III’, Financial Times Fund Management Supplement, 18 April 2011. The leverage capacity of one UCITS fund, which held a total return swap on a proprietary index that could be leveraged up to thirty-​five times, while permissible, was described by some industry figures as ‘horrid’ and ‘extraordinary’: Johnson, S, ‘Swaps Tactic Threatens UCITS Brand’, Financial Times Fund Supplement, 14 November 2011. 241 Skypala, P, ‘What will the banks think of next?’, Financial Times Fund Management Supplement, 14 November 2011. 242 2022 ESMA Retail Investment Products Report, n 8.

III.4  The UCITS Regime  275 organizational requirements, specific to collective investment management, set out in Article 12.243 The Article 12 conflict-​of-​interest regime, for example, is directed to ensuring that the management company is structured and organized in such a way as to minimize the risk of clients’ or UCITSs’ interests being prejudiced by conflicts of interest.244 It also requires that, where the management company engages in discretionary investment management, the management company cannot invest all or part of the investor’s portfolio in units of a CIS it manages without prior approval from the client (Article 12(2)). Reflecting the extent to which delegation practices are embedded within the structure of the EU UCITS industry,245 delegation (including of core investment and risk management functions)246 is not prohibited, but its use is subject to discrete regulation (Article 13). Delegation is permitted where it is allowed by Member States and where the delegation is for the purpose of a ‘more efficient conduct’ of business (Article 13(1)). At the heart of the delegation regime is the securing of adequate substance within the management company: the rules are designed to ensure that the delegation of functions must not be of such a scale that the management company becomes a ‘letter box’. A series of related conditions apply, including that the liability of the management company cannot be affected by the delegation (Article 13(1) and (2)).247 The delegation regime, which permits delegation of investment management functions to a third country, as long as supervisory cooperation is ensured (Article 13(1)(d)), has been the subject of some contestation, including but not only in relation to Brexit.248 The Commission, in the proposal for what would become the 2017 ESA Reform Regulation, proposed that NCAs be required to notify ESMA where they intended to authorize a financial market participant (such as a UCITS management company) whose business plan involved the outsourcing, delegation, or risk transfer of a material part of its activities into third countries, while benefiting from an EU passport.249 ESMA would review whether the proposed authorization complied with EU law and ESMA soft law, and could issue a recommendation to an NCA, including that it review a decision or withdraw an authorization. The proposal did not survive the negotiation process, with significant concern in the asset management sector that it prejudiced NCAs’ autonomy as regards authorization and disturbed the pre-​eminence of home NCAs as regards authorization and in the granting of the

243 These relate to administrative and accounting procedures, internal control mechanisms (including personal transactions by employees), compliance, record-​keeping (in order, in particular, to ensure that UCITSs’ transactions can be reconstructed, where necessary), and conflict-​of-​interest management. 244 Including conflicts between two UCITSs managed by the management company: Art 12(1)(b). 245 Delegation, including of investment management, is an embedded feature of the industry and has been associated with supporting the efficient sourcing of asset-​and market-​specific expertise in investment management in particular: 2021 AIFMD/​UCITS Proposal, n 30, 3. 246 In this case, the delegation must only be to entities authorized or registered for the purpose of investment management and subject to prudential regulation: Art 13(1). 247 The Art 13 requirements, which impose high-​level conditions on the delegation mandate, are designed to ensure that supervision is not prejudiced, that the entity to which functions are delegated is appropriately regulated and supervised, and capable of undertaking the delegated functions, and that the management company monitors that entity and can give additional instructions to that entity. In order to protect the independence of the depositary, core investment management functions must not be delegated to the depositary (or to any undertaking whose interests may conflict with those of the management company or unit-​holders). 248 See further Ch X section 5 on the third country dimension. 249 2017 ESA Reform Proposal (COM(2017) 536) Art 31a(2). The Commission described the proposed power as an ‘early intervention’ mechanism to address supervisory arbitrage risks: Commission, Reinforcing Integrated Supervision to Strengthen Capital Markets Union and Financial Integration in a Changing Environment (COM(2017) 542) 6.

276  Collective investment Management single market passport.250 The fracas underlines, however, the centrality of delegation to the UCITS sector and the industry, supervisory, and political tensions it can raise, particularly as regards third country delegation. Delegation practices returned to the spotlight, however, with the 2021 AIFMD/​UCITS Proposal. It seeks to enhance the supervision of delegation arrangements and to ensure a minimum resourcing level in management companies, reflecting significant supervisory concern, articulated by ESMA in particular, that, particularly in the case of extensive delegation to third country firms, an insufficient presence was being retained in the EU.251 It proposes a series of enhancements to the Article 13 regime, including as regards minimum substance,252 an obligation on the management company to justify its delegation structure on objective grounds (as already applies under the AIFMD), reporting to ESMA by NCAs on delegation practices, and regular peer review by ESMA of NCAs’ supervision of delegation. While this reform would tighten the delegation regime, it would also strengthen ESMA’s capacity to shape NCA practices in what is an area of some contestation. Management companies are in addition subject to conduct rules. In an echo of the MiFID II regime (and in an obligation introduced by the 2014 UCITS V reforms) management companies are subject to the over-​arching obligation to act honestly, fairly, professionally, independently, and in the interests of the UCITS and the investors of the UCITS (Article 25(2)). The more specific conduct requirements are similar, in broad design, to the MiFID II conduct regime (Articles 14 and 15).253 This operational regime is amplified by the detailed organizational and conduct administrative rulebook which applies under the 2010 Commission Management Company Directive (which is dwarfed, however, by the leviathan-​like administrative rulebook that applies to investment firms under MiFID II). It sets out in considerable detail a suite of rules applicable to organizational matters,254 although the rules are tailored to the nature, scale, and complexity of the management company’s business. Detailed administrative conduct

250 Industry concern was significant. See, eg, Mooney, A and Thompson, J, ‘Europe’s National Regulators Clash Over Delegation’, Financial Times, 8 October 2017. Certain NCAs, particularly those with large CIS sectors, also expressed concern (eg, Cross G, Central Bank of Ireland, Opening Statement to the Oireachtas Committee on Finance, Public Expenditure and Reform, 28 November 2017). Others, notably the French NCA, were supportive (AMF, Review of the European Supervisory Authorities, February 2018), reflecting the competitive territory at stake. 251 ESMA warned of the extent to which UCITS and AIF managers were engaging in delegation, including to third countries, of increased operational, regulatory arbitrage, and supervisory risks, and of the need to ensure sufficient substance remained in the EU and subject to local supervision and the EU single rulebook: 2020 ESMA AIFMD Review Letter, n 47, 5–​6. 252 The Proposal suggests that the management company must employ at least two persons, or engage at least two non-​employees, in the EU who conduct the business of the management company. 253 The Art 14 principles with which Member States’ conduct rules must comply include that the management company: acts honestly and fairly in the best interests of the UCITSs under management and the integrity of the market; acts with due care, skill, and diligence; has and employs effectively the resources and procedures necessary for the proper performance of its business; tries to avoid conflicts of interest and, where they are unavoidable, ensures the UCITSs it manages are fairly treated; and complies with all regulatory requirements. Art 15 requires that complaint management systems are in place. 254 The Directive covers: organizational procedures, including accounting systems and business continuity (Art 4); resources (Art 5); complaints handling (Art 6); data processing (Art 7); accounting procedures (Art 8); senior management controls and functions (Art 9); compliance, audit, and risk management functions (Arts 10–​12); personal transactions (Art 13); recording of portfolio transactions (Art 14); recording of subscription and redemption orders (Art 15); record-​keeping (Art 16); and conflict-​of-​interest management, including identification, conflict-​ of-​interest policy, management, and related voting right strategies (Arts 17–​21).

III.4  The UCITS Regime  277 rules also apply under the 2010 Directive to the particular conduct risks generated by collective investment management, and in particular by trading practices.255 A broadly similar operating regime (Articles 30–​1) applies under the UCITS Directive to investment companies which do not appoint a separate management company,256 although the regime is significantly more attenuated in places,257 reflecting the reduced agency risks in these structures.

III.4.7.2 UCITS V and the Remuneration Rules The 2014 UCITS V reforms to the 2009 Directive expanded these operating requirements by addressing the remuneration policies and practices of management companies (Articles 14a and 14b). In a striking example of how reforms leaked across regulated sectors over the crisis era, these requirements are based on the earlier and granular 2011 AIFMD remuneration regime, which in turn was based on the crisis-​era CRD III reforms to bank remuneration.258 In their high level of detail and prescription, which follows the AIFMD model, the remuneration requirements sit uneasily alongside the relatively high-​level legislative requirements that otherwise apply to management company operation. The remuneration rules require that management companies establish and apply remuneration policies and practices that are consistent with and promote sound and effective risk management (detailed principles, based on the AIFMD regime, govern these policies and practices);259 and that remuneration policies and practices must not encourage risk-​taking inconsistent with the risk profiles, rules, or instruments of incorporation of the UCITSs managed, and not impair compliance with the management company’s duty to act in the best interests of the UCITSs managed (Article 14a(1)). The regime has a wide scope. The required policies and procedures must apply to those categories of staff, including senior management, risk-​takers, control functions, and any employee receiving total remuneration that falls within the remuneration bracket of senior management and risk-​takers, whose professional activities have a material impact on the risk profiles of the management company or of the UCITSs managed (Article 14a(3)). Management companies which are significant in terms of size (or the size of the UCITSs they manage), their internal organization, and the

255 The conduct regime addresses: the obligation to act in the best interests of the UCITS (Art 22); due diligence and related risk management (Art 23); reporting on execution of subscription and redemption orders (Art 24); best execution (Art 25); order handling and trading processes (Arts 26–​8); and safeguarding the UCITS’ best interests (Art 29). 256 Where an investment company appoints a separate management company, the operating regime for management companies supplants that applicable to investment companies, although the basic authorization conditions for investment companies apply. 257 Although the same delegation and conduct rules (including the administrative regime) apply (Art 30), the organizational regime has not been amplified through administrative rules and remains governed by general principles (save with respect to risk management—​2010 Delegated Management Company Directive Art 12): Art 31. 258 On the AIFMD remuneration regime see, in outline, section 5.8. On the foundational bank executive remuneration rules see Ch IV section 9.4.6. 259 18 highly specified principles, to be applied to the extent appropriate to the size, internal organization, and the nature, scope, and complexity of the company’s activities, govern the content of these policies and practices: Art 14b(1). These are very similar (but not identical) to the principles applicable to remuneration under the AIFMD (n 479). They cover, inter alia, remuneration governance, alignment with risk-​taking, and, in detail, the design of remuneration, including with respect to the treatment of fixed and variable remuneration (eg, each component must be appropriately balanced; at least 40 per cent of variable remuneration must be deferred for at least three years; at least 50 per cent of variable remuneration must consist of units or shares in the UCITSs concerned (or of ‘equivalent instruments’ delivering equivalent incentives); and guaranteed variable remuneration must be exceptional and only apply in the context of the first year of remuneration for new staff).

278  Collective investment Management nature, scope, and complexity of their activities must establish a remuneration committee, responsible for remuneration (Article 14b(4)). Remuneration must be reported on in the UCITS prospectus and annual report (Article 69(1) and (3)). In addition, information on remuneration policies may be requested from NCAs by ESMA (Article 14b(2)). Efforts by the European Parliament to introduce a ‘bonus cap’ similar to the highly contested cap which applies under the banking rulebook failed, following intensive lobbying by the fund management industry.260 Detailed ESMA Guidelines, mandated by Article 14a(4), amplify the remuneration rules.261 While it is now well-​established, difficulties remain with what is a highly granular and wide-​ ranging regime, particularly as regards the scope of the framing proportionality principle and the extent to which it can moderate the costs and complexities of the regime for smaller firms.262

III.4.8  The Depositary III.4.8.1 The Depositary and the UCITS V Reforms The depositary is central to the Directive’s investor protection scheme being the custodian of UCITS assets, responsible for essential technical procedures relating to asset administration, and thereby for overseeing the UCITS.263 Prior to the 2014 UCITS V reforms, the depositary was not subject to extensive regulation, reflecting in part that depositaries were (and still are) often regulated credit institutions, but conditions were imposed, chief among them that the depositary take the form of an institution subject to prudential regulation and ongoing supervision, and the imposition of fit and proper requirements on depositary directors (the fit and proper requirement 260 Barber, B and Marriage, M, ‘Fund Managers Thank Stalinists for Bonus Vote’, Financial Times, 3 July 2013. The banking rulebook applies, however, to bank-​owned asset managers, which led to concerns that they would be placed at a significant disadvantage to independent asset managers: Marriage, M, ‘EU Bonus Cap Hits Bank-​ owned Asset Managers’, Financial Times Fund Management Supplement, 8 July 2013. 261 2016 UCITS Remuneration Guidelines, n 162. The detailed Guidelines cover, inter alia, the application of the proportionality principle; the governance of remuneration, including as regards the management body, remuneration committee, and control functions; risk alignment; and disclosure. 262 While ESMA’s 2016 Guidelines address how the proportionality principle can apply, they do not specify whether the proportionality principle can, where a management company’s features so warrant, lead to the full disapplication of certain of the Directive’s requirements. This absence reflects the similar (and contested) approach EBA took to the application of the banking rulebook remuneration rules. After extensive consultations in 2015, EBA took the view that the proportionality qualification could not lead to a dis-​application, although it called on the Commission to revise the banking rulebook to allow for dis-​application given the difficulties created for smaller institutions. In a lengthy analysis for the Commission in 2016, ESMA called for legislative clarification, given its view that certain of the specific UCITS and AIFMD remuneration rules could be disproportionate for smaller funds: ESMA, Letter to the Commission (the Proportionality Principle and Remuneration Rules), 31 March 2016. Although the banking rulebook remuneration rules were reformed in 2019 to allow for the dis-​ application of certain remuneration rules for smaller firms and certain classes of employees who do not receive (or receive little) variable pay (Directive 2019/​878 [2019] OJ L150/​253), changes have yet to be made to the UCITS regime (or the AIFMD regime). ESMA raised the need for clarification in its 2020 AIFMD Review Letter (n 47, 12), and the AIFMD Review noted the difficulties and the need for clarification (2021 UCITS/​AIFMD Proposal IA, n 33, 166), but reform did not form part of the 2021 AIFMD/​UCITS Proposal. 263 Under Art 22(3) the depositary is to ensure that the sale, issue, repurchase, redemption, and cancellation of units are carried out in accordance with applicable national law and fund rules/​instruments of incorporation and that the value of units is calculated in accordance with applicable national law and fund rules/​instruments of incorporation; carry out the instructions of the management company/​investment company, unless they conflict with applicable national law or fund rules/​instruments of incorporation; ensure that any consideration due is remitted within the usual time limits; and ensure that the scheme’s income is applied in accordance with national law and the fund rules/​instruments of incorporation.

III.4  The UCITS Regime  279 continues to apply).264 Further, the choice of depositary was restricted by the requirement that it have its registered office or be established in the UCITS home Member State so as to facilitate supervision (this requirement, one of the defining features of the depositary regime, continues to apply);265 UCITS depositaries accordingly did not (and still do not) benefit from passporting. The independence of the depositary in overseeing the UCITS was supported by the requirement that the same company could not act as both a management company and a depositary, a foundational requirement that continues to apply (Article 25(1)). The depositary was not otherwise subject to ongoing regulation to any meaningful extent given that, in practice, the banking regime provided a regulatory proxy, at least as regards prudential regulation. This was despite the pivotal role played by the depositary under the UCITS Regulation and the specificities of its monitoring and custody functions. Enhancements to the depositary regime had been under discussion since the launch of the UCITS Review in 2004. But it would not be until a decade later that the 2014 UCITS V reform, which was shaped by the US Madoff scandal which had global implications,266 would see the adoption of more articulated rules, tailored to the depositary’s functions. Only a small number of UCITSs were affected by the Madoff scandal,267 but it exposed weaknesses in the Directive’s depositary arrangements, particularly as regards the use of sub-​custodians to hold UCITS assets and carry out depositary functions. In particular, concerns arose that Luxembourg and Ireland, the two centres with UCITSs exposed to the Madoff fraud, had not imposed sufficiently rigorous controls on UCITSs’ depositaries who had outsourced custodian functions to Madoff affiliates.268 The financial crisis further underlined the risks associated with delegation of depositary functions to sub-​custodians, in that it heightened the need for careful asset recording and robust custody arrangements over periods of acute market volatility.269 Pressure for reform was increased by legal uncertainty as to the scope of depositary liability in the event of failure by sub-​custodians. This uncertainty led to political tensions270 and to industry concern as to potential damage to the UCITS brand were assets perceived as being under threat.271 In this febrile environment, reaction from the Commission was swift, with two Commission Consultations272 preceding its 2012 UCITS V Proposal, which was closely based on the 2011 AIFMD template for depositary regulation.273 The new regime, adopted in 2014, was designed to address the delegation and liability issues associated with the Madoff scandal. But it also sought to address 264 These fit and proper requirements are still in force: Art 5(4). 265 Under Art 23(1). 266 In the region of $50 billion of losses were sustained following the exposure of the Madoff funds as forming part of a Ponzi scheme which dissipated client assets. 267 Four UCITS funds entrusted assets to Madoff affiliates: Commission, Press Release, 29 January 2009. One UCITS fund lost in the region of $1.4 billion in acting as a feeder fund to a Madoff fund. Its authorization was withdrawn and it was placed in liquidation: 2012 UCITS V Proposal IA, n 128, 6 and 22. 268 eg Grene, S, ‘Luxembourg Called On to “Brush Up” Governance’, Financial Times Fund Management Supplement, 26 January 2009. 269 FSA, Financial Risk Outlook (2009) 66. 270 France, whose investors were significantly exposed to Madoff failures, claimed that its rules relating to depositary liability were of a higher standard than those of other Member States, and implicitly criticized the Luxembourg regime, triggering a hostile response from the Luxembourg authorities: Hollinger, P, Hall, B, and Tait, N, ‘Grand Duchy Hits Back at Madoff ’, Financial Times, 14 January 2009. 271 Grene, S, ‘Luxembourg Called On to “Brush Up” Governance’, Financial Times Fund Management Supplement, 26 January 2009. 272 July 2009 and December 2010. 273 And which followed a CESR mapping exercise: CESR, Mapping of Duties and Liabilities of UCITS Depositaries (2009).

280  Collective investment Management the heightened custody risks which arise with more sophisticated UCITS funds, whose complex investments may be issued and held in third countries and across chains of custodians and, alongside, to update the original regime to engage with electronic custody of dematerialized securities. The UCITS V reforms were amplified in detail, including as regards custody arrangements and their delegation to sub-​custodians, by the 2016 Delegated Depositary Regulation.274 Since the UCITS V reform, the depositary regime has been stable. The reform debate periodically turns to the desirability of a depositary passport,275 most recently under the AIFMD Review,276 but the 2021 AIFMD/​UCITS Proposal has been cautious in this regard. It maintains the status quo for the UCITS depositary regime, although it liberalizes, somewhat, the parallel AIFMD regime. It proposes that cross-​border depositary services can be procured by the AIFMD fund manager (as a response to the difficulties created where the depositary market, in the home State of the AIF, is small), but does not provide for a passport, given the risk that a passport could prompt concentration in the depositary market, but also the supervisory and investor protection risks which have, from the outset, been raised in the context of depositary passporting.277

III.4.8.2 The Depositary Regime Under Article 22, a single depositary must be appointed for each UCITS.278 The entities which can act as depositaries are limited to national central banks, EU-​authorized credit institutions, or ‘other legal entities’ authorized by an NCA to carry out depositary functions and which are subject to capital adequacy requirements and prudential requirements in accordance with specified minimum standards (which address, inter alia, infrastructure, compliance, management, internal controls, conflicts of interest, record-​keeping, and business continuity) (Article 23(2)). Depositaries are subject to an over-​arching obligation to act honestly, fairly, professionally, independently, and solely in the interest of the UCITS and UCITS investors (Article 25(2)). They are also subject to a foundational conflict-​of-​interest management and independence obligation which has two elements: no company can act as a management/​investment company and as a depositary (Article 25(1); and the depositary must not carry out activities regarding the UCITS or management company that may create conflicts of interest, unless the depositary has functionally and hierarchically separated the performance of its depositary tasks from other potentially conflicting tasks, and the potential

274 Delegated Regulation (EU) 2016/​438 [2016] OJ L78/​11. The Delegated Regulation was revised in 2018 to clarify, inter alia, that sub-​custodians, carrying out delegated custody functions, can hold the UCITS and AIF assets of one depositary client in a single omnibus account for that depositary, and so on down the custody chain, with an omnibus account being permitted at each level of the chain for the delegating client/​custodian in the level above (depositaries, the first level in the custody chain, must provide individual accounts for each UCITS client). The Regulation also addresses the procedures governing these omnibus accounts and tightens the requirements relating to the delegation by the depositary of custody functions: Delegated Regulation (EU) 2018/​1619 [2018] OJ L271/​6. 275 For recent supportive comment see Buttigeig, C, ‘The Rationale for an EU Fund Depositary Passport’, Global Risk Regulator, 18 November 2021 and Hooghiemstra, S N, Towards a Cross-​sectoral European Depositary Passport in European Investment Law (2019), available via . 276 ESMA supported a review of depositary passporting: 2020 AIFMD Review Letter, n 47, 14. 277 2021 AIFMD/​UCITS Proposal: n 30, 7. 278 Art 22(1) also specifies that the appointment must be evidenced by a written contract which must, inter alia, govern the flow of information necessary for the depositary to carry out its functions.

III.4  The UCITS Regime  281 conflicts are properly identified, managed, monitored, and disclosed to the UCITS’ investors (Article 25(2)).279 The depositary’s monitoring functions follow the original UCITS IV regime (Article 22(3)),280 with the addition of a specific monitoring obligation in relation to cash accounts and to cash flows, designed to prevent a Madoff-​style fraudulent diversion of funds (Article 22(4)).281 The pivotal custody process is subject to specific requirements, including as regards the custody arrangements to be used for financial instruments which may be held in custody, and the ownership verification and record-​keeping obligations for complex OTC assets which cannot be held in custody (Article 22(5)).282 In addition, a prohibition applies to the reuse by the depositary of assets held in custody (including their transfer, pledge, sale, or lending) (Article 22(7)); reuse is permitted only where the reuse is executed for the account of the UCITS, the depositary is carrying out the instructions of the management company on behalf of the UCITS, the reuse is for the benefit of the UCITS and in the interests of unit-​ holders, and the transaction is covered by high-​quality and liquid collateral. The depositary must also provide the management company (or investment company) with a comprehensive inventory of all UCITS’ assets on a regular basis (Article 22(6)). The delegation of depositary functions, including custody functions, is regulated and restricted under a regime closely based on that developed under the AIFMD (Article 22a). Depositaries are not permitted to delegate their Article 22(3) and (4) monitoring functions. They can only delegate their custody and verification/​record-​keeping obligations (Article 22(5)), and then only where a series of conditions are met, including that the delegation is not designed to avoid the Directive, there is an objective reason for it, and the depositary has exercised all due skill care and diligence in the selection, appointment, and monitoring of the third party delegate (Article 22a(2)).283 Conditions also apply to the third party delegate (Article 22a(3)).284

279 The independence/​conflict-​of-​interest obligation is amplified by the 2016 Delegated Depositary Regulation which imposes a series of obligations relating to the required governance separation between the depositary and management/​investment company; the independence and due process arrangements governing the appointment of the depositary by the management/​investment company and related NCA reporting requirements; and conflict-​ of-​interest management and related management board arrangements where a link or group link exists between the depositary and the investment/​management company (Arts 20–​3). 280 n 263. 281 The rules are designed to ensure that no cash account associated with the UCITS’ transactions can be opened without the depositary’s knowledge. Under Art 22(4), the depositary must, inter alia, ensure that UCITS’ cash flows are properly monitored and that all UCITS’ cash is booked in cash accounts that meet the Art 22(4) requirements (including that the account be in the name of the UCITS, management company, or depositary, and be opened in an eligible institution (essentially, a central bank or EU/​third country authorized deposit-​taking credit institution)). 282 The custody (and monitoring) obligations are amplified in detail by the 2016 Delegated Depositary Regulation (Arts 3–​14), including as regards initial risk assessment by the depositary and the development of oversight procedures; the administrative operations carried out by the depositary in relation to units, the monitoring of UCITS cash flow, custody processes, safekeeping duties; and information flows between the management/​investment company and the depositary. 283 The delegation regime is amplified by the 2016 Delegated Depositary Regulation, including as regards the extensive due diligence to be performed by the depositary and the verification obligations of the depositary as regards segregation of financial instruments by the delegate (Arts 15 and 16). It was strengthened in 2018 (n 274). 284 These include that the delegate has structures and expertise adequate and proportionate to the nature and complexity of the assets (or the management company), is subject to effective prudential regulation (including minimum capital requirements) as regards its custody tasks, its custody tasks are subject to external periodic audit, depositary assets are segregated, and it complies with the custody and asset reuse requirements.

282  Collective investment Management Liability arrangements are not typically addressed by the single rulebook,285 but given the distinct safeguarding role of the depositary and the pivotal importance of asset security to the design of the UCITS, a framework liability regime applies under Article 24. It provides that the depositary is liable to the UCITS and its unit-​holders for loss by the depositary or by a third party to whom the custody of financial instruments (held in custody in accordance with Article 22(5)(a))286 has been delegated (Article 24(1)). Where a financial instrument is lost,287 the depositary is required to return a financial instrument of identical type and corresponding amount to the UCITS (or management company) without delay. The depositary will not be liable if it can prove that the loss has arisen as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary (Article 24(1)).288 The depositary is also liable to the UCITS and unit-​holders for all other losses suffered because of the depositary’s negligent or intentional failure to properly fulfill its obligations under the Directive (Article 24(1)). This liability will not be affected by any delegation and, by contrast with the 2011 AIFMD regime but reflecting the retail orientation of the UCITS regime, cannot be excluded by agreement (Article 24(2), (3), and (4)). UCITS unit-​holders have a direct right of redress against the depositary and are not required to proceed through the management company (or investment company), as long as this does not lead to a duplication of redress or to the unequal treatment of unit-​holders.

III.4.9  UCITS Disclosure III.4.9.1 Prospectus and Ongoing Disclosure Notwithstanding the depth and range of the UCITS rulebook, disclosure remains a central element of the regulatory scheme and has recently been expanded to address sustainability-​ related disclosures (section 3.2.4). A management company or investment company must publish a UCITS prospectus (which must be kept up to date),289 an audited annual report on the UCITS (within four months of the end of the financial year), and a half-​yearly UCITS report, covering the first six months of the financial year (within two months of the end of the six-​month period) (Articles 68 and 73). The Directive adopts a framework approach to the UCITS prospectus (which is not subject to NCA approval), which is in stark contrast to the granular approach of the Prospectus Regulation, but which reflects the scale of the asset allocation, risk management, and management company/​depositary rules that govern UCITS operation. A catch-​all materiality

285 The rating agency regime and PRIIPs regimes provide unusual examples: see Ch VII section 15 and Ch IX section 5.3.4. 286 Which governs how financial instruments are to be held in custody. 287 A ‘loss’ of a financial instrument held in custody is deemed to take place where either a stated right of ownership of the UCITS is demonstrated not to be valid because it either ceased to exist or never existed; the UCITS has been definitively deprived of its right of ownership over the financial instrument; or the UCITS is definitively unable to directly or indirectly dispose of the financial instrument: 2016 Delegated Depositary Regulation Art 18. 288 The nature of this liability discharge is amplified by the 2016 Delegated Depositary Regulation which provides that liability will not be discharged unless the specified conditions are met (Art 19). 289 Art 72. The nature of the review or review cycle is not specified.

III.4  The UCITS Regime  283 obligation, similar to those applicable across the single rulebook as regards disclosure, applies: the UCITS prospectus must include the information necessary for the investor to be able to make an informed judgement on the investment and of its risks (Article 69(1)). The legislative scheme further requires that the UCITS prospectus contain a clear and easily understandable explanation of the scheme’s risk profile (Article 69(1)). Beyond a requirement that the prospectus indicate the categories of assets in which the UCITS is authorized to invest, whether financial derivatives transactions are authorized, their use (hedging or investment), and impact on the fund’s risk profile, and other risk disclosures relating to more complex investments or strategies (Article 70(1)),290 the substantive content is not harmonized.291 The Directive contains a basic schedule of the information which must be disclosed (Annex I, which also covers the periodic reports) unless that information is otherwise disclosed in the fund rules or instruments of incorporation (these form an integral part of the prospectus and must be annexed to it) (Article 71(1)).292 The Directive does not address sanctions or remedies in respect of false or misleading disclosure or require a responsibility statement in respect of the prospectus disclosure. The prospectus is not NCA-​approved but it must be sent (with any related amendments) to the UCITS home NCA, as must be the annual and half-​yearly UCITS reports, a requirement that engages deterrent effects. These disclosures must also be provided to the management company’s home NCA on request, an obligation which forms part of the Directive’s scheme for supporting supervision where jurisdiction is split between the UCITS and management company NCAs and risks to information flow accordingly arise (Article 74). As regards distribution, the prospectus and most recent financial reports must be provided on request to investors; the prospectus must be provided in a durable medium or by means of a website (Article 75).293 The UCITS must also make public the issue, sale, repurchase, or redemption price of its units each time it issues, sells, or repurchases them, and at least twice a month (Article 76(1)).294 By contrast with the prospectus regime, notification of the prospectus to ESMA is not required and there is no EU-​level repository for UCITS 290 Where the UCITS invests principally in assets other than transferable securities or money-​market instruments, or replicates an index, the prospectus must include a prominent statement to this effect; such a statement is also required where the UCITS NAV is likely to be highly volatile given the portfolio composition or portfolio management techniques envisaged. Where ‘necessary’ (not defined), marketing communications must also include such statements. Art 70(2) and (3). 291 The 2015 Securities Financing Transactions Regulation, however, requires that UCITSs (and AIFs) provide prospectus disclosures on the extent to which they use, and the risks attendant on, securities financing transactions. It also requires that specified aggregated disclosures be made on the use of securities financing transactions in ongoing reports: Ch VI section 4. 292 Annex I, Sch A. The requirements range from basic requirements such as name and address, management information, and particulars concerning the auditor to requirements concerning the units (such as their tax treatment; their characteristics; issue, sale, repurchase, and redemption procedures; and the rules for determining and applying income), to descriptions of the UCITS’ investment objectives. Information must also be provided on how UCITS assets are valued and how the sale, issue, redemption, and repurchase prices of units are determined. Information requirements apply to the depositary, including disclosure of the depositary’s identity, a description of its duties and of any safe-​keeping functions delegated by the depositary, the identification of the delegate, and any conflicts of interest which may arise from the delegation. Disclosure is also required concerning any advisory firms or external investment advisers who give advice under a contract which is paid for out of the assets of the UCITS. The Directive also addresses the content of the annual and half-​yearly UCITS financial reports, including remuneration-​related disclosures: Art 69(3) and (4) and Annex I, Sch B. 293 Administrative rules govern prospectus publication through a durable medium under the 2010 Commission KIID Regulation. The financial reports are to be provided in accordance with the distribution mechanism which the UCITS specifies in the prospectus or KIID. 294 The frequency can be reduced where the NCA is satisfied that a derogation does not prejudice unit-​holders’ interests: Art 76(2).

284  Collective investment Management prospectuses. The proposed European Single Point of Access for disclosure (ESAP) will mark a significant change to UCITS disclosure distribution as it proposes that all required UCITS disclosures (including the prospectus, short form disclosures (the Key Information Document), and financial reports), as well the prospectuses and required disclosures of AIFs, EuSEFs, EuVECAs and ELTIFs, be reported to the new ESAP database to be hosted by ESMA. Planned to be in place for 2024, this innovation promises to significantly facilitate and streamline investor access to disclosure.295

III.4.9.2 Short-​Form Disclosure, the Retail Markets, and the KIID/​KID a. Short-​Form CIS Disclosure and the Retail Markets Disclosure is strongly associated with investor protection, and particularly retail investor protection, in the CIS market, particularly in the US market where funds are subject to extensive disclosure requirements.296 Where it improves investor decision-​making, disclosure can support optimal CIS selection, enhance CIS quality, and lead to downward pressure on CIS costs.297 But designing effective disclosure for retail-​oriented CISs is a complex exercise given the weight of evidence that retail investors do not read full CIS prospectus disclosures, find them complex, and favour short-​form disclosures,298 and also given the distinct design challenges associated with CIS disclosure. For example, past performance information, strongly associated with CIS disclosure (albeit, in a highly contested innovation, expressly excluded from the short-​form ‘key information document’ (KID) required for packaged retail and insurance-​based investment products (PRIIPs)),299 is often poorly understood and vulnerable to investor over-​reaction.300 Similarly, standardized or synthetic risk indicators as to CIS risk and performance can support investor understanding and facilitate comparability across CISs,301 but they pose many design challenges and risks. CIS costs disclosure, which is also challenging to design, is particularly troublesome, given the range of CIS costs which can be incurred by investors, directly and indirectly,302 and given that the impact of costs is a key determinant of CIS returns303 and also the most significant means through

295 2021 Commission ESAP Proposal (COM(2021) 723). See further Ch II section 7.3. 296 See, eg, Howell, J, ‘A System of Fiduciary Protections for Mutual Funds’ in Laby, A and Russell, J (eds), Fiduciary Obligations in Business (2023). 297 Cox, J and Payne, J, ‘Mutual Fund Expense Disclosures: A Behavioural Perspective’ (2005) 83 Washington University LQ 907. 298 The research is of longstanding. One US industry study (Investment Company Institute, Understanding Investor Preferences for Mutual Fund Disclosure (2006)) found that only one third of investors surveyed read fund prospectuses, 60 per cent found them difficult to read, and 90 per cent preferred short-​form disclosure: at 4–​5 and 8–​9. The similar and extensive early UK evidence includes FSA, Consumer Research Paper No 5, which reported that investors were ‘simply not reading’ product disclosures (at 22–​3). 299 See Ch IX section 5. 300 eg Hu, H, ‘The New Portfolio Society, SEC Mutual Fund Disclosure, and the Public Corporation Model’ (2005) 60 Business Lawyer 1303. 301 eg Optem, Pre-​contractual Information for Financial Services. Qualitative Study in the 27 Member States (2008). 302 Including direct exit and entry costs; indirect costs charged to the scheme, including marketing and distribution costs, management and administration costs, and portfolio transaction costs (or the brokerage costs of executing fund transactions); performance fees; and fee-​sharing arrangements and commissions as regards distribution. 303 For the recent EU evidence, see section 10.

III.4  The UCITS Regime  285 which CIS managers can extract value to the detriment of investors.304 The disclosure design challenges are accordingly substantial and persistent.305 b. The UCITS KIID The UCITS regime has, however, acted as something of a laboratory for short-​form CIS disclosure. A series of reforms over time led to a major innovation in the form of the UCITS Key Investor Information Document (KIID). Adopted under the 2009 UCITS IV Directive, it subsequently shaped the 2014 Packaged Retail and Insurance-​Based Investment Products (PRIIPs) Regulation’s Key Information Document (KID),306 which covers all ‘packaged retail and insurance-​based investment products’ (PRIIPs), and also the prospectus summary under the 2017 Prospectus Regulation.307 Despite its influence, the KIID was recently phased out. As a UCITS is a form of PRIIP, the UCITS KIID was to be replaced by the PRIIP KID after a transitional period. The design difficulties that emerged with the PRIIPs KID, significant UCITS industry hostility to the replacement of the KIID by the KID, and inter-​institutional wrangles led to the UCITS exemption from the PRIIPs regime being repeatedly extended, but the KIID was finally replaced by the KID in January 2023. The KIID emerged from what was, at the time, a pathbreaking development process.308 Its origins lay in the failed UCITS III-​era ‘simplified prospectus’.309 Adopted without ex-​ante testing, it only shortened the lengthy UCITS prospectus disclosures and did not engage with presentation or format.310 The Commission’s dismal finding was that the UCITS III summary prospectus had ‘manifestly failed’ and had led to a ‘massive paper chase of limited value to investors and a considerable overhead for the fund industry’.311 Following a then-​novel development process, which included Commission workshops, extensive CESR preparatory work,312 and extensive

304 eg Coates, J and Hubbard, R, ‘Competition in the Mutual Fund Industry: Evidence and Implications for Policy’ (2007) 33 J Corp L 151. 305 The disclosure requirements for US mutual funds, eg, are undergoing a major overhaul designed to ensure the disclosures are better tailored to investors’, and particularly retail investors’, needs: SEC, Tailored Shareholder Reports, Treatment of Annual Prospectus Updates for Existing Investors, and Improved Fee and Risk Disclosures for Mutual Funds and Exchange-​Traded Funds; Fee Information in Investment Company Advertisements (2020). The SEC’s new approach is based on providing investors with ‘more digestible, tailored disclosure that fund shareholders can use to monitor their ongoing fund investments efficiently and meaningfully,’ and with additional ‘layered information’, that may be less relevant to retail investors, made available online and on request: at 44–​ 5. The new regime would still require a traditional prospectus, but a new, twice-​yearly, streamlined, and retail-​ oriented ‘shareholder report’ would deliver key disclosures in a more accessible manner. 306 Regulation (EU) No 1286/​2014 [2014] OJ L352/​1. See Ch IX section 5. 307 See Ch II section 4.9.8. 308 For an extended account see Moloney, N, How to Protect Investors. Lessons from the EU and the UK (2010) 312–​22. 309 Directive 2001/​107/​EEC [2002] OJ L41/​20. It was amplified by Commission Recommendation 2004/​384/​EC [2004] OJ L199/​30. 310 Major concerns included complexity, poor comparability, and the production of overly long and complex simplified prospectuses which varied in length from two to four pages (UK), to eight (France), to 11 (Italy): Commission Feedback Statement to the Green Paper on Enhancing the European Framework for Investment Funds (2006) 8. 311 2006 Investment Funds White Paper, n 55, 10. 312 CESR’s extensive initial consultations included three calls for evidence (one on the content of the prospectus, one on distribution, and one targeted to the retail sector (CESR/​07-​241, CESR/​07-​214, and CESR/​07-​205)) in April 2007; a subsequent October 2007 consultation paper (CESR/​07-​669), including a summary retail market version (CESR/​07-​753), and concluded with its February 2008 technical advice to the Commission on the KIID (CESR/​08-​087), which shaped the UCITS IV KIID reforms.

286  Collective investment Management testing,313 the radically different KIID was adopted as part of the 2009 UCITS IV Directive (Articles 78–​81) and amplified by detailed technical rules on format and content by the 2010 Commission KIID Regulation. The KIID regime was also supported by a detailed and extensive suite of CESR/​ESMA supervisory convergence measures, which addressed, inter alia, the use of ‘clear language’ and layout in the KIID, the template for KIID design, methodologies to be used, including with respect to performance scenarios for structured UCITSs, the KIID synthetic risk indicator, and ongoing charges disclosure. While it was replaced by the PRIIPs KID in January 2023, the UCITS KIID remains a remarkable innovation. The level of harmonization achieved with respect to the KIID, in terms of content, format, and the methodologies used to produce the required disclosures, was, at the time, without precedent across the EU’s retail disclosure regime for financial markets, as was the extensive testing and empirical assessment over the KIID development process, and it proved influential on the PRIIPs and Prospectus Regulations short-​form disclosure regimes. Its main features are accordingly noted here. Prior to its replacement by the PRIIPs KID, each management company (or investment company) was required to draw up a ‘short document’ containing ‘key information’ for investors (the KIID), which included appropriate information about the essential characteristics of the UCITS, and which was to be provided to investors so that they were reasonably able to understand the nature and risks of the investment product being offered to them and, consequently, to take investment decisions on an informed basis. The KIID was not NCA-​ approved but, supporting ex-​post supervision of compliance, was to be sent to the home NCA (Article 82(1)). The KIID, which was designed as a regulated, pre-​contractual disclosure document and not as a marketing document, was to be written in a concise manner and in non-​technical language; and was to be drawn up in a common format which allowed for comparability and to be presented in a way likely to be understood by retail investors (Article 78(5)). The KIID was designed to operate as a stand-​alone document; its essential elements were to be comprehensible without reference to any other documents. Disclosure, in the familiar requirement, was to be ‘fair, clear and not misleading’, as well as consistent with relevant parts of the prospectus (Article 79(1)). The KIID liability regime was similar to that which still applies to prospectus summaries under the Prospectus Regulation in that it limited liability, providing that Member States were to ensure that a person did not incur civil liability on the basis of the KIID (or any translation of the KIID) unless it was misleading, inaccurate, or inconsistent with the relevant parts of the UCITS prospectus, and the KIID was to contain a clear warning in that respect (Article 79(2)). Distribution was addressed by a direct/​indirect sales regime (Article 80) which required, with respect to direct sales, that the management company or investment company which sold UCITS units directly, or through a tied agent, provided investors with the KIID in good time before the proposed subscription of units. As regards indirect sales (such as those by investment advisers), the management company or investment company was to provide the KIID to product manufacturers and intermediaries who sold and advised investors on potential UCITS investments or, importantly, on products which offered exposure to such UCITSs (such as wrapped products). The KIID could be passported but, as a retail document, was to be translated into the official language or one of the official languages of the host Member States or into a language approved by the host NCA(s) (Article 94(1)(b)).

313

For a review see CESR, Consultation Paper on Technical Issues related to KII Disclosures for UCITS (2008).

III.4  The UCITS Regime  287 The KIID regime, in one of its major innovations, was amplified in detail by the 2010 Commission KIID Regulation which specified in an ‘exhaustive manner’ the form and content of the KIID covering, inter alia, the order of information, presentation and language, length—​the KIID could not exceed two A4 pages —​description of the objectives of the investment policy, the presentation of risks and reward, including the totemic ‘synthetic risk indicator’, which was based on a numerical (1–​7) scale,314 charges disclosure, and past performance disclosure. The KIID regime was also calibrated to particular types of UCITSs, including funds of funds and structured UCITSs (Articles 36–​7). The KIID was, at the time of its adoption, a landmark measure, in terms of substantive reform (particularly with respect to the synthetic risk indicator), the process through which it emerged, and the level of standardization it achieved. It experienced some difficulties, notably as regards the synthetic risk indicator315 but was, very broadly, regarded as a success, being associated with stronger investor understanding.316 Most difficulties related to the interaction between the KIID and its successor PRIIPs KID. The PRIIPs KID is designed as the default summary disclosure document for all packaged retail and insurance-​based investment products. UCITSs fall within the perimeter of the PRIIPs regime but were exempt from the KIID requirement for a transitional period. The rollout of the PRIIPs regime was, however, beset with design difficulties, including as regards its novel, forward-​looking ‘performance scenario’ requirements, which became associated with projecting outlandish returns, and its exclusion, unlike the UCITS KIID, of past performance information.317 In addition, the UCITS industry fiercely resisted the replacement of what it regarded as a well-​functioning KIID with a flawed PRIIPs KID, in particular given the KID’s exclusion of past performance data, which data is strongly associated with CIS disclosure and longstanding in the UCITS sector, and also given the costs of the large-​scale transition from the KIID to the KID for the UCITS sector.318 Following lengthy and inconclusive inter-​institutional wrangling between the European Supervisory Authorities (ESAs), the Commission, and the Parliament as regards the PRIIPs KID review process and the KID/​KIID interaction, and the delayed adoption of refinements to the PRIIPs KID design,319 the 2021 UCITS Directive and PRIIPs Regulation ‘quick fix’ reforms extended the original transitional exemption for UCITSs from the PRIIPs KID requirement (previously until 31 December 2019, then 31 December 2021) until 31 December 2022.320 While the fracas is a distinctly EU one, it nonetheless underlines the difficulties posed by summary retail market disclosures.

314 The indicator was designed to captures the fund’s historic volatility, based on five years of data. 315 Some early difficulties emerged in practice, with funds ‘herding’ to a similar indicator: 2012 KPMG Report, n 123. 316 Study for the Commission, Consumer Decision Making in Retail Investment Services. A Behavioural Perspective. Co-​ordinated by Decision Technology (2010) and UCITS Disclosure Testing Research Report. Prepared by IFF Research and YouGov for the Commission (2009). 317 See Ch IX section 5.4. 318 See, eg, EFAMA, EFAMA Calls for Urgent Level 1 Review and Extension of the UCITS Exemption, Press Release, 5 August 2020 and Riding, S, ‘EU Fund Groups Call for Extension from Maligned Performance Forecasts’ Financial Times, 5 August 2020. 319 Delegated Regulation (EU) 2021/​2268 [2021] OJ L455/​1 (see Ch IX section 5.4). 320 The Commission initially proposed that the exemption be extended to 1 July 2022 (COM(2021) 397, PRIIPs ‘quick fix’; COM(2021) 399, UCITS ‘quick fix’), but this was extended by the Parliament to 31 December 2022 and agreed by the Council: Regulation (EU) 2021/​2259 [2021] OJ L455/​1. Alongside, and to avoid the circulation of KIDs and KIIDs for the same UCITS, and to avoid investor confusion, the UCITS ‘quick fix’ confirms that where a UCITS provides (as required from January 2023) a PRIIPs KID document, this meets the KIID requirement (UCITS Directive, Art 82a, as inserted by Directive (EU) 2021/​2261 [2021] OJ L455/​15).

288  Collective investment Management

III.4.10  The Retail Markets The UCITS fund is strongly associated with the retail markets and with retail investor protection. Its core structural feature, redemption on demand, is a powerful investor protection mechanism, providing significant mitigation of investor liquidity risks. The UCITS fund also sits within a dense regulatory system, including asset allocation and risk management requirements, organizational and conduct regulation of the management company and the depositary, and UCITS distribution requirements, chiefly as regards disclosure (the PRIIPs KID, previously the UCITS KIID) and marketing (via the 2019 Refit Package). In practice, UCITS investment tends to be predominantly retail, with in the region of 60 per cent of UCITS AUM relating to retail investment.321 Retail investment in UCITSs tends to be in more traditional UCITS portfolios, with most retail UCITS investments held through equity UCITSs, followed by mixed bond/​equity UCITSs and bond UCITSs; there is only limited retail participation in UCITSs which follow more complex, alternative investment strategies.322 The UCITS market has not experienced major mis-​selling episodes (albeit that the practice of ‘closet indexing’ has drawn supervisory attention),323 and is associated with high standards of investor protection, but there are weaknesses in its regulatory scheme as regards the retail markets. The UCITS regulatory regime is distinct in EU financial markets regulation in that it is product-​oriented, being based on product authorization and on product design requirements (via the UCITS authorization and asset allocation rules). It does not, however, include a product governance requirement as regards assessment of the UCITS’ suitability for retail distribution. By contrast, one of the key MiFID II requirements for investment services generally relates to the product governance obligation imposed on MiFID II investment firms (which do not include collective investment managers) to ensure that the products they manufacture are designed to meet the ‘needs, characteristics, and objectives’ of a specified target market and that distribution arrangements are tailored to the relevant target market. UCITS managers are not subject to such an obligation (the ELTIF fund, however, which ‘locks up’ investor capital, does not provide for redemption on demand, and so has a riskier structure, is subject to the product-​governance-​related requirement that its suitability for retail investment be assessed where it is to be marketed to retail investors (section 6)). Such an obligation for UCITS managers might be regarded as redundant in light of the extensive UCITS rulebook, but it would have the merit of requiring that the design of a UCITS’ asset allocation strategy focus on retail market needs, particularly where the fund is expressly targeted to the retail market. Similarly, the ‘last resort’ temporary/​permanent product intervention powers that ESMA/​NCAs can exercise under MiFIR (Chapter IX 321 Since their initial publication in 2019, ESMA’s annual reports on ‘Performance and Costs of Retail Investment Products in the EU’ have reported on a retail share of the UCITS market (from the extensive sample of funds reviewed) of in the region of 65 per cent (2019) to 59 per cent (2022). 322 The annual ‘Performance and Costs’ reports consistently report on retail investment in UCITSs being primarily dispersed across equity UCITSs, followed by bond and mixed UCITSs. For the most recent data see 2022 ESMA Retail Investment Products Report, n 8, 57. 323 ‘Closet indexing’ refers to the practice whereby a fund claims to be actively managed and charges fees accordingly, but in practice follows an index very closely. ESMA’s funds’ supervisory convergence agenda has included monitoring the market for this practice, issuing recommendations to management companies, and coordinating NCA practices. See, eg, Danieli, L, Harris, A, and Pichini, G, Closet Indexing Indicators and Investor Outcomes, ESMA WP No 2 (2020) and ESMA, Public Statement (Supervisory Work on Potential Closet Index Tracking), 2 February 2016.

III.4  The UCITS Regime  289 section 4.12) do not apply to UCITSs/​their managers (although NCAs are empowered under the UCITS Directive to withdraw a UCITS’ authorization (Article 98)). There are also weaknesses as regards the regulation of distribution. Where UCITS sales occur through MiFID II investment firms’ advice or execution-​only distribution channels (such as investment advisers or brokers), the panoply of related MiFID II conduct rules apply, including investment advice requirements, marketing requirements, and specific protections as regards the execution-​only distribution of structured UCITSs.324 UCITS sales may, however, also take place through direct UCITS execution-​only (and marketing) channels. These channels fall outside MiFID II and its protections as collective investment management is not a MiFID II investment service. Again, the ELTIF regime applies more extensive protections, imposing advice-​related requirements on ELTIF managers where they market ELTIFs to the retail sector. More generally, costs remain a challenge in the UCITS sector. Costs are not subject to intensive regulation, but management companies (and investment companies) are subject to the over-​arching obligation to act honestly and fairly, and with due skill, care, and diligence (Articles 14 and 30), while the 2010 Commission Management Company Directive provides that management companies and investment companies must act in such a way as to prevent ‘undue costs’ being charged to the UCITS and unitholders (Article 22(4)). Reflecting the intensifying influence of technocracy on the UCITS regime, ESMA has significantly amplified these costs-​related requirements through its data collection, guidance, and supervisory convergence activities. Since 2019, and following a Commission mandate, ESMA annually reports on the cost and performance of retail investment products, including UCITSs. These reports underline the extent to which costs, and particularly ongoing costs, can erode retail investor returns. UCITS performance tends to reflect the performance of the underlying asset market and so can be volatile,325 but UCITS costs have remained broadly stable326 and can have a significant impact on returns.327 The significantly increased transparency that ESMA’s reporting is bringing to UCITS cost structures328 (as well as the short-​form costs disclosures provided in the KID which support comparability (Chapter IX section 5)) may come to exert downward pressure on costs, albeit that retail investors are poorly equipped to bring such pressure to bear, as is clear from the higher costs carried by retail investors as compared to institutional investors.329 More traction is likely 324 See Ch IX section 4.9. 325 ESMA’s annual reports show that equity UCITS returns increased in the last ten years, along with increasing equity market valuations, but that bond UCITS returns decreased, reflecting the lower interest rate environment. Equity valuations can, however, shift dramatically. In 2022 ESMA reported that UCITS performance had been highly volatile, given the impact of the pandemic: annual gross performance of equity UCITSs, over a one-​year horizon, was 1.3 per cent in 2020, compared to 10.7 per cent in 2019 (8.2 per cent over 2011–​2020 and 11 per cent over 2010–​2019): n 89, 10. 326 2022 ESMA Retail Investment Products Report, n 8, 10 and 27, finding that cost levels have reduced only moderately over time. 327 ESMA reported in 2022 that, over a ten-​year horizon, and when costs are taken into account, the value of a UCITS investment (in a hypothetical retail portfolio of equity, bond, and mixed UCITSs) declines by about 14 per cent for retail investors and noted ‘how crucial the role of costs is in evaluating the outcome of an investment’ and, in consequence, the importance of clear costs disclosure: n 8, 11. 328 Including as regards the relatively stronger performance of cheaper passive UCITSs over more expensive active UCITSs: ESMA’s 2022 report, reflecting earlier reports, found that passive equity and bond UCITSs outperformed their active counterparts over a ten-​year horizon (but underperformed at the one-​year horizon): n 8, 27. 329 This is a recurring feature of ESMA’s reports and has been related to the lower costs of institutional UCITS share classes for UCITS managers as well as to the stronger bargaining power of institutional investors: ESMA, Performance and Costs of Retail Investment Products (2019) 17.

290  Collective investment Management to be exerted by NCA supervision of the ‘undue costs’ requirement330 and of ESMA’s 2020 Guidelines on performance fees.331

III.4.11  Supervision and Enforcement III.4.11.1 NCAs Following the model adopted across the single rulebook, albeit in a less articulated manner than later crisis-​era and subsequent measures, the 2009 UCITS IV Directive addresses the form and organization of NCAs (they must take the form of public authorities (Article 97)) and prescribes the minimum powers NCAs must have at their disposal (Article 98).332 Supervision is reinforced by the requirement imposed on auditors to report to the relevant NCAs with respect to identified matters, including breaches of the UCITS Directive (Article 106). III.4.11.2 Supervisory Cooperation The 2009 UCITS IV Directive also follows the model in place across the single rulebook as regards supervisory cooperation. NCAs are, accordingly, subject to a general cooperation obligation, as well as to specific obligations as regards information exchange, on-​the-​spot verifications, investigations, and notifying the relevant NCA where an NCA suspects acts contrary to the Directive are being carried out in another Member State; as well as to the now standard obligation to cooperate with ESMA and to provide it, without delay, with all information necessary to carry out its duties (Article 101).333 Similarly, ESMA’s binding mediation powers can be exercised by ESMA in relation to cooperation-​related disputes that arise between NCAs (Article 101). A related information exchange regime applies to protect the confidentiality of information and impose professional secrecy obligations, and

330 ESMA has adopted a ‘Supervisory Briefing’ (a supervisory convergence measure) on NCA supervision of the ‘undue costs’ obligation, in response to a mapping exercise which showed significant variation across NCAs as regards how this obligation was supervised, and which underlined the related risk of regulatory arbitrage and competitive distortions: ESMA, Supervisory Briefing on Supervision of Costs in UCITS and AIFs (2020). 331 ESMA, Guidelines on Performance Fees in UCITS and Certain Types of AIF (2020). The Guidelines are designed to signal NCAs’ supervisory expectations as regards how performance fees comply with fund managers’ duties (whether under the UCITS or AIFMD regime) to act honestly, fairly, and professionally and to act with due skill, care, and diligence. Highly technical and operational, the Guidelines cover performance fee calculation models, the alignment between such models and fund investment strategies, the non-​application of fees in a negative performance context, and disclosure. ESMA’s 2022 report on its 2021 Common Supervisory Action on fund costs and fees (including the ‘undue costs’ requirement) noted a series of weaknesses and divergences in funds’ practices, called on NCAs to consider enforcement where appropriate, and underlined the ‘huge relevance’ of costs and fees for investor protection: ESMA, Final Report on the 2021 Common Supervisory Action on Costs and Fees (2022). 332 These include the power to access documents, carry out on-​site inspections, impose injunctions, require the freezing of assets, temporarily prohibit professional activities, and, more specifically, require the suspension of the issue, repurchase, or redemption of UCITS units in the interests of unit-​holders or of the public, withdraw UCITS authorization, and adopt any type of measure to ensure that investment companies, management companies, and depositaries comply with the Directive. They also include the power to acquire data traffic records from a telecommunications operator where there is a reasonable suspicion of a breach, and where such records are relevant to an investigation, and to require existing recordings of telephone calls or electronic communications or other data traffic records held by UCITSs, management companies, investment companies, depositaries, or any other entities regulated by the Directive. 333 Administrative rules govern information exchange and verifications/​ inspections: 2010 Delegated Notifications and Information Exchange Regulation.

III.4  The UCITS Regime  291 to identify those NCAs with which information can be exchanged (Articles 102–​4). The Directive also specifies the limited conditions under which an NCA may refuse to act on a request for information or to cooperate with an investigation (Article 99(3)). As regards the allocation of supervisory jurisdiction and the UCITS, the UCITS home NCA is allocated the power to take action where the UCITS infringes the UCITS regime or any of its fund rules or instruments of incorporation.334 UCITS host NCAs retain jurisdiction with respect to rules which fall outside the UCITS Directive (Article 108(1)). As is the case across the single rulebook, the UCITS host NCA also retains exceptional precautionary powers as regards breaches of Directive rules which otherwise fall outside its competence (Article 108(4) and (5)). As regards the allocation of supervisory jurisdiction and the management company, a discrete cooperation regime applies where the management company of a UCITS is established in a different Member State to the UCITS, reflecting the coordination risks arising from the jurisdictional split of supervision. Article 108(3) clarifies that the management company home NCA or the UCITS home NCA, as relevant, are to take action against the management company where the company infringes rules under their respective responsibility (Article 108(3)). Notification requirements also apply. The management company home NCA must notify the UCITS home NCA of any problems which may materially affect the ability of the management company to perform its duties with respect to the UCITS, or of any breach of the Directive’s management company rules; likewise, the UCITS home NCA must notify the management company home NCA of similar problems at the level of the UCITS (Article 109(3) and (4)). With respect to host NCA obligations, where a management company operates in one or more host Member States, all the NCAs of the Member States concerned must collaborate closely, including with respect to information exchange likely to facilitate the monitoring of the company (Article 109(1)). The management company host NCA(s) must also inform the management company home NCA of any precautionary measures taken against the management company (Article 109(2)). Host NCAs of a management company are further required, where the management company pursues activities in the Member State through a branch, to ensure that the home NCA, having informed the host NCA, can carry out (on its own or through an intermediary) an on-​the-​spot verification of information likely to facilitate the monitoring of the management company (Article 110(1)).

III.4.11.3 Supervisory Convergence and ESMA This formal cooperation system is nested within the now intricate UCITS supervisory convergence framework. The UCITS regime has been something of a laboratory for the development of supervisory convergence measures, being an early focus for CESR’s measures which, for example, included peer reviews of the UCITS regime, particularly as regards the UCITS passporting regime,335 albeit with mixed results;336 coordination of the NCA response to the Madoff 334 The home NCA must notify the host NCA where it has withdrawn the UCITS’ authorization, suspended the issue, repurchase, or redemption of its units, or taken other serious measures against the UCITS: Art 108(2). 335 CESR/​09-​1034. 336 The 2009 UCITS peer review (n 335), eg, revealed low levels of compliance with the earlier CESR guidelines on UCITS notification, with only five Member States in full application of the guidelines and 20 Member States not applying at least one

292  Collective investment Management scandal and the provision of related investor advice;337 as well as the adoption of a series of pivotal Guidelines which are still used by ESMA. Since then, whether through soft law such as Guidelines, the UCITS Q&A, and other measures, or whether through more operational initiatives, such as ESMA’s stress testing/​ review activities and its ‘Common Supervisory Actions’ (which were to the fore following the fund market disruption in early 2020 (section 4.2.5)), and its ad hoc industry investigations,338 ESMA has been fast constructing a nascent UCITS supervisory handbook and developing a related capacity to monitor the UCITS market. ESMA’s extensive suite of supervisory convergence measures is supported by its collection and interrogation of UCITS market data, primarily through its bi-​annual Trends, Risks and Vulnerabilities Reports (TRVs) and its annual reports on UCITS performance and costs. ESMA’s data capacity can be expected to strengthen following the UCITS reporting review envisaged by the 2021 AIFMD/​UCITS Proposal. ESMA’s burgeoning supervisory convergence agenda can be associated with a de facto harmonization of NCAs’ UCITS supervisory practices in recent years and, overall, the supervision by home NCAs of passporting activity has not generated major difficulties.339 Strains remain in the UCITS supervisory system, however, given the distinct features of the UCITS market. For example, as noted in section 4.7.1, the extent to which delegation is used as a business organization tool across the UCITS market has led to some contestation across NCAs as to the extent to which delegation arrangements should be permitted by home NCAs, particularly as regards delegation to third countries. Further, given the extent to which UCITS home supervision tends to be concentrated in a small number of home Member States,340 some tensions have arisen as to the efficacy of home NCA supervision over passporting UCITSs, albeit that the pre-​eminent position of the home NCA is a foundational principle of EU financial markets governance.341 Relatedly, host NCA precautionary powers have been exercised over passporting management companies and, in one case, ESMA’s binding mediation powers were deployed following a disagreement between the home and host NCAs concerned.342 The 2021 AIFMD/​UCITS Proposal suggests that home NCAs may be subject to additional scrutiny as it proposes an empowerment of the UCITS host NCA to request the UCITS home NCA to exercise, without delay, any of its supervisory powers. It also injects 337 CESR Public Statement, 4 February 2009. 338 ESMA, eg, adopted a series of recommendations regarding ‘closet indexing’ practices (where a manager charges a fee for active fund management but is in practice following an index), following stakeholder concern and as NCAs were beginning to take investigatory action: ESMA, Public Statement (Supervisory Work on Potential Closet Index Tracking), 2 February 2016. See also n 323. 339 ESMA’s 2017 thematic review of cross-​border supervision in the UCITS/​AIFMD sector found that there were no immediate shortcomings but identified a series of good practices designed to enhance supervision of the cross-​border market: ESMA, Notification Frameworks and Home-​Host Responsibilities under UCITS and AIFMD. Thematic Study among NCAs (2017). 340 One NCA reported for ESMA’s 2017 thematic study that of the 9,806 UCITSs it authorized, over 8,000 (85 per cent) were marketed in other Member State: 2017 ESMA Home/​Host Thematic Review, n 339, 14. 341 These tensions were clear in a 2019 joint ESA report on cross-​border supervision which identified some NCA concern that home NCAs might not sufficiently prioritize the supervision of a passporting UCITS where the UCITS was only ‘marginally offered and sold’ in the home Member State and where the home NCA might accordingly ‘have little incentives’ to assign adequate resources to the supervision of such UCITS: ESMA, EBA, and EIOPA, Report on Cross-​Border Supervision of Retail Financial Services (2019) 11. 342 2017 ESMA Home/​Host Thematic Review, n 339, 14. ESMA reported that over 2014–​2016 host NCAs had taken action against passporting management companies (or their branches), including as regards resourcing (at branch level), valuation, investment limits, and non-​compliance with investment limits.

III.4  The UCITS Regime  293 ESMA more deeply into the supervision of the UCITS market by proposing that ESMA undertake peer reviews of NCA supervision of delegation practices, and also by proposing that ESMA be empowered to request an NCA to ‘submit explanations’ to it in relation to specific cases that may have cross-​border implications and as regards investor protection or financial stability risks.343 Whether or not such a tightening of oversight over the home NCA would reduce tensions and enhance supervision, or instead disrupt home NCAs’ supervisory models and increase tensions, remains to be seen but it illustrates the ongoing ‘Europeanization’ of supervision.

III.4.11.4 Sanctions and Enforcement The administrative sanctions regime aligns with the harmonization of administrative sanctions associated with the financial-​crisis-​era reforms generally. Accordingly, the 2009 UCITS IV Directive requires that effective, proportionate, and dissuasive administrative sanctions and measures must be available (Article 99(1)) (criminal sanctions may be deployed in substitution for administrative sanctions, but these must be notified to the Commission and appropriate measures must be in place such that NCAs have all necessary powers to liaise with the judicial authorities to receive information and to transmit it as required to other NCAs and ESMA); specifies the identified breaches of the Directive which must be subject to administrative sanctions or measures (Article 99a); specifies the minimum suite of administrative sanctions and measures which must be available (Article 99(6));344 details how sanctions and measures are to be applied (Article 99c);345 addresses ‘whistle-​blowing’ (Article 99d); and provides for mandatory NCA public reporting of administrative sanctions and measures (and the conditions under which the public reporting requirement can be lifted) (Article 99b) and for NCA reporting to ESMA on sanctioning (Article 99e). In practice, sanctions are not widely used across all Member States and, as regards monetary penalties, are relatively low.346

343 2021 AIFMD/​UCITS Proposal (n 30), UCITS Directive, new Arts 98(3), Art 100a, and Art 98(4), respectively. 344 The suite of measures includes public statements, injunctions, withdrawals of authorization, temporary and permanent bans on exercising management functions, and pecuniary sanctions (up to (as a minimum) 10 per cent of annual turnover of a legal person or €5 million; and up to €5 million in the case of a natural person), including pecuniary sanctions of up to twice the amount of the profits gained or losses avoided (even where that exceeds the aforenoted thresholds). 345 Including, as across the crisis-​era reforms generally, with reference to the gravity and duration of the breach, the degree of responsibility of the person responsible and that person’s financial strength, the importance of profits gained or losses avoided, the degree of cooperation by the person concerned, and previous breaches by that person. In addition, the assessment must take into account the damage to other persons and, where applicable, the damage to the functioning of markets or the wider economy. 346 ESMA’s 2022 report on 2021 (its 5th such annual report) noted that the data persistently evidenced that sanctioning powers were not equally used across NCAs (twelve NCAs imposed monetary penalties and eighteen8 NCAs other sanctioning measures in 2021) and that the number of sanctions and amount of monetary penalties imposed were relatively low. ESMA also reported that over the five-​year period 2016-​2021 the number of NCAs imposing monetary penalties, eg, ranged from eight (2016) to fourteen (2018) (twelve in 2021), and on total amounts levied across all NCAs of a low of €1,100,986 (2020) to a high of €38,784,536 (2021). The 2021 figure was, however, skewed by a single high penalty. ESMA suggested that, once this penalty was discounted, ‘a very low amount of penalties’ was imposed, particularly in light of the more than €11 trillion of UCITS assets domiciled in the EU. ESMA acknowledged, however, that ‘no automatic parallelism’ should be drawn between numbers of measures/​amount of penalties and the quality of supervision, given the complex and multi-​faceted nature of enforcement (and as some national sanctions used may sit outside the UCITS reporting regime), but that the sanctioning data was useful to prompt discussions with NCAs: ESMA, Penalties and Measures Imposed under the UCITS Directive in 2021 (2022).

294  Collective investment Management Member States must also ensure that efficient and effective complaints and redress procedures are in place for out-​of-​court settlement of consumer disputes relating to UCITS activity (Article 100).

III.5  The AIFMD III.5.1  The Regulatory and EU Context The 2011 AIFMD347 addresses the collective investment management of the universe of non-​UCITS alternative investment funds (AIFs) by AIF managers (AIFMs), capturing a vast array of diverse funds and their managers. It is a sprawling, horizontal legislative regime of immense technical complexity and is encrusted with highly detailed administrative rules which delve into dense operational technicalities, from risk management to depositary regulation. It also supports the management of the EU’s three bespoke fund vehicles (the EuVECA, the EuSEF, and the ELTIF), the management of which is nested within the AIFMD regime. It draws on a host of regulatory tools, from authorization, to conduct and prudential regulation (including process-​based and often highly quantitative requirements), to macroprudential regulation, to disclosure. The bifurcation of collective investment management regulation into UCITS and non-​ UCITS segments is a financial-​crisis-​era phenomenon. The AIFMD’s tortured genesis and the febrile political context in which it was negotiated obscured somewhat the objectives for regulating the previously largely non-​regulated AIF sector at the time, but two objectives were more or less clear: first, management of the financial stability risks associated with AIFs; and second, and notwithstanding the largely professional investor base, management of the distinct investor protection risks as regards AIF liquidity, disclosures, and fair treatment. The EU AIF sector is now associated with a great variety of funds which include funds of funds, as well as real estate, hedge, private equity, commodity, and infrastructure funds, and which are primarily, although by no means always, designed for institutional investment: retail participation amounts to some 14 per cent of AIF NAV, and is primarily directed to real estate funds (24 per cent) and funds of funds (19 per cent).348 Functionally the AIF asset class can, very broadly, be associated with more illiquid asset portfolios, the use by some funds of closed-​end structures, and a more strongly institutional investor base. The defining regulatory feature of the AIF asset class is that an AIF does not fall within the definition of a UCITS. Similarly, the defining design feature of the AIFMD is that it is not, by contrast with the UCITS Directive, product-​related. It addresses the collective investment management of AIFs generally and so is designed to operate across a heterogenous class of AIFs and their managers.

347 The main elements of the legislative history are: Commission Proposal COM(2009) 207, IA (SEC(2009) 576); report by the ECON Committee, 11 June 2010 (A7-​0171/​2010) (2010 ECON Report), on which the European Parliament’s Negotiating Position was based; and Council General Approach, 18 May 2010 (Council Document 7377/​10). 348 2022 ESMA AIF Report, n 18, 4.

III.5  The AIFMD  295 The negotiation and the 2011 adoption of the AIFMD was fiercely contested and associated with hedge funds in particular. While hedge funds can defy categorization,349 they are typically characterized as actively managed funds which use a diverse range of investment strategies, but in particular high levels of leverage (debt-​and derivative-​based) to generate high absolute returns.350 Among the features associated with the sector are the reliance of the hedge fund manager on ‘prime brokerage services’ (such as credit, execution, and research services) from an investment firm and the opening thereby of a significant risk transmission channel;351 the pivotal importance of the valuation process (through independent fund administrators given the often illiquid nature of the asset base); and the redemption restrictions imposed on investors (typically institutional, who usually access hedge funds through private placements), given the illiquid nature of hedge fund assets. Hedge funds are widely acknowledged to support market efficiency by providing liquidity and by supporting price efficiency, risk distribution, and diversification.352 But they also generate material risks,353 chief among them systemic risks, through the credit risk and market risk transmission channels, and investor protection risks, primarily deriving from liquidity and valuation risks. While, prior to the financial crisis, the hedge fund sector had been drawing regulatory attention,354 the financial-​crisis era saw regulatory and also political attention became acute, particularly in the EU. Despite a fairly broad consensus that hedge funds were not directly implicated in the financial crisis, and while the sector recovered quickly,355

349 As was acknowledged by IOSCO over the development of its financial-​crisis era response to hedge fund risk: IOSCO, Hedge Funds Oversight. Consultation Report (2009). Similarly, pre-​crisis the US SEC struggled with classification difficulties as it sought (and failed) to design a hedge fund regulatory regime: Paredes, T, ‘On the Decision to Regulate Hedge Funds: The SEC’s Regulatory Philosophy, Style, and Mission’ (2006) University of Illinois LR 975. 350 eg FSA, Discussion Paper No 05/​3, Wider Range Retail Investment Products. Consumer protection in a rapidly changing world (2005). 351 As was illustrated by the 2021 failure of Archegos, a hedge fund which collapsed following failures in leverage risk management, triggering large-​scale losses of some $10 billion in major prime broking investment firms internationally, as well as a retreat from prime broking services by major investment firms. Concerns followed that the prime brokerage market had become overly concentrated among a small number of global investment firms (on the collapse see Walker, O and Noonan, L, ‘Prime Broking Braced for New Era after Archegos Collapse’, Financial Times, 12 November 2021). For a review of the regulatory implications for investment firm regulation, including as regards risk management and the quality of reporting on derivatives transactions, see Branzoli, N et al, ‘Lessons Learned from the Collapse of Archegos: Policy and Financial Stability Implications’ (2021) 26 Banca d’Italia. Notes on Financial Stability and Supervision. 352 eg FSA, Discussion Paper No 05/​4, Hedge Funds. A Discussion of Risks and Regulatory Engagement (2005). 353 See, eg, from the crisis-​era period, when hedge fund risk was closely followed: Awrey, D, ‘The Limits of EU Hedge Fund Regulation’ (2011) 5 LFMR 119; Athanassiou, P, ‘The Conceptual Underpinnings of Onshore Hedge Fund Regulation: A Global and European Perspective’ (2008) 8 JCLS 251; McVea, H, ‘Hedge Funds and the New Regulatory Agenda’ (2007) 27 Legal Studies 709; and Moloney, N, ‘The EC and the Hedge Fund Challenge: A Test Case for EC Securities Policy after the Financial Services Action Plan’ (2006) 6 JCLS 1. 354 International dialogue on hedge fund regulation had been taking place since the 1998 Long-​Term Capital Management fund crisis. As the sector experienced massive growth in the pre-​financial-​crisis era, closer international regulatory attention followed, in particular as regards financial stability risks and the ‘retailization’ of hedge fund investment. See, eg, IOSCO’s reports on Regulatory and Investor Protection Issues Arising from Participation by Retail Investors in (Funds of) Hedge Funds (2003) and on The Regulatory Environment for Hedge Funds. A Survey and Comparison (2006); and its Principles for Valuation of Hedge Fund Portfolios (2007) and Funds of Hedge Funds (2008). 355 In 2012, the UK FSA reported that the aggregate ‘footprint’ of hedge funds was modest in most markets, that leverage was relatively low, and that there was no evidence of liquidity pressure on hedge funds: FSA, Assessing the Possible Sources of Systemic Risk from Hedge Funds (2012).

296  Collective investment Management hedge funds were associated with the amplification of liquidity risks and so were drawn into the global reform agenda.356 But although the financial-​crisis era saw vigorous debate in the EU and internationally on the risks and appropriate regulation of the sector, the hedge fund sector is now a quieter corner of financial markets regulation, certainly in the EU. This reflects its coming within the AIFMD regulatory perimeter but also less vertiginous growth levels in the sector.357 The other target of financial-​crisis era AIF regulatory attention in the EU, the private equity sector,358 continues to draw some fire, but more as regards the impact of the explosive growth in private equity funding, reflecting an accommodative monetary policy environment (until 2022), on public markets than as regards fund regulation (private equity funds now represent some 6 per cent of the AIF market, larger than the hedge fund sector359).360 The intervening decade or so since the adoption of the AIFMD has, accordingly, seen the AIF/​AIFM regulation debate in the EU change. The rationale for regulating AIFs/​ AIFMs has become largely uncontroversial, in particular in light of the recognition that non-​bank financial intermediation, and the activities of open-​ended AIFs in particular, can generate financial stability risks, particularly as regards liquidity. Similarly, while initially strongly associated with hedge fund regulation, the AIFMD has since become the EU’s means for managing the risks associated with the burgeoning AIF sector generally, which had grown to an NAV of €5.9 trillion by 2020, of which hedge fund NAV represented only some €89 billion NAV (2 per cent of the sector NAV).361 Relatedly, while hedge fund leverage remains on the regulatory radar in the EU, it has not prompted undue concern.362

356 The massive and destabilizing market volatility over 2007–​8 was in part associated with major hedge funds deleveraging and unwinding positions in response to tightened credit conditions, with investor redemption demands, and with the generation thereby of powerful procyclical effects. Additionally, the general opacity and complexity associated with the hedge fund sector and the widespread use by hedge funds of short-​selling strategies, made them a politically attractive target for the nascent reform movement. For analysis of how the international reform developed see Ferran, E, ‘After the Crisis: The Regulation of Hedge Funds and Private Equity in the EU’ (2011) 12 EBOLR 379. 357 See McCahery, J and de Roode, A, ‘The Lost Decade for Hedge Funds: Three Threats’ in Cumming, D (ed), The Oxford Handbook of Hedge Funds (2021) 35. . 358 On the evolving regulatory approach to private equity pre-​crisis see Payne, J, ‘Private Equity and Its Regulation in Europe’ (2011) 12 EBOLR 559 and MacNeil, I, ‘Private Equity: The UK Regulatory Response’ (2007) CMLJ 18. The private equity sector did not draw material policy attention internationally (save for some IOSCO reporting). Its inclusion in the EU response to the financial crisis can be regarded as a function of the distinct political conditions which prevailed in the EU. 359 2022 ESMA AIF Report, n 18, 6. 360 See Ch II section 2. 361 2022 ESMA AIF Report, n 18, 6. This data has been impacted by Brexit, given that the UK is a major centre for AIFs, particularly hedge funds. The 2021 ESMA AIF Report (including UK data) reported on an overall industry NAV of €6.8 trillion, with hedge funds accounting for €350 billion and 5 per cent of NAV: ESMA, Annual Statistical Report on EU Alternative Investment Funds (2021) 6. The sector has experienced strong growth since the financial crisis, increasing from an NAV of €4.9 trillion in 2017 (ESMA, Annual Statistical Report on EU Alternative Investment Funds (2019) 5), but also showing growth from 2011 (total net assets of €2.3 trillion: Commission, Report Assessing the Application and Scope of the AIFMD (COM(2020) 232) 5). Brexit has, however, seen a contraction and it remains to be seen how it will impact on the AIF sector. 362 While the ESRB has repeatedly reported in its annual Non-​Bank Financial Intermediation Risk Monitor on the hedge fund sector as carrying the highest levels of leverage in the AIF sector (as has ESMA), the sector has not been a target for heightened regulatory concern, reflecting the controls now in place under the AIFMD.

III.5  The AIFMD  297

III.5.2  The Evolution of the AIFMD III.5.2.1 The Pre Global Financial Crisis Period, The EU AIFM/​AIF sector was not unregulated prior to the financial crisis.363 EU-​based AIFMs were subject to authorization, conduct, and prudential requirements under MiFID I where they engaged in MiFID I activities and to market abuse prohibitions under the market abuse regime; disclosure requirements applied to AIFs admitted to trading on regulated markets; and authorization regimes applied at national level. As the AIF sector moved on to the EU policy agenda prior to the financial crisis, as part of the 2004 UCITS Review, a low-​key, facilitative approach prevailed, with the 2006 Investment Funds White Paper largely concerned with supporting cross-​border transactions in AIFs. But although the Council took a similarly sanguine approach in 2007,364 a more hostile position was adopted in some Member States, particularly as regards hedge funds, the regulation of which came to frame the AIF debate.365 The European Parliament and the European Central Bank (ECB) were also more sceptical, The ECB repeatedly highlighted the potential financial stability risks posed by hedge funds.366 The Parliament’s position, while cognizant of the potential financial stability risks of hedge funds, was driven by concerns as to ‘aggressive’ speculation and shareholder capitalism more generally, albeit that it adopted a largely facilitative approach, calling for closer monitoring.367 The pre-​financial-​crisis policy debate also engaged the ‘retailization’ of AIF investments, with the UCITS Review seeing extensive discussion on whether a new regulatory regime should be developed to accommodate easier retail access to AIFs and to strengthen investor protection, reflecting a febrile discussion at the time on retail investor exposure to hedge fund risk.368 While this initiative was soon becalmed369 and did not survive the financial

363 See generally Wymeersch, E, The Regulation of Private Equity, Hedge Funds and State Funds, Financial Law Institute WP No 2010-​06 (2010), available at . 364 The May 2007 ECOFIN Council adopted a resolution on hedge funds which acknowledged their role in supporting market efficiency, stressed the potential risks they posed, noted indirect supervision through monitoring of the exposure of credit institutions (prime brokers) to hedge funds, and supported a review of retail access: 2798th Council Meeting, ECOFIN Council Conclusions on Hedge Funds, 8 May 2007. 365 Political criticism was particularly strong in France and Germany, with then presidential candidate Sarkozy calling for a tax on speculative capital movements: Arnold, M, ‘Sarkozy Aims to Push for European Tax on Hedge Funds’, Financial Times, 14 February 2007. In Germany, hedge funds came in for significant opprobrium (a widely reported remark by the Minister for Labour in 2005 likened hedge funds to locusts), related in part to the success of the highly activist The Children’s Fund in scuppering Deutsche Börse’s bid for the London Stock Exchange. Germany’s calls for conduct and transparency standards for the hedge fund industry failed at the May 2007 G8 meeting following US and UK opposition. 366 eg ECB, Financial Stability Review (2006). 367 Purvis Report (ECON Committee) on the Future of Hedge Funds and Derivatives, 17 December 2003 (A5–​ 0476/​2003); European Parliament Klinz II Resolution on Asset Management, 13 December 2007 (P6_​TA(2007) 0627); and European Parliament Van den Burg II Resolution on Financial Services Policy 2005–​2010, 11 July 2007 (P6_​TA-​(2007) 0338). 368 The debate drove the Commission’s Expert Group on Alternative Investments to call for a ‘rational and dispassionate debate on the conditions under which retail access to hedge-​fund-​based investments could be contemplated’: Report of the Alternative Investment Expert Group Report, Managing, Servicing, and Marketing Hedge Funds in Europe (2006) 6. The leading consumer stakeholder FIN-​USE, by contrast, was ‘alarmed’ by the Expert Group’s broadly facilitative approach: FIN-​USE, Response to the Report of the Alternative Investment Expert Group—​Managing, Servicing and Marketing Hedge Funds in Europe (2006) 1. 369 The 2006 Investment Funds White Paper took a restrained approach, committing only to studying retail access to alternative investments: n 55, 12. A major study on retailization in the non-​UCITS sector was published in 2008 but action was suspended with the advent of the financial crisis: PriceWaterhouseCoopers, The Retailization of non-​Harmonized Investment Funds in the European Union. Prepared for the European Commission (2008).

298  Collective investment Management crisis, it underscores the broadly facilitative approach taken to AIFs immediately prior to the crisis.

III.5.2.2 The Global Financial Crisis and the AIFMD Negotiations Over 2008 and as the financial crisis deepened, institutional positions in the EU shifted rapidly, reflecting the changed political environment and the international reform agenda (as expressed by the November 2008 Washington G20 commitment to ensuring that all financial markets, products, and participants were subject to appropriate regulation). The European Parliament’s position hardened over autumn 2008, with it adopting a resolution calling for the regulation of hedge funds and private equity.370 The Commission initially refused to accede to the Parliament’s request for action, but in December 2008, in response to the changed EU and international climate, and in something of a rearguard action, issued a consultation on hedge fund regulation which highlighted the financial stability risks associated with hedge funds and with the prime broker credit risk transmission channel, but which did not commit to extensive regulation of the AIFM sector.371 The momentum for reform continued to build in spring 2009, but by then reform was being cast in terms of AIF/​AIFM regulation generally to reflect the November 2008 Washington G20 commitment to address unregulated sectors. ECOFIN political support for regulation to be extended to hedge funds but also to other AIFs372 followed and was endorsed by the spring 2009 European Council.373 Following internal political machinations,374 the Commission’s Proposal for what would become the AIFMD was adopted in April 2009 and marked the start of protracted and bruising political negotiations in the European Parliament and Council, as well as between the Commission, Parliament, and Council in the subsequent trilogue negotiations.375 The Proposal was designed to extend appropriate regulation and oversight to the AIF/​ AIFM sector, but also had an eye to shaping the emerging international response.376 Although it noted that AIFs and AIFMs generally had not caused the financial crisis, it highlighted the range of financial stability, investor protection, market efficiency, and market integrity risks which could arise and suggested that these had crystallized in the case of hedge funds (which had contributed to market volatility by unwinding large, leveraged positions in response to tightening credit conditions). Although the Commission was more sanguine in relation to private equity funds, and acknowledged they did not contribute

370 Resolution with Recommendations to the Commission on Hedge Funds and Private Equity, 23 September 2008 (P6_​TA-​PROV(2008) 0425) (based on the earlier Rasmussen Report (for the ECON Committee) with Recommendations to the Commission on Hedge Funds and Private Equity, 22 September 2008 (A6-​0338/​2008)). 371 Commission, Consultation Paper on Hedge Funds (2008). 372 ECOFIN, Key Issues Document for the Spring 2009 European Council, 5 March 2009 (Council Document 6784/​1/​093). 373 European Council Conclusions, 19–​20 March 2009 (7880/​1/​09 Rev 1). 374 The Financial Times reported that the Proposal was ‘forged in a backroom deal between socialist groups in the European Parliament and [Commission President] Barosso’: Editorial, Financial Times, 15 April 2010. 375 The 2011 AIFMD negotiations have been subject to extensive review. See, eg, Woll, C, ‘Lobbying under Pressure: the Effect of Salience on EU Hedge Fund Regulation’ (2012) 51 JCMS 55, Ferran, n 356, and Quaglia, L, ‘The “Old” and “New” Political Economy of Hedge Fund Regulation in the EU’ (2011) 34 West European Politics 665. 376 The Commission hoped that the Proposal would make an important contribution to the global approach to the supervision of the AIFM/​AIF industry (AIFMD Proposal, n 347, 4), while the accompanying Press Release trumpeted the Proposal as the ‘first attempt in any jurisdiction to create a comprehensive framework for the direct regulation and supervision of the alternative fund industry’: Commission Press Release, 29 April 2009.

III.5  The AIFMD  299 to financial stability risks, it highlighted the wider economic impact of the ongoing contraction in private equity funding on the highly leveraged companies which drew on such funding. Side-​stepping the severe definitional difficulties posed by the legislative capture of hedge funds and private equity funds, the Commission proposed that the new regime apply to ‘non-​UCITS’ funds generally to avoid the otherwise significant regulatory arbitrage risks. The Proposal presented a detailed template for AIFM regulation, based on the earlier UCITS and MiFID I collective and discretionary investment management frameworks, and covering operational, organizational, liquidity, leverage, and asset custody regulation. Although much of this template was adopted under the AIFMD, the Proposal was greeted by a firestorm of criticism377 and generated widespread industry (and, in some quarters, political) hostility as an overly blunt measure which threatened to seriously disrupt the EU’s AIF market.378 Certainly, the regulatory challenge was immense. The febrile political, market, and institutional environment, and the tangle of objectives and rationales related to the Proposal, were not conducive to effective rule-​making—​which was all the more difficult given the elusive quality of the AIF and AIFM sector, and the technical challenges posed by leverage, liquidity, and depositary regulation in particular. As the negotiations developed, different and parallel Council and European Parliament drafts introduced further difficulties as well as enhancements.379 The leverage, delegation, depositary, disclosure, and third country rules, in particular, were subject to repeated and often conflicting revisions across the different texts as the institutions liberalized or tightened the rules. The Parliament’s initial November 2009 ECON Report introduced significant technical nuance to the Commission’s Proposal,380 but it fuelled controversy by, inter alia, proposing radical restrictions on short selling, although it was overall regarded as refining the regime.381 Council negotiations were extremely difficult (although alliances shifted depending on the issues at hand, the UK—​the centre of the EU’s hedge fund industry—​generally led the efforts to dilute the Proposal, while France and Germany were most strongly associated with toughening the Proposal) and stretched across three Council Presidencies.382 During the trilogue discussions, negotiations remained difficult, with the European Parliament concerned in particular to strengthen the depositary regime and the private equity fund requirements (notably the asset stripping rules), and Council difficulties with respect to the third country regime.383 377 Commissioner Barnier was subsequently reported as conceding that the Proposal had been rushed and badly drafted: Parker, G and Tait, N, ‘City Purrs After Charm Offensive’, Financial Times, 3 March 2010. 378 The Financial Times reported on the ‘accusations of protectionism, anti-​Anglo-​Saxon bias and unnecessary meddling’ and on the proposal being regarded as motivated by ‘deep seated envy in continental Europe of London’s success’: Woolfe, J, ‘Brussels Official Faces Up to Sharp Criticism of “Ogres” ’, Financial Times Fund Management Supplement, 27 July 2009. 379 A comparative table of the main points of difference between the final Commission, Parliament, and Council texts was set out in ECON Committee, Background Note on the AIFMD 7–​9 (AIFMD Comparative Table). 380 Including with respect to the initial capital regime, the valuation regime, the depositary regime, and the leverage rules (in respect of which it suggested a disclosure-​based regime and limited the scope of the Commission’s proposed leverage-​limit-​setting powers). 381 eg Ferran, n 356. 382 The UK’s agreement was reported as being linked to its concern not to deploy any further political capital on a measure which was strongly supported by France and Germany, given the need to keep capital for the parallel negotiations on the ESAs: Parker, G, Tait, B, and Jones, S, ‘Osborne Bows to EU Hedge Fund Rules’, Financial Times, 19 May 2010. 383 The last-​minute sticking-​points in the trilogue negotiations in October 2010 included the asset stripping regime for private equity funds: Tait, N and Arnold, M, ‘Brussels Agrees Hedge Fund Rules’, Financial Times, 27 October 2010.

300  Collective investment Management Agreement was finally formalized with the Parliament’s adoption of the agreed text on 11 November 2010.384 The negotiations remain a paradigmatic example of how different varieties of capitalism can shape pillar single rulebook measures.

III.5.2.3 The Post Global Financial Crisis Agenda and the AIFMD The AIFMD negotiations were among the most difficult in the history of the single rulebook. Nonetheless, and in a vindication of its related administrative rule-​making process in particular, the AIFMD has, since its adoption, become embedded within EU financial markets regulation with little angst. Similarly, the ongoing alignment of the UCITS regime to the more extensive rules of the AIFMD regime is a testament to the extent to which the AIFMD has come to shape fund regulation in the EU. Shortly after its 2011 adoption, hostility to the AIFMD was already abating.385 Since then, the AIFMD, has been more or less stable. The post-​financial-​crisis development of the AIFMD has, like that of the UCITS regime, been shaped by three forces, the management of financial stability risks, technocracy, and the CMU agenda, all of which can be associated with the AIFMD Review and the related 2021 AIFMD/​UCITS Proposal. The capacity of the AIF sector to generate leverage and liquidity risks which can amplify financial stability risks has shaped much of the regulatory debate since 2011. Over 2016–​ 2018, the ESRB, through its regular monitoring of non-​bank financial intermediation risk, noted the increasing stability risks posed by the AIF sector as it grew, given in particular the higher levels of leverage carried by hedge funds and real estate funds,386 but also the liquidity risks associated with open-​ended real estate funds. In response, it adopted a 2018 Recommendation which called for, inter alia, harmonized rules governing liquidity management tools, ESMA Guidelines on liquidity stress testing, and ESMA Guidelines on leverage limits.387 Liquidity management tool reforms followed with the 2021 AIFMD/​ UCITS Proposal, while ESMA Guidelines for AIF (and UCITS) liquidity stress testing and ESMA Guidelines on the imposition by NCAs of leverage limits (providing guidance on the related AIFMD Article 25 ;(section 5.10)) followed in 2020 and 2021, respectively.388 The AIFMD regulatory regime has not, however, come under undue strain as regards the management of financial stability risks. Its extensive liquidity risk management requirements (which are more granular than those applicable to UCITSs) and its leverage requirements stood up relatively well to the March 2020 market turbulence. While some liquidity mismatch risk was identified in open-​ended real estate funds,389 this segment did 384 The Directive and its administrative rules were to be implemented by 22 July 2013. It applied to all new AIFMs and AIFs as at that date, but existing AIFMs did not become subject to the rules until 22 July 2014. 385 eg Slaughter and May, The Alternative Investment Fund Manager Directive: A Tolerable Compromise? (2012), suggesting that while the AIFMD would curtail operational freedom and bring costs, it was ‘not all bad news’ and should improve ease of access to EU investors: at 1. The AIF industry was also reported to regard the AIFMD as a viable way forward: Sullivan, R, ‘Industry Mulls over Alternatives Directive’, Financial Times Fund Management Supplement, 22 November 2010. 386 The hedge fund sector aside, EU AIFs tend not to be highly leveraged: 2022 ESMA AIF Report, n 18, 6, reporting that hedge funds carry gross leverage of some 548 per cent of NAV, as compared to 141 per cent for real estate funds and 120 per cent for funds of funds, 387 2018 ESRB Recommendation, n 47. 388 ESMA, Guidelines on Liquidity Stress Testing in UCITS and AIFs (2020) (these highly technical Guidelines address the operational modalities of stress testing); and ESMA, Guidelines on Article 25 of the AIFMD (2021) (the Guidelines address how NCAs are to assess leverage-​related risk and the imposition of leverage-​related limits on AIFs, in accordance with AIFMD Art 25). 389 ESRB, EU Non-​Bank Financial Intermediation Risk Monitor No 6 August (2021) 4.

III.5  The AIFMD  301 not experience significant redemption pressure and used liquidity management tools to a limited extent only.390 As suggested by the ESRB’s close monitoring of the AIF sector and by its adoption of related Recommendations which have shaped soft law and the legislative reform process,391 technocratic influence on the AIFMD has been strong. ESMA has adopted extensive soft law (which includes several sets of Guidelines) and has also established a significant data-​ hub on the AIF sector which informs its supervisory convergence action as well as the regulatory reform process.392 Also, the CMU agenda has sought to strengthen the AIF market, in particular by seeking to reduce regulatory barriers to cross-​border AIF distribution through the 2019 Refit Package reforms (section 3.2.2) which include a pre-​marketing regime to allow AIFMs to test market appetite for new funds (section 5.7.4). These forces (the financial stability agenda, technocracy, and CMU) also all shaped the AIFMD Review which led to the 2021 AIFMD/​UCITS Proposal, the most significant reform to date. Mandated by the AIFMD’s review clause,393 the Review was accompanied by a series of analyses394 and culminated in the Commission’s June 2020 AIFMD Report. It found that the regime was a ‘significant pillar’ of CMU, facilitated the improved monitoring of risks to the financial system as well as the cross-​border raising of capital for investment in alternative assets, and was working well, but that a series of enhancements could be made.395 The Commission argued that while the EU AIF market had experienced continuous growth since 2011, facilitated by the AIFMD passport, passporting was impaired by a series of frictions;396 and while the Directive’s regulatory scheme was assessed as working well, including as regards the support of financial stability,397 the absence of a depositary passport was hindering cross-​border distribution and generating concentration risk.398 The subsequent 2021 AIFMD/​UCITS Proposal399 is relatively 390 ESMA reported that only two open-​ended real estate funds suspended redemptions (in June 2020) and that more generally there was limited reliance on liquidity management tools, albeit that some funds experienced valuation difficulties: 2021 ESMA AIF Report, n 361, 9–​10. 391 Alongside the 2018 Recommendation, the ESRB also adopted a 2020 Recommendation on investment fund liquidity risks (n 140) which called for ESMA’s subsequent review of the management of liquidity risk over the early 2020 market turbulence. 392 ESMA has, since 2019 and supported by the extensive supervisory reporting required under the AIFMD, published an annual report on the AIF sector as well as regular reports on the real estate exposure of AIFs. 393 AIFMD Art 69 required that the Commission commence a review of the Directive by July 2017. 394 Including Report on the Operation of the AIFMD (FISMA/​2016/​105(02)/​C) (2018) (2018 KPMG Report), as well as a series of ESMA reports, including its annual reports on the AIF sector, its 2017 review of home/​host NCA cooperation (n 339), and its reports on the operation of the AIFMD third country regime (see Ch X section 5). 395 This assessment reflected the KPMG Report which, drawing on an extensive survey of stakeholders including AIFMs, investors, depositaries, AIF distributors, and NCAs, found that the Directive had facilitated the creation of an internal market for AIFs and AIFMs and did not find evidence of major difficulties with the regime, although it noted widespread industry dissatisfaction relating to the volume of reporting required. 396 Including in relation to host State marketing rules (which the Refit Package is designed to address) but also the limited scope of the AIFMD passport, which cannot be used for retail distribution (albeit that the retail distribution of AIFs is primarily through MiFID II-​scope firms and advisers): 2020 Commission AIFMD Review, n 361, 5–​6. 397 The subsequent Proposal suggested that the AIFMD had performed well over the early 2020 Covid-​19 pandemic period of volatility, with only some €5 billion of assets being subject to liquidity management tools, and only fifty-​six of 30,357 AIFs being liquidated or entering into liquidation: 2021 AIFMD/​UCITS Proposal IA, n 33, 10. 398 The Commission reported that, depending on local market structure, a single depositary could hold all the assets of AIFs authorized in a particular Member State: 2020 Commission AIFMD Review, n 361, 7. 399 n 30 . It was preceded by a Commission consultation: Commission, Consultation on the Review of the AIFMD (2020).

302  Collective investment Management restrained.400 Its most significant reforms are a new regime governing loan origination by AIFs, designed to support CMU by expanding market-​based financing sources and by diversifying and supporting liquidity in the credit markets, but also to support financial stability by securing a solid regulatory framework for the developing fund loan origination market (section 5.10); and a new liquidity management tools framework (section 5.9). Reflecting the generally modest aims of the Proposal, both reforms are designed as framework measures, albeit supported by administrative rules which may come to thicken the reforms. Similarly, rather than engaging in adventures in depositary regulation and in depositary passport design, the Proposal has, in response to some capacity constraints in the home AIF Member State depositary populations from which depositaries must be drawn, suggested a relaxation of the depositary rules to allow an AIFM to procure depositary services on a cross-​border services basis (section 5.11). Following a decade or so after the tumultuous AIFMD negotiations, the relatively modest reach of the 2021 Proposal suggests that the AIFMD has proved workable in practice.401 Certainly, the AIF market has grown, although this does not necessarily imply that the AIFMD has been an enabler.402 By 2020, AIF NAV represented over €5.9 trillion (some one-​third of the EU fund industry), up from €4.9 trillion in 2017.403 In a sign of the diversity of the market, ‘other AIFs’ represented the largest share of the market (62 per cent),404 followed by funds of funds (typically investing in bond and equity UCITSs) (15 per cent), real estate funds (13 per cent), private equity funds (6 per cent), and, the most highly leveraged asset class, hedge funds (2 per cent).405 That major regulatory design weaknesses have not emerged (including over the March 2020 market turmoil) can be related in part to the testing negotiation process from which the AIFMD emerged; the AIFMD emerged from a process through which the bulk of its most initially troubling features were removed and nuance was introduced.406 It can also be related to the resilience of the AIFMD’s manager-​ oriented regulatory design which, despite is intricacy and technical complexity, requires less regulatory engineering than the product design approach on which the UCITS regime is based; as well as to the now significant technocratic capacity, primarily in the form of ESMA but also the ESRB, that supports the AIFMD through risk monitoring, soft law adoption, and supervisory convergence.

400 The Proposal noted that the Review had suggested that the AIFMD was generally meeting its objectives; and that the proposed reforms were improvements designed to target areas that had not been sufficiently addressed when the Directive was originally adopted: n 30, 2 and 6. 401 The KPMG review found that ‘the AIFMD has played a major role in helping to create an internal market for AIFs and a harmonised and stringent regulatory and supervisory framework for AIFMs . . . most areas of the provisions [of the AIFMD] are assessed as having contributed to [the] achievement of the specific and operational objectives [of the AIFMD], to have done so effectively, efficiently, and coherently, to remain relevant and to have EU added value: n 394, 20. 402 Although stakeholder opinion has been supportive: n 394. 403 Albeit down on 2019 given the withdrawal of the UK: n 361. 404 ‘Other AIFs’, a classification used by ESMA, use a wide diversity of investment strategies, typically based on equity and fixed income investment. 405 2022 ESMA AIF Report, n 18. 406 eg Herbert Smith, The AIFMD. Case Studies and Reference Manual (2011) 3, noting the ‘long, difficult, but ultimately largely successful battle to remedy the Directive’s most worrying shortcomings’.

III.5  The AIFMD  303

III.5.3  The AIFMD Rulebook: Legislation, Administrative Rules, and Soft Law Despite its scale and intricacy,407 the 2011 AIFMD is not formally a maximum harmonization measure.408 Any such ambition would have been impractical given the multiplicity of AIFs and AIFMs which it covers. The Directive accordingly expressly refers to Member State rules in places, including with respect to the de minimis regime (Article 3), reporting to NCAs (Article 24(5)), and valuation (Article 19). The Directive is also calibrated in that NCAs are to apply some of its requirements subject to a proportionality principle, notably with respect to risk management. Nonetheless, it achieves a very high level of harmonization409 and is, for a legislative measure, highly detailed.410 It has also been amplified to a very significant extent.411 The 2013 Delegated AIFMD Regulation412 is the centrepiece of the administrative rulebook and addresses a host of key operational areas, including the key calculation of AUM, which drives the AIFMD’s exemption regime; the method and calculation of leverage; the initial own funds regime; operating conditions for AIFMs; investment in securitized positions; organizational requirements; valuation; delegation; the depositary;413 transparency requirements; third country rules; and information exchange between NCAs. The Delegated Regulation is accompanied by administrative rules of more limited scope which address the AIFMD’s ‘opt-​in’ procedure,414 types of AIF,415 NCA reporting to ESMA,416 and the third country regime.417 As is the case with the UCITS regime, ESMA’s soft law measures have materially thickened this rulebook. ESMA has, for example, adopted several sets of Guidelines,418 typically of quasi-​regulatory colour (the 2014 AIFMD Reporting Guidelines, for example, supplement the already detailed AIFMD reporting requirements and include over 130 specific guidelines directing how firms should provide AIFMD disclosures), and, alongside,

407 Only its main features are accordingly covered in this discussion. 408 The Commission has described it as a minimum standards measure: 2012 Delegated AIFMD Regulation Proposal (C(2012) 8370) 2. 409 The AIFMD Review did not find major difficulties as regards diverging national approaches to the implementation of the Directive. While stakeholders identified divergences, they did not support additional large-​scale harmonization as a mitigant: 2018 KPMG Review, n 394, 21. 410 Leading the Commission to highlight that its discretion in adopting the administrative regime was limited as a result: 2012 Delegated AIFMD Regulation Proposal IA (SWD(2012) 386) 62. 411 The first suite of AIFMD administrative rules was among the first of the rules to be adopted following the establishment of ESMA (and so to use the then-​new BTS process and also to engage ESMA in providing technical advice on delegated acts) and accordingly experienced some ESMA/​Commission tensions as the new process bedded in. For further discussion see Moloney, N, The Age of ESMA. Governing EU Capital Markets (2018) Ch 3. 412 Delegated Regulation (EU) No 231/​2013 [2013] OJ L83/​1. A regulation was employed in order to reduce the costs of cross-​border activity, ensure uniform requirements applied given the systemic risks posed by some fund managers, and given the detailed operational calculations and methodologies required, particularly with respect to leverage and reporting: 2012 Delegated AIFMD Regulation Proposal, n 408, 4. 413 The Delegated Regulation was amended as regards the regulation of the depositary in 2018 by means of Delegated Regulation (EU) 2018/​1618 [2018] OJ L271/​1. 414 Implementing Regulation (EU) No 447/​2013 [2013] OJ L132/​1. 415 RTS 694/​2014 [2014] OJ L183/​18 (the 2014 AIF Types RTS) 416 Delegated Regulation (EU) 2015/​514 [2015] OJ L82/​5. 417 Implementing Regulation (EU) No 448/​2013 [2013] OJ L132/​3. The third country regime is considered in Ch X. 418 Guidelines on Art 25 AIFMD (leverage reporting) (2021); Guidelines on Liquidity Stress-​Testing in UCITS and AIFs (2020); Guidelines on Performance Fees in UCITS and Certain Types of AIF (2020); Guidelines on AIFMD Reporting (2014); Guidelines on Key Concepts of the AIFMD (2013); and Guidelines on Sound Remuneration Policies under the AIFMD (2013, revised 2016).

304  Collective investment Management maintains a regularly revised AIFMD Q&A and adopts Opinions on the operation of the AIFMD.419

III.5.4  The Directive: Objectives The AIFMD lay down rules for the authorization, ongoing operation, and transparency of managers of alternative investment funds (AIFMs) which manage and/​or market alternative investment funds (AIFs) in the EU (Article 1). Of wide reach,420 its objective is the establishment of common requirements governing the authorization and supervision of AIFMs in order to provide a coherent approach to the related risks and their impact on investors and markets in the EU (recital 2).421 It accordingly seeks to ensure that AIFMs are subject to supervision, to improve the monitoring of systemic risk generated in the AIF sector, to enhance risk management, to ensure a common approach to investor protection (through disclosure, conduct, and fair treatment rules), and, specifically with respect to private equity funds, to bring greater public accountability to bear on funds in relation to investments in firms.422 By contrast with the UCITS regime, the Directive has a macroprudential quality.423 It applies a macroprudential tool-​kit (novel at the time of the Directive’s adoption) to leverage risks, based on leverage monitoring and the empowerment of NCAs to adopt leverage limits (section 5.10).

III.5.5  Calibration and Differentiation The AIFMD has a vast scope. It captures the collective investment management of in excess of 30,000 funds managed by the AIFMs within its scope, including funds of funds, real estate funds, hedge funds, private equity funds, and other non-​UCITS funds (including commodity and infrastructure funds), and so the wide range of investment strategies that characterizes the AIF market.424 Accordingly, the AIFMD regime is designed as a framework collective investment management regime. Certain of its rules are calibrated to different types of AIF and AIFM, and in particular to whether AIFs are open-​or closed-​ended (both of which funds are within the scope of the AIFMD),425 given that open-​ended funds are most exposed to liquidity risks. The valuation regime, for example, tailors the rules applicable to whether an AIF is open-​or closed-​end (Article 19(3)). Similarly, the liquidity management rules apply only to AIFs other than 419 A May 2021 ESMA Opinion, eg, recommends that NCAs require additional reporting on systemic risks from AIFMs to supplement the reporting already required under the AIFMD rulebook and its Guidelines. 420 The Directive addresses AIFMs but also prime brokers (albeit that they are primarily regulated under MiFID II), depositaries, providers of AIF valuation services, AIF administrators, and, in the case of private equity funds, the boards of directors of the portfolio companies in which private equity funds invest. 421 More recently, the 2021 AIFMD/​UCITS Proposal characterized the AIFMD as seeking a coherent supervisory approach to the risks that the activities of AIFs may generate and to provide high-​level investor protection while facilitating the integrating of AIFs in the EU market: n 30, 1. 422 As summarized by the Commission in the IA for the 2012 Delegated AIFMD Regulation Proposal: n 410, 14. 423 On macroprudential regulation see n 22. 424 ESMA’s 2022 AIF Report recorded a total of 30,035 AIFs in the EU, composed of 5,362 funds of funds, 3,978 real estate funds, 930 hedge funds, 4,992 private equity funds, and 14,324 ‘other’ AIFs: n 18. 425 See n 35 on open-​ended funds.

III.5  The AIFMD  305 unleveraged closed-​end funds (Article 16(1)). The 2014 AIFM Types RTS amplifies the meaning of open-​ended and closed-​end in the AIFMD context, providing that an AIFM manages an open-​ended AIF where the shares or units are, at the request of shareholders/​ unitholders, repurchased or redeemed prior to the commencement of its liquidation or wind-​down, directly or indirectly, out of the assets of the AIF and in accordance with the AIF’s constitutive documents or prospectus/​offering disclosures.426 A specific regime applies to the management of private equity funds (section 5.13). More generally, the regime embeds proportionality mechanisms, given the wide range of AIFMs and AIFs within its scope. The de minimis exemption (section 5.7.2) is designed to remove managers of smaller funds with lower potential for systemic risk from the AIFMD’s scope (albeit that this exemption also removes the AIFMD passport).427 Similarly, the application of some provisions, particularly with respect to risk management, is calibrated to the size and organization of the AIFM and the nature, scale, and complexity of the AIFs under management.428

III.5.6  Setting the Perimeter: Scope Under Article 1, the Directive lays down rules governing the authorization, ongoing operation, and transparency of AIFMs which manage and/​or market AIFs in the EU. ‘AIFs’ are accordingly one of the triggers for the Directive’s application to collective investment managers. They are very widely defined as collective investment undertakings429 which raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors, and which do not require authorization under the UCITS Directive (Article 4(1)(a)).430 The use of this ‘non-​UCITS’ definition to frame the AIFMD is pragmatic and avoids the definitional contortions which capturing the nature of AIFs with sufficient certainty for the purposes of regulation would have required.431 But it has powerful centripetal effects, pulling in a multiplicity of very different funds, including funds which invest in less liquid assets (such as hedge funds, property 426 2014 AIFM Types RTS Art 1(2). The RTS also specifies that a decrease in the capital of an AIF that is connected to distribution is not to be taken into account for the purposes of establishing if an AIF is open-​ended, and that whether an AIF’s shares or units are traded on the secondary markets (and not repurchased/​redeemed by the AIF) is also not to be taken into account for such purposes. 427 A disadvantage noted by the AIFMD Review but which has not prompted proposals to change the relevant thresholds: 2020 Commission AIFMD Review, n 361, 5. 428 The risk management and compliance requirements, in particular, can be adjusted for smaller AIFMs, as long as conflict-​of-​interest risks are appropriately managed. As regards risk management see, eg, 2013 Delegated AIFMD Regulation Arts 42–​3 and 45, reflecting AIFMD Art 15(1) which provides that the functional and hierarchical separation by AIFMs of risk management functions is to be reviewed by NCAs in accordance with the proportionality principle. The remuneration regime is also designed to reflect the different features of AIFMs and the AIFs they manage (AIFMD recital 24). Relatedly, ESMA’s detailed 2013 AIFMD Remuneration Guidelines are designed to apply proportionately and to reflect the nature of the AIFM in question; the proportionality assessment by the AIFM may lead to certain guidelines being disapplied (n 418, 10–​12). 429 Including investment compartments thereof. 430 The AIF’s structure (closed-​or open-​ended), form (whether based on the law of contract, trust law, corporate law, or otherwise), and legal structure do not have a bearing on whether such a fund is in scope (Art 2(2)). The 2013 ESMA Key Concepts Guidelines address several concepts relevant to the definition of an AIF, including ‘defined investment policy’, ‘number of investors’, ‘raising capital’, and ‘collective investment undertaking’. 431 Formally justified as necessary to establish a framework capable of addressing the risks that many AIFM strategies can generate, taking into account the diverse range of investment strategies and techniques employed by AIFMs: recital 3.

306  Collective investment Management funds, infrastructure funds, commodity funds, and private equity funds) and more traditional funds (including equity funds, which, because of their design, fall outside the UCITS regime). The range of assets, investment strategies, and risk profiles engaged by the AIFMD is accordingly immense. AIFMs, the subject of the AIFMD, are defined as legal persons whose regular business is the managing of one or more AIFs (Article 4(1)(b)). ‘Managing of AIFs’, is defined in terms of the AIFM performing at least portfolio management or risk management services for one or more AIFs.432 ‘Marketing’, which is relevant in particular for the EU AIFM passport and for how the AIFMD applies to non-​EU AIFMs (Chapter X), is defined in terms of a direct or indirect offering or placement at the initiative of the AIFM, or on behalf of the AIFM, of units or shares in an AIF which it manages, to or with investors domiciled or with a registered office in the EU.433 Unlike the UCITS regime which is product-​oriented, the AIFMD does not address the AIF itself directly or confer any form of regulatory brand on the AIF,434 but regulates the fund manager. That the manager anchors the Directive’s regulatory scheme is clear from Article 5(1), which provides that each AIF managed within the scope of the Directive must have a single AIFM responsible for compliance with the Directive. The AIFM can either take the form of an external manager appointed by the AIF or on its behalf, or, where the legal form of the AIF permits internal management, the AIF itself, which must accordingly be authorized as an AIFM (Article 5(1)).435 Only limited exemptions are available from the Directive’s scope.436 A discrete and light-​ touch de minimis regime, however, applies to two types of AIFM (Article 3(2)): AIFMs managing portfolios of AIFs437 whose AUM,438 including assets acquired through the use of leverage, do not exceed €100 million; and AIFMs managing portfolios of AIFs whose AUM do not exceed €500 million, where the AIFs are unleveraged and have no redemption rights exercisable within five years of the initial investment in each AIF (and accordingly have lower liquidity risk profiles). These de minimis thresholds are designed to take smaller funds with less potential for systemic risk almost entirely outside the scope of the Directive. Where the AIFM falls into these categories, a light-​touch, registration-​based regime applies. Since the adoption of the AIFMD, three bespoke regimes have developed for smaller AIFs (EuVECAs, EuSEFs, and ELTIFs) which provide regulatory but also passporting systems for their AIFMs given the capital-​raising potential of these funds (section 6). The jurisdictional scope of the Directive (Article 2(1)) is equally wide as outlined further in Chapter X. The Directive applies to EU AIFMs439 which manage one or more AIFs, 432 Art 4(1)(w). 433 Art 4(1)(x). 434 AIF-​related regulation remains a national competence: recital 10. 435 Where the external AIFM is unable to ensure compliance, it must immediately inform the relevant NCAs and, ultimately, must resign (Art 5(2) and (3)). 436 Including for holding companies; occupational retirement schemes; employee participation schemes or employee saving schemes; public authorities such as the ECB and national central banks; national, regional and local governments; and securitization special purpose entities: Art 2(3). The AIFMD is also disapplied from intra-​group activities where the AIFM manages only AIFs whose only investors are the AIFM, its parent companies, its subsidiaries, or subsidiaries of the parent: Art 3(1). 437 The de minimis regime applies in relation to AIFs which are either directly or indirectly, through a company with which the AIFM is linked by common management or control, or by a substantive direct or indirect holding, managed by the AIFM. 438 The calculation of AUM is addressed by the 2013 Delegated AIFMD Regulation Arts 2–​5. Reflecting the importance of this calculation for the scope of the Directive, AUM must be constantly monitored. 439 Defined as an AIFM which has a registered office in the EU: Art 4(1)(l).

III.5  The AIFMD  307 irrespective of whether such AIFs are EU or non-​EU AIFs. But it also applies to non-​EU AIFMs which manage one or more EU AIFs or which market one or more AIFs in the EU, irrespective of whether the AIFs are EU or non-​EU; only non-​EU AIFMs of non-​EU AIFs which are not marketed in the EU escape the reach of the Directive.

III.5.7  Authorization and the AIFM Passport III.5.7.1 AIFM Authorization and the Home Member State At the heart of the Directive is the obligation on Member States to ensure that no AIFMs manage AIFs unless they are authorized (Article 6(1)). Non-​AIFM investment firms and credit institutions are not required to secure special AIFMD authorization to provide services such as discretionary investment management services to AIFs (MiFID II governs these services), but units of AIFs may not be offered to or placed with investors by such firms (through investment advice services or execution platforms, for example), unless the AIF is marketed by the AIFM in accordance with the Directive (Article 6(8)). A central register of all authorized AIFMs is maintained by ESMA (Article 7(5)). As across the single rulebook, authorization is the responsibility of the AIFM’s home Member State (Article 7(1)), defined as the AIFM’s Member State of registration (in effect, the NCA of the home Member State is responsible for authorization). AIFMs must comply with the authorization conditions at all times and provide home NCAs with the information required to monitor compliance with the authorization conditions (Article 6(1) and (7)). The authorization process is broadly similar to that which applies to discretionary investment managers under MiFID II, and to UCITS collective investment managers under the 2009 UCITS IV Directive, albeit calibrated to the particular risks posed by alternative investment management. The authorization application, for example, must include information on remuneration policies and practices, as well as on delegation arrangements, along with the information typically required across the single rulebook in relation to management, qualifying shareholders, and programme of activities, including compliance arrangements (Article 7(2)). Additionally, AIFMs must provide extensive information on the AIFs managed, including with respect to: investment strategies, use of leverage, risk profiles, and the Member States or third countries in which the AIFs are established; master-​feeder AIFs; the rules and instruments of incorporation of the AIFs; and depositary monitoring arrangements (Article 7(3)).440 The authorization conditions also share many of the features of the UCITS regime for UCITS collective investment managers and of the MiFID II regime for discretionary investment managers. AIFMs are, for example, limited in the range of activities they can carry out. To promote strong incentive alignment, internal and external AIFMs can only carry out the investment management activities listed in AIFMD Annex I (external AIFMs can also carry out UCITS management activities).441 Reflecting the structure of the asset management industry, external AIFMs can additionally engage in discretionary investment 440 Where a UCITS Directive-​authorized management company applies to be authorized as an AIFM, it is not required to provide any still current information already provided in the context of its prior authorization: Art 7(4). 441 Art 6(2) and (3). The Annex I activities include portfolio and risk management, as well as AIF administration, marketing, and activities relating to the assets of AIFs and necessary to meet the fiduciary duties of the AIFM, and including real estate administration and advice to undertakings on capital structure.

308  Collective investment Management management, including for institutional clients, and in the identified ‘non-​core’ services of investment advice, safekeeping and administration of shares and CIS units, and brokerage (Article 6(4)), subject to a series of restrictions442 designed to support strong incentives for robust risk management.443 As under the UCITS and MiFID II regimes, AIFMs are subject to requirements relating to ‘fit and proper’ managers, qualifying shareholders, alignment of head office and registered office, and the necessity for any close links between the AIFM and other persons not to prejudice supervision (Article 8(1) and 8(3)). A distinct initial capital regime applies (Article 9).444 Internal AIFMs must have initial capital445 of €300,000 and external AIFMs of €125,000. An additional capital charge related to the value of AUM applies,446 as does a specific capital charge related to potential professional liability risks,447 which has been amplified by the 2013 Delegated AIFMD Regulation.448 Home NCAs may also impose restrictions on the investment strategies of the AIFM’s AIFs (Article 8(4)).

III.5.7.2  De Minimis AIFMs Where the AIFM falls into a de minimis category (Article 3(2)), a light-​touch, registration-​ based regime applies (Article 3(3)) as a safeguard against the risks which the AIFs managed may pose in aggregate. The AIFM must register with its home NCA, identify itself and the AIFs under management, provide the NCA with information on its investment strategies at the time of registration, and thereafter provide the NCA with information on the main instruments in which it trades and on the principal exposures and most important concentrations of the AIFs managed, to enable the NCA to monitor systemic risk. It must also inform the NCA where it no longer meets the de minimis conditions. Member States may apply additional rules to these AIFMs. Article 3(2) de minimis AIFMs do not enjoy passport rights under the Directive but may opt-​in to the Directive,449 thereby triggering passport rights as well as the full range of obligations which apply under the Directive (Article 3(4)).

442 And compliance with the related MiFID II rules governing these services: Art 6(6). 443 AIFMs cannot be authorized to provide only Art 6(4) services, may not be authorized to carry out non-​core services unless they also carry out discretionary investment management services, and may not be authorized to carry out only the administration, marketing, and other AIFM services under Annex I, or to provide AIFM portfolio management services, without risk-​management services, and vice versa: Art 6(5). 444 AIFMs which are also UCITS management companies are not required to meet the capital requirements, save with respect to professional liability risks: Art 9(10). 445 Defined by reference to the own funds identified in the banking rulebook (see further Ch IV sections 9.3 and 9.4). 446 Where the value of the portfolio of AIFs (including AIFs for which the AIFM retains delegated responsibility, but not including those in relation to which it is acting under a delegation) exceeds €250 million, an additional own funds requirement, equal to 0.02 per cent of the amount by which the portfolio exceeds €250 million, applies. This amount is capped at €10 million (Art 9(3)) and AIFMs may benefit from a 50 per cent reduction in these additional capital charges where an equivalent guarantee is provided by an EU-​registered (or equivalent third country) credit institution or insurance company (Art 9(6)). Following the 2019 Investment Firm Directive/​Regulation reform, and tracking the parallel reform to the UCITS regime, the own funds of an AIFM can never fall below the level set by the Investment Firm Regulation (see n 198). 447 AIFMs must either have additional own funds to cover professional liability risks, or hold professional indemnity insurance: Art 9(7). 448 The 2013 Delegated AIFMD Regulation (Arts 12–​15) sets out the conditions applicable to indemnity insurance (including that insurance cover 0.7 per cent of AUM per individual claim) and to the additional own funds required (which must, inter alia, represent 0.01 per cent of the value of AUM). 449 This procedure is governed by the 2013 Implementing ‘Opt In’ Regulation.

III.5  The AIFMD  309

III.5.7.3 The Passport and EU AIFMs Once granted, AIFM authorization is valid for all Member States (Article 8(1)). The AIFMD contains a related passport regime for EU AIFMs:450 with respect to the marketing of EU AIFs451 (Articles 31 and 32); and with respect to the management of EU AIFs (Article 33).452 The definition of the EU AIFM host Member State is accordingly broad.453 The EU AIFM marketing passport for EU AIFs has two elements: the marketing of EU AIFs in the AIFM home Member State (as the AIF may be authorized/​registered/​established in another Member State) (Article 31); and the marketing of EU AIFs in other Member States (Article 32). Under Article 31, Member States must ensure that EU AIFMs can market EU AIFs, which they manage, to ‘professional investors’454 in the AIFM home Member State. Notification requirements apply (to the AIFM home NCA)455 and marketing can only be prevented by the AIFM’s home NCA where the AIFM’s management of the AIF, and the AIFM generally, does not or will not comply with the Directive. The AIFM is required to notify its home NCA of any changes to the disclosures originally provided with the notification. The Article 32 passport for marketing of EU AIFs in other Member States (the AIFM host Member State(s)), which is again available only for marketing to professional investors, is similarly conditional on the AIFM providing the related notification to its home NCA;456 but also on the home NCA’s transmission of the notification to the authorities of the Member States in which it is intended the AIF is marketed (the notification must be in a language common in the sphere of international finance), once the home NCA is satisfied that the AIFM’s management of the AIF, and the AIFM generally, complies with the Directive.457 Marketing rules are the responsibility of the AIFM host Member State. The EU AIFM management passport is addressed by Article 33. The passport applies in relation to the management of EU AIFs which are established outside the AIFM home Member State (and whether management services are provided directly by the AIFM by means of cross-​border services or through a branch).458 Following a MiFID II clarification, the passport also applies to the Article 6(4) discretionary investment management and non-​core services for which the AIFM may be authorized (Article 33(1)). The notification system follows the system deployed across the single rulebook. Management on a services basis requires notification to the home NCA, as does branch-​based management, 450 Defined as an AIFM which has its registered office in a Member State: Art 4(1)(l). 451 Defined widely as an AIF which is authorized or registered in a Member State under the applicable national law, or an AIF which is not authorized or registered in a Member State but which has its registered office or head office in a Member State: Art 4(1)(k). 452 Specific arrangements apply to the marketing of non-​EU AIFs, as noted briefly in Ch X section 5. 453 The host Member State of an EU AIFM is one of the following: a Member State, other than the home Member State, in which an EU AIFM manages EU AIFs; a Member State, other than the home Member State, in which an EU AIFM markets an EU AIF; or a Member State, other than the home Member State, in which an EU AIFM markets a non-​EU AIF: Art 4(1)(r). 454 Defined in accordance with the MiFID II classification regime (see Ch IV). In practice, different approaches to this definition obtain across the EU as regards AIFM passporting and have led ESMA to call for clarification under the AIFMD: 2020 ESMA AIFMD Letter, n 47, 11. 455 The content of the notification required of the AIFM is set out in Annex III to the Directive. 456 The Art 32 notification is similar to the Art 31 notification, but also requires identification of the Member States in which the AIF will be marketed: Annex IV. 457 The home NCA must also include a statement that the AIFM is authorized to manage AIFs with a particular investment strategy. 458 A branch is defined as a place of business which is part of an AIFM but has no legal personality, and which provides services for which the AIFM has been authorized; all places of business established in the same Member State by an AIFM acting on a cross-​border basis are regarded as a single branch (thereby facilitating exercise of the host NCA’s supervisory powers over branches): Art 4(1)(c).

310  Collective investment Management but more detailed information is required of branch-​based activity.459 The home NCA must transmit the notification to the AIFM host Member State for management activities, as long as the management by the AIFM of the AIF(s), and the AIFM generally, complies with the Directive.460 The passport is then available and, accordingly, the host AIFM authority may not impose any additional requirements, within the scope of the AIFMD, on the AIFM. As across the single rulebook, the AIFMD allocates supervisory obligations between the different NCAs engaged (Article 45). In principle, the prudential supervision of the AIFM is the responsibility of the AIFM home Member State, whether or not the AIFM manages or markets AIFs in another Member State. As also is standard across the single rulebook, particular responsibilities are allocated to branch NCAs: the general operating requirements applicable under Article 12 and the Article 14 conflicts of interest regime are the responsibility of the AIFM host NCA where the AIFM manages or markets AIFs through a branch in that Member State. Host AIFM NCAs are empowered to require AIFMs managing or marketing AIFs in their territory to provide the information necessary for the supervision of the AIFM’s compliance with the rules for which the authority is responsible.461 A host NCA precautionary powers regime, based on the model which applies across the single rulebook, also applies. Where the AIFM breaches rules under the responsibility of the host NCA or refuses to provide information required by the host NCA, and the action taken by the home NCA (following a request by the host NCA) is inadequate, the host NCA can take action in respect of the breach, once notification requirements are met.462 Where the rules in question are not the responsibility of the host State but the NCA has ‘clear and demonstrable grounds’ for believing a breach has taken place, the host NCA can still take action (absent an adequate response by the home NCA and subject to notification obligations), but only where the AIFM continues to act in a manner clearly prejudicial to the interests of investors in the AIF(s) or to financial stability and the integrity of the market in the host State.463 ESMA is empowered to mediate between NCAs where disagreements arise related to the Article 45 distribution of NCA power.

III.5.7.4 Facilitating the Passport and the 2019 Refit Reforms The 2019 Refit Package reforms to the AIFMD, part of the CMU agenda, are designed to facilitate passporting. They follow the Refit revisions to the UCITS regime and accordingly include the introduction, by the Refit Directive, of a ‘de-​notification’ procedure (AIFMD Directive Article 32a) which allows AIFMs to withdraw from the cross-​border marketing of an AIF;464 and a new regime, under the Refit Regulation, governing marketing and designed 459 Services-​related management requires disclosure of the Member State in which the management services will be carried out and the programme of operations to be carried out (including an identification of the AIFs). Branch-​related management requires additional disclosures related to the branch’s organizational structure, the address in the AIF’s home Member State from which documents may be obtained, and the names and contact details of those responsible for the branch: Art 33(2) and (3). 460 The AIFM home NCA must also provide a statement to the host NCA that it has authorized the AIFM. 461 Any related information requirements imposed cannot be more stringent than those which the host NCA imposes on its domestic AIFMs. 462 The host NCA may take appropriate action (including administrative measures and penalties) to prevent or penalize further irregularities and, so far as necessary, to prevent the AIFM from initiating further transactions in the host State. The host NCA may also prevent an AIFM from managing AIFs. 463 The host NCA may take all appropriate measures needed to protect the investors in the relevant AIF and the financial stability and integrity of the host State market, including a prohibition on AIF marketing. 464 The conditions are less dense than those that apply to UCITSs, reflecting the professional investor orientation of the AIFMD.

III.5  The AIFMD  311 to establish harmonized minimum standards and thereby to minimize any frictions caused by host Member State marketing requirements. The new marketing regime requires that all marketing communications must be identifiable as such and must describe the risks and rewards of purchasing AIF shares/​units in an equally prominent manner, and that all information in marketing communications must be fair, clear, and not misleading; marketing communications must also specify where information on investor rights can be obtained and must be consistent with disclosures provided to investors (Refit Regulation Article 4(1), (3) and (4)). In addition, NCAs are to publish their marketing requirements and ESMA is to maintain a related central data-​base (Articles 5 and 6). Host NCAs, if they require marketing communications directed to retail investors (where the host Member State permits retail marketing of AIFs) to be approved, are subject to a series of conditions (Article 7(3)). The supervisory fees imposed by host NCAs are also addressed and are subject to the same principles as apply in the UCITS context (Articles 9–​11). ESMA is to maintain a central data-​base of all AIFs marketed cross-​border (Article 12). These marketing requirements follow those applicable under the Refit Regulation to UCITS marketing (section 4.5.3). In addition, the Refit Directive adopted a ‘pre-​marketing’ regime for AIFMs, the need for which had been signalled in the Refit consultation.465 The pre-​marketing regime (AIFMD Directive Article 30a) allows an AIFM to test the market for an AIF, without being subject to host or home NCA conditions. Pre-​marketing466 is permitted as long as the information disclosed through the pre-​marketing is not sufficient to allow investors to commit to acquiring AIF units/​shares; does not amount to subscription forms or similar documents;467 and does not amount to constitutional documents, a prospectus, or other offering document of an AIF which has yet to be established (Article 30a(1)). A draft prospectus or offering document can, however, be used for pre-​marketing, as long as it does not contain sufficient information to allow an investor to take an investment decision; and as long as it clearly states that it does not constitute an offer or invitation to subscribe and that the information presented should not be relied on as it is incomplete and may change (Article 30a(1)). A series of other conditions apply, including as regards the AIFM ensuring that investors do not acquire units/​shares through pre-​marketing; that pre-​marketing is adequately documented; that pre-​marketing, where carried out by third parties, is only engaged in by authorized credit institutions, investment firms, UCITS management companies, AIFMs, or MiFID II tied agents and complies with Article 30a; and that the AIFM sends an ‘informal letter’ to the home NCA regarding the pre-​marketing and containing the specified disclosures.468 The pre-​marketing regime represents a significant innovation in that, in effect, it provides for a non-​notified passport.469 465 The 2017 Commission Barriers Report reported on high levels of legal uncertainty regarding the early stages of fund development and called for a related pre-​marketing regime: n 56, 3–​4. 466 Which is defined as the provision of information on investment strategies or ideas by an EU AIFM (or on its behalf) to potential professional investors to test their interest in an AIF which is not yet established (or established and not notified for marketing under Arts 31 or 32) and which does not amount to an offer or placement to the potential investor: Art 4(1)(aea) 467 Any subscription by professional investors within 18 months of the pre-​marketing is regarded as having been a result of AIFM marketing and is accordingly subject to the Art 31 and 32 notification procedures. 468 The limited information required (within two weeks of the pre-​marketing commencing) relates to the Member States in which and the period over which the pre-​marketing will take place, a brief description of the information disclosed, and the AIFs subject to pre-​marketing. The home NCA must then inform the relevant host NCAs who may request further information. 469 See further Howell, E, ‘Post-​‘Brexit’ UK Fund Regulation: Equivalence, Divergence or Convergence’ (2020) 21 EBOLR 611.

312  Collective investment Management Finally, the Refit reforms (via the Refit Directive) align the AIFMD regime with the UCITS regime by imposing a new requirement for specified facilities to be available in host Member States where an AIF is marketed to retail investors (AIFMD Article 43a),470 reflecting the not immaterial (although still low) levels of retail investment in AIFs.471 The AIFMD passport has been troublesome,472 albeit that the supporting home/​host NCA cooperation and jurisdiction allocation framework appears to be working well.473 The AIFMD Review found that the passport had been an important factor in a doubling of the cross-​border distribution of AIFs over 2017–​2019 and that it was, overall, working well. But it also reported on weaknesses, including as regards divergences in host marketing rules, and also as regards the restriction of the AIFMD passport to professional investors only, which was leaving retail marketing to be governed by often diverging and restrictive national rules.474 The persistent stickiness of the AIFMD passport has been acknowledged by the Refit Directive which inserted a review clause into the AIFMD requiring an assessment of its operation (Article 69a).

III.5.8  Operational and Organizational Requirements An extensive operational and organizational regime, which serves investor protection and financial stability objectives, applies under the AIFMD and the 2013 Delegated AIFMD Regulation. A series of general principles apply under AIFMD Article 12,475 including an AIF investor fair treatment obligation,476 which have been amplified by the 2013 Delegated AIFMD Regulation.477 Reflecting the financial-​crisis-​era focus on the link between remuneration and risk management, the AIFMD also imposes detailed, and at the time of their adoption controversial,478 remuneration policy requirements on AIFMs (Article 13), on which the UCITS

470 Including as regards the processing of subscriptions and the availability of disclosures. These facilities are not required to be in the form of a physical presence (in alignment with the Refit reform that removed the physical facility requirement from the UCITS Directive). 471 While declining, some 14 per cent of all AIF investment is retail: 2022 ESMA AIF Report, n 18, 11. 472 A 2017 ESMA review found that while AIFMs in most Member States had notified cross-​border investment management and AIF marketing activities through the passport system, the AIF marketing passport had a significantly lower uptake than the UCITS passport, and that AIFMs used the AIFMD passports to a much lesser extent, and in fewer Member States, as compared to the UCITS sector. ESMA related these passporting patterns to the (then) early stage of the Directive’s implementation, lower number of AIFs than UCITSs, and, in a theme that has recurred since, the limitation of the AIF marketing passport to professional investors: 2017 ESMA Home/​Host Thematic Review, n 339, 21–​2. 473 ESMA’s 2017 review of the home/​host NCA relationship did not expose major difficulties, and found that the related notification arrangements were well-​established, but it recommended a series of best practices to enhance cross-​border supervision: n 339. 474 2020 Commission AIFMD Review, n 361, 6–​7. 475 Including that the AIFM act honestly and with due care, skill, and diligence, act in the best interests of the AIF or AIF investors and the integrity of the market, have and employ the necessary resources and procedures, avoid or identify, manage, monitor, and disclose conflicts of interest, and comply with all regulatory requirements: Art 12(1). 476 AIFMs must treat all AIF investors fairly and no AIF investor should obtain preferential treatment unless this is disclosed in the AIF rules or instruments of incorporation: Art 12(1). 477 2013 Delegated AIFMD Regulation Arts 16–​29, which include rules governing due diligence when investing in assets of limited liquidity and in selecting counterparties and prime brokers; inducements; and order handling. 478 Given the restrictions placed as a result on long-​established pay practices in the AIF industry. The remuneration clawback and deferral requirements proved particularly controversial: Barker, A and Jones, S, ‘EU Hedge Funds Face Pay Threat’, Financial Times, 13 August 2012.

III.5  The AIFMD  313 remuneration regime was subsequently based. The over-​arching obligation requires that AIFMs apply remuneration policies and practices, which are consistent with and promote sound risk management and which reflect the detailed AIFMD Annex II remuneration requirements (which are subject to a proportionality principle),479 to identified staff.480 Article 13 is supported by ESMA’s extensive and operationally oriented Remuneration Guidelines481 which, while highly detailed, are designed to calibrate the remuneration requirements to the multiplicity of remuneration structures across the AIF industry.482 The remuneration rules have been associated with a more risk-​conscious approach to remuneration,483 but difficulties remain regarding the application of the proportionality principle which the AIFMD Review has not addressed.484 Conflict-​of-​interest management is also addressed, with conflict-​of-​interest avoidance and management one of the AIFMD Article 12(1) general principles.485 Article 14 sets out the foundational conflict-​of-​interest management obligation, requiring AIFMs to maintain and operate effective organizational and administrative arrangements with a view to taking all reasonable steps designed to identify, prevent, manage, and monitor conflicts of interest; and to disclose those conflicts where it cannot be ensured with reasonable confidence that damage to investor interests will be prevented.486 The distinct conflicts of interest inherent in the prime broker/​AIF relationship are expressly addressed by Article 14(3), which requires the AIFM to exercise due care, skill, and diligence in the selection of the prime broker487 and to ensure all terms are set out in a written contract, including as regards any transfer and reuse of AIF assets by the prime broker.

479 The highly detailed Annex II reflects the approach adopted to remuneration under the banking rulebook over the financial crisis, albeit that it is tailored to the fund context, and addresses, inter alia, remuneration governance; alignment with risk-​taking; and the design of remuneration, including with respect to the treatment of fixed and variable remuneration (eg each component must be appropriately balanced, at least 40 per cent of variable remuneration must be deferred for at least three to five years, at least 50 per cent of variable remuneration must consist of units or shares in the AIF concerned (or ‘equivalent instruments’), and guaranteed variable remuneration must be exceptional and only apply in the context of the first year of remuneration for new staff). The principles are to be applied in a way and to the extent appropriate to the AIFM’s size, internal organization, and the nature, scope, and complexity of its activities. These requirements were subsequently reflected in the UCITS regime under the UCITS V reforms (UCITS Directive Art 14b). 480 The remuneration regime must apply to those categories of staff (including senior management, risk-​takers, and control functions) whose professional activities have a material impact on the risk profiles of the AIFM or its AIFs (Art 13(1)). 481 2013 ESMA Remuneration Guidelines (n 418). The Guidelines were revised in 2016 to confirm that they apply to AIFMs which are subsidiaries of a credit institution. 482 The appropriate application of the proportionality principle is addressed at length by the Guidelines which also contain detailed recommendations relating to, inter alia: the definition of in-​scope remuneration; the identification of ‘identified staff ’ subject to the regime; application in a group context; remuneration governance; risk alignment arrangements (including in relation to any personal hedging arrangements, discretionary pensions, and severance pay); variable remuneration; performance assessment and risk management; ex-​post risk adjustment; retention policy; and disclosure. 483 2021 AIFMD/​UCITS Proposal IA, n 33, 166. 484 See n 262 in the UCITS context. 485 Art 12 also provides, reflecting a similar requirement under the UCITS regime, that where an AIFM engages in discretionary investment management, it cannot invest all or part of a client’s portfolio in AIFs under its collective investment management, unless it has prior approval from the client (Art 12(2)). 486 The administrative regime amplifies the nature of potential conflict-​of-​interest risk, the required conflict-​ of-​interest policy, procedures, and measures for preventing, managing, and monitoring conflict-​of-​interest risk, and the management of conflict-​of-​interest risk specifically as regards the exercise of voting rights: 2013 Delegated AIFMD Regulation Arts 30–​7. 487 Defined as a regulated institution which provides services to professional investors primarily to finance or execute transactions in financial instruments as counterparty, and which may also provide other services, such as clearing and settlement of trades, custodial services, securities lending, customized technology, and operational facilities: Art 4(1)(af).

314  Collective investment Management Extensive organizational requirements apply to the AIFM, including in relation to general organizational principles and the deployment of appropriate resources to the management of AIFs (Article 18).488 Given that AIFs can invest in complex and often illiquid assets, the valuation process is specifically addressed, including by the foundational requirement that valuation must be carried out by an external valuer; an internal valuer can be used, however, where the specified conditions are met (Article 19).489 While a significant reform at the time of its adoption, the valuation regime has performed relatively well, being associated with bringing increased discipline and structure to the valuation process.490 The AIFMD also addresses the delegation of functions by the AIFM (which can include the delegation of pivotal functions such as portfolio management and risk management), reflecting the importance of delegation as an organizational model in the EU fund sector.491 A series of restrictions and conditions apply (Article 20) which are amplified by extensive administrative rules.492 These requirements are designed to reinforce the ultimate responsibility of the AIFM over delegated activities and to support effective supervision. The Article 20 delegation regime is based on the delegation being subject to notification to the home NCA; a series of conditions applying to the delegation;493 restrictions on further sub-​ delegations by the delegate; a prohibition on the delegation of portfolio management or risk management functions to the depositary or to entities whose interests may conflict with those of the AIFM or AIF investors; the AIFM’s liability not being affected by any delegation or sub-​delegation; and a prohibition on the AIFM delegating activities to the extent that it can no longer be considered to be the AIF’s manager and has become a ‘letter box’ entity.494 The delegation regime is likely to be further tightened, given the 2021 AIFMD/​UCITS Proposal reforms, including to ensure that a sufficient minimum presence is retained by the AIFM where delegation is relied on to a substantial degree.495

488 Amplified by the 2013 Delegated AIFMD Regulation Arts 57–​66 (including in relation to data processing, accounting, senior management control, the permanent compliance function, the permanent audit function, personal transactions, recording of portfolio transactions, and record-​keeping). 489 Valuation is mainly governed by national rules, but Art 19 imposes a series of requirements, including: that AIFMs have in place appropriate and consistent procedures to support proper and independent valuation and that the valuation be performed impartially and with all due skill, care, and diligence; that valuation be carried out by an external valuer (appointment conditions apply) or, as long as independence requirements are met, internally by the AIFM (the depositary may not act as a valuer, unless it has functionally and hierarchically separated this function from its other tasks and managed the related conflicts of interest); and that NAV calculations take place at least once a year and, for open-​ended AIFs, at intervals appropriate to its issuance and redemption frequency, and, for closed-​end AIFs, whenever the fund’s capital is increased or decreased: Art 19. The 2013 Delegated AIFMD Regulation (Arts 67–​74) amplifies this regime and addresses, inter alia, valuation policies and procedures, the use of models, consistent application and periodic review of policies and procedures, review of individual asset values, and the calculation of NAV. 490 2021 AIFMD/​UCITS Proposal, n 30, 1. Despite some industry disquiet as regards the ‘binary choice’ between external and internal valuers and capacity restrictions in the external valuation market (2018 KPMG Report, n 394, 21–​2), the Proposal did not suggest reforms. 491 On the interaction between the delegation requirements and the third country regime see Ch X section 5. 492 2013 Delegated AIFMD Regulation Arts 75–​82. 493 Including that the entire delegation structure must be justifiable by objective reasons; that where the delegation relates to portfolio or risk management, the delegate is authorized or registered for that purpose and, where the delegate is a third country undertaking, supervisory cooperation is ensured; and that the AIFM can demonstrate that the delegate is qualified and capable of undertaking the functions in question: Art 20(1). 494 A series of requirements apply under the Delegated Regulation in this respect, including that the AIFM must engage in either risk management or portfolio management. 495 The reforms are broadly similar to those proposed for the UCITS regime and are based on ensuring a minimum EU presence, enhanced reporting, and ESMA peer review of NCA supervision (section 4.7.1).

III.5  The AIFMD  315

III.5.9  Risk Management The risk management regime is at the core of the AIFMD.496 It is primarily associated with AIF-​/​AIFM-​level risk management, but it also has a system-​wide macroprudential dimension as regards the management of leverage risk (section 5.10). By contrast with the UCITS regime which, aside from its asset allocation rules, relies on ESMA soft law and supervisory convergence measures to a significant extent to govern risk management practices, the AIFMD risk management regime is heavily based on legislative and administrative requirements, albeit also supported by ESMA measures. In practice, while some differences remain, the UCITS and AIFMD risk management requirements are not dissimilar.497 The AIFMD risk management regime is framed by the foundational Article 15(1) and (2) obligation which is subject to detailed amplification by administrative rules: AIFMs must implement adequate risk management systems to identify, measure, manage, and monitor all relevant risks;498 and the risk management function must be functionally and hierarchically separate from operating units, including the portfolio management function.499 Also, as the single rulebook has become more granular, it has started to carry some of the regulatory weight as regards risk management. The management of the risks associated with securitization positions, for example, is now also dealt with through the 2017 Securitization Regulation which is tied into the AIFMD: where AIFMs are exposed to a securitization that no longer meets the Regulation’s requirements, they must, in the best interests of investors in the relevant AIF, act and take corrective action if appropriate (Article 17). Liquidity risk management, particularly for open-​ended AIFs which may face liquidity mismatch risks, has recently framed much of the technocratic engagement in the EU on AIF risk management, with the ESRB and ESMA regularly highlighting the liquidity risks to which open-​ended AIFs are exposed,500 and the 2018 ESRB Recommendation on Liquidity and Leverage, and ESMA’s subsequent 2020 Guidelines for UCITS and AIFs on Liquidity Stress Testing, following. These measures amplify the foundational Article 16 liquidity risk management obligation (which applies to AIFs other than unleveraged, closed-​end funds given these funds’ lower liquidity risks): AIFMs must apply appropriate liquidity risk management procedures to enable them to monitor their AIFs’ liquidity risks, and to ensure that the liquidity profile of these AIFs’ investments complies with their underlying obligations, including by means of the use of stress tests.501 The AIFMD liquidity risk management system performed relatively well when tested over the March 2020 Covid-​19 496 And has been expanded to address sustainability risks: section 3.2.4. 497 The AIFMD Review found that the introduction of the risk management rules did not lead to major change for most AIFMSs, given that AIFMs either followed national rules previously in place or followed the UCITS regime: 2021 AIFMD/​UCITS Proposal IA, n 33, 141. 498 Art 15 also specifies that AIFMs must at least implement a due diligence process for AIF investments, ensure that risks are appropriately identified, measured, managed, and monitored, including through stress testing, and ensure that AIFs’ risk profiles correspond to their size, portfolio, investment strategies, and objectives: Art 15(3). 499 The 2013 Delegated AIFMD Regulation addresses, inter alia, the responsibilities of the risk management function, the risk management policy, review of risk management systems, the functional/​hierarchical separation requirement, risk limits (including as regards market, credit, liquidity, counterparty, and operational risks), and risk measurement and management: Arts 38–​45. 500 ESMA’s annual AIF Reports (since 2019) and the ESRB’s annual Non-​Bank Financial Intermediation Risk Monitors have repeatedly highlighted the extent of the liquidity risks, particularly in open-​ended AIFs and notably real estate funds. 501 The 2013 Delegated AIFMD Regulation addresses, inter alia, the functions to be carried out by the liquidity management system, and liquidity limits and stress tests: Arts 46–​9.

316  Collective investment Management pandemic-​related market dislocation, with those AIFs most vulnerable to liquidity risk (real estate funds) by and large not being required to undertake exceptional liquidity management operations. The market disruption exposed, however, the need for a harmonized liquidity management tools framework, a proposal for which followed in the 2021 AIFMD/​ UCITS Proposal. Under the Proposal’s revised Article 16, AIFMs (of open-​ended AIFs) would be required to select at least one liquidity management tool from the harmonized list of the minimum suite of tools Member States would be required to make available,502 which could then be activated by the AIFM, as necessary, in accordance with policies and procedures to be adopted by the AIFM (its use would be notified to the home NCA). In addition, the revised Article 16 would also empower open-​ended AIFs to temporarily suspend redemptions in exceptional circumstances. In parallel, NCAs would be empowered to require the use of liquidity management tools and subject to strengthened cooperation obligations.

III.5.10  Leverage: Macroprudential Risk Management and Loan Origination III.5.10.1 Leverage Fund leverage, which includes synthetic leverage from the use of derivatives,503 has the capacity to amplify the financial stability risks which the fund sector generates, particularly where funds deleverage in stressed market conditions; it is one of the main characteristics of fund operation that draws funds into the non-​bank financial intermediation reform debate (section 3.2.1). The extent to which a UCITS can sustain leverage is restricted by the UCITS Directive (section 4.6.7). By contrast, the AIFMD, reflecting the importance of leverage as an investment strategy for some AIF asset classes, does not impose limits on leverage, but instead deploys a risk monitoring system, backstopped by NCA intervention powers. In practice, the AIF sector in the EU is not highly leveraged and leverage levels have not generated significant regulatory concern.504 The hedge fund sector, which relies on high levels of leverage as an investment strategy, has, however, been identified a source of potential risk if abrupt deleveraging amplified financial stability risks in conditions of market stress.505 The AIFMD leverage regime has a number of elements. In order to support market monitoring, extensive information on leverage must be disclosed to investors in the initial AIF disclosure document (Article 23(1)); and periodically (in relation to the total amount of leverage sustained by the AIF and to changes to the maximum level of leverage which

502 See n 177 on the similar UCITS tools proposed. 503 ‘Leverage’ is widely defined under the AIFMD as any method by which the AIFM increases the exposure of an AIF it manages, whether through borrowing of cash or securities, or leverage embedded in derivative positions, or by any other means (Art 4(1)(v)). 504 The 2021 collapse of the highly leveraged US-​based Archegos hedge fund (n 351), and its implications for leveraged funds, however, drew ESMA’s attention: ESMA, TRV No 2 (2021) 22–​3. 505 In 2020, of the 30,035 AIFs in the EU, 4,345 were leveraged. The highest level of leverage was sustained by hedge funds (548 per cent (gross leverage as a percentage of NAV)), followed, much further behind, by real estate funds (141 per cent). The ‘other AIF’ sector, which covers a multiplicity of funds, sustained levels of 154 per cent: 2022 ESMA AIF Report, n 18, 6. The ESRB has regularly highlighted high levels of hedge fund leverage as potentially amplifying stability risks but has not raised significant concerns (eg, 2018 Shadow Banking Monitor, n 138, 9).

III.5  The AIFMD  317 the AIFM may employ (Article 23(5)).506 Given the myriad ways in which leverage can be calculated, the calculation of AIF leverage is subject to detailed, operational rules under the 2013 Delegated AIFMD Regulation which requires calculation under the ‘gross notional exposure’ and ‘commitment’ methods and specifies how these methods are to be used.507 Extensive supervisory reporting requirements also apply. Supervisory reporting on leverage forms part of the AIFM authorization process (Article 7(3)(a)).508 In addition, AIFMs employing leverage on a ‘substantial basis’509 are subject to ongoing and granular NCA reporting obligations, being required to report to the home NCA on the overall level of leverage employed by each AIF under management, on the breakdown between leverage arising from borrowing and from derivatives, and on the extent to which the AIF’s assets have been reused under leverage arrangements; the five largest sources of borrowed cash or securities for each AIF, and the amount of leverage from each, must also be disclosed (Article 24(4)). These disclosures are to be used by the home NCA to assess the extent to which leverage use contributes to the build-​up of systemic risk, risks of disorderly markets, or risks to long-​term economic growth, and must be shared with the other NCAs, ESMA, and the ESRB (Article 25(1) and (2)). In practice, these disclosures have supported the development of the EU’s now significant risk monitoring capacity, which includes the ESRB’s regular reports on non-​bank financial intermediation risks and ESMA’s annual AIF reports. They have also supported the adoption of related recommendations for policy and supervisory action, such as the ESRB’s 2018 Recommendation on Liquidity and Leverage,510 which led to ESMA’s 2021 Guidelines on Leverage Limits. Also, AIFMs must impose limits on leverage use: an AIFM must set a maximum level for the leverage which it may employ for each AIF it manages (Article 15(4));511 and it must also demonstrate to the NCA that the leverage limits for each AIF managed are reasonable and that it complies with these limits (Article 25(3)). In addition, and in what was at the time a significant change for most NCAs, the AIFM home NCA must assess the risks posed by leverage use and, where necessary to support the stability and integrity of the financial system, impose limits on the level of leverage which an 506 Relatedly, the 2015 Securities Financing Transactions Regulation requires prospectus and ongoing disclosure on funds’ use of securities financing transactions, such as the ‘repo’ arrangements through which funds can raise funding by pledging securities: Ch VI section 4. 507 Arts 6–​11. Despite significant industry agitation, as these methods can lead to higher levels of leverage being reported as compared to the more facilitative ‘advanced’ method, the Commission did not follow ESMA’s technical advice that AIFMs be allowed, additionally, to use the ‘advanced’ method: 2012 Delegated AIFMD Regulation Proposal, n 408, 6. The Commission’s decision to reject ESMA’s technical advice was based on its concern that the advanced method, which affords AIFMs considerable discretion, might lead to an under-​reporting of leverage levels: 2012 Delegated AIFMD Regulation Proposal IA, n 410, 25. By the time of the AIFMD Review, however, the AIFMD calculation methods were regarded as ‘comprehensive and advanced’: 2021 AIFMD/​UCITS Proposal IA, n 33, 137. Adjustments may follow as the global agenda on non-​bank financial intermediation develops. IOSCO has reviewed leverage calculation methods (IOSCO, Recommendations for a Framework Assessing Leverage in Investment Funds (2019)), leading ESMA to suggest reforms may be necessary to the ‘gross’ calculation method: 2020 ESMA AIFMD Review Letter, n 47, 9. 508 Which requires the AIFM to notify the home NCA of its policy on the use of leverage. 509 Leverage is employed on a ‘substantial basis’ where the exposure of the AIF, calculated under the commitment method, exceeds its NAV by a factor of 3: 2013 Delegated AIFMD Regulation Art 111. 510 2018 ESRB Recommendation, n 47, Recommendation E, calling for guidance on the design, calibration, and implementation of macroprudential leverage limits. 511 The AIFM must take into account a series of factors, including the type of AIF, its investment strategy and sources of leverage, interlinkages or relevant relationships with other financial services institutions which could pose systemic risk, the need to limit exposure to any single counterparty, the extent to which leverage is collateralized, the asset-​liability ratio, and the scale, nature and extent of the AIFM’s activity on the market concerned (Art 15(4)).

318  Collective investment Management AIFM can employ, or other restrictions (Article 25(3)).512 Given the potential market impact of this form of macroprudentially-​oriented intervention (which is reflected in the administrative amplification of the Article 25(3) principles that govern NCA intervention513 and in the adoption of the related ESMA 2021 Guidelines on Leverage Limits),514 ESMA, the ESRB, and the NCA of the AIF must all be notified in advance. In addition, ESMA must issue advice to the relevant NCA about the leverage measure in question and as to whether the governing Article 25(3) conditions are met, whether the measure is appropriate, and the duration of the intervention (Article 25(3)–​(6)). ESMA is additionally conferred with a general facilitation and coordination role (Article 25(5)). It is also empowered to intervene more intrusively by issuing advice to NCAs that specifies the remedial action to be taken (including leverage limits) where it determines that the leverage employed by an AIFM (or group of AIFMs) poses a substantial risk to the stability and integrity of the financial system. Where an NCA does not follow this advice (or ESMA’s advice in relation to NCA leverage limits), it must notify ESMA accordingly and ESMA can choose to make public disclosures to this effect (Article 25(7)–​(8)).

III.5.10.2 Loan Origination A new framework governing AIF loan origination (lending) has been proposed under the 2021 AIFMD/​UCITS Proposal, reflecting an earlier CMU commitment.515 It responds to increasing growth in loan origination by AIFs, which is regarded as placing pressure on the AIFMD’s risk management rules and which is leading to diverging NCA practices in response.516 Loan-​originating AIFs tend not to be highly leveraged,517 but they are exposed to distinct risks, including as regards failures in credit risk management where risk assessment processes are not robust; interconnectedness risks, in particular to the banking sector, where banks use AIF investments as a balance sheet management technique and so become exposed to AIF risk; and the risk of amplifying procyclicality.518 AIF lending does, however, diversify the credit market, provide a liquidity buffer when traditional lenders pull back from lending, and widen sources of finance, for SMEs in particular. It accordingly engages CMU’s concern to strengthen market-​based funding sources. AIF loan origination is already permitted and regulated under the EuSEF, EuVECA, and ELITF regimes (section 6). But it is not expressly addressed (albeit not prohibited) under the AIFMD. The proposed regime, which is designed to facilitate AIF lending while securing financial stability, is based on recognizing lending as an AIFM activity and so on extending the AIFMD passport to the granting of loans by AIFs cross-​border; and on requiring AIFMs which manage loan originating AIFs to have in place effective policies and 512 Some NCAs have deployed leverage limits, albeit often calibrated and depending on the type of AIF investor (the German NCA, eg, has placed 50 per cent leverage limits on real estate funds targeted to institutional investors), but these have not been designed as macroprudential measures or adopted under Art 25. 513 2013 Commission Delegated Regulation Art 112. 514 The Guidelines have a strongly operational colour and cover, inter alia, the related NCA risk assessment, the data sources to be used, implementation and timing of limits, and the avoidance of procyclicality. 515 The 2015 CMU Action Plan contained a commitment to review AIF loan origination. This led to a supportive ESMA Opinion which called for the construction of a harmonized regime which would mitigate regulatory and market fragmentation and support financial stability: 2016 ESMA Loan Origination Opinion, n 54. 516 While most Member States permit AIFs to engage in loan origination, one third have adopted bespoke regulatory regimes: 2021 AIFMD/​UCITS Proposal IA n 33, 14. 517 2021 AIFMD/​UCITS Proposal IA n 33, 15. 518 As highlighted by the 2021 AIFMD/​UCITS Proposal IA, n 33, 15–​16.

III.5  The AIFMD  319 procedures governing the granting of loans as well as related credit risk management procedures. Specific restrictions are envisaged to support risk management and financial stability, including limits on loans to financial institutions.519

III.5.11  The Depositary As under the UCITS regime, the depositary is central to the AIFMD’s risk management and investor protection scheme, being charged with monitoring and custody functions. It is heavily regulated accordingly, through detailed legislative requirements (addressing structure, disclosure, custody, delegation, and conduct) which are amplified by the 2013 Delegated AIFMD Regulation.520 The AIFMD’s regulatory model was subsequently applied to the UCITS sector by the UCITS V reforms. Article 21 specifies and restricts the types of entity which may act as an AIF depositary, essentially restricting depositary activities to EU-​registered financial institutions,521 although a third country regime applies (at the European Parliament’s instigation).522 It also, as is the case under the UCITS regime as regards UCITS managers, prohibits AIFMs from acting as depositaries, as well as, in a reflection of the structure of the AIF industry, prime brokers (unless, and in response to the widespread industry practice whereby prime brokers provide depositary services, they have functionally and hierarchically separated depositary functions from prime brokerage functions and managed the related conflicts of interest arising from their acting as counterparty to the AIF) (Article 21(4)). For EU AIFs, depositaries must (as under the UCITS regime) be established in the home Member State of the AIF (and so cannot passport).523 A single depositary must be appointed to each AIF (Article 21(1)) and is responsible for asset custody and verification (Article 21(8)), for monitoring AIF cash flows (Article 21(7)),524 for overseeing AIF transactions more generally (Article 21(9)),525 and for making available to the NCA all information necessary (Article 21(16)). Information flows between the depositary and the AIFM and AIF are supported by the mandatory written agreement which must evidence the appointment of the depositary and regulate the required flows of

519 In effect, the proposed regime imposes a limit of 20 per cent of AIF capital on loans originated to a single borrower where the borrower is an AIF, a UCITS, or a regulated financial institution. 520 2013 Delegated AIFMD Regulation Arts 83–​102. These rules were adjusted, as regards the custody of assets, by the 2018 Delegated Depositary Regulation to facilitate the delegation process 521 Essentially, EU-​authorized credit institutions and investment firms, and UCITS Directive-​scope depositaries: Art 21(3). In an exemption designed to ease the costs of the depositary regime for private equity, venture capital, and real estate funds which typically do not have investments in the types of assets which must be placed in custody (recital 34), where the AIF has a five-​year lock-​up on redemption, does not generally invest in assets which must be held in custody, and generally invests in order to acquire control, the depositary may be another entity which carries out depositary functions as part of its professional or business activities (Art 21(3)). 522 Reflecting concern that a restrictive approach could have limited the pool of eligible depositaries and thereby increased systemic risk, the European Parliament supported a third country depositary regime; the Commission and Council positions required the depositary to be EU-​located. 523 Art 21(5). A discrete regime applies to the depositaries of third country AIFs. 524 The operational requirements for cash monitoring are set out in the 2013 Delegated AIFMD Regulation Arts 85–​6. The regime is designed to ensure the depositary has a clear overview of all AIF cash flows, controls the accounts to which cash payments are made, and monitors cash flows and undertakes related reconciliations (including on a daily basis for significant cash flows). 525 Including ensuring that the sale, issue, repurchase, redemption, and cancellation of AIF units, valuation, and the application of AIF income are all carried out in accordance with the applicable rules.

320  Collective investment Management information (Article 21(2)). In addition, the prime broker is required to report to the depositary on specified matters.526 In performing their respective duties, the depositary and the AIFM must act honestly, fairly, professionally, independently, and in the interests of the AIF and its investors; the depositary is also subject to a specific conflict-​of-​interest avoidance obligation (Article 21(10)). Given the complex AIF assets in which AIFMs often invest, and industry practices under which AIF assets are typically subject to collateral and similar arrangements (usually engaging the prime broker in the case of hedge funds), and thus are not regarded as being in formal custody by the depositary, considerable controversy attended the Directive’s specification of the depositary’s custody obligations. Under the compromise adopted by the Directive, two forms of custodial obligation apply. Where financial instruments can be held in custody,527 the Directive specifies the required custody and segregation arrangements (Article 21(8)(a)).528 For all other instruments, the depositary is to verify the ownership of the AIF or AIFM of the assets and to maintain an up-​to-​date record of these assets (Article 21(8)(b)).529 Despite significant industry opposition over the negotiations, assets may not be excluded from the scope of the custody obligation because they are subject to particular business transactions, such as collateral arrangements.530 As with the AIFM delegation regime generally, conditions and restrictions are imposed on the extent to which depositaries can delegate functions, including with respect to the objective necessity of the delegation, the diligence of the depositary in selecting the sub-​ depositary, the ability of the sub-​depositary to carry out the delegated functions (including with respect to asset segregation), and the effective regulation and supervision of the sub-​ depositary in the relevant jurisdiction (Article 21(11)). Under the liability regime,531 the depositary is liable to the AIF (or AIF investors) for loss by the depositary or a third party to whom custody has been delegated of financial instruments held in custody under Article 21(8)(a); in the case of such a loss, the depositary 526 Under 2013 Delegated AIFMD Regulation Art 91 and in relation to assets held in custody, as well as in relation to loans, trading-​related information (including in relation to short sales by the prime broker on behalf of the AIF), and cash margins held by the prime broker in respect of open futures contracts. 527 The custody obligation applies to all financial instruments which can be physically delivered to the depositary and to those which can be registered in a financial instrument account—​essentially transferable securities (including those which embed derivatives), money-​market instruments, and units in CISs: Art 21(8)(a) and 2013 Delegated AIFMD Regulation Art 88. 528 The nature of these arrangements is further amplified by the 2013 Delegated AIFMD Regulation Art 89 which addresses, inter alia, record-​keeping and segregation, reconciliation, the assessment of custody risks, the care obligation (‘due care’ must be exercised in order ensure a high standard of investor protection), organizational arrangements, and the verification of ownership rights. Article 89 also specifies the obligations applicable where custody is delegated. Under the 2018 reforms to the Regulation, these obligations were adjusted to facilitate the delegation process and reflect the practicalities of sub-​custodianship. 529 The verification is to be based on information provided by the AIF or AIFM or on external evidence, where available. The nature of this obligation is specified in detail by Art 90 of the 2013 Delegated AIFMD Regulation which addresses, inter alia, information requirements, record-​keeping, verification procedures, and the detection of anomalies. 530 2013 Delegated AIFMD Regulation recital 100. The recital also specifies the types of custody arrangements which are to be used in relation to assets subject to collateral and similar arrangements. In practice, prime brokers who hold AIF assets as collateral are required to act as delegates of the depositary and become subject to the delegation rules applicable to depositary functions. 531 The depositary liability regime, given the potential costs for the industry, was a stumbling block from the outset of the AIFMD negotiation process, although the Commission and Council took a more facilitative approach than the European Parliament by supporting transfers of liability. The final version broadly follows the Parliament’s strict liability approach, but permits a transfer of liability to sub-​depositaries in limited circumstances, in response to strong industry concern

III.5  The AIFMD  321 must return a financial instrument of identical type (or the corresponding amount) without undue delay (Article 21(12)). The depositary is not liable where it can prove that the loss has arisen as a result of an ‘external event’ beyond its ‘reasonable control’, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary (Article 21(12)).532 The depositary is also liable for all other losses suffered by the AIF or AIF investors as a result of negligent or intentional failure by the depositary to fulfil its obligations. The depositary’s liability is not affected by delegation, although it can discharge itself of liability under the Directive and in accordance with the Directive’s strict conditions (Article 21(13)).533 Discharge is also possible where the assets were required to be held in a third country depositary and where the related conditions are met (Article 21(14)). The AIFMD depositary regime, despite its specificity and maturity, has remained on the regulatory agenda, in particular as regards the construction of a depositary passport.534 The 2021 AIFMD/​UCITS Proposal was cautious in this regard, given the pivotal importance of the depositary to asset protection and AIF monitoring, the basis of much of depositary regulation (as regards ownership rights, for example) in national law, and the complexities associated with cross-​border supervision.535 But, and given concerns as to concentration risks and higher costs in some Member States given the limited number of ‘home’ depositaries available to AIFMs, the Proposal suggests that AIFMs be able to procure depositary services cross-​border.536

III.5.12  Disclosure and Supervisory Reporting As can be expected of a Directive which was, from early in its evolution, designed to shed light on hedge fund risk in particular, detailed disclosure obligations are imposed on the AIFM with respect to initial and ongoing disclosure to investors and with respect to NCA supervisory reporting.537 532 Article 101 of the 2013 Delegated AIFMD Regulation clarifies in detail the strict conditions which govern when liability is not triggered as: (a) that the event which led to the loss was not the result of any act or omission of the depositary or its delegate; (b) that the depositary could not reasonably have prevented the occurrence of the event which led to the loss, despite adopting all precautions incumbent on a diligent depositary as reflected in common industry practice; and (c) that, despite rigorous and comprehensive due diligence, the depositary could not have prevented the loss (the conditions under which the due diligence standard is met are specified). It also specifies when circumstances dictate that these conditions are met, including as regards the depositary’s procedures. 533 Liability may be discharged where the requirements for delegation have been met, a written agreement between the depositary and delegate expressly transfers liability and makes it possible for the AIF to claim against the delegate, and a written contract between the depositary and the AIF or AIFM expressly permits the discharge and establishes an ‘objective reason’ for it: Art 21(13). Given that Art 101 of the 2013 Delegated AIFMD Regulation clarifies that the conditions for depositary liability discharge generally are not deemed to be met where the loss involves accounting error, operational failure, fraud, or failure to apply segregation, whether at the depository or delegate level (Art 101(3)), the nature of the ‘objective reasons’ which can be accepted for liability transfers are amplified in the Regulation (Art 102). 534 The possibility of a passport was aired but rejected over the AIFMD negotiations which left a legacy in the form of recital 36 which invited the Commission to examine the possibility of cross-​border depositary access rights. 535 There was, relatedly, little stakeholder support for a depositary passport: 2021 AIFMD/​UCITS Proposal n 30, 7. 536 The Proposal also provides for the use of central securities depositaries (CSDs) as sub-​custodians and clarifies that, where one is deployed as a sub-​custodian, this does not entail a delegation of depositary functions (given the separate regulation of CSDs under the CSD Regulation), alleviating thereby the related due diligence for depositaries. 537 And are extensively amplified by the 2013 Delegated AIFMD Regulation (Arts 103–​10).

322  Collective investment Management The relevance of the mandatory investor-​facing disclosures is doubtful, given the strong market discipline which investors can exert on AIFs and AIFMs in relation to the disclosures they require. Nonetheless, the AIFM must produce, for each EU AIF it either manages or markets, an annual report containing the disclosures mandated by the Directive (Article 22) and amplified in the 2013 Commission AIFMD Regulation.538 It must also provide the required initial (prospectus) disclosures relating to those AIFs,539 as well as the required periodic disclosures.540 The extensive NCA supervisory reporting obligations, however, have had traction, informing risk monitoring at NCA level but also by ESMA and the ESRB. The vast wealth of AIFM supervisory reporting derives from the obligation imposed on the AIFM to report to its home NCA, in relation to each of the AIFs it manages or markets in the EU, on a wide range of matters, including the leverage reports designed to manage macroprudential risks.541 The frequency of the reports depends on the size and complexity of the AIFs under management.542 NCAs may also require reporting on additional matters, where necessary for the effective monitoring of systemic risk, and, in exceptional circumstances, ESMA may request home NCAs to impose additional reporting requirements (Article 24(5)).543 The AIFMD’s dense supervisory reporting regime544 has created a massive AIF/​AIFM data-​hub, hosted by ESMA, and has materially enhanced the EU’s risk monitoring capacity. It remains something of a work-​in-​progress, and is evolving in response to the maturing non-​bank financial intermediation risk monitoring agenda. The AIFMD Review revealed significant industry concern as to the scale and practical operation of the reporting rules,545 but also countering NCA concerns as to whether AIFMD reporting was sufficiently granular to support financial stability monitoring.546 Major reporting change brings, 538 Including: balance sheet or statement of assets and liabilities; income and expenditure account; report on activities; and total amount of remuneration paid (split into fixed and variable components). Where the AIF already provides an annual report under the Transparency Directive (Ch II) only those additional requirements under the AIFMD must be met. The 2013 Delegated AIFMD Regulation amplifies the content of these disclosure items in great detail (Arts 103–​107). 539 Article 23(1) and (2), covering disclosure relating to investment strategies and objectives and to leverage and how it is employed, as well as disclosures relating to delegation, valuation, liquidity risk management and redemption, the fair treatment obligation and any preferential treatment of investors, the latest NAV, the identity of the prime broker, and any discharges of depositary liability. 540 Article 23(4) and (5) and 2013 Delegated AIFMD Regulation Arts 108–​109. The legislative requirements include disclosure relating to new liquidity arrangements, the current risk profile of the AIF, changes to the maximum leverage level which the AIFM may employ, and the total amount of leverage employed. The administrative regime amplifies the disclosures related to liquidity arrangements and leverage changes. 541 These requirements are set out in Art 24 and in 2013 Delegated AIFMD Regulation Art 110. They relate to, inter alia, the AIFs’ risk profiles, liquidity arrangements, the assets in which the AIFs are invested, and the principal markets and instruments in which the AIFM trades. Particular requirements apply to leverage levels as noted in section 5.10. The technical modalities of reporting and related content templates are governed by the 2013 ESMA Reporting Guidelines. 542 2013 Delegated AIFMD Regulation Art 110. The most frequent reporting cycle (quarterly) applies to AIFMs that manage portfolios of AIFs in excess of €1 billion. 543 The data flows continue to increase. In a highly technical Opinion, ESMA recommended that NCAs collect additional, specified data as regards systemic risk: ESMA, Opinion on the Collection of Information for the Effective Monitoring of Systemic Risk (2021). 544 The supervisory reporting regime extends to sixty-​nine different reporting obligations requiring 517 data points and accounts for some 70 per cent of AIFM supervisory costs: 2021 AIFMD/​UCITS Proposal IA, n 33, 133 and 150. 545 Including as regards reports characterized as being unnecessary or as duplicative and overlapping with other EU-​required reports, particularly ECB statistical reports, and as regards NCAs’ discretion to require additional reporting as well as to specify delivery methods: 2021 AIFMD/​UCITS Proposal IA, n 33, 135. 546 NCAs called for additional data on liquidity, leverage, loan origination, margin, and Value at Risk: 2021 AIFMD/​UCITS Proposal IA, n 33, 20–​1 and 133.

III.5  The AIFMD  323 however, significant costs and business disruption to firms. The 2021 AIFMD/​UCITS Proposal adopted a careful approach, charging ESMA, which sits at the epicentre of AIF/​ AIFM data flows, with reviewing the AIFMD (and UCITS) reporting regime in order to enhance data collection, remove inconsistencies, and align the regime with reporting across the single rulebook. This ambitious mandate, which underlines the extent to which collective investment management policy has come to rely on ESMA’s technocratic capacity, is also designed to support the enhancement of supervisory data being pursued under the Digital Finance Strategy.547

III.5.13  Private Equity AIFs The management of private equity AIFs is subject to additional requirements, primarily directed to supervisory reporting and public disclosure. These requirements, highly contested over the AIFMD negotiations (Articles 26–​30), apply to AIFMs managing one or more AIFs which acquire control (more than 50 per cent of the voting rights) of a non-​listed company;548 and to AIFMs cooperating with one or more other AIFMs on the basis of an agreement under which the AIFs managed by those AIFMs jointly acquire such control (Article 26(1) and (5)). Reflecting the then and current concern to promote SME access to capital, the regime does not apply where the non-​listed company is an SME.549 These AIFMs must make supervisory ownership notifications as regards their investments in these ‘portfolio companies’, similar to those notifications required in respect of ownership in regulated-​market-​admitted companies under the Transparency Directive, although the AIFMD reporting requirements are significantly less fine-​grained as the portfolio companies are not publicly traded and so the market efficiency and pricing risks associated with the public markets do not arise (Article 27).550 In addition, notification and disclosure requirements (to the relevant portfolio company, its shareholders, and the AIFM home NCA) apply on an acquisition of control and cover, inter alia, the voting rights held by the AIF, the conditions subject to which control was acquired, the identity of the AIFM which manages the AIF, the policy for preventing and managing conflicts of interest between the AIFM, the AIF, and the company, and the policy for communications regarding employees (Articles 27 and 28). The AIFM must also disclose (to the company and its shareholders) its intentions regarding the future business of the company and the likely repercussions on employment and employment conditions

547 COM(2020) 591 12–​14. The strategy includes a commitment to build a ‘common financial data space’ for regulated, machine-​readable data (and includes the development of the European Single Access Point project noted in Ch II). 548 Either individually or jointly on the basis of an agreement aimed at acquiring control. 549 Article 26(2)(a). The definition of SME is linked to that used in the Commission’s 2003 Recommendation on micro, small and medium-​sized enterprises (Recommendation 2003/​362/​EC). The exemption also applies to special purpose vehicles for purchasing, holding, or administering real estate. The Council related this exemption to the concern to avoid hampering start-​up or venture capital: Council Press Release on Adoption of the AIFMD: 27 May 2011 (Council Document 10791/​11). 550 The AIFM must notify its home NCA where the AIF’s holding in the non-​listed company reaches, exceeds, or falls below 10, 20, 30, 50, and 75 per cent.

324  Collective investment Management (Article 28(4)).551 Particular requirements apply to the notification of, and disclosure to be provided to, employees.552 In a significantly more intrusive requirement, private equity fund managers are also subject to an asset stripping prohibition.553 As the AIFMD is primarily concerned with financial stability risk, its capturing of private equity funds (which do not typically generate liquidity or leverage risks and which provide extensive disclosure to AIF investors through private contracting) led to trenchant opposition from the private equity and venture capital industry.554 A decade or so later, the AIFMD Review did not expose significant concerns, and reform has not followed.555 The massive growth in the private equity sector in the intervening decade556 suggests that the rules have not had an unduly obstructive effect.

III.5.14  The Retail Markets Notwithstanding the pre-​financial-​crisis discussions on facilitating retail investor exposure to alternative investments (section 5.2), the AIFMD does not confer a passport in relation to the retail markets, although in practice there is a not immaterial level of retail investment in AIF asset classes.557 Member States may, however, permit AIFMs to market units or shares of the AIFs they manage to retail investors in their territory, irrespective of whether the AIFs are marketed on a domestic or cross-​border basis, or whether they are EU or non-​ EU AIFs (Article 43).558 The sensitivities as regards the elevated risks associated with retail access to alternative investments are underlined by Member States being permitted to impose stricter requirements on the relevant AIFM (or the AIF) than those applicable in relation to AIFs marketed to professional investors in the territory in accordance with the Directive.559 Liberalization of cross-​border access seems unlikely at present, particularly

551 This information would ordinarily be regarded as commercially sensitive. Recital 58 acknowledges, however, that the regime is not aimed at making public proprietary information which would put the AIFM at a disadvantage to potential competitors, and that confidentiality obligations apply. 552 Articles 27(4) and 28(3). 553 For a period of twenty-​four months from the acquisition of control, the AIFM may not facilitate, support, instruct or vote in support of any distribution, capital reduction, share redemption and/​or acquisition of own shares by the company. It must also ‘use its best efforts’ to prevent such transactions: Art 30(1). 554 The industry’s opposition was based in particular on what it regarded as an inappropriate alignment by the Proposal of hedge fund and private equity risk, the non-​systemic impact of private equity funds, and the damage the Proposal could have wreaked on the industry’s potential to support economic recovery in the EU. 555 Although the 2018 KPMG Report found that the extent of the NCA notifications was overly burdensome for smaller AIFs (n 394, 23), the Commission’s subsequent 2020 review reported that the disclosure and asset stripping requirements had not been troublesome, although it acknowledged that it had not been possible to establish their ‘added value’: n 361, 9. 556 As noted in Ch II section 2, the scale of growth in private equity funding has led to concern that public markets are in retreat. This growth is reflected in the growth of private equity AIFs which, as recorded in ESMA’s Annual AIF Reports, grew from 3,369 funds, representing €205 billion NAV and 4 per cent of EU AIF NAV, to 4,992 funds, €363 billion NAV, and 6 per cent of EU AIF NAV, over 2017–​2020. 557 While levels are declining, in its annual AIF Reports ESMA has reported on not insignificant levels of retail participation (14 per cent of NAV (2020), 15 per cent (2019), 16 per cent (2018), and 19 per cent (2017)). Most retail investment is in funds of funds, which primarily follow equity and fixed income strategies. 558 In practice, significant restrictions apply to the cross-​border marketing of AIFs to retail investors, including local product requirements: 2018 KPMG Report, n 394, 24. 559 Member States may not, however, discriminate by imposing stricter or additional conditions on EU AIFs established in another Member State and marketed on a cross-​border basis.

III.5  The AIFMD  325 given the restrictions applicable to the distribution of complex investments under MiFID II (including their exclusion from execution-​only distribution), and also given the distribution restrictions that apply to the EuVECA and EuSEF AIFs (section 6)).560

III.5.15  Supervision and Enforcement The AIFMD follows the supervision and enforcement model which applies across the single rulebook, albeit that it is not yet aligned with the financial-​crisis-​era revisions made across the single rulebook as regards administrative sanctions. Accordingly, the AIFMD requires Member States to designate NCAs (in the form of public authorities) for the purposes of the Directive (Article 44), identifies the powers which they must have (Article 46),561 and imposes cooperation obligations between NCAs and between NCAs and ESMA (Article 50) in relation to information exchange and on-​the-​spot verifications and investigations (Articles 50 and 54) and with respect to informing the relevant NCAs of AIFMD breaches (Article 50).562 ESMA’s competence to resolve disputes between NCAs is also specified (Article 55). The standard professional secrecy and related information exchange rules, including with respect to third countries, apply.563 The AIFMD administrative sanctions regime, however, is out of step with that now in place across the single rulebook, being based on the earlier FSAP-​era model, and only requiring that Member States ensure (without prejudice to Member States’ rights to impose criminal penalties) that appropriate administrative penalties are available which are effective, proportionate, and dissuasive (Article 48(1)). Member States have the option of requiring NCAs to make their sanctioning decisions public (Article 48(2)) and ESMA is to report annually on the application of administrative measures and penalties (Article 48(3)). As under the UCTS regime, administrative sanctions are not widely used across all Member States and, as regards monetary penalties, are relatively low.564

560 Both these AIFs can only be marketed to professional investors, or to retail investors making a minimum investment of €100,000. While the 2016 review of the related Regulations identified this restriction as limiting the capacity of the regime to attract household capital, there was little appetite for liberalization, particularly as to do so would have required a material expansion of the Regulations’ investor protection rules: 2016 EuVECA/​EuSEF Reform Proposal (COM(2016) 461). 561 These powers are similar to those which are required under the UCITS regime: section 4.11. 562 In a parallel reform to that proposed for the UCITS regime, the 2021 AIFMD/​UCITS Proposal seeks to strengthen the supervisory cooperation regime by empowering the host AIFM NCA to request the home AIFM NCA to exercise its supervisory powers, and by empowering ESMA to request an NCA to present on supervisory cases that may have cross-​border implications. 563 Articles 47(2) and (3), 51, and 52. 564 ESMA’s 2022 report on 2021 sanctioning data (its third annual report) noted that the data gathered to date evidenced that sanctioning powers were not equally used across NCAs (six NCAs imposed sanctioning measures and ten imposed financial penalties in 2021) and that the number of sanctions, and the amount of monetary penalties imposed, were relatively low: ESMA, Penalties and Measures Imposed under the AIFMD in 2021 (2022). As with the UCITS regime (n 346), ESMA noted that, and reviewing the period 2013-​2021 (ESMA has collected sanctioning data since 2013), once the single highest penalties for a period were excluded, a ‘very low amount of penalties’ was imposed overall, particularly in light of the circa €7.2 trillion of AIF assets domiciled in the EU. As it also did with the UCITS data, ESMA warned against drawing conclusions as to the quality of supervision given the complexities associated with enforcement, but committed to promoting convergence in the use of sanctioning powers.

326  Collective investment Management As is also the case with the UCITS regime, ESMA’s supervisory convergence activities have come to frame NCA supervision and cooperation, and extend from ESMA’s adoption of soft law, in particular Guidelines, to its steering of NCA supervisory priorities (including in the wake of the March 2020 pandemic-​related market dislocation), and to data collection and risk monitoring. By contrast with the UCITS regime, ESMA is also conferred with more interventionist powers, chiefly with respect to how NCAs impose leverage limits on AIFMs (section 5.10), although there are few signs that it seeks to deploy this power; in practice, ESMA’s extensive and operationally oriented 2020 Guidelines on Leverage Limits allow ESMA to exert very significant influence over how NCAs approach leverage limits, in a good example of how soft supervisory convergence powers can yield similar results to direct executive powers.

III.6  Discrete AIF Regulation: The EuVECA, EuSEF, and ELTIF Vehicles III.6.1  Fund Vehicles and Capital-​raising The regulation of collective investment management has become increasingly atomized since the financial crisis, with discrete regimes now applying to MMFs (section 7), but also to the pathfinders for discrete regulation, the EuVECA (venture capital funds), the EuSEF (social entrepreneurship funds), and the ELTIF (long-​term investment funds) structures. These latter regulatory schemes are directed to the support of capital-​raising and exemplify how fund policy and regulation can be used proactively in service of the EU’s CMU project. The EuVECA and EuSEF regulatory schemes are designed to provide a fund-​raising and passporting vehicle for AIFs that support early-​stage investment in smaller and growth firms and in ‘social enterprises.’ Subsequently refined under the CMU agenda, the two structures were initially adopted in 2013 as a response to the post-​financial-​ crisis EU growth agenda565 in that they support smaller and more specialized AIFs in intermediating capital. The AIFMD de minimis exemption protects the managers of non-​systemic AIFs from overly burdensome regulation through a registration system. But it also withholds the pan-​EU passport from such registered AIFMs. Accordingly, two passporting regimes, designed for the institutional market, were constructed for venture capital funds and for social entrepreneurship funds, the managers of which typically fall far below the AUM thresholds that govern the AIFMD’s application, in order to facilitate access to finance. The ELTIF is similarly designed to support fund-​raising but it has a different orientation and design. It facilitates long-​term investment by providing a specialist vehicle for ‘locked up’ closed-​end investment. Directed to larger AIFMs authorized under the AIFMD, and with a strongly retail orientation, it has a different regulatory design based on asset allocation regulation and intensive retail market protection requirements.

565 Set out in, eg, the EU’s Europe 2020 Strategy (2010) and the related Innovation Union Strategy (COM(2010) 546).

III.6  Discrete AIF Regulation: The EuVECA, EuSEF, and ELTIF Vehicles   327

III.6.2  The EuVECA Regulation The EuVECA Regulation is designed to support venture capital.566 Venture capital is typically associated with early-​stage funding (typically equity-​based) for smaller and growth firms and is raised and intermediated by specialized funds which usually exit from their investments through the public markets. Venture capital accordingly forms part of the ‘funding escalator’, supporting firms as they move towards public funding, and so falls squarely within the CMU agenda. The thinness of the venture capital market in the EU has long been a source of policy concern.567 It came under renewed and close scrutiny in the wake of the financial crisis as the EU sought to strengthen SME funding sources,568 an exercise that led to the 2013 EuVECA Regulation. As the 2015 CMU agenda was launched, however, the venture capital market remained small and dispersed,569 prompting an early CMU-​driven review of the Regulation. This review reported on continued sluggish growth in the sector and identified a series of frictions related to the Regulation’s design.570 In response, and in an effort to increase economies of scale, reduce costs, improve competition, and widen investor choice, the 2017 EuVECA/​EuSEF Reform Regulation liberalized the 2013 Regulation.571 It made a series of reforms designed to make the EuVECA vehicle more attractive and effective, including an expansion of the range of ‘eligible undertakings’ in which an EuVECA can invest to include a wider range of undertakings. The 2013 Regulation was revised again by the 2019 Refit Package which extends to the management of EuVECAs (including as regards the Refit reform’s ‘pre-​marketing’ regime (section 5.7.4). The 2013 EuVECA Regulation, as amended, is designed to support the venture capital sector by providing an ‘opt-​in’ regulatory and passporting regime (the passport, like the AIFMD passport, is for the pan-​EU institutional market only) for AIFMs ‘registered’ under the AIFMD and specializing in venture capital investment; and to provide a related marketing label, the ‘EuVECA’, that can be used by the AIFM when marketing qualifying AIFs (Article 1).

566 Regulation (EU) No 345/​2013 [2013] OJ L115/​1; Commission Proposal (COM(2011) 860), IA SEC(2011) 1515); European Parliament Negotiating Position, 13 September 2012 (T7-​ 0346/​ 2012); Council General Approach, 26 June 2012 (Council Document 11761/​12). 567 Venture capital funds, and the benefits of a related harmonized regime, were a feature of the 2004 UCITS Review and the related 2005 Green and 2006 White Investment Fund Papers. Early initiatives included the 1998 Risk Capital Action Plan (SEC(1998) 552), a series of taxation and state-​aid related initiatives, and the Commission’s 2007 Communication on Venture Capital (COM(2007) 853). The Commission also engaged in a number of fact-​finds, including its 2009 Report on Cross-​border Venture Capital in the EU. 568 See, eg, Communication on an Action Plan to Improve Access to Finance for SMEs (COM(2011) 870). 569 The 2015 CMU Action Plan highlighted the small scale of the EU venture capital segment, noting that were the EU venture capital market to be of the same scale as the US market, some €90 billion would have been available to finance firms over 2009–​2014. The average venture capital fund was half the size of the average US fund (at €60 million) and the industry was concentrated in eight Member States: 2015 CMU Action Plan, n 1, 4 and 8. 570 Chiefly as regard the restrictive portfolio allocation/​eligible assets rules which limited EuVECA investments to investments in smaller firms; restrictions on the extent to which larger AIFMs could benefit from the Regulation and so on the scalability of EuVECA funds; and diverging national rules, particularly as regards the EuVECA AIFM’s own funds/​capital (which was not harmonized under the 2013 Regulation). The Commission also reported that only seventy AIFs were in the form of EuVECAs and that the venture capital market remained underdeveloped, with venture capital funding representing less than 0.1 per cent of GDP in the strongest venture capital markets in the EU: n 560. 571 Regulation (EU) 2017/​1991 [2017] OJ L293/​1.

328  Collective investment Management The Regulation’s regulatory design, which is amplified by administrative rules,572 draws on the UCITS and AIFMD regimes. At its heart are the portfolio composition/​asset allocation requirements on which the EuVECA designation depends. In this sense, the regime has resonances with the UCITS regime, albeit that the asset-​allocation requirements here have a single focus on venture capital investments. But the Regulation also constitutes a collective investment management regime, imposing organization, conduct, and transparency requirements on EuVECA managers, and in this sense is similar in design to the AIFMD. The Regulation does not impose an AIF authorization requirement, and is materially less dense than the AIFMD as regards manager regulation (it adopts a principles-​based approach), but it is nonetheless highly specified in places.573 The Regulation also includes the necessary notification and supervisory ‘technology’ required to support passporting of registered EuVECA AIFMs, which technology draws on the UCITS and AIFMD passporting regimes. The EuVECA Regulation is accordingly a fully articulated regulatory regime, notwithstanding its singular focus.574 The EuVECA regime is available for those smaller EU AIFMs that are registered (rather than authorized) under the AIFMD’s de minimis registration regime for those AIFMs that fall below the AIFMD’s €500 million AUM threshold; and that, crucially, manage portfolios of ‘qualifying venture capital funds’ (Article 2). Following the 2017 reforms, larger EU AIFMs, authorized under the AIFMD as they pass its AUM threshold, can also use the ‘EuVECA’ label for qualifying venture capital funds, as long as they follow identified EuVECA rules.575 The ‘qualifying venture capital fund’, the management of which is the gateway to the EuVECA regime and to the use by the AIFM of the EuVECA label when marketing such funds, must meet a series of conditions. The foundational requirement is that the fund, which must be established in the EU, must intend to invest at least 70 per cent of its capital (aggregate capital contributions and uncalled committed capital) in ‘qualifying investments’, within the time frame set out in the fund’s rules/​instruments of incorporation (Article 3(b)). ‘Qualifying investments’ cover equity/​quasi-​equity securities576 issued by, or loans granted by the fund577 to, a ‘qualifying portfolio undertaking’ (Article 3((e)).578 Following the expansion of the scope of ‘qualifying portfolio undertakings’ by the 2017 reforms to include larger undertakings, these undertakings are widely defined as covering: undertakings which are not (at the time of the investment) admitted to trading on a regulated market or multilateral trading facility (MTF) and employ up to 499 persons; or undertakings which

572 Primarily Delegated Regulation (EU) 2019/​820 [2019] OJ L134/​8, which amplifies the conflict-​of-​interest rules applicable to EuVECA AIFMs. 573 It imposes specific requirements relating to leverage and own funds, eg (Arts 5 and 10). 574 Only its main features are outlined here. 575 These are primarily in relation to qualifying portfolio investments and marketing. The conduct and organizational rules imposed on registered AIFMs by the Regulation do not apply to authorized AIFMs as they are regulated by the significantly more intensive AIFMD regime. 576 A quasi-​equity security is defined as a financing instrument which is a combination of equity and debt, where the return on the instrument is linked to the profit or loss of the undertaking, and where the repayment of the instrument in the event of default is not fully secured: Art 3(h). 577 By contrast with the AIFMD, accordingly, and pending adoption of the 2021 proposals for an AIFMD loan origination regime (section 5.10), the EuVECA Regulation expressly address loan origination. Restrictions apply in that the fund must already hold a qualifying investment in the undertaking and that no more than 30 per cent of the fund’s capital can be used for such loans: Art 3(e)(ii). 578 Investment in other qualifying venture capital funds is also permitted (Art 3(e)(iv)).

III.6  Discrete AIF Regulation: The EuVECA, EuSEF, and ELTIF Vehicles   329 fall within the MiFID II definition of an SME579 and are listed on an MTF in the form of an SME Growth Market (Article 3(d)).580 Use by the AIFM of the EuVECA designation for EU marketing of qualifying venture capital funds is contingent on its compliance with a series of collective investment management requirements, including, as noted, the pivotal requirement relating to portfolio allocation/​qualifying investments (Article 3), but also in relation to leverage (Article 5);581 marketing (the fund can only be marketed to professional investors or investors making a minimum investment of €100,000: Article 6));582 and attenuated organizational and operational requirements which reflect—​albeit in significantly less detail—​the main principles underlying the UCITS and AIFMD regimes.583 Where these requirements are met, the AIFM can use the EuVECA label in relation to the marketing of qualifying venture capital funds in the EU (Article 4). AIFMs managing qualifying venture capital funds that intend to use the EuVECA designation for these funds must be also registered by their home NCA in accordance with the required procedure and conditions, which include a fitness and probity requirement (Article 14). This registration, following the 2017 reforms, also suffices for the purposes of the AIFM registration required under the AIFMD, but only as regards the management of EuVECAs.584 A passport for cross-​border marketing is then available, following compliance with the required notification process, and allows the registered AIFM to use the EuVECA designation for relevant funds across the EU (Article 15–​16). A ‘pre-​marketing’ regime is also available and facilitates the testing of market appetite without the imposition of passporting-​related requirements (Article 4a).585 The EuVECA Regulation was at the time of its adoption and remains an experiment in regulatory design. Given the currently small scale of the EU venture capital market, it is charged with some heavy lifting, particularly as it is not clear that regulatory accommodations of this nature can have significant transformative effects, given the range of factors, including investor appetite and competing sources of finance, that shape the venture capital 579 An undertaking that has an average market capitalization of less than €200 million for the previous three years. 580 On SME Growth Markets see Ch II section 8. A ‘qualifying portfolio undertaking’ must also not be one of the specified financial institutions (essentially banks, investment firms, CISs, and insurance companies) and must be established in the EU. Non-​EU undertakings can qualify as investments, subject to the standard conditions that apply to third countries relating to tax cooperation and compliance with anti-​money laundering/​anti-​terrorism financing standards (see further Ch X). 581 The manager must not employ (at the level of the EuVECA fund) any method by which the exposure of the fund would be increased beyond the level of its committed capital (whether through borrowing of cash or securities, derivatives use, or other means); and the manager (at the level of the EuVECA fund) can only borrow, issue debt obligations, or provide guarantees where such action is covered by uncalled commitments. 582 ‘Professional investor’ is defined in accordance with the MiFID II regime for ‘professional clients’ (Ch IV section 6.2). Where the fund is marketed to other investors (who must commit to a minimum investment of €100,000) these investors must state in writing that they are aware of the risks associated with the investment (Art 6(1)). This restriction does not apply to the executives, directors, or employees of portfolio undertakings. 583 Principles-​based requirements apply with respect to conduct of business (Art 7), delegation (Art 8), conflicts-​of-​interest management (Art 9), an own funds/​capital regime (added by the 2017 reforms to address the costs and fragmentation risks that had arisen from diverging national own funds regimes) (Art 10), valuation (Art 11), annual NCA supervisory reporting (Art 12), and disclosure to investors (including in relation to the fund’s manager, investment strategy, risk profile, valuation procedures, manager remuneration, costs, historical financial performance, where relevant, and procedures for changing the fund’s investment strategy) (Art 13). 584 AIFMs authorized under the AIFMD are not subject to the registration requirement, but the EuVECA funds they propose to manage must be registered in accordance with Art 14a which requires that authorized AIFMs register the relevant funds with the funds’ home NCA. 585 This regime follows the AIFMD pre-​marketing regime: section 5.7.4.

330  Collective investment Management sector.586 The Regulation also exemplifies the challenges in using CIS regulation to achieve specific market effects; the early liberalization brought by the 2017 reforms underscores that it has proved difficult to capture, to optimal effect, the relevant investments which the Regulation seeks to facilitate. It remains to be seen whether the 2017 reforms, in combination with the 2019 Refit revisions (including as regards pre-​marketing), will have traction on the venture capital market. Like the parallel EuSEF reforms noted below in this section they do, however, signal an increasingly muscular and agile approach to legislative reform as well as an EU appetite to experiment with legislative change, as least where the target market sector is relatively small, to achieve desired outcomes.

III.6.3  The EuSEF Regulation The 2013 European Social Entrepreneurship Funds (EuSEF) Regulation587 follows the same regulatory design as the EuVECA Regulation and has been similarly reformed by the 2017 EuVECA/​EuSEF Regulation and the 2019 Refit Package reforms. Its objectives and the regulatory challenges which it addresses are, however, different. Social Entrepreneurship Funds (SEFs) invest in what can be broadly described as firms which seek to achieve ‘social impact’ (social businesses or enterprises), and which have a strong focus on sustainable or inclusive development and on addressing social challenges.588 As the ‘social enterprise’ sector has grown, investor interest in ‘social returns’ has led to the development of a small but growing AIF SEF segment which focuses on such social enterprises. SEFs have, however, struggled to draw in capital across the EU because of regulatory barriers, poorly tailored rules, size constraints, weak branding dynamics which make it difficult for SEFs to identify themselves to potential investors, and investor wariness.589 The embryonic SEF sector has also been hampered by the diffuse nature of ‘social enterprise’ and the related difficulties in quantifying, inter alia, ‘social impact’ and ‘social returns’. Accordingly, and by contrast with the EuVECA Regulation which responds to longstanding difficulties in the venture capital market, the EuSEF Regulation is designed to promote an emerging investment class and to establish key metrics, particularly with respect to the measurement of social impact. The EuSEF Regulation, as recently amended by the 2019 Refit Package and the 2017 EuVECA/​EuSEF Regulation,590 follows the EuVECA Regulation’s regulatory design, but its qualifying investment requirement (as with the EuVECA regime, 70 per cent of the portfolio must be composed of qualifying investments) relates to social enterprises.591 It 586 The venture capital regulatory agenda is accompanied by reviews of tax incentives and also by direct investment initiatives (including through ‘VentureEU’, the EU’s venture capital funds of funds programme which is supported by public investment). 587 Regulation (EU) No 346/​2013 [2013] OJ L115/​18; Commission Proposal COM(2011) 862; IA SEC(2011) 1512/​ 2; European Parliament Negotiating Position, 13 September 2012 (T7-​ 0345/​ 2012); Council General Approach, 26 June 2012 (Council Document 11762/​12). 588 2011 EuSEF Regulation Proposal IA, n 587, 5. 589 2011 EuSEF Regulation Proposal IA, n 587, 19–​26. Subsequent to the adoption of the 2013 EuSEF Regulation, the 2016 EuVECA/​EuSEF Proposal (n 560) reported on very poor take up, with only four EuSEFs registered across the EU. 590 The regime has been liberalized in a similar way as the EuVECA regime has been, including through an expansion of its qualifying investment requirements. 591 A qualifying investment relates here to an undertaking which, in addition to not being admitted to trading on a regulated market or MTF at the time of the investment, has the achievement of measurable, positive ‘social

III.6  Discrete AIF Regulation: The EuVECA, EuSEF, and ELTIF Vehicles   331 is also tailored to the specificities of social enterprise investments, including as regards the measurement of social impact;592 these specificities are also addressed by its administrative rules.593 The Regulation provides the ‘EuSEF’ label and related marketing passport (the passport, like the EuVECA passport, is only available for marketing to professional investors). Like the EuVECA, the EuSEF represents an experiment in regulatory design, albeit one with greater transformative ambitions than the EuVECA given the nascent state of the EU social enterprise market. Its impact has been immediate, nonetheless, in that it has led to the development of new fund performance metrics, with ESMA developing indicators to measure social impact. The challenges are, however, considerable. Visibility is a key friction in this market and doubts remain as to the efficacy of the EuSEF structure, particularly as the EuVECA model can be used by AIFMs who focus on social impact but find the requirements of the EuSEF model overly restrictive.594

III.6.4  The European Long-​term Investment Fund A further specialist Regulation provides a vehicle for long-​term investments: the European Long Term Investment Fund (ELTIF) Regulation.595 The long-​term focus of the ELTIF distinguishes it from the EuSEF/​EuVECA regimes. Its genesis lies in the post-​financial-​crisis concern to strengthen the capacity of the EU financial markets to support long-​term investments, in particular in infrastructure-​related projects, given projected high levels of demand for infrastructure funding596 and a related funding gap.597 The Commission’s 2013 ELTIF Proposal598 was therefore designed to deepen the pool of long-​term capital available by facilitating specialist AIF vehicles which would take a long-​term investment horizon and impacts’ as its primary objective and provides services or goods which generate a ‘social return’ (this broad formula was adopted in 2017; the 2013 formula was more restrictive, referring to an enterprise providing services or goods to ‘vulnerable or marginalized, disadvantaged or excluded persons’); or employs a method of production of goods or services that embodies its social objectives; or provides financial support exclusively to undertakings of this nature. The undertaking must also use its profits primarily to achieve its primary social objectives and employ predefined processes and rules which determine the circumstances in which profits are distributed to owners and shareholders to ensure that distributions do not undermine its primary objectives. The undertaking must also be managed in an accountable and transparent way, in particular by involving workers, customers, and stakeholders affected by its business activities: Art 3(1)(d). 592 Article 10 requires the AIFM to have procedures in place to measure the extent to which the relevant undertaking achieves the positive ‘social impact’ to which it is committed. The related indicators can include impacts in relation to, inter alia, employment and labour markets, social inclusion, equal treatment, social protection, and public health and education. 593 Delegated Regulation 2019/​819 [2019] OJ L134/​1. Like the parallel EuVECA Delegated Regulation, it amplifies the conflict-​of-​interest management requirements, but also covers the measurement of social impact and the required disclosures to investors. 594 European Venture Philanthropy Association, Policy Brief. How EuSEF’s Reform can Impact the VP/​SI Sector (2018). 595 Regulation (EU) 2015/​760 [2015] OJ L123/​98. 596 Some €1,500–​2,000 billion in infrastructure funding was, when the ELTIF was initially mooted, estimated as required within the EU by 2020: Commission, ELTIF—​Frequently Asked Questions, 26 June 2013 (MEMO/​13/​ 611). 597 The Commission reported when the ELTIF Proposal was unveiled that many infrastructure projects had not been able to raise financing suited to their time horizon and that there was a need to replace bank-​based funding with capital market funding: Commission, European Long-​Term Investment Fund Proposal IA (SWD(2013) 230) 18. 598 COM(2013) 462.

332  Collective investment Management ‘lock up’ the pooled capital accordingly.599 To achieve this, a new regulatory design was required as these vehicles would not fit within the open-​ended UCITS model, and also would not easily fit within the AIFMD as they would seek to intermediate household capital. The ELTIF Regulation is accordingly based on a bespoke regulatory model, which draws on elements of the UCITS and AIFMD regimes, and has a complex, blended design. Its main features are considered in the following sections.

III.6.4.1 The ELTIF Regulation a. Regulatory Design: the AIFMD and the ELTIF Regulation The ELTIF Regulation, which has been amplified by the 2018 ELTIF RTS,600 is an opt-​in regime. It lays down uniform rules on the authorization, investment policies, and operating conditions for EU AIFs marketed in the EU as ELTIFs (Article 1(1)). Its objective is to raise and channel capital towards European long-​term investment in the real economy, in line with the EU objective of smart, sustainable, and inclusive growth (Article 1(2)). The Regulation is strongly oriented to product regulation in that it is based on the ELTIF being authorized by the ELTIF’s NCA (Articles 4(1) and 5(1)). But it draws on the AIFMD, as only an EU AIFM authorized under the AIFMD can apply to the ELTIF’s NCA to manage such an ELTIF (Article 5(2)):601 the ELTIF authorization process, while directed to the ELTIF fund, requires specific approval, by the ELTIF NCA, of the previously authorized AIFM to manage the ELTIF (as well as of the choice of depositary (Article 6(1)). The AIFMD otherwise carries the weight of authorizing and regulating the AIFM. The ELTIF Regulation is primarily concerned with regulating the ELTIF: its foundational requirements provide that the ELTIF designation can only be used by EU AIFs (Article 3(2)) and where the relevant AIF has been authorized in accordance with the Regulation (Article 4(1)). Similarly, an ELTIF may only be marketed in the EU where it has been authorized in accordance with the Regulation (Article 3(1)).602 The Regulation is, however, closely connected to the AIFMD which governs the authorization and regulation of the ELTIF’s AIFM, and which also applies to the ELTIF passporting process. Once an ELTIF is authorized by its home NCA, it can be marketed by its AIFM to professional and retail investors603 in the ELTIF home Member State and also cross-​border, in accordance with the ELTIF-​specific notifications, and also following compliance with the required notifications under the AIFMD notification system (for cross-​border AIF marketing) (Article 31)). Also, the AIFMD’s requirements governing NCA supervision, and NCA home/​host cooperation and supervisory coordination, including as regards the imposition of host NCA marketing rules (and as revised by the Refit Package which applies to ELTIFs), broadly apply 599 The Proposal envisaged that the ELTIF would increase the capital available for energy, transport and communication infrastructures, industrial and service facilities, and education and R&D: n 598, 2. 600 RTS (EU) 2018/​480 [2018] OJ L81/​1. The RTS covers the hedging activities permitted, how the ‘sufficient’ life of the ELTIF is to be measured, asset allocation, the asset divestment process, and the facilities to be available to retail investors. 601 The AIFM must comply at all times with the AIFMD (Art 7(2)) and the ELTIF NCA may refuse to approve the ELTIF where the AIFM does not comply with the AIFMD or is not authorized by its home NCA to manage AIFs that follow long-​term investment strategies (Art 6(3)). 602 ESMA maintains a register of ELTIFS (and EuSEFs and EuVECAs). 603 As is typical across the single rulebook, retail investor is defined as not being a professional investor; professional investor is as defined under the MiFID II regime for professional clients (Ch IV section 6.2): Art 2(3) and (4).

III.6  Discrete AIF Regulation: The EuVECA, EuSEF, and ELTIF Vehicles   333 to the AIFM’s management and marketing of the ELTIF. These requirements are, however, adjusted to the ELTIF context by the Regulation, including as regards the specification of the ELTIF’s NCA’s powers to supervise the ELTIF’s compliance with the Regulation and the specification of the AIFM’s NCA’s related powers; the transmission of ELTIF-​related documentation to AIFMs’ host NCAs; and the specification, in cross-​border AIFM notifications, of whether the ELTIF will be marketed to retail investors (Articles 31–​5). b. Product Regulation: Redemption Restrictions and Asset Allocation Authorization as an ELTIF is subject to the AIF meeting the Regulation’s requirements (Article 6(1)). Chief among these are the ELTIF asset-​allocation rules. These are modelled on the UCITS template,604 but reflect the design of the ELTIF as a closed-​end fund which pays out at the end of its pre-​determined life-​cycle, when the portfolio’s long-​term assets mature, and so also address redemption restrictions. ELTIFs are illiquid investments, reflecting the long-​term nature of the underlying investments and the related illiquidity premium associated with such investments.605 The regulatory regime is therefore designed to ensure that AIFMs have sufficient flexibility to design the ELTIF such that the risk/​return profile of the underlying assets is reflected in the investment holding period and in the ELTIF’s life, and to prohibit early redemption rights which could disturb the ELTIF’s structure. The decision as to the lifetime of the ELTIF is reserved to the AIFM and investors may not ask for redemption of their investment before the end of the ELTIF’s life606 (which must be clearly indicated in the fund’s rules and disclosed to investors) (Article 18 (1)).607 The Regulation does not place parameters on the ELTIF life-​ cycle, save to require that it must be sufficient in length to cover the life-​cycle of each of the individual assets held by the ELTIF, measured according to the illiquidity profile and economic life-​cycle of each asset and the ELTIF’s investment objective (Article 18(3)). ELTIFs are also required to establish a schedule governing the orderly disposal of assets to ensure redemption of investors’ shares or units (Article 21). Investors are not, however, without an exit mechanism: ELTIF shares or units can be admitted to trading on a MiFID II/​MiFIR trading venue (Article 19). An ELTIF may only invest in ‘eligible investment assets’ and in eligible assets under the UCITS regime; at least 70 per cent of its assets, however, must be invested in ‘eligible investment assets’ (Article 9(1) and 13(1)). The 30 per cent UCITS assets tranche is designed to operate as a liquidity buffer for ELTIFs, to manage cash flow requirements as assets are constituted and/​or replaced.608 Eligible investment assets are very broadly defined as equity and debt in ‘qualifying portfolio undertakings’, or as loans by the ELTIF to qualifying portfolio undertakings,609 as well as units/​shares in other ELTIFs, EuVECAs, and 604 The Proposal sought to follow the ‘tried and tested’ UCITS model: 2013 ELTIF Proposal, n 598, 4. 605 An illiquidity premium is typically contingent on an investment being held for ten to twenty years. 606 To avoid the danger of ‘fire sales’ of assets originally acquired to be held for longer periods, and related prejudice to the returns of investors remaining in the fund. 607 The Regulation specifies the circumstances under which the ELTIF can provide for early redemption, including that, through the life of the ELTIF, the AIFM can demonstrate that an appropriate liquidity management system, and liquidity risk monitoring procedures, are in place, compatible with the long-​term investment strategy of the ELTIF and the proposed redemption policy: Art 18(2). 608 2013 ELTIF Proposal, n 598, 4. 609 As with the EuSEF/​EuVECA regimes, a distinct loan origination regime accordingly applies here, by contrast with the AIFMD and pending the 2021 loan origination reforms. The ELTIF is not subject to a lending cap, but the loans must not have a maturity beyond the life of the ELTIF: Art 10(c).

334  Collective investment Management EuSEFs.610 They also include holdings of individual ‘real assets’ of value of at least €10 million, albeit the investment must be made through a qualifying undertaking (Article 10).611 The pivotal ‘qualifying portfolio undertaking’ which frames ELTIF asset allocation612 is one which is not a CIS; not a financial undertaking;613 not admitted to trading on a MiFID II/​MiFIR trading venue614 or, if it is so admitted, has a market capitalization of less than €500 million; and which is established in a Member State or a third country jurisdiction which meets the regime’s requirements (Article 11).615 The main qualifying condition for an eligible long-​term investment in an undertaking, accordingly, is that the underlying (non-​financial) undertaking is not listed on a trading venue or, if it is listed, is a smaller undertaking—​SME investments are, accordingly, envisaged. The Article 13 risk-​spreading rules are similar in design to those that apply under the UCITS regime and are likewise designed to limit concentration risk.616 The ELTIF cannot invest more than 10 per cent of its capital in assets issued by a single qualifying portfolio undertaking and in an individual real asset;617 more than 10 per cent of its capital in units or shares of any single ELTIF, EuVECA, or EuSEF;618 or more than 5 per cent of its assets in UCITS eligible assets issued by a single body.619 Reflecting the portfolio construction period required to build the fund’s mix of long-​term assets, these limits do not apply immediately but must be met by the date specified by the ELTIF, taking into account the features and characteristics of the portfolio assets, but must be met no later than five years from authorization, or half of the life of the ELTIF, whichever is earlier (Article 17(1)). A series of restrictions apply to the investment techniques in which the ELTIF can engage. It is prohibited from engaging in short selling; taking direct or indirect exposures to commodities, including through derivatives; entering into securities lending and borrowing agreements and repurchase agreements and other agreements that would encumber the ELTIF’s assets, if these transactions would affect more than 10 per cent of ELTIF assets; and, in a significant contrast to the UCITS regime, from using financial derivatives (unless

610 As long as these other CISs do not have investments of more than 10 per cent of their capital in ELTIFs: Art 10(d). 611 A ‘real asset’ is defined as one that has value due to its substance and properties and that may provide returns, and as including infrastructure and other assets that give rise to economic or social benefits (such as education, counselling, R&D), but including commercial property and housing only where they are integral to, or an ancillary element of, a long-​term investment project that contributes to the EU objectives of smart, sustainable, and inclusive growth: Art 2(6). 612 In practice, some 60 per cent of ELTIF assets are in the form of qualifying undertakings: 2021 Commission ELTIF Proposal IA (SWD(2021) 342) 8. 613 Essentially, credit institutions, investment firms, insurance undertakings, and UCITS/​ AIFMD managers: Art 2(7). An exception is available for financial undertakings that exclusively finance qualifying undertakings (Art 11(2)). 614 Regulated markets, MTFs, and organized trading facilities (see Ch V). 615 In relation to tax cooperation and compliance with anti-​money-​laundering and anti-​terrorism financing standards. 616 In practice they have the effect of limiting ELTIFs’ investment to ten investments: ESMA, Letter to the Commission (Review of the ELTIF Regulation), 3 February 2021. 617 The ELTIF may raise this limit to 20 per cent, as long as the aggregate value of the assets held in which it invests more than 10 per cent of its capital does not exceed 40 per cent of its capital. 618 Additionally, the aggregate value of units or shares of ELTIFs, EuVECAs, and EuSEFs may not exceed 20 per cent of the ELTIF’s capital and the ELTIF may not acquire more than 25 per cent of the units or shares of a single one of these entities: Art 13(3) and 15(1). 619 Additionally, the aggregate risk exposure to an ELTIF counterparty arising from eligible OTC derivative transactions or from reverse repurchase agreements cannot exceed 5 per cent of its capital: Art 13(4).

III.6  Discrete AIF Regulation: The EuVECA, EuSEF, and ELTIF Vehicles   335 the derivatives are used solely for hedging the ELTIF’s duration and exchange risks) (Article 9(2)); cash borrowing limits requirements also apply (Article 16).620 c.  Disclosure As under the UCITS and AIFMD regimes, transparency requirements apply (Articles 23–​ 5), but they are tailored to the particular risks posed by ELTIFs and have a precautionary colour, reflecting the ELTIF’s retail orientation. The foundational obligation requires that a prospectus, containing the information necessary for investors to make an informed judgement regarding the investment and the risks attached, must be published prior to the marketing of the ELTIF (Article 23(1) and (2)).621 In the case of retail marketing, a Key Information Document (KID), prepared in accordance with the PRIIPs disclosure regime, must also be prepared (Article 23(1)). The illiquid nature of the ELTIF must be highlighted in the prospectus and in any other marketing documents; these must also advise investors that only a small proportion of their investment portfolio should be invested in an ELTIF and inform investors of the risks relating to investing in real assets (Article 23(4)). Discrete cost disclosure requirements also apply (Article 25).

III.6.4.2 Retail Marketing The ELTIF marked, at the time of its adoption, a new departure in EU fund regulation in that, unlike the UCITS regime, it embeds specific and extensive retail marketing protections where the ELTIF is to be marketed to retail investors. Unlike UCITS managers, the ELTIF manager is subject to a distinct MiFID II-​like product governance obligation: prior to marketing or distribution to retail investors, the manager must establish an internal ELTIF assessment/​product governance process which includes an assessment of whether the ELTIF is ‘suitable’ for marketing to retail investors, taking into account at least the life of the ELTIF and its investment strategy; the manager must also make available to any ELTIF distributor all appropriate information on the ELTIF, including as regards its life and investment strategy and the internal product governance process (Article 27). While this process is not as articulated or densely regulated as its MiFID II product governance counterpart, it nonetheless marked a step change in fund regulation. In a similarly innovative design choice, the marketing of ELTIFs to the retail market is subject to the requirement that retail investors are provided with ‘appropriate investment advice’ from the AIFM (or the distributor)622 (Article 30(1)): in effect, this entails a form of prohibition on execution-​only sales.623 Relatedly, an attenuated form of the MiFID II 620 In essence, ELTIF cash borrowing may not represent more than 30 per cent of its capital, must serve the purpose of acquiring a participation in eligible investment assets, must not encumber the ELTIF’s assets or hinder their realization, and not extend beyond the maturity of the ELTIF. 621 The prospectus, which must be kept up to date (Art 24(5)), is not subject to approval, but must (with the fund’s annual report, which is subject to the AIFMD regime for annual AIF reporting as well as to the additional requirements that are specified in Art 23(5)) be sent to its NCA (and the AIFM NCA, on request): Art 24. The prospectus content, which must include the fund rules and constitutional documents, is specified under Arts 23 and 24 which include requirements specific to the ELTIF context, including that the prospectus contain a specific statement on how the ELTIF’s investment objectives and strategy qualify it as a long-​term fund, a prominent indication of the categories of assets in which the AIFM is authorized to invest, and any other information requested by the NCA as relevant. 622 Which may be a MiFID II firm and regulated under that regime. 623 Accordingly, the ELTIF AIFM may only market the ELTIF to retail investors where it is authorized, under the AIFMD, to provide investment advice services alongside AIF management services.

336  Collective investment Management suitability regime applies where the AIFM directly offers ELTIF investments to retail investors and provides the required ‘appropriate investment advice’ (Article 28(1) and 30(1)): the AIFM must obtain information regarding the retail investor’s knowledge and experience in the investment field relevant to the ELTIF, financial situation (including ability to bear losses), and investment objectives (including time horizon) and, based on this information, only recommend the ELTIF if it is suitable for the retail investor. In a precautionary form of intervention, and one which sits uneasily with the aim of the ELTIF Regulation to facilitate retail investment, the AIFM (and the distributor) must also, where the financial instrument portfolio (including cash deposits) of a potential retail investor does not exceed €500,000, and having performed the required suitability test, and provided ‘appropriate investment advice’, ensure (on the basis of the information provided by the investor) that the investor does not invest an aggregate amount (across all ELTIFs) in excess of 10 per cent of its financial instrument portfolio in ELTIFs; and an initial minimum investment requirement of €10,000 applies (Article 30(3)).624 Both requirements combine to represent a potentially significant deterrent to household investment. In addition, a risk warning requirement applies: where the life of the ELTIF exceeds ten years, the AIFM or distributor must issue a ‘clear written alert’ that the product may not be suitable for retail investors that are not able to sustain such a long-​term and illiquid commitment (Article 28(2)). Retail investors also have a two-​week ‘cooling-​off ’ period (Article 30(6)).625

III.6.4.3 The ELTIF Experiment and 2021 ELTIF Proposal The ELTIF Regulation, like its EuSEF and EuVECA counterparts, is designed to shape market behaviour by providing a bespoke regulatory vehicle to unlock sources of capital. It represented, on its adoption, a muscular application of EU collective investment scheme policy. It also represented a significant innovation in EU retail market policy in that it constructed a retail-​oriented AIF vehicle. In practice, the ELTIF has shared the fate of the EuVECA/​EuSEF vehicles. Only 57 ELTIF vehicles had been formed by October 2021 (domiciled in only four Member States), with AUM in the region of only €2.4 billion (from an overall AIF market at the time of some €6.8 trillion).626 But demand for capital for long-​term investment, and in particular for long-​ term SME finance and for the green transition, has grown. Review of the ELTIF Regulation was relatedly swift, with the second phase of the CMU agenda identifying it as in need of reform.627 The subsequent review identified the limited scope of ELTIF eligible assets and the access barriers faced by investors, in particular retail investors, as constraining the ELTIF market.628 The 2021 ELTIF Reform Proposal followed in November 2021.629 Wide-​ranging and sharply tilted towards ELTIF liberalization, the Proposal’s reforms, first, very significantly 624 The retail investor is responsible for providing the AIFM or distributor with accurate information. 625 Additional requirements apply where the ELTIF is marketed to retail investors including specific requirements governing the depositary, including restrictions on discharge of liability and exclusions of liability, and more stringent custody rules (Art 29); that the legal form of the ELTIF must not lead to any further liability for retail investors or require additional capital commitments (Art 30(5)); complaint procedures (Art 30(7)); and the specification in fund rules of an equal treatment obligation and a prohibition on preferential treatment (Art 30(4)). 626 2021 ELTIF Proposal IA, n 612, 8. 627 2020 CMU Action Plan, n 1, 8. Alongside, the Report of the High Level Forum on CMU identified an extensive set of reforms: n 19. 628 Outlined in the 2021 Impact Assessment: n 612. 629 2021 Commission ELTIF Proposal (COM(2021) 722) 2.

III.6  Discrete AIF Regulation: The EuVECA, EuSEF, and ELTIF Vehicles   337 loosen the investment restrictions; and, second, recast the retail marketing protections to align the ELTIF regime directly with MiFID II and to facilitate retail access to ELTIFs.630 The Proposal extends the eligible investments regime in several ways: it provides for ELTIF investment in other AIFs and UCITSs and thereby supports the development of ELTIF fund-​of-​fund structures; liberalizes the real asset investment regime by materially broadening the definition of a ‘real asset’,631 removing the current requirement that real asset investment be carried out through a qualifying undertaking, and reducing the minimum €10 million investment to €1 million; provides for investment in simple, transparent, and standardized (STS) securitizations (as regulated by the securitization regime); and expands the range of listed undertakings that can constitute eligible investments from those with a market capitalization of €500 million to those with a capitalization of €1 billion. It also materially liberalizes the risk-​spreading regime by bifurcating it into separate regimes: for ELTIFs marketed to professional investors; and those marketed to retail investors. For ELTIFs marketed to professional investors, the regime is radically liberalized by the Proposal: the only restriction relates to the overall requirement that 60 per cent (down from 70 per cent) of the ELTIF’s capital take the form of eligible investment assets. For retail-​marketed ELTIFs, the Proposal also adopts the lower 60 per cent threshold, but retains the risk-​spreading requirements while increasing the relevant limits.632 As regards retail marketing, the Proposal retains the novel product governance requirement introduced by the Regulation. But it replaces the Regulation’s bespoke investment advice/​suitability regime with the MiFID II regime. It thereby brings the highly articulated set of MiFID II suitability rules to bear directly on ELTIF managers, in a significant innovation for EU fund regulation. It also removes the quantitative restrictions on retail investment, which had become strongly associated with deterring retail investors and, in particular, with preventing retail investors from scaling-​up ELTIF positions over time as they became familiar with ELTIF investment. The Proposal accordingly significantly liberalizes retail investment but balances this liberalization by applying the more granular and sophisticated MiFID II suitability regime. Provisional agreement on the Proposal was reached relatively speedily in October 2022. While the agreement retains many of the Proposal’s core features it is more liberal, for example extending the range of listed undertakings that can constitute eligible investments from those with a market capitalization of €500 million to those with a capitalization of €1.5 billion (the Proposal called for €1 billion), removing the value limit on real estate investment, and loosening the requirement that the eligible asset qualification be met by 70 per

630 The Proposal also streamlines the authorization process, including by clarifying that the ELTIF NCA has no role in the authorization of the ELTIF AIFM. 631 By adopting the much simpler definition of ‘an asset that has an intrinsic value due to its substance and properties’, a definition that is materially broader and clearer than the current more heavily qualified version (n 611). 632 From, as regards the relevant proportion of the ELTIF’s capital, 10 per cent to 20 per cent in the case of investment in a single entity, real asset, or fund; 5 per cent to 10 per cent in the case of UCITS eligible assets issued by a single body; 20 per cent to 40 per cent as regards the aggregate value of CIS investments; 5 per cent to 10 per cent in the case of average risk exposure to a counterparty from derivative and similar transactions; 25 per cent to 30 per cent as regards investments in a single CIS; and from 30 per cent to 50 per cent as regards cash borrowing. A 20 per cent limit would apply to retail ELTIF investment in the new eligible asset class of STS securitization positions. The Proposal also provides for master/​feeder ELTIFs (where the ELTIF invests 85 per cent of capital in a master ELTIF) and related prospectus disclosure rules (including retail-​oriented disclosures) and master/​feeder information exchange requirements.

338  Collective investment Management cent of the portfolio to 55 per cent (the Proposal called for 60 per cent). As regards the retail markets, the agreement broadly followed the Proposal.633 Like the EuVECA/​EuSEF innovation, the ELTIF, while on its adoption a striking experiment in regulatory design, has struggled. The relative agility of the reform response, however, augurs well for the ability of the EU to fine-​tune this suite of bespoke AIFs. Whether or not the atomization of the AIF universe into discrete regulatory schemes will facilitate capital-​raising, however, remains unclear, particularly in light of the other factors, taxation among them, that shape asset allocation. Certainly, regulatory design of this type is not easy, as the revisions to these schemes underline.

III.7  Money-​Market Funds III.7.1  Money-​Market Funds and Liquidity Risks The ELTIF, EuVECA, and EuSEF regulatory regimes are all designed as vehicles to support capital-​raising. The money-​market funds (MMFs) regime, by contrast, is driven by the financial stability concerns that flow from the central role MMFs play in the short-​term debt markets (money markets) and from their vulnerability to de-​stabilizing liquidity risks.634 The distinct risks raised by MMFs derive from their asset and liability structure. On the asset side, MMFs are major funders to the short-​term debt markets, markets that are of critical importance for government, financial sector, and corporate issuers. They typically invest in short-​term debt assets such as short-​term government debt, commercial paper, negotiable certificates of deposit, and repurchase agreements (‘repos’),635 all typically regarded as high quality, lower risk debt instruments, as well as in cash.636 MMFs are as a result primary providers of short-​term funding to financial institutions and are thereby systemically significant.637 On the liability side, MMFs are similarly systemically significant. MMF units/​shares provide on-​demand liquidity (as well a money market yield638 and risk diversification) to mainly institutional investors. A distinct feature of the liquidity offered by MMFs is that they seek to allow investors to redeem at a stable NAV per unit/​share: that is, the investor is not exposed to fluctuations in the value of the fund but can redeem at a guaranteed principal value, or close to.639 MMF units/​shares can, accordingly, act as a 633 The agreement also, inter alia, aligned the product governance assessment to the MiFID II regime but removed the requirement for ‘appropriate investment advice’. 634 On MMF regulation see generally Baes, M, Bouveret, A, and Schaanning, E, Regulatory Constraints for Money Market Funds: the impossible trinity? (2021), available via . 635 On repos and their regulation under the Securities Financing Transactions Regulation see Ch VI section 4. 636 Some 50 per cent of the commercial paper and certificates of deposits issued by financial institutions is held by MMFs in the EU and US: Baes et al, n 634, 6. 637 Euro Area MMF AUM represented €1.44 trillion at end 2020 and were primarily in the form of exposures to non-​Euro Area banks (33 per cent of assets) and Euro Area banks (31 per cent of assets). EU US$-​denominated MMFs are a particularly important source of US$ funding to the EU financial sector: ESMA, EU Money Market Fund Regulation—​legislative review (2021) 7 and 10. 638 Which is typically higher than deposit rates. 639 MMFs with a ‘constant’ NAV (per unit or share) commit to allowing redemption of shares/​units at a stable or constant NAV (such as 1.00 in the relevant currency), regardless of the marked-​to-​market NAV, and so have strongly ‘cash like’ features. An MMF unit with a face value of 1.00 euro, eg, would redeem at 1.00 euro, regardless of the market valuation of the fund, where the NAV was constant.

III.7  Money-Market Funds  339 functional substitute for cash and be used for liquidity management purposes, including to meet margin calls. The ability of MMFs to meet on-​demand redemption at a stable (or close to) per unit/​share NAV is supported by the short-​term nature of the debt instruments which form the basis of MMFs’ portfolios. Liquidity transformation risk is, however, significant given the mismatch between less liquid MMF short-​term debt assets and highly liquid, short-​term MMF liabilities. Short-​term debt markets are, even in steady state, subject to illiquidity risks, being typically ‘buy to hold’ markets that do not display deep liquidity, particularly as the dealing banks that distribute short-​term debt do not typically undertake secondary market dealing obligations. MMF investors, however, can withdraw on demand and, heightening the liquidity risk, with a relatively stable principal value which the fund must meet. MMFs are also, and relatedly, subject to pre-​ emptive redemption risks given their use for short-​term cash and liquidity management purposes by investors: the prospect of fund liquidity management action where the fund experiences stress, such as the imposition by the fund of constraints on redemption such as redemption gates or liquidity fees,640 can generate ‘first mover advantage’ effects and precipitate runs. MMFs are accordingly exposed to two mutually reinforcing vulnerabilities: liability-​ related redemption pressure given their use by investors in liquidity management; and asset-​related challenges where short-​term debt markets are disrupted and assets are not sufficiently liquid.641 MMF stress and related market dislocation was a feature of the financial crisis, particularly in the US642 but also, albeit to a lesser extent, in the EU.643 MMF stress was also, as noted below, strongly associated with the March 2020 pandemic-​related market disruption.

The extent to which an MMF can offer a constant NAV depends on the relevant regulatory regime. Constant NAV funds pose distinct liquidity risks given the fixed redemption obligation placed on the fund, and so are subject to specific regulation; variable NAV (VNAV) funds do not face the same liquidity constraints. In the US, eg, ‘prime’ MMFs for institutional investment (‘prime’ US MMFs invest in private debt, primarily commercial paper/​certificates of deposit) must sell and redeem their units/​shares at a variable, market-​based NAV, but in practice they seek to preserve investors’ principal and to manage unit/​share volatility to allow redemption at close to $1.0000 per share/​unit. In the EU, constant NAV funds are prohibited (save for certain public debt MMFs), but funds are permitted to take the form of ‘low volatility’ NAV MMFs which, in practice, seek to redeem at a constant NAV, and are subject to specific liquidity requirements accordingly. EU MMFs are denominated in a range of currencies, with some 45 per cent of MMF AUM being euro denominated, and US$-​and £-​denominated MMFs representing 32 per cent and 23 per cent, respectively, of AUM: Baes et al, n 634, 5. 640 See n 171 on these liquidity management techniques. 641 2021 FSB MMF Policy Proposals, n 46, 1. 642 On 18 September 2008 the Reserve Primary Fund ‘broke the buck’ (could not redeem at its constant NAV), having written down Lehman debt assets. This led to a run on MMFs generally, with some $300 billion of withdrawals across the MMF sector. The US Treasury was required to temporarily guarantee investments in MMFs, while the US Federal Reserve provided exceptional liquidity support. Over 2011, a ‘quiet’ or ‘slow’ run on MMFs took place, reflecting market concerns as to the exposure of US MMFs to EU sovereign debt risk: IOSCO, Consultation on Money Market Funds (2012) 6. 643 In 2007, several EU MMFs experienced difficulties arising from investments in securitized assets exposed to the US sub-​prime market. EU MMFs came under redemption pressure more generally in 2008, reflecting thin liquidity in the short-​term debt market after the Lehman collapse, increased investor demand for cash, and outflows from MMFs to bank deposits, given the crisis-​era enhancements to deposit protection: ESMA, Response to the Commission Shadow Banking Green Paper (2012) 8. The ECB did not support MMFs directly, but eased liquidity pressure by lowering interest rates and broadening the scope of eligible collateral for ECB credit: Commission, 2013 MMF Proposal IA (SWD(2013) 315) 17.

340  Collective investment Management

III.7.2  The MMF Regulation EU MMFs are governed by either the UCITS Directive or the AIFMD and, in parallel, by the 2017 Money Market Fund (MMF) Regulation, which came into force in July 2018.644 The Regulation’s roots are in the financial-​crisis era. Reflecting the international shadow banking/​non-​bank financial intermediation reform movement,645 and foreshadowing the strong technocratic influence on EU MMF governance which would follow, CESR adopted extensive MMF Guidelines in 2010.646 Prior to the adoption of the 2017 Regulation, these Guidelines formed a quasi-​binding rulebook for EU MMFs, as was underlined by the 2013 ESMA peer review of their application.647 Pressure for legislative action came, however, from a number of sources, including the ESRB.648 The Commission’s 2012 UCITS VI Consultation subsequently consulted on the main features of a potential reform and was followed by the 2013 MMF Proposal. It provided for an authorization and regulatory regime for MMFs and was designed to operate as a UCITS-​like ‘product’ regime and to sit within the wider UCITS or AIFMD frameworks which would govern the MMF manager. Following a lengthy and difficult negotiation process,649 the MMF Regulation was finally adopted in 2017.650 The MMF Regulation is, in essence, a form of product regulation that is directed to the support of financial stability and, specifically, to managing the discrete liquidity and redemption risks to which MMFs are exposed. Detailed and granular, and more akin in places to an administrative rule than legislation, it applies to collective investment undertakings that either require authorization (or are authorized) under the UCITS Directive or are AIFs under the AIFMD; invest in short-​term assets (financial assets with a residual maturity not exceeding two years (Article 2(1)); and have distinct or cumulative objectives offering 644 Regulation (EU) 2017/​1131 [2017] OJ L169/​8. The Regulation is amplified by three sets of delegated rules, as regards the specification of eligible assets (Delegated Regulations (EU) 2021/​1383 [2021] OJ L298/​1 and 2018/​990 [2018] OJ L177/​1) and reporting (ITS 2018/​708 [2018] OJ L119/​5). 645 See n 31. The IOSCO-​led MMF stream of the FSB’s financial-​crisis era shadow banking agenda recommended liquidity management policies, valuation rules, and disclosure to investors, as well as reforms related to stable/​constant NAV: IOSCO, Policy Recommendations for Money Market Funds (2012). 646 CESR, Guidelines on a Common Definition of European Money Market Funds (2010). They addressed inter alia, credit quality/​maturity of underlying investments and MMF transparency and were designed to ensure that the value of MMF investments was maintained and daily redemption supported. 647 ESMA, Money Market Fund Guidelines Peer Review (2013) (ESMA found generally strong NCA compliance). The Guidelines were also supported by the ECB, which used them as a classification tool for different operational purposes; and by the industry (EFAMA Annual Report (2011)). 648 The ESRB adopted a Recommendation in 2012 which called for MMF reform, including that all MMFs take the form of variable NAV funds: ESRB Recommendation 2012/​1 [2013] OJ C146/​1. 649 Trilogue negotiations did not start until July 2016, nearly three years after the Commission’s September 2013 adoption of the Proposal. The earlier failure to reach agreement by the closing of the Commission and Parliamentary terms in 2014 moved the negotiations on to the following parliamentary session. Particular difficulties arose in relation to the Commission’s proposal that CNAV funds be allowed, but subject to a 3 per cent capital buffer, with the Parliament’s Economic and Monetary Affairs (ECON) committee split on the desirability of a buffer (to which the industry was hostile). The Parliament in the end amended the Proposal to provide for a new regime for CNAV funds, based on CNAV funds being permitted only for public debt MMFs and for a limited range of other MMFs, including funds directed to charities and local authorities; and on the introduction of a new category of low volatility NAV funds. The public debt CNAV funds (PDCNAV MMFs) and low volatility funds (LVNAV MMFs) reforms were agreed by the Council and, with variable NAV MMFs (VNAV MMFs), form the basis of the MMF Regulation. 650 The main elements of the legislative history are: Commission Proposal (COM(2013) 615/​2)) and IA, n 643); report by the Economic and Monetary Affairs Committee (A8-​0041/​2015) and Negotiating Position text adopted by the European Parliament, 29 April 2015 (T8-​0170/​2015); and Council General Approach, 10 June 2016 (Council Document 9874/​16).

III.7  Money-Market Funds  341 returns in line with money market rates or preserving the value of the investment (Article 1). The Regulation lays down rules for MMFs established, managed, or marketed in the EU as regards eligible assets, the MMF portfolio, valuation, and reporting requirements (Article 1). It also and relatedly imposes an authorization requirement: no collective investment undertaking can be established, marketed, or managed in the EU as an MMF unless it has been authorized in accordance with the Regulation (Article 4).651 The Regulation’s regulation of the MMF fund is nested within the UCITS/​AIFMD collective investment management regimes: managers of MMFs must be authorized either under the UCITS Directive or the AIFMD (Article 7). The Regulation also prohibits ‘external support’ of MMFs by third parties,652 including credit institutions, to minimize the amplification of financial stability risks (Article 35).653 The extensive and fine-​grained asset allocation, liquidity buffer, and risk-​spreading rules at the core of the Regulation (which also includes extensive supervisory reporting and public disclosure requirements, including weekly MMF data reports to investors)654 are designed to ensure that MMF portfolio assets are in the form of well-​diversified assets of strong credit quality, to minimize liquidity risks. These rules are built around a classification framework. EU MMFs must take one of three forms (Articles 3 and 29–​34). The variable NAV (VNAV) MMF can have a fluctuating or floating NAV (with related fluctuations in the dealing/​redemption price). It is less prone to redemption/​liquidity risks and benefits from a more liberal portfolio management regime. The public debt constant NAV (PDCNAV) MMF can have a constant NAV for dealing/​redemption purposes (and so a constant redemption price) but must invest 99.5 per cent of its assets in government debt instruments or cash and is subject to a series of portfolio allocation requirements, noted below. The low-​ volatility NAV (LVNAV) MMF, the dominant form of EU MMF,655 can maintain a constant NAV for dealing/​redemption purposes (and so a constant redemption price) but is subject to a series of conditions, including portfolio allocation requirements but also the ‘collar’ obligation that the market NAV of the fund does not deviate from the dealing NAV by more than 20 basis points.656 If it does, the MMF must convert to a VNAV MMF.657 PDCNAV 651 Authorization as an MMF forms part of the UCITS authorization process where the MMF is constituted as a UCITS: Art 4(2). A specific authorization process applies under the Regulation to MMFs constituted as AIFs (as AIFs are not authorized under the AIFMD): Art 5. 652 External support means any direct or indirect support offered to an MMF by a third party that is intended for or in effect would result in guaranteeing the liquidity of an MMF or in stabilizing the NAV per unit/​share of the MMF, including cash support, asset purchases at inflated prices, and purchases of MMF units/​shares to provide liquidity: Art 35. 653 Following the central bank interventions in support of liquidity in the short-​term debt markets in March 2020, ESMA clarified the application of Art 35 as regards arms’ length action by credit institutions benefiting from the liquidity provided by such interventions: ESMA, Public Statement (External Support within the Meaning of Art 35), 9 July 2020. 654 Articles 36–​7. Given the cash-​like treatment of MMF investments by investors, fund disclosures must make clear that the MMF is not a guaranteed investment, is different to an investment in deposits, that the principal invested is capable of fluctuation, and that the investor carries the risk of loss of the principal: Art 36(3). 655 LVNAV MMFs represent some 48 per cent of the sector, followed by VNAV funds (45 per cent), with PDCNAV funds having a much smaller footprint at 7 per cent: Baes et al, n 634, 5. 656 In effect, the LVNAV fund can deploy a per unit/​share NAV of 1, allowing redemption at par, as long as the mark-​to-​market NAV remains within a tolerance of 20 basis points (the basis points restriction therefore operates as a ‘collar’ for LVNAV funds). 657 Different valuation requirements apply under Arts 29–​33. The VNAV must use mark-​to-​market/​mark-​to-​ model valuation methods, while the PDCNAV must use the amortized cost method, as must the LVNAV MMF (as long as, for LVNAV MMFs, this does not lead to a valuation that deviates from market value by more than 10 basis points).

342  Collective investment Management MMFs and LVNAV MMS are also required to have in place liquidity management procedures that reflect the distinct risks generated by their commitment to redeem at a constant value. All MMFs, of whatever form, are subject to eligible assets rules which require MMFs to invest only in the assets specified by the Regulation, including money-​market instruments and deposits, and in accordance with the conditions that apply to these assets (Article 9).658 These conditions include maturity restrictions, chief among them that ‘short-​term’ MMFs, which can take the form of VNAV, PDCNAV, or LVNAV MMFs, must invest in money-​ market instruments that are shortterm, in that they mature in 397 days or less; ‘standard’ MMFs, which can only take the form of VNAV MMFs, have a longer liquidity profile and may invest in money-​market instruments of maturity less than or equal to two years (Article 10).659 Risk-​spreading rules governing portfolio construction also apply (Articles 17 and 18).660 They include that the MMF can invest no more than 5 per cent of its assets in money-​market instruments, securitizations, and asset-​backed commercial paper issued by the same body661 and 10 per cent of its assets in deposits with the same credit institution;662 that the aggregate risk exposure to a single counterparty from OTC derivative transaction must not exceed 5 per cent of its assets; and that the aggregate amount of cash provided to a single counterparty under a reverse repurchase agreement does not exceed 15 per cent of its assets.663 An MMF may, however, invest up to 100 per cent of its assets in different money-​ market instruments of a single public issuer, subject to a series of conditions.664 An MMF is also prohibited from holding more than 10 per cent of the money-​market instruments, securitizations, and asset-​backed commercial paper issued by a single body.665 Requirements governing credit quality assessment procedures apply, including a prohibition on sole or mechanistic reliance on credit ratings, although an MMF manager can have regard to ratings (Articles 19–​23). Minimum portfolio allocation rules, which operate as liquidity buffers, also apply, calibrated to short-​term and standard MMFs. Short-​term MMFs (LVNAV, PDCNAV, and VNAV MMFs) must ensure a weighted average maturity 658 As regards ‘money-​market instrument’ investments, eg (specified by Art 9(1)(a)), money-​market instruments are defined by reference to the UCITS Directive: instruments normally dealt in on the money market which are liquid and have a value which can be accurately determined at any time (UCITS Directive Art 2(1)(o)). They are further specified by Art 9(1)(a) as including money-​market instruments issued by the EU, Member States and their regional and local administrations, and specified EU and international public bodies (hereafter, public issuers). Eligible assets also cover, under Art 9(1)(b)–​(g): securitizations and asset-​backed commercial paper; deposits with credit institutions; financial derivative instruments; repurchase and reverse repurchase agreements; and units or shares of other MMFs. Conditions apply to these instruments under Arts 10–​16. 659 Similarly, maturity restrictions apply to short-​term MMFs as regards investments in eligible securitizations or asset-​backed commercial paper (Art 11). 660 Risk-​spreading rules also apply to investments in MMFs, including the requirements that no more than 10 per cent of the assets of the ‘target’ MMF can be invested in aggregate in units or shares of other MMFs, that the MMF does not invest more than 5 per cent of its assets in units or shares of a single MMF, and that, in aggregate, all MMF investments amount to no more than 17.5 per cent of the MMF’s assets: Art 16. 661 VNAV MMFs can invest up to 10 per cent, as long as the total value of such investments does not exceed 40 per cent of its assets: Art 17(2)). 662 Unless the structure of the banking sector in the Member State in which the MMF is domiciled is such that there are insufficient viable credit institutions, in which case a 15 per cent limit applies. 663 In addition, where the MMF is exposed to different investments in/​deposits with/​exposures to the same counterparty, an overall exposure limit, to that counterparty, of 15 per cent of MMF assets applies. 664 The MMF must hold money-​market instruments from at least six different issues by the issuer, a 30 per cent of assets limit on investments in a single issue applies, and disclosure requirements are imposed. 665 Art 18. Subject to an exemption for instruments issued by public issuers.

III.7  Money-Market Funds  343 for the fund portfolio of no more than sixty days and a weighted average life of no more than 120 days; and (short-​term LVNAV and PDCNAV MMFs only) maintain a minimum 10 per cent portfolio investment in daily maturing assets and a 30 per cent portfolio investment in weekly maturing assets (7.5 per cent and 15 per cent for short-​term VNAV MMFs) (Article 24). Where these limits are breached, an escalating liquidity management system applies, based on the application of specified liquidity management tools (liquidity fees, redemption gates, and the suspension of redemptions); if, within a period of ninety days, suspensions exceed fifteen days, the PDCNAV MMF or LVNAV MMF automatically ceases to operate as such (Article 34). For standard MMFs (which can only take the form of VNAV funds), a weighted average maturity of six months and weighted average life of twelve months applies, alongside a 7.5 per cent minimum requirement for daily maturing assets and 15 per cent for weekly maturing assets (Article 25). Liquidity risk management is also addressed by the requirement for managers to consider future redemption pressures, in light of the fund’s investor profile (Article 27), and to engage in regular stress testing (Article 28). As with the UCITS and AIFMD regimes, ESMA has materially amplified and proceduralized the MMF Regulation, including through detailed Guidelines which address the supervisory reporting required of MMFs under the Regulation.666 Most significantly, ESMA has adopted extensive, operationally oriented Guidelines which govern the stress testing of MMFs and which represent a major innovation in ESMA’s supervisory convergence tool-​box.667 Stress testing has long been associated with banking regulation but remains relatively new territory for financial markets regulation. ESMA’s Stress Testing Guidelines mark a significant development, accordingly, providing an operational template for MMFs as to how stress testing is to be carried out, and thereby shaping how the stress testing tool is developed, as well as underlining ESMA’s influence on the supervisory governance of the fund market.

III.7.3  The March 2020 Liquidity Crisis and MMF Reform The initial market transition to the MMF Regulation’s requirements, and the introduction of LVNAV funds, was smooth.668 The MMF market subsequently came under severe pressure, however, in March 2020 as the Covid-​19 pandemic roiled economies and financial markets internationally. While inflows to public debt MMFs surged as investors fled to safe assets, the structural vulnerability in the private debt MMF market, on both sides of the MMF balance sheet (in the form of the liquidity mismatch between a potentially illiquid asset base and a liability base that, with cash-​like features, was vulnerable to destabilizing redemption pressure), was exposed to searing effect globally.669 By contrast with the financial-​crisis-​era disruption to the MMF sector, redemption pressure was not driven by elevated credit risk in MMF asset portfolios, or by the crystallization of asset liquidity risks, but by institutional 666 ESMA, Guidelines on Reporting (2020). 667 ESMA, Guidelines on Stress Test Scenarios (2018, as updated). The Guidelines are updated annually to reflect market developments and related adjustments to the stress testing scenarios. 668 ESMA, TRV No 2 (2019) 23. 669 For regulatory/​policy analysis of the global and EU experience see 2021 FSB MMF Policy Proposals, n 46; ESRB, Issues Note on Systemic Vulnerabilities of and Preliminary Policy Considerations to Reform Money Market Funds (2021); Baklanova, V, Kuznits, I and Tatum, T, Prime MMFs at the Outset of the Pandemic: Asset Flows, Liquidity Buffers and NAVs, SEC Public Information, 15 April 2021; and 2020 FSB Market Turmoil Report, n 44.

344  Collective investment Management investors repositioning their portfolio allocations away from MMFs and towards cash, including in response to margin calls.670 In the EU, certain LVNAV and VNAV funds, particularly US$-​ denominated funds, experienced sustained and large-​ scale redemption pressure.671 The scale of the redemption pressure led to the prospect of MMFs then placing additional liquidity strain, through asset sales,672 on to a short-​term debt market that was critical for liquidity management purposes but which was already severely disrupted as investors withdrew from trading in short-​term debt and sought safer assets.673 LVNAV funds faced specific cliff-​edge risks as to redemption-​constraining events arising, which could have precipitated further and pre-​emptive redemption pressures: additional sales of liquid daily and weekly maturing assets to meet redemption pressures could have disrupted their minimum required holdings of daily and weekly maturing assets, and triggered the use of liquidity management tools, including redemption suspensions; while sales of less liquid assets at a discount risked their market NAVs deviating more than 20 basis points from their constant NAVs and, accordingly, as required under the Regulation, requiring their conversion to VNAV status.674 In practice, the MMF sector as a whole did not generate large-​scale instability. Massive central bank intervention in mid-​March 2020,675 alongside unprecedented governmental support of economies, stabilized markets, disruption in the EU MMF sector was confined to particular currency segments,676 and no EU MMF was required to use redemption gates, liquidity fees, or redemption suspensions.677 The disruption and the structural vulnerabilities it exposed, however, brought MMFs on to the reform agenda globally678 and in the EU.679

670 For an analysis of institutional investor behaviour in the US MMF market see Avalos, F and Xia, D, ‘Investor Size, Liquidity and Prime Money Market Fund Stress’ (2021) BIS Quarterly, March, 17. 671 2020 FSB Non-​Bank Financial Intermediation Report, n 31, 67 and 72. In the week of 13–​20 March 2020, euro area MMFs experienced outflows amounting to 8 per cent of AUM, the second highest on record, and only exceeded by outflows in the teeth of the financial crisis in September 2008: 2020 ESRB Non-​Bank Financial Intermediation Monitor, n 45, 7–​8. 672 US$ MMFs in the EU and US were estimated to have sold more than US$50 billion of commercial paper, more than five times the capacity of dealing banks’ inventories and swamping the capacity, to the extent it existed, for dealing banks to carry the excess sales: ESMA, EU Money Market Fund Regulation. Legislative review (2021) 11. 673 2020 FSB Non-​Bank Intermediation Report n 31, 71, noting that the stress that emerged in short-​term debt markets over the first two weeks of March 2020 was exacerbated by selling pressure from MMFs. 674 Although no fund required conversion, some came close with NAV deviations in some cases reaching 18 basis points: ESMA Chair Maijoor, Speech, 13 November 2020. 675 Including via outright purchases of commercial paper on the primary and secondary short-​term debt markets (ECB, Bank of England, and US Federal Reserve), provision of bank lending facilities to buy MMF assets (Federal Reserve), and extension of the range of eligible collateral for access to central bank funding to include unsecured bank debt (ECB): 2021 ESMA MMF Legislative Review, n 672, 9. 676 US$ LVNAV MMFs experienced significant difficulties, with outflows from mid-​March representing more than 25 per cent of US$ LVNAV assets domiciled in Luxembourg and Ireland. Remedial action by funds included selling weekly maturing assets and not reinvesting maturing money-​market instruments. € LVNAV funds (mainly domiciled in France) also experienced strain (outflows in early March representing 15 per cent of assets) which they managed through asset sales: 2020 FSB Market Turmoil Report, n 44, 20. 677 2021 ESMA MMF Legislative Review, n 672, 9. 678 eg the FSB initially took a cautious and flexible approach, recommending that regulators review local MMF market vulnerabilities and address any risks using its ‘tool-​kit’, which included liquidity management tools such as redemption fees, removing regulatory cliff-​edge effects, and eligible assets requirements: 2021 FSB MMF Policy Proposals, n 46. 679 ESMA, TRV No 2 (2021) and 2021 ESRB Non-​Bank Financial Intermediation Risk Monitor, n 389, noting the stabilization of the MMF market, but reporting on heightened regulatory concern as to the structural vulnerability of the sector to liquidity risks.

III.7  Money-Market Funds  345 The MMF Regulation, supported by the UCITS and AIFMD regimes, was perceived to have worked well, overall, with large-​scale and broad-​based stress in the MMF sector avoided in March 2020.680 Nonetheless, the risks posed by the constant NAV offered by LVNAV funds, the cliff-​edge effects associated with breaches by LVNAV funds of the Regulation’s portfolio limits, and the need for an enhancement of liquidity requirements and for more detailed reporting on investor profiles and related redemption risks, as well as the more radical reform of requiring all MMFs to be VNAV funds and eliminating stable/​ constant NAV options, all emerged as recurring themes of the debate.681 While the contours of any future reforms are not yet clear, a number of themes can be identified which chime with the overall direction of EU collective investment management regulation and policy. Technocratic influence is significant. ESMA in late 2021 pre-​empted the Commission’s required review of the MMF Regulation in 2022 by consulting generally on MMF reform and proposing reforms in early 2022,682 while the ESRB, which monitors the MMF market through its non-​bank financial intermediation work programme, has repeatedly called for reforms. ESMA’s now considerable operational capacity as regards collective investment management can also be expected to shape any reforms, particularly given its development of the novel MMF stress testing tool. The main preoccupation of the MMF reform agenda is with financial stability, a concern which has emerged as the major preoccupation of post-​crisis AIFMD and UCITS policy also. But the pivotal role of MMFs in intermediating in the short-​term debt markets and, thereby, in supporting the funding of the financial system and the real economy, is also to the fore in the reform debate,683 reflecting the wider influence of the CMU agenda on EU fund governance. 684

680 2021 ESRB Issues Note, n 669, 25. 681 2021 ESRB Issues Note, n 669, 28–​9 and 2020 ESMA MMF Legislative Review, n 672, 24–​40. 682 2021 ESMA MMF Legislative Review, n 672 and ESMA, Opinion on the Review of the MMF Regulation (2022). ESMA proposed, inter alia, reforms designed to address the cliff-​edge risks that the portfolio threshold requirements generate for LVNAVs, liquidity management tool requirements, liquidity buffers, and enhancements to reporting and stress testing. 683 Both the ESRB and ESMA have repeatedly underlined the importance of MMFs in supporting the short-​ term debt market. 684 The Commission’s pathfinder consultation was issued in April 2022 but did not give clear indications as to a direction of travel, although it did canvass views on the implications of the LVNAV MMF being no longer available: Commission, Consultation on the Functioning of the Money Market Fund Regulation (2022).

IV

INVESTMENT FIRMS AND INVESTMENT SERVICES IV.1  Introduction: The Intermediation Process, Investment Firms, and Regulation This chapter, along with Chapters V (trading venues), VI (trading), and IX (the retail markets), is concerned with the regulation of investment firms and their role in the intermediation process.1 Investment firms, like the collective investment managers considered in Chapter III, form a critical institutional component of financial markets by intermediating between suppliers and seekers of capital.2 Investment firm intermediation, which encompasses a host of investment activities and services from underwriting and proprietary (or principal/​own account) dealing to broking and investment advice, reduces the frictions to efficient capital allocation which can be generated by information and transaction costs, is associated with productive innovation, and can drive welfare-​enhancing growth in the financial system.3 In principle, intermediation by investment firms plays a critical role in the financial markets by providing market-​access channels for capital providers and for capital seekers. By providing services such as investment advice, discretionary asset management, and brokerage services, and by acting as distribution channels for investment products, investment intermediaries act as a bridge between capital providers and capital seekers, supporting the signalling of issuer quality and the achievement of returns. Similarly, by using their balance sheets to engage in proprietary risk-​taking activities such as underwriting, proprietary dealing, and market-​making, and by thereby facilitating the development of liquid secondary trading markets, they support the development of markets through which capital can be allocated. Investment intermediaries can also generate and promote innovation in financial markets, including the development of risk-​management techniques and products which allow risks to be hedged, diversified, and traded, markets to be ‘completed’,4 and, thereby, resources to be productively allocated.5 1 Investment intermediation can be carried out by a host of actors from multi-​function credit institutions and investment firms, to specialist actors such as algorithmic traders and commodity derivative brokers, to non-​ financial companies (NFCs) that engage in investment activities incidentally to manage risks. This introductory section uses the term ‘investment firm’ to capture this population. The related EU rulebook, discussed in subsequent sections, also uses the term ‘investment firm’ although it also covers credit institutions where they carry out investment services and activities. 2 For an early examination of the rise of market intermediaries, such as investment firms, as a dominant economic influence see Clark, R, ‘The Four Stages of Capitalism’ (1981) 94 Harv LR 561. 3 See, eg, Mayer, C, ‘Economic Development, Financial Systems and the Law’ in Moloney, N, Ferran, E, and Payne J (eds), Oxford Handbook of Financial Regulation (2015) 41 and Awrey, D, ‘Complexity, Innovation and the Regulation of Modern Financial Markets’ (2012) 2 Harv Bus LR 401. 4 A theoretically ‘complete’ market is one in which actors can hedge against all contingencies: Spencer, P, The Structure and Regulation of Financial Markets (2000) 2–​3. 5 From the foundational analyses see Merton, R, ‘A Functional Perspective of Financial Intermediation’ (1995) 24 Financial Management 23 and Silber, W, ‘The Process of Financial Innovation’ (1983) 73 Amer Econ Rev 89.

348  Investment Firms and Investment Services The recent history of financial markets over and since the global financial crisis underlines, however, that investment intermediation can generate risk-​taking and rent-​seeking inefficiencies which can disrupt and destabilize financial markets,6 and that innovation in service of yield, and which does not sufficiently internalize the cost of risks, can amplify financial stability risks.7 While the risks associated with investment intermediation crystallized to catastrophic effect over the financial-​crisis era, the global regulatory preoccupation since then with the burgeoning growth in non-​bank financial intermediation generally, and with its potential to undermine financial stability, underlines the extent to which investment intermediation can generate risks which are amplified by the multiplicity of connections between investment intermediaries and markets.8 Relatedly, the 2021 collapse of the Archegos hedge fund placed a spotlight globally on the resilience of investment firms’ risk management processes, following the major losses sustained by leading investment banks globally that provided ‘prime broking’ services to the fund.9 These risks are dynamic. For example, digital innovation, exemplified by the development of trading apps, is generating new settings for intermediation risks, well-​illustrated by the 2021 Gamestop episode and the questions it raised regarding the conflict-​of-​interest risks generated by brokerage firms’ payment-​for-​order-​flow revenue models.10 But while the risks associated with investment intermediation are dynamic, and while the expression of these risks changes in line with market innovation, the rationale for the regulation of investment intermediation is longstanding: it is traditionally associated with the correction of market failures related to asymmetric information and to financial-​stability-​ related externalities. These market failures classically fall into two broad categories. First, information asymmetries can generate agency costs and risks for the client of the intermediating firm where the interests of the principal client and agent firm diverge and where monitoring is difficult.11 These costs can become significant in the presence

6 For a financial-​crisis-​era review oriented to conflict-​of-​interest risks see Judge, K, ‘Intermediary Influence’ (2015) U of Chicago LR 573. 7 The financial crisis period prompted extensive consideration of the extent to which financial innovation by intermediaries was productive, given in particular the destructive impact of complex securitized products, developed by intermediaries in response to yield pressures, on financial stability. See, eg, Gennaioli, N, Shliefer, A, and Vishny, R, ‘Neglected Risks, Financial Innovation and Financial Fragility’ (2012) 104 JFE 452 and Lerner, J and Tufano, P, ‘The Consequences of Financial Innovation: A Counterfactual Research Agenda’ (2011) 3 Ann Rev of Fin Economics 41. Among the major policy contributions to this debate was the UK Financial Services Authority’s 2009 Turner Review, which suggested that, beyond a certain degree of liquidity and market completion, the additional allocative efficiency benefits of further liquidity and market completion might be relatively slight and outweighed by increased instability risks: FSA, The Turner Review. A Regulatory Response to the Global Banking Crisis (2009) 16–​18 and 41–​2. 8 The risks posed by investment intermediation, which were brought into sharp relief by the liquidity strains experienced by money-​market funds in March 2020, following the contraction of dealing capacity in short-​term debt markets as the global pandemic deepened, and by the consequent financial stability risks, are regularly reported on in the EU through the European Systemic Risk Board’s (ESRB) annual Non-​Bank Financial Intermediation Risk Monitor which, inter alia, reports on dealing in financial instruments. See further Ch III on the non-​bank financial intermediation agenda as regards investment funds and Ch VI as regards trading practices. 9 The collapse drew the ESRB’s attention as an example of the financial stability risks posed by non-​bank financial intermediation: ESRB, EU Non-​Bank Financial Intermediation Risk Monitor, August (2021) 33–​4. For a review of the regulatory implications for investment firm regulation, including as regards risk management and the quality of reporting on derivatives transactions, see Branzoli, N et al, ‘Lessons Learned from the Collapse of Archegos: Policy and Financial Stability Implications’ (2021) 26 Banca d’Italia. Notes on Financial Stability and Supervision 1. 10 See further Ch VI section 2.2. 11 For an examination in the US context see Langevoort, D, Selling Hope, Selling Risk. Corporations, Wall Street and the Dilemmas of Investor Protection (2016).

IV.1 Introduction  349 of conflicts of interests. In the retail markets, agency costs and risks can be acute, given retail clients’ limited ability to monitor firms and the powerful incentives for mis-​selling that can be generated by remuneration structures. But agency costs and risks arise across the intermediation chain, as the mis-​selling of complex derivatives to professional clients over the financial crisis underlined.12 The regulatory response to agency costs has typically been some combination of authorization requirements (designed to filter out incompetent, fraudulent, or otherwise unsound firms), conduct regulation (in the form of default and standardized conduct standards governing, inter alia, disclosure, fair treatment, know-​ your-​client/​quality of advice, and order handling rules), and operational/​organizational regulation (including conflict-​of-​interest management, internal control, and asset protection requirements).13 The second broad category of market failure associated with investment intermediation relates to the externalities which can prejudice financial stability and which were strongly associated with the global financial crisis period.14 These externalities are associated in particular with the liquidity and solvency risks which can arise from large-​scale dealing and market-​making activities, and which are amplified by market interconnectedness but also by macro-​economic conditions, in particular where accommodating monetary policy lowers the cost of credit.15 The regulatory response to financial stability risks typically engages prudential regulation, albeit that conduct failures on a large scale can also be associated with risks to financial stability.16 Prudential rules are designed to reduce, but not to eliminate, the risk of intermediary failure by managing the level of risk which intermediaries assume and by containing the risks of intermediary failure.17 While mainly concerned with financial stability, they also serve a client-​facing function by bolstering the soundness and solvency of firms and, thereby, protecting client assets. Including internal control and risk-​management requirements and incentive management rules (including with respect to governance and remuneration), prudential regulation is strongly associated with capital requirements, which are designed to internalize the cost of risk taking, and support orderly wind-​down, by means of minimum capital ratios for different risks and also minimum requirements relating to the constituents of capital. The extent to which investment intermediation activities or services generate risks tends to dictate the nature of the regulatory response; calibration and segmentation are strongly

12 For a recent analysis of mis-​selling risks in the derivatives markets see Braithwaite, J, The Financial Courts: Adjudicating Disputes in Derivatives Markets (2021). 13 See, eg, Tuch, A, ‘Conduct of Business Regulation’ in Moloney et al, n 3, 537 and Choi, S, ‘A Framework for the Regulation of Securities Market Intermediaries’ (2004) 1 Berkeley Business LJ 45. 14 From an extensive literature see, eg, Partnoy, F, ‘Financial Systems, Crises and Regulation’ in Moloney et al, n 3, 68. 15 In the period leading to the financial crisis, a series of destabilizing factors, including large-​scale searching for yield in a low interest-​rate environment, combined to create strong incentives for levels of risk-​taking which proved to be excessive and for poor monitoring of risks: eg, Schwarcz, S, ‘Systemic Risk’ (2008) 97 Georgetown LJ 193. 16 The series of misconduct scandals which beset the wholesale markets, and which emerged over the financial crisis and as it was receding, led to a wave of enforcement action globally and to fines of in the order of US$320 billion over 2007–​2018. The scale of the fines and their potential to weaken the sanctioned firms was identified by the Financial Stability Board (FSB) as a source of systemic risk and prompted an FSB-​led workplan on mitigating misconduct in the wholesale markets. See, eg, FSB, Strengthening Governance Frameworks to Mitigate Misconduct Risks (2018). 17 See generally on prudential tools Jackson, H, ‘Regulation in a Multi-​sectored Financial Services Industry: An Exploration Essay’ (1997) 77 Washington University LQ 319.

350  Investment Firms and Investment Services associated with investment intermediary regulation. Retail investment advice and the retail distribution of investment products, for example, are prone to agency costs and risks given their exposure to potentially significant conflict-​of-​interest risks, but they do not carry material risks to financial stability. Proprietary dealing and market-​making activities, by contrast, can generate significant financial stability risks, particularly where dealers cannot provide liquidity support where markets are stressed.18 Organizational and business models also shape the regulatory response. Multi-​function investment intermediaries, for example, are more prone to conflict-​of-​interest failures than single-​function algorithmic dealers. Similarly, the segmentation of rules according to the nature of intermediaries’ clients is one of the defining features of intermediary regulation, albeit that the related regulatory boundaries and categories can be fluid and responsive to market (and political) conditions. But while calibration and segmentation can support efficient regulatory design, regulatory arbitrage can be a significant risk where functionally similar actors and activities are not subject to the same rules. The regulatory devices and tools deployed by investment intermediary regulation have undergone repeated cycles of reform. The financial crisis period led to the regulatory perimeter being cast around a significantly wider set of investment services and activities and it also prompted a material intensification of regulation in support of financial stability. Since then, the financial stability imperative has framed much of the post-​crisis reform movement. For example, the financial stability risks posed by the expansion of non-​bank financial intermediation, and by the related build-​up of credit and market risk, have led to an intensification of data collection efforts globally,19 while the capital treatment of market risks has been extensively reformed by the Basel Committee.20 Investment intermediary regulation remains, a decade or so after the financial crisis, a somewhat unsettled area. This is in part a function of the scale of sector, the complexities of the risks it generates, and the constant innovation that shapes its evolution. It also reflects the frontier-​like quality of investment intermediary regulation, certainly as compared to bank regulation. For example, the extent to which, how, and the channels through which investment firm intermediation (in particular proprietary dealing and market-​making) generates and amplifies financial stability risk is still not fully understood,21 as the severe dislocation in short-​term funding markets in March 2020, as the Covid-​19 pandemic deepened and dealer capacity thinned, underlined.22 These dynamics and influences are at play in the EU’s now behemoth rulebook on investment intermediation. But this rulebook is also shaped by the institutional importance of investment intermediation to the embedding of market finance in the EU and to financial market integration. Relatedly, the 2015 and 2020 Capital Market Union (CMU) Action

18 As happened, as noted in n 8, in the March 2020 Covid-​19 pandemic-​related market disruption when dealers in short-​term debt were unable to provide liquidity support to the short-​term debt market by buying back short-​ term debt from money-​market funds. See further Ch III in the context of the stability risks to which money-​ market funds were relatedly exposed. 19 Spearheaded by the FSB and its annual Global Monitoring Report on Non-​Bank Financial Intermediation. 20 In particular under the 2017/​2019 Fundamental Review of the Trading Book: see section 9.1 and 9.2. 21 For two post-​crisis policy reviews see ESRB, Market Liquidity and Market Making (2016) and FCA, Occasional Paper 18, Market-​Based Finance: Its Contributions and Emerging Issues (2016). 22 FSB, Lessons Learnt from the Covid-​19 Pandemic from a Financial Stability Perspective (2021).

IV.2  The EU Investment Firm Rulebook  351 Plans were infused by a concern to support effective investment intermediation as a means for supporting a deep and integrated financial market.23 Reflecting the reach of the investment intermediation rulebook, investment firm regulation is addressed across four chapters. This chapter considers the framework authorization and conduct/​prudential regime which applies to the conduct of investment activities and the provision of investment services generally, Chapter VI considers the trading process, and Chapter IX considers the distinct regulatory issues which arise in the retail markets. Investment firms also intermediate by operating trading venues, an area that raises distinct regulatory issues and is discussed in Chapter V.

IV.2  The EU Investment Firm Rulebook IV.2.1  MiFID II/​MiFIR: A Brief Tour The regulation of investment services and activities in the EU is primarily a function of the leviathan of the single rulebook, the behemoth 2014 Markets in Financial Instruments Directive II (MiFID II)/​Markets in Financial Instruments Regulation (MiFIR) regime,24 which came into force on 3 January 2018 and which replaced the precursor 2004 MiFID I.25 The MiFID II/​MiFIR regime, discussed across the following chapters, and a towering presence in the single rulebook, is a construction of immense depth and breadth and great technical complexity.26 The scale of the implementation exercise, which included the construction of new data infrastructures, required a year-​long extension to the original 2017 implementation deadline27 and generated costs in the region of €2.5 billion.28 MiFID II applies to investment firms, market operators, and third country firms providing investment services or performing investment activities through the establishment 23 Commission, Action Plan on Building a Capital Markets Union (COM(2015) 468) and Commission, A Capital Markets Union for People and Businesses. New Action Plan (COM(2020) 590)). Both Action Plans underlined the importance of investment intermediation to the unlocking of household capital and proposed related reforms, and also sought to enhance the efficiency of trading venues and of order execution (see Chs V and IX). 24 Markets in Financial Instruments Directive II 2014/​65/​EU [2014] OJ L173/​349 (MiFID II) and Markets in Financial Instruments Regulation EU (No) 600/​2014 [2014] OJ L173/​84 (MiFIR). The main elements of the legislative history of MiFID II/​MiFIR are: MiFID II Commission Proposal (COM(2011) 656/​4), MiFIR Commission Proposal (COM(2011) 652/​4), and MIFID II/​MiFIR Proposals Impact Assessment (IA) (SEC(2011) 1226); MiFID II Council General Approach, 18 June 2013 (Council Document 11006/​13) and MiFIR Council General Approach 18 June 2013 (Council Document 11007/​13); and European Parliament MiFID II Negotiating Position text, 26 October 2012 (T7-​0406/​2012) and on MiFIR, 26 October 2012 (T7-​0407/​2012). The ECB and EECS also adopted Opinions: [2016] OJ C161/​3 and CES1083/​2012, respectively. 25 Directive 2004/​39/​EC [2004] OJ L145/​1. In its day, MiFID I was described as a ‘sprawling directive with far-​ reaching implications for any firm involved in buying and selling securities in Europe’: Editorial, Financial Times, 23 August 2005. 26 For a wide-​ranging review see Busch, D and Ferrarini, G (eds), Regulation of the EU Financial Markets. MiFID II and MiFIR (2017). 27 By means of Directive 2016/​1034 [2016] OJ L175/​8. The delay was primarily caused by the massive data infrastructure construction exercise required of ESMA, NCAs, trading venues, and investment firms to meet the new reporting obligations. Delays in the construction of these complex systems (in part because of delays in the adoption of the related administrative rules) meant that the data on which the operation of much of MiFID II/​MiFIR depends would not have been available in time. The unusual implementation extension was accordingly agreed as an ‘urgent action’ to ensure legal certainty and avoid market disruption: Directive 2016/​1034 recital 9. 28 eg, Stafford, P and Murphy, H, ‘Investor Relief at Smooth Launch of MiFID II Reforms’, Financial Times, 3 January 2018.

352  Investment Firms and Investment Services of a branch in the EU.29 Accordingly, it governs the authorization and operating conditions for investment firms (including firms that operate trading venues); the authorization and operating conditions for ‘regulated markets’ (a form of trading venue not operated by investment firms but by market operators); and the arrangements governing supervision and enforcement by national competent authorities (NCAs). It originally also covered the regulation and supervision of data reporting services providers, but this regulatory system has been moved into MiFIR following the 2019 conferral on the European Securities and Markets Authority (ESMA) of direct supervisory powers over these entities.30 MiFIR is largely concerned with trading venue and trading regulation and governs, inter alia, the disclosure of trade/​transparency data; supervisory reporting to NCAs on transactions in financial instruments; the regulation of data reporting services providers; the trading of derivatives on organized venues; and ESMA/​NCA position-​management and position-​ limit powers (as regards the commodity derivatives markets). MiFIR also covers the retail market-​oriented product intervention regime as well as aspects of the third country regime. The MiFID II/​MiFIR regime is composed of harmonized EU legislation of finely granular quality; a vast administrative rulebook composed of more than seventy separate sets of administrative rules;31 and dense and intricate soft law which includes a formidable array of detailed ESMA Guidelines,32 Q&As,33 and other soft measures. It has also led to the construction of a data collection infrastructure, at the heart of which is the massive Financial Instruments Reference Data System (FIRDS) which is maintained by ESMA.34 ESMA has, relatedly, emerged as a determinative if technocratic influence on MiFID II/​MiFIR, being the crucible for its vast administrative rulebook and presiding over the construction of a soft law ‘rulebook’ which has become hardwired in the internal processes of investment firms. Similarly, ESMA’s multi-​faceted supervisory convergence agenda as regards the application and supervision of MiFID II/​MiFIR is leading to a bottom-​up ‘Europeanization’ of how the sprawling regime is supervised. In force since 2018, MiFID II/​MiFIR has proved to be dynamic. Although the legislative regime has been repeatedly reformed,35 the 2021 MiFID II ‘Quick Fix’ Directive represents the most substantive reform to date, bringing a series of liberalizations to MiFID II that are

29 See Ch X section 8 on the third country rules. 30 See Ch V section 12. 31 The MiFID II/​MiFIR administrative rulebook is currently composed of some thirty-​eight RTSs, eight delegated acts, and multiple implementing acts and ITSs. 32 These include investor-​protection-​oriented Guidelines on Cross-​Selling (2018), Product Governance (2018), and Suitability/​Know your Client (2018 and 2022); governance-​oriented Guidelines on the Compliance Function (2021) and the Management Body of Market Operators and Data Services Providers (2017); and a series of Guidelines on different aspects of the trading venue regime. 33 Chief among them the weighty MiFID II/​MiFIR Investor Protection Q&A and the MiFID II/​MiFIR Secondary Markets Q&A. 34 The immense FIRDS database, which is maintained by ESMA, collates in a uniform manner a series of characteristics of every financial instrument subject to MiFID II/​MiFIR reporting and also links data-​feeds between ESMA, trading venues, and NCAs across the EU. See further Ch V section 13.2. 35 Some of the reforms have been driven by the adoption of subsequent, cognate regimes, such as the adoption of the 2020 Crowdfunding Services Providers Regulation 2020 (Regulation (EU) 2020/​1503 [2020] OJ L347/​1), discussed in Ch II, which led to a MiFID II revision to provide an exemption for the entities authorized under the Regulation (Directive 2020/​1504 [2020] OJ L347/​50). Others have been more substantial. The CMU agenda has left a mark in the form of revisions to the MiFID II regime governing the ‘SME Growth Market’ (a form of trading venue constructed by MiFID II), achieved by means of the SME Regulation (Regulation (EU) 2019/​2115 [2019] OJ L320/​1), as outlined in Ch II.

IV.2  The EU Investment Firm Rulebook  353 designed to support intermediation and fund-​raising as the EU economy recovers from the pandemic.36 The Quick Fix Directive also illustrates the centrality of MiFID II/​MiFIR in EU financial markets regulation and its tendency, accordingly, to act as a vector along which pressure for reform is mediated. The major reform driver, however, has been the wide-​ ranging MiFID II/​MiFIR Review, which led to the 2021 MiFID III/​MiFIR 2 Proposals,37 and, as regards the retail markets specifically, the Commission’s reviews relating to its Retail Investment Strategy (Chapter IX).

IV.2.2  Beyond MiFID II/​MiFIR MiFID II/​MiFIR dominates the investment firm rulebook, but it is not the only measure that governs investment firms and investment intermediation. MiFID II/​MiFIR applies in tandem with the 2019 Investment Firm Directive/​Regulation (IFD/​IFR) which governs the prudential regulation of most EU investment firms.38 The prudential regulation of the largest and most complex firms is governed by the Capital Requirements Directive IV/​Capital Requirements Regulation (CRD IV/​CRR) regime, which also constitutes the EU’s ‘banking rulebook’.39 In addition, discrete regimes address different aspects of investment firm regulation, notably the 2012 European Market Infrastructure Regulation (EMIR), as regards the OTC derivatives markets, and the 2016 Packaged Retail and Insurance-​based Investment Products (PRIIPs) Regulation, as regards the distribution of investment products.40

IV.2.3  Organization of Coverage This chapter addresses the regulatory framework governing the authorization and ongoing regulation of investment firms, which is covered by MiFID II. It also addresses the IFD/​IFR and CRD IV/​CRR frameworks which govern investment firm prudential regulation. Chapter V addresses the regulation of trading venues, which is governed by MiFIR but also by MiFID II. Chapter VI addresses the trading process, which is subject to a discrete set of rules at the core of which sit MiFID II/​MiFIR but also, as regards the OTC derivatives markets, EMIR. Finally, Chapter IX addresses the retail markets and how MiFID II/​MiFIR and the PRIIPs Regulation form the backbone of the EU’s retail investor protection system.

36 MiFID II Quick Fix Directive 2021/​338 [2021] OJ L68/​14. 37 COM(2021) 726 (MiFID III Proposal) and COM(2021) 727 (MiFIR 2 Proposal). These reforms are primarily concerned with trading venues and order execution and are considered in Chs V and VI. 38 Directive (EU) 2019/​2034 [2019] OJ L314/​64 and Regulation (EU) 2019/​2033 [2019] OJ L314/​1. 39 Directive 2013/​36/​EU [2013] OJ L176/​338 (Capital Requirements Directive IV (CRD IV)) and Regulation (EU) No 575/​2013 [2013] OJ L176/​1 (Capital Requirements Regulation (CRR)) were revised in 2019 by Directive (EU) 2019/​878 [2019] OJ L150/​253 (CRD V) and Regulation (EU) 2019/​876 [2019] OJ L150/​1 (CRR 2). The revised regime is referred to in this chapter as CRD IV/​CRR, with reference made separately to the CRD V/​CRR 2 reforms as appropriate. CRD VI/​CRR 3 reforms are in train (section 9.4). 40 Respectively, Regulation (EU) No 648/​2012 [2012] OJ L201/​1 and Regulation (EU) 2016/​2340 [2016] OJ L354/​35.

354  Investment Firms and Investment Services

IV.3  The Evolution of MiFID II IV.3.1  Initial Developments and the 1993 Investment Services Directive MiFID II and its related administrative rules now constitutes an immensely granular rulebook on investment firm regulation but at bedrock it is designed to support the embedding of market finance and market integration and, specifically, investment firm passporting. It roots can be traced to the seminal 1966 Segré Report which found that while the participation of market intermediaries was critical to the creation of a European capital market, they were hampered by varying rules and supervisory practices, and called for harmonization.41 A first step was taken with the 1977 non-​binding, principles-​based Code of Conduct,42 but very little progress would be made thereafter until the early 1990s, with investment firm regulation in the EU taking the form of a patchwork of national rules.43 Market integration was significantly impeded by protectionist entry requirements44 and by diverging national rules,45 as well as by the limited purchase of market finance and the related dominance of universal banks across the EU.46 As market finance began to take root in the late 1980s/​early 1990s (spurred by the arrival of major US investment firms), and as Member States began to engage with the then-​novel policy challenges associated with investor protection, market efficiency, and financial stability, an explosion of regulatory activity47 led to new national regulatory regimes48 which, in some cases, had protectionist elements.49 The Commission’s 1985 White Paper on ‘Completing the Internal Market’ provided the mutual recognition legal technology on which the EU response was, initially, based.50 In a 41 Report by a Group of Experts Appointed by the EEC Commission, The Development of a European Capital Market (the Segré Report) (1966) 32 and 267–​71. 42 Commission Recommendation 77/​ 534/​ EEC concerning a European Code of Conduct Relating to Transactions in Transferable Securities [1977] OJ L212/​37. It contained general high-​level principles relating to the regulation of investment firms. 43 Wymeersch, E, Control of Securities Markets in the European Economic Community. Collection Studies. Competition—​Approximation of Legislation Series No 3 (1977). 44 In Germany, eg, investment services could be carried out only through a credit institution incorporated in Germany. 45 The 1977 landscape stands in stark contrast to the MiFID II landscape: ‘In France, the passing-​on of stock exchange orders, as well as portfolio management, is subject to some measures of investor protection. In the United Kingdom, some investment consultants and intermediate brokers could come within the scope of the Prevention of Fraud (Investments) Act . . . there are many exceptions to this rule . . . In Belgium and the Netherlands only securities brokerage is reserved to the recognized securities business: investment advisory services or portfolio management are offered absolutely freely . . . In Luxembourg the question is solved by the application of the Order controlling the opening of new business, while in Germany problems have arisen both with portfolio managers or consultants and with sellers of securities from their own portfolios. In Italy there is complete freedom’: Wymeersch, n 43, 60–​1. For an early examination of the barriers to integration, see Commission, Research on the ‘Cost of Non-​ Europe’, Basic Findings, vol 9, ‘The Cost of Non-​Europe in Financial Services’ (1988) 62. 46 eg Farmery, P, ‘Looking Towards a European Internal Market in Financial Services: Some Paradoxes and Paradigms: A Survey of Current Problems and Issues’ (1992) 3 EBLR 94. 47 In his Opinion in Commission v Italy, Lenz AG noted that ‘[i]‌n a period of less than 10 years the legislatures of the Member States of the European Communities evidently recognized a need for regulation’: Case C-​101/​94 Commission v Italy (ECLI:EU:C:1996:115), para 40. 48 The UK, eg, in 1986 introduced the Financial Services Act which changed the regulation of investment services from a self-​regulatory regime to a statutory system, while in 1988 France introduced a major reform of stockbroker regulation. Also in 1988, Spain adopted a Securities Markets Act which radically restructured its securities markets. See Poser, N, International Securities Regulation. London’s ‘Big Bang’ and the European Securities Markets (1991) 379–​441. 49 Most notably the 1991 Italian ‘SIM’ legislation which introduced licensing requirements for securities firms and included an establishment requirement for cross-​border activity, leading to successful enforcement action by the Commission in Commission v Italy. 50 COM(85) 310 para 64.

IV.3  The Evolution of MiFID II  355 groundbreaking intervention, the White Paper argued that each Member State retain its own system of regulation and that the internal market be supported through mutual recognition of national regulation. The White Paper expressly addressed financial services, arguing that ‘liberalisation of financial services, linked to that of capital movements, will represent a major step towards Community financial integration and the widening of the Internal Market’, and proposed that financial services be supervised by the relevant ‘home’ authority, in accordance with minimum harmonized rules, which would support mutual recognition.51 In parallel, the 1987 Single European Act reforms to the (then) EC Treaty acted as a spur to action by providing for qualified majority voting in the Council. The first step towards an investment services regime was sideways in the form of the (now repealed) 1989 Second Banking Co-​ordination Directive (BCD II).52 It followed the White Paper’s model and granted a mutual recognition ‘passport’, based on minimum harmonized rules and ‘home’ authority supervision, to deposit-​taking ‘credit institutions’ in respect of BCD II activities which, critically, included the provision of specified investment services. The gap in the regime for non-​banks was addressed in 1993 with the Investment Services Directive (ISD).53 It granted a regulatory passport, based on home authority supervision, to investment firms within its scope and imposed related minimum authorization and operating requirements. The parallel 1993 Capital Adequacy Directive54 was a key ancillary measure to the ISD, setting out the harmonized capital requirements applicable to investment firms (and also to credit institutions in respect of their investment services and activities). This bifurcation in investment firm/​banking regulation persists to this day, with credit institutions providing investment services regulated under a combination of MiFID II (as regards ongoing regulation of investment services activities) and CRD IV/​CRR (as regards authorization and prudential regulation), and has been deepened with the recharacterization by the IFD/​IFR reforms of the largest and most complex investment firms as ‘credit institutions’ (section 9).

IV.3.2  Pre-Global Financial Crisis: The Financial Services Action Plan and MiFID I The strains in the ISD’s regulatory design quickly became apparent as rapidly developing financial markets outpaced its scope and coverage. The ISD’s minimum-​harmonization model also came under strain, most notoriously as regards conduct regulation. In one of the most striking contrasts between the ISD and MiFID II, which speaks to the paradigmatic shift that has occurred over some thirty years, conduct regulation was not harmonized and was addressed by a set of high-​level principles to be followed by Member States 51 1985 Internal Market White Paper, n 50, paras 101 and 103. The adoption by the Commission of the mutual-​recognition technique for financial-​services harmonization built on the ground-​breaking Court ruling in Case 120/​78 Rewe-​Zentral AG v Bundesmonopolverwaltung für Branntwein (the Cassis de Dijon ruling) (ECLI:EU:C:1979:42), which applied mutual recognition to the free movement of goods. The Internal Market White Paper also included in its annexed Timetable For Completing the Internal Market by 1992 the intriguingly entitled ‘Proposal for a Directive concerning investment advisors’, which was to be presented in 1989 and adopted in 1989 (para 1.3). In the event, investment advice would not come within the Community regime until the adoption of MiFID I in 2004. 52 Directive 89/​646/​EC [1989] OJ L386/​1. 53 Directive 93/​22/​EC [1993] OJ L141/​27. 54 Directive 93/​6/​EC [1993] OJ L141/​1.

356  Investment Firms and Investment Services and which, as regards investment firm compliance, were subject to host State control, under the notorious ISD Article 11.55 The related tangle of compliance costs, enforcement risks, jurisdiction opacity, scope difficulties, and investor protection risks all obstructed market integration and were exacerbated by host Member States’ power to impose national rules in the ‘general good’ (a consequence of the limited degree of harmonization). By the end of the 1990s, it was clear that the ISD was neither keeping pace with market developments nor delivering an integrated investment services market and its reform became a central preoccupation of the seminal 1999 Financial Services Action Plan (FSAP), which set out the key measures required to achieve a single market in financial services.56 The subsequent 2000 ISD Communication launched the review which would lead to MiFID I,57 but reflecting the increasing sophistication in regulatory governance which can be observed from the FSAP period on, further public consultations followed,58 as did the first major engagement by the European Parliament as regards investment services.59 Impact analysis was limited, however, reflecting the absence of the technocratic capacity now provided by ESMA.60 The subsequent 2002 MiFID I Proposal proposed a new investment services regime, based on an extension of the investment services covered by the ISD, enhanced authorization and regulatory requirements, and a significant reduction of host State jurisdiction.61 During the institutional negotiations,62 the investment firm elements of MiFID I (it also covered trading venues as discussed in Chapter V) proved largely uncontroversial; institutional relations were generally good and the negotiations for the most part refined the proposed regime. MiFID I was adopted in April 2004, some eighteen months after the Proposal’s adoption: by contrast with legislative processes over the pre-​FSAP era, this was a relatively quick process. As with MiFID II, the scale and complexity of MiFID I63 required an extension of its original implementation deadline. Although, as was also the 55 Particular difficulties attended the nature of the host State’s jurisdiction as jurisdiction was linked to the Member State ‘within which the service [was] provided’. This Delphic formula generated widespread confusion as to when a Member State’s conduct regime was engaged and required Commission interpretive intervention: Commission, Communication on Article 11 (COM(2000) 722). See, eg, Tison, M, ‘Conduct of Business Rules and Their Implementation in the EU Member States’ in Ferrarini, G, Hopt, K, and Wymeersch, E (eds), Capital Markets in the Age of the Euro (2002) 65. 56 Commission, Communication on Implementing the Framework for Financial Markets Action Plan (COM(1999) 232) (FSAP). 57 Commission, Communication on Upgrading the Investment Services Directive (COM(2000) 729). 58 Commission, Overview of Proposed Adjustments to the Investment Services Directive. Working Document of Services of DG Internal Market. Document 1 (2001) and Commission, Revision of the ISD. Second Consultation, Overview Paper (2002). Extensive consultations also took place during the subsequent administrative rule-​making process. In all, the Commission estimated that more than fifteen public consultations took place during the MiFID I processes, a step change from the ISD era: Commission, Background Note to Draft Commission Regulation Implementing Directive 2004/​39/​EC (February 2006) 1. 59 A5-​0106/​2001 (the Katiforis Report on ISD reform generally) and A5-​0105/​2001 (the Kauppi Report on the reforms to conduct-​of-​business regulation). 60 The empirical analysis in the MiFID I IA was confined to reiterating the main findings of the London Economics study into the integration of securities markets generally: London Economics, Quantification of the Macro-​Economic Impact of Integration of EU Financial Markets. Final Report to the EU Commission (2002). 61 COM(2002) 625. 62 The main elements of the legislative history are: Commission Proposal n 61; ECOSOC Opinion [2003] OJ C220/​1; ECB Opinion [2003] OJ C144/​6; First Reading by the European Parliament [2004] OJ C77/​264 (ECON report at A5-​0287/​2003); Council Common Position [2004] OJ C60/​1; and Second Reading by the European Parliament [2004] OJ C102/​33 (ECON Report at A5-​0114/​2004). 63 Its scale did not go unnoticed by the US SEC: ‘The unprecedented scope of harmonization and resulting open architecture—​particularly in trade execution and reporting—​will cause profound changes in existing market structures.’ SEC Commissioner Campos, Speech, 10 May 2007.

IV.3  The Evolution of MiFID II  357 case with the MiFID II extension, opening up MiFID I to revision was not without risk or controversy,64 the original implementation deadline was extended from 30 April 2006 to 31 January 200765 in order, in particular, to allow time for implementation of the related administrative rules.66 MiFID I, with its administrative rules, led to the establishment, for the first time, of a comprehensive EU regulatory framework governing the provision of investment services by investment firms (and credit institutions). It brought a wide range of investment services (including investment advice) and an extensive array of financial instruments (including commodity derivatives) within its scope; addressed authorization, operational/​organizational regulation, and conduct regulation; removed, for the most part, the host Member State from the regulation and supervision of cross-​border activity; introduced a streamlined notification system for passporting; and enhanced the NCA cooperation and coordination regime. It can be strongly associated with the decisive shift towards more extensive harmonization over the FSAP era and, relatedly, relied heavily on administrative rule-​ making, which had been facilitated following the 2001 Lamfalussy Review and the related establishment of the Committee of European Securities Regulators (CESR).67 The MiFID I era also, and in consequence, saw CESR emerge as a nascent technocratic influence on the investment firm regime, particularly through its supervisory convergence measures which quickly began to form an embryonic ‘soft rulebook’.

IV.3.3  MiFID II: The MiFID I Review, the Global Financial Crisis, and the MiFID II Negotiations The origins of MiFID II are in the wide-​ranging MiFID I Review which followed from the review obligations embedded in MiFID I. These review clauses, then a novel feature of measures adopted over the FSAP period and now standard, required the Commission to review a range of MiFID I provisions, generally within one to three years of the Directive coming into force (over 2008–​10). The Review was accordingly undertaken over the financial-​ crisis period and was shaped by it, although from the outset the Commission cleaved to the view that MiFID I had stood up relatively well to the onslaught of the financial crisis.68 The 64 The Commission emphasized that the revision was driven by force majeure given industry concerns and insisted that it would not ‘allow any debates to be re-​opened or any deals to re-​negotiated’: European Securities Committee Minutes, 23 February 2005. The MiFID II extension process saw a similar concern to contain reform impulses and to protect the difficult legislative compromise achieved, albeit that a small number of technical changes (to the exemption for commodity dealers and the third country regime) were also adopted. 65 By Directive 2006/​31/​EC [2006] OJ L114/​60 (2006 MiFID I Amending Directive). 66 The Financial Times marked the occasion by opining that ‘MiFID is a substantial and potentially sweeping piece of EU law-​making. Its objectives of creating efficient conditions for trading securities and other financial instruments, promoting competition and providing EU-​wide standards for investor protection serve the laudable goal of fostering economic growth in Europe through the creation of deep, liquid, and well-​regulated markets of a continental scale’ (Editorial, ‘Day of the MiFID’, Financial Times, 1 November 2007). 67 See in outline Ch I section 6.2. 68 The Commission suggested that MiFID I had provided firms with the freedom to provide investment services across the EU and that higher and more comprehensive investor protection requirements had followed: Commission, Public Consultation on Review of the Markets in Financial Instruments Directive (2010) 5, while the 2011 MiFID II Proposal suggested that MiFID I had been ‘largely vindicated amid the experience of the financial crisis’: 2011 MiFID II Proposal, n 24, 2. The two major empirical assessments of MiFID I focused mainly on the trading venue rules: Europe Economics, MiFID I Review—​Data Gathering and Cost Benefit Analysis (2011) and PriceWaterhouseCoopers, Data Gathering and Analysis in the Context of the MiFID I Review. Final Report (2010). The more widely cast 2009 Europe Economics study for the Commission on the costs of key FSAP

358  Investment Firms and Investment Services Review was accompanied by an extensive fact-​finding process which, and foreshadowing the MiFID II/​MiFIR Review in which ESMA has been centrally engaged, also harnessed CESR’s expertise.69 The pathfinding December 2010 Commission Consultation on the MiFID I Review70 was largely concerned with revising the trading venue elements of MiFID I. The Commission was relatively sanguine as to the resilience of MiFID I as regards investment firm regulation, although it sought an enhancement of investor protection, and also greater standardization of investment firm regulation in order to strengthen the then-​developing ‘single rulebook’, the construction of which was at the heart of the wider financial-​crisis-​era reform agenda. The December 2010 Consultation identified a series of potential reforms to the scope of MiFID I, including as regards narrowing the exemptions for commodity firms in relation to their proprietary dealing in commodity derivatives (reflecting concerns as to potential investor protection risks were these exempted firms to engage in investment services more generally); expanding the regime to cover emission allowances (reflecting the evolution of the EU’s approach to the regulation of carbon trading) and structured deposits (reflecting concerns as to the exclusion from MiFID I of deposit-​based investments, functionally similar to other MiFID I financial instruments); and tightening the exemption for small investment firms which did not hold client assets (reflecting concerns as to potential investor protection risks). The Consultation also proposed a series of substantive reforms to MiFID I, including with respect to client classification (designed to enhance the protections for professional investors), firm governance (designed to clarify senior management roles, strengthen the ‘fit and proper’ assessment, and improve incentives for sound risk-​taking), and specific aspects of investment firm regulation. In common with the wider financial-​crisis-​era reform agenda, the Consultation also proposed a strengthening of NCA supervisory and enforcement powers. The October 2011 MiFID II Proposal,71 followed the Consultation in most respects. The Proposal reflected the Commission’s view that the ‘wholesale repairs’ required in other segments of the financial system, and ‘a comprehensive review of the underlying precepts and building blocks of MiFID [I]‌’ was neither necessary nor appropriate; an approach targeted at ‘fixing visible flaws’ was best.72 The 2011 MiFID II Proposal would, however, change substantially over the course of the institutional negotiations and become encrusted with regulatory detail and calibrations. Negotiations proved slow, the pace being set by discussions on the highly contested trading venue aspects of the MiFID II/​MiFIR package. Council discussions spanned the Polish, Danish, Cypriot, and Irish presidencies (autumn 2011 to June 2013) and focused primarily on the trading venue requirements.73 But the investment firm authorization and operating conditions also proved contentious. The Council measures (Europe Economics, Survey on the Cost of Compliance with Selected FSAP Measures (2009)), however, found that MiFID I had been a major driver of increased costs for banks, investment firms, and asset managers, and that the costs had fallen more heavily on smaller firms. 69 CESR’s advice on the investment firm aspects of the MiFID I Review was contained in CESR/​10-​1040 (client categorization) and CESR/​10-​1254 (investor protection and intermediaries). 70 n 68. 71 n 24. 72 2011 MiFID II/​MiFIR Proposals IA, n 24, 6. 73 An April 2013 progress report from the Irish Presidency reported that a qualified majority vote (QMV) on MiFID II/​MiFIR was dependent on agreement on the MiFIR provisions related to access to trading venues: Irish Presidency Progress Report on MiFID II/​MiFIR, 15 April 2013 (Council Document 8322/​13).

IV.3  The Evolution of MiFID II  359 struggled to reach a position on, for example, the reach of MiFID II with respect to firms selling structured deposits; by contrast, Council consensus was more easily achieved with respect to the proposed firm governance requirements.74 Overall, however, the Council’s June 2013 general approach retained the main elements of the Commission’s MiFID II Proposal. The European Parliament reached a negotiating position earlier in October 2012,75 after the ECON Committee’s September 2012 agreement on the over 1,300 amendments proposed to its original March 2012 Ferber Report on the MiFID II Proposal.76 The Parliament’s position differed from the Council’s in a number of respects, notably with respect to the more stringent conditions the Parliament imposed on firm governance and as regards organizational requirements. During the final Commission/​Council/​European Parliament trilogue negotiations, most attention focused on the retail-​market-​related and trading venue/​trading-​process-​related reforms; the core investment firm regime was not heavily contested. Trilogue negotiations were conducted under some time pressure, given the imminent 2014 closure of the Commission and European Parliament terms. Agreement was finally reached on the massive text in February 2014 which finally came into force on 3 January 2018. The 2014 adoption of the legislative text, and the adoption accordingly of the mandates for delegated rule-​making, cleared the way for the construction of the vast MiFID II administrative rulebook on which the operation of MiFID II depends. While MiFID I had been a trail-​blazer in the extent to which it was amplified by administrative rules, the MiFID II administrative rule-​making process was epochal. MiFID II contained a swathe of delegations for administrative rule-​making,77 the unprecedented breadth of which reflected both the complexity and ambition of MiFID II, but also increased institutional experience with, and confidence in, ESMA which by then had been tested by the administrative rule development processes for a series of financial-​crisis-​era measures. In excess of forty separate sets of detailed MiFID II administrative rules followed, most of them adopted in March 2017 in advance of MiFID II coming into force in January 2018.78 As outlined in section 4, the rule development process was, particularly given its scale, relatively smooth and characterized by an effective Commission/​ESMA working relationship as well as by extensive consultation and empirical assessment. The MiFID II administrative rulebook contains a host of rules governing investment firm operation, but chief among them are Delegated Regulation 2017/​565 on core definitions and the organization and operating conditions for investment firms, and Delegated

74 The MiFID II/​MiFIR negotiations were notable for the extensive numbers of Presidency Compromise drafts circulated. The first Presidency Compromise was issued in June 2012 by the Danish Presidency, and was followed by repeated compromise drafts, which increased significantly in number over the final stages of the Irish Presidency. Summaries of the status of the negotiations were issued at the end of the Cyprus Presidency (Cyprus Presidency Progress Report on MiFID II/​MiFIR, 13 December 2012 (Council Document 16523/​12)) and the Danish Presidency (Danish Presidency Progress Report on MiFID II/​MiFIR, 20 June 2012 (Council Document 11536/​12)). 75 n 24. 76 ECON, Draft Report on the MiFID II Proposal (A7-​0306/​2012) (Ferber Report). 77 As the MiFID II negotiations entered their closing stages, ESMA highlighted that, given the scale and ambition of the proposed administrative regime, it was committing significant resources to advance preparations: ESMA, Annual Report (2012) 43. 78 Many were published in [2017] OJ L87.

360  Investment Firms and Investment Services Directive 2017/​593 which covers a range of conduct-​of-​business-​oriented rules, including as regards asset protection, product governance, and conflicts of interest.79

IV.3.4  The Post Global Financial Crisis Era: Prudential Regulation, Technocracy, and Legislative Reform Since its adoption in 2014 and its coming into force in 2018, MiFID II has been shaped by three major forces that are considered across this chapter. First, the financial stability imperative that can be associated with much of post-​ financial-​crisis EU financial markets regulation has led to a transformation of investment firm prudential regulation in the form of the IFD/​IFR regime, adopted in 2019 (section 9). It sits alongside MiFID II but does not act in isolation from it. The IFD/​IFR’s ‘risk-​to-​client’ capital requirements and enhanced firm governance requirements, for example, can be expected to exert a strong influence on the risk governance and culture of MiFID II firms and on how they apply MiFID II’s conduct and operational requirements. Second, the development of MiFID II since 2014 has in large part been a function of ‘bottom-​up’ technocracy. While this is the case for much of the single rulebook it is particularly marked with respect to MiFID II (and MiFIR). ESMA’s influence on the ‘first generation’ MiFID II administrative rulebook, as adopted in 2017, was determinative, with the Commission following the vast bulk of ESMA’s proposals for RTSs and of its technical advice for delegated acts, with few revisions.80 Since then, revisions to administrative rules, often prompted by ESMA, have become a means for making technical adjustments to MiFID II as distortions and ambiguities have emerged.81 They have also been used to adjust MiFID II to reflect EU priorities. Revisions to administrative rules, shaped by ESMA, have, for example, been used to embed the management of sustainability-​related risks into the MiFID II regime as the EU’s sustainable finance agenda has evolved.82 Alongside, the flow of ESMA soft law, which shapes how NCAs and the regulated sector apply MiFID II, is showing no sign of abating.83 Finally, and notwithstanding this technocratic dynamic, MiFID II has also been subject to legislative revision. The most substantial reforms to date flow from the 2020 ‘Quick Fix’/​ Capital Markets Recovery Package, a series of liberalizing reforms designed to support the EU’s recovery from the Covid-​19 pandemic, and a novelty in EU financial markets governance as legislation is not typically deployed as a ‘quick reaction’.84 The 2020 reform package included what became the 2021 MiFID II Quick Fix Directive.85 Something of a scattergun 79 Delegated Regulation (EU) 2017/​565 [2017] L87/​1 and Delegated Directive (EU) 2017/​593 [2017] OJ L87/​ 500. 80 See section 4. 81 eg, the ESMA-​driven refinement of Delegated Regulation 2017/​565 (a core element of the MiFID II administrative rulebook) to address potential competitive distortions arising from the treatment by MiFID II of ‘systematic internalizers’ (an investment firm classification relating to order execution). The revision was achieved by means of Delegated Regulation 2017/​2294 [2017] OJ L329/​4. See further Ch V section 5.5. 82 As noted in section 3.5. 83 2022 saw, eg, the adoption of Guidelines on the MiFID II know-​your-​client/​appropriateness rules (April 2022) and on its requirements relating to firms’ remuneration policies and practices (March 2022), as well as of a Supervisory Briefing in relation to the MiFID II tied agent rules (February 2022). 84 The MiFID II Quick Fix Proposal, eg, called for a ‘quick reaction’ to support capital market participants: COM(2020) 280 1. 85 Directive (EU) 2021/​338 [2021] OJ L68/​14.

IV.3  The Evolution of MiFID II  361 reform, the Quick Fix Directive was designed to support the ‘rapid recapitalization’ of European companies by revising aspects of the MiFID II conduct regime which were identified as being ‘overly burdensome’,86 in particular where investment services were provided to professional clients. The reform suggests a welcome legislative agility and capacity to calibrate, but it has troublesome features. It was not accompanied by the extensive consultation and impact assessment that typically attends legislative reform;87 it pre-​empted the MiFID II/​MiFIR Review which was already underway; and it created a precedent for reactive and piecemeal legislative reform, which could have unintended effects, to address short-​term shocks. The considerable technocratic capacity that ESMA now provides suggests that soft law, ESMA-​coordinated NCA supervisory forbearance, and, where necessary, revisions to administrative rules can, where appropriate and where legitimation risks can be managed, better provide short-​term alleviations which also protect the integrity and stability of legislation.88 The large-​scale MiFID II/​MiFIR Review, launched in 2020 and undertaken to meet the review obligations imposed by MiFID II and MiFIR but also associated with the CMU agenda, was primarily concerned with trading venues and order execution.89 It led to the proposal of a series of reforms to MiFIR (the 2021 MiFIR 2 Proposal), but it did not generate material reform proposals for MiFID II.90 Reform of the MiFID II conduct regime may follow, however, through the Commission’s CMU-​related Retail Investment Strategy, the development of which was launched in 2021 and supported by a series of reviews.91

IV.3.5  Sustainable Finance The sustainable finance agenda which is increasingly shaping EU financial markets regulation (as outlined in Chapter I section 7.2), is also shaping the regulation of investment services, as regards disclosure obligations but also as regards firms’ risk management and wider operational processes. As in-​scope ‘financial market participants’, MiFID II investment firms (but only those that provide portfolio management services and/​ or investment advice) are subject to the extensive entity-​ level disclosure requirements that apply to financial market participants as regards their sustainability-​ related activities and impacts under the 2019 Sustainable Finance Disclosure (SFD) Regulation,92 as specified as regards environmental sustainability by the 2020 Taxonomy 86 2020 MiFID II Quick Fix Proposal, n 84, 1. The reforms are outlined in Ch IX. 87 The Directive was not, ‘given the urgency’, subject to an impact assessment (2020 Quick Fix Proposal, n 84, 1 and 3), while the Staff Working Document which provided the extended justification for all the Quick Fix measures was short on empirical analysis, although it made brief reference to national and industry studies and to patchy firm-​level data on certain of the costs of MiFID II implementation: SWD(2020) 120, 10 and 13. 88 Some degree of unease can be detected in the Directive which notes that the reforms were addressed to administrative ‘red tape’ and did not address ‘complex legislative questions’ which were reserved to the MiFID II Review (recital 1). 89 It is accordingly considered in Ch V. 90 The MiFID III Proposal reforms are limited and are related to the interaction with MiFIR and the regulation of trading and trading venues. 91 See Ch IX. The Commission’s related reform agenda was expected for quarter 2 2023. 92 Regulation (EU) 2019/​2088 [2019] OJ L317/​1. The Regulation applies to ‘financial market participants’ (which include investment firms that engage in portfolio management) and also to ‘financial advisers’ (which include investment firms providing investment advice): Art 2(1) and (11). See Ch I section 7.2 in outline on these disclosures which relate, inter alia, to whether the firm assesses the ‘principal adverse impacts’ of its investment decisions on ‘sustainability factors’ (as defined) and to how this assessment is to be disclosed (and, if not, the

362  Investment Firms and Investment Services Regulation.93 The management of sustainability risks is also being embedded into investment firms’ operating procedures, primarily by revisions to MiFID II administrative rules which have required, inter alia, firms to address ‘sustainability risks’ (as defined under the SFD Regulation) in their risk management processes, take into account clients’ ‘sustainability preferences’ (as defined under the SFD Regulation) when managing conflict-​of-​interest risk, and to address client sustainability preferences in providing investment advice.94 In addition, the prudential regulation regime is evolving to consider how sustainability risks, and in particular climate-​related risks, are to be embedded in risk management processes and disclosed, albeit that the risk modelling and data challenges in this regard are significant.95

IV.4  The MiFID II Rulebook: Legislation, Administrative Rules, and Soft Law MiFID II takes the form of a directive but in practice the scale of its administrative amplification means that it amounts to de facto maximum harmonization. This is underlined by the express concessions, couched as exceptions, to the Member States to adopt rules additional to those set out in MiFID II with respect to asset protection (Article 16(11)) and to conduct regulation (Article 24(12)). In these two areas, Member States may, in exceptional cases, impose additional requirements on investment firms, but these requirements must be objectively justified and proportionate so as to address specific risks to investor protection or to market integrity which are of particular importance in the circumstances of the market structure of the Member State in question, notified to the Commission, and cannot restrict or otherwise affect the passporting rights of investment firms.96 The directive is amplified by a vast administrative rulebook composed of in the region of twenty RTSs and eight delegated acts (which amplify MiFID II and have a strong regulatory colour) and ten ITSs (which primarily address reporting formats and templates).97 Much of this administrative rulebook concerns the granular specificities of the MiFID II

disclosures to be made); to how remuneration policies integrate ‘sustainability risks’ (as defined); and to the disclosures to be made as to how the firm integrates sustainability risks in its investment decisions, and as regards the results of the firm’s assessment of the likely impact of sustainability risks on the returns of the ‘financial products’ it makes available (including as regards portfolio management services). In addition, an investment firm engaging in portfolio management is subject to the ‘product-​level’ disclosures which also apply under the SFD Regulation (as specified further in relation to environmental sustainability by the Taxonomy Regulation) as regards the management of the portfolio. 93 Regulation (EU) 2020/​852 [2020] OJ L198/​13. 94 These revisions have been achieved by Delegated Regulation (EU) 2021/​1253 [2021] OJ L277/​1 and are noted in sections 8.2 and 8.3 in the context of MiFID II’s operating requirements and, as regards investment advice, in Ch IX section 4.8. Also, Delegated Directive 2021/​1269 [2021] OJ L277/​137 has revised the MiFID II administrative rules on product governance to embed consideration of sustainability risks (noted in Ch IX section 11). 95 See section 9.4.8. 96 Notifications have been limited with only Ireland (2017, in relation to Art 16(11)) and Spain and Sweden (2017, in relation to Art 24(12)) making notifications. The UK also made a notification in 2019 prior to its departure. 97 It also includes the implementing acts which adopt equivalence decisions relating to the third country regime (see Ch X section 8).

IV.4  The MiFID II Rulebook  363 trading/​order execution regime (discussed in Chapter VI),98 but several of its measures are of pivotal importance to the core MiFID II regime governing investment firm authorization and regulation, in particular Delegated Regulation 2017/​565 (on definitions and organizational/​operational requirements) and Delegated Directive 2017/​593 (on aspects of the conduct regime).99 ESMA was the defining influence on the construction of the MiFID II administrative rulebook. Its approach was, by and large, empirically informed, reflective of NCA deliberation and experience, and responsive to market concerns.100 Further, while the political salience of the MiFID II/​MiFIR legislative package, the sensitivity accordingly of delegated rule-​making, and the scale of the rule-​making mandate, had the potential to disrupt relations between the Commission (the constitutional location of rule-​making) and ESMA (the technocratic adviser), the process was generally smooth. ESMA’s technical advice to the Commission on the two key measures, Delegated Regulation 2017/​565 and Delegated Directive 2017/​593,101 was in very large part relied on by the Commission.102 Likewise, the vast bulk of the MiFID II RTSs proposed by ESMA were adopted by the Commission, with only the proposed RTS on the MiFID II exemption for dealing in commodity derivatives experiencing some contestation.103 Overall, while the scale and complexity of the MiFID II mandate for administrative rules was a significant test for the administrative rule-​making process, at a time when ESMA was a nascent institutional actor, the process proved effective.104 The MiFID II administrative rulebook continues to evolve, typically in response to legislative change.105 This administrative and legislative rulebook is supported by a dense soft law ‘rulebook’ at the core of which are the ESMA Guidelines which, in effect, form a quasi-​operating-​manual for investment firms.106 Several sets of Guidelines have shaped the application of the MiFID II authorization/​ongoing regulation regime including the 2021 ESMA Guidelines on the 98 Including as regards algorithmic trading, market-​making, best execution, trading disruption, commodity derivatives positions reporting, and related reports. 99 In addition, RTS 2017/​1943 [2017] OJ L276/​4 on the authorization process, RTS 2017/​586 [2017] OJ L87/​ 382 on NCA cooperation, and Delegated Regulation (EU) 2021/​1833 [2021] OJ L372/​1 on the exemption for commodity derivatives dealing are of direct relevance to the MiFID II investment firm authorization and operational/​ organizational regime. 100 Initial market reaction to ESMA’s approach was broadly favourable: Stafford, P, ‘Steven Maijoor, European Regulator Who Became Mr MiFID’, Financial Times, 5 January 2018. For extended analysis of ESMA’s approach to the MiFID II/​MiFIR administrative rule-​making process see further Moloney, N, The Age of ESMA. Governing EU Financial Markets (2018) ch 3. 101 Set out in ESMA/​2014/​1569, a vast set of technical advice which also covered ESMA’s technical advice on aspects of the trading venue/​trading regime. 102 The extent of the Commission’s reliance on ESMA’s technical advice can be traced across the Commission’s IAs for the 2017 Delegated Regulation and Directive: SWD(2016) 157 and 138, respectively. The Commission also engaged with ESMA after the delivery of its technical advice and as the draft measures went through the adoption process: C(2016) 2031, Explanatory Memorandum to Directive 2017/​593. 103 ESMA adopted a stricter approach to the exemption than that which the Commission finally adopted: Commission, Letter to ESMA, 20 April 2016. 104 ESMA was, however, careful to protect its procedural rights. eg, on receipt of informal Commission indications in March 2016 that some aspects of its draft MiFID II/​MiFIR RTSs were to be revised, ESMA wrote to the Commission to advise that it would assume the RTS revision process had been formally triggered, although a formal indication had not been received from the Commission. But while ESMA was careful to insist on its procedural prerogatives, it was also willing to accommodate the Commission, given that MiFID II was ‘a complex and extraordinary project’. Letter from ESMA Chair Maijoor to the Commission, 21 March 2016. 105 eg the RTS governing the exemption for commodity derivatives dealing (RTS 2017/​592 [2017] OJ L87/​492) was replaced to reflect the 2021 Quick Fix reforms by Delegated Regulation 2021/​1833 [2021] OJ L372/​1. 106 At the time of writing, fourteen sets of Guidelines operationalized different aspects of MiFID II/​MiFIR, with at least two in the pipeline. ESMA, Guidelines Table, 5 October 2022.

364  Investment Firms and Investment Services investment firm compliance function, which specify in detail how the function should be designed and operate; the 2021 joint ESMA/​EBA Guidelines on how the ‘fit and proper’ assessment of management body/​board members is to be addressed; and the series of ESMA Guidelines which address MiFID II conduct requirements.107 Alongside, ESMA’s extensive and iterative MiFID II Investor Protection and Intermediaries Q&A provides detailed and often practically oriented answers to questions submitted by stakeholders, while a multitude of ESMA Opinions, Supervisory Briefings, and other supervisory convergence measures have further expanded the soft law ‘rulebook’.

IV.5  Setting the MiFID II Perimeter: Scope IV.5.1  A Functional Approach MiFID II applies to investment firms and market operators108 (and third country investment firms providing investment services and/​or performing investment activities through the establishment of a branch in the EU)109 (Article 1(1)). It establishes requirements in relation to the authorization and operating conditions for investment firms110 and in relation to supervision, cooperation, and enforcement by NCAs (Article 1(2)). MiFID II also acts as a form of regulatory perimeter control for EU financial markets regulation generally as the pivotal MiFID II definitions of ‘investment services’ and ‘financial instruments’ often define the scope of other measures. The scope of MiFID II is organized on a functional basis.111 Accordingly, it applies to the provision or conduct of MiFID II ‘investment services and activities’ and its application does not depend on the organizational or legal status of the relevant actor (for example, whether the provider is a multi-​function investment firm, an asset manager, or other specialist investment firm). Under MiFID II’s functional model, credit institutions112 are subject to specified MiFID II rules when they provide one or more MiFID II investment services and/​or perform MiFID II investment activities, and they also benefit from the MiFID II passport, although they are not authorized under MiFID II as they are authorized under the CRD IV/​ CRR regime (Article 1(3)).113 107 Including as regards the know-​your-​client ‘appropriateness’ and ‘suitability’ assessments (2022 and 2018) and as regards firm’ remuneration policies (2022). 108 The term ‘market operator’ relates to the entities that operate trading venues in the form of ‘regulated markets’. See Ch V section 6. 109 See Ch X section 8 on the third country regime. 110 And also addresses regulated markets. See Ch V section 6. 111 This approach has long been a feature of investment services regulation: Ferrarini, G, ‘Towards a European Law of Investment Services and Institutions’ (1994) 21 CMLRev 1283. 112 Credit institutions are defined under CRR as undertakings whose business is to receive deposits or other repayable funds from the public and to grant credits for their own account, as well as, following the 2019 IFD/​IFR reforms, investment firms engaging in own-​account dealing, underwriting, or placing activities with consolidated assets in excess of €30 billion: Art 4(1)(1). See further section 9.3 and 9.4. 113 Given the extensive CRD IV/​CRR (as revised by CRD V/​CRR 2) authorization and prudential regime for credit institutions, credit institutions are subject under MiFID II to: an attenuated firm governance regime (designed to ensure credit institution governance incorporates the risks associated with investment services/​activities); the investor compensation scheme requirement; and the operational and conduct regime. Credit institutions benefit from passporting rights as regards their MiFID II investment services/​activities but are not subject to the related MiFID II notification requirements, given the application of the CRD IV passporting regime to credit institutions. Supervision of credit institutions is governed by the CRD IV regime, supplemented by the specific NCA

IV.5  Setting the MiFID II Perimeter: Scope  365 MiFID II’s functional approach is designed to ensure that it applies widely and does not generate regulatory gaps. The use of ‘financial instruments’ to delineate the scope of MiFID II’s application does, however, generate regulatory arbitrage risks as it has the effect of excluding from MiFID II certain instruments which fall outside the definition of ‘financial instruments’ but which are functionally similar, as is discussed further in Chapter IX. In response to these risks MiFID II applies a distinct regime to investment firms (and credit institutions) when they sell, or advise clients in relation to, ‘structured deposits’ (deposits the return from which is exposed to market fluctuations and which are functionally similar to, but not included within, ‘financial instruments’).114 Investment firms and credit institutions selling or advising clients in relation to structured deposits are subject to a tailored set of MiFID II rules designed to capture the related risks, particularly with respect to the quality of advice (Article 1(4)).115 This bespoke treatment for structured deposits is designed to capture regulatory arbitrage risks, but it underlines that the MiFID II regulatory perimeter is not easy to fix and can be placed under pressure by market developments. To take another example, the scope of ‘financial instruments’ also leads to the exclusion of insurance-​ related investment products from MiFID II, albeit that these products are also functional substitutes for MiFID II financial instruments. The distribution of these products is instead addressed by the 2016 Insurance Distribution Directive which is based on, but not fully aligned with, MiFID II.116

IV.5.2  Investment Services and Activities MiFID II applies to ‘investment firms’: any legal person whose regular occupation or business is the provision of one or more ‘investment services’ to third parties and/​or the performance of one or more ‘investment activities’ on a professional basis (Article 4(1)(1)).117 The pivotal ‘investment services and activities’ qualifier is defined by reference to the services and activities listed in Annex I, Section A. These services and activities only come within MiFID II where they also relate to the instruments listed in Annex I, Section C (‘financial instruments’): MiFID II Article 4(1)(2)) and Article 4(1)(15).

powers and sanctioning arrangements required by MiFID II and also by the powers that MiFID II confers on host NCAs as regards investment services/​activities. 114 Defined as a deposit that meets the requirements of the Deposit Guarantee Directive (Directive 2014/​49/​EU OJ L173/​149) and that is fully repayable at maturity on terms under which any interest or premium will be paid (or is at risk) according to a formula involving factors such as: (i) an index or combination of indices, excluding variable rate deposits whose return is directly linked to an interest rate index; (ii) a financial instrument or combination of such financial instruments; (iii) a commodity or combination of commodities (or other physical or non-​physical fungible assets); or (iv) a foreign exchange rate or combination of foreign exchange rates: Art 4(1) (43). This definition is designed to exclude deposits which cannot be characterized as investment products. 115 The MiFID II rules in relation to management body oversight of firm governance (Art 9(3)); investor compensation schemes (Art 14); organizational requirements (Art 16(2) (compliance), 16(3) (conflict-​of-​interest management), and 16(6) (record keeping)); relevant elements of the conduct regime (Arts 23–​6, 28, and 29); and supervision and enforcement. 116 Directive (EU) 2016/​97 [2016] OJ L26/​19. See further Ch IX section 4.13. 117 Member States may choose to bring firms which are not legal persons (natural persons) within the scope of ‘investment firms’ subject to a series of conditions designed to ensure that the absence of legal personality does not generate risks, particularly as regards asset protection.

366  Investment Firms and Investment Services The Annex I(A) list of in-​scope ‘investment services and activities’ is, along with the Annex I(C) list of ‘financial instruments’, the key perimeter control on MiFID II, as well as a tool for calibrating the application of its rules: the conduct rules, for example, are calibrated to the type of service/​activity engaged in. Annex I(A) also determines the scope of the CRD IV/​CRR prudential regime as that regime covers (in part) firms engaging in the MiFID II services of own-​ account dealing, underwriting, and placing, where other, primarily size-​related conditions, are met (section 9). Annex I(A) sets out the extensive list of investment services and activities which have long acted to set the scope of EU investment services regulation: the reception and transmission of orders in relation to one or more financial instruments;118 the execution of orders on behalf of ‘clients’;119 dealing on own account (defined as trading against proprietary capital resulting in the conclusion of transactions in one or more financial instruments (Article 4(1)(6)); portfolio management (defined as managing portfolios in accordance with mandates given by clients on a discretionary client-​by-​client basis where such portfolios include one or more financial instruments (Article 4(1)(8)); investment advice;120 underwriting of financial instruments and/​or placing of financial instruments on a firm commitment basis; placing of financial instruments without a firm commitment basis; and the operation of order execution trading venues.121 The classic broking, advice, asset management, dealing, and underwriting functions associated with investment firm intermediation all accordingly come within the scope of MiFID II. MiFID II introduced some refinements to this list from MiFID I, primarily in relation to the ‘execution of orders on behalf of clients’ and in order to clarify that primary market sales by MiFID II firms of their proprietary instruments come within MiFID II, in the wake of a series of financial-​crisis-​era mis-​selling scandals relating to the sale by banks of proprietary securities and some confusion as to whether such sales came within MiFID I.122 The order execution definition was accordingly clarified, in an example of the perennial instability associated with perimeter-​fixing, to include the conclusion of agreements to sell financial instruments issued by a credit institution or an investment firm at the moment of their issuance (Article 4(1)(5)). Reflecting a longstanding feature of the investment services regime, MiFID II also contains a second tier of ‘ancillary services’ (listed in Annex I(B)). Although authorization may be granted to investment firms which, in addition to Annex I(A) activities, cover one or more of these ancillary activities, authorization may not be granted to investment firms which provide only ancillary services (Article 6(1)). One of the effects of this regulatory design is to take boutique investment research firms outside MiFID II as investment research is an ancillary service.123 The provision of these services is, however, subject to MiFID II once provided by a MiFID-​authorized firm. 118 The Court of Justice has adopted a narrow interpretation of this service, ruling that it relates only to financial instruments, and cannot be interpreted broadly to include facilitation of the conclusion of an asset management agreement (termed ‘brokering’ in the ruling) between a client and the relevant asset manager: Case C-​678/​15 Khorassani v Pflanz (ECLI:EU:C:2017:451). 119 Defined as acting to conclude agreements to buy or sell one or more financial instruments on behalf of clients: Art 4(1)(5). A client is defined as any natural or legal person to whom an investment firm provides investment or ancillary services: Art 4(1)(9). 120 See further Ch IX section 4.10 on the definition of investment advice. 121 See further Ch V on trading venues. 122 See further Ch IX. 123 These ancillary or ‘non-​core’ activities are: (i) safekeeping and administration of financial instruments for the account of clients, including custodianship and related services such as cash/​collateral management but excluding

IV.5  Setting the MiFID II Perimeter: Scope  367

IV.5.3  Financial Instruments The ‘financial instruments’ which govern the scope of MiFID II (and many other measures, including the prospectus regime) are set out in Annex I(C), which has been subject to legislative specification as well as to extensive amplification by administrative rules.124 The list includes (numbering follows Annex I(C)): (1) transferable securities;125 (2) money-​ market instruments;126 (3) units in collective investment undertakings; (4) derivatives in the form of options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, emission allowances or other derivative instruments, financial indices or financial measures which may be settled physically or in cash;127 (8) credit derivatives; (9) financial contracts for differences; and (10) cash-​settled ‘exotic’ derivatives relating to a range of underlyings, including climatic variables, freight rates, or inflation rates (or other official economic statistics) which must be settled in cash or which may be settled in cash at the option of one or more of the parties (other than by reason of default or other termination event), as well as any other derivatives not mentioned in Annex I(C) which have the characteristics of other financial derivatives, having regard to whether, inter alia, they are traded on a regulated trading venue.128 In addition to these financial derivatives of various design, MiFID II covers commodity derivatives (Annex I(C)(5)–​(7));129 these derivatives are also subject to specific position the maintenance of securities accounts governed by the central securities depositaries (CSD) regime (this regime is noted in Ch V section 14); (ii) granting credits or loans to an investor to allow that investor to carry out a transaction in one or more financial instruments, where the firm granting the loan is involved in the transaction (margin-​ trading services); (iii) advice to undertakings on capital structure, industrial strategy, and related matters, and advice and services relating to mergers and the purchase of undertakings; (iv) foreign-​exchange services where these are connected to the provision of investment services; (v) investment research and financial analysis or other forms of general recommendation relating to transactions in financial instruments; (vi) services relating to underwriting; and (vii) investment services and activities (as well as ancillary services) relating to the underlying of commodity derivatives (and derivatives covered by section C(10)—​see below). 124 As well as judicial clarification in Case C-​604/​11 Genil 48 SL, Comercial Hostelera de Grandes Vinos SL v Bankinter SA, Banca Bilbao Vizcaya Argentaria SA (ECLI:EU:C:2013:344) which confirmed that interest rate swaps were within the scope of MiFID I. 125 Defined in Art 4(1)(44) as those classes of securities which are negotiable on the capital markets, with the exception of instruments of payment. Three examples are given by the Art: (a) shares in companies and other securities equivalent to shares in companies, partnerships or other entities, and depositary receipts in respect of shares; (b) bonds or other forms of securitized debt, including depositary receipts in respect of such securities; and (c) any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures. Depositary receipts are defined as securities which are negotiable on the capital market and which represent ownership of the securities of a non-​domiciled issuer while being able to be admitted to trading on a regulated market and traded independently of the securities of the non-​domiciled issuer: Art 4(1)(45). 126 Defined as those classes of instruments which are normally dealt in on the money market, such as treasury bills, certificates of deposit, and commercial paper, but excluding instruments of payment: Art 4(1)(17). This definition has been further amplified by Delegated Regulation 2017/​565 Art 11 which includes other instruments with substantively equivalent features, where they have a value that can be determined at any time, are not derivatives, and, reflecting the short-​term nature of the money market, have a maturity at issuance of 397 days or less. 127 Further amplified, in detail, by Delegated Regulation 2017/​565 Art 10 as regards the types of currency derivatives which do not constitute financial instruments, in particular ‘spot’ foreign exchange contracts (which are physically settled through exchanges of currencies). 128 ‘C(10) derivatives’ have been amplified by Delegated Regulation 2017/​565 Arts 7(3) and 8 which set out criteria for C(10) derivatives and also further specify the types of underlyings covered. 129 C(5) covers cash commodity derivatives: options, futures, swaps, forwards, and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties (other than by reason of default or other termination event) (the option is designed to ensure that industry-​ wide, netting master agreements to manage credit risks can be used). C(6) covers commodity derivatives which

368  Investment Firms and Investment Services risk management requirements (Chapter VI).130 As MiFID II is designed to catch commodity derivatives that are akin to financial derivative instruments, the related definitions are based on defining characteristics designed to distinguish between commodity derivatives used for investment purposes and those used for commercial purposes; these characteristics are amplified in some detail under Delegated Regulation 2017/​565.131 Emission allowances created under the EU Emission Trading Scheme (the EU’s carbon trading scheme) (C(11)) are also included.132 The classification of emission allowances as MiFID II financial instruments had, at the time of MiFID II’s development, potentially major implications for the EU’s carbon trading market, which includes large and sophisticated industrial organizations but also small buyers. Following extensive and specialist consultations, emission allowances were, however, included given concerns that the secondary trading of such ‘spot’ emission allowances133 was largely unregulated and that leaving the regulation of this emerging market to potentially diverging national regimes would be detrimental to the market’s development.134 The effect of the inclusion of emission allowances is that the MiFID II rulebook applies to all trading venues and intermediaries operating in the secondary spot trading market for emission allowances, unless they benefit from an exemption.135 This fixing of the regulatory perimeter by means of reliance on a wide range of ‘financial instruments’ requires parallel calibration of the regulatory regime to reflect the specific risks of these instruments and also to avoid the disproportionate regulation of non-​financial counterparties (NFCs) who use MiFID II instruments for commercial hedging purposes. MiFID II accordingly contains a series of calibrations designed to protect NFCs from the can be physically settled, as long as they are traded on a MiFID II/​MiFIR trading venue, except for certain wholesale energy products traded on an ‘organized trading facility’ (a form of MIFID II/​MiFIR trading venue) that must be physically settled. C(7) covers a residual category of commodity derivatives which may be physically settled and which are not covered by C(6) and which are not for commercial purposes, but which have the characteristics of other derivative financial instruments. 130 Commodity derivatives were first included in investment services regulation by MiFID I. In its MiFID I Proposal, the Commission argued that the exclusion of commodity derivatives under the earlier ISD regime and the absence of a single-​market framework was anachronistic given in particular the liberalization of underlying commodity and energy markets: 2002 MiFID I Proposal, n 61, 71. 131 Including as regards the ‘must be physically settled’ exemption for C(6) wholesale energy products (which was a source of some concern over the negotiations, given the danger that this could be deployed to avoid MiFID II/​MiFIR and could generate arbitrage risks): Delegated Regulation 2017/​565 Arts 5–​6. These rules, while designed to avoid arbitrage, take a more flexible approach than did ESMA in its related technical advice, in order to avoid any impairment of market liquidity or price impact in the wholesale energy market: Commission, IA for Delegated Regulation 2017/​565 (SWD(2016) 138) 47–​52. Underlining the operational importance but also the complexity of the commodity derivatives rules, ESMA has adopted Guidelines (based on the precursor MiFID I Guidelines) which provide additional guidance on the scope of C(6) and C(7) instruments: ESMA, Guidelines on the Application of C6 and C7 of Annex I of MiFID II (2019). 132 Directive 2003/​87/​EC [2003] OJ L275/​32 establishes the ‘ETS’. 133 In a ‘spot’ trade, the asset is delivered immediately (by comparison with derivative trades). The term is associated with the underlying commodity/​asset, in this case the emission allowance (rather than derivatives based on such allowances). 134 The Commission’s MiFID II IA highlighted that the derivatives market for emissions was regulated (under MiFID I) but that secondary spot trading was not regulated, leaving a significant gap in the regulatory treatment of emission allowances: n 24, 14. 135 ESMA’s 2022 report on the emission allowances/​carbon market, which supported the Commission’s then ongoing assessment of the operation of the carbon market, made a series of recommendations to enhance transparency in and the monitoring of the market, including in relation to position management and reporting (emission allowance derivatives are not classed as commodity derivatives and do not currently come within the MiFID II position management system) and in relation to trade reporting: ESMA, Emission Allowances and Associated Derivatives (2022).

IV.6  Calibration and Differentiation under MiFID II  369 full rigours of its requirements where NFCs’ activities are limited to hedging in support of commercial activities: typically, transactions in derivatives, where the transactions are ‘objectively measurable as reducing risks directly related’ to commercial activities and/​or treasury financing activity, are either excluded or subject to a calibrated regime.136

IV.6  Calibration and Differentiation under MiFID II IV.6.1  Exemptions The extensive exemptions from MiFID II respond to a range of drivers, from the effects of the longstanding silo structure of EU financial regulation, to national market features,137 and to the need to exempt actors whose MiFID II activities are incidental and of a small scale and, relatedly, to avoid the imposition of disproportionate regulatory burdens, particularly on NFC commercial hedging activities. While the exemption regime is, in its essentials, of long-​standing, MiFID II tightened the MiFID I exemption regime, reflecting the financial-​ crisis-​era concern to construct a single rulebook and to close regulatory loopholes. MiFID II does not apply to undertakings regulated under discrete EU regulatory regimes. Accordingly, insurance undertakings or undertakings carrying on reinsurance and retrocession activities governed by the EU insurance regime are excluded from the scope of MiFID II (Article 2(1)(a)), as are collective investment undertakings and pension funds—​ whether coordinated at EU level or not—​and the depositaries and managers of such undertakings (Article 2(1)(i)).138 Similarly, central securities depositaries (CSDs), also subject to discrete EU regulation, are excluded (Article 2(1)(o)). As is the case across EU financial markets regulation, the members of the European System of Central Banks (ESCB) and other national bodies performing similar functions in the EU; other public bodies charged with or intervening in the management of public debt in the EU; and international financial institutions, established by two or more Member States, which have the purpose of mobilizing funding and providing financial assistance to the benefit of their members that are experiencing or threatened by severe financial difficulties are also excluded (Article 2(1)(h)).139 A major group of exclusions applies to firms providing investment services in specified circumstances. Persons which provide investment services exclusively for their parent undertakings, for their subsidiaries, or for other subsidiaries of their parent are excluded under Article 2(1)(b), as are persons that provide investment services consisting exclusively 136 This is the case with respect to, eg, the MiFID II position management regime (Ch VI section 2.5) and the MiFID II exemption regime (section 6). 137 Under Art 2(1)(l), associations set up by Danish and Finnish pension funds with the sole aim of managing the assets of the pension funds which are members of such associations are excluded, as are, under Art 2(1)(m), Italian agenti di cambio, regulated under relevant Italian law. 138 Where UCITS (Undertaking for Collective Investment in Transferable Securities) managers under the UCITS Directive (Directive 2009/​65/​EC [2009] OJ L302/​32) and managers within the scope of the Alternative Investment Fund Managers Directive (AIFMD) (Directive 2011/​61/​EU [2011] OJ L174/​1) engage in discretionary asset management, the MiFID II regime applies. See Ch III. 139 Similarly, the rights conferred by MiFID II do not extend to the provision of services as counterparty in transactions carried out by public bodies dealing with public debt or by members of the ESCB performing their tasks as provided for by the Treaty and the Statute of the ECB and ESCB, or performing equivalent functions under national provisions: Art 2(2).

370  Investment Firms and Investment Services in the administration of employee-​participation schemes (Article 2(1)(f)). Article 2(1)(c) excludes persons providing an investment service where that service is provided in an ‘incidental manner’ in the course of a professional activity, and where that activity is regulated by legal or regulatory provisions or a code of ethics governing the profession which do not exclude the provision of that service;140 relatedly, Article 2(1)(k) excludes persons who provide investment advice in the course of providing another professional activity not covered by MiFID II, as long as the advice is not specifically remunerated.141 Specific exclusions apply to own-​account dealing. As own-​account dealing in financial instruments is a MiFID II investment activity, a vast array of otherwise non-​regulated actors who engage in dealing activities, whether for commercial hedging purposes or otherwise, but who do not pose the risks which MiFID II seeks to mitigate, could come within its scope. Two discrete exemptions are accordingly available for own-​account dealing (one for financial instruments other than commodity derivatives/​emission allowances and related derivatives (Article 2(1)(d))); the other for commodity derivatives/​emission allowances and related derivatives (Article 2(1)(j)) to avoid the disproportionate application of MiFID II.142 These exemptions were previously available under MiFID I but were tightened by MiFID II, reflecting the financial-​crisis-​era focus on prudent risk management and the prevailing concern to dampen perceived excessive speculation and financial market intensity, as well as the Council’s concern that all MiFID II exemptions be clear, narrowly framed, and avoid unintended consequences and loopholes.143 The default exemption (Article 2(1)(d)) is for persons who deal on own account in financial instruments (other than commodity derivatives or emission allowances/​derivatives thereof) and do not provide any other investment services and/​or perform any other investment activities in financial instruments (other than commodity derivatives or emission allowances/​derivatives thereof).144 The exemption is not available, however, where the risks to the market are regarded as elevated, namely where the person in question is a market-​ maker;145 is a member of or participant in a regulated market or multilateral trading facility (MTF) or has direct electronic access to a trading venue (unless the dealer is a non-​financial entity acting to reduce entity or group risks relating to commercial or treasury financing activity);146 applies a high frequency algorithmic trading technique; or deals on own account

140 Delegated Regulation 2017/​565 Art 4 sets out the conditions governing when investment services qualify as being ‘incidental’, including that the provision of investment services does not aim to provide a systematic source of income. 141 Exemptions also apply under Art 2(1)(e) and (n) as regards persons regulated under the EU’s energy market regime. 142 The exemptions apply cumulatively, as clarified by recital 22. The recital also underlines that those persons who do not qualify for the Art 2(1)(d) exemption, but may benefit from Art 2(1)(j), come within MiFID II in relation to activities outside the scope of the Art 2(1)(j) exemption. 143 The two exemptions for dealers became more restricted over the Council negotiations, which saw significant Member State concern as to the market efficiency and investor protection risks were the exemptions to allow dealing to leak outside the regulated sphere. 144 Article 2(1)(d) clarifies that persons who otherwise qualify for exemption as insurance undertakings and as collective investment schemes (CISs), and for the exemption relating to dealing in commodity derivatives and emission allowances/​derivatives thereto, are not required to meet these conditions to be so exempt. 145 Defined as a person who holds himself out on the financial markets on a continuous basis as being willing to deal on own account by buying and selling financial instruments against his proprietary capital at prices defined by him: Art 4(1)(7). See further Ch VI section 2.4. 146 The 2021 MiFID III Proposal liberalizes the exemption by removing the direct electronic access exclusion, on the grounds that the MiFID II rules governing direct electronic access, which require that access is through an authorized investment firm or credit institution, are (impliedly, have proved to be) sufficiently robust to obviate the need to impose MiFID II rules directly on such dealers: 2021 MiFID III Proposal, recital 5 and Art 1(2). On direct electronic access and algorithmic trading see Ch VI section 2.3

IV.6  Calibration and Differentiation under MiFID II  371 by executing client orders. The exemption is accordingly not available where the dealer’s activities may impact on market stability, liquidity, and efficiency, and where investor protection risks (including conflict-​of-​interest risks) arise where the dealer executes a client order against its proprietary trading book.147 A similar exemption is available for dealers in commodity derivatives and emission allowances/​derivatives thereof (Article 2(1)(j)). This exemption is primarily designed to avoid pulling the NFCs who use these derivatives for commercial (hedging) purposes into the regulatory net, given the lower risk profile of these actors and of their dealing activities. Unlike the Article 2(1)(d) exemption, however, it is available for market-​makers, reflecting the particular dynamics of these markets. Persons who either deal on own account in commodity derivatives or emission allowances/​derivatives thereof (including market-​makers but excluding persons who deal on own account by executing client orders), or persons who provide investment services (other than dealing on own account) in these instruments to the customers or suppliers of their main business, are exempted from MiFID II. In one of the more contested elements of MiFID II, the exemption is restricted by an ‘ancillary activities’ condition. Individually and on aggregate basis, the exempted activity must be ancillary to the exempted person’s main business when considered on a group basis (and that ‘main business’ must not be the provision of investment services or banking services or acting as a market-​maker in relation to commodity derivatives).148 Exempted persons must also notify the relevant NCA annually of their use of the exemption and (on request) report to the NCA the basis on which they have concluded that the relevant exempted activities are ancillary to their main business. How ‘ancillary activity’ is measured has become one of the more contested elements of MiFID II, reflecting the importance of the exemption in the commodity/​ energy markets but also the difficulties that exemptions generally can generate and how prevailing political and market conditions can shape how they operate. The negotiations on the MiFID II delegation for related administrative rules regarding ‘ancillary activity’ were difficult,149 while the subsequent adoption of the rules led to one of the very few serious disagreements between ESMA and the Commission across the vast MiFID II/​MiFIR administrative rulebook, with the administrative rules, as originally adopted in 2017,150 reflecting the Commission’s adoption of a more flexible approach than ESMA to the relevant test.151 Subsequently, and reflecting concern that changes to the structure of the EU’s energy market would mean that many entities would lose the exemption and that the market would be disrupted,152 as well as experience with the costs associated with the calculation of, and supervisory reporting on, the relevant and complex tests,153 the 2021 Quick Fix Directive led to a further refinement of the ‘ancillary activities’ requirement, designed to ease and simplify the applicable tests. While a relatively technical (if operationally significant)

147 As discussed in Ch V, where orders are executed against the dealer’s proprietary trading book in a systematic manner and on a large scale, the MiFID II/​MiFIR regime for ‘systematic internalizers’ applies. 148 In addition, the exempted person must not apply a high frequency algorithmic trading technique. 149 The delegation became more detailed over the negotiations, with the Council in particular concerned that it be more detailed as regards the nature of the ancillary business permitted: Danish Presidency Progress Report, n 74, 3. 150 Set out originally in Delegated Regulation 2017/​592 (since repealed). 151 The Commission adopted a more flexible approach to the assessment of ‘ancillary activity’ based on a wider number of factors. ESMA made public its disagreement, suggesting that the Commission’s approach be adjusted: Commission, Letter to ESMA, 20 April 2016 and ESMA Opinion 2016/​730. 152 The structural changes included the development of a euro-​denominated commodity contract market. 153 2020 Quick Fix SWD, n 87, 11 and 33.

372  Investment Firms and Investment Services matter, the development of the exemption, as well the potential for further reform in light of the volatility experienced in commodity derivatives markets in 2022, underlines the complexities engaged by perimeter design, as well as the facility the administrative rulebook has given to the EU for addressing technical but material issues.154 Member States can also apply an optional exemption, available for identified persons for which they are the home Member State, as long as the activities of those exempted persons are authorized and regulated at national level (Article 3).155 This exemption is broadly designed to exempt those investment firms which, for the most part, do not operate cross-​ border, pose little or no systemic risk, and do not hold client assets (typically, firms that receive and transmit client orders and provide investment advice),156 as long as broadly equivalent requirements apply at national level. These exempted firms do not benefit from the MiFID II passport. By contrast with the precursor MiFID I exemption, which simply required that exempted persons be regulated, exempted persons must be subject to ‘analogous’ authorization, regulatory, and supervisory requirements at national level,157 and with respect to MiFID II authorization, certain of its organizational/​prudential requirements,158 and its investor protection/​quality of advice regime (Article 3(2)).159 Exempted persons must also be covered by an investor compensation scheme recognized under the 1997 Investor Compensation Schemes Directive160 or, reflecting some Member State concern that this requirement was disproportionate,161 by professional indemnity insurance which provides equivalent cover.162

IV.6.2  Client Classification MiFID II also relies on a client classification system (set out in Annex II) to calibrate its application, primarily as regards the extent to which its conduct rules apply and in relation to the capacity of the relevant client or counterparty to assess and manage risk.163 The client 154 The new test, based on the Quick Fix Directive, is set out in Delegated Regulation 2021/​1834, which adopts a more liberal approach. The liquidity strain experienced in certain commodity derivatives markets consequent on the elevated volatility that followed Russia’s invasion of Ukraine may, however, lead to a contraction of the exemption. ESMA suggested that the scope of the exemption be reconsidered to ensure that significant non-​financial entities trading and providing investment services in commodity derivatives be subject to appropriate regulation: ESMA, Letter to the Commission (Excessive Volatility in Energy Markets), 22 September 2022. 155 Article 3 also includes optional exemptions relating to the energy markets. 156 Article 3(1)(a)–​(c). Orders can be transmitted to specified regulated entities, primarily investment firms, collective investment undertakings and their managers, and credit institutions. 157 The reliance on ‘analogous’ rather than the more usual ‘equivalent’ requirement was designed to ensure that the exemption was flexible and did not lead to market exits, a risk that had been identified by the 2011 Europe Economics Report: n 68, xvii. 158 With respect to conflict-​of-​interest management, record-​keeping, and call recording. 159 Where a Member State exercises an Art 3 optional exemption, it must inform the Commission and ESMA, ensure it complies with Art 3, and communicate to ESMA the provisions of national law analogous to MiFID II. 160 Directive 97/​9/​EC [1997] OJ L84/​22. See Ch IX section 6. 161 Danish Presidency Progress Report, n 74, 4. 162 Member States may derogate from this requirement where the exempted persons provide order reception and transmission/​advice services in relation to CIS units and act as an intermediary for a UCITS management company, and are jointly and severally liable with the UCITS management company for any damage incurred by the client. 163 Prescribed in some detail by MiFID II, the classification system is further amplified by Delegated Regulation 2017/​565 which requires that new clients be informed of their status, of their right (where applicable) to request a different classification, and of any limitations to the level of client protection under MiFID II that may follow: Art 45.

IV.6  Calibration and Differentiation under MiFID II  373 classification regime segments clients/​counterparties into three categories: eligible counterparties; professional clients; and retail clients. The extent to which the MiFID II conduct regime applies depends on the relevant classification, with its full protections applying to retail clients and only limited protections applying to eligible counterparties. Classification is a difficult regulatory tool to craft and deploy, not least as classes run the risk of over-​and under-​inclusivity and of requiring continual revision in light of market practice, and as the construction, application, and revision of related client classification systems can generate significant costs for firms. The MiFID II classification system has struggled, with the different classes expanding and contracting with prevailing political and market conditions. The challenges have been most significant as regards the retail client classification, as fixing this classification’s perimeter requires a balance to be struck between investor protection and investor autonomy, as discussed in Chapter IX. The professional and eligible counterparty classifications have also proved troublesome. The MiFID I regime, which established the client classification system, adopted a liberal approach, applying only a limited subset of conduct rules to the professional client segment and minimal requirements to eligible counterparties. MiFID II broadly followed the MiFID I model,164 but it adopted a more restrictive approach, in particular by contracting the professional client classification (following evidence that local authorities, previously classed as professional clients, had been exposed to high levels of detriment from investments in more risky products)165 and by extending the conduct requirements applicable to services provided to professional clients. Since then, the 2021 MiFID II Quick Fix Directive has reverted to a more liberal approach. Privileging cost reduction over the wide application of investor protection requirements,166 it has significantly limited the application of conduct rules to professional clients. As revised and liberalized by the 2021 Quick Fix reforms, the MiFID II conduct regime is, in effect, disapplied from transactions with ‘eligible counterparties’ (broadly, regulated financial institutions)167 (Article 30).168 Under Article 30(1), investment firms authorized to execute orders on behalf of clients and/​or to deal on own account and/​or to receive and 164 The Commission described the MiFID I classification system as providing an adequate and satisfactory degree of flexibility: 2010 MiFID I Review Consultation, n 68, 61. 165 Over the financial crisis, a range of non-​retail clients—​chief among them municipal and local public authorities—​sustained heavy losses in relation to sales and advice related to complex financial instruments and came to be regarded as requiring additional protections: 2010 PWC Report, n 68, 374–​9 and 2010 MiFID I Review Consultation, n 68, 61–​2. 166 The 2021 Quick Fix Directive liberalized the application of MiFID II’s conduct rules in order to achieve a more ‘balanced’ approach to investor protection which did not ‘hinder the smooth execution of investment decisions’ (recital 3). 167 Eligible counterparties are defined as investment firms, credit institutions, insurance companies, UCITSs and their management companies, pension funds and their management companies, other financial institutions authorized or regulated under EU law or national law, national governments, and their corresponding offices (including public offices that deal with public debt at national level), central banks, and supranational organizations: Art 30(2). Member States may also recognize as eligible counterparties undertakings meeting predetermined and proportionate requirements, including quantitative thresholds, and third country entities equivalent to these and Art 30(2) entities (Art 30(3)). Delegated Regulation 2017/​565 amplifies the eligible counterparties classification, including by specifying that Member States may move an undertaking considered to be a professional client into the eligible counterparty class: Art 71. 168 Eligible counterparties may request (either generally on a trade-​by-​trade basis) to be classified as clients (professional or retail) who benefit from the conduct regime (Art 30(2)), but this qualifier serves more to emphasize the default approach to eligible counterparties than to signify that this channel is necessary to alleviate material conduct risks to eligible counterparties. The modalities of such a request are governed by Delegated Regulation 2017/​565 Art 71.

374  Investment Firms and Investment Services transmit orders, may bring about or enter into transactions with eligible counterparties without being obliged to comply with: the Article 24 general conduct principles;169 the Article 25 know-​your-​client requirements; and the Article 27 (best execution) and Article 28(1) (order handling) requirements. An over-​arching fair treatment obligation applies, however, similar to the foundational Article 24(1) fair treatment obligation which investment firms are otherwise subject to: in their relationships with eligible counterparties, investment firms must act honestly, fairly, and professionally and communicate in a way which is fair, clear, and not misleading, taking into account the nature of the eligible counterparty and of its business. The classification of the wider and more elusive population of ‘professional clients’ is governed in detail by MiFID II Annex II. Professional clients are those who possess the experience, knowledge, and expertise to make their own investment decisions and to properly assess the risks they incur. These clients are further segmented into two categories. The first category relates to those considered to be professional by default (default professional clients) and broadly covers authorized financial institutions, large corporates, and specified public bodies.170 Default professional clients can, however, request a higher level of protection.171 The second category relates to those considered to be non-​professional (as they fall outside the default category) but who request to be treated as professional and are so categorized by the investment firm, in accordance with the Annex II procedure (‘opt-​in professional clients’).172 Prior to the 2021 MiFID II Quick Fix reforms, most of the conduct regime applied to professional clients, although the extent to which certain rules applied (mainly disclosure, reporting, and know-​your-​client obligations) was calibrated by administrative rules, primarily Delegated Regulation 2017/​565. Most of the conduct regime continues to apply to professional clients, but the 2021 Quick Fix reform, in an effort to reduce regulatory burdens,173 has liberalized its application by disapplying three sets of reporting-​related requirements which were deemed to be disproportionate, given the costs they imposed and their limited value to professional clients.174 Accordingly, the new MiFID II Article 29a disapplies, for professional clients, the detailed Article 24(4)(c) cost and charges disclosure requirements (apart from where investment advice/​portfolio management services are provided);175 the cost/​benefit suitability assessment and client reporting required where 169 Apart from Art 24(5a), a Quick Fix reform which provides that electronic delivery is the default delivery mode for all MiFID II disclosures (save for retail clients who can request paper disclosures). 170 This category includes: entities required to be authorized or regulated in the financial markets (credit institutions; investment firms; other authorized or regulated financial institutions; insurance companies; CISs and their management companies; pension funds and their management companies; commodity and commodity derivatives dealers; and other institutional investors); large undertakings (meeting two of three requirements: total balance sheet of €20 million; net turnover of €40 million; and own funds of €20 million); national and regional governments, including public bodies that manage public debt at a national or regional level, central banks, and international and supranational organizations such as the World Bank, the IMF, the ECB, the EIB, and similar institutions; and other institutional investors whose main activity is to invest in financial instruments, including entities dedicated to the securitization of assets or other financing transactions. 171 Requests to be treated as non-​professional are governed by the Annex II(I)(4) procedure, which provides, inter alia, that it is the responsibility of a client which is deemed to be professional to ask for a higher level of protection where it deems it is unable to properly assess or manage the risks involved, and requires that a written agreement be entered into between the professional client and the firm which specifies the range of transactions and services to which the new classification applies. 172 Discussed further in the context of the retail markets in Ch IX section 4.4. 173 The reforms sought a ‘more finely calibrated view of investor requirements’ which would reduce firms’ regulatory burdens and facilitate them in supporting the Covid-​19 recovery: 2020 MiFID II Quick Fix Proposal, n 84, 1. 174 The reform drew on data gathered over the MiFID II Review (2020 MiFID II Quick Fix Directive recital 5). 175 The detailed cost disclosure requirements that apply under Delegated Regulation 2017/​565 are accordingly also disapplied. The Commission noted that eligible counterparties, professional clients, and ESMA had

IV.7  The MiFID II Authorization Process  375 financial instruments are switched in the context of advice/​portfolio management services (Article 25(2), paragraph 3), unless requested by the professional client;176 and the ongoing obligation to provide ex-​post reports on services provided to clients, unless requested by the professional client (Article 25(6)).177 The conduct regime otherwise continues to apply, albeit with the calibrations previously adopted under Delegated Regulation 2017/​565.178 The treatment of non-​professional (retail) clients is considered in Chapter IX.

IV.7  The MiFID II Authorization Process IV.7.1  Jurisdiction to Authorize and the Home NCA The ‘gateway’ authorization process is pivotal to the application of MiFID II as it requires that firms engaging in investment services/​activities must be authorized (and thereby controls access to investment services/​activity business), brings such firms into the MiFID II regulatory scheme, and opens access to the MiFID II passport for such firms. Under Article 5(1) each Member State must require that the provision of investment services and/​or the performance of investment activities as a regular occupation or business on a professional basis must be subject to prior authorization in accordance with MiFID II’s requirements. Authorization may not be granted unless and until the NCA is fully satisfied that the applicant complies with all MiFID II requirements (Article 7(1)). The investment firm must provide all information (including a programme of operations) necessary to enable the NCA to satisfy itself that the firm has established, at the time of initial authorization, all the necessary arrangements to meet its authorization obligations (Article 7(2)).179 The authorization obligations (noted below) are ongoing: Member States are to require that investment firms authorized in their territory comply at all times with the conditions for initial authorization (Article 21).180 Member States must also establish a publicly accessible and regularly updated register of all authorized investment firms (Article 5(3)).181 Once

unanimously and repeatedly advised that these disclosures had no benefit outside the investment advice/​asset management context: 2020 MiFID II Quick Fix Proposal, n 84, 6. 176 Delegated Regulation 2017/​565 Art 54(11) amplifies the Art 25(2) suitability/​know-​your-​client requirement by imposing specific suitability assessment requirements where financial instruments are switched in the course of advice/​portfolio management services. The Quick Fix reform inserted this requirement into MiFID II Art 25(2) and, at the same time, provided an exemption for professional clients. 177 The raft of post-​execution reports triggered by the administrative rules that amplify Art 25(6) when markets are volatile and professional clients trade in large volumes, or when their portfolios are constantly rebalanced (the related administrative rules require, eg, alongside detailed execution reports, end-​of-​day loss reporting when a portfolio reduces by 10 per cent: Delegated Regulation 2017/​565 Art 62)), drew particular concern in the wholesale markets over the Covid-​19 pandemic as generating a flood of unnecessary, standardized, high frequency reports of little value: 2020 MiFID II Quick Fix Proposal, n 84, 7. The effect of the reform is that the detailed rules applicable to ongoing service reports under Delegated Regulation 2017/​565 are disapplied. 178 As a general rule, the detailed administrative rules that amplify the conduct regime under Delegated Regulation 2017/​565 all apply to professional clients (unless entirely carved out by the 2021 Quick Fix Reforms), albeit with specified alleviations (such as, eg, those applicable to the know-​your-​client/​appropriateness regime (Art 56)). In specified cases, more stringent protections apply to retail clients. 179 The information requirements are amplified by RTS 2017/​1943. 180 To that end, NCAs must establish appropriate monitoring methods, and investment firms must notify the NCAs of any material changes to the conditions for initial authorization (Art 21(2)). 181 Each authorization must also be notified to ESMA which, through its Registries Database, holds consolidated data on all investment firms authorized in the EU, based on links to national registries (in compliance with its Art 5(3) obligation to maintain a list of all authorized investment firms).

376  Investment Firms and Investment Services granted, authorization is valid for the entire EU and allows an investment firm to provide the services or perform the activities for which it has been authorized throughout the EU, through either the right of establishment, including through a branch, or the freedom to provide services (Article 6(3)).182 While authorization may cover ‘ancillary services’ (specified in Annex I(B)), in no case can authorization be granted solely for the provision of ancillary services (Article 6(1)). The authorization responsibility imposed on the Member State (and its NCA) applies only to investment firms for which it is the ‘home State’ (Article 5(1)). Three tests govern the identification of the home Member State (Article 4(1)(55)) and, by extension, whether an NCA is a home NCA. Where the investment firm is a natural person, the Member State in which the head office is situated is the home Member State. Where the investment firm is a legal person, the home Member State is the State in which the registered office is situated. Where the investment firm has, under its national law, no registered office, the home Member State is the State where the head office is situated. The home Member State model was originally adopted under the 1993 ISD and, as the ISD was a minimum standards directive, it presaged the possibility of competitive regulatory arbitrage. This possibility is much weaker now given the decisive financial-​crisis-​era move to a single rulebook, as well as the emergence and maturing of ESMA-​led supervisory convergence as a means for driving the de facto harmonization of supervisory practices. Nonetheless, MiFID II incorporates the checks which originally provided a defence to forum-​shopping by ISD firms. To prevent investment firms from opening up ‘letter box’ registered offices or head offices in order to engage in regulatory/​supervisory arbitrage, Article 5(4) requires that an investment firm which is a legal person must have its head office in the same Member State as its registered office, and that an investment firm which is not a legal person, and an investment firm without a registered office, must have its head office in the Member State in which it actually carries on business.183 Similarly, MiFID II recital 46 provides that the principles of mutual recognition and of home Member State supervision require that authorization should not be granted (or should be withdrawn) where factors such as the content of the programme of operations, the geographical distribution, or the activities actually carried on indicate clearly that an investment firm is choosing the legal system of one Member State in order to evade the standards imposed by the Member State in which it intends to carry on or does carry on the greater part of its activities. The home NCA is also required to consult with other NCAs in specified circumstances prior to granting authorization (Article 84).184 While these checks are long established, they faced a significant test with Brexit.185 Brexit generated some NCA and Member State concern that authorization and supervision could 182 The authorization must specify the investment services or activities which the firm is authorized to provide (Art 6(1)). An extension of authorization must be applied for where an investment firm seeks to extend its business to additional investments or activities (or ancillary services) not foreseen at the time of the initial authorization (Art 6(2)). 183 Although a critical term for the purposes of identifying the home Member State, and central to the letter box avoidance system, ‘head office’ is not defined, albeit that it implies that a significant amount of firm management (such as personnel functions and risk management), as well as a considerable degree of high-​level, central decision-​making, occurs in the Member State in which the ‘head office’ is situated. 184 The consultation process is directed towards ensuring NCAs exchange information in group contexts (where an investment firm subsidiary seeks authorization) and as regards the suitability of shareholders and those who direct the business: Art 84(3). 185 On Brexit and the EU third country regime see Ch X.

IV.7  The MiFID II Authorization Process  377 become instruments of competition were Member States/​NCAs to seek competitive advantage from the passporting-​driven relocation of some UK investment services/​activities business to the EU by providing authorizations for firms in UK groups despite there being a sub-​optimal level of local presence in the relevant Member State (in effect, allowing UK firms to carry out most of their business in the UK while using an EU-​based ‘letter box’ firm for pan-​EU passporting rights). In response, and alongside detailed guidance on supervisory expectations as to the minimum presence required in the EU for authorization,186 ESMA established a ‘Supervisory Co-​ordination Network’ to provide a forum for overseeing NCA practices relating to Brexit-​associated authorizations and for ensuring a high level of consistency in authorization and supervision. The Network, which concluded its work in 2020, had material operational traction, discussing 250 live authorization cases, holding thematic discussions, and building a data-​set that allowed examination of relocation trends and appropriate supervisory responses.187 While these actions stabilized the potentially serious fault-​line in the MiFID II authorization system that showed some signs of emerging with Brexit, they also underline ESMA’s pivotal operational role in the management of supervisory tensions and in maintaining the integrity of the MiFID II authorization system. While the Brexit-​related concerns have receded, the home NCA remains under scrutiny, particularly as regards its role as the EU supervisory anchor once a firm is authorized. A 2019 Joint Report by the European Supervisory Authorities (ESAs) on the cross-​border supervision of retail financial services, including MiFID II investment services, noted a series of difficulties relating to passporting, including a lack of clarity in the allocation of responsibilities between home and host NCAs, failures to follow passport procedures consistently and, most seriously for the passporting concept and relatedly for home NCA control, dangers that home NCAs prioritized the supervision of financial institutions that represented a higher risk in their own territories.188 The Report was primarily oriented to conduct supervision and the retail markets and should not be over-​played, particularly as, in practice, the authorization system and the related MiFID II passporting process do not generate material difficulties and also given the CMU imperative which currently frames financial markets policy. Nonetheless, the Report may come to be seen as a straw in the wind that marked greater concern by NCAs and Member States to protect their markets from passporting actors and, relatedly, the emergence of some appetite for incursions into the primacy of the home NCA, whether as regards authorization or supervision. Similarly, ESMA’s 2022 peer review of home NCA supervision of cross-​border activity by MiFID II firms in the retail markets called for improvements in how cross-​border activities were supervised.189 Accordingly, the home NCA authorization process, while a longstanding feature of the EU investment services regime, remains of freighted importance. 186 ESMA made clear in a series of summer 2017 Opinions that NCAs were not to authorize firms where they were shell companies without an appropriate local risk management capacity. On MiFID II firms, see ESMA, Opinion (Supervisory Convergence in the area of Investment Firms in the context of the UK Withdrawal), 13 July 2017 which covered, inter alia, the authorization process and the required ‘substance’ for authorization (including as regards adequate governance and internal controls; financial/​non-​financial resources; and the extent to which outsourcing (back to the UK) could be permitted). 187 ESMA, Press Release (Supervisory Co-​ordination Network Concludes its Work), 29 May 2020. 188 ESA Joint Committee, Report on Cross-​border Supervision of Retail Financial Services (2019). 189 ESMA, Peer Review on Supervision of Cross-​border Activities of Investment Firms (2022). The report examined six NCAs’ practices and called for improvements as regards authorization, supervision, investigatory activities, and enforcement in relation to cross-​border activities. It reported that home NCAs had not sufficiently

378  Investment Firms and Investment Services

IV.7.2  The Authorization Process A series of conditions, directed to firm soundness and stability, and of longstanding in EU investment services regulation but finessed by MiFID II (in particular as regards internal firm governance), must be met for authorization and are noted below.190 MiFID II also sets out, non-​exhaustively, the circumstances when an NCA may, in an exercise of its discretion, withdraw authorization. These range from failure by the firm to make use of the authorization within twelve months or the firm renouncing the authorization, to irregularities committed by the firm in the authorization process, to failure to comply with the authorization conditions, to serious and systematic infringement of MiFID II/​MiFIR (Article 8).

IV.7.2.1 Authorization Process: Minimum Initial Capital As discussed further in section 9, authorization may not be granted unless the investment firm has sufficient initial capital. This requirement is set in accordance with the investment firm prudential regime governed by the 2019 IFD/​IFR. IV.7.2.2 Authorization Process: Firm Governance Requirements The financial-​crisis era saw internal firm governance become subject to regulatory requirements given the association, over this period, between excessive risk-​taking, on the one hand, and financial institution governance structures that were geared to shareholder interests and insufficiently focused on risks, including to the financial system generally, on the other.191 MiFID II followed this trend, injecting related management body/​board governance requirements into the authorization process (Article 9).192 The roots of this regime are in the EU’s financial-​crisis-​era agenda on financial institution governance generally193 which led to the governance requirements which now apply to rating agencies under the rating agency regime, managers of alternative investment funds under the AIFMD and of UCITSs under the UCITS Directive, central clearing counterparties (CCPs) under EMIR, and credit institutions under CRD IV/​CRR. The MiFID II Article 9 firm governance regime draws heavily on the CRD IV governance regime: CRD gathered or used relevant information on how firms organized and carried out cross-​border activities, notwithstanding the distinct risks associated with cross-​border activities and the consequent need for enhanced internal controls within firms. An ESMA consultation on a proposal to expand the RTS governing the information required on authorization, to include more details on cross-​border activity and so support supervision, followed in November 2022. 190 Procedural protections for the applicant firm are also specified as regards timelines (the firm must be informed within six months of the outcome, Art 7(3)); and reasons and appeals (Art 74). 191 Much of the debate concerned the shareholder-​value orientation of much of corporate governance theory and practice, and its implications for the distinct, and in particular systemic, risks posed by financial institutions. For a recent technocratic perspective see the 2021 ESMA/​EBA ‘Fit and Proper’ Guidelines which suggest that weaknesses in corporate governance, including inadequate oversight by and challenge from the management body/​board, have contributed to excessive and imprudent risk-​taking. The Guidelines underline the need to strengthen the role and responsibilities of the management body in order to ensure sound and prudent management and to protect the integrity of the market, as well as consumers’ interests: Joint ESMA and EBA Guidelines on the Assessment of the Suitability of Members of the Management Body and Key Function Holders under Directive 2013/​36/​EU and Directive 2014/​65/​EU (2021) 6. The context for the firm governance requirements is discussed further in section 9.4.6. 192 See Binder, J, ‘Governance of Investment Firms under MiFID II’ in Busch and Ferrarini, n 26, 49. 193 Set out in Commission, Green Paper on Corporate Governance in Financial Institutions (COM(2010) 284).

IV.7  The MiFID II Authorization Process  379 IV Articles 88 and 91 (the management body/​board requirements) are directly incorporated into Article 9. CRD IV therefore carries out most of the regulatory heavy lifting as regards investment firm governance, as board responsibilities are prescribed in some detail under Articles 88 and 91. CRD IV also imposes executive remuneration requirements on the subset of investment firms that come within the definition of ‘credit institution’ and so are subject to CRD IV (section 9.4.6).194 The MiFID II firm governance regime represented, on its adoption, a striking departure from MiFID I, the main obligation under which was that the persons who ‘effectively direct the business’ of the investment firm be of sufficiently good repute and sufficiently experienced so as to ensure the sound and prudent management of the investment firm.195 Despite the scale of the MiFID II governance reforms, they were not heavily contested during the institutional negotiations.196 The Council and European Parliament approaches to how the governance requirements should be designed were, however, different. The Council’s position was largely based on the Commission’s governance proposals, although it took a more flexible approach.197 The Parliament’s approach was significantly more detailed, specified the duties of non-​executive directors, placed additional restrictions on the types of directorships which management body/​board members could hold, and addressed civil and criminal liability for management body/​board members.198 The Council’s approach ultimately prevailed, although the investment firm governance regime reflects the Parliament’s concern that the management body/​board oversee the firm’s employee remuneration policy, with particular reference to ensuring the fair treatment of clients. Since its coming into force in 2018, the investment firm governance regime has proved dynamic and has relatedly become increasingly operationalized and granular. The 2019 IFD/​IFR imposed executive remuneration requirements on all investment firms; the 2019 CRD V reforms, which were directly incorporated in MiFID II, brought greater specification to the responsibilities of management body/​board members; and the proposed 2021 CRD VI governance reforms, if adopted, will bring further prescription, including as regards the ‘fit and proper’ assessment of ‘key function holders’ (section 9). In addition, a substantial and procedurally oriented soft law ‘rulebook’ has been constructed, at the heart of which are the extensive 2021 joint ESMA/​EBA Guidelines on the ‘fit and proper’ assessment of management body/​board members.199 Accordingly, while the investment firm governance regime is designed to be flexible and to apply proportionately, given the wide and diverse population of investment firms and their different operating models and governance settings,200 it nonetheless brings significant regulatory prescription to firms’ governance arrangements. 194 The CRD IV remuneration rules apply to ‘credit institutions’ (which now include the largest and most complex investment firms), as well as other large investment firms that come within CRD IV, and have also acted as the template for the remuneration rules that now apply to all other investment firms under the IFD/​IFR (outlined in section 9.3.4). 195 It also imposed obligations relating to NCA notification as regards changes to management. 196 In part as the earlier 2013 CRD IV/​CRR regime had addressed governance reform, covering inter alia, remuneration, limitations on the number of directorships held by management body members, and board diversity. 197 eg, the Council removed the Commission’s proposal that the composition of, and obligations imposed on, the management body be further amplified by administrative rules. 198 European Parliament Negotiating Position, n 24, Art 9. 199 2021 ESMA/​EBA Fit and Proper Guidelines, n 191. 200 An extensive scholarship canvasses the merits of a flexible approach given the different corporate governance models (including single-​and two-​tier board structures; and shareholder/​stakeholder governance models) in operation across the EU. See, for early discussions, Enriques, L and Volpin, P, ‘Corporate Governance Reforms in

380  Investment Firms and Investment Services The Article 9 governance requirements are addressed to the ‘management body’ of the investment firm, defined as the body or bodies, appointed in accordance with national law, which is or are empowered to set the firm’s strategy, objectives, and overall direction, and which oversee and monitor management decision-​making and include persons who effectively direct the business of the entity (in effect, the board of directors) (Article 4(1) (36)). The regime is designed to capture all forms of board structure.201 The totemic ‘fit and proper’ suitability assessment of board members is at the heart of the Article 9 regime: an NCA must refuse a firm authorization where it is not satisfied that the members of the management body are of sufficiently good repute, possess sufficient knowledge, skills, and experience, and commit sufficient time to perform their functions, or if there are objective and demonstrable grounds for believing that the management body may pose a threat to the firm’s effective, sound, and prudent management and to the adequate consideration of the interests of the firm’s clients and the integrity of the market (Article 9(4)).202 Extensive ESMA/​EBA guidelines on how this gateway ‘fit and proper’ assessment operates have followed.203 Alongside, a minimum capacity standard applies in that at least two persons must effectively direct the firm (the ‘four eyes’ principle) (Article 9(6)).204 The substantive detail of the regime applies via CRD IV. NCAs granting authorization must ensure that investment firms and their management bodies (boards) comply with the detailed Articles 88 and 91 CRD IV governance requirements —​which address the composition of the management body, its duties, and the board nomination committee (section 9.4.6)—​but with the calibration that management body members can, on the approval of the NCA, hold an additional non-​executive directorship in excess of the limits on such directorships imposed by Article 91 (Article 9(2)). In addition, Article 9 imposes an additional governance standard, oriented to the risks posed by investment firms (Article 9(3)): the management body of an investment firm must define, oversee, and be accountable for the implementation of governance arrangements that ensure effective and prudent management, including the segregation of duties and the prevention of conflicts of interests, in a manner that promotes the integrity of the market and the interests of clients.205 Without prejudice to the parallel CRD IV Article 88(1) regime, these arrangements must ensure that management body defines, approves, and oversees the organization of the firm for the provision of investment services and activities and ancillary services, including the skills, knowledge, and expertise required by personnel, the resources, the procedures, and the arrangements for the provision of services and activities, taking into account the nature, scale, and complexity of its business. The management body

Continental Europe’ (2007) 21 J of Econ Perspectives 117 and Hertig, G, ‘Ongoing Board Reforms: One Size Fits All and Regulatory Capture’ (2005) 21 Oxford Rev of Economic Policy 269. 201 MiFID II recital 55 acknowledges the different governance structures used across the Member States, and underlines that the regime is designed to embrace all existing structures, ‘without advocating any particular structure’. 202 The investment firm must notify the NCA of all members of its management body and of any membership changes, along with all information necessary to ensure compliance with Art 9. 203 n 191. The Guidelines address the ‘fit and proper’ assessment in exhaustive detail, including as to how the time commitment of non-​executive directors should be reviewed. 204 A derogation is available for firms that are natural persons or legal persons managed by a single person as long as alternative arrangements are in place: Art 9(6). 205 This provision is similar to CRD IV Art 88(1), but with the additional reference to market integrity and client interests.

IV.7  The MiFID II Authorization Process  381 must in addition define, approve, and oversee a policy relating to the services, activities, products, and operations offered or provided by the firm, in accordance with the firm’s risk tolerance and the characteristics and needs of its clients, which includes stress testing where appropriate (Article 9(3)).206 Reflecting a European Parliament amendment and the MiFID II concern to address remuneration-​related risks, particularly in investment product distribution, the management body must also design, approve, and oversee a remuneration policy (in relation to persons involved in the provision of services to clients) aimed at encouraging responsible business conduct and fair treatment of clients, as well as avoiding conflicts of interest in relationships with clients.207 Finally, the management body must monitor and periodically assess the adequacy and implementation of the firm’s strategic objectives in the provision of investment services and activities and ancillary services, the effectiveness of the firm’s governance arrangements, and the adequacy of its policies related to the provision of services to clients, and take appropriate remedial steps to address deficiencies. In order to fulfil their functions, management body members must have adequate access to the information and documents needed to oversee and monitor management decision-​making. Alongside, the more detailed Articles 88 and 91 CRD IV management board requirements and the IFD/​IFR executive remuneration rules (and their CRD IV counterparts for relevant investment firms) apply in parallel (section 9). The extent to which weaknesses in firm governance structures contributed to the financial crisis was and remains contested, as does the ability of mandatory governance requirements to support better risk management by firms.208 But whatever their merits, where governance requirements are the subject of legislative fiat, their effectiveness in practice is in part a function of the quality of related supervision, including as regards the robustness of the initial NCA ‘fit and proper’ assessment of management body members but also as regards the extent to which NCAs take an appropriately proportionate approach to governance arrangements in light of firm diversity. Their effectiveness also depends on enforcement and the related incentives it creates for the management body.209 Enforcement is partially addressed by MiFID II which provides that NCAs must be empowered to require the removal of a natural person from the management board and that the suite of sanctions with which NCAs must be equipped must be applicable to management body members (Article 69).210 Private/​civil liability remains a function of national law and the different approaches which characterize private liability both generally and as regards board members, across the Member States.

IV.7.2.3 Authorization Process: Ownership Structure The authorization process also extends to review of those persons who exercise control over or materially influence the investment firm (Article 10). Before an NCA grants an authorization, it must be informed of the identities of those shareholders or members, whether 206 This obligation forms part of the MiFID II product governance regime, which is of particular importance for the retail markets. See further Ch IX section 4.11. 207 This obligation accordingly strengthens the conflict-​of-​interest management regime which applies to the distribution of retail investment products. See further Ch IX section 4.10. 208 An extensive literature considers the nature and effectiveness of the financial-​crisis-​era firm governance reforms, given the role of prudential regulation in managing risk (see further section 9.4.6). 209 eg, the extent to which individual senior managers or board members can be made responsible for institutional failures. 210 Subject to national law conditions in relation to areas not harmonized by MiFID II.

382  Investment Firms and Investment Services direct or indirect,211 and whether natural or legal persons, that have ‘qualifying holdings’212 and of the amount of those holdings (Article 10(1)). Authorization must be refused if, taking into account the need to ensure the sound and prudent management of an investment firm, the NCA is not satisfied about the suitability of the qualifying shareholders. Similarly, Article 10(1) also provides that where ‘close links’ exist between the investment firm and other natural or legal persons (‘close links’ are defined as links where two or more natural or legal persons are linked by ‘participation’213 or ‘control’)214 the NCA can grant authorization only where those links do not prevent the effective exercise of the NCA’s supervisory function. NCAs must also refuse authorization if the laws, regulations, or administrative provisions of a third country governing one or more natural or legal persons with which the undertaking has close links, or difficulties involved in their enforcement, prevent the effective exercise of their supervisory function. These provisions are designed to ensure that the group structure within which the investment firm operates is sufficiently transparent such that the firm can be effectively supervised. Relatedly, an oversight process applies on an ongoing basis to acquisitions of qualifying holdings in authorized investment firms (Articles 11–​13). Given the political, commercial, and market risks associated with supervisory review of acquisitions, the nature of the NCA review process, NCA consultation requirements, the review criteria, and the remediations required where non-​compliance arises are all specified, in order to support legal certainty, equity, and predictability and to ensure that the assessment is only made on specified prudential grounds and without discriminatory intent.

IV.7.3.4 Authorization Process: Organizational Structure and Operational Requirements The authorization process also addresses the firm’s organizational structure, given that how a firm is structured and organized can impede or support the outcomes sought by regulation. Article 7(2) accordingly provides that a programme of operations which details the organizational structure of the investment firm and the type of business to be undertaken must be provided prior to authorization. Relatedly, authorization requires compliance with the Article 16 organizational/​operational requirements, discussed in section 8, and which address the compliance function, conflict-​of-​interest management, product governance, the continuity and regularity of services, internal controls and outsourcing, record-​keeping, and client-​asset protection.

211 NCAs are accordingly required to look through the direct shareholder to the ultimate beneficial holder. 212 Qualifying holdings are any direct or indirect holdings in an investment firm which represent 10 per cent or more of the capital or voting rights, each as defined under the 2004 Transparency Directive (see Ch II section 5), and taking into account the conditions regarding the aggregation of holdings set out in that Directive; or which make it possible to exercise a significant influence over the management of the relevant investment firm: Art 4(1) (31). 213 Participation is defined under Art 4(1)(35) in terms of the ownership, direct or by way of control, of 20 per cent or more of the voting rights or capital of the undertaking. 214 Control (Art 4(1)(35)) is defined in terms of the relationship between a parent undertaking and a subsidiary, as described in the 2013 Accounting Directive (Directive 2013/​34/​EU [2013] OJ L182/​19), and similar relationships between any natural or legal person and an undertaking. The effect of this definition is to ensure that a control relationship exists whenever a Member State’s legal regime requires the preparation of consolidated accounts. Close links also exist where two or more natural or legal persons are permanently linked to one and the same person by a control relationship.

IV.8  MiFID II Organizational and Conduct Requirements  383

IV.7.3.5 Authorization Process: Investor Compensation Schemes MiFID II incorporates the protections, for retail clients in particular, provided by the parallel Investor Compensation Schemes Directive by requiring that any entity seeking authorization as an investment firm must meet its obligations under that Directive at the time of authorization (Article 14).215 As regards structured deposits (not covered by the Investor Compensation Schemes Directive) the compensation scheme requirement is met where the credit institution issuing the deposits is a member of a deposit guarantee scheme recognized under the EU’s deposit guarantee scheme regime.

IV.8  MiFID II Operating Conditions: Organizational and Conduct Requirements IV.8.1  A Multi-​layered Regime A multi-​layered regime governs the operating requirements imposed on investment firms by MiFID II (ongoing compliance with the authorization requirements is also required under Article 21). MiFID II addresses: organizational requirements (Article 16; this section); rules governing trading venue operation, market-​making, and algorithmic trading (Articles 17–​20 and 31–​3; Chapters V and VI); conduct rules (including with respect to conflict-​of-​interest management (Articles 16(3) and 23; this section and Chapter IX) and with respect to fair treatment, disclosure, marketing, and quality of advice/​know-​your-​ client requirements (Articles 24 and 25; this section and Chapter IX)); and client order handling and best execution requirements (Articles 27–​8; Chapter VI). MiFID II also addresses the use by investment firms of tied agents (Article 29). A dense administrative rulebook, primarily set out in Delegated Regulation 2017/​565 and Delegated Directive 2017/​593, amplifies these requirements and calibrates them to specific situations. In addition, extensive ESMA soft law, including Guidelines, the MiFID II/​ MiFIR Investor Protection and Intermediaries Q&A, and a host of supervisory convergence measures, has built out how these rules apply in practice. MiFID II has, accordingly, led to the adoption of what can reasonably be termed a dense operating manual for firms that is of marked dynamic quality given the pace at which ESMA soft law develops. In parallel with the MiFID II operational regime, an interlocking prudential regime applies under IFD/​IFR and CRD IV/​CRR and is discussed in section 9.

IV.8.2  Organizational and Operational Requirements IV.8.2.1 The Legislative Regime Article 16 sets out the high-​level legislative requirements which govern investment firm organization and operation and which address risk management and, in particular, operational risk.



215

See further Ch IX section 6 on the Directive.

384  Investment Firms and Investment Services Under the cornerstone compliance requirement, a firm must establish adequate policies and procedures sufficient to ensure the firm’s compliance, including by its managers, employees, and tied agents, with MiFID II obligations, and also establish appropriate rules governing personal transactions by these persons (Article 16(2)). Conflicts of interest are expressly addressed as an organizational risk: a firm must maintain and operate effective organizational and administrative arrangements with a view to taking ‘all reasonable steps’ designed to prevent conflicts of interest (as defined under Article 23; section 8.3) (Article 16(3)). A novel product governance requirement, one of the major MiFID II innovations, and oriented to retail market risk, applies under Article 16(3).216 Business continuity risk is addressed by the requirement that the firm must take reasonable steps to ensure continuity and regularity in the performance of investment services and activities—​appropriate and proportionate systems, procedures, and resources must be deployed to this end (Article 16(4)). Outsourcing risk is addressed by the requirement that the firm, when relying on a third party for the performance of operational functions ‘which are critical for the provision of continuous and satisfactory service to clients and the performance of investment activities on a continuous and satisfactory basis’, takes reasonable steps to avoid undue operational risk; outsourcing of important operational functions may not be undertaken in such a way as to impair materially the quality of the firm’s internal controls and the ability of the NCA to monitor the firm’s compliance with all its obligations (Article 16(5)). These requirements are buttressed by an over-​arching omnibus ‘systems and controls’ requirement: firms must have in place sound administrative and accounting procedures, internal control mechanisms, effective procedures for risk assessment, and effective control and safeguard arrangements for information processing systems (Article 16(5)).217 Alongside, the new DORA Regulation, noted in Chapter I section 7.3, will impose wide-​ranging obligations on investment firms as regards their digital resilience, reflecting the extent to which financial firms’ resilience and security, and their capacity to comply with regulatory obligations, is now a function of the robustness of their systems against system failure and external threats, including cyber-​attacks.218 A related and extensive record-​keeping requirement applies under Article 16(6)–​(7). Article 16(6) requires the investment firm to arrange for records to be kept of all services, activities, and transactions it undertakes, which must be sufficient to enable the NCA to fulfil its supervisory tasks and perform its enforcement functions under MiFID II, MiFIR, and the market abuse regime, as well as to ascertain that the firm has complied with its obligations, including client-​facing obligations and those relating to market integrity. A telephone call recording requirement applies under Article 16(7) which was, at the time of MiFID II’s adoption, designed to bring consistency, given the diverging approaches adopted 216 This requirement, one of the keystone MiFID II reforms, is of material importance to EU retail market regulation and is considered in Ch IX section 11. It applies generally to the product design process, however, and so catches products designed for professional clients, although financial instruments marketed or distributed to eligible counterparties are exempt, following the 2021 Quick Fix reforms: Art 16a. 217 Including the data security requirement that investment firms have sound security mechanisms in place to guarantee the security and authentication of the means of transfer of information, minimize the risk of data corruption and of unauthorized access, and prevent information leakage and maintain the confidentiality of data at all times. In addition, the EU’s data protection requirements apply, chief among them the GDPR regime (Regulation (EU) 2016/​679 [2016] OJ L119/​1). 218 The Digital Operational Resilience Act (DORA) addresses the security of financial firms’ network and information systems and the ability of financial firms to withstand threats and disruptions. Provisional agreement on DORA was reached in May 2022 (the Commission Proposal is at COM(2020) 595). See in outline Ch I section 7.3.

IV.8  MiFID II Organizational and Conduct Requirements  385 by Member States, and to support stronger enforcement. The call-​recording obligation is specified in some detail, but the core obligation requires firms to record telephone conversations or electronic communications related to, at least, transactions concluded when dealing on own account, and the provision of client order services that relate to order execution (in effect, trading-​related services).219 Asset protection requirements, pivotal to investor protection and of critical importance when firms face solvency pressures, apply under Article 16(8)–​(10).220 In relation to a client’s financial instruments, the firm must make adequate arrangements to safeguard the client’s ownership rights (especially in the event of insolvency) and to prevent the use of a client’s instruments on own account, except with the client’s express consent (Article 16(8)). In relation to client funds, the firm must similarly make adequate arrangements to safeguard the client’s rights and, except in the case of credit institutions, prevent the use of client funds for own account. Reflecting incidences of asset loss and disputes over firm practices and firm liability over the financial crisis,221 firms must not conclude title transfer collateral arrangements (securities financing transactions) with retail clients for the purpose of securing or covering these clients’ present or future, actual or contingent or prospective obligations (Article 16(10)).222

IV.8.2.2 The Administrative Rulebook This framework regime is amplified by a suite of detailed administrative rules under Delegated Regulation 2017/​565 (Article 16 organizational/​operational requirements) and Delegated Directive 2017/​593 (asset protection) that, in accordance with the related Article 16(2) delegation, specifies the ‘concrete organizational requirements’ to be imposed on investment firms. The adoption of these rules was largely (but not entirely) uncontroversial. Their relatively smooth passage can be related to the extent to which they were based on the precursor MiFID I administrative rules, as well as to the development process borrowing from soft law that ESMA had earlier adopted under MiFID I223 and from international standards developed over the financial-​crisis era.224

219 The outbreak of the Covid-​19 pandemic in March 2020 led to NCAs, coordinated by ESMA, exercising supervisory forbearance as regards this obligation as employees worked from home: ESMA, Public Statement Covid-​19 and MiFID II Recording of Telephone Conversation Requirements), 20 March 2020. 220 Member States may apply additional national rules with respect to asset protection, as long as the Art 16(11) conditions are met (section 4). 221 2010 MiFID I Review Consultation, n 68, 70. 222 Also, stability-​oriented disclosure requirements apply as regards securities financing transactions generally under the 2015 Securities Financing Transactions Regulation (Regulation (EU) 2015/​2365 [2015] OJ L337/​1) (Ch VI section 4). Administrative rules govern such arrangements with clients other than retail clients, as noted in this section below. 223 The rule development process and the outcomes of the related consultations can be traced in ESMA’s technical advice (n 101). eg, the compliance function rules, while more extensive than the precursor MiFID I requirements, were uncontroversial, being regarded as providing more legal certainty and also as being already tested in practice, as the enhancements were in part based on ESMA’s earlier 2012 guidelines on the MiFID I compliance function (at 17). ESMA’s technical advice was, in very large part, accepted by the Commission and not subject to additional impact assessment given the large degree of consensus regarding and, in some cases, considerable experience with, the rules: 2016 Commission Proposal Commission, 2016 Proposal for Delegated Regulation 2017/​ 565 (COM(2016) 2398) 3. 224 The asset protection rules, eg, drew on financial-​crisis-​era reviews by IOSCO (Recommendations Regarding the Protection of Client Assets (2014)) as well as the FSB’s financial-​crisis era workstream on resolution (Key Attributes of Effective Resolution Regimes (2011).

386  Investment Firms and Investment Services These rules have a distinctly procedural orientation, being designed to specify how the framework legislative requirements are to be embedded within firms through structures, functions, policies, and processes. They are designed, however, to apply flexibly, given the immense heterogeneity that characterizes the investment firm population. The Delegated Regulation 2017/​565 rules are wide in reach and drill deep into firms’ operating processes, but they are, accordingly, proportionate in design:225 the proportionality injunction that firms, in applying the rules, take into account ‘the nature, scale, and complexity of the business of the firm, and the nature and range of investment services and activities undertaken in the course of that business’, recurs across these rules. The asset protection rules (Delegated Directive 2017/​593) are, reflecting their fundamental role in investor protection, more prescriptive and less accommodating as regards the specificities of firms’ design and operation.226 The organizational/​operational rules set out in Delegated Regulation 2017/​565 are designed to ensure a ‘high level of integrity, competence and soundness’ and ‘rigorous procedures’227 and cover general organizational requirements (Article 21), compliance (Article 22), risk management (Article 23), internal audit (Article 24), senior management responsibility (Article 25), complaints handling (Article 26), personal transaction reporting (Articles 28–​29), outsourcing (Articles 30–​32), and record-​keeping (Articles 72 and 74–​ 77).228 Reflecting the post-​financial-​crisis concern to establish clear lines of accountability within regulated firms for regulatory obligations, an accountability requirement frames the different Delegated Regulation 2017/​565 requirements: senior management are responsible for ensuring firm compliance and for reviewing the effectiveness of related policies and procedures (Article 25). The rules have a wide reach, spanning the panoply of organizational and operational risks within firms and requiring structural and procedural risk management systems but, in essence, firms are required to establish a clearly documented, robust, organizational structure, which supports the allocation of management responsibility, robust risk management, and transparency. The general organizational requirement (Article 21), for example, specifies a series of organizational obligations that must be met through appropriate internal systems which range from procedures and structures that specify the allocation of management responsibilities, to internal control mechanisms, personnel having the necessary skills, knowledge and expertise, effective internal reporting, orderly record-​keeping, and including data security and business continuity policies. This requirement has been finessed, by a 2021 revision, to refer to the management of sustainability-​ related risks.229 The establishment of related and appropriate governance, through discrete compliance, risk management, and audit functions (Articles 22–​24), is also required, although these functions can be embedded in a firm in different ways, depending on the firm’s organization and business and risk profile. The Article 22 compliance function regime, for 225 Firms are to ‘comply with their high level obligations and design and adopt measures that are best suited to their particular nature and circumstances’: recital 33. 226 Albeit that firms have discretion as to how they organize the required compliance oversight of asset protection requirements: Delegated Directive 2017/​593 Art 7. 227 Recitals 28 and 29. 228 Including as regards record-​keeping in relation to client orders (Arts 74–​75) and firms’ call recording policies (Art 77). 229 By Delegated Regulation 2021/​1253 which requires that firms take into account ‘sustainability risks’ when complying with Art 21. ‘Sustainability risks’ are defined by reference to the 2019 SFD Regulation (see Ch I section 7.2).

IV.8  MiFID II Organizational and Conduct Requirements  387 example, cascades from a general obligation to have effective compliance systems in place to the specific obligation to establish a permanent and effective compliance function that operates independently and meets the specified requirements as to responsibilities, resources, and reporting lines; this specific obligation is tailored to smaller firms by the lifting of the more onerous independence-​related requirements where the firm can demonstrate that, in view of the nature, scale, and complexity of its business, and the nature and range of its investment services and activities, these requirements are not proportionate. Similarly, the risk management governance requirements are based on the firm operating adequate risk management policies and procedures, which identify and manage risks effectively in light of the firm’s risk tolerance, but an independent risk management function is required only where the nature of the firm so warrants (Article 23).230 Following a 2021 reform, risk management systems must in addition take into account sustainability risks.231 The regime as whole is oriented towards systems and processes, but with the highest degree of specification and prescription applying to outsourcing (Articles 30-​32), reflecting the significant risks that can arise where ‘critical and important’ functions are outsourced from the regulated actor without sufficient oversight,232 and which are elevated where the outsourcing is to a third country.233 The detailed asset protection regime (Delegated Directive 2017/​593 Articles 2-​8) imposes the highest degree of prescription, reflecting its materiality for investor protection. It materially extended and strengthened the precursor regime, and thereby generated some contestation, particularly as regards the restrictions placed on using client assets for securities financing (stock lending) purposes.234 The rules address asset record-​keeping, identification, segregation, and related processes; supervisory reporting; annual audit; the holding of funds and instruments by third party custodians and depositaries and the related conditions and due diligence requirements (including restrictions on the entities with

230 Recital 37 acknowledges that the risk management function could be combined with the compliance function without compromising the independence of either. The over-​arching Art 23 risk management requirement is supported by the specific prudential risk management requirements that apply under the IFD/​IFR and CRD IV/​ CRR regimes, outlined in section 9.3 and 9.4. 231 By Delegated Regulation 2021/​1253. ‘Sustainability risks’ are defined by reference to the 2019 SFD Regulation (see Ch I section 7.2). 232 Outsourcing is not prohibited. Authorization cannot therefore be conditional on a prohibition on outsourcing, although the adoption of outsourcing arrangements relating to ‘critical and important’ functions, after authorization, can trigger the general authorization obligation to notify the NCA of any material changes to the firm since authorization (recitals 43 and 44). The outsourcing regime is directing to ensuring appropriate oversight of outsourcing, and not to preventing outsourcing, as it can bring efficiencies for firms, in particular by allowing firms to access specialized services. A similar concern animates the regulation of delegation by collective investment managers (Ch III). 233 The rules cover the scope of the outsourcing rules (which apply to ‘critical and important’ functions); the conditions which any outsourcing decision must comply with (including that the outsourcing does not result in senior management delegating its responsibilities); the requirement for due skill, care, and diligence in managing the outsourcing and the related obligations to be placed on the service provider; and specific requirements relating to outsourcing to third countries, including as regards the need for cooperation agreements between the home NCA and the relevant third country supervisor. 234 The Art 16 delegation for administrative rules did not address asset protection specifically, but the Commission, building on the prohibition in Art 16(10) on firms entering into agreements with retail clients for title transfer collateral arrangements, charged ESMA with providing advice on measures to ensure the appropriate use of such arrangements. Industry concern was marked, however, reflecting the importance of securities financing transactions generally in supporting liquidity, albeit that the rules in their final form largely formalize existing market practice: 2014 Technical Advice, n 101, 65–​8.

388  Investment Firms and Investment Services which client funds can be deposited235 and diversification requirements); the conditions on using non-​retail client instruments for securities financing transactions—​a significant reform, responding to financial-​crisis-​era risks;236 and related compliance and governance requirements. The Article 16 administrative rulebook on organizational/​operational requirements acts as form of highly articulated skeleton for firms on which they are to place their internal systems and related governance arrangements. The focus on appropriate systems and governance should support a ‘compliance culture’ being institutionalized within firms, but this depends on firms having the capacity to interpret the rulebook in way that reflects their operating models and risks, and also on NCA supervision which ensures compliance but is responsive to firm specificities. The technocratic capacity ESMA has brought, however, is supporting the application and supervision of these requirements. For example, as regards the compliance function (which is key to firms’ compliance with MiFID II as well as a critical information source and bellwether for NCAs as regards firms’ compliance and risk cultures) ESMA has adopted extensive, practically oriented Guidelines237 and engaged in a peer review of NCA supervision.238

IV.8.3  Conflict-​of-​interest Management IV.8.3.1 The Legislative Regime Enhancement of the MiFID I conflict-​of-​interest management regime was one of the major themes of the MiFID I Review, albeit specifically as regards the use of inducements in the retail distribution market. A new approach to inducements and the provision of investment advice followed, in one of MiFID II’s flagship reforms and as discussed in Chapter IX. But MiFID II also contains a series of interlocking requirements designed to protect clients and the market generally against conflict-​of-​interest risk and related prejudicial incentives, and which build on the MiFID I approach. The cornerstone measures are the organizational and disclosure requirements (Articles 16(3) and 23) discussed in this section. Conflict-​of-​interest management is also addressed, however, through the best execution and order-​handling requirements which apply to the trading process (Chapter VI), through the organizational and other requirements which apply to firms which operate trading 235 Essentially, central banks, credit institutions, and qualifying money-​market funds. Specific requirements govern the holding of client funds with money-​market funds (through money-​market fund units or shares). See further Ch III on money-​market funds. 236 MiFID II Art 16(10) prohibits firms from concluding title transfer collateral arrangements with retail client assets, but they are permitted for other clients, thereby generating asset protection risks that the securities financing transactions rules seek to address. The rules are primarily directed to internal processes, disclosure, client consent, the provision of collateral by the borrower of the instruments, and requirements for the firm to consider the appropriateness of any such transactions in light of the nature of the client’s obligations (liabilities) to the firm and the client assets subject to title transfer arrangements. 237 ESMA’s 2021 Compliance Function Guidelines specify the considerations to be taken into account in designing the compliance function and provide guidance on the criteria to be considered by firms in assessing the proportionate application of the rules. 238 The peer review assessed NCAs’ supervisory approaches to the original (MiFID I) Compliance Function Guidelines (2012, revised 2021): ESMA, Peer Review on Certain Aspects of the Compliance Function under MiFID I (2017). While the Report found generally high levels of NCA compliance with the Guidelines, it also reported on ‘quite some diversity’ in the supervisory approaches applied and set out a series of related recommendations for best practice, as well as specific remedial actions for the individual NCAs which took part in the review’s on-​site inspections.

IV.8  MiFID II Organizational and Conduct Requirements  389 venues (Chapter V), and through the fair treatment and quality of advice conduct requirements which apply to the firm/​client relationship (Chapter IX). Conflict-​of-​interest management has also been embedded into investment firm governance, with the management body enjoined to take responsibility for governance arrangements and policies governing conflicts of interest (Article 9(3)). Conflicts-​of-​interest within investment firms have long been a priority preoccupation of regulators internationally, given the powerful capacity of such conflicts to subvert regulatory requirements and to generate material investor protection, market efficiency, and financial stability risks.239 They can be difficult to address, however, given the highly dynamic nature of intermediation and, accordingly, of the potentially prejudicial incentives it can generate. The Enron-​era equity market scandals at the turn of the century, for example, saw investment research became the poster-​child for poor conflict-​of-​interest management in the multi-​service firm.240 Conflicts of interest were subsequently strongly associated with the financial-​crisis era and implicated in, for example, insufficiently risk-​sensitive internal governance within financial institutions (including as regards executive remuneration), excessive rating agency reliance on securitization fees, and the mis-​selling of complex products.241 More recently, the spate of scandals in the FICC (fixed income, currency, and commodity) markets can be associated with conflicts of interests that led to abusive conduct,242 digital innovation is being associated with elevated conflict-​of-​interest risks (for example where payment-​for-​order-​flow revenues support low-​cost trading apps),243 and so is the growth of sustainable finance.244 Conflict-​of-​interest risk is of longstanding in the multi-​service investment firm in particular. The intersection of corporate finance advice services, particularly M&A advice, and own-​account dealing, for example, is a classic setting for the generation of conflict-​ of-​interest risks.245 Securities underwriting/​placing and investment advice, to take another example, can generate such risks where poor-​quality securities, underwritten by the firm, are mis-​sold, while the allocation of underwritings and placings can generate significant conflict-​of-​interest risks, including where favoured clients are offered securities in over-​ subscribed offerings. Asset-​management services, to take a final example, also generate conflict-​of-​interest risks, including with respect to the ‘churning’ of portfolios to generate fees and the use of firm products, and of securities which are held on own account, in asset allocation.

239 See, eg, Alexander, K, Regulating Risk Culture in Banks (2019) available via ; Judge, n 6; Kumpans, C and Leyens, P, ‘Conflicts of Interest of Financial Intermediaries—​Towards a Global Common Core in Conflict of Interest Regulation’ (2008) 4 ECFLR 72; Mehran, H and Stulz, R, The Economics of Conflicts of Interest in Financial Institutions (2007) 85 JFE 267; and Tuch, A, ‘Investment Banking: Immediate Challenges and Future Directions’ (2006) 20 Commercial LQ 37 240 See further Ch II section 9. 241 See, eg, Tuch, A, ‘Conflicted Gate-​keepers. The Volcker Rule and Goldman Sachs’ (2012) 7 Virginia L & Bus Rev 365. 242 See in outline Ch VIII section 3.3. 243 See Ch VI section 2.2. 244 Including as regards ‘greenwashing’ risks. The MiFID II administrative rules governing conflict-​of-​interest management have recently been reformed accordingly (n 255). 245 eg Tuch, A, ‘Contemporary Challenges in Takeovers: Avoiding Conflicts, Preserving Confidence and Taming the Commercial Imperative’ (2006) 24 Company and Securities LJ 107 and Hopt, K, ‘Takeovers, Secrecy, and Conflicts of Interest: Problems for Boards and Banks’ in Payne, J (ed), Takeovers in English and German Law (2002) 33.

390  Investment Firms and Investment Services The regulation of firms’ conflict-​of-​interest management processes, typically by requiring that conflicts be identified,246 and prevented, managed, or disclosed, is only one response to the incentive risks which flow from conflicts of interest and which can lead to client costs, poor risk management, and, ultimately, the generation of risks to financial stability.247 But it is a longstanding regulatory tool and has been a prominent feature of EU investment firm regulation since MiFID I. It is embedded in MiFID II by Articles 16(3) and 23 which apply regardless of whether the client is a retail client, a professional client, or an eligible counterparty and are designed to operate ex-​ante and to contain prejudicial conflicts of interests through identification and management techniques. Under Article 23, investment firms must take ‘all appropriate steps’248 to identify, and to prevent or manage, conflicts of interest that arise in the course of providing any investment or ancillary services (Article 23(1)). These are broadly defined as conflicts arising between themselves (including their managers, employees, and tied agents, or any person directly or indirectly linked to them by control) and their clients, or between one client and another. The conflict-​of-​interest regime is not therefore dependent on a fiduciary obligation existing. Article 23(1) is supported by an organizational requirement. Under Article 16(3), firms must maintain and operate effective organizational and administrative arrangements with a view to taking all reasonable steps designed to prevent conflicts of interest (as defined in Article 23) from adversely affecting the interests of their clients. These two foundational obligations are linked by a default disclosure requirement. Under Article 23(2), where the organizational and administrative arrangements adopted by the firm under Article 16(3) to prevent conflicts of interest from adversely affecting the interests of its clients are not sufficient to ensure ‘with reasonable confidence’ that risks of damage to client interests will be prevented, the firm must clearly disclose to the client the general nature and/​or the sources of the conflicts of interest and the steps taken to mitigate those risks, before undertaking business on its behalf.249 In addition, specific requirements apply under Article 24 to inducements and remuneration arrangements and are considered in Chapter IX section 10 given their relevance to retail distribution. The MiFID II approach to conflict-​of-​interest management is accordingly based on the management of conflicts of interest (rather than their elimination) through widely cast ex-​ ante organizational requirements (back-​stopped by disclosure), which are designed to be tailored by firms to address their conflict-​of-​interest risk profiles. It is generic in design and does not address the particular conflicts of interest generated by specific firm activities. The administrative regime, however, has materially thickened these legislative requirements and specified how they apply in particular firm settings.

246 The existence of a conflict usually demands some form of fiduciary relationship, albeit not always, as conflict-​ of-​interest requirements can apply (as under the MiFID II regime) to arm’s-​length contracting. 247 See, eg, Alexander, n 239, on how related risk cultures can be strengthened. 248 The Art 23 MiFID II standard is higher than the MiFID I standard which required that firms take all ‘reasonable steps’, a standard arguably more vulnerable to investment firms claiming that their practices were reasonable in light of prevailing practices; ‘appropriate’ can be associated with an objective assessment. 249 Article 23(2) specifies the nature of this disclosure, including that it provide sufficient detail, taking into account the nature of the client, to enable the client to take an informed decision with respect to the service in question: boilerplate disclosures of generic conflicts are not therefore sufficient.

IV.8  MiFID II Organizational and Conduct Requirements  391

IV.8.3.2 The Administrative Rulebook The related MiFID II administrative rulebook (Delegated Regulation 2017/​565 Articles 33-​43) amplifies these legislative requirements by specifying the required processes and governance arrangements for identifying, managing, and disclosing conflicts.250 Like the legislative framework, these rules favour ex-​ante procedural controls over disclosure (which acts as a backstop) and thereby place responsibility on firms to address conflicts—​a responsibility which disclosure, where it is the sole regulatory requirement, can reduce or disable altogether:251 Article 34(4) emphasizes that disclosure is a ‘measure of last resort’.252 These rules do not distinguish as between retail and professional clients or eligible counterparties, given the impact flawed incentives, deriving from conflicts of interest, can have on investor protection but also on market efficiency and financial stability. Delegated Regulation 2017/​565, which builds on and expands the precursor MiFID I administrative regime as regards conflicts of interest, and which was not significantly contested in this regard,253 amplifies the legislative regime by specifying criteria for identifying conflicts of interest that could damage a client’s interests (Article 33).254 These interests were refined in 2021 to incorporate a client’s sustainability preferences.255 The Delegated Regulation also, under Article 34, amplifies in detail the required coverage of the firm’s conflict-​of-​interest management policy (which must be reviewed at least annually), requiring firms to establish, implement, and maintain an effective policy (appropriate to the size and organization of the firm and to the nature, scale, and complexity of its business) which identifies the specific firm activities that may generate conflicts detrimental to clients and the procedures for managing such conflicts. It drills into the coverage of the policy, requiring that the relevant conflict-​of-​interest management procedures ensure that firm activities are carried out ‘at a level of independence appropriate to the size and activities of the firm’, and also specifying the minimum set of procedures and institutional arrangements necessary for a firm to ensure the ‘requisite degree of 250 Reflecting the Art 23(4) delegation for the adoption of administrative rules governing the steps firms might reasonably be expected to take to identify, prevent, manage, and disclose conflicts of interest, and setting out the appropriate criteria for determining the types of conflict of interest whose existence could damage the interests of clients or potential clients. 251 Cain, D, Loewenstein, G, and Moore, D, ‘The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest’ (2005) 34 J of Legal Studies 1. 252 Similarly, recital 48 underlines that over-​reliance on disclosure without adequate consideration of conflict prevention and management should not be permitted. 253 ESMA’s proposals were largely uncontroversial, save with respect to the requirement that the conflicts policy be reviewed annually, but ESMA retained this requirement: 2014 ESMA Technical Advice, n 101, 80–​3. 254 The minimum criteria as regards the identification of damage to a client’s interests relate to the firm or person: being likely to make a financial gain or avoid a loss at the expense of the client; having an interest in the outcome of the services or transaction distinct from the client’s outcome; having an incentive to favour the interests of another client/​group of clients; carrying on the same business as the client; or receiving an inducement. The existence of a conflict requires therefore an asymmetrical outcome; it is not sufficient simply that the firm gains—​there must be a loss or disadvantage to the client to whom the firm has a duty (recital 45). 255 This reform was achieved by Delegated Regulation 2021/​1253. ‘Sustainability preferences’ means the client’s choice as to whether (and, if so, to what extent) the following financial instruments are integrated into the client’s investment: a financial instrument (ie a share) for which the client determines that a minimum proportion be invested in ‘environmentally sustainable’ investments (as defined under the 2020 Taxonomy Regulation); a financial instrument for which the client determines that a minimum proportion be invested in ‘sustainable investments’ (as defined under the 2019 SFD Regulation); or a financial instrument that considers principal adverse impacts on ‘sustainability factors’ (as defined under the 2019 SFD Regulation), where qualitative or quantitative elements demonstrating that consideration are determined by the client . The notion of ‘sustainability preferences’, which draws on the Taxonomy and SFD Regulations (noted in Ch I section 7.2), has also been used to refine the MiFID II ‘know-​your-​client’ regime, as outlined in Ch IX section 8.

392  Investment Firms and Investment Services independence’: information controls; separate supervision of persons where appropriate; removal of remuneration structures that may generate conflicts; measures to prevent the exercise of inappropriate influence; and measures to prevent the simultaneous or sequential involvement of persons in investment activities or services where this may impair the proper management of conflicts of interests.256 The extent to which these procedures and arrangements should be deployed is not specified, but firms are directed to pay ‘special attention’ to investment research, advice, proprietary trading, portfolio management, and corporate finance business, in particular where the firm performs combinations of these services (recital 47). Alongside, specific rules address investment research, as discussed in Chapter II section 9, and also underwriting/​placing. In a material reform (the MiFID I regime did not address underwriting/​placing in detail), and in the face of some industry resistance,257 Delegated Directive 2017/​565 imposes detailed rules addressing the conflict-​of-​interest risks specific to underwriting and placing (Articles 38–​44). These risks can be significant given the level of judgment engaged in related pricing and allocation activities, the returns at stake, and the strong incentives that can be generated to favour firm and particular clients’ interests over those of the issuer client and other clients. The pricing process, for example, can generate conflicts between the issuer client and a firm’s own-​account dealing business, while the allocation process can generate conflicts between favoured and other clients. While the rules are primarily directed to the adoption of procedures and policies, they also have prescriptive elements, including the prohibition of identified practices (particularly as regards placings258). The rules address the required disclosures to be made to issuer clients (including as regards the investors to be targeted; the management of the conflicts that may arise where the firm places the relevant financial instruments with its clients or with its own-​ account dealing book; how the issue price and offer timings are set; and how any underwriting strategies deployed, such as stabilization or hedging strategies, may impact the issuer client’s interests); and also underwriting/​placing-​specific policies and procedures. Extensive record-​keeping requirements also apply, including in relation to the recording and justifying of the allocation decisions for each placing or underwriting (as regards which

256 The rules also cover the disclosure to be provided to clients where conflicts cannot be appropriately managed, and require records to kept as to the activities/​services in relation to which a conflict of interest entailing a risk of damage to the interests of clients may arise (Arts 34(4) and 35). 257 The Commission did not expressly mandate ESMA to consider underwriting/​placing risks and the rules proposed by ESMA, as part of its technical advice on conflict-​of-​interest management, were among the most contentious of its proposals. Market participants highlighted, eg, that pricing practices were not an ‘exact science’, called for flexibility as regards the allocation rules, and asked for differentiation between equity and debt markets. ESMA took a robust approach in response, noting, eg, its concern (based on evidence from NCAs) that firms were unable to justify allocations and did not have clear policies in place: 2014 Technical Advice, n 101, 84–​91. In an indication of the materiality of these rules for industry practice, they have been subject to further clarification in the MiFID II/​MiFIR Investor Protection and Intermediaries Q&A (section 6). 258 Additional requirements apply to placing, given the heightened risk of firms using the placing of the related financial instruments to further their own interests, to the detriment of the issuer client and its investment clients. The firm must adopt arrangements to prevent placing recommendations being unduly influenced by existing or future firm relationships, as well as arrangements to prevent or manage conflicts in the allocation process, alongside an allocation policy that sets out the process for developing allocation recommendations. Further, the use by firms of placing as means for incentivizing the payment of disproportionately high fees for unrelated services as compensation for the placing (‘laddering’) or to encourage the awarding of contracts for future firm services (the practice of ‘spinning’), and the making of placings conditional (expressly or implicitly) on future orders or the purchase of services, are all expressly prohibited.

IV.8  MiFID II Organizational and Conduct Requirements  393 a ‘complete audit trail’ must be maintained). The acute conflicts of interests generated where an investment firm places proprietary instruments (‘self-​placement’)259 are also addressed, including by means of a retail-​client-​oriented obligation to explain the difference between the relevant financial instrument and bank deposits in terms of yield, risk, and liquidity. Detailed and specific, the underwriting rules provide a clear illustration of the extent to which MiFID II, by means of the administrative rulebook, reaches into firms’ operating procedures.

IV.8.4  Conduct Regulation Client-​facing conduct-​of-​business rules, designed to support investor protection, are a central component of the MiFID II operating regime. Article 24 sits at the heart of the conduct regime. As under MiFID I, investment firms are subject to an over-​arching ‘fair treatment’ obligation: when providing investment services (or ancillary services) to clients, firms must act honestly, fairly, and professionally, in accordance with the best interests of the client, and comply with the Article 24 conduct principles and the related quality of advice rules which apply under Article 25 (Article 24(1)). This foundational obligation is supported by a series of more specific requirements which attach to all stages of the investment distribution lifecycle, from product design to distribution (advice, asset management, brokerage), and in relation to pre-​contractual and ongoing disclosure. Much of the conduct regime is concerned with the quality of advice, including by means of discrete requirements governing ‘independent’ investment advice (Article 24), and by means of know-​your-​client rules that govern the extent to which suitability assessments must be undertaken when different services, from investment advice to execution-​only brokerage, are provided (Article 25). Threaded through the conduct regime is a concern to manage the conflict-​of-​interest risk generated by inducements in the investment product distribution process, with specific requirements applying as regards remuneration arrangements and when inducements or commissions can be accepted (Article 24). Article 24 also addresses disclosure, by means of the foundational requirement that all information—​ including marketing communications—​addressed by the investment firm to clients or potential clients must be, in the totemic obligation, ‘fair, clear, and not misleading’; but also by means of specific requirements relating to the minimum disclosures which must be provided to clients with respect to the firm and its services, including as to risk warnings and cost disclosures. Product governance requirements also apply, designed to ensure firms develop products that reflect the ‘needs, characteristics, and objectives’ of an identified target market of investors and that are distributed to this target market (Articles 24 and 16(3)). The Article 24/​25 conduct regime has been significantly amplified under Delegated Regulation 2017/​565. The conduct requirements are strongly associated with retail client protection and the investment product distribution process and so are examined in Chapter IX. They apply,

259 As noted in section 5, following a series of financial-​crisis-​era scandals, MiFID II specified that self-​ placement activities are investment services within MiFID II.

394  Investment Firms and Investment Services however, to professional clients (but not eligible counterparties), subject to calibrations primarily, but not entirely, at the administrative level.

IV.8.5  Trading Rules, Trading Venues, and Transaction Reporting In one of the most significant financial-​crisis-​era reforms, MiFID II/​MiFIR led to the construction of a new rulebook on trading activities and related transaction reporting and on the operation of trading venues, which is examined in Chapters V and VI.

IV.9  Prudential Regulation IV.9.1  A Distinctive Regime Prudential regulation is concerned with the solvency of financial institutions and with the securing of financial stability: it seeks to manage the risks which financial institutions assume and to internalize within such institutions the costs of these risks; and it seeks to contain the risks of institution failure, given the dangers which any consequent contagion poses to the financial system.260 It typically includes governance requirements, including as regards remuneration; internal control/​risk management requirements; and, most intrusively, capital/​own funds, liquidity, and leverage requirements.261 The capital requirements which are most strongly associated with prudential regulation are designed to impose internal costs on risk, to absorb the losses which an institution does not expect to make in the ordinary course of business, and to support orderly winding up in an insolvency. In effect, they require that the risks carried by firms are at all times proportionate to the levels of capital they hold. While investment firms do not take deposits and so are less exposed to financial stability risks than banks (which face maturity mismatch risks and the related risk of a run on deposits),262 their activities generate risks for markets, clients, and their own balance sheets which are addressed by prudential regulation. Investment firms raise particular challenges for prudential regulation, however. Their activities range from own-​account dealing, underwriting, and placing activities, which can generate material and bank-​like credit and market risks to financial stability when carried out at scale (as is reflected in the debate on non-​bank financial intermediation);263 to the holding of client assets, which can generate 260 Prudential regulation has micro (firm-​related) and macro (system-​related) elements. Macroprudential regulation is primarily associated with bank regulation and with capital requirements designed to mitigate pro-​ cyclicality risks. It is less associated with investment firm regulation, although macroprudential tools, such as leverage limits, are being developed in the collective investment management/​investment fund context, as noted in Ch III. 261 The EU tends to use the term ‘own funds’ in relation to capital, particularly in legislative measures. On EU prudential regulation, and the own funds and liquidity requirements with which it is closely associated, see Joosen, B, Lamandini, M, and Tröger, T (eds), Capital and Liquidity Requirements for European Banks (2022) and Alexander, K, ‘The Role of Capital in Supporting Banking Stability’ in Moloney et al, n 3, 334. 262 The defining maturity mismatch risk that banks are subject to, and that generates financial stability risks, derives from the mismatch between their deposit liabilities (which can be withdrawn without notice) and their loan assets (which have specified terms and may not be liquid). 263 See further Ch III section 3.2.1.

IV.9  Prudential Regulation  395 client losses in an disorderly wind-​down; to investment advice activities, which carry minimal prudential risks, primarily relating to the extent to which a client can claim damages against an investment firm. The EU’s prudential regime for investment firms is, like much of the investment firm rulebook, extensive and multi-​layered but it is also distinctive within this rulebook. Most significantly, its roots are in, and it remains heavily based on, the EU’s prudential regime for banks (credit institutions), notwithstanding the 2019 adoption of a distinct regime for investment firms through the IFD/​IFR. This leads to a series of distinguishing characteristics. The EU prudential regime for banks is closely based on the Basel prudential standards for banks, and so the investment firm prudential regime, based on the bank regime, is deeply embedded in the Basel standard-​setting process.264 It has therefore been shaped by the distinct political economy associated with, first, the Basel process and, second, the implementation of the Basel standards in the EU. Relatedly, the investment firm prudential regime is highly dynamic, as it is shaped by the Basel process: since 2010, the EU has been engaged in a massive exercise to implement the financial-​crisis-​era Basel III reforms and their subsequent adjustments, a process which is not due to complete fully until near the end of this decade. Further, given its bank-​centric nature, EBA, rather than ESMA, provides technocratic support to the investment firm prudential regime. The regime has, as a result, been shaped by EBA’s distinct technocratic ecosystem on which ECB Banking Supervision exerts material influence. One of the defining features of EBA is the centripetal pull of ECB Banking Supervision on its operation given the Banking Union arrangements that, through the Single Supervisory Mechanism (SSM) (overseen by ECB Banking Supervision), govern the supervision of banks in the euro area (and in Member States that opt-​in to Banking Union).265 Having its roots in bank prudential regulation also means the investment firm prudential regime is highly technical, proceduralized, and operational, even by the standards of the MiFID II/​MiFIR rulebook, and contains complex risk calculation models, calibrated to different business structures, activities, and instruments, alongside high-​level risk management and governance principles. It is also, and relatedly, amplified to a significantly greater extent than other aspects of the single rulebook. The main legislative measure governing the prudential regulation of larger and more complex investment firms, CRD IV/​CRR, is supported by a dense thicket of over 100 separate administrative rules and by extensive soft law. Its sister measure for the smaller and less complex investment firms which dominate in the EU investment firm landscape, the IFD/​IFR, is also subject to extensive amplification. Reflecting the cost of these complex rules and of the firm systems that they require, but also the driving imperative of ensuring optimal risk sensitivity, mechanisms to support proportionality, calibration, and tailoring are embedded features of the investment firm prudential regime, to a significantly greater extent than elsewhere in the single rulebook: references to governance rules being tailored to the size, complexity, and activities of 264 The Basel Committee is the international standard-​setter for bank prudential standards and the most influential standard-​setter globally. For a financial-​crisis-​era review see Barr, M, ‘Who’s in Charge of Global Finance’ (2014) 4 Georgetown J Int’l L 971. 265 For a review of the implications and the nature of ECB influence on EBA see Moloney, N, ‘The 2013 Capital Requirements Directive and Capital Requirements Regulation: A Helicopter View of Its Coverage and Implications’ (2016) 71 Zeitschrift für öffentliches Recht 385.

396  Investment Firms and Investment Services firms abound across the regime, as do specific ameliorations for different categories of firm, in particular small and non-​or less-​complex firms. This approach reached its apotheosis in 2019 when the investment firm prudential regime was carved into two segments: the CRD IV/​CRR (as revised by CRD V/​CRR 2) regime for the largest and most complex firms; and the 2019 IFD/​IFR regime for the rest of the investment firm population. This feature has also embedded complex dynamics into the application of the investment firm prudential regime: as the regulatory perimeter separating the IFD/​IFR and CRD IV/​CRR regimes is a function of investment firm size, and as how the IFD/​IFR applies is also in part a function of investment firm size, firms can move across and within the two regulatory systems, which can drive complexity and costs.266 The distinctiveness extends to supervision. Unusually in the financial markets sphere, the supervisory process is highly harmonized and articulated. The Supervisory Review and Evaluation Process (SREP) which governs how the investment firm prudential requirements are supervised, and which allows NCAs to impose additional prudential requirements based on firm-​specific circumstances, sits within an increasingly prescriptive ‘SREP’ legislative framework, supported by extensive EBA soft law.267 Finally, the investment firm prudential regime has experienced large-​scale change since the financial crisis. Much of this change has been driven by the Basel process. But it has also been driven by EU-​specific preoccupations, including as regards, initially, firm governance and remuneration and, subsequently, sustainability-​related risk management and also enhancements to supervision. Relatedly, the arc of the regime has been bending continually to greater prescription, in part to ensure that the rules are sufficiently calibrated to the risks of firms, which increases pressure for rule harmonization and amplification. The 2019 adoption of the IFD/​IFR regime, for example, is designed to deliver greater risk sensitivity, while the most recent 2021 reforms to the CRD IV package are designed in large part to calibrate pre-​existing rules to ensure greater risk-​sensitivity.268 Given the scale of the investment firm prudential regime, only its main features can be considered in the following discussion which examines the twin pillars of the prudential regime: the CRD IV/​CRR (as revised by CRD V/​CRR 2) regime for the largest and most complex investment firms;269 and the 2019 IFR/​IFD regime for all other investment firms. In addition, the EU’s resolution regime also forms part of the prudential framework, but only for the largest and most complex investment firms.270

266 The need to support fluid transitioning arrangements was acknowledged by EBA in developing the related administrative rules and soft law: EBA, Investment Firm Roadmap (2020). 267 In addition, the most complex investment firms have been redesignated as ‘credit institutions’ and so are supervised through Banking Union’s Single Supervisory Mechanism (section 11 and as outlined also in Ch I sections 5.2 and 6.6). 268 Under the 2021 CRR VI/​CRR 3 package, outlined below in this section. 269 CRD IV/​CRR refers to the current consolidated CRD/​CRR package (adopted as Directive 2013/​36/​EU [2013] OJ L176/​338 (CRD IV) and Regulation (EU No 575/​2013 [2013] OJ L176/​1 (CRR)), as most significantly revised by the CRD V/​CRR 2 reforms (Directive 2019/​2034 [2019] OJ L314/​64 (CRD V) and Regulation 2019/​ 2033 [2019] OJ L314/​1 (CRR 2). 270 The EU’s recovery and resolution regime is set out in the 2014 Bank Recovery and Resolution Directive (Directive 2014/​59/​EU [2014] OJ L173/​190) (which also covers the largest and most complex investment firms, treated as ‘credit institutions’ under CRD IV/​CRR)) and which is operationalized within Banking Union through the Single Resolution Mechanism.

IV.9  Prudential Regulation  397

IV.9.2  The Evolution of the Prudential Regime IV.9.2.1 The Roots of the Prudential Regime and the CRD Package The now deep roots of the investment firm prudential regime lie in the prudential rules which have governed EU banks since their first iteration in 1989 (under the Banking Co-​ ordination Directive II and its related measures), and which have been heavily influenced by the standards adopted by the Basel Committee. The first prudential rules, directed to credit institutions (who were permitted to also carry out investment services activities), were originally oriented towards the credit risk strongly associated with banking business.271 Following the adoption of the ISD in 1993 and the development of a discrete regulatory scheme for investment firms, these rules were expanded by the 1993 Capital Adequacy Directive to cover the market risks272 to which credit institutions and investment firms are exposed (primarily through their ‘trading book’ activities’,273 a proxy for the risks posed by positions in traded instruments).274 After multiple revisions and recastings, the disparate components of the original prudential regime developed and coalesced to become the omnibus Capital Requirements Directive (CRD I), a package of prudential rules, for credit institutions and investment firms, that also implemented the ‘Basel II’ capital standards and that thereby established in the EU the twin pillars of Basel capital calculation: the ‘standardized’ and ‘internal model’ approaches.275 While applicable to credit institutions and investment firms, the management of credit risk was at the core of CRD I. The catastrophic crystallization of risk over the financial crisis led to a large-​scale overhaul of the EU prudential regime. This overhaul was heavily influenced by the related ‘Basel III’ reform process,276 which, framed by the initial 2010 Basel III reforms, has taken over a decade (the final implementation stage was to start by January 2023),277 but was also shaped by EU-​specific reforms, as well by the many associated and intricate transitional arrangements and phasing-​ins. 271 Primarily under the since repealed 1989 Solvency Ratio Directive. 272 Market risk involves a number of elements, including the risk of the market moving against a particular instrument, risks inherent in the instrument itself, and general market movement risk (for example, interest rate movement risk) which could affect the instrument in question. 273 The ‘trading book’ is, in essence, composed of instruments held for trading and subject to market risk capital requirements. By contrast, the ‘banking book’ is composed of exposures subject to credit risk capital requirements. 274 The 1993 Capital Adequacy Directive, in response to the need for a more fully articulated prudential regulation scheme for market risk to accompany the ISD, covered capital requirements for the market risks to which investment firms but also credit institutions were exposed and established the ‘trading book’ notion as means for capturing market risk. 275 The Basel system is, very broadly, based on the calculation of capital requirements (for a series of risks) by means of the application of the specified capital ratio for the risk in question (expressed as a percentage) to the firm’s ‘risk weighted assets’ (or RWAs). The calculation of RWAs, which drives the capital requirement for the risk in question, is based on one of two approaches: the ‘standardized’ Basel approach, which follows the relevant Basel requirements and calculations; and the internal-​model-​based approach, which is based on firms using internal models (which are subject to supervisory approval) to calculate their RWAs. 276 It was also shaped by the FSB-​led international reform agenda on global systemically important banks and financial institutions, which included resolution-​related reforms as regards their ‘total loss absorbing capacity’ (TLAC) capital requirements (termed ‘minimum own funds and eligible liabilities’ (MREL) in the EU). For a consideration of the changes to how prudential regulation was designed, applied, and supervised globally over the crisis era see, eg, Avgouleas, E, The Governance of Global Financial Markets: the Law, the Governance, the Politics (2012). 277 The initial 2010 Basel III reforms were followed by the 2016/​2019 Basel trading book reforms, and by the informally termed ‘Basel IV’ process, which relates to the finalization of the Basel III process (including as regards credit risk, operational risk, credit valuation adjustment, and the imposition of an ‘output floor’ on the impact of internal models for assessing the RWAs against which capital requirements are calculated).

398  Investment Firms and Investment Services The foundational 2010 Basel III reform278 is based on three ‘Pillars’: standards (Pillar 1); internal firm assessment and supervisory review (Pillar 2); and public disclosure and supervisory reporting (Pillar 3). It significantly reformed the treatment of capital including by means of new counterparty credit risk requirements, which also strengthened the prudential treatment of the trading book; operational risk requirements; a stricter definition of the constituents of capital; new capital buffers designed to address macroprudential risks; and higher capital requirements generally. It also provided for new prudential requirements in the form of leverage and liquidity requirements. The Basel process also saw reform of how market/​trading book risk was treated. The financial crisis had revealed that firms exposed to market/​trading book risks were only thinly capitalized against trading losses, as a consequence of the pre-​crisis assumption that trading book assets were generally liquid and that positions could quickly be unwound. Relatedly, the two Basel II approaches used to assess market risk in the trading book and related capital requirements (the internal-​models-​based approach, which was based on Value-​at-​Risk; and the standardized approach) proved to be insufficiently comprehensive (as regards the use of internal models) and also lacking in risk sensitivity (as regards the standardized approach, and particularly as regards illiquid assets).279 The interim Basel ‘2.5’ process accordingly led to a series of reforms to how trading book risk was calculated, with the major reforms following under the subsequent ‘Fundamental Review of the Trading Book’ (FRTB) process. Initially adopted in 2016 but revised and refined in 2019,280 the related new Basel standards for capital requirements for market risk set out stricter criteria for the assignment of instruments to the trading book (to address weaknesses in the earlier trading-​intent-​ based regime, which allowed firms to move instruments to the banking book to achieve a lower capital requirement); reform the internal-​models-​based approach to assessing capital requirements to be more risk sensitive, including by requiring more stringent capital requirements for risks deemed to be ‘non-​modellable’, and strengthen the related supervisory approval process for internal models; and introduce a new and more risk sensitive standardized approach to assessing capital requirements.281 Alongside, the 2010 Basel III standards were revised and finalized in 2017 by the informally termed ‘Basel IV’ reform package,282 which is designed to enhance the risk sensitivity and credibility of the capital assessment process. Its main element is a fundamental reform of the internal-​models-​based approach to assessing capital requirements, including by means of an ‘output floor’ which ensures firms using internal models are subject to a minimum capital requirement.283 It includes a host of other revisions, however, including 278 Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems (2010). 279 See, eg, Basel Committee, Explanatory Note on the Minimum Capital Requirements for Market Risk (2019); Haldane, A and Nelson, B, Tails of the Unexpected, Bank of England Paper (2012), and Turner Review, n 7. 280 The new standards for calculating trading book risk are set out in Basel Committee, Minimum Capital Requirements for Market Risk (2019, initially adopted in 2016). 281 The 2016 reforms were originally based on the standardized approach (in the form of a standard but highly complex model designed to ensure calibrated treatment of market risk and to act as a credible alternative to internal models) and the internal-​model-​based approach. Subsequently, the ‘simplified standardized approach’ was adopted for use by firms with small or non-​complex trading portfolios. 282 Basel Committee, Basel III: Finalizing Post Crisis Reforms (2017). For a review see Feridun, M and Ozün, A, ‘Basel IV Implementation: A Review of the Case of the European Union’ (2020) 4 J of Cap Mkt Studies 7. 283 The reform is designed to address variability in the use and risk sensitivity of internal models, and the related risk that capital requirements are insufficient, by imposing constraints on the use of models (in effect, it targets model risk).

IV.9  Prudential Regulation  399 refinements to the standardized capital assessment process for credit risk and for operational risk and a strengthening of the leverage ratio originally adopted in 2010. Following a one-​year pandemic-​related delay, the implementation process for this final Basel package was to start by January 2023. In addition, FSB-​led reforms have followed for the additional capital to be held by global systemically important financial institutions and to support their orderly resolution.284 In the EU, these Basel reforms have been implemented through the 2013 CRD IV/​CRR package, as revised by the 2019 CRD V/​CRR 2 reforms and to be completed, as regards the Basel process, by the 2021 CRD VI/​CRR 3 proposals.285 The phased and piecemeal Basel implementation process has been deeply technical.286 It has also been profoundly political, in particular because the EU applies the Basel standards (which are designed to apply to large, internationally active banks) to a wide population of credit institutions and investment firms.287 EU influence on Basel standard-​setting has been strong, but it has not always been able to impose its preferences.288 As a result, subsequent implementation in the EU has required adjustments to be made and compromises to be constructed,289 given persistent structural differences in financial systems across the EU.290 Calibrations, adjustments, revisions, and phasing-​in arrangements have therefore been a consistent feature of the EU’s implementation of the Basel reforms.291 The many examples include carve-​outs to support SME finance; distinct treatment for certain instruments, including covered bonds (to avoid disruption to the EU covered bond market); distinct treatment for non-​performing loans (reflecting the EU’s agenda to reduce such non-​performing exposures); and proportionality mechanisms, designed to manage the application of the Basel standards to smaller and less complex firms. The coverage of the vast CRD IV/​CRR (as revised by CRD V/​CRR 2) legislative package, after these reforms, includes the constituents of capital/​own funds; capital requirements for credit, market, operational, settlement, and leverage risk; capital buffers; leverage and liquidity ratios; capital and eligible liabilities requirements to support the resolution of global 284 FSB, Guiding Principles on the Internal Loss-​Absorbing Capacity of G-​SIBs (2017). 285 COM(2021) 663 (CRD VI) and COM(2021) 664 (CRR 3). 286 It has also been informed by significant technocratic input from EBA on the impact of the Basel reforms. EBA, eg, semi-​annually systematically reviews the impact of the Basel III reforms and also engages in extensive ad hoc assessments of the CRD package. See, eg, its early review of the CRD IV package: EBA, Overview of the Potential Implications of Regulatory Measures for Banks’ Business Models (2015). 287 As was acknowledged by the Basel Committee: Regulatory Consistency Assessment Programme (RCAP), Assessment of Basel III Regulation. European Union, December 2014. Notably, the US applies Basel standards only to the largest and most systemically significant banks. 288 For discussion of how individual Member State interests and collective EU interests are imposed (or not) on the Basel processes see Quaglia L and James, S, The UK and Multi-​level Financial Regulation (2020), Quaglia, L, The European Union & Global Financial Regulation (2014) and Blom, J, ‘Banking’ in Mügge, D (ed), Europe and the Governance of Global Finance (2014). 289 From the political science literature on the EU implementation of Basel standards see Greenwood, J, ‘The ‘Europeanization’ of the Basel Process: Financial Harmonisation between Globalization and Parliamentarization’ (2015) 9 Reg & Gov 325. 290 The main points of contention on the CRD IV/​CRR process, eg, included the extent to which Member States could vary capital requirements, the extent and scale of the CRD IV capital buffers (which extended beyond the Basel III requirements), and the highly contested ‘bonus cap’. The CRD V/​CRR 2 and CRD VI/​CRR 3 packages have been similarly contested: Meridun and Ozün, n 282. 291 The Commission’s development of the CRD VI/​CRR 3 Proposals, eg, was shaped by the Commission’s concern to ensure a faithful implementation of the related Basel standards, but also to avoid a significant increase in bank capital, adjust the Basel standards where they would have unintended or disproportionate effects, avoid competitive distortions with international competitors, and ensure proportionality: Commission, Q&A on the CRD VI/​CRR 3 Package (2020).

400  Investment Firms and Investment Services systemically important institutions (G-​SIIs); operational and risk management requirements; governance and remuneration requirements; public disclosure requirements; supervisory reporting; and supervisory arrangements, including the framework governing the imposition by NCAs of additional capital and liquidity requirements beyond those required by the CRD rulebook. While reflecting the Basel (and FSB) processes, the CRD IV/​CRR package also reflects EU-​specific reforms. These include, from among the many examples, firm governance and executive remuneration requirements; enhanced Pillar 3 disclosure requirements; additional capital buffers; the conditions placed on the extent to which NCAs can impose additional capital requirements under the Pillar 2 supervisory process; and sustainability-​related requirements. As noted below, the CRD IV/​CRR package applies to credit institutions, which now include the largest and most complex investment firms, as well as to specified larger investment firms.

IV.9.2.2 A Bespoke Investment Firm Regime: The IFD/​IFR The 2019 IFD/​IFR regime, which came into force in 2021, is derived from the CRD IV/​CRR package but is designed to ensure a bespoke and risk sensitive treatment for the smaller and less complex investment firms which dominate in the EU market.292 Its roots lie in the 2013 adoption of CRD IV/​CRR and the related realization at the time that this regime, which applied to investment firms as well as to credit institutions, was poorly attuned to the distinct risks posed by smaller investment firms. A series of review clauses accordingly charged the Commission with reviewing the possibility of a targeted investment firm regime which would better reflect the prudential risks of most investment firms in the EU. EBA, charged with delivering the review, delivered an innovative and influential series of reports and advice to the Commission across 2015-​2017. Its pathfinding 2015 report identified a series of difficulties with the CRD IV/​CRR package, as regards investment firms, which were obstructing delivery of the goals of prudential regulation.293 These included its immense complexity (the CRD IV/​CRR package segmented investment firms into eleven categories, based on MiFID II activities and services, which dictated the extent to which the package applied);294 the high degree of regulatory fragmentation and inconsistency flowing from a lack of clarity as to the key elements of this classification system, including as regards the pivotal activity of ‘holding client money and securities’, which dictated much of the regime’s application; and its lack of risk sensitivity as the CRD IV/​CRR package applied in a crude and insufficiently calibrated manner to the nature of investment firm risk.295 In

292 In 2015, EBA reported that 80 per cent of the total assets held by the 6,000 or so MiFID firms were held by eight to ten firms: EBA, Report on Investment Firms (2015) 27. 293 n 292. EBA identified the purpose of prudential regulation as supporting financial stability and investor protection by strengthening the soundness and stability of firms on a going concern basis, avoiding failures which could materially impact stability, and supporting orderly failure and the distribution of client assets and securities: at 5–​6. 294 The regime was designed to identify those firms providing services which should be subject to the full set of prudential requirements (primarily firms engaging in own-​account dealing, underwriting, and placing) and to progressively lift the rules applicable for other firms, depending in particular on the extent to which they held client money or assets. 295 EBA noted, eg, that investment firms that did not hold client money/​assets but that engaged in own-​account dealing were subject to a weighty application of the CRD IV package, albeit that independent investment firms, dealing on own account outside a group structure, could, in practice, pose only minimal risks to financial stability: 2015 Report, n 292, 19.

IV.9  Prudential Regulation  401 response, EBA called for a three-​tier approach which would distinguish between: the small number of complex, bank-​like investment firms which were exposed to material credit risks (counterparty credit risks) and market risks through significant own-​account dealing, underwriting, and placing activities, and which would be subject to rules equivalent to those applying to credit institutions; a second tier of other firms which did not pose risks on such a scale and would be subject to a tailored set of rules governing the risks they posed to clients and the market, and including credit, market, operational, and liquidity risk; and a final tier of small and non-​interconnected firms which would be subject to a simple regime designed to support their wind down and primarily based on a fixed-​overheads-​based minimum capital requirement. A subsequent EBA paper called for a bifurcated approach, based on subjecting ‘tier one’ firms to the CRD IV/​CRR package and other firms to a new, tailored regime, the application of which would be adjusted for small and non-​interconnected firms.296 EBA’s proposed criteria for identifying the ‘tier one’ bank-​like firms subject to the CRD IV/​CRR package were presented in 2016.297 A detailed EBA proposal for a new prudential regime for other investment firms followed in September 2017.298 This proposal was framed by the principle that investment firm prudential regulation, and in particular capital requirements, for firms which are not systemic, should be proportionate and directed to the scale of the different risks an investment firm poses to the market, to clients, and to its own balance sheet. EBA used a new ‘K factor’ metric to capture the different activities which generate these risks as well as their scale, and to generate a more highly differentiated and calibrated capital requirement. This new approach was not primarily concerned with financial stability or with providing similar levels of assurance as CRD IV/​CRR provides for bank-​like firms. Its primary concern was with managing the detriment that the failure of an investment firm could visit on clients and markets, in particular by means of requirements directed to ensuring that firms could absorb a degree of loss and remain in business, had appropriate liquidity measures, and had sufficient capital and liquid assets to wind down in an orderly manner. Following a truncated development process (given the extent of EBA’s preparatory work and widespread stakeholder support), the Commission proposals for IFD/​ IFR followed in December 2017.299 Despite the novelty of the reform, the negotiation process was relatively straightforward, with EBA’s model prevailing in almost all of its essentials. The Commission’s proposals were closely based on EBA’s approach.300 The most significant deviation related to identification of the ‘bank-​like’ firms subject to the CRD IV/​CRR package (‘Class 1’ firms). While the Commission supported such firms being subject to CRD IV/​CRR,301 rather than leaving the specification of this class to amplification by EBA (as had been recommended by EBA), the Commission adopted a legislative approach, identifying, in the approach which would prevail, Class 1 firms as firms engaging in own-​account dealing, underwriting, or placing, 296 EBA, Discussion Paper on Designing a New Prudential Regime for Investment Firms (2016). 297 EBA, Opinion on the First Part of the Call for Advice on Investment Firms (2016). 298 EBA, Opinion in response to the Commission’s Call for Advice on Investment Firms (2017). 299 COM(2017) 791 (IFD) and COM(2017) 790 (IFR). 300 The Commission supported EBA’s assessment that the CRD IV/​CRR approach was excessively complex, applied disproportionately, was based on poorly tailored and insensitive risk metrics, and had generated material national divergences in implementation. Given the scale of EBA’s preparatory work, the Commission did not engage in a pre-​proposal consultation or impact assessment, but reported on widespread support for EBA’s approach: IFR Proposal, n 299, 8 and Commission, Inception Impact Assessment (Ref. Ares(2017) 1546878). 301 Given in particular their significant exposure to credit risk (counterparty credit risk) and to market risk from own account positions: IFR Proposal, n 299, 2.

402  Investment Firms and Investment Services and with assets equal to or in excess of €30 billion. This approach was designed to ensure identity between the supervisory treatment of the largest and most complex investment firms, and the largest banks subject to direct supervision by the ECB within the SSM (a €30 billion asset threshold is one of the proxies used to determine the largest and most complex banks subject to direct ECB supervision). Most contestation, primarily in the Council, related to the classification system, given the material cost implications flowing from the different classifications; and to the components of the different ‘K-​factors’ which drive the capital requirements. The Council broadly followed the Commission’s approach to classification, but, in a revision which was adopted despite some Member State resistance, expanded the reach of the CRD IV/​CRR package by extending it to ‘Class 1 Minus’ firms, very broadly those firms with assets of €5-​€15 billion and depending on the application of different conditions.302 The Council also nuanced the Commission’s proposals in a number of respects, including by refining (and typically thereby reducing the potential capital burden) the different K factors which ground the capital requirement. The subsequent 2019 adoption of the IFD/​IFR heralded a major reform. It is designed to streamline and simplify prudential requirements for investment firms, to align prudential regulation to investment firms’ business models, and to deliver greater consistency of treatment. It is significantly simpler than the full-​scale CRD IV/​CRR package, although it draws heavily on its rules in certain key respects. The pivotal market risk and firm governance requirements, as well as the rules governing the permissible constituents of capital, for example, are heavily based on parallel CRD IV/​CRR rules. The IFD/​IFR also shares many features with CRD IV/​CRR, including as regards the extent of its amplification by administrative rules and soft law, its embedding of proportionality-​related mechanisms, and its granular articulation and proceduralization of supervisory processes, through the IFD/​IFR Supervisory Review and Evaluation Process (SREP). It is distinct from CRD IV/​CRR, however, as regards its much more acute focus on client-​facing prudential risks and, accordingly, on investor protection.303 The IFD/​IFR brings most change for medium-​sized, ‘Class 2’ firms, who become subject to the full weight of the IFD/​IFR, having previously benefited from a series of exemptions under the CRD IV/​CRR regime. Small firms benefit from an extensive series of IFD/​IFR exemptions, while the largest investment firms, now subject to the CRD IV/​CRR regime, remain subject to a broadly similar regime as previously applied to them under the CRD IV/​CRR package. The new regime can be expected to be dynamic. This is in part a function of EBA’s amplification of the regime through mandated administrative rules and soft law, as well as its own-​initiative measures. But it also a function of the extensive review clauses for both measures which require extensive reports by June 2024.304

302 Council Documents 7460/​19 ADD 1(IFD) and 7460/​19 ADD 2 (IFR), 19 March 2019 303 eg, EBA noted the importance of prudential requirements for ensuring that, where a client suffers losses from investment advice, the firm has sufficient financial resources, on an ongoing basis, to correct any detriment suffered by the client, and that client assets are transferred in an orderly manner if the firm is wound down: 2016 EBA Discussion Paper, n 296, 16–​17. 304 The IFD review clause (Art 66) covers remuneration, supervisory reporting and public disclosure, sustainability-​related matters, macroprudential tools, and the border between it and the CRD package, while the IFR clause (Art 60) includes the K-​factor model and the liquidity rules.

IV.9  Prudential Regulation  403

IV.9.3  The IFD/​IFR IV.9.3.1 Scope and Classes The IFD and IFR, which came into force in June 2021,305 together cover the prudential regulation of investment firms, including as regards organizational, capital, and liquidity requirements, and the related supervisory regime. The IFD addresses initial capital and organizational requirements, NCAs’ supervisory powers and cooperation arrangements, and NCA publication requirements (IFD Article 1); the IFR addresses ‘uniform prudential requirements’ in relation to own funds/​capital requirements (relating to quantifiable, uniform, and standardized elements of risk-​to-​firm (RtF), risk-​to-​client (RtC), and risk-​to-​ market (RtM)), concentration risk requirements, liquidity requirements (relating to quantifiable, uniform, and standardized elements of liquidity risk), supervisory reporting, and public disclosure requirements (IFR Article 1). The Regulation and Directive apply to investment firms authorized and supervised under MiFID II (IFD Article 2(1); IFR Article 1(2)) and so cover MiFID II investment services and activities. The regime is supervised on a consolidated basis, with the IFR’s requirements applying also on an individual as well as consolidated basis.306 Reflecting the concern animating the development of the IFD/​IFR regime that it apply in a proportionate manner, tailored to the risk profiles of firms, the regime is segmented as regards its application to: investment firms regarded as credit institutions (Class 1); larger and more complex investment firms (Class 1 Minus); medium-​sized investment firms (Class 2); and small investment firms (Class 3).307 Class 1 investment firms (firms that engage in own-​account dealing in, or in underwriting and/​or placing on a firm commitment basis of, financial instruments; and the total value of whose consolidated assets is equal to or in excess of €30 billion) are defined as ‘credit institutions’ and, as such, are subject to the full application of the CRD IV/​CRR regime and fall outside the IFD/​IFR.308 These firms must, accordingly, be authorized as credit institutions under CRD IV/​CRR and, as credit institutions, are subject to MiFID II/​MiFIR in respect of their MiFID II/​MiFIR activities. 305 A series of transitional arrangements apply, including as regards the capital requirements and the calculation of market risk relating to trading activities. 306 The IFD and IFR both provide for consolidated supervision and so also address the related allocation of NCA competence. The application of the IFR’s requirements, however, is on an individual (Art 5) as well as on a consolidated (Art 7) basis, albeit that there is an exemption (Art 6) for small (Class 3) firms from the individual application requirement (save as regards liquidity requirements, in relation to which specific exemption requirements apply under Art 6(3) designed to ensure the free movement of funds from the parent to the firm), where such firms form part of a credit institution, investment firm, or insurance group that is subject to consolidated supervision, and also subject to conditions designed to ensure joined-​up supervision and the adequacy of own funds, including as regards the transfer of capital or repayment of liabilities by the group parent (Art 6). A substitute group capital test for investment firm groups (Art 8) applies by way of exemption from the Art 7 consolidation requirement for group structures which are deemed ‘sufficiently simple’, as long as there are no significant risks to clients or to the market from the group that would require consolidated supervision. For the purposes of consolidation, the parent undertaking and any IFR-​scope subsidiaries must establish proper organizational structures and appropriate internal control mechanisms to ensure the capturing of the data required for consolidation. CRR governs the specific application of consolidation principles to the application of the IFR own funds regime. 307 Discussion of the different classes follows below. The ‘class’ terminology is not used in the Directive or Regulation but was used by EBA in the development of the regime, is used by the Commission, and has since become the accepted common, if informal, terminology for the scope of the IFD/​IFR. 308 CRR Art 4(1), as revised by IFR Art 62 (commodity and emission allowance dealers, collective investment undertakings, and insurance undertakings are expressly excluded). An investment firm also comes within this recharacterization where it falls under the asset threshold, but certain group-​related tests are met, as outlined below.

404  Investment Firms and Investment Services Class 1 Minus, Class 2, and Class 3 firms are all authorized under MiFID II/​MiFIR and all come within the IFD/​IFR regime, albeit that it applies to different degrees; the IFD/​IFR regime is highly calibrated. Class 1 Minus firms are, for the most part, exempted from the IFD/​IFR regime and subject instead to CRD IV/​CRR; Class 3 firms are exempted from much of the IFD/​IFR regime and are subject to a lighter own funds regime; and the full application of the IFR/​IFD regime is in practice reserved to the default class of Class 2 firms. Class 1 Minus investment firms are regarded as systemic, bank-​like firms and are, accordingly, subject to most of the CRD IV/​CRR regime.309 These firms are identified by a combination of service/​activity and balance sheet proxies. The class covers, by default, firms which carry out own-​account dealing in or underwriting and/​or the placing of financial instruments on a firm commitment basis and that have a total value of consolidated assets of equal or in excess of €15 billion (IFD Article 2(2); IFR Article 1(2)).310 In addition, a firm carrying out own-​account dealing/​underwriting/​placing may, without any qualification as to assets, choose to be designated in this way and so to be regulated under CRD IV/​CRR, as long as it is included in the supervision on a consolidated basis of a credit institution, and subject to the approval of its NCA (IFD Article 2(2); IFR Article 1(5)).311 Finally, these Class 1 Minus investment firms can also include investment firms who meet a lower asset threshold (consolidated assets equal to or in excess of €5 billion)312 where the firm’s NCA, at its discretion, decides to so treat the investment firm in question (IFD Art 5; IFR Article 1(2)). The NCA can choose to bring these firms within the class where one or more of a series of (mainly subjective) criteria are met relating to whether the firm carries on activities on such a scale that firm distress or failure could generate systemic risk, and to whether the designation is justified in light of the size, nature, scale, and complexity of the firm’s activities, taking into account the proportionality principle and having regard to a series of specified factors. In addition, the NCA can choose to require CRD IV/​CRR application/​Class 1 Minus designation where the firm meets the asset test and is a clearing member of a CCP. Class 3 (small and non-​interconnected) firms benefit from an extensive series of exemptions from the IFD/​IFR. They are, in effect, exempted from the IFD’s organizational requirements and the IFR’s liquidity requirements, and are subject to a lighter IFR capital regime which does not include the risk-​based K-​factor own funds requirements. Designation as a small and non-​interconnected firm (hereafter, ‘small firm’ or Class 3 firm) is governed by IFR Article 12. It sets out a series of conditions all of which must be met for the designation.313 They take the form of balance sheet/​size conditions and nature of business 309 IFD Art 2(2) and IFR Art 1(2) provide that these firms are to apply CRR and the CRD IV prudential supervision requirements. In practice, this means that only the IFD initial capital requirement rules and the IFD supervisory reporting requirements governing their asset value apply to Class 1 Minus investment firms. 310 Excluding commodity and emission allowance dealers, collective investment undertakings, or insurance undertakings. The asset value is calculated as an average of the previous twelve months and excluding the value of individual assets of non-​EU subsidiaries that carry out own-​account dealing/​underwriting/​placing. This definition also covers firms of total value of less than €15 billion, where group-​related tests are met. 311 The application of CRR must not result in a reduction of the capital requirements which would otherwise apply under the IFR and the election by the investment firm must not be driven by regulatory arbitrage: IFR Art 1(5)(c). This route is also available where the investment firm is included in the consolidated supervision of a financial holding company or mixed financial holding company, each as defined under CRD IV (in effect, groups composed of financial institutions): IFR Art 1(5)(a). 312 Calculated as an average of the previous twelve months (commodity and emission allowance dealers, collective investment undertakings, and insurance undertakings are excluded). 313 The IFD/​IFR address the application of the rules where a firm ceases to meet the Art 12 conditions and also where it subsequently meets them, having previously not been classed as a small firm.

IV.9  Prudential Regulation  405 conditions, and are designed to ensure that firms which do not generate material stability risks, and in relation to which prudential regulation is primarily designed to support an orderly wind down and protection of investor assets, are subject to a proportionate and targeted prudential regulation regime which is primarily based on permanent minimum capital, linked to fixed overheads. Designation (which is internally assessed by firms) as a Class 3 firm can follow where the firm’s on-​and off-​balance sheet total is less than €100 million, and the total annual gross revenue from investment services and activities is less than €30 million.314 In addition, Article 12 uses the risk proxies on which the ‘K factor’ capital regime is based as conditions relating to the nature of the firm’s business. Two are pivotal (although all the conditions must be met): assets under management (discretionary; and non-​discretionary/​collective where it constitutes ongoing investment advice)315 (AUM) must be less than €1.2 billion; and client orders handled (COH) by the firm must be less than €100 million/​day for cash trades or €1 billion/​day for derivatives. These firms also cannot hold client money/​securities or deal in securities (the Article 12 regime formally imposes a ‘zero requirement’ on the related proxies)316 and so are limited to brokerage, investment advice, and asset management services. All other firms (Class 2 firms) are subject to the full application of the IFD/​IFR regime, although certain ameliorations, primarily in relation to the remuneration regime, are available for firms with a balance sheet of equal or less than €100 million. The IFD/​IFR is amplified by an extensive suite of administrative rules and soft law developed by EBA (typically in consultation with ESMA) and covering, inter alia, the application of the regime’s thresholds and criteria, capital requirements (including the K-​factor calculations), reporting and disclosure, remuneration and firm governance, and supervisory convergence and the IFD/​IFR SREP.317

IV.9.3.2 The Own Funds Regime and K-​Factors The own funds (or capital adequacy) regime is at the heart of the IFR and has two components: initial capital requirements; and ongoing own funds requirements. The initial capital requirement for all investment firms (excluding those designated as credit institutions who are subject to the CRD IV initial capital requirement of €5 million) is set by IFD Article 9. The requirement is calibrated to the risk posed by the firm’s activities, with the highest requirement (€750,000) set for firms engaging in own-​account dealing and firm commitment underwriting/​placing activities.318 The lowest requirement (€75,000) applies to firms who provide MiFID II investment services, apart from own-​account dealing and underwriting/​placing on a firm commitment basis, but who are not permitted 314 Calculated on the basis of annual figures over the preceding two-​year period. 315 See n 326. 316 Article 12 is structured so as to require that assets safeguarded and administered (ASA), client money held (CMH), clearing margin given/​net position risk (CMG/​NPR), daily trading flow (DTF), and trading counterparty default exposures (TCD) are all zero. 317 For a review see EBA, Roadmap on Investment Firms (2020). The delayed adoption of the extensive administrative rules required (which were not in place when the regime came into force in June 2021 and are, at the time of writing, in the process of being adopted) led to the Commission stating that the legislative framework provided NCAs with sufficient flexibility to ensure appropriate regulation and supervision: Commission, Statement, 24 June 2021. 318 This level also applies to firms that operate an organized trading facility (OTF) where the firm engages in dealing (an OTF is distinct in the EU trading venue classification system in that the operator can deal on the system). See Ch V section 8.

406  Investment Firms and Investment Services to hold client money or securities. All other firms are subject to a €150,000 requirement. The qualifying own funds that can constitute initial capital are set out in Article 9 of the IFR, which closely reflects the foundational definition of own funds established by the CRR regime. In addition to the initial capital requirement, firms are required to maintain at all times the own funds required under the IFR in accordance with Articles 9 and 11.319 Article 9 sets out the ratios which govern the proportion of the different quality own funds which must be held to meet the own funds requirement. The highest quality own funds (Common Equity Tier 1 capital), for example, must represent at least or greater than 56 per cent of the firm’s own funds requirements. Article 9 also sets out the constituents of own funds as regards the Common Equity Tier 1 capital, Additional Tier 1 capital, and Tier 2 capital classifications used to meet capital requirements. It is closely based on the detailed CRR regime governing the composition of these different classifications of own funds, but nuanced to reflect the particular risk profile of IFR-​scope firms, in particular as regards the required deductions from capital. Article 11 is the pivotal provision. It requires that firms must have, at all times, own funds in accordance with Article 9 which amount to at least the highest of three requirements: their fixed overheads requirement (Article 13); their permanent minimum capital requirement (Article 14); or their ‘K-​factor’ requirement (Article 15). In an important calibration, small and non-​interconnected firms (Class 3 firms) benefit from a discrete regime, being required to hold the higher of either the fixed overheads or permanent minimum capital requirement and not being subject to the K-​factor regime; this approach tracks the previous approach to small firms under the CRD IV/​CRR package. All other IFR-​scope firms not subject to CRD IV/​CRR are subject to the full regime and its novel ‘K-​factor’ requirement which is designed to better calibrate own funds to the specific size, scale, and activities of individual firms. Of the three requirements, the highest of which constitutes the own funds requirement, two are familiar from the CRR regime: the permanent minimum capital requirement (in effect, the initial capital required of the firm: Article 14); and the fixed overheads requirement (one-​quarter of the fixed overheads of the previous year,320 subject to a series of deductions:321 Article 13)). The third requirement (the overall K-​factor requirement) is new and, as outlined above, is designed to allow the better calibration of own funds requirements. It is based on using a series of risk proxies to establish an own funds requirement for the sum of the discrete risks posed by the firm, captured by the overall K-​factor requirement.322 The overall K-​factor requirement is a sum, composed of individual K-​factor requirements grouped into three categories each representing the major families of investment 319 A transitional arrangement (for five years until 2026) allows firms to apply a lower capital requirement based on the application of the previous CRR regime (twice the previous CRR requirement or twice the fixed overhead requirements for firms not previously subject to the CRR). 320 Subject to the power of an NCA to adjust this where there has been a material change in a firm’s activities (Art 13(2)). 321 Including as regards remuneration, profit shares, and commissions and fees (as amplified by administrative rules). 322 The K-​factors are designed to provide a set of observable proxies which represent the risks posed by investment firms (often associated with levels of operational risk), and a set of related scalars to reflect size, which can produce risk-​sensitive capital requirements. The factors are based on information a firm may ‘generally wish to know and hold about its business’ rather than information that only has meaning for the purposes of determining capital: 2016 EBA Discussion Paper, n 296, 17–​18.

IV.9  Prudential Regulation  407 firm risk: the risk-​to-​client (RtC) K-​factors; the risk-​to-​market (RtM) K-​factors; and the risk-​to-​firm (RtF) K-​factors (Article 15).323 Each of these K-​factors is segmented into sub K-​factors,324 which are, in turn, subject to detailed rules on how they are measured and applied. The category of K-​factors is not closed; the Commission is to consider whether, following a review by EBA, dedicated prudential treatment of assets exposed to activities associated substantially with environmental or social objectives, in the form of a related K-​ factor, would be justified (Article 34). The RtC K-​factor requirement is concerned with the risks to which clients are exposed. It is composed of the sum of K-​AUM (assets under management), K-​CMH (client money held), K-​ASA (assets administered or safeguarded), and K-​COH (client orders handled) (Article 16). The measurement of each of these components is specified by the IFR and each component, once measured, is subject to the application of a coefficient fixed by Article 16. Calibrations apply to reflect the rolling nature of investment firm business and to avoid spikes in the related own funds requirements. For example, K-​AUM (Article 17)325 is related to the value of assets that a firm manages for its clients under discretionary portfolio mandates and non-​discretionary arrangements constituting ‘investment advice of an ongoing nature’326 (Article 4(1)(27)). A rolling valuation model applies to avoid spike impacts: AUM are measured as the rolling average of the total monthly assets under management, measured on the last business day of each of the previous fifteen months, but excluding the three most recent months. Once the AUM are measured, a 0.02 per cent coefficient applies. This K-​AUM amount is then included, with the other RtC components, in the overall calculation of the RtC K-​factor requirement; this RtC K-​factor requirement is then added to the RtM and RtF K-​factor requirements to form the overall K-​factor requirement which, if higher than the permanent minimum capital or fixed overhead requirement, sets the own funds requirement for the firm (in accordance with Article 9). To take another example, the K-​ CMH component of the RtC K-​factor (Article 18)327 measures the client money that an investment firm holds, taking into account relevant legal arrangements in relation to asset segregation, and irrespective of the national accounting regime applicable (Article 4(1) (28)).328 Again, a rolling approach is adopted: CMH is based on the rolling average of the value of total daily client money held, measured at the end of each business day for the previous nine months, but excluding the three most recent months. A coefficient applies (based on whether the client accounts are segregated (0.4 per cent) or not (0.5 per cent) to produce the K-​CMH amount. 323 K-​factors are defined as the own funds requirements for the risks an investment firm poses to clients, markets, and to itself (Art 4(1)(26). 324 These K-​factors cover AUM (asset under management), CMH (client money held), ASA (assets safeguarded and administered), COH (client orders handled), CON (concentration risk), CMG (clearing margin given), DTF (daily trading flow), NPR (net position risk), and trading counterparty default (TCD), all of which are defined under Art 4(1)(27)–​(35). 325 Which is designed to capture the potential risk of client harm from, eg, incorrect management/​execution or related unsuitable advice: 2016 EBA Discussion Paper, n 296, 19. 326 Defined as the recurring provision of investment advice as well as the continuous or periodic assessment and monitoring or review of a client portfolio of financial instruments, including of investments undertaken by the client on the basis of a contractual arrangement: Art 4(1)(21). 327 Which is designed to capture the potentially wide range of risks to clients from the holding of client assets and securities: 2016 EBA Discussion Paper, n 296, 19. 328 This formula, by relating client assets to those held by firm, taking into account relevant legal custody requirements, reduces the scope of the formula originally proposed by the Commission (and EBA), which related K-​CMH to simple ‘control’ of the funds, regardless of the legal requirements applicable.

408  Investment Firms and Investment Services The RtM K-​factor calculation (which does not deploy coefficients) is based on the risk posed to the market by positions in the ‘trading book’ of a firm dealing on own account,329 whether for itself or on behalf of a client (Article 21(1)).330 The ‘trading book’ relates to the positions in financial instruments and commodities held by the firm, either with trading intent, or in order to hedge positions held with trading intent.331 The RtM K-​factor requirement can be based on one of two risk proxies: K-​NPR (net position risk, the value of the transactions recorded in the firm’s trading book (Article 4(1)(34)); or K-​CMG (client margin given, the total margin required by a clearing member of a CCP, where the execution and settlement of transactions by a firm dealing on own account takes place under the responsibility of the clearing member or CCP (Article 4(1)(32)). The K-​NPR measurement process follows, for the most part, the CRR regime for measuring trading book risk (section 9.4); it provides for standardized but also internal-​model-​based approaches (Article 22). Investment firms are also required to manage their trading books in accordance with the extensive risk management, valuation, and organizational requirements applied by the CRR to trading books (Article 21(2)).332 K-​CMG is to be measured in accordance with the related IFR requirements (Article 23). Finally, the RtF K-​factor requirement addresses the traditional concern of own funds regulation: the risks posed to firms’ balance sheets by their activities. This requirement is derived from the sum of three components (Article 24), the measurement of each of which is specified to a granular extent: K-​TCD (trading counterparty default, or the exposure of specified trading book positions333 to trading counterparty default risk) (Article 4(1)(35)); K-​DTF (daily trading flow, or the daily value of transactions entered into by a firm on own account or on behalf of clients in its own name334 (Article 4(1)(33)); and K-​CON (concentration risk, or, in effect, large exposures risk in the form of exposures to a client or a group of clients in excess of the exposure limits imposed by the IFR concentration risk regime) (Article 4(1)(31)). The measurement of K-​TCD is specified in detail and is based on a combination of steps and elements (Articles 25–​32). Its scope is confined to specified instruments carrying increased counterparty credit risk335 and less risky counterparties are excluded (including public sector counterparties and group members) (Article 25). It is measured by means of the determination of the associated exposure value, the application of a risk factor to the relevant counterparty, and the application of a credit valuation adjustment. K-​DTF is a function of the rolling average of the value of the DTF on a business day 329 Including positions in debt instruments (including securitization instruments), equity instruments, collective investment undertakings, foreign exchange, gold, and commodities (including emission allowances) (Art 21(3)). 330 This K-​factor is designed to capture the impact the firm can have in the market in which it operates, such as a temporary dislocation in liquidity, or detriment to market confidence or liquidity, that may arise where the firm fails or needs to exit the market: 2016 EBA Discussion Paper, n 296, 20. 331 As defined under Art 4(1)(54). Where a position is held with ‘trading intent’ it is either a proprietary position or a position arising from client servicing and market-​making, a position intended to be resold in the short-​term, or a position intended to benefit from short-​term price movements (Art 4(1)(55). 332 CRR Arts 102–​106. These requirements include rules governing the allocation of positions to the trading book for own funds purposes, the ‘prudent valuation’ requirement, the management of the trading book, the organization and operation of trading desks, trading strategy, and internal hedging. The effect of this requirement and the IFR definition of ‘trading book’ is to align the risk-​to-​market regime closely with the rules applicable to the trading book under the CRR (these rules are noted in outline in section 9.4). 333 Specified in Art 25 and including non-​centrally cleared /​non-​exchange-​traded derivatives, repos, securities lending and borrowing arrangements, and margin lending transactions, 334 Exclusions relating to agency brokerage apply. 335 n 333.

IV.9  Prudential Regulation  409 basis (on a nine-​month basis and excluding the most recent three months) and the application of a related coefficient (Articles 33 and 15). K-​CON which, in effect, measures large exposure risk, applies an own funds requirement to the extent to which the firm exceeds the exposure value limits set by the IFR (Article 39): Article 37 sets a limit of 25 per cent of own funds to the exposure value to an individual client or group of clients.336 Investment firms are also required to monitor and control their concentration risk by means of sound administrative and accounting procedures and robust internal control mechanisms (Article 35)337 and must provide the required notification to their NCA when the exposure limit is breached (Article 38).338

IV.9.3.3 Liquidity and Liquid Assets All IFR-​scope firms are subject to the IFR’s liquidity requirements which are designed to ensure that the firm has sufficient liquidity for an orderly wind-​down over one month; the requirements operate on a ‘gone concern’ basis.339 The obligation takes the form of a requirement to hold ‘liquid assets’ equivalent to at least one-​third of the Article 13 fixed overhead requirement (Article 43). NCAs may, however, exempt small and non-​interconnected/​ Class 3 firms from this requirement. The composition of ‘liquid assets’ is, broadly, a function of the CRD IV/​CRR Liquidity Coverage Ratio, specifically the CRR Liquidity Coverage Delegated Regulation.340 Where small firms are not exempted by their NCA, they can draw on a wider range of liquid assets, in the form of receivables from trade debtors and fees and commissions receivable. IV.9.3.4 Organizational Requirements and Firm Governance Alongside, the IFD imposes organizational and firm governance/​board requirements on in-​scope firms.341 Small and non-​interconnected firms (Class 3 firms) are, for the most part, exempt from these requirements; these firms remain, however, subject to the MiFID II organizational/​governance requirements. At the core of the organizational regime is the Article 24 requirement for firms to have internal capital adequacy and liquidity assessment strategies and processes to ensure they have adequate capital and liquid assets to cover the nature and level of risks which they may pose to others and to which they are or might be exposed;342 these arrangements are to be 336 A higher limit applies where the client is a credit institution or investment firm (the higher of either 25 per cent of own funds or €150 million, but not in excess of 100 per cent of the firm’s own funds). Certain specified exposures are exempted, including exposures entirely deducted from the firm’s own funds, claims against public authorities and CCPs, as well those exposures which an NCA can choose to exempt, including covered bonds and certain group exposures (Art 41). 337 Investment firms are also prohibited from managing exposure limits by temporarily transferring exposures to another company or by entering into artificial transactions to close out the exposures: Art 40. 338 NCAs may give firms a specified, limited period of time to comply with the limit. 339 Previously, only firms engaging in own-​account dealing/​underwriting/​placing were subject to liquidity requirements under the CRD IV/​CRR package. 340 Delegated Regulation (EU) 2015/​61 [2015] OJ L11/​1. It covers ‘Level 1’ liquid assets, including coins and bank notes, claims on central banks and governments, bank debt, high quality covered bonds, as well as ‘Level 2A’ and ‘Level 2B’ assets, such as asset-​backed securities, corporate debt, shares, and securitizations. In addition, firms can use other traded financial instruments for which there is a liquid market and unencumbered short-​term bank deposits. 341 On the context to the governance requirements that apply to investment firms (and credit institutions) see section 9.4.6. 342 This requirement is an attenuated version of the extensive Internal Capital Adequacy Assessment Process (ICAAP) and Internal Liquidity Adequacy Assessment Process (ILAAP) that applies under CRD IV/​CRR.

410  Investment Firms and Investment Services sound, effective, and comprehensive, and also appropriate and proportionate to the nature, scale, and complexity of the firm’s activities and subject to regular review. Small and non-​ interconnected firms (Class 3 firms) are exempt from this requirement, although an NCA may require that such a firm comply to the extent it deems appropriate. In addition, a series of related organizational and risk management requirements apply (Articles 26-​34), from which Class 3 firms are (for the most part) exempted (Article 25). Article 26 imposes a series of organizational requirements akin to those applicable under MiFID II. It requires that firms have in place robust governance arrangements, including a clear organizational structure with well-​defined, transparent, and consistent lines of responsibility; effective risk management processes; adequate internal control mechanisms (including sound administration and accounting procedures); and remuneration policies that are consistent with and promote sound and effective risk management. These arrangements are to be appropriate and proportionate to the nature, scale, and complexity of the risks inherent in the firm’s business model and activities. The firm’s risk management obligations are further specified by Article 29. It requires that risk management policies and processes cover the identification, measurement, management, and monitoring of material sources and effects of risk to clients, the market, and the firm, including as regards the impact on own funds, and also liquidity risk.343 These policies and processes must be tailored to the firm and, in particular, be proportionate to the firm’s complexity, risk profile, scope of operation, and risk tolerance, and also reflect the importance of the firm in each Member State in which it carries out business. Small and non-​interconnected (Class 3) firms, otherwise exempt from the Articles 26–​34 organizational requirements, are required by Article 29 to monitor material sources and effects of risk to clients and to the firm, and to monitor liquidity risks. Accordingly, while Class 3 firms are not subject to the K-​factor own funds requirements, and can be exempted by their NCA from the liquidity requirements, they are not exempt from monitoring risks. Risk management arrangements are, reflecting their central importance to firms’ management of risk, to be approved and reviewed by the management body, which is also charged with managing, monitoring, and mitigating the firm’s risks, taking into account macroeconomic conditions and the firm’s business cycle (Article 28).344 Firms are, relatedly, required to have a risk management committee (composed entirely of non-​executive members of the management body who are also subject to competence requirements), although firms with a balance sheet of equal or less than €100 million are exempt from this requirement (Article 28). The IFD also address management body/​board governance,345 specifically as regards executive remuneration. As outlined in section 7.2, MiFID II firms are subject to management body requirements through the firm authorization process, including the management body requirements imposed under CRD IV/​CRR Articles 88 and 91. MiFID II does not, however, directly apply the CRD IV rules on executive remuneration, a gap which has been

343 This ‘treatment of risks’ requirement maps that applicable under CRR (Art 76). 344 Allied requirements relating to reporting lines to the management body, the adequacy of management body time and resources devoted to risk management, and information flows to the management body also apply: Art 28. 345 An extensive set of EBA Guidelines covers the role and composition of the management body, its governance framework, risk culture and business conduct, and internal controls: EBA, Guidelines on Internal Governance under Directive (EU) 2019/​2034 (2021).

IV.9  Prudential Regulation  411 filled by the IFD.346 The IFD’s remuneration rules (which do not apply to small and non-​ interconnected/​Class 3 firms) are broadly similar to those that apply under CRD IV/​CCR, but with a series of ameliorations designed to reflect the lower risk profile and smaller size of IFD-​scope firms. The remuneration regime is accordingly based on remuneration policy requirements, specific obligations relating to variable remuneration, and remuneration governance requirements. At the core of the regime is the requirement that firms establish a remuneration policy which must comply with a specified and extensive series of principles and which must be applied to specified categories of employee347 (Article 30). The governing principles are similar to those applicable under CRD IV,348 and are to apply in a manner appropriate to the firm’s size and internal organization, and to the nature, scope, and complexity of its activities. Firms are not, however, subject to a form of the totemic CRD IV ‘bonus cap’; they are required instead to set an appropriate ratio between variable and fixed remuneration in their remuneration policies, taking into account business activities and associated risks and the impact of relevant employee categories on the firm’s risk profile (Article 30). Specific requirements apply to the design of variable remuneration, similar to those applicable under CRD IV (Article 32),349 and include the requirements that 50 per cent of variable remuneration be in the form of equity-​related instruments (alternative arrangements may be approved by NCAs where a firm does not issue such instruments); and that 40 per cent of variable remuneration be deferred over a three-​to five-​year period.350 Similar requirement apply to collective investment managers under the UCITS and AIFMD regimes, also based on the CRD regime. In a significant amelioration, the 50 per cent and 40 per cent limits do not apply to firms with a balance sheet equal or less than €100 million or to individuals whose annual variable remuneration does not exceed €50,000.351 Investment 346 Executive remuneration requirements, designed to support effective risk management and of broadly similar design, are imposed across the single rulebook, including for collective investment managers (Ch III) and rating agencies (Ch VII). 347 Senior management, risk takers, staff engaged in control functions, and employees whose professional activities may have a material impact on the firm’s risk profile or the assets it manages (where those employees are in receipt of remuneration equal to at least the lowest remuneration received by senior management or risk takers). 348 Including that the firm remuneration policy must be clearly documented and proportionate to the firm’s features; gender-​neutral; consistent with and promote sound and effective risk management; aligned to the firm’s business strategy; avoids conflicts of interest and encourages sound business conduct; is reviewed by the management body which must also be responsible for the policy, and is also annually and independently reviewed by the firm’s control function; separates the remuneration process for staff in control functions from business units and ensures that the remuneration of senior risk and compliance officers is overseen by the firm remuneration committee or the management body; and, as regards components of remuneration, makes a clear distinction between fixed remuneration (designed to reflect the experience and responsibility of an employee) and variable remuneration (which reflects sustainable and risk-​adjusted employee performance as well as performance in excess of what is required) and ensures that the fixed component is set at a sufficiently high proportion of remuneration to accommodate a fully flexible variable remuneration policy (which can include that no variable remuneration is paid). 349 Including that variable pay is linked to firm as well as individual performance; financial and non-​financial criteria are used; performance assessment is over a multi-​year period; variable pay does not affect the firm’s ability to ensure a sound capital base; early termination payments are not ‘rewards for failure’; performance assessments take into account the firm’s current and future risks and costs of capital and liquidity; and up to 100 per cent of variable remuneration can be contracted or clawed back where the firm’s financial performance is subdued or negative (this requirement specifies that claw-​back arrangements be available to address situations where the individual in question is no longer considered ‘fit and proper’ or has participated in/​was responsible for conduct which led to significant firm losses). 350 Depending on the firm’s business cycle, business, and risks and the activities of the individual in question. The provision also requires that 60 per cent of variable remuneration must be deferred ‘in the case of variable remuneration of a particularly high amount’. 351 This exemption can be expanded by Member States in line with the systemic-​impact-​related criteria set by Art 32(5). Member States may also lower the €100 million threshold where it is appropriate to do so given the firm’s activities, organization, and the group within which it operates, and may similarly lower the employee threshold (Art 32 (6) and (7)).

412  Investment Firms and Investment Services firms are also required to establish a remuneration committee, composed of non-​executive members, responsible for reviewing remuneration policy and for preparing remuneration decisions for the management body (Article 33); firms with a balance sheet equal or less than €100 million are also exempt from this requirement. The remuneration regime has been amplified by administrative rules and EBA Guidelines.352

IV.9.3.5 Prudential Treatment of Sustainability-​related Risks While the IFD/​IFR regime does not currently directly address sustainability-​related risks in detail (save for reporting requirements, as noted below), reforms are likely to follow on foot of the reports required of EBA as regards the prudential treatment of related risks.353 IV.9.3.6 Public Disclosure and Supervisory Reporting Transparency requirements, designed to support market monitoring, also form part of the IFD/​IFR prudential regime, in a reflection of the CRD IV/​CRR ‘Pillar 3’ transparency requirements. Under the IFR, investment firms must provide a series of specified annual disclosures (accompanying their annual financial statements) as regards risk management, governance, own funds, remuneration policy, investment/​voting policy as regards shares held, and environmental, social, and governance (ESG) risks (Articles 46–​53). Small and non-​interconnected firms (Class 3 firms) are exempt from the reporting regime unless they issue Additional Tier 1 instruments, in which case they are required to make disclosures as regards risk management and own funds (Article 46(2)). A further calibration exempts firms with a balance sheet of (or less than) €100 million from the investment policy disclosures (Article 52). Also, extensive supervisory reporting requirements apply under the IFR, reflecting the extent to which EU financial markets regulation has become oriented towards data collection, as noted in Chapter I. The IFR requires investment firms to report to the relevant NCA as regards own funds, levels of activity in specified business areas, concentration risk, and liquidity requirements.354 A further supervisory reporting requirement, designed to support perimeter control by the relevant NCA given that the application of the IFD/​IFR (and of CRD IV/​CRR) depends in part on the firm’s size, applies: investment firms that engage in own-​account dealing/​underwriting/​placing activities are required to verify the value of their total assets on a monthly basis, and to report, on a quarterly cycle, to their NCAs where their consolidated assets equal or exceed €5 billion. A significant degree of standardization has accordingly been brought to investment firm reporting by the IFD/​IFR. Previously, levels and content of reporting were variable across the Member States as the CRD IV package imposed different sets of requirements for different classes of firm.355 352 The EBA Guidelines (EBA, Guidelines on Sound Remuneration Policies under Directive (EU) 2019/​2034 (2021)) address remuneration policy, the structure of remuneration, the remuneration of specific functions, and variable remuneration. Highly specified and technical, they operate, in effect, as a manual on the design of remuneration policies and packages. 353 IFD Art 35 and IFR Art 34(2). Reforms are also envisaged under the CRD VI regime which will likely shape the IFD/​IFR (section 9.4.8). 354 Small and non-​interconnected firms (Class 3 firms) report on a less frequent cycle (annual rather than quarterly), are not subject to concentration risk reporting (being exempt from this regime) or, where an exemption to the liquidity regime has been granted by an NCA, to the liquidity reporting requirements. 355 A New European Prudential Framework for Investment Firms, Deutsche Bundesbank Monitoring Report, March 2021, 43.

IV.9  Prudential Regulation  413

IV.9.4  CRD IV/​CRR IV.9.4.1  Design Alongside, the behemoth CRD IV/​CRR regime (as revised by CRD V/​CRR 2) governs prudential requirements for the largest and most complex investment firms that pose the most significant risks to the financial system. CRD IV/​CRR, and its accompanying and vast administrative rulebook, is primarily concerned with bank solvency and with implementing Basel standards. It is, in its fundamentals and reflecting the Basel regime on which it is based, concerned with the prudential regulation of deposit-​taking credit institutions and covers own funds requirements for credit risk (calculated by reference to risk weighted assets (RWAs)); leverage restrictions; and liquidity/​funding requirements. But it also addresses a host of other prudential matters, including, of particular relevance for in-​scope investment services and activities, own funds and risk management requirements for market risk arising from the trading book. The CRD IV/​CRR regime is based on the three ‘Pillars’ of the Basel regime: Pillar 1—​capital/​ own funds requirements (including for credit, market, and operational risk), capital buffers, securitization-​specific requirements, clearing and over-​the-​counter (OTC) derivative-​related requirements, large exposures requirements, leverage and liquidity restrictions and requirements, and governance and risk management requirements; Pillar 2—​internal firm assessment of compliance with prudential requirements, including as regards own funds, and subsequent supervisory review by NCAs (the Supervisory Review and Evaluation Process (SREP)); and Pillar 3—​market disclosures (designed to support market oversight and discipline) and supervisory reporting. Specifically, CRD IV addresses access to the activity of credit institutions (and, accordingly, the authorization requirements that now apply to investment firms that are designated as credit institutions); ‘supervisory powers and tools for the prudential supervision of credit institutions by NCAs’ (in effect, the swathe of organizational and operational requirements that apply); the supervisory process; and publication requirements for NCAs (CRD IV Article 1). From an investment services/​activities perspective and as regards prudential regulation (and whether the relevant firm is designated as a credit institution or as an investment firm), the main features of CRD IV relate to initial capital, risk management processes (including as regards market risk), firm governance (including remuneration), and the SREP supervisory process. CRR addresses own funds requirements relating to ‘entirely quantifiable, uniform and standardized elements’ of credit risk, market risk, operational risk, settlement risk, and leverage; requirements limiting large exposures; liquidity requirements relating to ‘entirely quantifiable, uniform and standardized elements’ of liquidity risk; supervisory reporting; public disclosure; and the resolution-​related requirements that apply, in accordance with international standards, to global systemically important institutions (CRR Article 1). From an investment services/​activities perspective, the main features of CRR relate to the constituents of the own funds which can be used by firms to meet capital requirements (these also govern the IFD/​IFR own funds regime), the capital/​own funds requirements associated with risks other than core credit risk (in particular counterparty credit risk and market risk), liquidity requirements, and the reporting/​disclosure regime. The CRD IV/​CRR regime is vast (CRR alone runs to over 500 Articles; and the full CRD IV/​CRR package is amplified by over 100 separate administrative measures and supported

414  Investment Firms and Investment Services by extensive EBA soft law),356 highly technical (drilling deep into the workings of the risk management and capital planning systems of financial institutions), and imposes a level of harmonization unparalleled (even by MiFID II/​MiFIR) across EU financial regulation generally. It is considered here in outline only and as regards its implications for investment firm prudential regulation.357

IV.9.4.2 Scope and Investment Firms CRD IV/​CRR (as revised by CRD V/​CRR 2), while primarily associated with the prudential regulation of banks, also governs prudential regulation for a sub-​set of large, systemically significant investment firms. These investment firms fall into two classes: investment firms designated as ‘credit institutions’, who are authorized and regulated under CRD IV/​CRR (Class 1 investment firms) (alongside, these firms are also subject to MiFID II/​MiFIR);358 and certain other large investment firms (Class 1 Minus firms) who are authorized and regulated under MiFID II, but who are subject to CRD IV/​CRR as regards prudential regulation by means of the operation of the IFD/​IFR, their default prudential regulation regime. As regards Class 1 investment firms, the 2019 reorganization of the investment firm prudential regulation regime led to the largest and most systemically significant investment firms in the EU being recharacterized as ‘credit institutions’ and so authorized and regulated under CRD IV/​CRR.359 Previously, the CRD IV/​CRR regime had applied to all investment firms, albeit in a segmented manner. The 2019 reforms to investment firm prudential regulation led to most investment firms falling out of the CRD IV/​CRR regime and into the new IFD/​IFR regime. In parallel, the CRD IV/​CRR definition of ‘credit institution’ was revised by CRR 2 (in 2019) to include the largest and most complex investment firms which now fall fully into CRD IV/​CRR. Given the scale and complexity of their risk profiles, and their potential to generate financial stability risks, these firms are authorized, regulated, and supervised as credit institutions, albeit that aspects of the CRD IV/​CRR package, notably the own funds requirements for credit risk in relation to loan assets, will be less relevant (and, as credit institutions, these firms continue to be subject to MiFID II as regards their investment services/​activities). The test governing whether an investment firm is redesignated as a credit institution has quantitative (asset-​based) and qualitative (function-​based) elements. Under CRR Article 4(1) (as revised by CRR 2), the definition of a ‘credit institution’ has been expanded beyond deposit-​taking entities to include firms engaging in own-​account dealing or firm commitment underwriting/​placing (and that are not a commodity or emission allowance dealer,

356 The coverage of the administrative rulebook and the soft law ‘rulebook’ includes the constituents of own funds; own funds requirements and the related calculations for credit, market, counterparty, credit valuation adjustment, and operational risk; large exposures; liquidity risk; model validation; internal governance; executive remuneration; supervisory reporting; and the supervisory SREP process. 357 An extensive academic and policy literature considers the different elements of the regime and its implications for the EU and global financial systems, albeit primarily as regards its impact on bank prudential regulation. For a range of perspectives see, eg, Boosen et al, n 261; Feridun and Ozün, n 282; Amorello, L, ‘Europe Goes ‘Countercyclical’: A Legal Assessment of the New Countercyclical Dimension of the CRR/​CRD IV Package’ (2016) 17 EBOLR 137; Alexander, n 261; and Enriques, L and Zetsche, D, ‘Quack Corporate Governance, Round III? Bank Board Regulation under the New European Capital Requirement Directive’ (2015) 16 Theoretical Inquiries in L 211. 358 Although as ‘credit institutions’ they are only subject to specified provisions, primarily as regards operational and conduct of business regulation: section 5. 359 See section 9.2 on the context.

IV.9  Prudential Regulation  415 a collective investment undertaking, or an insurance undertaking) where the total value of the consolidated assets of the firm is equal to or exceeds €30 billion (assessment on an individual/​stand-​alone basis); or, alternatively, the total value of the assets of the firm is less than €30 billion, but the firm is part of a group in which the total value of the consolidated assets of all undertakings in that group that individually have total assets of less than €30 billion and that carry out own-​account dealing or underwriting/​placing is equal to or exceeds €30 billion (assessment on a combined basis). In both these cases, designation as a credit institution is mandatory. Investment firms can also be designated as credit institutions on the exercise of supervisory discretion: where the total value of the assets of the firm is less than €30 billion, and the firm is part of a group in which the total value of the consolidated assets of all undertakings in the group that carry out own-​account dealing or underwriting/​placing activities is equal to or exceeds EUR 30 billion (in effect, there are group entities that qualify as credit institutions), the relevant consolidating supervisor, in consultation with the relevant supervisory college, can decide to so designate the firm in order to address potential risks of circumvention and potential risks for the financial stability of the Union. On the coming into force of the CRD V/​CRR 2 revisions to CRD IV/​CRR in 2021, firms meeting these tests were (and will be as asset profiles change) required to be reauthorized as credit institutions under the CRD IV authorization process (previously, these firms were authorized under MiFID II).360 In addition, while these firms were already subject to much of CRD IV/​CRR, as investment firms engaging in own-​account dealing/​underwriting/​placing, they are now subject to all its requirements.361 In practice, this redesignation has had significant effects for the largest, most complex, and most systemically significant investment firms in the EU that extend beyond the application of the full weight of CRD IV/​CRR. The redesignation also has the effect of bringing these investment firms, where registered in a Member State participating in Banking Union, within Banking Union’s Single Supervisory Mechanism (SSM) which governs the supervision of credit institutions registered in a Member State that participates in Banking Union. Further, given the modalities that govern the operation of the SSM and the related competences of ECB Banking Supervision, including as direct banking supervisor of specified classes of credit institution within the SSM (in effect, ‘significant’ credit institutions: the largest credit institutions and those posing the highest level of financial stability risk), the redesignation has required that such investment firms be reauthorized as credit institutions by the ECB and come within direct ECB supervision.362 A major transition exercise

360 A grace period of one year was given to Class 1 firms from the 2021 application of the designation change (for firms which fall into Class 1 subsequently a one-​year grace period will be available from the point at which the firm meets the asset threshold). 361 eg, previously, national rules, supplemented by the LCR Delegated Regulation, applied as regards liquidity: Deutsche Bundesbank Monitor, n 355. 362 The €30 billion asset test governing redesignation as a credit institution also governs, in part, the extent to which the ECB has direct supervisory jurisdiction over ‘significant’ credit institutions within the SSM: SSM Regulation (EU) No 1024/​2013 [2013] OJ L287/​63 Art 6. On the approach taken by ECB Banking Supervision to the reauthorization process (which is initiated by the investment firm’s NCA but the responsibility of the ECB) see ECB Banking Supervision, Large investment firms: new license, new supervisor, Supervision Newsletter, 19 May 2021.The implications of this transfer of executive supervisory powers from NCAs to the ECB is outlined in brief in section 11.3 and in Ch I section 6.6.

416  Investment Firms and Investment Services was therefore required for the small number of investment firms redesignated as credit institutions.363 In addition, a sub-​set of investment firms (Class 1 Minus firms), which can be loosely categorized as large investment firms with consolidated assets in excess of €5 billion, and which either engage in own-​account dealing/​underwriting/​placing or are judged by their NCA to carry significant risks (see section 9.3), are subject to the CRD IV/​CRR regime, through the operation of the IFD/​IFR.364 As with the largest investment firms (now designated as credit institutions), these firms were already subject to much of CRD IV/​CRR but now are subject to its (more or less) full application. The treatment of both sets of firms (Class 1 and Class 1 Minus) under CRD IV/​CRR is not identical. Investment firms characterized as credit institutions (Class 1 firms) are authorized under CRD IV/​CRR (albeit subject to MiFID II as regards investment services/​ activities), may be supervised as credit institutions by the ECB within the SSM (where Banking Union’s arrangements apply), and are subject to a higher initial minimum capital requirement of €5 million. Class 1 Minus investment firms are authorized and supervised as investment firms by NCAs under MiFID II, are subject to the IFD/​IFR regime as their default prudential regime (albeit that CRD IV/​CRR applies to these firms by operation of the IFD/​IFR), are subject to the IFD rules on initial capital (which impose lighter requirements), and are supervised, as regards prudential regulation, by NCAs and within the IFD/​ IFR supervisory framework.

IV.9.4.3 Own Funds and Trading Book Risk The CRR own funds regime is the leviathan of EU financial regulation. It sets out extensive rules governing the composition of own funds (CRR Part Two) (which are reflected, in a slightly nuanced form, in the IFD/​IFR); and also the detailed calculations governing the own funds requirements that apply to credit risk (Part Three, Title II), operational risk (Part Three, Title III), market risk (Part Three, Title IV), settlement risk (Part Three, Title V), and credit valuation adjustment risk (Part Three, Title VI). All these risks are relevant to the most complex and largest investment firms within the scope of CRD IV/​CRR, but the market risk requirements, which apply to firms’ ‘trading book’ positions,365 are of central importance to these firms’ prudential risk management; the related risk measurement rules also apply, with some nuances, under IFD/​IFR. The original CRR own funds requirements for market risk were significantly reformed following the Basel FRTB process (section 9.2), by CRD V/​CRR 2, to become significantly more risk sensitive. The net effect of the reforms is that the CRR market risk rules now delineate much 363 The ECB estimated in 2021 that some 20 investment firms were expected to fall within the credit institution authorization requirement and reported that NCAs had informed the ECB of 11 authorization applications: ECB, Annual Report on Supervisory Activities (2021) para 2.2. 364 IFR Art 1(2) and (5); IFD Arts 2 and 5. 365 The pivotal ‘trading book’ concept is defined as all positions in financial instruments and commodities held with ‘trading intent’ (proprietary positions and positions arising from client servicing and market-​making; positions intended to be resold in the short term; or positions intended to benefit from actual or expected short-​term price differences between buying and selling prices or from other price or interest rate variations: Art 4(1)(85)) or to hedge positions held with trading intent, in accordance with the rules applicable to the management of the trading book which apply through Art 104 (Art 4(1)(86)). These rules cover the processes for determining inclusion in, and management of, the trading book, trading desk management requirements, prudent valuation, and hedging. The market risk rules also apply to banking book positions that are subject to foreign exchange and commodity risk (CRR Art 325).

IV.9  Prudential Regulation  417 more clearly the boundary between the trading book and the banking book;366 address the organization and regulation of firm trading desks as regards compliance with the market risk rules and as regards trading book management; and apply a strengthened and calibrated approach to the measurement of market risk and to the application of the related capital requirements. Two classes of approach can be used to measure market risk and to apply the related capital requirements; these approaches reflect the standardized/​internal-​ model-​based approaches used to calculate capital requirements under the Basel model generally, but are based on the Basel FRTB requirements, originally adopted in 2016 and finalized in 2019. The new ‘alternative standardized’ approach for assessing market risk capital requirements,367 which is used by most firms,368 is complex but it is significantly more risk sensitive than the previous standardized approach. It is, relatedly, better aligned to firms’ risk management practices, being more sensitive to changes in market risk factors (including interest rates and credit spreads) as well as to the hedging and diversification techniques used by firms. Firms can, alternatively, choose to use the ‘alternative internal model’ approach. This approach is based on the use of internal firm models to quantify risk and the related capital requirements and requires NCA approval, which is contingent on the firm’s compliance with a series of quantitative and qualitative model-​related conditions and also independent validation requirements. The application of the new market risk regime has been staggered. The original CRD V/​ CRR 2 Proposal envisaged the imposition of a binding capital requirement for own funds as regards market risk and under the FRTB rules, but the FRTB timetable and the subsequent review of the 2016 FRTB standards (which completed in 2019) led to the CRD V/​CRR 2 reforms ultimately using the new FRTB approach only for market risk reporting, and not for the calculation and application of capital requirements. The 2021 CRD VI/​CRR 3 Proposal sets out the proposed binding capital requirement for market risk, but it also refines the related measurement and calculation process to take account of the 2019 FTRB revisions. The market risk regime accordingly remains in a state of flux that reflects its novelty but also the material costs it represents for the industry. The Commission has underlined that its proposals remain somewhat contingent as they may be revised to reflect how other jurisdictions apply the Basel FRTB standards.369 Market/​trading book risk is also addressed across the other heads of risk covered by the CRR, including credit risk. ‘Counterparty credit risk’ (or the risk of a counterparty to a transaction defaulting before final settlement), for example, is subject to a discrete capital requirement, the calculation of which takes account of the impact of diversification, hedging, collateral, and netting. Further, the capital charge for ‘credit valuation adjustment’ (CVA) risk (originally introduced under CRD IV/​CRR and being refined by the CRD VI/​ CRR 3 Proposal to reflect Basel III/​IV reforms) is also significant for trading book activities. It is designed to capture the risk associated with a deterioration in the creditworthiness of a counterparty; such a deterioration can have material systemic implications when related 366 CRR Arts 102–​106. 367 The additional ‘simplified standardized’ approach applies a simplified regime to firms with small trading books (under €50 million and less than 3 per cent of total assets) and a proportionate regime to medium-​sized trading books (under €300 million and less than 10 per cent of assets). 368 ECB Banking Supervision, Market Risk: new reporting requirements to start in 2021 (2020). 369 2021 CRD VI/​CRR 3 Q&A, n 291.

418  Investment Firms and Investment Services ratings downgrades and consequent capital adjustments occur. As the financial crisis revealed, CVA risk is particularly acute with respect to OTC derivatives. The CVA capital regime accordingly applies a capital charge to these instruments and related activities.

IV.9.4.4 Large Exposures, Liquidity, and Leverage The CRR regime, reflecting a longstanding element of bank prudential regulation, addresses ‘large exposures’,370 imposing related reporting requirements, exposure limits, and, for trading book exposures, own funds requirements (CRR Part Four). Liquidity management is a newer element of the regime and was originally introduced by CRD IV/​CRR (which reflected the related Basel III reforms). Following the CRD V/​CRR 2 reforms, CRR Part Five now governs the liquidity coverage requirement (LCR), which is designed to support short-​term liquidity resilience; the net stable funding requirement (NSFR), which is designed to ensure an institution has an acceptable amount of stable funding over a one-​year period; and related liquidity and stable funding reporting.371 These requirements are designed to ensure that institutions manage their cash flows and liquidity effectively and can better predict liquidity requirements and respond to liquidity strains. They are particularly concerned with banks’ ability to manage deposit outflows in a stressed environment. The leverage ratio (LR) is also a newer element of the regime and was originally introduced in the form of a reporting requirement under CRD IV/​CRR (reflecting Basel III) and adopted as a binding ratio following the CRD V/​CRR 2 reforms.372 It is designed to restrict the build-​up of excessive leverage and operates as a backstop against failure of the risk models on which credit risk assessments are made, and against any related gaming by institutions. The LR is governed by CRR Part Six, which also includes detailed rules on the calculation of exposure values, including as regards derivatives. IV.9.4.5 Organizational Requirements and Risk Management Extensive risk management requirements apply through the CRR regime but also through the organizational requirements mandated by CRD IV (as revised by CRD V). As well as high-​level requirements relating to robust internal governance (Article 74), risk governance and the role of the management body (Article 76), and internal capital adequacy assessment processes (Article 73),373 CRD IV imposes specific requirements as regards the calculation of own funds and in relation to credit and counterparty, residual, concentration, securitization, market, interest rate, operational, liquidity, and leverage risk (Articles 73-​87).

370 These constitute exposures to a client, or group of connected clients, equal to or in excess of 10 per cent of the firm’s Tier 1 capital: a 25 per cent of own funds limit applies to such exposures. 371 The LCR (a Basel III reform agreed in 2013) is concerned with assets. It requires firms to hold liquid assets (as defined by the LCR Delegated Regulation: n 340) so that they have a sufficient liquidity buffer in place to address liquidity imbalances in ‘gravely stressed conditions’ over a thirty-​day period. The NSFR (a Basel III reform agreed in 2014 and implemented by the CRD V/​CRR 2 reforms, having initially been addressed in CRD IV/​CRR by means of a reporting requirement) is concerned with liabilities. It is designed to ensure that firms can meet their funding requirements with a diverse set of funding instruments that are stable in normal and stressed conditions. 372 A binding LR of 3 per cent of non-​risk-​weighted assets applies. 373 These high-​level organizational requirements are reflected in the parallel requirements applicable under the IFD (see section 9.3).

IV.9  Prudential Regulation  419

IV.9.4.6 Firm Governance and Executive Remuneration One of the major reforms to prudential regulation introduced by CRD IV/​CRR over the financial-​crisis era concerned firm governance374 and the related imposition of requirements as regards governance structures, the fitness, probity, and competence of management body (board) members and senior management, executive remuneration, and the clear attribution of responsibility to directors and senior management.375 These reforms were not a function of the Basel process, being EU-​specific.376 Traditionally, corporate governance structures and practices have been deployed to improve interest alignment between shareholders and management in firms, and to address related agency costs; they have typically been a function of corporate law, corporate governance codes, and the admission of securities to trading and related admission requirements. The financial crisis led to corporate governance being redeployed as part of EU prudential regulation in order to respond to the systemic risks posed by financial institutions and, relatedly, to align the interests of a wider set of stakeholders beyond shareholders (including debt-​holders)377 with those of management, and to drive a more risk-​sensitive culture.378 This re-​tooling of corporate governance to serve regulatory outcomes was at the time, and remains, contested. The wide-​ranging debate canvasses, for example, whether the empirical evidence suggested major failures of corporate governance over the financial-​crisis era; the extent to which regulation can effectively deploy corporate governance tools, given the linkage between the particular corporate governance structures used within firms and firms’ specificities, operating models, and wider governance environments; the potential disruption caused by ‘one size fits all’ models; and the appropriate role of corporate governance reform, given its shareholder orientation, in managing risk.379 The regulatory

374 Previously, governance requirements for financial institutions had primarily been a function of the EU’s corporate governance regime for listed companies. See, eg, Moloney, N, Ferrarini, G, and Ungureanu, MC, ‘Executive Remuneration in Crisis’ (2010) 10 JCLS 73. 375 For reviews of the financial-​crisis-​era reforms as regards firm governance see Cheffins, B, ‘The Corporate Governance Movement, Banks, and the Financial Crisis’ (2015) 16 Theoretical Inquiries in L 1 and Hopt, K, ‘Better Governance of Financial Institutions’ in Ferrarini, G, Hopt, K, and Wymeersch, E (eds), Financial Regulation and Supervision. A Post-​Crisis Analysis (2013) 337. 376 The Basel Committee did, however, adopt high-​level principles in 2010, designed to address what it identified as corporate governance failures and lapses, including in relation to insufficient board oversight of management, and covering board practices and remuneration: Principles for Enhancing Corporate Governance (2010). Since then, the international reform movement has tilted more sharply to addressing governance issues, including as part of the wider reform agenda on conduct and culture. See, eg, FSB, Strengthening Governance Frameworks to Mitigate Misconduct Risks (2018). 377 In effect, ‘debt governance’, associated with banks in particular, came to the fore. Debt governance is associated with aligning management interests with those of, eg, bond-​holders and depositors, and with a lower tolerance for risk. On the related ‘specialness’ of bank governance structures given systemic risks see, eg, Macey, J and O Hara, M, ‘The Corporate Governance of Banks’ April (2013) Federal Reserve Bank of New York Economic Policy Rev 91. 378 The determinants of firm culture are, however, elusive, and the extent to which mandated corporate governance requirements can construct and maintain a desired culture unclear. From an extensive literature see Alexander, n 239; Lo, A, ‘The Gordon Gekko Effect: The Role of Culture in the Financial Industry’ (2016) August Economic Policy Review 17; and Kershaw, D and Awrey, D, ‘Towards a More Ethical Culture in Finance: Regulatory and Governance Strategies’ in Morris, N and Vines, D (eds), Capital Failure: Rebuilding Trust in Finance (2014) 277. 379 From an extensive literature, and from financial-​crisis era and post-​crisis perspectives, see, eg, Hopt, K, ‘Corporate Governance of Banks and Financial Institutions: Economic Theory, Supervisory Practice, Evidence and Policy’ (2021) 22 EBOLR 13; Enriques and Zetsche, n 357; Armour J and Gordon, J, ‘Systemic Harms and Shareholder Value’ (2014) J of Legal Analysis 35; Hopt, K, ‘Corporate Governance of Banks and other Financial Institutions after the Financial Crisis’ (2013) 13 JCLS 219; and Mülbert, P, ‘Corporate Governance of Banks’ (2009) 15 EBOLR 411.

420  Investment Firms and Investment Services prescription and supervision of firm governance arrangements has, however, since become embedded within prudential regulation. The governance arrangements required of credit institutions (including the Class 1 investment firms that fall within this definition) and of Class 1 Minus investment firms are set out in CRD IV. The foundational elements of this regime, Articles 88 and 91, also apply directly to all investment firms, being incorporated into MiFID II Article 9 (section 7.2). The CRD IV regime addresses management body380 composition and functioning in detail in order to support oversight of risk management and to reduce the incidence of excessive risk-​taking; and also, and relatedly, addresses executive remuneration policy and practices. Wide-​ranging and granular, the regime is calibrated in places to apply proportionately and to reflect firms’ different operating environments. Under Article 88(1), the core obligation requires the management body to define, oversee, and be accountable for the implementation of the governance arrangements that ensure the effective and prudent management of an institution, including the segregation of duties in the organization and the prevention of conflicts of interest. These arrangements must comply with a number of principles: the management body must have overall responsibility for the institution, and approve and oversee the implementation of the institution’s strategic objectives, risk strategy, and internal governance; it must ensure the integrity of accounting and financial reporting systems (including financial and operational controls and compliance with the law and relevant standards); it must oversee the process of disclosure and communications; and it must be responsible for providing effective oversight of senior management. The management body must also monitor and periodically assess the effectiveness of the institution’s governance arrangements and take appropriate remedial steps. Specific organizational requirements designed to enhance management body effectiveness apply under Article 88. The chairman of the management body (in its supervisory function, where the function of the body is split, as under the two-​tier board system) must not exercise simultaneously the functions of a chief executive officer within the same institution (unless justified by the institution and authorized by the NCA) (Article 88(1)).381 A nomination committee is required, but only for institutions which are significant in terms of size, internal organization, and the nature, scope, and complexity of their activities (Article 88(2)).382 Article 91 addresses the composition and competence of the management body in detail and the related ‘fit and proper’ requirements, including as regards the good reputation, honesty, integrity and independence, and also skills and experience of members; members’ ability to understand the firm’s activities and risks; members’ obligation to challenge management; board diversity; and the powers of NCAs to remove management body

380 The management body is the body (or bodies), appointed in accordance with national law, and empowered to set the institution’s strategy, objectives, and overall direction, which oversees and monitors management decision-​ making, and which includes the persons who effectively direct the business of the institution: Art 4(1)(7). 381 A CRD V reform, designed to address conflicts of interests, requires that data on loans to members of the management body (and related parties, including family members and companies in which the member has a 10 per cent holding) are properly documented and made available to NCAs on request (Art 88(1)). 382 The functions of the nomination committee are specified in some detail under Art 88(2), which requires the nomination committee to identify and recommend candidates for the management body, but also periodically (and at least annually) to assess the structure, size, composition, and performance of the management body and to make recommendations for any changes to the management body, as well as to assess the knowledge, skills, and experience of individual board members and of the management body collectively.

IV.9  Prudential Regulation  421 members.383 Capacity-​related conditions also apply, including as regards limits on the number of directorships that can be undertaken by management board members.384 The 2021 CRD VI/​CRR 3 Proposal reform package proposed a significant strengthening of these requirements, albeit that the reforms are closely based on the extensive EBA/​ESMA Guidelines that have amplified how the firm governance regime is supervised by NCAs.385 The reforms are primarily directed to oversight, setting out a legislative framework governing the role of firms and of NCAs in ensuring compliance with the ‘fit and proper’ requirements, but also establishing a new ‘fit and proper’ regime for ‘key function holders’ below board level386 and related firm and NCA oversight arrangements. One of the most distinctive features of the EU’s prudential regime relates to its prescriptive regulation of executive remuneration. The executive remuneration requirements were originally adopted under the financial-​crisis era 2010 ‘CRD III’ reforms387 (the influential CRD III reforms also shaped the executive remuneration requirements adopted under the AIFMD and UCITS regimes), folded into the 2013 CRD IV (which also introduced the highly contested ‘bonus cap’), and nuanced by the 2019 CRD V reforms (including to provide greater flexibility for smaller firms). The CRD IV requirements, and also their CRD III antecedents, were controversial at the time of their adoption. They reflected the prevailing concern across the financial-​crisis-​era reform programme to promote stronger risk-​ management practices and more effective risk-​management incentives,388 but were also shaped by a febrile debate on perceived excesses in ‘bankers’ pay’ and, in particular, by the strong concern of the European Parliament to impose limits on variable pay. The extent to which disclosure, governance, and substantive remuneration design requirements should be deployed in service of prudential regulation outcomes was, however, at the time, and remains, highly contested.389 At the core of the executive remuneration regime (Article 92) is the requirement that firms comply (in a manner and to the extent appropriate to their size, internal organization, and the nature, scope, and complexity of their activities) with a series of specified principles when establishing and applying the ‘total remuneration’ policies (inclusive of salaries and discretionary pension benefits) for particular categories of staff whose professional 383 Article 91 has been strengthened from its original CRD IV iteration, including as regards specifying that primary responsibility for ensuring that members of the management body are of sufficiently good repute, and have sufficient competence, lies with the firm. 384 Members of the management body of an institution that is significant in terms of size, internal organization, and the nature, scope, and complexity of its activities, must not hold more than one of the following combinations of directorships at the same time: one executive directorship with two non-​executive directorships; or four non-​ executive directorships. 385 n 191. 386 The reform is designed to capture persons who have significant influence on the direction of the firm but are not members of the management body, including the CFO and heads of internal control functions. 387 The CRD III reforms were adopted at the height of the financial crisis under Directive 2010/​76/​EU [2010] OJ L329/​3 (CRD III). The Directive introduced the detailed remuneration principles (including as regards variable remuneration) now contained in CRD IV. For discussion of the context see, eg, Ferran, E, ‘New Regulation of Remuneration in the Financial Sector in the EU’ (2012) 9 ECFR 1. 388 Internationally coordinated reform of remuneration practices was identified as a priority by the London April 2009 G20 Summit and subsequently pursued by the FSB through its Principles for Sound Compensation Practices (2009) which are regularly reviewed (see recently FSB Effective Implementation of FSB Principles for Sound Compensation Practices and Implementation Standards. 2021 Progress Report (2021)). 389 The role of remuneration regulation in supporting financial stability was extensively examined in the financial-​crisis-​era literature. See, eg: Ferran, n 387; Ferrarini, G and Ungureanu, MC, ‘Economics, Politics, and the International Principles for Sound Compensation Practices’ (2011) 64 Vanderbilt LR 431; and Bebchuk, L and Spamann, H, ‘Regulating Bankers’ Pay’ (2010) 98 Georgetown LJ 247.

422  Investment Firms and Investment Services activities have a material impact on the firm’s risk profile, including senior management and staff engaged in the management of control functions or material business units. Remuneration governance is also addressed: where a firm is significant in terms of its size and internal organization, and the nature, scope, and complexity of its activities, it must establish a remuneration committee responsible for remuneration decisions (Article 95). The extensive Article 92 principles, based on the 2010 CRD III reforms, are designed to ensure that remuneration policies and practices do not lead to excessive risk taking and are subject to robust oversight. They require that: the institution’s remuneration policy is consistent with and promotes sound and effective risk-​management and does not encourage risk-​taking that exceeds the level of tolerated risk of the institution; the policy is in line with the institution’s business strategy, objectives, values, and long-​term interests, and incorporates measures to avoid conflicts of interests; the management body adopts and periodically reviews the general principles of the remuneration policy and is responsible for overseeing its implementation; the implementation of the policy is subject to central and independent internal review; staff engaged in control functions are independent from the business units they oversee, have appropriate authority, and are remunerated in accordance with achievement of the objectives linked to their functions, independent of the performance of the business areas they control; the remuneration of the senior officers in the risk-​management and compliance function is overseen by the remuneration committee (or the management body where a committee is not established); and the remuneration policy, taking into account national criteria on wage setting, makes a clear distinction between criteria for fixing basic remuneration (which should primarily reflect relevant professional expertise and organizational responsibility) and variable remuneration (which should reflect a sustainable and risk-​adjusted performance, as well as performance in excess of that required to fulfil the employee’s job description). Like the governance regime generally, diversity objectives are also addressed.390 The CRD IV remuneration regime is strongly associated with the constraints it places (based on the CRD III reforms) on variable remuneration and which are designed to reduce incentives for excessive risk-​taking (Article 94). These include: the requirement that performance-​related remuneration be based on a combined assessment of the performance of the individual, the business unit, and the firm; the requirement that performance assessments be set in a multi-​year framework; the highly contested ratio rule (‘bonus cap’),391 introduced by CRD IV and which requires that the variable component of remuneration cannot exceed 100 per cent of the fixed component of total remuneration for each individual;392 the requirement that at least 50 per cent of variable remuneration take the form of shares or equivalent ownership interests; the requirement that a substantial portion, and at least 40 per cent, of variable pay be deferred, for not less than three to five years; the 390 In a CRD V addition, remuneration policy must be gender neutral. 391 Prominent critics included Bank of England Governor Carney, who criticized the cap as adopting the wrong approach to the support of financial stability: Pickard, J, Goff, S, and Fleming, S, ‘BoE Chief Deals Blow to Miliband on Bonuses’, Financial Times, 16 January 2014. 392 The cap can be raised to 200 per cent, but a series of conditions apply, including with respect to NCA notification and shareholder approval. The cap, introduced by the European Parliament, was heavily resisted by the UK, which was reported to be in a minority of one in the final Council negotiations: Barber, A, Fontanella-​Khan, J, and Parker, G, ‘Brussels Deals Rare Blow to City on Bonuses’, Financial Times, 28 March 2013. In 2013, the UK launched a challenge to the cap before the European Court of Justice (Case C-​507/​13 UK v Parliament and Council (ECLI:EU:C:2014:248)) which it ultimately abandoned following the Advocate General’s November 2014 dismissal of its claim.

IV.9  Prudential Regulation  423 direction that all variable remuneration be subject to claw-​backs;393 and the requirement that variable remuneration (including deferred remuneration) vest only if it is sustainable according to the financial situation of the institution as a whole. The variable remuneration regime, despite the controversy that attended its adoption (across CRD III and CRD IV), remains largely as adopted by CRD IV, apart from, and reflecting significant disquiet at the difficulties the more prescriptive requirements posed for smaller firms, a finessing of the rules by CRD V to provide exemptions for smaller firms with assets equal or less than €5 billion (and for individuals whose variable remuneration does not exceed €50,000), in particular as regards the payment in shares and deferral of variable remuneration requirements. This mitigation followed difficulties with the extent to which the governance regime’s framing proportionality principle (which allows the tailoring of the application of the rules in a manner appropriate to a firm’s size, internal organization, and nature, scope, and complexity of its activities (Article 91)) could moderate the executive remuneration rules in practice.394 As the executive remuneration rules were implemented, the application of the proportionality principle became contested within EBA, with some NCAs supporting an application of the principle which could lead to the full dis-​application of certain remuneration requirements for particular firms, notably smaller and non-​complex firms.395 EBA’s 2015 Guidelines on the remuneration regime,396 however, adopted the position, reflecting the Commission’s view, that the proportionality principle, as expressed in Article 91, could not lead to a complete dis-​application/​waiver of specific remuneration requirements,397 albeit that EBA also warned of the difficulties the executive remuneration regime was generating and called for reform,398 which would follow with CRD V. A series of related supervisory reporting obligations also apply, including that NCAs benchmark remuneration trends and practices and collect data on the number of natural persons per institution that are remunerated by €1 million or more per financial year, data which is aggregated and reported by EBA.

IV.9.4.7 Supervisory Reporting and Public Disclosure Extensive ‘Pillar 3’ public disclosure and supervisory reporting requirements also apply across CRD IV/​CRR. The public reporting regime, designed to support market monitoring, is extensive, but it is dwarfed by the massive supervisory reporting regime on risks and their management, 393 The criteria for ‘claw-​back’ must include where the staff member participated in or was responsible for conduct which resulted in significant losses to the institution or failed to meet appropriate standards of fitness and propriety. 394 The over-​arching Art 74 requirement for robust firm governance arrangements also provides that related arrangements must be proportionate to the nature, scale, and complexity of the risks from the institution’s business model and activities (Art 74(2)). 395 EBA, Letter to the Commission, 8 January 2015, requesting clarification from the Commission as to whether the application of a proportionate approach could imply the full dis-​application of a rule. EBA highlighted the difficulties caused for smaller and non-​complex institutions by the deferral, payment in instruments (shares), and claw-​back aspects of the variable remuneration rules in particular, and suggested that dis-​application was justified for certain smaller and non-​complex institutions which paid limited variable remuneration and where there were almost no incentives to take excessive risks. 396 EBA, Guidelines on Sound Remuneration Policies under CRD IV (2015). 397 Commission, Letter to EBA, 23 February 2015. The Commission stated that general principles could not be used to justify the non-​application of rules, and that only the co-​legislators could revise the legislative framework. 398 EBA, December 2015 Opinion on the Application of Proportionality (2015).

424  Investment Firms and Investment Services in relation to which ‘FINREP’ (financial reporting) addresses financial reporting for supervisory purposes, and ‘COREP’ (reporting on risks and capital requirements) addresses supervisory reporting relating to capital.399 The CRD V/​CRR 2 reforms refined this regime to apply proportionately to small and non-​complex firms.400 As part of the wider efforts to centralize public reporting,401 the 2021 CRD VI/​CRR 3 proposals provide for reporting to be streamlined and published through a Single Access Point managed by EBA.

IV.9.4.8 Sustainability-​related Risks The management of sustainability risks through prudential regulation402 is currently evolving, reflecting international developments.403 The CRD IV/​CRR package laid the foundations, imposing ESG-​related risk disclosure requirements and requiring EBA to assess how ESG considerations could be incorporated in the supervisory SREP. While ESG-​ related risks are now incorporated in supervision,404 a step-​change is envisaged with the 2021 CRD VI/​CRR 3 proposals, which are designed to support the Sustainable Finance Strategy, and which seek to embed the management of sustainability risks, including by fine-​tuning the foundational capital assessment (CRD IV Article 73), internal governance (Article 74), and board oversight of risk management (Article 76) requirements to reflect ESG risk management.405 The reforms would also introduce a new, specific obligation on firms to identify, measure, manage, and monitor, through robust governance systems, ESG risks; expand related disclosure requirements; and specify that ESG risks be included in the SREP process (with related EBA Guidelines to follow), including as regards stress testing. It remains to be seen whether more intrusive intervention will follow in the form of specific capital requirements, with EBA charged with assessing whether capital requirements should be calibrated to reflect the sustainability impact of assets.406 399 The FINREP and COREP reporting scheme is of immense breadth and detail and is governed by extensive administrative rules which cover, eg, format, frequency, standardized templates, required data points, and validation models. 400 In effect, in-​scope firms with assets of less than €5 billion are subject to a proportionate regime. 401 See Ch II on the Single Electronic Access Point project. 402 The prudential management of ESG, and particularly climate-​related, risks is at an early stage within regulated firms, reflecting, in part, the significant risk-​modelling challenges (including as regards the impact on credit risk) which flow from the lack of reliable longitudinal data on which models can be based. The ECB adopted its Guide on Climate-​related and Environmental Risks in 2020, which addresses supervisory expectations as regards risk management and disclosure. It has since reported on banks’ approaches to managing climate and environmental risk, finding initially that ‘none of the institutions are close to fully aligning their practices with the supervisory expectations’, but acknowledging the challenges: ECB, The State of Climate and Environmental Risk Management in the Banking Sector (2021). Its subsequent 2022 thematic review of bank practices was similar in tone, acknowledging improvements, including as regards capacity building, but finding that nearly all the banks reviewed needed to make ‘far-​reaching and enduring efforts’ to develop ‘consequential, granular, and forward-​looking’ approaches to manage climate and environmental risks: ECB, Walking the Talk: Results of the 2022 Thematic Review on Climate-​Related and Environmental Risks (2022). The ECB also reports on disclosure practices, finding in 2022 that disclosures were improving but that further improvements were needed: ECB, Supervisory Assessment of Institutions’ Climate-​related and Environmental Risks Disclosures (2022). 403 The Basel Committee has adopted related principles, which include that banks assess the materiality of climate risks and their business model impact, and that climate risks be incorporated into internal capital and liquidity assessment processes: Principles for the Effective Management and Supervision of Climate-​related Risks (2022). 404 See n 402 as regards the SSM. 405 Through the CRD VI Proposal: n 285. 406 EBA’s initial assessment suggested that specific capital/​own funds treatment for exposures associated with environmental risks was best achieved through adjustments to the current CRD IV/​CRR/​IFD/​IFR framework, given the uncertainties and complexities associated with developing specific risk-​weighted adjustments: EBA, The Role of Environmental Risks in the Prudential Framework (2022). ESG risks can also be addressed through the

IV.10  The Passport for Investment Services and Activities  425

IV.10  The Passport for Investment Services and Activities IV.10.1  Passport Rights and the Home NCA Home NCA authorization supports mutual recognition by the host NCA407 and, relatedly, the MiFID II passport which is conferred by MiFID II Articles 34 and 35 and in relation to the services and activities covered by the authorization.408 Article 34 addresses cross-​border market access through services provision. It requires that Member States must ensure that any investment firms authorized and supervised by the NCA of another Member State, in accordance with MiFID II (and credit institutions, also including investment firms so designated, authorized under the CRD IV regime), may freely perform investment services and/​or activities, as well as ancillary services, within their territories, as long as such services and activities are covered by the authorization (Article 34(1)).409 Mutual recognition and related home Member State/​NCA control is at the heart of Article 34(1) which provides that Member States may not impose any additional requirements on such investment firms or credit institutions in respect of the matters covered by MiFID II. Article 35 governs the right of establishment, whether through a branch410 or a tied agent. While very similar to the Article 34 services passport (and applicable also to credit institutions), the Article 35 establishment passport is more restrictive given the oversight powers conferred on host NCAs over branches (Article 35(8)), as noted below. Home State control is reinforced by Article 21 which requires that Member States must require that investment firms authorized in their territory comply at all times with the authorization requirements, including the Article 16 organizational requirements; Article 16 similarly expressly reserves compliance with its requirements to the home Member State. The jurisdiction-​allocation clause for MiFID II’s other operating requirements is not made similarly express, but home Member State control is implicit in Articles 34 and 35. The position with respect to conduct-​of-​business regulation is different. It stays with the home Member State for services but moves to the branch Member State for branches. The extent of the harmonization of conduct regulation means that differences between the home and host regime are likely to arise only with respect to supervisory techniques and enforcement strategies, and even here ESMA’s supervisory convergence powers are likely to minimize material divergences.

CRR’s macroprudential systemic risk buffer (CRR Art 133), as underlined by the Commission in the 2021 CRD VI Proposal. 407 Defined as the Member State, other than the home Member State, in which an investment firm has a branch or performs services and/​or activities: Art 4(1)(56). 408 Where an investment firm uses a subsidiary to operate cross-​border it does not benefit from passporting and must be authorized by the subsidiary’s home NCA, although the NCA must consult with the NCAs of the parent undertaking’s home Member State under Art 84. 409 Reflecting Art 6(1), ancillary services may only be provided together with a core activity or service (Art 34(1)). 410 A place of business other than the head office which is a part of an investment firm, which has no legal personality, and which provides investment services and/​or activities (it may also perform ancillary services for which the firm has been authorized): Art 4(1)(30). All places of business set up in the same Member State by an investment firm with headquarters in another Member State are regarded as forming a single branch.

426  Investment Firms and Investment Services

IV.10.2  Host Control and the Host NCA The MiFID II passporting system is designed to oust the host NCA from supervision of cross-​border investment services provision/​conduct of investment activities (save as regards branches and conduct regulation), but precautionary powers remain with the host NCA (as they do across the single rulebook). Article 86(1) confers wide-​ranging precautionary powers on host NCAs, but also delineates the grounds on which these powers can be used, using an escalation-​based approach. Where a host NCA has ‘clear and demonstrable’ grounds411 for believing that an investment firm, acting in its territory under the freedom to provide services, is in breach of MiFID II obligations, or that a firm with a branch in its territory is in breach of MiFID II obligations which do not confer power on the host NCA, it must refer those findings to the home NCA. If, despite the measures taken by the home NCA (or where such measures prove inadequate), the firm persists in acting in a manner that is clearly prejudicial to the interests of host Member State investors or to the orderly functioning of markets, the host NCA may, after informing the home NCA, ‘take all appropriate measures’ (which can include preventing the firm from initiating any further transactions within the host State’s territory) in order to protect investors and the proper functioning of the markets. These measures, in an indication of the risk these powers pose to home Member State control and to the MiFID II passport, must be notified to the Commission and ESMA without undue delay; ESMA can also exercise its mediation powers where the host NCA refers the issue in question to ESMA binding mediation. The passporting branch NCA also has oversight of the branch’s compliance with (broadly) conduct regulation (Article 35(8)).412 This allocation of supervisory jurisdiction represents a significant incursion into the home NCA model which otherwise governs supervision (although it is one of longstanding, being introduced by MiFID I). It reflects the greater integration of branches into the local host economy, a privileging of conduct regulation (which is at the sharp edge of investor protection), and the strong incentives the branch NCA has to ensure effective supervision of the branch, given the NCA’s exposure were local investors to suffer detriment. Under Article 35(8), the NCA of the Member State in which the passporting branch is located has responsibility for ensuring that all services provided by the branch within its territory comply with the Article 24 and 25 conduct rules and Article 27 and 28 order handling/​best execution rules (as well as with the MiFIR rules governing investment firm transaction reporting and trade transparency), as well as with any additional domestic ‘gold-​plating’ rules adopted under Article 24(12).413 The branch NCA also enjoys the right to examine branch arrangements and to request such changes as are ‘strictly needed’ to enforce these obligations with respect to the services and/​or activities provided by the branch within its territory (Article 35(8)). The home NCA must, 411 NCAs have called for a lessening of this threshold to ‘reasonable grounds’, reflecting the slight but discernible pressure on the passporting model that is beginning to emerge (section 7.1): ESMA, Technical Advice to the Commission on the Application of Administrative and Criminal Sanctions under MiFID II/​MiFIR (2021). 412 Host NCAs may also, for statistical purposes, require all investment firms with branches in their territories to report to them periodically on branch activities (Art 85(1)). Host NCAs may also require branches to provide the information necessary for the monitoring of their compliance with host rules applicable under Article 35(8) (Art 85(2)). 413 As outlined in section 4, Member States may, exceptionally, adopt appropriately justified rules additional to the conduct rules set out in Art 24.

IV.10  The Passport for Investment Services and Activities  427 however, be permitted to carry out on-​site branch inspections (in the exercise of its responsibilities and after informing the host NCA) (Article 35(9)). Although organizational requirements are reserved to the home Member State/​NCA (Article 16(1)), the branch NCA is empowered to enforce the Article 16 record-​keeping obligation, with respect to transactions undertaken by the branch, without prejudice to the possibility of the home NCA having direct access to those records (Article 16(11)). Article 86(2) deals with the branch NCA’s related enforcement powers through a system of escalating powers. Where the host NCA finds that a firm with a branch in its territory is in breach of the host State’s rules adopted under MiFID II and which it may apply to branches, the NCA must require the firm to ‘put an end to its irregular situation’. If the firm fails to take the necessary steps, the host NCA must take all ‘appropriate measures’ to ensure this ends and communicate those measures to the home NCA. But if, despite those measures, the firm persists in its breach, the host NCA may, after informing the Commission and ESMA (without undue delay), take all the appropriate measures needed in order to protect investors and the proper functioning of the markets. The host NCA may also refer the matter to ESMA for binding mediation.414

IV.10.3  The Notification Process As across the single rulebook, a passporting notification system supports the intra-​NCA trust, and the home NCA supervisory effectiveness, on which the passport depends. The notification system is designed to ensure that home NCAs are informed as to the cross-​ border activities undertaken by the investment firms which they have authorized; and to alert host NCAs and thereby support their exercise of precautionary powers and, where relevant, their oversight of branches.415 The notification process is the responsibility of the home NCA which can also and relatedly block the exercise of passport rights, although only as regards branch establishment. The host NCA cannot block access by the investment firm and is not an operative part of the notification process. As regard cross-​border services, where an investment firm416 wishes to provide services or conduct activities within another Member State for the first time (or wishes to change the range of passported services/​activities), it must communicate to the home NCA the Member State in question, the programme of operations intended, and whether it will provide services through tied agents established in the home State (Article 34(2)).417 The 414 Early in the application of MiFID I, difficulties arose as to the extent to which the branch NCA or the home NCA supervised cross-​border services carried out from the branch and led to Commission guidance (Commission, Supervision of Branches under MiFID (2007)). The guidance clarified that where both the branch through which the service was provided and the client were in the host Member State, supervisory responsibility was to be allocated to the branch NCA; where the client was in the home Member State, the home NCA was to be allocated supervisory responsibility; and, in other ‘grey areas’ responsibility was to be decided through NCA coordination (where, eg, the client was not in either the host or home Member State, or where parts of a service were carried out across different Member States (through outsourcing, eg)). CESR established a related Branch Protocol for supporting NCA coordination (CESR, Protocol on the Supervision of Branches under MiFID (2007)). 415 In its guidance on the MiFID I passport, CESR underlined that it was important that the host NCA be ‘put on notice’ as to the firm’s activities and ‘ha[ve] the comfort that the home Member State knows that this is the case’: CESR, MiFID Passport Guidance (2007). 416 These requirements do not apply to credit institutions (including investment firms designed as credit institutions) who are subject to the CRD IV notification process. 417 Additional information requirements apply where the firm intends to use tied agents. Art 34(5) applies these requirements to credit institutions where relevant as the CRD IV notification system does not cover tied agents.

428  Investment Firms and Investment Services process is designed to be expeditious. Within one month of receiving the required information, the home NCA must forward it to the host NCA, following which the investment firm can provide the investment service(s) in the host Member State (Article 34(3)). The provision of cross-​border services is not accordingly automatic: it depends on the notification being transmitted to the host NCA by the home NCA. The transmission obligation is, however, cast in mandatory terms,418 and MiFID II does not provide grounds under which a home NCA can refuse to transmit the notification—​the position is different for branches. Similar but more intensive procedures apply to the cross-​border establishment of a branch.419 Here the notification serves two purposes, given the split of responsibility between the host and home NCAs as regards branches: it alerts the host NCA to the activities of the branch and the triggering of its supervisory responsibilities; and it supports the home NCA in supervising the branch as regards the requirements under its default jurisdiction as home NCA. Where an investment firm wishes to establish a branch in a host State, it must notify the home NCA and provide it with the required disclosures, which are more extensive than those required for services provision (Article 35(2)), covering the Member State(s) in which a branch is to be established, a programme of operations, the branch organizational structure, the host address from which documents can be obtained, and the names of those responsible for the management of the branch. By contrast with the services notification process, the home NCA can block cross-​border operation through branches; accordingly, the review process is more intensive and subject to longer time periods. Unless the home NCA has ‘reason to doubt the adequacy of the administrative structure or the financial situation’ of the firm (taking into account the activities envisaged) it must, within three months of receiving the required information from the firm, communicate it to the host NCA (Article 35(3)). The branch may be established and commence business on receipt of a communication from the host NCA or, failing such communication, at the latest two months after the date of the transmission of the original communication by the home NCA to the host NCA (Article 35(6)). These procedures envisage the possibility that the home NCA may raise concerns as to the branch’s establishment and not forward the communication to the host NCA. Such action by the home NCA blocks the branch establishment, as establishment is contingent on prior communication from the home NCA to the host NCA. Article 35(5) deals with refusals to communicate and requires the home NCA give reasons for its refusal to the investment firm within three months of receiving all the information. In practice, the MiFID II passport has proved to be less troublesome than, for example, the funds passporting system which has required repeated refinements to remove operational frictions (Chapter III). The modalities of the notification process are governed by NCA-​NCA cooperation and well-​tested notification formats and processes,420 supported by ESMA.421 Nonetheless, and as outlined in section 7.1, some wariness is emerging as regards 418 The home NCA ‘shall’ forward the information within one month (Art 34(3)). 419 Specific requirements apply under Art 35(2) to the firm’s use of tied agents established in another Member State in a Member State in which the firm has not established a branch, as well as to the use by a branch of tied agents. As the CRD IV notification process does not cover tied agents, credit institutions are subject to the procedures specified in Art 35(7) as regards their use of tied agents to provide investment services/​activities outside the home Member State. 420 The notification forms required for services (and for branch establishment) are set out in ITS 2017/​2382 [2017] OJ L340/​6. 421 Technocratic support of passporting is of longstanding and includes the MiFID II Investor Protection and Intermediaries Q&A which addressed passporting issues arising over the transition from MiFID I to MiFID II.

IV.11  Supervision and Enforcement  429 the effectiveness of home NCA supervision of cross-​border activities, particularly as regards the retail markets, which may, over time, lead to a tightening of the passport system.

IV.11  Supervision and Enforcement IV.11.1  MiFID II and IFD/​IFR-​CRD IV/​CRR Two sets of institutional arrangements apply to the supervision of investment firms. MiFID II establishes the over-​arching framework. It covers NCA supervision and enforcement and NCA/​ESMA cooperation and coordination as regards the application of MiFID II/​MiFIR. In parallel, a discrete system applies to prudential supervision under the IFD/​IFR and CRD IV/​CRR. This supervisory system reflects the distinct modalities associated with prudential supervision, notably the ‘supervisory review and evaluation process’ (SREP) which can lead to the imposition of additional prudential measures, including as regards capital requirements, on firms. Within the prudential supervision system, the largest and most complex investment firms (those designated as credit institutions under CRD IV/​CRR) are subject to discrete supervisory arrangements: as credit institutions, they are supervised within Banking Union’s Single Supervisory Mechanism (SSM) where they are established in a Member State that participates in Banking Union.422

IV.11.2  The MiFID II Supervisory Framework MiFID II’s supervisory arrangements are based on the single rulebook’s default model for supervision, being anchored to the home NCA and supported by ESMA.423 MiFID II requires that NCAs be so designated by Member States; specifies the minimum suite of powers that NCAs must be conferred with (including enforcement powers); and establishes NCA coordination and cooperation requirements, supported by ESMA’s now well-​established role in supporting supervisory convergence and coordination. These arrangements are built on MiFID I’s approach to supervision, but MiFID II brought significantly greater harmonization to NCAs’ required powers, reflecting the financial-​crisis-​era drive to enhance supervision generally but also specific concerns as to weaknesses in the MiFID I supervisory framework.424

IV.11.2.1  NCAs a. Designation and Delegation Article 67 addresses the designation of the NCAs responsible for oversight of MiFID II/​ MiFIR. It is also designed to support NCA cooperation by providing clarity with respect to

422 SSM Regulation Arts 1 and 4. 423 The MiFID II supervisory architecture supports MiFID II and also MiFIR. A number of specific supervisory arrangements apply in relation to trading venues/​trading and are considered in Chs V and VI. 424 CESR’s 2004 ‘Himalaya Report’ had earlier raised concerns as to the capacity of MiFID I to manage the supervisory strains consequent on increased cross-​border activity, given differences in NCAs’ supervisory powers and resources: CESR, Which Supervisory Tools for the EU Securities Markets? Preliminary Progress Report (2004).

430  Investment Firms and Investment Services the relevant responsible authorities, given the possibility that multiple authorities could be engaged in supervising the wide-​ranging MiFID II/​MiFIR regime. Each Member State must designate the NCAs which are to carry out the duties provided for under MiFID II and MiFIR, and inform the Commission, ESMA, and the NCAs of other Member States accordingly, including as regards any division of duties across NCAs (Article 67(1)).425 Where a Member State designates more than one NCA, their respective roles must be clearly defined and they must cooperate closely (Article 68(1)). Similarly, each Member State must require that cooperation take place between the authorities responsible for MiFID II and those responsible in the Member State for the supervision of credit and other financial institutions, pension funds, UCITSs, insurance and reinsurance intermediaries, and insurance undertakings, and that those authorities exchange any information essential or relevant to the exercise of their functions and duties (Article 68(1)). The form NCAs must take is subject to only limited specification; the primary requirement is that NCAs must take the form of ‘public authorities’ (Article 67(2)). NCAs may delegate tasks to other entities where this is provided for in MiFID II (for the most part with respect to tied agents (Article 29(4)). Otherwise, while delegation by NCAs is permitted, subject to a number of restrictions,426 the final responsibility for supervising MiFID II compliance must remain with the relevant NCA (Article 67(2)). As across the single rulebook, professional secrecy obligations, and related arrangements for the exchange of information, apply (Article 76). b. NCA Supervisory and Investigatory Powers In a formula that recurs across the single rulebook, NCAs must be given all supervisory powers (including investigatory powers and powers to impose remedies) necessary to fulfil their MiFID II/​MiFIR duties (Article 69). These powers are to be exercised either directly, in collaboration with other authorities, by delegation in accordance with Article 67(2), or by application to the competent judicial authorities (Article 72). As is also now standard across the single rulebook, MiFID II builds out this foundational obligation by specifying an extensive suite of powers which must be available to NCAs. These powers must include, at least, the right/​power to: have access to documents or other data which the NCA considers could be relevant for the performance of its duties; demand information from any person and, if necessary, summon and question persons; carry out on-​site inspections/​investigations; require existing recordings of telephone and electronic communications held by an investment firm, credit institution, or other entity regulated under MiFID II/​MiFIR; require the freezing or sequestration of assets; request the temporary prohibition of professional activity; require authorized investment firms’ auditors to provide information;427 refer matters for criminal prosecution; allow auditors or experts to carry out verifications or investigations; require or demand information including all relevant documentation from any person regarding the size and purpose of a position or exposure entered into via a commodity derivative, and any assets or liabilities in the underlying market;428 require the temporary or permanent cessation of any practice or conduct 425 ESMA maintains a list of MiFID II NCAs: Art 67(3). 426 The conditions include that any delegation to non-​public authorities may not involve the exercise of public authority or the use of discretionary judgment, and requirements as regards the adequacy of the capacity and resources of the delegatee. 427 And auditors of regulated markets (MiFID II’s coverage of regulated markets is addressed in Ch V). 428 See further Ch VI section 2.5 on position management.

IV.11  Supervision and Enforcement  431 the NCA considers contrary to MiFIR/​MiFID II and prevent repetition of that practice; adopt any type of measure to ensure that investment firms (and regulated markets and other persons to whom MiFID II/​MiFIR applies) continue to comply with legal requirements; require the suspension of trading in a financial instrument; require the removal of a financial instrument from trading, whether on a regulated market or under other trading arrangements; request any person to take steps to reduce the size of a position or exposure; limit the ability of any person to enter into a commodity derivative (including through position limits);429 issue public notices; require, in so far as permitted by national law, existing data traffic records held by a telecommunication operator, where there is a reasonable suspicion of breach and where such records may be relevant; suspend the marketing or sale of financial instruments or structured deposits where the NCA’s related product intervention powers activate or where there is a breach of the Article 16(3) product governance regime;430 and require the removal of a natural person from a firm’s management body. Supervision is further supported by the reporting obligations imposed on statutory auditors (Article 77(1)).431 While such auditor whistle-​blowing was introduced under MiFID I, MiFID II added the requirement that Member States establish more general whistle-​blowing regimes (Article 73(1))432—​an obligation also imposed across a number of financial-​crisis-​era measures, including the market abuse regime.433 A parallel obligation applies to investment firms which must put in place autonomous and independent internal firm systems to support whistle-​blowing by employees (Article 73(2)). c. Supervisory Cooperation The foundational NCA cooperation obligation, which supports the home/​host NCA supervisory framework, is set out in Article 79. NCAs of different Member States must cooperate with each other ‘where necessary’ for the purpose of carrying out their duties under MiFID II/​MiFIR, making use of their powers, whether set out in MiFID II/​MiFIR or in national law (Article 79(1)). This obligation is operationalized through specific NCA and Member State obligations. In particular, NCAs must render assistance to other NCAs and exchange information and cooperate in any investigatory or supervisory activities (Article 79(1)):434 a related obligation is imposed on Member States to take the necessary administrative and organizational measures to facilitate cooperation (Article 79(3)).435 Distinct cooperation obligations are imposed with respect to ESMA (Article 87): NCAs must cooperate with ESMA for the

429 See further Ch VI section 2.5 on position management. 430 See further Ch IX section 4.11. 431 Statutory auditors must ‘report promptly’ to the NCAs any fact or decision liable to constitute a material breach of the investment services rules, affect the continuous functioning of the investment firm, or lead to a refusal to certify, or a reservation concerning, the accounts. This duty extends to similar facts or decisions in respect of an undertaking having ‘close links’ with the investment firm. 432 Member States must ensure that NCAs establish effective mechanisms to encourage reporting of actual or potential breaches of MiFID II/​MiFIR; Art 73 specifies minimum requirements, including as regards the protection of reporting persons who are employees of financial institutions. 433 See Ch VIII. 434 Member States must designate a single NCA as the contact point for the purposes of MiFID II/​MiFIR cooperation and information exchange and notify the Commission and ESMA accordingly (Art 79(1)). This obligation anchors the information exchange regime set out in Art 81. 435 NCAs may use their powers for the purpose of cooperation, even where the conduct under investigation does not constitute an infringement of any regulation in force in their Member State: Art 79(3).

432  Investment Firms and Investment Services purposes of MiFID II and must, without undue delay, provide ESMA with all information necessary to carry out its duties. Article 79(4) reinforces the importance of ongoing NCA cooperation and supervisory dialogue by requiring NCAs to be on the alert for infringements by firms. It provides that where an NCA has good reasons to suspect that acts in breach of MiFID II/​MiFIR have been carried out in the territory of another Member State by an entity which is not under its supervision, it must notify the NCA of that other Member State in as specific a manner as possible. The notified NCA must take appropriate action and inform the notifying NCA of the outcome of the action and any interim developments. More specific obligations are imposed under Article 80, particularly with respect to investigations. An NCA may request the cooperation of the NCA of another Member State in a ‘supervisory activity’, or for an on-​the-​spot verification, or in an investigation. Where an NCA receives a request concerning a verification or investigation it must, within the framework of its powers, either carry out the verification or investigation itself, allow the requesting authority to carry out the verification or investigation, or allow auditors or experts to carry out the verification or investigation. ESMA is empowered to participate in such investigations where coordinating colleges of supervisors are engaged;436 it can participate in the activities of colleges of supervisors, including on-​site verifications or investigations carried out jointly by two or more NCAs. The modalities of these supervisory engagements are governed by administrative rules.437 Information exchange, the lifeblood of NCA cooperation, is governed by the specific requirements which apply under Article 81438 and by the related procedures set out in administrative rules.439 NCAs must ‘immediately’ supply one another with the information required for the purposes of carrying out their duties. NCAs may, however, indicate, at the time the information is communicated, that it must not be disclosed without their express agreement. NCAs in receipt of such information may pass it on through a subsequent ‘information gateway’, in that they can pass it on to other competent authorities within the Member State—​but the receiving authorities may not transmit the information to other bodies or natural or legal persons without the express agreement of the authorities which disclosed it, and then only for the purposes for which the authorities gave their agreement, except in duly justified circumstances.440 Additionally, an NCA is not prevented from transmitting confidential information intended for the purpose of its tasks to ESMA, the European Systemic Risk Board (ESRB), central banks, the European System of Central Banks (ESCB), and the ECB—​the latter in their capacity as monetary authorities—​ and, where appropriate, to other public authorities responsible for overseeing payment and settlement systems; similarly, these bodies are not prevented from communicating to the

436 In practice, colleges of supervisors are typically used for specific sectors, including as regards CCPs and benchmarks. 437 Set out in RTS 2017/​586 [2017] OJ L87/​382 and ITS 2017/​980 [2017] OJ L148/​3. 438 Information exchange with third countries is governed by Art 88. Member States and ESMA may conclude cooperation agreements providing for the exchange of information with third country competent authorities only if the information disclosed is subject to guarantees of professional secrecy equivalent to those required under MiFID II. 439 Set out in RTS 2017/​586 and ITS 2017/​980. 440 Art 81(3) specifies that those in receipt of exchanged information can use it only in the course of their duties, and the purposes for which it can be used (including the checking of authorization conditions and facilitating ongoing monitoring).

IV.11  Supervision and Enforcement  433 NCAs such information as they may need for performing their functions under MiFID II/​ MiFIR. Refusals to cooperate are addressed by Article 83, which restricts the circumstances in which an NCA can withhold cooperation. An NCA may refuse to act on a request for cooperation in carrying out an investigation/​on-​the-​spot investigation, or in relation to an authorization of an investment firm which forms part of a pan-​EU group, or as regards an Article 81 request for information, in only two very limited circumstances: judicial proceedings have already been initiated in respect of the same actions and the same persons before the authorities of the Member State addressed; or final judgment has already been delivered in the Member State addressed in respect of the same persons and the same actions. The refusing NCA must notify the requesting NCA accordingly and provide as much detailed information as possible. ESMA’s binding meditation powers can also be deployed to address cooperation failures: Article 82 specifies that NCAs may refer to ESMA for binding mediation where a request (relating to information exchange or the carrying out of a supervisory activity, on-​the-​spot verification, or an investigation) has been rejected or has not been acted on within a reasonable time. Ultimately, ESMA can use its powers to take action against an NCA for breach of EU law.441

IV.11.2.2 Supervisory Convergence and ESMA In support of this supervisory architecture, ESMA performs a range of different supervision-​ related functions which support NCA coordination and cooperation as well as consistency in NCA supervisory practices. These include its functions of a more vertical and hierarchical quality, exemplified by its direct MiFID II/​MiFIR supervision and intervention powers, with respect to product intervention (Chapter IX) and position management (Chapter VI), which also shape parallel NCA action, but also including its swathe of powers to review NCA supervisory action, including in relation to NCA MiFIR transparency waivers (Chapter V), NCA position management decisions (Chapter VI), and NCA product intervention decisions (Chapter IX). ESMA’s supervision-​related functions also include its construction, hosting, and interrogation of the now massive data-​bases relating to transactions and trading under MiFID II/​MiFIR which support supervision (Chapter V). In addition, and as outlined in Chapter I, ESMA has a wide range of supervisory convergence powers and tasks ranging from soft law adoption (including Guidelines and Q&As), to the adoption of the host of Opinions and similar measures it can deploy under its general power to support a common supervisory culture, to peer review. This wide tool-​box, combined with the scale of the MiFID II/​MiFIR regime, means that the channels through which ESMA supports, and exerts influence on, MiFID II/​MiFIR supervision are many and various. By way of illustration, the coming into force of MiFID II/​MiFIR in January 2018 saw ESMA adopt a swathe of soft measures to support the regime’s consistent application and supervision.442 Similarly, as the Covid-​19 pandemic upended business practices and 441 See in outline Ch I section 6. 442 ESMA adopted a host of soft measures to address multiple thorny operational difficulties including: Q&As on the application of the MiFID II/​MiFIR investment research rules; Q&As opining that authorizations and notifications under the precursor MiFID I regime would remain valid in the event of late transposition by Member States of MiFID II; and the announcement, just days before MiFID II/​MiFIR came into force, of an informal six-​ month forbearance period to allow market participants to acquire the ‘Legal Entity Identifier’ (LEI) code required under MiFID II/​MiFIR for all transaction reporting by investment firms and trading venues, as the lack of industry

434  Investment Firms and Investment Services markets in March 2020, ESMA coordinated NCAs in adopting related supervisory forbearance measures (or the informal suspension of requirements).443 Further, ESMA’s MiFID II/​MiFIR soft law ‘rulebook’ has burgeoned, institutionalizing NCAs’ common understandings as to the application of MiFID II, and thereby supporting consistency in supervision. This soft law has been accompanied by more operational measures. By way of example, NCA supervision of the MiFID II quality-​of-​advice rules has been supported by Supervisory Briefings (designed to provide practical assistance to NCAs),444 Common Supervisory Actions (CSAs, in which NCAs, coordinated by ESMA, carry out a thematic supervision of a particular area),445 and peer review.446 ESMA’s supervisory convergence activities are also evolving, pivoting to address, for example, the supervisory challenges relating to digitalization447 and sustainable finance,448 and becoming more intrusive.449 Over time, this multi-​faceted approach to supervisory convergence can be expected to have something of a sedimentary effect, shaping NCAs’ supervisory practices as regards MiFID II/​MiFIR into a European operating model. In this regard, while the movement in 2021 of the supervision of the largest and most complex investment firms (registered in a Banking Union Member State) from NCAs into the Single Supervisory Mechanism and direct ECB supervision,450 can be regarded as a potentially pathbreaking development (albeit that it only effects CRD IV/​CRR prudential supervision, not MiFID II/​MiFIR), in practice, ESMA’s steady accretion of influence over the quotidian business of day-​to-​day MiFID II/​MiFIR operational supervision is likely to lead to a material operational harmonization of how supervision is carried out.451

IV.11.3  Prudential Supervision and the SREP IV.11.3.1 CRD IV/​CRR and the SREP Process The supervision of the CRD IV/​CRR prudential regulation package is supported by a home NCA/​host NCA supervisory framework that is based on the minimum powers/​cooperation/​information exchange arrangements familiar across the single rulebook and from preparedness emerged. ESMA Executive Director Ross identified ‘an inexhaustible demand for clarification and guidance’ on MiFID II/​MiFIR: Speech 20 September 2017. 443 Including the informal suspension of the MiFID II call recording rules. See further Moloney, N and Conac, P-​H, ‘Financial Market Governance and the Covid-​19 Crisis’ (2020) 17 ECFR 363. 444 The Supervisory Briefing on the MiFID II know-​your-​client/​suitability requirements (2018), eg, is designed as a ‘useful starting point when deciding on areas of supervisory focus’ and includes indicative questions for NCAs to consider when supervising firms. 445 A CSA was launched in 2020, eg, on the application of the MiFID II suitability rules. The exercise was designed to ensure consistent implementation and application of the rules but also to improve NCAs’ understanding of supervisory approaches and the sharing of knowledge and experience. See further ESMA, Public Statement on 2020 Common Supervisory Action on Suitability (2021). 446 See further Ch IX section 4.8 as regards the MiFID II ‘know-​your-​client’ regime. 447 ESMA is, eg, a member of the European Forum for Innovation Facilitators which, supported by the 2020 Digital Finance Strategy (COM(2020) 59; see in outline Ch I section 7.3), facilitates cooperation between NCAs as regards the facilitation of innovation, including regulatory sandboxes. 448 eg ESMA’s 2022 Work Plan as regards MiFID II/​MiFIR supervisory convergence included supervisory convergence tools as regards conduct of business and organizational requirements but also sustainable finance requirements: ESMA, 2022 Annual Work Programme (2021) 12. 449 As indicated by the 2022 peer review of home NCA supervision of cross-​border activities: section 7.1. 450 See section 9.4. 451 See also Ch I sections 5.2 and 6.6.

IV.11  Supervision and Enforcement  435 MiFID II, but likely to be strengthened by the 2021 CRD VI/​CRR 3 Proposals.452 While similar to the MiFID II framework as it regards its foundational home/​host NCA arrangements, the CRD IV/​CRR supervisory framework is, however, sharply distinct from it in a number of respects. First, it includes, and reflecting a longstanding preoccupation of prudential regulation internationally, extensive requirements relating to the effective supervision of groups and the related consolidation process. Second, it is based on the Basel ‘Pillar 2’ supervisory process which has brought intensive operational harmonization to how NCAs engage in supervision. This process is based on in-​ depth NCA review of a firm’s CRD IV/​CRR compliance and on the NCA then requiring any related specific risk mitigation measures, calibrated to the individual firm’s risk profile, including, where appropriate, additional capital and liquidity requirements (what are termed ‘Pillar 2 add-​ons’). The Pillar 2 process has two elements which operate on a broadly annual cycle. First, firms review their capital and liquidity needs (the internal ‘ICAAP’ and ‘ILAAP’ processes). This internal review is followed by the Supervisory Review and Evaluation Process (the ‘SREP’) which, required to take place annually and supported by stress testing, is designed to ensure that firms have adequate arrangements, strategies, processes, and mechanisms, as well as capital and liquidity, to ensure sound management and coverage of their risks (CRD IV Articles 97–​110). As it seeks to ensure that firm-​specific prudential measures (such as additional capital or liquidity requirements) are imposed where necessary to ensure the adequacy of capital and liquidity arrangements, the SREP is an important safety valve for NCAs, given the otherwise prescriptive harmonization under the capital regime in particular; albeit that firms may face considerable uncertainty as a result in their operating environments. The swingeing supervisory powers which NCAs must be able to wield under the SREP include powers to: require firms to hold additional own funds; reinforce internal capital and governance systems; require firms to apply specific provisioning policies; restrict or request the divestment of excessively risky activities; require firms to limit variable remuneration where such remuneration is inconsistent with the maintenance of a sound capital base; restrict or prohibit distributions or interest payments; require firms to engage in more frequent reporting; and impose specific liquidity requirements (Article 104). The technical modalities of the SREP are specified in some detail by CRD IV Article 98, which requires, inter alia, that the results of stress tests are considered and that exposure to and management of identified risks are examined. The SREP is supported by the extensive and highly operational EBA SREP Guidelines, mandated by CRD IV, which govern the practical conduct by NCAs of the SREP.453 The Pillar 2 and SREP process has the effect of the CRD IV/​CRR package being composed of different forms of capital and liquidity requirements arising from Pillar 1 (deriving from mandatory rules) and Pillar 2 (deriving from supervisory ‘add-​ons’).454 Following significant contestation as to the extent to which 452 The reforms propose a strengthening of NCA powers and of their independence in response, in part, to the weaknesses which the 2020 Wirecard scandal exposed (noted in Ch II section 6). 453 EBA, Guidelines on the Revised Common Procedures and Methodologies for the SREP and Supervisory Stress Testing (2022) (the Guidelines are regularly revised; the 2022 iteration, which responds to the CRD V/​CRR 2 reforms, replaced the 2018 version). Also, a host of soft law addresses different aspects of the SREP, including firms’ internal capital and liquidity assessment processes (the ICAAP and ILAAP) and the treatment of particular risks under the SREP. 454 Capital requirements are regarded, accordingly, as being ‘stacked’, based on the source of the relevant obligation. Conditions apply to when add-​ons can be required. See n 464 as regards the IFD/​IFR regime.

436  Investment Firms and Investment Services NCAs can impose additional Pillar 2 requirements on firms, the CRD V reforms imposed additional conditions on NCAs as regards the application of capital ‘add-​ons’ (Article 104a) and also clarified the interaction between mandatory, binding Pillar 1 requirements, additional binding Pillar 2 ‘add-​on’ requirements, and the non-​binding ‘supervisory expectations’ that NCAs can set, through Pillar 2 guidance, for firms (Article 104b).455 Finally, the supervision of CRD IV/​CRR sits within Banking Union’s distinct and centralized arrangements for supervision where the relevant credit institution is established in a Member State that participates in Banking Union. Where this is the case, the credit institution is supervised within the Single Supervisory Mechanism (SSM), in accordance with the 2013 SSM Regulation. As outlined in section 9.4, the redesignation by the CRD V/​CRR 2 reforms and the IFD/​IFR of certain investment firms as credit institutions has brought them (when registered in a participating Member State) within the SSM and, specifically, given the operation of the SSM Regulation, under direct ECB supervision. An entirely different supervisory arrangement applies, accordingly, which has bespoke institutional structures and supervisory procedures and which is shaped by distinct legal, constitutional, market, and political dynamics.456 This arrangement only applies, however, as regards CRD IV/​ CRR: these investment firms remain subject to NCA supervision as regards their compliance with MiFID II/​MiFIR. This split of supervision generates operational, coordination, legal, and political intricacies of some delicacy and complexity. It situates the supervision of the most complex investment firms, which pose the greatest risk to financial stability, within a complex institutional setting in which the ECB, EBA, ESMA, and relevant NCAs all have different but related supervisory, supervisory convergence, and supervisory coordination competences under CRD IV/​CRR and MiFID II/​MiFIR. It remains to be seen how effective the underpinning coordination and cooperation arrangements will be in practice and over time; the redesignation requirement only came into force in June 2021. But the inclusion of these investment firms within the SSM will likely pose a significant test of the efficacy of institutional coordination arrangements. The inclusion may also generate unhelpful institutional frictions where the perimeters which mark the different spheres of operation of the key institutional players are blurred.457 It also raises the freighted question of what it suggests as to the organization of EU financial markets supervision generally. As suggested in Chapter I, this transfer of competence might be best regarded as sui generis, and as reflecting the distinct features of prudential regulation. But this is an area where it is notoriously difficult to predict the EU’s trajectory, given the political, market, constitutional, and legal forces engaged.

455 Pillar 2 ‘guidance’ is designed to indicate to firms the levels of capital which should be maintained to provide a sufficient buffer against stressed situations; it is not binding. 456 From the extensive literature on Banking Union and the SSM see, for a recent treatment and in light of experience since its coming into force, Busch, D and Ferrarini, G (eds), European Banking Union (2nd edn, 2020). As regards the SSM’s interplay with the single rulebook and the ESAs (including ESMA) see, eg: Moloney, N, ‘EU Financial Governance after Brexit: the rise of technocracy and the absorption of the UK’s withdrawal’ in Alexander, K, Barnard, C, Ferran, E, Lang, A, and Moloney, N, Brexit and Financial Services: Law and Policy (2018) 61; Ferran, E, ‘The Existential Search of the European Banking Authority’ (2016) 17 EBOLR 285; and Lastra, R, ‘Banking Union and Single Market: Conflict or Companionship?’ (2013) 36 Fordham Int’l LJ 1190. 457 The SSM Regulation makes clear that the SSM only applies as regards prudential supervision and does not engage with conduct-​related and other supervision (Art 1). There are, however, several grey zones where prudential and conduct regulation meet and where the related institutional complexities are significant. See further Moloney, n 265, 316–​26.

IV.11  Supervision and Enforcement  437

IV.11.3.2 The IFD/​IFR SREP A distinct supervisory framework also applies to prudential supervision under the IFD/​ IFR. It is set out in the IFD which establishes the framework governing the allocation of supervisory jurisdiction to NCAs, their powers, and cooperation arrangements. Prudential supervision under the IFD/​IFR is the responsibility of the home NCA (Article 12), although specific arrangements govern the consolidated supervision of groups. Home NCA supervision is supported by legislative requirements governing cooperation obligations (including as regards the foundational obligation to cooperate closely (Article 13(1)), information exchange,458 host NCA precautionary powers,459 home NCA on-​the-​spot-​checking and inspection of host NCA branches,460 and cooperation and information exchange with third countries (Article 15));461 NCA resources and powers;462 NCAs’ required information-​ gathering, inspection, and investigatory powers (Article 19); and the availability and imposition of sanctions.463 In addition, and as under CRD IV/​CRR, specific supervisory powers are conferred on NCAs as regards the SREP (Articles 36–​45). The IFD/​IFR SREP is based on the NCA reviewing a firm’s IFD/​IFR compliance arrangements and evaluating its risk profile (including as regards own funds and liquidity risks but also other risks, including in relation to business model, IT, interest rate exposure, and governance risks) so as to ensure the sound management and coverage of the firm’s risks (Article 36). The frequency of a firm’s SREP (typically annual) and its intensity is to be determined by the NCA having regard to the firm’s size, nature, scale, and complexity (and systemic importance, where relevant) and taking into account the proportionality principle. As regards small and non-​ interconnected (Class 3) firms, NCAs are to decide, on a case-​by-​case basis, the form which the SREP assessment is to take, but it is only to be carried out where necessary given the size, nature, scale, and complexity of the firm (Article 36). The measures an NCA can deploy under the SREP process are specified in Article 39 and include requiring the holding of additional own funds and imposing specific liquidity requirements (‘add-​ons’);464 458 Article 13 specifies in detail the nature of the information exchange obligation, including as regards firm compliance with own funds and concentration/​liquidity risk requirements, and the home NCA’s obligation to inform the host NCA of any client protection or stability risks to which the host State is exposed from any home-​ supervised firms. 459 Articles 13(3) and (4). Home NCAs are to act on information provided by host NCAs by taking all measures necessary to avert or remedy potential problems, failing which host NCA intervention powers can be exercised. Failures to cooperate/​exchange information can be subject to EBA mediation. 460 Under Art 14, these checks and inspections must be permitted by the host NCA. While prudential supervision is the responsibility of the home NCA, the host NCA is empowered by Art 14 to inspect host branches, where necessary on financial stability grounds. 461 NCAs, EBA, and ESMA are empowered to enter into cooperation arrangements with third country authorities, subject to the IFD’s professional secrecy requirements relating to information exchange (Arts 15 and 16). 462 NCAs must have the expertise, resources, operational capacity, powers, and independence necessary to carry out their prudential supervision, investigation, and sanctioning functions (Art 4(4)) as well as all necessary powers to obtain the information necessary to assess compliance and investigate breaches (Art 4(3)). 463 Articles 18 and 20–​23 address administrative sanctions, identifying the specific IFD/​IFR breaches which must be eligible for sanctioning action; and addressing the minimum suite of sanctions required and how they are to be applied, appeals, and sanctions publication and reporting (to EBA rather than ESMA). 464 Subject in each case to the conditions that apply to the imposition of such ‘add-​on’ measures under Arts 40 (own funds) and 42 (liquidity measures). In the case of own funds, NCAs can also, under the IFD capital guidance power (Art 41), require investment firms to have levels of own funds above those required by the IFR to ensure that cyclical economic fluctuations do not lead to a breach of the IFR or SREP requirements or threaten the firm’s ability to wind down in an orderly manner.

438  Investment Firms and Investment Services requiring net profits to be used to strengthen own funds; requiring additional disclosures and reporting requirements; imposing restrictions or prohibitions on dividend payments; imposing restrictions on variable remuneration; and restricting or limiting specified business operations or requiring the divestment of activities that pose excessive risks to financial soundness. Prior to the adoption of the IFD/​IFR, NCAs typically relied heavily on CRR Pillar 2 measures (‘add-​ons’) to manage the specific risks associated with investment firms. With the adoption of the IFD/​IFR such add-​ons are likely to become more risk-​ based. As is the case for the CRD IV/​CRR SREP, the SREP is supported by extensive, operationally oriented EBA soft law.

IV.11.4  Enforcement and Administrative Sanctions IV.11.4.1 Administrative Sanctions MiFID II, as is standard across the single rulebook, also addresses enforcement.465 The MiFID I enforcement regime was based on the minimum requirement that Member States had in place administrative sanctions which were effective, proportionate, and dissuasive. The financial-​crisis-​era reform programme led to significantly greater specification across the single rulebook of the administrative sanctions which must be available, and of how those sanctions are applied, with MiFID II one of the pathfinder measures in this regard. The foundational Article 70(1) obligation requires that (without prejudice to NCAs’ supervisory powers and the right of Member States to provide for and impose criminal sanctions) Member States must ensure their NCAs can impose administrative sanctions and measures, applicable to MiFID II/​MiFIR breaches (and breaches of related national law), which must be effective, proportionate, and dissuasive, and apply to breaches even where such breaches are not specifically referenced in MiFID II as requiring an administrative sanction or measure (Article 70(1)). Criminal sanctions may be deployed in substitution, but these must be notified to the Commission, and appropriate measures must be in place such that NCAs have all necessary powers to liaise with the judicial authorities to receive information and to transmit it as required to other NCAs and ESMA (Article 70(1) and 79(1)). MiFID II also specifies the particular breaches of MiFID II/​MiFIR which must be subject to administrative sanctions or measures (Article 70(3)); specifies the minimum suite of administrative sanctions and measures which must be available to NCAs (Article 70(6));466 details how administrative sanctions and measures are to be applied (Article 72);467

465 Similar enforcement regimes apply under CRD IV/​CRR and IFD/​IFR (eg, see n 463). 466 The suite of measures required covers: public statements; injunctions; withdrawals/​suspensions of authorization; temporary and (for frequent, serious breaches) permanent bans on exercising management functions; temporary bans on being a member of a trading venue; and pecuniary sanctions (up to (as a minimum) 10 per cent of annual turnover for a legal person or €5 million; and up to (as a minimum) €5 million in the case of a natural person), including pecuniary sanctions of up to twice the amount of the profits gained or losses avoided (even where that exceeds the aforenoted thresholds). NCAs must cooperate to facilitate the recovery of pecuniary sanctions (Art 79(1)). Additional sanctions and measures can be provided at national level. 467 Including with reference to the gravity and duration of the breach, the degree of responsibility of the person responsible and that person’s financial strength, the importance of profits gained or losses avoided, losses for third parties, the degree of cooperation by the person concerned, and previous breaches by that person.

IV.11  Supervision and Enforcement  439 and provides for mandatory public reporting by NCAs of administrative sanctions and measures imposed (and specifies the conditions under which the public reporting requirement can be lifted), as well as for NCA reporting to ESMA on sanctioning (Article 71). Reflecting the financial-​crisis-​era concern with firm governance, sanctions and measures must be applicable to management body members (and any other natural persons responsible for breach), albeit subject to the conditions laid down in national law in areas not harmonized by the Directive (Article 70(2)). There is little data so far on MiFID II/​MiFIR enforcement trends, with the first ESMA reports published in 2019 and insufficient data available so far to discern trends.468 The administrative sanctions regime appears, overall, to have performed well so far, with NCAs reporting in 2021 that it had helped ensure the efficient enforcement and application of MiFID II, albeit that they noted the convergence challenges posed by diverging procedural frameworks across the Member States, and also called for additional powers that would empower NCAs to enter into settlements.469

IV.11.4.2 Civil Liability Harmonized private causes of action are rarely deployed across the single rulebook as a disciplining mechanism,470 and have not been relied on by MiFID II. At an early stage of the MiFID I Review, the Commission proposed that a harmonized civil liability regime be available for regulatory breaches by investment firms; it would have supported retail clients by providing a harmonized civil liability regime governing actions for breach of the disclosure, quality of advice, client reporting, best execution, or order handling rules.471 The European Parliament similarly proposed that where a member of a firm’s management body breached MiFID II/​MiFIR, Member States’ legal regimes should provide for civil causes of action.472 These proposals did not acquire any traction—​ reflecting significant industry hostility but also the legal and procedural complexities associated with the harmonization of civil liability. MiFID II provides, however, that Member States must ensure that mechanisms are in place to ensure that compensation may be paid

468 ESMA’s first two reports (on 2018 and 2019) did not attempt analysis given the limited data they presented and given the length of time enforcement procedures can take which could mean that, as MiFID II came into force only in 2018, the data was not representative of levels of enforcement activity. ESMA’s third report (on 2020) was heavily caveated and cautioned that, given the local idiosyncrasies and complexities associated with domestic sanctioning systems, automatic parallels should not be drawn between levels of sanctions and the quality of supervisory activity. It nonetheless identified increasing sanctioning activity by NCAs since 2018 and 2019. Five NCAs did not impose any sanctions (as compared to thirteen in 2019), with the highest numbers of sanctions imposed by Bulgaria (195), Luxembourg (108), and Belgium (103). The majority of NCAs (14), however, imposed less than ten sanctions: ESMA, Sanctions and Measures Imposed under MiFID II in 2020 (2021). ESMA’s fourth report (on 2021) reported on a decrease in the total number of sanctions imposed across the EU, although it also reported on a reduction in the number of NCAs not imposing any sanctions (four) and an increase in the total monetary amount of fines levied. As in 2021, it warned against ‘automatic parallelism’ between the quality of supervisory activity and levels of sanctioning, particularly as NCAs could potentially impose sanctions under national law that were not captured by the MiFID II reporting framework: ESMA, Sanctions and Measures Imposed under MiFID II in 2021 (2022). 469 ESMA, Technical Advice to the Commission on the Application of Administrative and Criminal Sanctions under MiFID II/​MiFIR (2021). 470 See Ch II section 4.12 on the prospectus regime, eg. The rating agency and PRIIPs regimes remain notable exceptions (Chs VII section 15 and IX section 5.3.4). 471 2010 MiFID I Review Consultation, n 68, 63. 472 European Parliament Negotiating Position, n 24, Art 9(8a).

440  Investment Firms and Investment Services or other remedial action taken in accordance with national law for any financial loss or damage suffered as a result of breach of MiFID II/​MiFIR (Article 69). Effective redress for retail investors has long been a concern of EU retail market policy, given the very considerable difficulties retail investors can face in achieving redress. This policy agenda has focused primarily on alternative dispute resolution (ADR),473 however, which is also promoted through MiFID II.474

473 Including through FIN-​NET, the pan-​EU network of national ADR schemes. Access to schemes and the enforceability of awards cross-​border are among the challenges ADR faces in a pan-​EU context, as noted in FIN-​ NET’s most recent publicly available report: FIN-​NET Activity Report 2018 (2019). 474 Article 75 provides that Member States must ensure the setting up of ‘efficient and effective’ complaints and redress procedures for the out-​of-​court settlement of consumer disputes concerning the provision of investment and ancillary services by investment firms, using existing bodies where appropriate, and ensure cooperation between those bodies and their cross-​border counterparts.

V

ORDER EXECUTION VENUES V.1  Order Execution Venues and Regulation V.1.1  Introduction This chapter considers the regulation of order execution venues (or ‘venues’),1 from traditional stock exchanges to investment firms that put their capital at risk to deal with clients on own account. Order execution venues, however organized, facilitate the buying and selling of financial instruments and, accordingly, provide one of the structural underpinnings of the financial system.2 Order execution venues are governed by the 2014 MiFID II/​MiFIR .3 While based on the deeply contested and much-​examined 2004 MiFID I regime for the regulation of order execution venues,4 MiFID II/​MiFIR materially expanded the MiFID I regime to apply to a significantly greater range of venues and asset classes. Its legislative passage as regards the order execution venue provisions was, like that of the precursor MiFID I provisions, fraught. Since its coming into force in 2018, however, the MiFID II/​MiFIR order execution venue regime has attracted less political contestation and has become more a creature of technocracy. Nonetheless, as underlined by the 2020 MiFID II/​MiFIR Review and the subsequent 2021 MiFID III/​MiFIR 2 Proposals,5 it continues to be the focal point for

1 This chapter uses the terms ‘order execution venue’ and ‘venue’ interchangeably to capture the range of organized/​formal and informal systems, multilateral and bilateral, on which trading (or order execution) can be organized and which can come within the purview of venue regulation. The term ‘trading venue’ has a specific meaning relating to the scope of the EU rules applicable in this area, as outlined below in this chapter. On the universe of systems which can potentially engage venue regulation see Mahoney, P and Rauterberg, G, ‘The Regulation of Trading Markets: A Survey and Evaluation’ in Fox, M et al (eds), Securities Market Issues for the 21st Century (2018) 221 and, from an earlier period of venue development, Macey, J and O’Hara, M, ‘From Markets to Venues: Securities Regulation in an Evolving World’ (2005) 58 Stanford LR 563. 2 This chapter is concerned with order execution venues and does not consider post-​trade procedures. The post-​ trade process is primarily addressed by the Central Securities Depositaries (CSD) Regulation (Regulation (EU) No 909/​2014 [2014] OJ L257/​1) which is noted in brief in the final section of this chapter. Similarly, the chapter is not concerned with financial market infrastructures generally, such as the central clearing counterparties (CCPs) that clear derivatives or the trade repositories (TRs) that act as repositories for reporting on derivatives transactions. CCPs and TRs, which are governed by the European Market Infrastructure Regulation (EMIR) (Regulation (EU) No 648/​2012 [2012] OJ L201/​1), are considered in Ch VI in the context of the regulation of trading practices. 3 Markets in Financial Instruments Directive 2014/​65/​EU [2014] OJ L173/​349 (MiFID II) and Markets in Financial Instruments Regulation (EU) No 600/​2014 [2014] OJ L173/​84 (MiFIR). As regards the order execution venue aspects of MiFID II/​MiFIR see, eg, Siri, M and Gargantini, M, ‘Securities and Derivatives Exchanges in the EU’ and Busch, D and Gulyás, J, ‘Alternative Trading Platforms in the EU’ in Binder, J-​H and Saguato, P (eds), Financial Market Infrastructures: Law and Regulation (2021); and Moloney, N, ‘EU Financial Governance and Transparency Regulation’ in Busch, D and Ferrarini, G (eds), Regulation of the EU Financial Markets. MiFID II and MiFIR (2017). 4 Directive 2004/​39/​EC [2004] OJ L145/​1. 5 COM(2022) 726 and COM(2022) 727. The Review and the Proposals are noted across the chapter.

442  Order Execution Venues longstanding and often febrile legacy debates on how order execution and order execution venues should be organized and regulated in the EU.6

V.1.2  Regulating Order Execution Venues V.1.2.1 Order Execution Venues and the Trading Process Order execution venues are a critical institutional component of financial markets. To different degrees, depending on the nature of the venue and of the instruments traded, such venues pool liquidity in the instruments traded, including by embedding liquidity providers such as market-​makers on the venue, and thereby support exchange; facilitate risk management; provide monitoring services (particularly over the stewardship of publicly traded firms and through share price movements); and, ultimately, allocate resources and mobilize savings.7 While venues provide different services, trading (execution) services and related price formation and liquidity provision are at the core of the venue business model.8 Cash (equity and bond) venues typically facilitate the raising of capital by capital-​seekers and the generation of returns for capital-​providers by providing an infrastructure that supports liquidity for the trading, hedging, and diversification of securities (and the related monitoring of publicly traded firms).9 Venues for derivative instruments typically facilitate the management and pricing of risks by supporting trading in standardized risk-​transfer and risk-​management instruments, including by making available liquidity providers for the instruments traded; the process of financial innovation is strongly associated with the transformation of bespoke, bilaterally negotiated risk management products into standardized products which are traded on organized venues and which allow market participants to manage risk more effectively.10 The provision of liquidity, and the use of different techniques to attract and retain liquidity, is, accordingly, at the heart of the venue business model, and is a driving concern for regulation in this area.11 For example, the rise of high frequency algorithmic traders as major suppliers of liquidity to order execution venues, in the closing

6 The digital agenda has seen cognate developments, notably the DLT Market Infrastructure Pilot Regulation (Regulation (EU) 2022/​858 [2022] OJ L151/​1). The Regulation provides for a novel pilot regime for the operation and regulation of venues trading crypto-​tokens (digital assets that represent financial instruments), noted in Ch I section 7.3. Also, the 2022 Markets in Crypto-​Assets Regulation (MiCAR), on which provisional agreement was reached in June 2022, puts in place a regime governing infrastructures for trading certain crypto-​assets. Crypto-​ assets and their regulation falls outside the scope of this book, as noted in Ch I section 7.3. 7 For an early assessment see Levine, R, ‘Financial Development and Economic Growth: Views and Agenda’ (1997) 35 J of Econ Lit 685. 8 For an early review see Fischel, D, ‘Organized Exchanges and the Regulation of Dual Class Common Stock’ (1987) 54 University of Chicago LR 119. 9 An extensive literature addresses the role of equity venues in supporting capital-​raising in the primary markets by providing secondary markets in which reliable prices are formed, liquidity is pooled (providing investors with an exit), and exchange is supported through standardized rules: eg Mahoney, P, ‘The Exchange as Regulator’ (1997) 83 Va LR 1453. The extent to which trading venues support capital-​raising is, however, increasingly contested. See further Ch II sections 2 and 8. 10 Gilson, R and Whitehead, C, ‘Deconstructing Equity: Public Ownership, Agency Costs and Complete Capital Markets’ (2009) 108 Col LR 231 and Merton, R, ‘A Functional Perspective of Financial Intermediation’ (1995) 24 Financial Management 23. The credit explosion prior to the financial crisis provided a paradigmatic example of this process, with loan credit risk being transferred into traded securitization products on a systemic scale: Gubler, Z, ‘The Financial Innovation Process: Theory and Application’ (2011) 36 Delaware J of Corporate Law 55. 11 Regulation is therefore concerned in particular with ‘market microstructure’ or with how venues, using different mechanisms, translate demand into prices and trading volumes.

V.1  Order Execution Venues and Regulation  443 years of and since the financial crisis, underlines how innovation in how liquidity is provided shapes not only venue models but also venue regulation.12 An array of factors have, for some time, created accommodating conditions for the development of a great variety of order execution venues operating under different trading functionalities and providing different services.13 These factors include technological innovation, including innovations facilitating the interlinkage of investment firms that deal in financial instruments; the ongoing standardization of risk-​management products (accelerated by financial-​crisis-​era regulatory reforms such as central clearing counterparty (CCP) clearing requirements for derivatives); the scale and acuity of competition between venues;14 and, earlier, the ‘unbundling’ of the primary market ‘admission to listing’ functions associated with cash venues from their secondary market trading functions, and the demutualization of incumbent stock exchanges (over the early 1990s–​mid-​2000s in particular).15 A broad distinction can, however, be made between two venue types: (i) formal/​ organized, multilateral (in that the venue acts as a platform which brings together multiple third party orders and does not put its capital at risk/​execute orders), non-​discretionary (in that trades are executed according to the venue’s pre-​set rules or parameters and the venue does not intervene in the trade), and ‘lit’ (in that trading orders/​interest are disclosed, typically through mandatory transparency requirements, to the market at large); and (ii) informal, bilateral (the venue deals with the originator of the order, putting its capital at risk), discretionary (in that trading is at the venue’s discretion), and ‘dark’ (trading orders/​interest are not publicly disclosed).16 The first venue type can be associated with major public venues, and particularly with public cash equity venues, and so with high levels of regulation. These venues are typically ‘lit’ and thereby support price formation, although they also usually accommodate dark trading (through what are often termed ‘dark pools’). They tend to operate through multilateral, non-​discretionary, public ‘central order books’ in which orders interact:17 12 For a US-​oriented analysis see Fox, M, Glosten, L, and Rauterberg, G, ‘The New Stock Market: Sense and Nonsense’ (2015) 65 Duke LJ 191. The MiFID II/​MiFIR regime expressly addresses the risks posed by the rise of algorithmic traders as liquidity providers on venues, as outlined below in this chapter. 13 An extensive literature examines the rise of different types of venues for the trading of financial instruments, beyond traditional stock exchanges. For early reviews see Fleckner, A, ‘Stock Exchanges at the Crossroads’ (2006) 74 Fordham LR 2541, Macey, J and O’Hara, M, ‘Regulating Exchanges and Alternative Trading Systems: A Law and Economics Perspective’ (1999) 28 J of Legal Studies 17, and Lee, R, What is an Exchange? The Automation, Management and Regulation of Financial Markets (1998). The sector continues to innovate, as outlined below in this chapter on the EU experience. For an analysis of post-​financial-​crisis venue innovation see Fox, M and Rauterberg, G, ‘Stock Market Futurism’ (2017) 42 J Corp L 793. 14 Competition continues to be a defining feature of the US and EU order execution venue settings. On the US setting see Yadav, Y, ‘Oversight Failure in Securities Markets’ (2019) 104 Cornell LR 1799 and, as regards the EU setting, see further below in this chapter. 15 Between 1993 and 2005, 40 per cent of the membership of the World Federation of Exchanges demutualized. On the progress of demutualization see, eg, International Organization of Securities Commissions (IOSCO), Exchange Demutualization in Emerging Markets (2005). 16 Venue classifications in EU-​oriented scholarship typically segment venues according to the extent to which they are multilateral/​bilateral, transparent/​dark, and public (regulated)/​private (framed by private contracting as regards access and transparency). See, eg, Ferrarini, G and Saguato, P, ‘Regulating Financial Market Infrastructures’ in Moloney, N, Ferran, E, and Payne, J (eds), The Oxford Handbook of Financial Regulation (2015) 568 and Ferrarini, G and Moloney, N, ‘Reshaping Order Execution in the EU and the Role of Interest Groups: From MiFID I to MiFID II’ (2012) 13 EBOLR 557. 17 Some 33 per cent of equity trading took place on lit central ‘limit’ order books in the EU in 2019: Oxera, Report for the Commission on Primary and Secondary Equity Markets in the EU (2020) 168. A range of orders can be fed into order books, including ‘limit orders’ (which specify price and size) and ‘at-​best orders’ and ‘market orders’, which are executed at the best price available. ‘Central limit order books’ are a key source of liquidity in the EU cash equity trading market.

444  Order Execution Venues liquidity is pooled on the order book and prices are set by the interaction of orders. Dealer-​ based systems, which use a different functionality, also operate within this venue type. On dealer-​based venues, trading is quote-​(not order-​) driven. Liquidity is provided by quote-​ supplying dealers, connected through electronic networks, who act as market-​makers and provide continuous, competing bid and offer (buy and sell) quotes. Many venues incorporate elements of both order and quote functionalities: central order book functionalities are most strongly associated with venues characterized by high volumes of trading in highly liquid instruments;18 dealer functionalities are more associated with trading in less liquid instruments, in which trading is thinner, and in respect of which liquidity is provided by dealers. Dealer functionalities also support specialist trading as they allow counterparties to execute complex orders (such as large, price-​moving orders). The second venue type embraces a very wide range of venues but is broadly concerned with bilateral execution and so with ‘off-​exchange’/​over-​the-​counter (OTC) trading. This category can be regarded as constituting a spectrum along which trading is organized to greater or lesser extents, with entirely bilateral trading at one end; and some degree of organized trading at the other. It can also be associated with the exercise, to greater or lesser extents, of venue discretion, whether with respect to venue membership, instruments traded, or how orders are executed;19 as well as with dark trading. In the cash equity markets, for example, this second form of venue type can be associated with investment firms providing bilateral, discretionary, execution services OTC to their clients: in this venue setting, orders from clients might be executed bilaterally by brokers, dealing, in this guise, as principal and on own account; or, alternatively, ‘crossed’ internally by brokers against other client orders -​in each case instead of being routed by brokers to an organized venue. Trading of this type has long been a feature of the cash equity markets in the EU and internationally.20 Technological innovation, such as the rise of automated, high volume ‘crossing’ services (in particular Broker Crossing Networks (BCNs)) and of networks which link dealers with liquidity providers,21 have led to a blurring of the distinction between formal/​informal and multilateral/​bilateral venues. Nonetheless, important differences of characterization and scale remain between multilateral and OTC/​bilateral venues. Bilateral trading, where it is not systematic, can be regarded, at bedrock, as a discretionary, client-​facing investment service, in the course of which the relevant dealer puts capital at risk, and is generally regulated through investment firm conduct and prudential requirements, and not the specialist rules governing multilateral venues (which do not put capital at risk). Overall, liquidity tends to determine the type of venue model deployed. Highly standardized, liquid instruments (such as cash equities) are usually traded on organized, multi-​ lateral, non-​discretionary order books. Venues become more bilateral and discretionary 18 Liquidity is also provided through market-​makers active on the order book. In addition, high frequency traders can act as quasi-​market-​makers where they continuously provide ‘two-​sided’ (buy and sell) liquidity to the order book. 19 For an analysis of the major venue types in terms of the degree of discretion deployed see Valiente, D, Setting the Institutional and Regulatory Framework for Trading Platforms: Does the MiFID Definition of OTF Make Sense? ECMI Research Report 8/​2012 (2012). 20 eg IOSCO, Principles for Dark Liquidity (2011) 4. 21 Shortly before MiFID II/​MiFIR came into force in 2018, concerns emerged as to whether the regulatory devices it uses to secure a level playing-​field between multilateral and bilateral venues were sufficiently robust to prohibit investment firms from dealing bilaterally and being regulated accordingly but, at the same time, drawing liquidity from networks of liquidity providers, including high frequency algorithmic traders, and thereby, in effect, acting as multilateral venues without being subject to appropriate regulation.

V.1  Order Execution Venues and Regulation  445 as the instruments traded become more complex and bespoke, and as trading, relatedly, moves from the secondary to the primary markets, and liquidity accordingly thins.

V.1.2.2 Regulation of Order Execution Venues Venue regulation accordingly faces significant challenges as to how the regulated population is fixed and how different execution functionalities are addressed. Its driving concern, however, is with ensuring market integrity, efficiency, and stability and with the related protection of liquidity.22 Venue regulation was originally directed to the major public cash equity venues or stock exchanges (organized, multilateral, and non-​discretionary). These exchanges, constituted as mutual structures owned by their members, and providing a wide range of services (including listing, trading, and data provision), were, however, regarded as quasi-​public-​ interest actors and were afforded significant discretion and flexibility in running their execution functionalities; regulators, in effect, outsourced regulation to the exchanges. The grip of regulation tightened in the wake of the 1990s stock exchange demutualization movement, given the related risk of incentive mis-​alignment between venue interests, shaped by shareholder interests, and public interests.23 Authorization, operational, and access requirements, as well as extensive transparency rules (or rules which require the disclosure of pre-​trade bid (buy)/​offer (sell) prices and of post-​trade price, volume, and time information to support of price formation) followed. A related set of reforms followed the rapid development of new forms of venue from the early 1990s on. These venues operated in parallel with the traditional stock exchanges but typically provided more limited services, usually trading services and not listing services, and targeted specific asset classes, usually bonds and derivatives.24 The reforms sought to protect the distinct functionalities of these new venues and their benefits, but to regulate the risks they generated. These ranged from risks to liquidity and to price formation (where liquidity fragmented across multiple venues and trading was ‘dark’); systemic risks (where venues (or their participants) did not have sufficient financial resources or where their trading functionalities were not adequately bolstered against counterparty risk); market abuse risks (where there was not sufficient regulatory oversight); and investor protection risks (including as regards the elevated conflict-​of-​interest risk that could arise where an investment firm executed a client order by ‘internalization’ (or by executing the order bilaterally by crossing client orders or by dealing on own account). Framing all these risks was the over-​arching risk of regulatory arbitrage, given a lack of clarity as to whether these new venues were simply a form of execution service provided by investment firms (and so best regulated by investment firm conduct and prudential requirements) or instead multilateral venues akin to stock exchanges (and so best regulated through discrete, venue-​related rules). The reform movement accordingly sought to address the different risks engaged, deploying classification techniques to identify the specific trading functionalities which required targeted regulation.25 22 eg Levine, n 7 and Amihud, Y and Mendelson, H, ‘Asset Pricing and the Bid Ask Spread’ (1986) 17 JFE 223. 23 From an extensive literature see Brummer, C, ‘Stock Exchanges and the New Markets for Securities Law’ (2008) 75 University of Chicago LR 1435; Fleckner, n 13; Jackson, H and Gadinis, S, ‘Markets as Regulators. A Survey’ (2007) 80 Southern California LR 1239; and Ferran, E, Building an EU Securities Market (2004) 239–​54. 24 See references at n 13. 25 See, eg, Lee, R, Running the World’s Markets. The Governance of Financial Infrastructure (2011).

446  Order Execution Venues The global financial crisis led to another reform cycle. Venue regulation was not a major feature of the international reform agenda, at least initially, with order execution venues performing reasonably well over the crisis.26 The G20 commitment to closing regulatory gaps and to increasing transparency,27 can, however, be associated with the sharpening regulatory focus, over the financial crisis period, on ‘dark’ trading volumes.28 Venue regulation also began to focus more closely on reducing financial stability risks and, relatedly, on venue resilience.29 Similarly, venue regulation moved beyond its traditional concern with supporting capital-​raising and price formation to become more associated with supporting risk management, particularly in the derivatives markets:30 the G20 commitment to repatriate the trading of standardized derivatives from the OTC space to organized order execution venues31 was designed to strengthen the resilience and transparency of derivatives trading by interposing trading infrastructures into derivatives transactions and by, in consequence, strengthening transparency, liquidity, and risk management in derivatives markets and bringing regulatory oversight to bear.32 Since the financial-​crisis period, and notwithstanding continued innovation,33 venue regulation has been one of the quieter corners of financial markets regulation. The wider infrastructure-​oriented reform agenda has been mainly focused on the clearing of OTC derivatives through CCPs (see Chapter VI); and on the appropriate infrastructures to support trading in crypto-​assets.34 For example, the capacity of order execution venues to manage market disruption has not drawn close attention from the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB) over recent periods of acute volatility, with venues broadly managing to contain the elevated volatility in certain market segments that was unleashed by the Covid-​19 pandemic over 2020 and

26 eg Angel, J, Harris, L, and Spatt, C, ‘Equity Trading in the 21st Century’ (2011) (1) Q J of Fin 1. ESMA’s Board of Supervisors similarly reported that trading market infrastructures held up well over the acute market volatility in the euro-​area sovereign debt markets over summer 2011: Board of Supervisors Meeting, 20 September 2011. 27 Washington G20 Summit, November 2009, Declaration of the Summit on Financial Markets and the World Economy, Action Plan to Implement Principles for Reform. 28 Dark equity trading came to attract close international attention over the crisis era from, inter alia, the US Securities and Exchange Commission (SEC) and the Australian regulator (ASIC): eg, US SEC Release No 34-​ 60997, Regulation of Non-​Public Trading Interests (2010) and US SEC Release No 34-​61358, Concept Release on Equity Market Structure (2010); and ASIC Consultation Paper 145, Australian Equity Market Structure: Proposals (2010). Similarly, IOSCO highlighted increasing fragmentation across equity trading venues and an increase in dark trading: IOSCO, Securities Markets Risk Outlook 2013–​2014 (2013). 29 Hu, H, ‘Efficient Markets and the Law: A Predictable Past and an Uncertain Future’ (2012) 4 Annual Rev of Financial Economics 179, suggesting that the US SEC, over the financial crisis, came to subordinate its traditional market efficiency priority to financial stability concerns. 30 See further Moloney, N, ‘The Legacy Effects of the Global Financial Crisis on Regulatory Design in the EU’ in Ferran, E, Moloney, N, Hill, J, and Coffee, J, The Regulatory Aftermath of the Global Financial Crisis (2012) 111; Langevoort, D, ‘Global Securities Regulation After the Financial Crisis’ (2010) 13 JIEL 799; and Anand, A, ‘Is Systemic Risk Relevant to Securities Regulation?’ (2010) 60 U of Toronto LJ 941. 31 Pittsburgh G20 Summit, September 2009, Leaders’ Statement. 32 Financial Stability Board (FSB), Implementing OTC Derivatives Market Reforms (2010) 39–​43. See further Ch VI section 5 on derivatives trading. 33 Particularly as regards the extent to which continuous liquidity is provided by actors other than traditional, on-​venue market-​makers (such as high frequency algorithmic traders): IOSCO, Liquidity Provision in the Secondary Market for Equity Securities (2020). 34 See, for a policy perspective, ECB Crypto-​Assets Task Force, Crypto-​Assets: Implications for Financial Stability, Monetary Policy and Payments and Market Infrastructures, Occasional Paper No 223 (2019) and, from the literature, Veil, R, ‘Blockchain and the Future of Financial Market Infrastructures’ in Binder and Saguato, n 3. As noted in n 6, the regulation of crypto-​assets falls outside the scope of this book but is noted in outline in Ch I section7.3.

V.1  Order Execution Venues and Regulation  447 by Russia’s invasion of Ukraine in 2022.35 Trading practices, rather than order execution venues, have drawn most concern.36 The area is not, however without contestation. The financial-​crisis-​era debate on the extent to which the expansion of venue regulation, and in particular of transparency regulation, would detrimentally reshape liquidity by reducing dealer capacity continues to roil.37 Common to all these reform periods are the regulatory challenges (and the related market and political contestation) generated by efforts to construct a regulatory framework for order execution venues that is stable, not distortive of liquidity, and supportive of competition between, and equivalent regulatory treatment of, different forms of venue.38 Transparency regulation poses distinct challenges in this regard, as discussed in the following section.

V.1.2.3 Order Execution, Venue Regulation, and Transparency Transparency regulation is a mainstay of venue regulation. It relates to the mandatory publication of the pre-​trade offer and post-​trade transaction information produced by a venue and its availability to the market on a real-​time basis, in order to attract and support liquidity and to strengthen price formation.39 Relatedly, it is typically regarded as a key regulatory mitigant of the risks from thin liquidity and to price formation that can arise where trading in a financial instrument is fractured across multiple venues: transparency regulation can have the effect of tying together execution data from different venues and of thereby reducing liquidity risks and supporting price formation.40 Mandatory transparency requirements can also support clients/​counterparties in monitoring the execution process and support regulators in detecting emerging risks and misconduct. But mandatory transparency requirements engage a trade-​off which can be difficult to calibrate accurately as different trading functionalities have different levels of sensitivity to mandatory transparency requirements. In particular, in quote-​driven or dealer venues, because trading sentiment 35 As regards the pandemic see, eg, IOSCO, Operational Resilience of Trading Venues and Market Intermediaries during the Covid-​19 Pandemic (2022). IOSCO reported that trading venues were largely resilient over the pandemic and had managed periods of extreme volatility and record trading volumes. Similarly, FSB, Lessons from the Covid-​19 Pandemic from a Financial Stability Perspective. Final Report (2021), reporting that financial market infrastructures had functioned as intended. As regards the volatility that followed the 2022 Russian invasion of Ukraine, the FSB reported that, despite increased volatility and price disruption (in commodity markets in particular), the financial system had functioned in an orderly manner: FSB, Letter to the G20, 14 April 2022. 36 Including as regards payment-​for-​order-​flow, the practice associated with the meme-​stock/​Gamestop trading spike in early 2021 (see further Ch VI section 2.2). 37 See nn 41 and 42. 38 These challenges remain at the heart of the EU debate, as discussed throughout this Ch. For a US assessment that is supportive of venue competition, and of tailored regulatory regimes that facilitate different forms of lightly regulated, dealer-​oriented venues, see Fox et al, n 12 and, for a more critical, internationally oriented assessment, that warns of the risks of ever-​expanding ‘decentralized networks’ of dealers and that emphasizes the value of concentrated, on-​venue trading see Donald, D, ‘From Block Lords to Blockchain. How Securities Dealers Make Markets’ (2018) 44 J Corp L 29. 39 An extensive, primarily finance oriented literature considers the interaction between transparency requirements, liquidity, and price formation. See, eg, Madhavan, A, ‘Market Microstructure: A Survey’ (2000) 3 J of Fin Markets 205. For a recent policy perspective (on equity market transparency regulation) see IOSCO, Market Data in the Secondary Equity Markets (2020), which takes the normative position that mandated transparency is a public good and focuses on how this data can be best accessed and consolidated. 40 See, on the US market experience, O’ Hara, M, ‘Is Market Fragmentation Harming Market Quality’ (2011) 100 JFE 459, finding that despite the fragmentation of trading across multiple venues in the US equity market, market quality (including price formation) was not prejudiced, and associating this with the sophisticated ‘consolidated tape’ which aggregates trade information across venues. By contrast, the fragmented EU market has yet to produce a consolidated tape (section 12.4).

448  Order Execution Venues reacts to action by dealers, the mandatory publication of a dealer’s position (the prices/​volumes it is willing to trade at) could lead to strategic behaviour by other traders and expose the dealer to market impact risks. These risks can be acute with pre-​trade transparency requirements. In principle, ‘lighting’ pre-​trade orders and quotes carries risks. From the client or counterparty perspective, pre-​ trade transparency requirements carry market impact risks, particularly for large orders, as the market may move against an order as it is disclosed to the market, pre trade, and executed (a large sell order, disclosed to the market, may drive the price down). From the venue perspective, multilateral order-​based venues are not exposed to risks (directly) from pre-​trade transparency requirements; these venues facilitate the interaction of different orders and do not trade directly or put their capital at risk and they also typically benefit from regulatory waivers that allow some degree of non-​transparent (dark) trading to protect large orders in particular. Dealer-​based and bilateral venues, however, face sharper risks from pre-​trade transparency requirements. As dealers execute orders against their capital and thereby take on principal risk (by either holding or selling the relevant financial instruments), mandatory pre-​trade transparency requirements meant that they become directly exposed to market impact risk, as their trading position is disclosed to the market and could be systematically undermined, increasing costs and creating incentives to withdraw from dealing. A withdrawal of dealing capacity can, in turn, drive a prejudicial contraction of liquidity in impacted asset classes and, potentially, generate stability risks in stressed conditions.41 Transparency requirements are also sensitive to the type of instrument traded. The equity markets are associated with multilateral order-​book trading, with high levels of trading activity and liquidity, and accordingly with significantly lower risks in terms of the market impact risk of pre-​trade transparency requirements. Non-​equity markets, however, typically operate through quote-​based dealer systems and can also be much less liquid, increasing the risks to dealers’ positions. Bond markets, for example, are considerably less liquid than the equity markets and experience much thinner trading patterns. Trading is typically concentrated at the time of issue, and over the months immediately following as the issue is redistributed; trading typically then thins very significantly until the period shortly before the issue matures, when taxation and other drivers prompt stronger trading. In addition, pricing (and liquidity) is affected by a range of factors beyond transparency data, including macro-​economic conditions (including, as conditions at the time of writing underline, the interest rate environment) and credit risk. Accordingly, transplantation of the transparency model for trading in equity asset classes to trading in less liquid non-​equity asset classes, as regards which dealers provide liquidity in conditions of often thin liquidity, can generate 41 This risk was the animating concern of the post-​financial-​crisis debate on whether bond market liquidity was being restructured by a withdrawal of dealing capacity (in response to the financial-​crisis-​era reforms which extended beyond transparency regulation to include the imposition of more costly capital requirements on dealing): see n 42 for representative studies. The Covid-​19 pandemic saw bond market liquidity come under renewed regulatory scrutiny. The severe dislocation internationally in certain bond market segments over the pandemic in 2020 (for an analysis of the US market experience see O’Hara, M and Zhou, X, ‘Anatomy of a Liquidity Crisis: Corporate Bonds in the Covid-​19 Crisis’ (2021) 142 JFE 46), which was arrested by central bank intervention globally, prompted an FSB-​led work programme on the constraints to dealing capacity and the related risks, but transparency regulation was not implicated: 2021 FSB Covid-​19 Lessons Learnt Report, n 35. Similarly, while the OECD raised concerns about liquidity in the sub-​investment-​grade bond market, the liquidity constraints were associated with bond issuance patterns and credit conditions, not with the impact of transparency requirements: OECD, Corporate Bond Market Trends, Emerging Risks and Monetary Policy (2020).

V.1  Order Execution Venues and Regulation  449 liquidity risks where dealers, in consequence, face elevated market impact risk, but there may not be significant benefits in terms of pricing dynamics. These risks can then be exacerbated by economic and market conditions and other factors, including other regulatory requirements, that can restructure non-​equity liquidity and change how dealers intermediate this liquidity.42 It is accordingly not easy to design a venue rulebook which is appropriately calibrated to the wide range of trading functionalities on which different asset classes trade, and which also supports an optimal level of transparency. As outlined later in this chapter, EU venue regulation has long struggled with how to capture different venue functionalities within a rulebook that also ensures a regulatory level playing-​field and does not distort the objectives of venue regulation, including as regards the support of liquidity.

V.1.3  Regulating Trading Venues and the EU As discussed throughout this chapter, the EU’s regulation of venues grapples with the major policy issues which venue regulation raises generally. But venue regulation in the EU has two distinct features. First, it has long been oriented towards internal market construction and market integration. The pivotal 2004 MiFID I regime, which first established a harmonized regulatory framework for venue regulation in the EU, was designed to liberalize order execution in shares and to promote competition between the then-​incumbent stock exchange sector and the emergent OTC sector. MiFID I accordingly abolished the ‘concentration’ requirement then in place in some Member States, which required all share orders to be centralized on the main stock exchange in that Member State, and opened the way for venue competition in share trading. To ensure a level playing-​field between competing share trading venues, support liquidity and price formation, and ensure investor protection, it also imposed a related venue classification and regulation regime, calibrated to different venue functionalities. Under MiFID II/​MiFIR, the venue regime, which is still designed to support competitive order execution, became more regulatory than liberalizing in orientation and extended venue regulation, particularly transparency regulation, from equity to non-​equity asset classes. Second, venue regulation has long been highly politicized in the EU. This reflects the competitive territory at stake, given the concentration of different types of venue in certain Member States. Member States have accordingly held sharply different positions on, for 42 Whether or not bond market liquidity has contracted to prejudicial effect, whether any such contraction has generated stability risks, and whether regulatory reform is implicated have been recurring features of the post-​ financial-​crisis debate on the risks posed by non-​bank financial intermediation. See, eg, the series of reports from IOSCO (Liquidity in Corporate Bond Markets in Stressed Conditions (2019); Regulatory Reporting and Public Transparency in the Secondary Corporate Bond Market (2018); and Examination of Liquidity of the Corporate Bond Markets (2016)) as well as the reviews by the UK Financial Conduct Authority (FCA, New Evidence on Liquidity in Corporate Bond Markets (2017) and FCA, Occasional Paper 14, Liquidity in the UK Corporate Bond Market: Evidence from Trade Data (2016)). Both sets of reviews found that there had not been a major reduction in liquidity. They did, however, suggest that dealer liquidity was being restructured: some dealers were withdrawing from market-​making activity, others were doing so on a risk-​less principal basis (using back-​to-​back trading and not putting capital at risk), and others were engaging only in agency (commission-​based) execution services. The change was primarily associated with wider market conditions, including central bank quantitative easing measures and related sharp increases in volumes of bond issuance, and less so with regulatory reforms.

450  Order Execution Venues example, whether share trading should be moved from the ‘dark’ bilateral/​OTC space to organized ‘lit’ venues.43 While Member State interests are in many respects entrenched and longstanding, they are also dynamic: the withdrawal of the UK from the EU has meant the removal of one of the strongest proponents of competition between different types of venue. As a result, while the regulatory design complexities which venue regulation generates are, in any event, considerable, they are all the greater in the EU as intense politicization can place considerable pressure on the quality of regulation. The political tensions have abated somewhat since the adoption of MiFID II/​MiFIR. Venue regulation has increasingly become a creature of metrics and data and the European Securities and Markets Authority (ESMA), relatedly, has become something of an engine-​room within which the venue regime is being refined and adjusted. The 2020 MiFID II/​MiFIR Review, however, saw the resurgence of longstanding interests and tensions as to how order execution venues should be organized and thereby exposed the persistent challenge the EU regulatory system faces in translating complex political compromises into stable and resilient regulation.

V.2  The Evolution of the Venue Regime V.2.1  From Concentration to Competition: MiFID I The regulation of venues was not comprehensively addressed by the EU until the 2004 adoption of MiFID I.44 MiFID I was a transformative measure.45 It abolished the ‘concentration’ rule which, under the 1993 Investment Services Directive (ISD),46 allowed Member States to require that equity orders be routed to national stock exchanges47 and thereby entrenched the centralization of equity trading on incumbent stock exchanges.48 MiFID I accordingly 43 France and the UK, in particular, long adopted different approaches to the organization of share trading. Over the financial-​crisis era, France used its 2011 Presidency of the G20 to promote the movement of share trading from OTC venues to the organized venue space (G20, Paris Communiqué (2011)). Its longstanding suspicion of pan-​EU competition between share trading venues can be traced back to earlier battles over the 1993 Investment Services Directive and to France’s attempts then to prevent the trading of French shares on SEAQ-​International in London. Conversely, the UK, pre-​Brexit the location of most OTC trading in the EU, consistently advocated for competitive order execution and a facilitative regulatory framework. 44 From the extensive MiFID I literature see Davies, R, Dufour, A, and Scott-​Quinn, B, ‘The MiFID: Competition in a New European Equity Market Regulatory Structure’ in Ferrarini, G and Wymeersch E (eds), Investor Protection in Europe. Corporate Law Making, the MiFID and Beyond (2006) 163; Alemanni, B, Lusignani, G, and Onado, M, ‘The European Securities Industry: Further Evidence on the Roadmap to Integration’, in Ferrarini and Wymeersch, 199; and Ferrarini, G and Recine, F, ‘The MiFID and Internalisation’, in Ferrarini and Wymeersch, 235. 45 eg Lannoo, K and Casey, JP, The MiFID Revolution. European Capital Markets Institute Policy Brief (2006). 46 Directive 93/​22/​EEC [1993] OJ L141/​27. The ISD was the EU’s first attempt at venue regulation. It was limited in scope and largely concerned with investment firm access to the then-​dominant stock exchanges. It introduced the concept of a ‘regulated market’, conferred a passport on investment firms to access regulated markets across the EU, and empowered regulated markets to maintain remote screens in host Member States (a form of passport, in effect). 47 It was most associated with France, Germany, and Italy. 48 The rule was the outcome of a polarized ISD negotiation which saw the ‘Alliance’ group of Member States (the UK, Germany, Ireland, Luxembourg, and the Netherlands) support free competition and raise concerns as to the damage which the concentration rule could wreak on OTC markets, and the ‘Club Med’ group (France, Spain, Portugal, Greece, Italy, and Belgium) demand the centralization of all transactions on a regulated market in order to support the liquidity of that market and ensure a high level of investor protection. Protectionist undercurrents were strong with certain Member States concerned to protect their markets from the then dominant London Stock Exchange; France, in particular, was concerned to repatriate French share trading, a significant proportion of which took place in London. A compromise position was finally adopted which made the concentration rule optional and imposed conditions on its use.

V.2  The Evolution of the Venue Regime  451 sought to impose competitive discipline on the EU’s incumbent stock exchanges and to harness ongoing industry innovation.49 It was the most ambitious of the Financial Services Action Plan (FSAP) reforms, and generated intense interest internationally.50 MiFID I also responded to a period of sweeping market structure change. From the mid-​1980s, market changes wrought by the euro, technological developments, new entrants (including the 2000 launch of Euronext), the emergence of an equity culture and the strengthening of market finance, and exchange demutualization were all driving greater competition between the incumbent stock exchanges for share business.51 The major exchanges remained dominant in share trading, however, particularly given the vertical integration of trading and post-​trading structures in some Member States but also the impact of concentration rules. And while organized venues began to develop outside traditional stock exchanges, their impact was primarily felt in bond trading (the MTS electronic trading platform for euro-​denominated sovereign debt, for example, centralized trading in the sovereign debt market), and they were not notably successful in attracting equity trading.52 Share trading remained the almost exclusive preserve of the major stock exchanges, and liquidity in shares remained ‘sticky’ and pooled at the major exchanges.53 MiFID I was accordingly designed to liberalize share trading and to promote competition between different share-​trading venues in the interests of innovation, price competition, and investor choice but it also had to resolve a regulatory conundrum which has troubled EU regulation since. Once order execution disperses across different venues in a competitive setting, a series of risks arise. Chief among them are the likely fragmentation of liquidity across different venue liquidity pools and a consequent diminution of the efficiency of the price-​formation process (as all orders do not interact)54 and of the ability of brokers to deliver best execution; and the generation of conflict-​of-​interest risk for clients, where client orders are executed by a broker and are not routed to a non-​discretionary multilateral platform.55 Supervisory risks are also generated, including as regards the monitoring of market abuse and of risks to financial stability arising from liquidity pressures. These risks can be in part addressed by transparency requirements, which tie together different liquidity pools and, to different degrees, expose trading interests and activity on competing venues.56 But venue regulation, including transparency regulation, in a competitive 49 The US at this time also supported competitive order execution through ‘Regulation NMS’, which came into force in March 2007. 50 US SEC Commissioner Campos stated that ‘it is not an overstatement to say that [MiFID] will markedly change the regulatory landscape in Europe and globally. It will be a new global frontier’: Speech, 10 May 2007. 51 See Pagano, M and Steil, B, ‘Equity Trading I: The Evolution of European Trading Systems’ in Steil, B (ed), The European Equity Markets: The State of the Union and an Agenda for the Millennium (1996) 1. 52 Webb, S, ‘Exchanges, MTFs, Systematic Internalisers, and Data Providers—​Winners and Losers in a Post-​ MiFID World’ in Skinner, C (ed), The Future of Investing in Europe’s Markets After MiFID (2007) 151. 53 The Commission reported in 2002 that alternative trading systems accounted for only 1 per cent of equity trading volumes: 2002 MiFID I Proposal (COM 2002) 625) 8. The ill-​fated Jiway platform, eg, a joint venture between Morgan Stanley and OM, was established as a pan-​EU platform for retail trades in European shares, but closed in early 2003 given high clearing and settlement costs, the ‘stickiness’ of liquidity, which remained pooled at the major exchanges, and limited demand from retail investors: JP Morgan, MiFID Report II. Earnings At Risk Analysis—​The Threat to the Integrated Banking Model (2006) 33–​4. 54 Price formation risks can become acute where informative ‘limit orders’, which specify a quantity and price, are not channeled through to the central order books of major public venues. Risks also arise where off-​exchange trading leads to the ‘hiding’ of large trading interests. 55 See generally Gadinis, S, ‘Market Structure for Institutional Investors: Comparing the US and EU Regimes’ (2008) 3 Virginia Law & Business Rev 311. 56 As well as by conduct rules, chief among them best execution requirements which require brokers to discover, and direct orders to, the liquidity pool which delivers the ‘best’ result for the client (Ch VI section 2.2).

452  Order Execution Venues venue setting, requires calibration according to venue functionality, a complex exercise which has preoccupied EU venue regulation since MiFID I. MiFID I accordingly sought to liberalize share trading and to manage, through regulation, the related fragmentation risks, but it also sought to construct a level regulatory playing-​field between the different order execution venues in the liberalized share trading market. To do so, it established a new venue classification system. Given the scale of the market restructuring implied, the related negotiations were the most bitter and complex of EU financial markets regulation pre-​financial-​crisis, seeing fierce clashes between the incumbent stock exchange sector and the bilateral/​OTC sector.57 The stock exchange sector sought to protect its position from competition and to concentrate share orders on exchanges or, failing that, to impose similar rules on off-​exchange/​OTC venues. The OTC sector argued that its dealing-​based (and also order-​crossing-​based) execution functionality was different to that of exchanges, and that the imposition of similar rules, and in particular transparency rules, would generate risks and costs of such magnitude that this execution business would become unsustainable, with consequent damage to innovation and investor choice.58 These entrenched positions were reflected in the sharply opposing positions taken by certain Member States and the institutions and shaped the very difficult Council and European Parliament negotiations. MiFID I’s classification model for venue regulation was, accordingly, a compromise which reflected the difficult political and institutional negotiations rather than a coherent expression of order execution regulation.59 The four-​level classification model MiFID I ultimately adopted has, however, proved resilient, with MiFID II/​MiFIR adding one more classification (the Organized Trading Facility (OTF)), and the 2020 MiFID II/​MiFIR Review and related 2021 MiFID III/​MiFIR 2 Proposals not suggesting major reforms. Under its venue classification model, MiFID I applied the highest level of regulation to multilateral, non-​discretionary venues (for MiFID I financial instruments), which brought together multiple third party buying and selling interests in accordance with non-​discretionary rules, and which took the form of ‘regulated markets’ (RMs). In practice, the RM classification captured the incumbent stock exchanges. RMs were subject to authorization requirements and high-​level organizational rules, including with respect to conflicts-​of-​interest management, risk management, trading rules, financial resources, and market monitoring. They were also subject to pre-​trade and post-​trade trading transparency rules with respect to shares admitted to trading on an RM (the MiFID I transparency rules applied to shares only; the MiFID II/​MiFIR transparency regime has a vastly wider reach across different asset classes), although Member States could apply waivers which supported dark trading in shares. The RM classification was (and remains) something of 57 The MiFID I negotiations have been extensively examined. See, eg, the third edition of this book at 769–​78, and Ferrarini and Recine, n 44. 58 An influential position paper by a group of UK trade associations argued that while the centralized limit order book operated by many exchanges was appropriate for orders of a similar size, where buyers and sellers were equally matched, and where there was no particular demand for immediate execution and investors could wait for their orders to be matched, it suffered from limitations, particularly for large, bespoke trades: APCIMS, FOA, IPMA, ISMA, ISDA, LIBA, and TBMA, Innovation, Competition, Diversity, Choice. A European Capital Market for the 21st Century (2002). 59 ‘[T]‌he drafters of the Directive . . . seem to have chosen to compromise with special interest group demands from the investment industry on the one hand and the operators of securities markets on the others’: Köndgen, J, and Theissen, E, ‘Internalization under the MiFID: Regulatory Overreaching or Landmark in Investor Protection’ in Ferrarini and Wymeersch, n 44, 271, 284.

V.2  The Evolution of the Venue Regime  453 a muddle, in that it blurred the secondary market trading functionality of RMs with their primary market ‘admission to trading’ and other issuer-​facing functionalities. This blurring arose as RMs were distinguished from other multilateral, non-​discretionary venues by the distinct regime which applied to the admission of securities to trading on an RM and by the extensive issuer-​disclosure obligations which followed; as discussed in Chapter II, admission to an RM is a key perimeter for the EU’s issuer disclosure regime. The RM classification, accordingly, was (and remains) discretionary, in that venues could ‘opt-​in’ to RM status. Second, multilateral, non-​discretionary venues (for MiFID I financial instruments), which brought together multiple third party buying and selling interests in accordance with non-​discretionary rules, but which did not opt for RM status, were designated as multilateral trading facilities (MTFs). The MTF classification was thus MiFID I’s attempt to capture the distinct trading functionality which distinguishes organized venues from bilateral/​ OTC venues. Operating an MTF was, however, characterized as an ‘investment service’: as remains the case, an MTF investment service could be provided by a ‘market operator’ (in effect, an RM operator) or by an investment firm. Where provided by an investment firm, the MTF investment service was subject to the MiFID I investment firm regime, albeit with additional requirements reflecting the multilateral trading functionality of this service and similar to the rules imposed on RMs. Market operators were also permitted to provide MTF investment services, subject to verification of their compliance with MiFID I’s conditions for investment firm authorization and their compliance with the investment firm rules governing MTF operation. In practice the operating regime applicable to RMs and MTFs was similar (but not identical), with MTFs also subject to pre-​and post-​trade transparency requirements regarding shares admitted to RMs. The OTC/​bilateral space was the default ‘venue classification’ for all other forms of order execution platform, albeit that MiFID I did not address OTC venues directly but rolled such execution services into the regulation of investment services generally. For example, pre-​trade transparency rules did not accordingly apply and so OTC venues were dark pre-​ trade. MiFID I required, however, in a significant change for some Member States, that post-​trade transparency disclosures be made by investment firms with respect to trades in RM-​admitted shares. MiFID I also imposed, as a compromise measure designed to bridge between organized venue and OTC/​bilateral interests, a specific regime on a subset of the OTC venue sector. The new regime for ‘systematic internalizers’ (SIs) applied to investment firms which executed (dealt in) client orders against their proprietary positions, but on a systematic basis: an SI was a firm which, on an ‘organized, frequent, and systematic basis’, dealt on own account by executing client orders outside an RM or MTF. Although regulated as investment firms, SIs were additionally subject to a highly contested pre-​trade transparency regime, applicable to trades in shares admitted to an RM. This regime was highly complex and calibrated, reflecting difficult institutional negotiations and the concern of the OTC sector that pre-​trade transparency requirements would expose SIs to significant position risk. The essentials of this regime (which was supported by extensive administrative rules under the 2006 Commission MiFID I Regulation),60 including the RM, MTF, and SI



60

Commission Regulation (EC) No 1287/​2006 [2006] OJ L241/​1.

454  Order Execution Venues classifications, remain in place under MiFID II/​MiFIR, although the regime has become much broader in scope and more nuanced in application.

V.2.2  Market Impact and MiFID I MiFID I was designed as a transformative measure but its impact, which was closely monitored and assessed,61 was not always as predicted,62 underlining the challenges in using what can be unwieldy, unpredictable, and novel regulatory tools to achieve structural change. These challenges have persisted with MiFID II/​MiFIR, as outlined below in this chapter. While it proved difficult to disaggregate the impact of MiFID I from the impact of changes in the order execution environment generally, its abolition of the share-​trading concentration rule certainly created a setting within which multiple competing equity trading venues could develop. Over the MiFID I-​era, equity trading fragmented across a range of venues—​ organized/​formal and OTC; and dark and lit.63 The Commission’s 2011 MiFID II/​MiFIR Impact Assessment identified 231 organized venues in the EU, including 139 MTFs and 92 RMs—​of which 45 RMs and 50 MTFs traded equities—​but only 12 SIs.64 Most equity trading was taking place on RMs and MTFs, which together accounted for some 60–​70 per cent of equity trading as the MiFID I Review progressed. Although RMs remained dominant in the organized venue space, reflecting their incumbency advantages with respect to liquidity, MTF market share significantly increased.65 A significant proportion of trading—​ some 30–​40 per cent—​remained OTC, however, albeit that, in a debate which continues to roil,66 the accuracy of this reporting was sharply contested.67 Relatedly, a significant proportion of equity trading (some 45 per cent or so) was reported as being dark at the time of

61 The market-​shaping effects of MiFID I were extensively analyzed, albeit primarily, and in contrast to the MiFID II/​MiFIR Review process which drew heavily on ESMA’s capacity, outside the EU’s institutional apparatus. See, eg, Assi, B and Valiante, D, MiFID Implementation in the Midst of the Financial Crisis, ECMI Research Report No 6 (2011); Lazzari, V (ed), Trends in the European Securities Industry (2011); Petrella, G, ‘MiFID, Reg NMS and Competition Across Trading Venues in Europe and the USA’ (2010) 18 JFRC 257; and Lannoo, K and Valiante, D, The MiFID Metamorphosis, ECMI Policy Brief No 16 (2010). From the array of empirical studies see, eg, MiFID: Spirit and Reality of a European Financial Markets Directive (2010), a report by Gomber, P and Pierron, A (2010 Celent Report); and London Economics, Understanding the Impact of MiFID in the Context of Global and National Regulatory Innovation (2010) and (2011), each for the City of London Corporation. 62 Notwithstanding the scale of the MiFID I reforms, but reflecting the then-​prevailing approach to regulatory design, the Commission did not engage in ex-​ante cost-​benefit analysis. A UK study quantified the first-​order benefits of MiFID I generally (and including the investment firm provisions) in terms of £200 million annually in direct benefits, second-​round economy-​wide benefits of £240 million (arising from deeper and more liquid capital markets), and unquantified third-​order benefits (related to the potential increase in the long-​term sustained growth rate for the UK). It estimated the one-​off costs in the region of £877 million to £1.71 billion, and ongoing costs in the region of £88 to £117 million: FSA, The Overall Impact of MiFID (2006). 63 eg Grob, S, ‘The Fragmentation of European Equity Markets’, in Lazzari, n 61, 127. 64 2011 MiFID II/​MiFIR Proposals Impact Assessment (IA) (SEC(2011) 1226) 88. 65 The largest MTFs accounted for 23 per cent of organized equity trading at January 2011, while MTFs generally accounted for 25–​30 per cent of trading activity in the main listed equities: 2011 MiFID II/​MiFIR Proposal IA, n 64, 88. 66 See n 321 in the context of the MiFID II/​MiFIR Review. 67 The scale of OTC equity trading was heavily contested by the industry (which argued that not all OTC trading represented ‘executable liquidity’ which could be transferred to organized venues). Over the MiFID I Review, the 30–​40 per cent OTC figure was supported by the Commission (2011 MiFID II/​MiFIR Proposals IA, n 64, 12 and 88 (estimating the OTC market at 37–​8 per cent of total trading)) and the European Parliament (Resolution on the Regulation of Trading in Financial Instruments, 14 December 2010 (A7-​0326/​2010) para H).

V.2  The Evolution of the Venue Regime  455 the MiFID I Review, reflecting the scale of OTC trading.68 Dark trading could take place on RM/​MTF venues (in ‘dark pools’ supported by transparency waivers), but trading on these venues was predominantly lit (90 per cent); most dark trading was taking place in the OTC space.69 The number of dark pools operated by RMs/​MTFs increased, however, following the adoption of MiFID I.70 Although the SI regime had dominated the MiFID I negotiations, the technology demands, the required risk appetite for managing position risk, the capital needed, and the necessary trading expertise had made it likely that only a limited number of firms would adopt the SI business model, and that other OTC firms would either limit their internalization activities to avoid classification as an SI, or operate as MTFs instead.71 In practice this was borne out: SIs did not capture large volumes of OTC share trading and accounted for only some 2 per cent of total trading.72 The unattractiveness of the SI business model was clear from the start, with only eleven firms initially registered as SIs.73 In terms of market quality, difficulties had emerged by the time of the MiFID I Review. While pre-​trade transparency had improved,74 liquidity fragmentation across venues, in combination with the rise of algorithmic trading, had become associated with a reduction in order size75 and with a related limiting of the capacity of institutional investors to manage the market impact of large equity trades. In addition, and although a large and competitive market in data had been predicted to follow from MiFID I, transparency data quality emerged as a concern76 (particularly with respect to proprietary OTC post-​trade transparency data-​streams), as did the limited progress made on the consolidation of transparency data. Further, while trading costs reduced,77 these reductions were asymmetrically allocated: liquidity providers benefited but other traders often did not see a real reduction in trading costs.78 Finally, the overall impact on liquidity, at the time of the MiFID I Review, was unclear, with some concern as to a thinning of liquidity and of MTFs pulling liquidity away from RMs rather than creating new liquidity,79 but with countering evidence that MTFs had attracted new liquidity from the OTC sector.80

68 While different accounts were provided by the industry, the Commission identified 45 per cent of trading as dark, with 38 per cent of dark trading in the OTC space: 2011 MiFID II/​MiFIR Proposals IA, n 64, 12. 69 Gomber, P and Gsell, M, ‘The Emerging Landscape in European Securities Trading’ in Lazzari, n 61, 89. 70 Grob referred to an ‘exponential increase’ since 2008: n 63, 158. 71 As was predicted in a leading report: Europe Economics, The Benefits of MiFID. A Report for the Financial Services Authority (2006). 72 Grob, n 63, 143. 73 CESR, Report. Impact of MiFID on Equity Secondary Market Functioning (2009) 15–​16. Six were registered with the UK authorities. SIs were also registered in Denmark and France. 74 eg London Economics (2010) and (2011) (n 61). 75 Between 2006 and 2009 the average trade size of a transaction in shares fell from approximately €25,000 to €10,000: Oxera, Monitoring Prices, Costs and Volumes of Trading and Post-​Trading Services. Report for the European Commission (2011). 76 eg 2009 CESR Equity Market Report, n 73, 26–​7. 77 2011 Oxera Report, n 75, finding that trading platforms’ costs for ‘on-​book’ trading in shares fell by 60 per cent between 2006 and 2009, although noting significant variation across platforms. 78 eg London Economics (2010), n 61. Oxera, however, reported that commission rates charged by retail brokers fell by around 35 per cent on a pan-​EU basis between 2006 and 2009: 2011 Oxera Report, n 75. 79 2010 Celent Report, n 61, 30. 80 2009 CESR Equity Market Report, n 73, 12.

456  Order Execution Venues

V.2.3  The MiFID I Review and the MiFID II/​MiFIR Proposals Although the Commission began to review the application of MiFID I almost immediately after the Directive’s November 2007 implementation,81 the MiFID I Review,82 which was required under the MiFID I review clause and which was, at the time, the most extensive and wide-​ranging review of any legislative measure of EU financial markets regulation, was launched in 2010.83 It was supported by a raft of empirical studies,84 including the extensive reviews by the Committee of European Securities Regulators (CESR)85 which foreshadowed the central role ESMA would come to play in the MiFID II/​MiFIR Review. The much-​anticipated reform proposals for what would become MiFID II/​MiFIR were published in October 2011.86 The Commission was relatively sanguine as regards the Review. It suggested that MiFID I had led to more competition, wider investor choice, a decrease in transaction costs, and deeper integration, and that the financial crisis experience had ‘largely vindicated’ its design.87 MiFID I’s underlying principles were, it suggested, valid, including with respect to competitive order execution, as long as the regulatory playing-​field remained level and transparency requirements were effective; wholesale repair was not, accordingly, required.88 The Commission’s approach to reform was accordingly based on the correction of specific weaknesses which had emerged, including as regards the pivotal venue classification model. Four developments were identified as undermining the MiFID I venue classification model: the application of less stringent rules to MTFs than RMs, despite their comparable functionality; the emergence of new venues of comparable functionality to RMs and MTFs (notably Broker Crossing Systems or Networks (BCSs/​BCNs) which allowed investment firms to internally cross client orders;89 and new derivatives trading platforms)90 but which were operating outside the RM/​MTF regulated space and which were not subject 81 The Commission-​sponsored CRA International review of the Financial Services Action Plan (FSAP) reviewed MiFID I, but reported that it was too soon after its implementation to deliver robust findings: CRA International, Evaluation of the Economic Impact of the FSAP (2009). 82 On the venue elements of the MiFID I Review see further Moloney and Ferrarini, n 16 and Clausen, N and Sørensen, K, ‘Reforming the Regulation of Trading Venues in the EU under the Proposed MiFID II—​Leveling the Playing Field and Overcoming Market Fragmentation’ (2012) 9 ECFR 275. 83 Commission, Public Consultation. Review of the Markets in Financial Instruments Directive (2010). 84 Including Europe Economics, MiFID I Review—​Data Gathering and Cost Benefit Analysis. Final Report Phase One (2011); PriceWaterhouseCoopers, Data Gathering and Analysis in the Context of the MiFID I Review. Final Report (2010); and the 2011 Oxera Report, n 75. 85 CESR/​10-​802 (2010 CESR Equity Market Technical Advice). Consultation Paper at CESR/​10-​394. CESR also presented technical advice on the trading of standardized derivatives (CESR/​10-​1096, Consultation Paper at CESR/​10-​610); on transparency in non-​equity asset classes (CESR/​10-​799, Consultation Paper at CESR/​10-​510); and on post-​trade transparency (CESR/​10-​882). 86 COM(2011) 652/​4 (2011 MiFIR Proposal) and COM(2011) 656/​4 (2011 MiFID II Proposal). 87 2011 MiFIR Proposal, n 86, 3 and 2011 MiFID II/​MiFIR Proposals IA, n 64, 5. 88 2011 MiFID II/​MiFIR Proposals IA, n 64, 5–​6. 89 The Commission acknowledged that levels of BCS/​BCN trading were low, but pointed to the US experience which suggested that these systems would grow significantly: 2011 MiFID II/​MiFIR Proposals IA, n 64, 11. CESR’s preparatory work had assessed the impact of these systems in detail and had led to it proposing a new venue classification model, based on a tailored regime applying to investment firms operating BCSs/​BCNs, and which would include volume limits on BCS/​BCN trading which, once passed, would require the investment firm, as regards BCS/​BCN operation, to become registered as an MTF: 2010 CESR Equity Market Technical Advice, n 85. Industry reaction was hostile, with concerns ranging from doubts as to whether special treatment was necessary given the SI/​MTF classifications, to the challenges raised by defining a BCS/​BCN appropriately, to whether the low volumes of BCS/​BCN trading warranted intervention. 90 The Commission pointed to the new US regulatory vehicle (the ‘swap execution facility’) created for such platforms: 2011 MiFIR Proposal, n 86, 11.

V.2  The Evolution of the Venue Regime  457 to functionally similar regulation; the scale of the growth of OTC trading, which could threaten the efficiency of price formation; and the need to provide a regulated venue for the trading of standardized OTC derivatives to comply with the related G20 commitment. In response, the 2011 MiFID II/​MiFIR Proposals revised the venue classification model across two dimensions. First, the Commission proposed that the RM and MTF rulebooks be more closely aligned and, as regards OTC trading, that the SI regime be retained but with clearer and more detailed rules to distinguish SI trading from OTC trading and to minimize regulatory arbitrage. Second, the Commission proposed the new OTF classification, which now forms part of MiFID II/​MiFIR. As originally envisaged by the Commission, the OTF was designed as an omnibus reform, and so to capture all non-​RM/​MTF trading on organized venues other than ad hoc bilateral trading between counterparties. Specifically, the OTF was to address the regulatory arbitrage difficulties generated in relation to equity trading under MiFID I (as regards BCSs/​BCNs in particular); and also to provide a regulated venue for the trading of standardized derivatives. Investment firms and market operators operating MTFs and OTFs would be subject to identical transparency regimes and to ‘nearly identical’ organization and market surveillance rules.91 The Commission distinguished OTFs, however, by permitting them to have a degree of discretion over order execution in order to reflect the nature of equity trading in BCSs/​BCNs as well as the illiquid and discretionary nature of trading in derivatives. In addition, the Commission proposed swingeing reform of the MiFID I transparency regime, proposing, reflecting CESR’s advice, the restriction of dark equity trading, a reform designed to mitigate the perceived risk that high volumes of dark equity trading were impeding price formation;92 and, in an epochal reform, an extension of the transparency regime to non-​equity asset classes.93 Given the complexity of the non-​equity reform, the intricacy of the compromise legislative solution adopted, the mammoth scale of the subsequent ESMA exercise in developing the related administrative rules for different asset classes, and the reach of the potential market impact risks, its origins warrant a brief excursus. Prior to the financial crisis and as MiFID I was implemented in 2007, CESR had advised the Commission that there was no evidence of market failure in the EU cash bond markets, in particular, with respect to transparency levels.94 The Commission subsequently concluded (reflecting also significant market hostility to a mandatory transparency regime)95 that the 91 2011 MiFIR Proposal, n 86, 7. 92 The Commission noted the increasing prevalence of ‘dark liquidity’ in the equity markets (highlighting that 45 per cent of equity trades were dark pre-​trade), the risk that ever-​expanding dark pools could come to prejudice price formation, and the need to balance the interest of market participants in managing trading risks with the wider market and public interest in transparency: 2011 MiFID II/​MiFIR Proposals IA, n 64, 12. 93 During the earlier MiFID I negotiations, the ECB had presciently criticized the exclusion of debt securities from the transparency regime given the size of the debt markets: ECB Opinion on the MiFID I Proposal [2003] OJ C144/​6, para 15. In practice, transparency requirements were typically imposed on non-​equity transactions only when concluded on RMs and then as a function of RM rules; transparency requirements were mandatory in only a few Member States. Considerable transparency data, and particularly pre-​trade transparency data, was, however, available from a range of market sources (such as the MTS platform, which at the time supported intra-​dealer trading in euro-​denominated government bonds; channels for the display of quotes from dealers; bond-​market indices; and trading platforms for cash bonds) and from the associated derivatives markets. 94 CESR, Response to the Commission on Non-​equities Transparency (2007) (which followed the earlier CESR, Non Equity Market Transparency, Consultation Paper (2007)). Similarly, European Securities Markets Expert Group (ESME), Non-​Equity Market Transparency (2007). 95 Commission, Feedback Statement, Pre-​and Post-​Transparency Provisions of MiFID in relation to transactions in classes of financial instruments other than shares (2006) 3–​4 and 5, noting that even positive responses tended only to be ‘open-​minded’ concerning reform.

458  Order Execution Venues market was best placed to drive transparency in non-​equity asset classes.96 The financial crisis reframed the debate, with low bond market transparency levels identified as a weakness in the international reform discussions.97 CESR, in an early crisis-​era intervention, reported that while the absence of harmonized transparency requirements was not a determinant of the severe liquidity problems certain non-​equity asset classes had experienced over the financial crisis, market-​led initiatives had not provided sufficient levels of transparency, and harmonized post-​trade transparency requirements would be beneficial.98 Subsequently, CESR recommended that harmonized pre-​trade requirements also apply, appropriately calibrated to address dealer position risks.99 The Commission’s initial reform orientations, set out in its 2010 MiFID I Review Consultation, broadly followed CESR’s approach. It called for a new pre-​and post-​trade transparency regime for bonds, structured products, and clearing-​eligible derivatives, calibrated to reflect liquidity risks, in order to address information asymmetries, support fair and orderly pricing, and improve overall market efficiency and resilience. It also suggested that this regime apply across the proposed new regulatory perimeter and accordingly to RMs, MTFs, and OTFs pre-​trade, and to these venues and all investment firms post-​trade. The Commission’s subsequent 2011 MiFIR Proposal articulated this model in more detail. The MiFID I Review also led the Commission to propose, reflecting CESR’s advice, significant enhancements to the legislative framework governing transparency data distribution and consolidation, reflecting widespread concerns as to data quality, cost, and consolidation. CESR also supported a market-​led development of a ‘European Consolidated Tape’ of transparency information, to be developed by the industry within a MiFID-​governed data quality and governance framework and time frame. The Commission followed this market-​ driven approach, rather than a public monopoly model for consolidating and distributing pre-​and post-​trade data, as being more likely to support innovation and client needs and to be cost-​effective.100 As outlined in section 12.4, this approach did not deliver the necessary consolidation and a more muscular approach is envisaged under the 2021 MiFID III/​MiFIR 2 Proposals.

V.2.4  The MiFID II/​MiFIR Negotiations The subsequent negotiations proved very difficult. Sharp points of difference emerged between the European Parliament and Council, and within the Council, with respect to how the venue classifications, and in particular the new OTF classification, should be organized; with respect to the balance between lit and dark trading and between organized venue and OTC trading; and with respect to the treatment of equity and non-​equity trading. The European Parliament’s October 2012 negotiating position101 deviated from the Commission’s Proposals in a number of respects. With respect to the equity markets, it 96 Commission, Report on Non-​equities Market Transparency pursuant to Art 65(1) of Directive 2004/​39/​EC on markets in financial instruments (2008). 97 Financial Stability Forum, Enhancing Market and Institutional Resilience (2008). 98 CESR, Transparency of Corporate Bond, Structured Finance, and Credit Derivatives Markets (2009). 99 n 85. 100 2011 MiFID II/​MiFIR Proposals IA, n 64, 42. 101 European Parliament MiFID II Negotiating Position Resolution, 26 October 2012 (T7-​0406/​2012) and MiFIR Negotiating Position Resolution, 26 October 2012 (T7-​0407/​2012).

V.2  The Evolution of the Venue Regime  459 removed the availability of the new OTF venue for equity trading, given its concerns as to potential detriment to price formation;102 and it also sought to restrict OTC equity trading by means of a general prohibition on shares/​equity-​like trading taking place outside an RM, MTF, or SI (what would become the share trading obligation (STO)). With respect to the non-​equity markets, it similarly restricted the extent to which non-​equity asset classes could be traded OTC, proposing that transactions in bonds, structured-​finance products, emission allowances, and CCP-​clearing-​eligible derivatives, which were not traded on an RM, MTF, or OTF, be concluded through an SI (subject to a series of exemptions to manage liquidity risk). The Council negotiations proved to be long and difficult103 and did not complete until June 2013.104 The sources of difficulty were many. Although the Council was in favour of placing some limits on dark trading,105 sharp divergences arose as regards the merits of organized venue (generally lit) trading as against OTC (generally dark) trading, which reflected longstanding differences as to the extent to which trades should be centralized on organized venues. The UK, the location of the largest OTC market in the EU, was in favour of a liberal OTC model which accommodated dark trading, while France, the standard-​bearer for organized, lit trading, sought to restrict the OTC (generally dark) space. Accordingly, the new OTF venue classification (designed to draw specified OTC trading on to organized, lit, and regulated venues) proved controversial in the Council, with some Member States in favour but calling for less stringent requirements to be imposed on the OTF, others in favour of a strict OTF regime, and others calling for its removal and for all trading to take place on RMs, MTFs, and SIs.106 The Council ultimately agreed to keep the OTF (for organized trading in equity and non-​equity asset classes), but resolved the difficulties generated within the Council by the Commission’s proposed prohibition on proprietary dealing by the OTF operator by allowing ‘matched principal trading’ within an OTF for non-​equity instruments.107 The SI proposals were also contested. Most Member States supported the Commission’s proposals for a more detailed SI definition to minimize arbitrage risks, but difficulties arose in relation to the SI pre-​trade transparency regime.108 The transparency regime for RMs, MTFs, and OTFs was less controversial within the Council, although significant differences arose across the Member States with respect to the transparency waivers

102 The Parliament was concerned to protect the quality of price formation in the equity markets given concerns as to the quality of the trading data which might emerge from OTFs (OTF trading could have a discretionary quality given the capacity of the OTF to intervene in trades; the published data might not, as a result, have reflected pricing conditions accurately): 2012 Parliament MiFIR Negotiating Position, n 101, recital 16. See also section 5.4. 103 The negotiations were reported as being fierce, particularly between the UK, France, and Germany: Stafford, P and Fontanella-​Khan, J, ‘UK Agrees EU Deal on City Regulation’, Financial Times, 18 June 2013. 104 Council MiFIR General Approach, 18 June 2013 (Council Document 11007/​13) and MiFID II General Approach, 18 June 2013 (Council Document 11006/​13). The first Presidency Compromises were issued in June 2012 by the Danish Presidency, and were followed by repeated compromise drafts, which increased in number over the final stages of the Irish Presidency. Summaries of the status of the negotiations were issued at the end of the Cyprus Presidency (Cyprus Presidency Progress Report on MiFID II/​MiFIR, 13 December 2012 (Council Document 16523/​12)) and the Danish Presidency (Danish Presidency Progress Report on MiFID II/​MiFIR, 20 June 2012 (Council Document 11536/​12)). 105 The Irish Presidency described the final Council agreement as showing that the ‘Council intends for the EU to lead the way in limiting dark pool trading’: Irish Presidency, ECOFIN Press Release, ‘Irish Presidency Reaches Breakthrough on new Proposals for Safer and More Open Financial Markets’, 17 June 2013. 106 Danish Presidency MiFID II/​MiFIR Progress Report, n 104, 4–​5 and Cyprus Presidency MiFID II/​MiFIR Progress Report, n 104, 4. See further section 5.4 on the development of the OTF regime. 107 Cyprus Presidency MiFID II/​MiFIR Progress Report, n 104, 5. 108 Danish Presidency MiFID II/​MiFIR Progress Report, n 104, 5.

460  Order Execution Venues for equity dark pools (which allow organized venues to support equity dark trading), with some seeking to restrict the waivers and others supportive of a more liberal approach. The Council ultimately adopted a more restrictive approach than the Commission’s to dark pool waivers for equity trading, providing for a new ‘volume cap’ on dark pool equity/​equity-​like trading.109 The Council also (and here like the European Parliament) sought to reduce the volume of OTC trading in equities (but unlike the Parliament, it did not seek to do so with respect to other asset classes) through a share trading obligation tied to RMs, MTFs, OTFs, and SIs. As regards the proposed new transparency regime for non-​equity asset classes, the Council adopted a significantly more articulated but also more liberal approach than the Commission’s and introduced an array of calibrations, including with respect to protecting dealers’ positions and empowering national competent authorities (NCAs) to suspend pre-​trade transparency requirements for non-​equity asset classes when liquidity levels fell below pre-​set thresholds.110 The subsequent Commission/​ Council/​ European Parliament trilogue negotiations (which took place under the shadow of the 2014 closure of the Parliament and Commission terms) proved long and complex. The major points of contention included: the OTF classification and whether it should be limited to non-​equity asset classes; the balance between dark and lit trading, particularly with respect to the transparency waiver regimes; and the extent to which detailed organizational regulation, oriented to algorithmic trading in particular, should be imposed on venues. The complex and detailed MiFID II/​MiFIR compromise as finally adopted reflects the Parliament’s position to a significant extent; in particular, the OTF classification is not available for equity/​equity-​like trading, a share trading obligation applies (designed to limit dark trading), and more intensive regulation of RMs, MTFs, and OTFs, particularly with respect to algorithmic trading, applies. Adopted in 2014, MiFID II/​MiFIR came into force on 3 January 2018, after a one-​year delay, with much attention focused on how the swingeing venue reforms would fare.111

V.2.5  From 2014 to the 2021 MiFID III/​MiFIR 2 Proposal V.2.5.1 Operationalizing MiFID II/​MiFIR The MiFID II/​MiFIR venue regime, in seeking to move trading from OTC venues to organized venues, is significantly more transformative in orientation than MiFID I and, relatedly, has a wider regulatory perimeter.112 The OTF venue classification, for example, is designed to draw non-​equity OTC trading into the regulatory net and on to organized venues, while the Share Trading Obligation (STO) is designed to reduce equity trading on OTC venues and to bring it on to more heavily regulated organized venues. Also, by extending transparency 109 See further section 11.3. 110 Particular difficulties arose also with respect to the waiver regime for non-​equity asset classes and in relation to ‘request for quote’ and ‘voice trading’ systems, and with respect to venues restricted to professional participants: Danish Presidency MiFID II/​MiFIR Progress Report, n 104, 6. 111 The legislative regime was revised shortly after its adoption to accommodate ‘package transactions’ and their distinct trading patterns and characteristics. A ‘package transaction’ is a form of derivative transaction involving the execution of an obligation to deliver an equivalent quantity of an underlying physical asset. The related ‘Quick Fix’ reform was delivered through Regulation (EU) 2016/​1033 [2016] OJ L175/​1. 112 MiFIR underlines that ‘it is important that trading in financial instruments is carried out as far as possible on organized venues and that all such venues are appropriately regulated’ (recital 6).

V.2  The Evolution of the Venue Regime  461 regulation to non-​equity asset classes, limiting the availability of transparency waivers, and imposing more intrusive operational requirements on organized venues, MiFID II/​MiFIR has very significantly extended the reach of venue regulation. The scale of the reforms is underscored by the extent to which the regime is calibrated to manage liquidity risks, particularly as regards the transparency regime and its application to non-​equity asset classes. Reflecting its reach and ambition, MiFID II/​MiFIR has, as regards venue regulation, been amplified by a monolithic administrative rulebook which has the effect of transforming the political decisions made under MiFID II/​MiFIR as to how EU order execution is to be organized into operational reality. The related administrative rule development process, which started before MiFID II/​MiFIR was adopted, was of a magnitude not previously witnessed in EU financial markets regulation.113 The technical challenge was immense: the scale of the administrative rules required was without precedent (over seventy separate sets of administrative rules were adopted, the majority concerned with venue regulation); and the risk of regulatory error was significant given the novelty of the reforms, the need for calibration against asset classes and execution functionalities to manage liquidity risks, the related technical complexity of the regime and its reliance on data and metrics (notably as regards the ‘tick size’ regime for share price increments; and the highly quantitative non-​ equity transparency regime), and the limited data available on which to base the heavily quantitative rules. The rule development process accordingly also required the construction of new data sources.114 The scale of the exercise was a factor driving the postponement of the MiFID II/​MiFIR implementation date by one year to January 2018, with the majority of the administrative rules not coming into force until mid-​2017.115 ESMA was the engine room in which data was gathered and interrogated, the operational detail of the administrative regime was hammered out, and, relatedly, the pivotal liquidity/​ transparency trade-​offs were made as regards different asset classes and execution functionalities.116 The vast bulk of the delegations for administrative rule-​making were in the form of RTSs to be adopted by the Commission but over which ESMA, as the drafter and proposer, exerted material influence.117 ESMA also was the determinative influence on the smaller number of delegated acts (directives and regulations) adopted by the Commission and on which it provided technical advice.118 In practice, ESMA was the architect of the venue administrative rulebook, with the Commission rarely deviating from its proposals or advice.119

113 The scale of the delegations for administrative rules led ESMA to engage in extensive preparatory activity prior to the adoption of the MiFID II/​MiFIR legislative texts: ESMA Annual Report (2012) 43–​4. 114 eg, while some data on bond market transparency was available from the market (including through bond indices and major bond trading platforms), bond market data was generally limited. 115 Most of the administrative measures were published in [2017[] OJ L87. 116 The Commission acknowledged that ‘it is not possible at this stage to assess the impact of such a regime on the liquidity of the market as this will largely depend on the calibration of the transparency requirements . . . in the implementing legislation’: 2011 MiFID II/​MiFIR IA, n 64, 66–​7. 117 The MiFID II/​MiFIR negotiations saw many of the delegations change from Commission-​led delegated acts to ESMA-​led RTSs, reflecting Council support for greater engagement by ESMA (Danish Presidency MiFID II/​MiFIR Progress Report, n 104, 13). The Commission, however, expressed its concern that this change from its Proposals did not respect the distinction between RTSs and delegated acts: Statement by Commission on the Adoption of MiFID II/​MiFIR, 7 May 2014 (Council Document 9344/​14). 118 See Ch I section 5.1 in outline on the administrative rule-​making process. 119 As noted in section 11.3, the only material deviation across the administrative rulebook as regards venues and order execution relates to the phasing-​in sequencing the Commission imposed on the non-​equity transparency regime, to limit liquidity risks.

462  Order Execution Venues Looked at simply in terms of process, the adoption of the vast, highly calibrated, and deeply quantitative administrative rulebook governing venues, and particularly its transparency rules, can reasonably be described as the apex of administrative rule-​making for financial markets in the EU since the crisis-​era reforms to the law-​making process; and also as cementing ESMA’s position as the steward of MiFID II/​MiFIR. Since their adoption in 2017, the venue administrative rules have been adjusted and refined, in a further indication of the extent to which the operation in practice of MiFID II/​MiFIR is a function of technocracy. Between 2014 and MiFID II/​MiFIR coming into force in 2018, ESMA also amplified the administrative rules governing venues by constructing an extensive soft law ‘rulebook’, which has a strongly dynamic quality, responding to market developments which raise questions as to how MiFID II/​MiFIR operates in practice. These rules and soft law and their implications are discussed throughout the chapter.

V.2.5.2 The MiFID II/​MiFIR Review and the 2021 MiFID III/​MiFIR 2 Proposals Reform on this scale, and of this intricacy, takes time to bed in. Nonetheless, MiFID II/​ MiFIR’s potentially transformative impact on market structure became evident soon after its January 2018 implementation; as outlined in section 11.2, the restrictions placed on RM and MTF equity ‘dark pools’ drove early and significant growth in the SI sector. Elsewhere, its initial effects were more limited. In particular, the cautious and phased-​in approach to the new non-​equity transparency regime, the flagship MiFID II/​MiFIR reform, meant that as the MiFID II/​MiFIR Review completed in 2021, there had been only minimal improvements in non-​equity transparency levels. The expected improvements to transparency data quality and availability also failed to materialize early, with the MiFID II/​MiFIR reforms associated instead with an initial increase in the price of data. The new regime also came under pressure as it came in contact with market practice and as arbitrage risks crystallized.120 A further inflection point came in January 2021 when EU law finally ceased to apply to the UK, following the end of the transition period which followed its withdrawal from the EU in January 2020. As is the case across the EU financial markets landscape and the single rulebook, the impact of Brexit on MiFID II/​MiFIR’s regulatory design remains to be seen.121 The trading/​venue environment can be regarded as particularly sensitive to Brexit, however, given the scale of trading in the UK.122 The effect of the Share Trading Obligation (STO) has moderated the impact of the UK withdrawal, with share trading reverting to the EU in consequence (section 10). No such obligation applies in the bond and derivatives markets, however, and the scale of OTC non-​equity trading in the UK,123 as well as the concentration of specialist infrastructures in the UK, may mean there is no major change in 120 See, eg, section 5.5 on the consequent reforms made to the SI regime. 121 On Brexit see Ch X section 11. 122 In 2020 (over which year the UK had left the EU but was still subject to EU law under the transition arrangements), eg, UK RMs and MTFs accounted for more than half (54 per cent) of total ‘on-​exchange’ (ESMA’s term) turnover in shares, and UK RMs, MTFs, and OTFs together accounted for more than three-​quarters of total on-​ exchange bond turnover: ESMA, Annual EU Securities Market Report (2021) 16 and 27. 123 In 2020, the share of OTC bond trading reported through UK ‘Approved Publication Arrangements’ (APAs, a key channel for reporting OTC transactions (section 12)) accounted for 75 per cent of total OTC bond trading in the EEA and UK, while 27 per cent of OTC trading in the UK was in EEA bonds: 2021 ESMA Annual Securities Market Report, n 122, 28. Similarly, turnover statistics for the EEA-​30 (without the UK) v EEA-​31 (with the UK) in 2020 were significantly lower at 62 per cent below (the EEA-​31 figures) for corporate bonds, 75 per cent below for sovereign bonds, and 93 per cent below for convertible bonds (at 10).

V.2  The Evolution of the Venue Regime  463 trading patterns here in the shorter term, with the UK likely remaining a major off-​shore trading centre for EU counterparties and EU non-​equity financial instruments. While there is little sign of any related change to the driving objectives of the EU’s regulation of order execution venues, particularly as regards its promotion of lit organized venue trading, if OTC trading continues in significant volumes in the UK, regulatory policy may tilt more towards supporting the local EU OTC segment. The 2020 MiFID II/​MiFIR Review, noted across the following sections, provided an early focal point for assessment.124 In a reflection of the risks associated with its implementation, MiFID II/​MiFIR contained several review obligations which required key elements of the venue regime (and of MiFID II/​MiFIR generally) to be reviewed by 2020, only two years after its coming into force.125 Launched in 2020 with the Commission’s Consultation,126 the related MiFID II/​MiFIR Review was accompanied by extensive empirical reviews, primarily by ESMA which was mandated by the Commission to provide a series of reports,127 but also including several Commission studies.128 While the initial 2020 Consultation addressed a range of issues, as the Review developed it became heavily tilted towards the venue elements of MiFID II/​MiFIR and, relatedly, it saw a relitigation of longstanding legacy debates between the organized/​multilateral venue and OTC/​bilateral segments, underscoring thereby the structural market fissure that the EU has been seeking to address since MiFID I in 2004.129 The 2021 MiFID III/​MiFIR 2 Proposals which followed contain a series of substantial reforms, mainly relating to the transparency regime, alongside potentially radical reforms relating to data consolidation (further reforms may follow to bolster the resilience of venues providing trading in energy derivatives, in light of the significant volatility in energy markets that followed the February 2022 Russian invasion of Ukraine). 130 The 124 MiFID II/​MiFIR is not directly associated with the Capital Markets Union (CMU) reform agenda. The 2020 CMU Action Plan, however, included the data consolidation reforms that were ultimately addressed by the 2021 MiFIR 2 Proposal. 125 MiFID II Art 90 and MiFIR Art 52. The review requirements relating to venue regulation covered, inter alia, the functioning of OTFs and the development of data pricing (Art 90); and the pre-​trade transparency regime, transaction reporting, data consolidation, and data pricing (Art 52). 126 Commission, Public Consultation on the Review of the MiFID II/​MiFIR Regulatory Framework (2020). 127 ESMA provided ten major reports on different aspects of the MiFID II/​MiFIR Review over 2019–​2022. The original timetable for its reviews was adjusted to reflect the uncertainties linked to Brexit and to ensure sufficient experience in practice with MiFID II/​MiFIR: Letter from ESMA Chairman Maijoor to the Commission, 16 January 2019. 128 Including Study for the European Commission by Market Structure Partners, Study on the Creation of an EU Consolidated Tape (2020) and 2020 Oxera Report, n 17. 129 ESMA’s 2020 review of the impact of MiFID II/​MiFIR on non-​equity market transparency, eg, reported on the divergence of views between the investment firm/​OTC sector (warning against any tightening of the rules given that firms were putting their capital at risk) and the organized venue sector (calling for reforms directed to simplifying the transparency regime for venues): ESMA, MiFID II/​MiFIR Review Report on the Transparency Regime for Non-​Equity Instruments and the Trading Obligation for Derivatives (2020) 10–​11 and 22–​4. The fissure between the organized venue/​OTC sectors ran across most of ESMA’s review reports, with the organized venue sector typically seeking the wider application of MiFID II/​MiFIR requirements and the OTC sector seeking to resist any reforms (particularly to SIs) that would increase transparency or reporting requirements. 130 n 5 (MiFID III/​MiFIR 2 Proposals). Among the series of initiatives considered in 2022 to bolster EU energy derivatives markets, which experienced elevated volatility and disruption to pricing mechanisms following the invasion, was consideration of whether a new type of trading halt (or ‘circuit breaker’), applicable to all EU trading venues for energy derivatives and subject to harmonized conditions, should be adopted to contain excessive volatility, protect price formation in volatile conditions, and constrain trading venues’ discretion regarding the use of circuit breakers, including by requiring their use in specified circumstances (particularly given the evidence that energy derivatives trading venues had not used circuit breakers to any significant extent to manage volatility). Relatedly, ESMA undertook a review of the existing MiFID II circuit breaker regime with a view to adopting clarifications through soft law, including specification of when circuit breakers should be used. See ESMA, Letter to the Commission (Excessive Volatility in Energy Markets), 22 September 2022 and Commission, Facing the Energy Crisis in the EU: Work Streams Relating to the Financial System (2022). On circuit breakers see section 6.3.2.

464  Order Execution Venues adoption by the Commission of the MiFID III/​MiFIR 2 reform proposals within three years of MiFID II/​MiFIR coming into force does not augur well for the stability of the legislative framework, although it does illustrate the challenges which legislative reform on the scale of MiFID II/​MiFIR engages and, more positively, suggests an EU capacity to revise and adjust the regime in light of market developments.

V.3  The Venue Rulebook: Legislation, Administrative Rules, and Soft Law As outlined in the following sections, the MiFID II/​MiFIR legislative framework for venues is designed to operate as a set of governing principles, albeit that in places it is fine-​grained and intricate, often because of difficult political compromises. MiFID II broadly covers the authorization, organizational, and operational requirements applicable to venues and the related venue classification system. MiFIR broadly covers the transparency regime, transaction reporting, and the Share Trading Obligation.131 The allocation of coverage across both measures is designed to ensure that areas where some degree of implementation discretion is appropriate are covered by the directive, and that those areas where uniformity is essential to market efficiency are covered by the regulation. The principles set out in MiFID II/​MiFIR as regards venue regulation are amplified in immense detail by an administrative rulebook that is without peer across EU financial markets regulation. It has a number of distinguishing characteristics, four in particular. First, it is of massive scale. Of the more than seventy separate delegated acts and RTSs that amplify MiFID II/​MiFIR, the majority address venues and the trading process. Chief among the measures of most significance to venue regulation are the rules addressing key definitions, including the quantitative metrics governing SI classification;132 the specific rules governing trading halts, business clocks, market-​makers, and algorithmic trading;133 the rules governing admission and suspension of instruments;134 and the ‘tick size’ rules of critical importance for liquidity.135 Alongside is the mammoth suite of rules, of immense complexity and granularity, that amplifies MiFIR’s cross-​asset pre-​and post-​trade transparency regime. Second, the administrative rulebook is, in places, heavily quantitative and dependent on metrics, most notably as regards the MiFIR transparency rules. The totemic transparency-​ related ‘RTS 1’ (equity asset classes) and ‘RTS 2’ (non-​equity asset classes),136 which govern how the transparency rules apply to different asset classes and venues, are data-​driven. They specify how the different calculations which dictate how the transparency rules apply are to 131 A regulation was deployed to provide for the uniform application of a single regulatory framework, strengthen confidence in the transparency of markets across the EU, reduce regulatory complexity and compliance costs, and contribute to the elimination of distortions of competition: 2014 MiFIR recital 3. 132 Delegated Regulation 2017/​565 [2017] OJ L87/​1. 133 RTS 2017/​570 [2017] OJ L87/​124; RTS 2017/​574 [2017] OJ L87/​148; RTS 2017/​578 [2017] OJ L87/​183; and RTS 2017/​584 [2017] OJ L87/​350 (governance relating to algorithmic trading), RTS 2017/​573 [2017] OJ L87/​145 (access and fees); RTS 2017/​566 [2017] OJ L87/​84 (disorderly trading). 134 RTS 2017/​568 [2017] OJ L87/​117 and RTS 2017/​569 [2017] OJ L87/​122. 135 RTS 2017/​588 [2017] OJ L87/​411. ‘Tick size’ refers to the minimum increment in which the price of an instrument can move; the larger the size of the minimum tick size or price increment, the greater the impact on liquidity given the amplifying effect of larger price movements. 136 RTS 1 2017/​587 [2017] OJ L87/​387; and RTS 2 2017/​583 [2017] OJ L87/​229.

V.3  The Venue Rulebook  465 be carried out, and include a series of fixed quantitative thresholds and metrics that are of defining importance to whether, and the extent to which, the transparency requirements apply. Their construction required an immense and pathbreaking ESMA-​led exercise in data collection and also (given the poor and patchy quality of data on key metrics such as the liquidity of different non-​equity asset classes, as a result of the limited scope of the pre-​ MiFID II/​MiFIR trading transparency rules and patchy data distribution systems) in data cleaning and data modelling. While their construction led to a transformation of ESMA’s capacity to collect and interrogate data, these rules are, given their dependence on data, significantly more at risk of requiring adjustment and correction in response to market conditions than other elements of the administrative rulebook. Third, the administrative rulebook is proving to have some degree of agility and dynamism, allowing the EU to adjust the complex venue regime as ambiguities, distortions, and arbitrage risks emerge. This agility and dynamism is in part embedded in the administrative rulebook. The non-​equity transparency regime (RTS 2) has a built-​in phasing mechanism designed to adjust the application of the rules as the market responds and which requires regular review and updating of RTS 2 (section 11.3). Otherwise, the tick size regime, for example, was revised shortly after its adoption in response to emerging market developments that threatened to compromise its operation,137 as were the administrative rules governing SIs.138 Finally, the administrative rulebook has strong transformative effects. The three major RTSs governing the transparency regime, ‘RTS 1’ (equity asset classes), ‘RTS 2’ (non-​equity asset classes), and ‘RTS 3’ (the double volume cap mechanism)139 are among the most material rules ever to have been adopted at the administrative level in EU financial markets regulation. This is because they calibrate the high-​level MiFIR transparency regime to the particularities of the multitude of asset class characteristics, trading patterns and platforms, and liquidity profiles which shape EU market microstructure. How this calibration has been achieved by the different devices, thresholds, and adjustments that these RTSs have adopted is shaping liquidity but also how competition operates between the different order execution venues that obtain in the EU. As previously noted, ESMA’s influence on this administrative rulebook has been determinative. In the case of the novel and highly contested transparency rules, for example, the Commission closely followed ESMA’s approach in all but one major respect: it adopted a significantly more cautious and phased approach to the introduction of the non-​equity transparency regime.140 Throughout the rule development process, ESMA adopted a 137 Delegated Regulation (EU) 2019/​442 [2019] OJ L77/​56 revised RTS 1 to require SIs to follow the tick size rules applicable to RMs and MTFs when providing pre-​trade quotes in order to address the competitive advantage SIs would have enjoyed had they been able to quote without being subject to minimum price increment requirements. Delegated Regulation 2019/​443 [2019] OJ L77/​59 revised the tick size regime to better reflect liquidity patterns where most trading in an instrument is outside the EU. In both cases, ESMA identified the potential distortions at an early stage (prior to the coming into force of MiFID II/​MiFIR in the case of Regulation 2019/​442) and proposed revisions to the Commission, which followed. 138 Delegated Regulation (EU) 2017/​2294 [2017] OJ L329/​4 revised Delegated Regulation 2017/​565 on the definition of an SI to address the emergence of a market practice whereby SIs were engaging in a form of multilateral order execution (which is prohibited under MiFID II/​MiFIR as SIs can engage in bilateral order execution only), through riskless back-​to-​back trading practices, and thereby gaining a competitive advantage over MTFs. This reform was adopted ‘as a matter of urgency’ (recital 5) following ESMA’s identification of the arbitrage risk. 139 RTS 3 2017/​577 [2017] OJ L87/​174. 140 As outlined in section 11.3, the non-​equity transparency regime is still being introduced on a phased basis, with the result that there has been little material change to transparency levels, particularly in the bond markets.

466  Order Execution Venues generally responsive and iterative approach, which was sensitive to the data difficulties that bedevilled the rule development process, particularly as regards the novel transparency requirements. For example, with respect to its proposed approach to the critical determination of whether particular non-​equity asset classes were ‘liquid’ (which governs how the MiFIR transparency regime applies), ESMA, in response to industry concerns, adopted a more granular and asset-​class-​specific approach to the assessment of liquidity,141 and also provided for liquidity thresholds to be reassessed regularly.142 The complexity that can be associated with much of the MiFID II/​MiFIR legislative regime governing venues has fuelled the explosive development of related soft law.143 As is common across the single rulebook, ESMA has adopted several sets of Guidelines.144 Less common is the density and breadth of the MiFIR Q&A on the transparency regime145 and the raft of Opinions and other soft measures which ESMA has used to explain its understanding of how the venue regime applies in practice to a host of specific situations and to the emergence of new forms of trading.146

V.4  MiFID II/​MiFIR and the Regulation of Order Execution Venues: Regulatory Design and Scope V.4.1  Multilateral and Bilateral Trading One of the animating purposes of MiFID II/​MiFIR as regards the organization of order execution is to ensure that all multilateral order execution venues, however organized, are within the same (broadly) regulatory perimeter and so operate on a level regulatory playing-​ field, taking due regard of their different functionalities. MiFID II/​MiFIR is also designed to support a level regulatory playing-​field between multilateral and bilateral order execution venues, again taking account of their different functionalities. Running across these two purposes is a market-​shaping concern: MiFID II/​MiFIR seeks to ensure that trading, particularly in the equity/​equity-​like market, takes place on organized venues147 which are transparent and subject to similar regulation and that the OTC trading space reduces.148 It uses a series of regulatory techniques to achieve these outcomes, but chief among these 141 ESMA’s approach to bond market liquidity, eg, changed over the rule development process, in part in response to stakeholder feedback. ESMA ultimately proposed an approach based on an ‘instrument-​by-​instrument’ approach (section 11.3) which was designed to more appropriately reflect observed liquidity levels in the bond markets: ESMA Chair Maijoor, ECON Scrutiny Speech—​MiFID 2, 10 November 2015. 142 Bond market liquidity is re-​assessed at the end of every quarter, based on the previous three months’ activity (section 11.3). 143 ESMA has, eg, noted that the complexity of the legislative requirements governing the waiver system for pre-​ trade transparency had led to it adopting a related Opinion as well as several Q&As in the MiFIR Transparency Q&A: ESMA, Annual Report on the Application of Waivers and Deferrals (2021). 144 Including Guidelines on market data (2021); trading halts (2017); and the management body of market operators (2017). 145 ESMA, Q&A on MiFID II and MiFIR Transparency Topics. It is accompanied by the Q&A on MiFIR Data Reporting. 146 Leading examples include the ESMA Opinions on Pre-​Trade Transparency Waivers (2020) and Frequent Batch Auctions (2019). 147 Which can be multilateral but also bilateral, where that bilateral trading is systematic, organized, and frequent and so subject to venue-​like regulation (ie in the form of a systematic internalizer (SI)). 148 MiFID II/​MiFIR is designed to ensure that all organized trading is conducted on regulated venues and is fully transparent, pre-​and post-​trade: MiFIR recital 10.

V.4  Regulatory Design and Scope  467 is venue classification, which is used to calibrate how different order execution venues are regulated, given their functionalities, as well as to ensure maximum coverage of the MiFID II/​MiFIR rules. There are three multilateral order execution venues under MiFID II/​MiFIR: RMs, MTFs, and OTFs (together, ‘trading venues’),149 all regulated in a similar manner. The OTF was added by MiFID II/​MiFIR. It is designed to ensure maximum coverage by the MiFID II/​ MiFIR regime of multilateral trading in derivatives, in particular as the OTF regime permits the OTF system operator to engage in specified discretionary intervention (discretionary intervention is prohibited under the RM and MTF classifications, but it is associated with organized trading in certain derivatives). MiFID II/​MiFIR also established a default definition of ‘multilateral system’, designed to ensure that all forms of multilateral venue are regulated within the MiFID II/​MiFIR regulatory perimeter for multilateral venues. As regards bilateral venues, MiFID II/​MiFIR sharpened the definition of the SI venue classification to minimize regulatory arbitrage between the more lightly-​regulated SI segment and the more heavily-​regulated multilateral venue segment, as well as to prevent the leakage of order execution to the OTC sector, where it should be executed through an SI. In addition, the novel Share Trading Obligation adopts a muscular approach to the organization of trading, requiring that all share trading take place on trading venues or on SIs. This matrix of rules is designed to level the regulatory playing-​field for order execution but also to tilt the organization of EU order execution towards organized venues (trading venues (multilateral) and SIs (bilateral)) and, relatedly given the operation of the transparency regime, towards lit trading. The different elements of this rulebook are outlined across the remainder of this chapter, after a review of the main organizing principles of the venue classification system.

V.4.2  Multilateral Systems and ‘Traded on a Trading Venue’ The regulation of multilateral venues is at the heart of the MiFID II/​MiFIR venue regulation regime. Under MiFID I, multilateral venues were classified into RMs and MTFs and subject to distinct rules designed to address the functionalities and risks of such venues. MiFID II expanded the regulated multilateral space by adding the OTF classification. It also sought to minimize regulatory arbitrage opportunities by establishing a framing definition for a ‘multilateral system’ (any system or facility in which multiple third party buying and selling trading interests in financial instruments are able to interact in the system (MiFID II Article 4(1)(19)); and by requiring that all multilateral systems in financial instruments either operate as MTFs, OTFs, or RMs (together, ‘trading venues’ (Article 4(1)(24)) (Article 1(7)). Article 1(7) is designed to ensure that all multilateral systems are regulated within one of the three trading venue classifications, even if the system in question does not map directly on to the systems commonly found, in practice, within each venue classification.150 149 MiFID II Art 4(1)(24) defines a ‘trading venue’ as an RM, MTF, or OTF. 150 ESMA has suggested that the mere fact that a trading facility does not fall within any type of RM/​MTF/​OTF does not take it outside the regulatory regime for multilateral systems and has underlined that operating in accordance with the multilateral system definition is sufficient to require authorization as a trading venue (whether as an RM, MTF, or OTF). ESMA has also specified that simple information exchange between third parties on the essential terms of a trade, which a view to future dealing (as would be the case with trading modalities for certain

468  Order Execution Venues The definition of ‘multilateral system’ is accordingly required to carry out the heavy lifting in terms of securing the MiFID II/​MiFIR regulatory perimeter around multilateral order execution. Technological developments, the diversity and range of trading practices, and the significant incentives to avoid regulatory treatment as a ‘trading venue’, given the distinct regulatory requirements which apply, all place considerable pressure on the ‘multilateral system’ definition, as evidenced by a rare excursion by the venue regime to the Court of Justice.151 But while the definition has not been amplified by administrative rules (unusually for a gateway definition), it has proved resilient in fixing the perimeter of the multilateral system/​trading venue regime, with the 2021 MiFID III/​MiFIR 2 Proposals not suggesting any revisions. The Proposals do, however, move the MiFID II Article 1(7) requirement for all multilateral systems to be authorized as trading venues from MiFID II to what will become MiFIR 2, in order to ensure the direct applicability of this keystone requirement.152 The resilience of this pivotal definition in the face of significant market dynamism can in part be related to the technocratic capacity ESMA brings to its operation by its adoption of explanatory soft law,153 which has obviated the need for repeated legislative/​ administrative reforms. The related ‘traded on a trading venue’ (ToTV) device is also used across MiFID II/​MiFIR to strengthen the gravitational pull of the ‘multilateral system’ concept on how trading is organized and regulated. The pivotal MiFIR Article 26 transaction reporting obligation, for example, applies to financial instruments admitted to trading or ‘traded on a trading venue’, regardless of where the specific transaction in question is executed. Similarly, the MiFIR transparency regime applies to instruments ‘traded on a trading venue’ (Articles 4, 6, 8, and 10), as does the Share Trading Obligation (Article 23). While at first glance straightforward, the ToTV device has proved difficult to apply in the OTC derivative markets, where a bilaterally-​agreed OTC derivative contract may be similar, but not exactly the same, as a functionally similar derivative traded between counterparties on a trading venue. ESMA soft law has provided a partial solution,154 but the ToTV device nonetheless illustrates the derivatives), is sufficient; the system does not have to lead to a contractual agreement: ESMA, MiFID II Review Report on the Functioning of OTFs (2021) 12. 151 In Case C-​658/​15 Robeco Hollands Bezit NV and Others v AFM (the Dutch financial regulator) (ECLI:EU:C:2017:870), the Court of Justice found (as regards the scope of ‘multilateral system’ as incorporated into the MiFID I definition of an RM) that a system which accommodated investment funds in executing different investor orders in fund shares (the orders were placed with the funds by brokers) was not bilateral (in practice, each fund separately executed the orders placed with it using the system, giving it a bilateral quality) given, inter alia, that the system was run by a third party (the market operator) which did not put its capital at risk in executing orders. 152 2021 MiFIR 2 Proposal, n 5, 14 reflecting ESMA’s recommendation to this effect (2021 ESMA OTF Report, n 150, 14–​15). 153 Primarily the extensive ESMA MiFID II/​MiFIR Market Structure Q&A which addresses, inter alia, the boundaries between MTF and OTF trading and when the SI classification applies. ESMA has also developed an Opinion explaining how different functionalities and technologies should be analyzed for the purposes of whether they are ‘multilateral systems’ and which includes ESMA’s determination that technologies which simply provide pricing data but do not support interaction between interests are not multilateral systems. ESMA, Consultation on ESMA’s Opinion on the Trading Venue Perimeter (2022). 154 In a 2017 Opinion ESMA limited the scope of the OTC derivatives transactions subject to Art 26 to only those derivatives that share the same ‘financial instrument reference data’ as those traded on a trading venue: ESMA, Opinion. OTC Derivatives Traded on a Trading Venue (2017). This approach has the effect, however, that there is very limited transaction reporting and transparency reporting on OTC derivatives. ESMA has since called for the removal of the ToTV device as a means for setting the scope of the transparency obligation for SI derivatives trading and for SIs instead to be subject to transparency requirements as regards all derivatives instruments for which they are registered as SIs: ESMA, MiFIR Review Report on the Obligation to Report Transactions and Reference Data (2021) 27–​35.

V.4  Regulatory Design and Scope  469 challenges that can arise in fixing the regulatory perimeter where trading patterns and functionalities are diverse and dynamic, asset classes have different trading and liquidity profiles, and where incentives are significant to avoid the regulatory orbit of multilateral systems and the related MiFID II Article 1(7) requirement to be regulated as a trading venue.

V.4.3  Bilateral Systems Most bilateral/​OTC order execution by investment firms is regulated as an investment service under MiFID II/​MiFIR. But where that order execution comes to share features with multilateral trading, in particular as regards its impact on price formation, it is regulated under discrete rules designed to accommodate the bilateral nature of the order execution while also ensuring a regulatory level playing-​field with multilateral systems. The main device used to achieve this is the SI classification. Originally introduced under MiFID I, it was finessed by MiFID II, and has been further refined through administrative rules as regulatory arbitrage weaknesses have emerged (section 5.5). Default rules also apply, designed to limit regulatory arbitrage risks. Under MiFID II Article 1(7), an investment firm which on an organized, frequent, systematic, and substantial basis deals on own account when executing orders outside an RM, MTF, or OTF must comply with the bespoke transparency rules that apply to SIs; and all transactions in financial instruments not concluded on a multilateral system or SI must comply with the transparency rules governing investment firms generally.155

V.4.4  Financial Instruments and Asset Classes The venue/​order execution regime applies generally to MiFID II ‘financial instruments’.156 It is, however, segmented by asset class, notably as regards the transparency regime. The transparency regime applies to two broad sets of asset class, equity and non-​equity, and is tailored to reflect the different trading patterns and liquidity risks of each asset class. The equity asset class covers shares, but also equity-​like instruments such as depositary receipts,157 exchange-​traded funds (ETFs),158 certificates,159 and other similar financial instruments ‘traded on a trading venue’ (ToTV). The non-​equity asset class covers bonds,

155 The 2021 MiFIR 2 Proposal moves this provision from MiFID II to MiFIR in order to ensure its general applicability. 156 As specified in MiFID II Annex I(C): see Ch IV section 5.3. 157 Depositary receipts are those securities negotiable on the capital markets and which represent ownership of the securities of a non-​domiciled issuer, while being able to be admitted to trading on a regulated market and traded independently of the securities of the non-​domiciled issuer: MiFID II Art 4(1)(45). 158 An ETF (exchange-​traded fund) is a fund of which at least one unit or share class is traded throughout the day on at least one trading venue, and with at least one market-​maker which takes action to ensure that the price of its units or shares on the trading venue does not vary significantly from its net asset value and, where applicable, from its indicative net asset value: MiFID II Art 4(1)(46). As outlined in section 11.2, ETF trading, which has burgeoned in the EU since the adoption of MiFID II, is subject to specific transparency requirements. 159 Certificates are defined as securities which are negotiable on the capital market and which, in case of a repayment of investment by the issuer, are ranked above shares but below unsecured bond instruments and other similar instruments: MiFIR Art 2(1)(27).

470  Order Execution Venues structured-​finance products,160 emission allowances, and derivatives.161 Particular asset classes, notably sovereign debt,162 are subject to additionally calibrated rules to protect liquidity. At the administrative level, the transparency rules are highly segmented into sub-​ asset classes to reflect the different modalities of trading in different sub-​asset classes. These rules can be expected to become further atomized in response to market developments.163

V.5  Venue Classification V.5.1  The Classification System Venue classification is at the heart of MiFID II/​MiFIR’s regulatory design and has market-​ shaping effects. Classification as a ‘trading venue’ (RM, MTF, or OTF) or as an SI qualifies a venue as eligible to meet the Share Trading Obligation, for example, while the operation of the transparency regime, and the extent to which a venue can engage in dark trading, depends on the classification system. The classification is based on four organized venues: RMs, MTFs, OTFs, and SIs. The RM, MTF, and OTF venues are multilateral and subject to broadly similar rules. RMs and MTFs dominate in the multilateral space, although the OTF has become established as part of the trading landscape.164 The SI venue, while organized, is essentially bilateral and sits in the OTC space. But, as the SI classification is designed to capture high volumes of ‘internalization’ activity by investment firms (firms executing client orders on own account), it is subject to tailored regulation. The SI sector has grown significantly since the coming into force of MiFID II.165 The OTC trading space remains undefined166 (as under MiFID I). The classification system can be segmented in three ways. A broad distinction can be made between multilateral trading venues, subject to similar levels of regulation (RMs, MTFs, and OTFs); bilateral venues in the OTC segment which are organized and systematized (SIs); and the bilateral OTC sector. 160 Defined as securities created to securitize and transfer credit risk associated with a pool of financial assets, entitling the security holder to receive regular payments that depend on the cash flow from the underlying assets: MiFIR Art 2(1)(28). 161 Defined as any securities which give the right to acquire or sell transferable securities or which give rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities, or other indices or measures, and which come within the scope of MiFID II/​MiFIR generally under MiFID II Annex I(C) paras (4)–​(10): MiFIR Art 2(1)(29). See further Ch IV section 5.3 on the MiFID II definition of derivatives. 162 Defined as debt instruments issued by a sovereign issuer (sovereign issuer is defined under MiFID II Art 4(1) (60)): MiFIR Art 2(1)(46). 163 Under the MiFID II/​MiFIR Review ESMA recommended that the transparency rules applicable to ETFs be refined to better reflect trading patterns in this market: section 11.2. 164 In 2020, 296 trading venues were registered in the EEA-​30 (EEA without the UK), comprising of 127 RMs, 142 MTFs, and 27 OTFs: 2021 ESMA Annual Securities Market Report, n 122, 4. The UK, prior to its departure from the EU, was a major location for trading venues. Over 2020 (the transition period over which the UK had left the EU but was still subject to EU law) there were 143 trading venues in the UK, accounting for (in 2020) 63 per cent of EEA-​31 (EEA including the UK) OTFs (45), 37 per cent of EEA-​31 MTFs (83), and 15 RMs (11 per cent) (at 9)). 165 The SI segment has grown significantly since the coming into force of MiFID II, with 172 SIs registered in the EEA-​30 in 2020: 2021 ESMA Annual Securities Report, n 122, 4. 166 The European Parliament, over the MiFID II/​MiFIR negotiations, proposed a definition based on the OTC space being limited to bilateral trading carried out by an eligible counterparty on its own account, outside a trading venue or an SI, on an occasional and irregular basis, with eligible counterparties, and always at large-​in-​scale sizes (2012 Parliament MiFIR Negotiating Position, n 101, Art 1(2c)), which was not adopted.

V.5  Venue Classification  471 A further distinction can be made as regards the discretionary/​non-​discretionary quality of the relevant venue:167 where trading on an organized venue has a discretionary element, such as with respect to the operator’s decision as to whether to admit the order to the venue or to execute it elsewhere (primarily SIs and OTFs), conduct rules, designed to reflect the related brokerage element of the service, and the agency risks to the investor arising from discretion, apply. Finally, the regime can be segmented according to whether the venue in question is regulated as an investment service. The provision of MTF, OTF, and SI systems are all investment services which can be provided by authorized investment firms under MiFID II/​MiFIR. They can also be provided by non-​investment-​firm ‘market operators’168 where the operator confirms compliance with the relevant investment firm requirements. The provider of the relevant system is accordingly regulated as an investment firm, although calibrated venue-​ oriented rules also apply. RMs, by contrast, are regulated under a distinct regime which is based on a ‘market operator’ running the market but which, with respect to the regulation of trading functionality, is broadly the same as the MTF and OTF regimes.

V.5.2  Regulated Markets A ‘regulated market’ (RM) is a multilateral system169 operated and/​or managed by a market operator, and which brings together, or facilitates the bringing together of, multiple third party buying and selling interests in financial instruments170 (in the system and in accordance with its non-​discretionary rules) in a way that results in a contract, in respect of the financial instruments admitted to trade under its rules and/​or systems, and which is authorized and functions regularly in accordance with the MiFID II/​MiFIR rules for RMs (MiFID II Article 4(1)(21)). The RM classification is an ‘opt-​in’ classification as RMs choose this designation and to operate under the RM rules. RM classification provides the venues which opt for this status with a branding mechanism, as regards their primary/​issuance market functionalities, that is related to the suite of issuer admission/​disclosure requirements that apply to RMs. These requirements are designed to reduce issuers’ cost of capital by signalling to investors that the highest levels of disclosure obligations apply to RM-​admitted issuers and that the instruments admitted to an RM meet a series of minimum conditions (see further Chapter II). RMs, which include the long-​established traditional ‘stock exchanges’ in the EU,171 always operate as primary/​issuance markets, as well as operating as secondary trading markets. By contrast, many MTFs offer only secondary trading services. Where MTFs offer primary/​issuance market services (in this guise, they are typically termed ‘exchange-​regulated 167 Non-​discretionary rules are rules which leave the RM or market operator (or investment firm operating an MTF) with no discretion as to how trading interests interact: MiFIR recital 7. 168 A market operator is a person who manages and/​or operates the business of a RM and may be the RM itself (MiFID II Art 4(1)(18)). 169 On the ‘multilateral system’ concept see section 4.2. 170 Including orders, quotes, and indications of interest: MiFIR recital 7. 171 Deutsche Börse and Euronext, eg, operate RM segments. Euronext operates seven RMs, many of them successors to long-​established stock exchanges (Amsterdam, Brussels, Dublin, Lisbon, Milan, Oslo, and Paris). The RM sector continues to grow, with two new RMs authorized in 2020. Germany (20), Sweden (16), and Spain (12) account for most RMs in the EEA-​30: 2021 ESMA Annual Securities Report, n 122, 12.

472  Order Execution Venues markets’), they have, by implication, chosen to eschew RM status (and the additional regulation it imposes on issuers) in order to compete for small and medium-​sized (SME) business in particular (Chapter II). For the purposes of venue/​order execution regulation, however, the RM has the same functionality and is regulated in the same way as the other multilateral, non-​discretionary organized venue, the MTF.

V.5.3  Multilateral Trading Facilities The MTF is the workhorse of the venue classification system as regards trading venues,172 albeit that the implementation of MiFID II/​MiFIR saw some equity trading move to SIs following the restrictions placed on MTF equity dark trading (section 11.2). An MTF is defined as a multilateral system, operated by an investment firm or a market operator, which brings together multiple third party buying and selling interests in financial instruments (in the system and in accordance with non-​discretionary rules) in a way that results in a contract in accordance with MiFID II/​MiFIR’s investment firm rules (MiFID II Article 4(1)(22)). Its classification accordingly follows the RM classification as regards trading functionality, but without the opt-​in to the distinct RM rules that are concerned with primary/​issuance market functions. Unlike RM operation, the operation of an MTF is characterized as an investment service provided by an investment firm (or market operator). In practice, the regulatory regime applicable to MTF operation is, with the exception of the admission-​to-​trading requirements, very similar to the RM regime. MTFs and RMs are neutral venues in that they cannot execute client orders against proprietary capital.173 Similarly, both venue types do not include bilateral systems where a firm enters into every trade on own account, including as a riskless counterparty interposed between the buyer and seller, where the orders are matched simultaneously (matched principal trading).174

V.5.4  Organized Trading Facilities V.5.4.1 The OTF The new MiFID II/​MiFIR venue, the OTF—​which is designed to ensure that all forms of organized trading are captured under MiFID II/​MiFIR175—​is also a multilateral system, but one which is not an RM or MTF, and in which multiple third party buying and selling 172 MTFs (142) account for most of the EU’s trading venues (although with RMs close behind at 127). Primarily concentrated in Germany (22) (followed by the Netherlands (21) and Italy 12)), they accounted for most equity/​ equity-​like trading in 2020 (25,000 of instruments available for trading v 7,500 instruments traded on RMs, 14,000 on SIs, and 13,000 OTC). Similarly, MTFs accounted for most bond trading (74,000 of instruments available for trading) (v 46,000 on RMs, 42,000 on SIs, 13,500 on OTFs, and 13,500 OTC), and representing 18 per cent of overall bond trading volumes (v 8 per cent on RMs). Their dominance in bond trading is reflected in the concentration of bond MTFs in Germany (13) and Italy (9): 2021 ESMA Annual Securities Report, n 122, 12–​13 and 33. 173 MiFIR recital 7. 174 MiFIR recital 7. 175 MiFIR recital 8.

V.5  Venue Classification  473 interests in bonds, structured-​finance products, emission allowances, or derivatives (but not, accordingly, equity and equity-​like instruments) are able to interact in the system in a way that results in a contract in accordance with the MiFID II/​MiFIR provisions for investment firms (MiFID II Article 4(1)(23)). By contrast with the RM and MTF, the OTF cannot, therefore, support trading in equity/​ equity-​like instruments. In addition, it does not operate under non-​discretionary rules, reflecting the discretionary quality of the different non-​equity venues this classification is designed to capture (primarily the different types of dealer-​based platform for trading derivatives): OTFs must operate on a discretionary basis or otherwise they must operate as MTFs: Article 20(6). The OTF venue is not, however, all-​encompassing and does not cover, for example, systems where there is no genuine trade execution or arranging, such as bulletin boards for advertising trading interests, electronic post-​trade confirmation services, or portfolio compression176 (MiFIR recital 8). The OTF regime was contested over the negotiations. The Commission’s proposal that the OTF could be used for equity trading raised a host of objections, among the most fundamental of which was that equity OTFs could potentially prejudice price formation—​given the potentially poor quality of the transparency data such discretionary venues would produce.177 Difficulties also arose as regards the Commission’s proposed prohibition of proprietary trading by the OTF operator in the OTF, with objections including that such a prohibition could have the effect, as regards derivatives trading platforms in particular, of reducing liquidity and increasing stability risks.178 Over the negotiations, equity/​equity-​like instruments were excluded from the OTF and the treatment of OTF operator discretion became more nuanced, in order to support derivatives trading in particular. In practice, the OTF regulatory design has not experienced major difficulties179 and the OTF has become a structural feature of the EU trading landscape for the trading of bonds and derivatives.180

V.5.4.2 The OTF and the Exercise of Discretion OTFs are subject to the rules which apply to RMs and MTFs but with two significant calibrations that reflect the discretionary quality of trading on OTFs.181 First, OTFs, as 176 Portfolio compression services relate to derivatives trading. 177 As OTF operators would accordingly have a degree of discretion over execution, could route orders to other venues, and could control access to their execution systems, the pricing information produced would not be of the same order as that produced by the neutral, non-​discretionary interplay of third-​party orders in a non-​ discretionary, open access, multilateral venue, and data quality risks could arise. 178 The UK FSA, eg, expressed concern that liquidity would be withdrawn: Lawton, D (FSA), Speech, 30 January 2012. 179 ESMA’s MiFID II/​MiFIR Review report was positive: 2021 ESMA OTF Report, n 150. 180 As at 2021, twenty-​seven OTFs were registered, trading in bonds (primarily corporate bonds) and derivatives. The OTF segment is a specialist one, with OTFs registered in only eight Member States and heavily concentrated in France (11/​27): 2021 ESMA Securities Markets Annual Report, n 122, 4 and 12. The low number of OTFs overall reflects the departure of the UK from the EU, with forty-​five OTFs authorized in the UK in 2020 (at 9). Most OTFs specialize in derivatives trading, with only ten actively trading bonds in 2020, albeit representing 9 per cent of bond trading volume (at 12 and 33). OTFs have come to play a key role in inter-​dealer markets in particular, and in the management of large trades: 2021 ESMA OTF Report, n 150, 8–​10. 181 Further, and in order to reduce arbitrage risks between the multilaterally oriented regulation of OTFs and the bilaterally oriented regulation of SIs, the operation of an OTF and an SI cannot take place within the same legal entity (an OTF must not connect with an SI in a way that enables orders in an OTF and orders or quotes in an SI to interact); the firm or operator operating an OTF is not, however, prohibited from engaging another investment firm to carry out market-​making in the OTF on an independent basis (Art 20(4) and (5)).

474  Order Execution Venues discretionary venues, are subject to related conduct rules, including best execution requirements (MiFID II Article 20(8)).182 Second, OTFs are subject to a series of restrictions on how they exercise discretion and, relatedly, on the trading functionality they can provide (Article 20). An OTF can use discretion in only two ways: when deciding to place an order in an OTF or to retract the order; and when deciding not to match a client order with other orders in the system at the time, as long as this complies with any specific instructions from the client and with best execution requirements (Article 20(6)).183 NCAs may require (either at the OTF authorization stage or on an ad hoc basis) detailed descriptions of how discretion will be exercised, particularly in relation to when an order may be retracted and how client orders are to be matched (Article 20(7)). OTF operators are, however, also permitted to engage in a form of riskless proprietary dealing: ‘matched principal trading’. As operators of neutral multilateral platforms, OTF operators are prevented from executing client orders against their proprietary capital (Article 20(1)).184 But in a concession to the nature of derivatives trading in particular, OTF operators, in order to support stable trading, are permitted to engage in ‘matched principal trading’, or riskless principal trading,185 which is not regarded as proprietary trading for these purposes (Article 20(2)) but which can support liquidity. A series of restrictions apply, given the potential for conflict-​of-​interest risk and also for price formation to be prejudiced. Matched principal trading is only permitted in relation to bonds, structured-​finance products, emission allowances, and derivatives which are not subject to the EMIR CCP clearing obligation, and the client must consent (Article 20(2)). Organizational and NCA monitoring requirements also apply.186 These conditions reflect the bias towards non-​discretionary, multilateral trading under MiFID II/​MiFIR, as does the power of the OTF’s NCA to require a detailed explanation of why the system does not correspond to and cannot operate as an RM, MTF, or SI (Article 20(7)).

182 Although much of the conduct regime will be disapplied where trading is between eligible counterparties (Ch IV section 6.2). 183 Where an OTF is in the form of a client order crossing system, the firm can decide if, when, and how much of two orders it wants to match. It may also facilitate negotiation between clients so as to bring together two or more potentially compatible trading interests: MiFID II Art 20(6). 184 The prohibition applies to the proprietary capital of the relevant investment firm or market operator and/​or capital from any entity that is part of the same corporate group and/​or legal person as the firm or market operator. Reflecting the concern of the Council over the negotiations to support sovereign debt markets, dealing on own account (other than by matched principal trading) by an OTF is, however, permitted in relation to illiquid sovereign debt instruments (Art 20(3)). 185 Matched principal trading is defined as a transaction where the facilitator (the OTF) interposes between the buyer and the seller in such a way that it is never exposed to market risk throughout the execution of the transaction, with both sides of the transaction executed simultaneously, and where the transaction is concluded at a price where the facilitator makes no profit or loss other than a previously disclosed commission, fee, or charge for the transaction: MiFID II Art 4(1)(38). 186 The investment firm or market operator running the OTF must establish arrangements ensuring adherence to the definition of matched principal trading, and also report to the NCA on its use of matched principal trading: Arts 20(2) and (7). The NCA must monitor the trading to ensure that it complies with the definition of matched principal trading and does not give rise to conflicts of interest (Art 20(7)).

V.5  Venue Classification  475

V.5.5  Systematic Internalizers In the bilateral OTC space, and following the pathbreaking introduction of the SI classification by MiFID I, investment firms which execute client orders bilaterally against their proprietary inventory (thereby putting their capital at risk), but which do so systematically and on a large scale, are treated as a specialist form of investment firm: the SI. They are, in consequence, subject to specific transparency and reporting requirements, alongside the conduct and organizational rules that apply to investment firms generally. These specific requirements are designed to ensure a level regulatory playing-​field between multilateral trading venues and SIs, while respecting their different functionalities, MiFID II/​MiFIR tightened the MiFID I SI classification to address the regulatory arbitrage difficulties associated with the primarily qualitative MiFID I SI definition.187 The SI definition now has a strongly quantitative quality. MiFID II Article 4(1)(20) provides that an SI is a firm which, on an organized, frequent, systematic, and substantial basis, deals on own account by executing client orders outside an RM, MTF, or OTF, without operating a multilateral system, but it further specifies that whether trading is ‘frequent and systematic’ is a quantitative assessment, based on the number of OTC trades in the relevant financial instrument carried out by the investment firm on own account when executing client orders. Article 4(1)(20) also provides that whether the activity is ‘substantial’ is a similarly quantitative assessment, being linked to the scale of such trading, either relative to the firm’s overall trading in the instrument, or to the firm’s trading relative to EU trading in the instrument. Both thresholds must be crossed for a firm to be required to register as an SI.188 Classification as an SI is instrument-​specific: firms are registered as SIs in relation to particular instruments (MiFIR recital 19). Granular administrative rules under Delegated Regulation 2017/​565 amplify and quantify the definition as regards equity/​equity-​like instruments, bonds, structured-​finance products, derivatives, and emission allowances, by means of quantitative metrics linked to number of transactions and turnover.189 Investment firms must assess whether they come within the SI criteria, and as regards these instruments, on a quarterly basis,190 but ESMA semi-​annually produces data to support the related calculations.191 Notwithstanding these quantitative refinements, the SI definition has struggled to manage the material regulatory arbitrage risks that arise at the SI/​multilateral system boundary, albeit that the law-​making process has showed some agility in response. Most difficulties have attended the emergence of SI ‘network arrangements’ which can operate, in practice, as multilateral systems, although SIs are prohibited from bringing together third-​ party interests and operating multilaterally (this activity requires registration as an RM, MTF, or OTF), being required to engage in proprietary dealing activities or, in effect, to put

187 Ambiguities in the MiFID I definition were associated with only a small number of firms being regulated under the SI regime: 2010 MiFID I Review Consultation, n 83, 17. 188 A firm can also opt-​in to SI registration: Art 4(1)(20). 189 Delegated Regulation 2017/​565 Arts 12–​16, which apply specific percentage metrics to the calculation of ‘frequent and systematic’ and ‘substantial’, in each case assessed over six-​month periods, and linked to number of transactions (‘frequent and systematic’) and turnover (‘substantial basis’), per asset class. 190 Delegated Regulation 2017/​565 Art 17 (each assessment is based on the previous six months of data). 191 ESMA provides this data, which it draws from the transparency and reporting data required under MiFIR, voluntarily and following requests from the industry.

476  Order Execution Venues capital at risk.192 Following the adoption of MiFID II/​MiFIR but prior to its 2018 application, the prospect of the emergence of networks of SIs, linked to other dealers providing liquidity, including through high frequency algorithmic techniques, and which would, in effect, allow multilateral trading under the SI designation, led to a swift refinement of the SI classification through an administrative amplification. Delegated Regulation 2017/​565 now specifies that an SI is prohibited from participating in matching arrangements, entered into with entities outside its own group, with the objective or consequence of carrying out de facto riskless back-​to-​back transactions (matched principal trading) outside a trading venue.193 ESMA soft law has reinforced the prohibition on SIs engaging in multilateral trading, emphasizing that SI dealing is characterized by its ‘risk-​facing’ quality.194 Contestation between the SI and multilateral trading sectors as to the extent to which SIs engage in the matching of third-​party interests, which can only be carried out by the more heavily regulated multilateral venues, has, however, persisted.195 Relatedly, a regulatory response was required to the heightened arbitrage risk which arose from the operation of the MiFID II/​MiFIR ‘tick size’ regime for shares, depositary receipts, and ETFs. Tick size regulation, which addresses the minimum increments in which instrument prices can move, is a means for supporting market liquidity and transparency as it prevents prices moving in overly large increments which can disrupt liquidity and price formation, or in overly small increments which can lead to excessive and noisy trading activity. While multilateral trading venues are, under MiFID II/​MiFIR subject to minimum tick size rules for equity instruments,196 SIs, originally, were not and accordingly benefited from a significant competitive advantage in that they could quote prices in narrower price increments than trading venues and so offer price improvement to their clients.197 While a rapid administrative rule reform followed ESMA’s identification of the loophole,198 the 192 The prohibition on operation on a multilateral basis is emphasized in MiFIR which notes that while a single-​ dealer platform could qualify as an SI, a multi-​dealer platform, where multiple dealers interact for the same financial instrument, cannot (MiFIR recital 20). 193 The prohibition, which was driven by ESMA, was achieved by the addition of a new Art 16a to Delegated Regulation 2017/​565 by Delegated Regulation 2017/​2294, which came into force in 2017 prior to the 2018 implementation of MiFID II/​MiFIR. ESMA had earlier raised concerns with the Commission that certain investment firms might be seeking to circumvent MiFID II by setting up networks of interconnected SIs and other liquidity providers (including algorithmic high frequency traders), initially for dealing in shares. These networks would allow SIs to cross third-​party interests by using matched principal trading and would also provide for liquidity provision between network members. While ESMA committed to using soft law as necessary, it encouraged the Commission to consider whether a regulatory response was needed: ESMA, Letter to Commission, 1 February 2017. In a clear example of the extent to which ESMA has become something of a steward of MiFID II/​MiFIR, the reform followed. 194 In detailed Q&As in its MiFID II/​MiFIR Market Structure Q&A (section 5, Q&As 26–​8), ESMA has underlined that SIs are prohibited not just from engaging in riskless back-​to-​back dealing, but also from operating any system that would bring together buying and selling interests in functionally the same way as a trading venue. It has similarly emphasized that, while SIs are a valuable source of liquidity in that they engage in risk-​facing transactions, the SI regulatory scheme is designed to avoid subjecting SIs to undue risks ‘based on the assumption and understanding that SIs are facing risks when trading’. 195 ESMA’s MiFID II/​MiFIR Review of the SI perimeter reported on trading venue concern that SI networks were breaching the prohibition on multilateral trading but did not find sufficient evidence to warrant a response: 2021 ESMA OTF Report, n 150, 18–​21. 196 MiFID II Art 49(1) and (2) requires RMs (and also MTFs) to adopt tick size regimes for shares, depositary receipts, ETFs, and similar instruments. RTS 2017/​588 (RTS 11) amplifies this requirement by specifying how minimum tick sizes are to be set for shares, depositary receipts, and ETFs. See section 6.3.2. 197 The initial rapid expansion in the growth of SIs following the implementation of MiFID II/​MiFIR was associated with the tick size advantage: 2020 Oxera Report, n 17, 169 and 172–​3. 198 RTS 1 was revised via Delegated Regulation 2019/​442 to require SIs to follow the minimum tick size increments set out in RTS 11 when providing quotes for shares and depositary receipts. Earlier ESMA had advised the Commission of the loophole and called for SIs to be subject to the full RTS 11 minimum tick size regime (including

V.6   Authorization and Ongoing Regulation of RMs  477 reform underscores the porous nature of the SI/​multilateral system border and the need for watchful oversight. The speed of the administrative rule reform, however, augurs well for the ability of the MiFID II/​MiFIR rulebook to adjust. The SI regime remains, some twenty years after its initial adoption under MiFID I, one of the most contested elements of the EU’s regulation of order execution venues. The sector has experienced significant growth since the coming into force of the MiFID II/​MiFIR reforms199 and is a major liquidity provider in the EU market.200 But the extent to which the scale of SI trading indicates that the regulatory scheme is failing to manage arbitrage risks, particularly as regards transparency regulation, continues to generate one of the most fractious and entrenched debates in EU financial markets regulation (see further section 11).

V.5.6  Investment Firms All other order execution by investment firms falls outside the organized (multilateral/​SI) venue space, although, as discussed below in this chapter, operational/​conduct, transparency, and reporting requirements apply. The following sections examine the major features of the operational regulation of these different venues for order execution.

V.6  Authorization and Ongoing Regulation of Trading Venues: Regulated Markets V.6.1  A Flexible Regime The RM regime is, overall, designed to be flexible and to allow RMs to design their own trading rules and access conditions and to operate different trading segments, subject to any additional local ‘public law’ rules, as is expressly permitted by MiFID II/​MiFIR.201 It has nonetheless been amplified by administrative rules, including as regards the stability and liquidity-​oriented rules relating to algorithmic trading and the liquidity-​oriented rules relating to tick sizes and market-​making,202 and supported by ESMA soft law.203 for ETFs), but the Commission restricted the reform to the minimum necessary to protect price formation (shares and depositary receipts), given that the co-​legislators had not, under the legislative scheme, provided for a general obligation on SIs to follow tick size increments: C(2018) 5369 (Commission Proposal for the RTS 1 reform). The 2021 MiFIR 2 Proposal, however, proposes the application of the full tick size regime to SIs. 199 2018 saw a sharp increase in the number of SIs from 11 to 109: ESMA Chairman Maijoor, Speech, 18 June 2018. Similarly, the coming into force of MiFID II/​MiFIR led to a sharp increase in SIs’ market share of share trading (to 24 per cent of turnover over 2018–​2019 from a ‘negligible’ level): 2020 Oxera Report, n 17, 173. 200 2020 Oxera Report, n 17, 179. 201 MiFID II Art 44(4). 202 The main administrative rules mainly address algorithmic trading on the RM (governance and oversight: RTS 2017/​584; fair and non-​discriminatory co-​location services and pricing: RTS 2017/​573; and the management of the risk of disorderly trading from algorithmic trading: RTS 2017/​566); market-​making (RTS 2017/​ 578); and tick sizes (RTS 2017/​588) and RM business clocks (RTS 2017/​574). The references for these measures are noted in section 3. 203 The ESMA MiFID II/​MiFIR Q&A on market structure addresses operational issues, including the algorithmic trading requirements and the tick size regime. ESMA has also adopted Guidelines relating to the circuit breakers and trading halts used to manage volatility (2017) and the ‘fit and proper’ assessment for management

478  Order Execution Venues The ongoing rules applicable to RMs also apply, for the most part, to MTFs and OTFs, albeit that only RMs, as primary/​issuance markets, are subject to specific admission to trading requirements, and that OTFs are subject to distinct constraints on the use of discretion.

V.6.2  Authorization RM authorization is governed by MiFID II. The foundational authorization condition applies under Article 44(1) which provides that authorization as an RM may only be granted where the NCA (the home NCA204) is satisfied that the market operator and the RM’s systems comply at least with the MiFID II requirements for RMs.205 NCAs must also keep the RM’s compliance with these requirements and the initial authorization conditions under regular review (Article 44(2)). Authorization is dependent on the market operator providing all necessary information, including a programme of operations which sets out the types of business envisaged and the organizational structure, to enable the NCA to satisfy itself that the RM has established, at the time of initial authorization, all the necessary arrangements in place to comply with MiFID II’s requirements (Article 44(1)).206 Authorization can be withdrawn in line with the specified conditions which are similar to those applicable across other segments of the single rulebook (Article 44(5)).207 The authorization process also addresses the market operator who is charged with performing tasks relating to the organization and operation of the RM under the NCA’s supervision (Article 44(2)) and who is responsible for compliance with MiFID II (Article 44(3)).208 In particular, governance requirements (similar to those applicable to investment firms)209 apply to the management body of the market operator210 (Article 45). Accordingly, members of the management body must at all times be of sufficiently good repute and possess sufficient knowledge, skills, and experience to perform their duties. In addition, members must commit sufficient time and comply with the restrictions which apply to cross-​directorships;211 possess adequate collective knowledge, skills, and experience to body members (2018), alongside the extensive Guidelines that amplify the MiFIR transparency and reporting requirements (noted in sections 11 and 12). 204 The State in which the regulated market is registered or, if under the law of that Member State it has no registered office, the Member State in which the head office of the regulated market is situated: Art 4(1)(55). 205 Where the market operator is other than the regulated market itself, Member States are to establish how MiFID II’s obligations are to be allocated between the regulated market and the market operator. 206 Each Member State must draw up a list of RMs for which it is the home Member State and forward it to the other Member States and ESMA (which maintains a register of all RMs): Art 56. 207 Authorization must be withdrawn where the RM: does not make use of the authorization within twelve months, renounces the authorization, or has not operated for the preceding six months (unless the Member State has provided for authorization to lapse in such cases); has obtained the authorization by making false statements or by any other irregular means; no longer meets the authorization conditions; has seriously and systematically infringed MiFID II; or falls within any of the cases where national law provides for withdrawal. ESMA must be notified of any withdrawals: Art 44(6). 208 The market operator is also entitled to exercise the MiFID II rights conferred on the RM. 209 See further Ch IV section 7.2. 210 The management body is the body (or bodies) of the market operator, appointed in accordance with national law, empowered to set the entity’s strategy, objectives, and overall direction, and which oversees and monitors management decision-​making (and includes persons who effectively direct the business of the market operator): Art 4(1)(36). 211 No more than one executive directorship with two non-​executive directorships, or no more than four non-​ executive directorships. The restriction applies to market operators that are significant in terms of their size, their

V.6   Authorization and Ongoing Regulation of RMs  479 understand the market operator’s activities and main risks; and act with honesty, integrity, and independence of mind to effectively challenge the decisions of senior management, where necessary, and to effectively oversee and monitor decision-​making.212 The oversight functions of the management body, which are oriented to ensuring prudent management and the promotion of market integrity, are specified (Article 45(6)).213 The management body must also include a nomination committee214 which fulfils the specified conditions and functions (Articles 45(4)). The NCA must refuse authorization where it is not satisfied that the members of the management body are of sufficiently good repute, possess sufficient knowledge, skills, and experience, and commit sufficient time, or if there are objective and demonstrable grounds for believing that the management body of the firm may pose a threat to its effective, sound, and prudent management, and to the adequate consideration of the integrity of the market (Article 45(7)).215 A qualifying-​holdings-​like requirement also applies to authorization. Under Article 46 (which is considerably lighter than the parallel regime which applies to ‘qualifying holdings’ in investment firms), those persons in a position to exercise, directly or indirectly, ‘significant influence’ over the management of the RM must be ‘suitable’.216

V.6.3  Ongoing Requirements V.6.3.1 Operational Requirements The operating regime for RMs is high-​level in design but is more interventionist than the precursor MiFID I regime, particularly with respect to market resilience and liquidity. A series of organizational principles relating to conflict-​of-​interest management, risk management, and the trading process apply under Article 47 (which, and in sharp contrast with the parallel investment firm organizational regime, is not amplified by administrative

internal organization, and the nature, scope, and complexity of their activities. An additional non-​executive directorship may be authorized by the NCA. 212 The overall composition of the management body must also reflect an appropriately broad range of experience. 213 Albeit in less detail than the MiFID II specification of investment firm management body responsibilities. The management body must define and oversee the implementation of governance arrangements that ensure effective and prudent management of the organization, including the segregation of duties in the organization and the prevention of conflicts of interest, in a manner which promotes the integrity of the market. The management body must also monitor and periodically assess the effectiveness of governance arrangements and take appropriate steps to address any deficiencies. 214 This requirement is calibrated in that it is mandatory only where the operator is significant in terms of its size, its internal organization, and the nature, scope, and complexity of its activities. The functions of the nomination committee are specified and reflect those which apply to investment firms generally. 215 Detailed ESMA Guidelines amplify these requirements, including as regards time commitment, knowledge, skills and experience, honesty and integrity, independence, board training and support, and record-​ keeping: ESMA, Guidelines on the Management Body of Market Operators and Data Reporting Services Providers (2017). 216 The market operator must provide the NCA with, and make public, information regarding the RM’s/​market operator’s ownership, in particular the identity and scale of interests of any parties in a position to exercise significant influence over management. It must also inform the NCA of, and make public, any transfer of ownership which gives rise to a change in the identity of the persons exercising significant influence over the operation of the regulated market. The NCA may refuse to approve changes to ‘controlling interests’ (undefined) where there are objective and demonstrable grounds for believing the changes would pose a threat to the sound and prudent management of the RM.

480  Order Execution Venues rules).217 The RM must have arrangements to clearly identify and manage the potential adverse consequences for the operation of the RM, or for its members or participants, of any conflict of interest between the interests of the RM, its owners or its operator, and the sound functioning of the RM. The RM must be adequately equipped to manage the risks to which it is exposed, have the appropriate systems to identify all significant risks to its operation, and put in place effective risk mitigation measures. It must also have arrangements for the sound management of the technical operations of the system (including contingency arrangements), transparent and non-​discretionary rules and procedures that support fair and orderly trading and efficient execution, effective arrangements for the finalization of transactions, and sufficient financial resources to facilitate its orderly functioning, having regard to its risk profile. Reflecting the MiFID II/​MiFIR concern to reduce regulatory arbitrage risks, market operators of RMs are prohibited from executing client orders against proprietary capital and from engaging in matched principal trading in any of the RMs which they operate (this activity is reserved to OTFs and SIs and is regulated accordingly).

V.6.3.2 Market Resilience and Liquidity Article 48 imposes a series of more detailed, operationally oriented requirements designed to support market resilience and liquidity and, in particular, to address the stability and liquidity risks posed by algorithmic trading (these rules also apply to MTFs and OTFs through Article 18(5)).218 In addition, minimum tick size requirements (Article 49) are also directed to supporting liquidity. The keystone Article 48 provision requires the RM to have in place effective systems, procedures, and arrangements to ensure its trading systems are resilient, have sufficient capacity to deal with peak order and messaging volumes, are able to ensure orderly trading under conditions of severe market stress, are fully tested to ensure such conditions are met, and are subject to effective business continuity arrangements if a failure arises (Article 48(1)). Further, in order to support system resilience, effective systems, procedures, and arrangements must be in place to reject orders that exceed predetermined price and volume thresholds or are clearly erroneous, and, in a requirement for ‘circuit breakers’, to temporarily halt trading or constrain it if there is a significant price movement in a financial instrument on the market (or a related market) during a short period, as well as, in exceptional cases, to cancel, vary, or correct any transaction (Article 48(4) and (5)). Reflecting the concern to support liquidity which is evident across much of the trading venue regime, the circuit breaker requirement is subject to liquidity conditions to protect liquidity levels.219 It has also been subject to administrative amplification, further underscoring the importance

217 RMs (and MTFs and OTFs) will also be subject to the Digital Operational Resilience Act (DORA) which addresses the security of financial firms’ network and information systems and the ability of financial firms to withstand threats and disruptions. Provisional agreement on DORA was reached in May 2022 (the Commission Proposal is at COM(2020) 595). See in outline Ch I section 7.3. 218 These requirements reflect the strengthening of the Commission’s original proposal by the European Parliament during the inter-​institutional negotiations, particularly as regards algorithmic trading. 219 Under Art 48, the parameters for halting trading (circuit breakers) must be appropriately calibrated to reflect the liquidity of the different asset classes engaged, the market model, and the types of market user, and be sufficient to avoid significant disruption to the orderliness of trading. The parameters (and any material changes) must also be reported to the NCA (and by the NCA to ESMA). Where any RM which is material in terms of liquidity in a particular instrument halts trading, it must have the necessary systems and procedures to notify NCAs so as to coordinate a market-​wide response and determine whether halts are required on other venues.

V.6   Authorization and Ongoing Regulation of RMs  481 of circuit breakers, and how they are used, to the maintenance of liquidity and stability.220 In practice, the circuit breaker regime seems to have performed effectively, for the most part, standing up well to the intense market volatility experienced over the deepening of the Covid-​19 pandemic in March 2020; the limited use of circuit breakers by trading venues providing trading in energy derivatives, and in order to manage the acute volatility in certain commodity derivatives markets following the Russian invasion of Ukraine, however, may lead to reform and, in particular, to greater prescription of when circuit breakers must be used.221 A series of related requirements (Article 48(6)) address the specific risks associated with algorithmic (or automated) trading,222 which was a major preoccupation of regulators and policy-​makers over the period MiFID II was adopted,223 including as regards the rise of algorithmic traders as major providers of liquidity, alongside traditional market-​makers.224 Systems and procedures must be in place to ensure that algorithmic trading cannot create or contribute to disorderly trading conditions on the market, and to manage any consequent disorderly trading conditions which arise. In particular, RMs must have systems which limit the ratio of unexecuted orders to transactions that may be entered into the system by a member or participant, which slow down the flow of orders if there is a risk of system capacity being reached, and which limit the minimum ‘tick size’ (see below) that may be executed on the market (Article 48(6)). RMs are also subject to conditions governing ‘direct electronic access’,225 which include that markets which permit such access must have in place effective systems, procedures, and arrangements to ensure that market members or participants only provide this service to their clients (typically high frequency algorithmic traders) where they are authorized as investment firms or credit institutions; that appropriate criteria are set and applied regarding the suitability of persons to whom such access can be provided; and that the member or participant in question retains responsibility for orders and trades made through direct electronic access (Article 48(7)).226 Reporting is also addressed, with RMs required to identify, through flagging mechanisms, orders generated through algorithmic trading, the different algorithms used for the creation of orders, and the persons initiating these orders, and provide this information to NCAs on request (Article 48(10)). Related fee structures are also regulated. Inter alia, an RM must ensure

220 RTS 2017/​570 addresses the NCA notification system for trading halts/​circuit breakers, while RTS 2017/​ 584 and RTS 2017/​566 specify how trading venues are to address disorderly trading conditions arising from algorithmic trading. In addition, detailed ESMA Guidelines specify how trading halts/​circuit breakers are to be deployed, including as regards their calibration to different instruments’ liquidity profiles: ESMA, Guidelines on the Calibration of Circuit Breakers and the Publication of Trading Halts under MiFID II (2017). 221 As regards the pandemic experience, ESMA reported that circuit breakers were widely and effectively used over this period of exceptionally high volatility when trading volumes reached all-​time highs: ESMA, MiFID II/​ MiFIR Report on Algorithmic Trading (2021) 60–​1 and ESMA, TRV No 2 (2020) 21. On the energy market experience as regards the war in Ukraine, see n 130. 222 On this definition see Ch VI section 2.3. 223 See further Ch VI section 2.3. 224 The extent to which algorithmic traders emerged as major suppliers of liquidity on order execution venues, including traditional stock exchanges, became one of the major financial-​crisis-​era/​post-​crisis concerns of venue regulation. See, eg, Fox et al, n 12. 225 Direct electronic access (which supports high frequency trading) relates to the access by persons to a trading venue through a member of or participant in a trading venue: Art 4(1)(41). See further Ch VI section 2.3. 226 The RM must also set appropriate standards regarding risk controls and thresholds on trading through such access, and must have arrangements in place to suspend or terminate the provision of direct electronic access. Co-​ location is also addressed, in that rules on co-​location services must be transparent, fair, and non-​discriminatory (Art 48(8)). See further Ch VI section 2.3.

482  Order Execution Venues that its fee structures (including execution fees, ancillary fees, and rebates) are transparent, fair, and non-​discriminatory, and do not create incentives to engage in the execution of transactions (such as placing, modifying, or cancelling orders) in a way that contributes to disorderly trading (Article 48(9)). By contrast with Article 47, these algorithmic-​trading-​ related requirements, novel at the time, have been extensively amplified through detailed administrative rules which are designed to address the risks associated with algorithmic trading but also to avoid damaging liquidity.227 Avoiding disruption to liquidity is also the concern of the market-​making requirements (Article 48(2) and (3)).228 An RM must have in place written agreements with all investment firms pursuing a market-​making strategy on the RM. It must also have in place market-​making schemes to ensure that a sufficient number of investment firms participate in such agreements and which require them to post firm quotes at competitive prices with the result of providing liquidity to the market on a ‘regular and predictable basis’, where such a requirement is appropriate to the nature and scale of trading on the RM.229 While these rules add little to the incentives RMs and other trading venues have to support liquidity,230 they underscore the priority given to the protection of liquidity across MiFID II/​MiFIR. Liquidity is also supported by the ‘tick size’ regime (Article 49). As outlined in section 5.5, tick size rules address the minimum increments in which prices can move and are designed to support liquidity and price formation by ensuring that price increments are not too small (leading to excessive and noisy trading) or too large (hindering price formation by masking real trading interest). Whether or not tick size rules can efficiently support liquidity and price formation is a function of the financial instrument in question and related trading patterns. In what was at the time a significant intensification of the venue regulation regime, driven by the European Parliament, RMs (and also MTFs and OTFs) must adopt tick size regimes for shares, depositary receipts, ETFs, certificates and other similar equity-​like instruments, in each case calibrated to the liquidity profile of the financial instrument and the average bid-​ask spread.231 Also, RTS 2017/​588 (RTS 11) applies harmonized minimum tick size requirements to shares, depositary receipts, and ETFs.232 While the minimum tick size 227 As regards governance and oversight, including circuit breakers (RTS 2017/​584); fair and non-​discriminatory co-​location services and pricing (RTS 2017/​573); and the management of the risk of disorderly trading (RTS 2017/​ 566). ESMA’s 2021 review suggested that the rules had, broadly, met their objectives and did not propose major reforms: 2021 ESMA Algorithmic Trading Report, n 221. 228 The algorithmic trading and market-​making rules are connected in that algorithmic high frequency traders in practice often act as market-​makers and as liquidity providers (see n 193 on their role in the SI regime), but can pull out in conditions of market stress, risking the destabilization of markets. 229 RTS 2017/​578 amplifies the market-​maker requirements, including by specifying that the market-​making commitment must require the posting of firm, two-​way simultaneous quotes of comparable size and competitive prices; and dealing on own account in at least one financial instrument on one trading venue for at least 50 per cent of the daily trading hours of continuous trading at the venue (excluding opening and closing auctions) (Art 1). The RTS also addresses the exceptional circumstances in which a market-​maker is not subject to the Art 48 obligation to provide liquidity on a ‘regular and predictable’ basis (Arts 3–​4) and the required content of the market-​making agreement. 230 ESMA’s 2021 review found that while the rules were not prejudicial, they were too general to ‘concretely incentivize’ liquidity and that trading venues were better placed to assess market-​making needs, and recommended simplification of the requirements: 2021 ESMA Algorithmic Trading Report, n 221, 95–​6. 231 In a refinement adopted by the 2019 Investment Firm Directive (Directive (EU) 2019/​2034 [2019] OJ L314/​ 64), and in response to market concern, tick size rules do not prevent RMs from matching orders that are large-​in-​ scale at the midpoint within the current bid and offer prices. The 2021 MiFIR 2 Proposal (Art 17a) would apply this refinement to SI trading also, given that the tick size regime now applies to SIs (n 137). 232 The delegation required that minimum tick sizes only be adopted where necessary to ensure the orderly functioning of markets (Art 49(3) and (4)). Minimum tick size requirements were deemed to be necessary only

V.6   Authorization and Ongoing Regulation of RMs  483 regime is designed to support liquidity it has proved troublesome in practice.233 Particular difficulties have arisen as regards its scope of application. It did not originally apply to SIs who were, accordingly, beneficiaries of a competitive advantage in that they could quote in narrower price increments than the minimum and thereby offer some price improvement to clients. While this gap was addressed through a reform to RTS 1 on equity market transparency,234 further reform has followed to RTS 2017/​588 (RTS 11) to calibrate it to reflect third country (in effect UK) trading patterns.235 The need for these two early refinements underlines that, as the EU trading venue regime has become increasingly driven by metrics, agile administrative reaction has become necessary to prevent distortions. Finally, and also related to liquidity through its connection to the transparency regime, all trading venues and their participants must synchronize their business clocks used for recording reportable events (Article 50).236

V.6.3.3 Market Access Access to RMs is governed by Article 53, which requires RMs to establish, implement, and maintain transparent and non-​discriminatory rules, based on objective criteria, which govern access to or membership of the RM; these rules must also cover the constitution and administration of the RM, transactions on the market, the professional standards imposed on those operating on the market, and clearing and settlement arrangements (Article 53(1) and (2)).237 While RMs can adopt their own access criteria, minimum requirements are imposed as regards those who may be admitted to the market. Authorized investment firms and credit institutions may be admitted, but all others must be of sufficient good repute, have a sufficient level of trading ability and competence, have adequate organizational arrangements, and have sufficient resources (Article 53(3)). Members and participants are not required to apply to each other the conduct-​of-​business requirements imposed under Article 24 (fair treatment and disclosure), Article 25 (know-​your-​client rules), Article 27 (best execution), for shares and for instruments closely related to shares (depositary receipts and ETFs): RTS 2017/​588 (RTS 11), recitals 2–​4. 233 Views differ on the extent to which it has supported liquidity. While some initial evidence on the operation of the minimum tick size regime suggested that it had been accurately calibrated and supported liquidity (AMF (French NCA), MiFID II: Impact of the New Tick Size Regime after Several Months of Implementation (2019)), market opinion, while broadly supportive of the rules, was polarized: 2021 ESMA Algorithmic Trading Report, n 221, 80–​2. 234 n 198. 235 This reform was required to recalibrate the minimum tick size calculations, which were originally based on the average daily number of transactions on the most liquid trading venue in the EU. Brexit generated the prospect, however, of the largest liquidity pool for a share being outside the EU and the tick size calculation being accordingly distorted (by being too large). RTS 2017/​588 (RTS 11) was accordingly revised (via Delegated Regulation 2019/​443) to allow NCAs to adjust a minimum tick size to address this situation. ESMA, which drove the reform, underlined the competitive disadvantage to EU trading venues were the EU minimum tick size to be larger as compared to narrower pricing increments on third country venues (which venues could then deliver price improvement) and accordingly to create incentives for trading and liquidity to move outside EU venues: ESMA, Final Report on Amendments to RTS 11 (2018). 236 Trading venue business clocks are governed by Delegated Regulation 2017/​574. The 2021 MiFIR 2 Proposal has proposed that this requirement, which is closely related to the MiFIR transparency regime, be directly applicable and situated in MiFIR. 237 These rules have not been amplified but have been addressed by the MiFID II/​MiFIR Market Structure Q&A. ESMA has advised that the access requirements are designed to support access to liquidity and, accordingly, that access conditions should not, eg, be linked to minimum levels of trading activity.

484  Order Execution Venues and Article 28 (order handling), but these obligations are imposed with respect to their clients when members and participants execute orders on their behalf (Article 53(4)). Remote access rights, and the placing by RMs of trading screens across the EU, are expressly addressed. As regards remote access rights, under Article 53(5) RM rules must provide for direct or, alternatively, remote participation by investment firms and credit institutions. In addition, remote participation is supported by investment firms’ related passporting rights under Article 36. Article 36 provides that Member States (in effect, the home Member State of the RM) must require that investment firms from other Member States, which are authorized to execute client orders or to deal on own account, have the right of membership or access to RMs established in their territory. This can be achieved by direct access through a branch in the RM’s Member State, or through remote membership or access without having to be established in the home Member State of the RM, where the trading procedures and systems in question do not require a physical presence. Member States may not impose any additional regulatory or administrative requirements on investment firms exercising this passport right. As regards RMs’ cross-​border rights, Member States must allow RMs from other Member States to provide appropriate arrangements on their territory to facilitate access to, and trading on, those markets by remote members or participants established in their territory (Article 53(6)).

V.6.3.4 Market Monitoring and Abusive Conduct RMs are also subject to market integrity requirements under Article 54, as regards their market rules but also relevant EU requirements. RMs must establish and maintain effective arrangements and procedures (including the necessary resources) for the regular monitoring of compliance with their rules on the part of their members or participants. They must also monitor orders sent (including cancellations)238 and transactions undertaken by their members and participants in order to identify rule breaches, disorderly trading conditions, conduct that may indicate abusive behaviour under the EU’s market abuse regime, or system disruptions in relation to a financial instrument. Supervisory reporting requirements also apply: market operators must immediately inform their NCAs of significant breaches of their rules, disorderly trading conditions, conduct that may indicate abusive behaviour under the EU’s market abuse regime, or system disruptions in relation to a financial instrument. Market operators must also supply the relevant information to the authority responsible for the investigation and prosecution of market abuse without undue delay, and provide full assistance to that authority (Article 54(3)). These requirements sit alongside the extensive transaction reporting requirements which apply to all trading venues and which are designed to support NCA monitoring, including as regards abusive conduct (section 12). More generally, NCAs must be empowered to have access to an RM’s order book, in order to monitor trading (Article 48(11)), a competence which also supports monitoring of the EU’s market abuse regime. V.6.3.5 Transparency Rules Extensive pre-​and post-​trade transparency requirements apply to RMs (and to MTFs and OTFs) under MiFIR (section 11).



238

In order to capture algorithmic/​high frequency trading.

V.7  Authorization and Ongoing Regulation of MTFs  485

V.6.3.6 Admission of Financial Instruments to Trading and Suspension and Removal of Instruments These requirements relate to the primary/​issuance market function of RMs and are considered in Chapter II.

V.7  Authorization and Ongoing Regulation of Trading Venues: Multilateral Trading Facilities V.7.1  Authorization The operation of an MTF (and an OTF) is characterized as an investment service under MiFID II.239 Investment firms which operate MTFs are accordingly subject to the authorization and ongoing requirements which apply to the provision of investment services under MiFID II/​MiFIR and, with respect to prudential regulation, under the Investment Firm Directive (IFD)/​Investment Firm Regulation (IFR) and Capital Requirements Directive IV (CRD IV)/​Capital Requirements Regulation (CRR) regimes (Chapter IV).240 An MTF (or OTF) can instead be operated by a market operator, rather than an investment firm, but the operator must verify in advance its compliance with the MiFID II authorization requirements.241 Alongside the ‘general’ investment services regime, a discrete set of MiFID II/​ MiFIR rules, designed to track the RM regime with respect to the regulation of trading functionalities, applies to the venue-​specific risks posed by the operation of an MTF. This regime, with calibrations designed to reflect their non-​discretionary trading functionality, also applies to OTFs. As regards authorization, where an investment firm (or market operator) seeks to operate an MTF, the usual investment firm authorization process (covering, inter alia, firm governance, qualifying shareholders, and initial capital) applies, save that the NCA must also be provided with a detailed description of the functioning of the MTF (or OTF) (Article 18(10)).242 Every authorization of an investment firm or market operator to operate an MTF (or OTF) must also be notified to ESMA, which maintains a register of MTFs and OTFs (Article 18(10)).

V.7.2  Ongoing Requirements V.7.2.1 Operational Requirements, Market Resilience, and Liquidity As regards ongoing regulation, the extensive organizational requirements applicable to investment firms under Article 16 (and its administrative rules and soft law) apply, alongside

239 MiFID II Annex I, section A(8) (and 9). 240 Directive (EU) 2019/​2034 [2019] OJ L314/​64 (IFD) and Regulation (EU) 2019/​2033 [2019] OJ L314/​1 (IFR); and Directive 2013/​36/​EU [2013] OJ L176/​338 (CRD IV)) and Regulation (EU) No 575/​2013 [2013] OJ L176/​1 (CRR), as revised by Directive (EU) 2019/​878 [2019] OJ L150/​253 (CRD V) and Regulation (EU) 2019/​876 [2019] OJ L150/​1 (CRR 2). 241 MiFID II Art 5(2). 242 Including details of any links to or participation by an RM, MTF, OTF, or SI owned by the same investment firm or market operator.

486  Order Execution Venues the investment firm prudential regime.243 These firm-​oriented requirements are supplemented by the Article 18 trading process requirements (which also apply to OTFs) and by the Article 19 MTF-​specific requirements. Accordingly, under Article 18, investment firms or market operators operating an MTF (or OTF) must, in addition to meeting the Article 16 investment firm organizational requirements, establish transparent rules and procedures for fair and orderly trading and establish objective criteria for the efficient execution of orders; they must also have in place arrangements for the sound management of the technical operations of the MTF (or OTF), including the establishment of effective contingency arrangements to cope with system disruption risks (Article 18(1)). Arrangements must also be in place to clearly identify and manage the potential adverse consequences for the operation of the MTF (or OTF), or for the members or participants and users, of any conflict of interest between the interests of the MTF (or OTF), its owners, or the investment firm or market operator operating the MTF (or OTF), and the sound operation of the MTF (or OTF) (Article 18(4)). Finally, the Article 48/​49 regime governing RM system resilience and liquidity (and including the requirements relating to algorithmic trading, market-​making, and tick sizes) is applied to MTFs (and OTFs) by Article 18(5)), with the addition of a specific liquidity-​supporting condition which requires that each MTF or OTF has at least three materially active members or users, each having the opportunity to interact with all the others in respect of price formation (Article 18(7)). Additional organizational requirements apply to MTFs only. Under Article 19(3), an MTF must, reflecting the Article 47 organizational regime which applies to RMs, and the MiFID II/​MiFIR concern to align MTF and RM regulation, be adequately equipped to manage the risks to which it is exposed, have effective arrangements to facilitate the efficient and timely finalization of transactions, and have available, at the time of authorization and on an ongoing basis, sufficient financial resources to facilitate its orderly functioning (having regard to the nature and extent of the transactions concluded on the market, and the range and degree of risk to which it is exposed). Additionally, reflecting their non-​ discretionary trading functionality, MTFs must establish and implement non-​discretionary rules for the execution of orders in the system (Article 19(1)). MTFs, as non-​discretionary multilateral venues (and as is also the case for RMs), may not execute client orders against proprietary capital or engage in matched principal trading (Article 19(5)).

V.7.2.2 Market Access Access rules also apply. Investment firms and market operators operating MTFs (or OTFs) must establish, publish, maintain, and implement transparent and non-​discriminatory rules, based on objective criteria, governing access to the trading facility (Article 18(3)). MTFs are additionally required to admit as members or participants only authorized investment firms or credit institutions and other persons who are of sufficient good repute, have a sufficient level of trading ability, competence, and experience, and have adequate organizational arrangements and sufficient resources for the role they are to perform (Article

243 As do the other MiFID II operational requirements (including the Art 23 conflicts of interest regime), although the conduct-​of-​business regime is dis-​applied from transactions between MTF/​OTF members, participants, or users. The investment firm prudential regime also applies. See further Ch IV.

V.7  Authorization and Ongoing Regulation of MTFs  487 19(2) and Article 53(3)).244 As under the RM regime, the conduct obligations of Articles 24, 25, 27, and 28 do not apply to transactions concluded under the rules governing an MTF between its members and participants, or between the MTF and its members and participants in relation to the use of the MTF, but they do apply where members or participants act on behalf of clients by executing orders through an MTF (Article 19(4)). Passport rights in relation to MTFs (and OTFs) (in effect, the right to set up remote screens) are governed by Article 34(6), which, in the context of the investment firm freedom to provide services, allows investment firms and market operators operating MTFs (and OTFs) from other Member States to provide appropriate ‘arrangements’ in host Member States to facilitate access to and use of their systems by remote users or participants established in the host Member State territory.

V.7.2.3 Market Monitoring and Abusive Conduct MTFs (and OTFs) are also subject to market monitoring rules that align with those which apply to RMs (Article 31). Accordingly, investment firms and market operators of MTFs (and OTFs) must establish and maintain effective arrangements and procedures, relevant to the MTF (or OTF), for the regular monitoring of compliance with MTF (and OTF) rules on the part of members, participants, or users; they must also monitor the orders sent (including cancellations) and transactions undertaken by their members, participants, or users under their systems in order to identify breaches of those rules, disorderly trading conditions, conduct that may indicate abusive behaviour under the EU market abuse regime, or system disruptions in relation to a financial instrument. In addition, they must deploy the resources necessary to ensure that such monitoring is effective (Article 31(1)). Reporting obligations apply as they do for RMs. Investment firms and markets operators operating an MTF (or OTF) must immediately inform their NCAs of significant breaches of their rules, disorderly trading conditions, conduct that may indicate abusive behaviour under the EU market abuse regime, or system disruptions in relation to a financial instrument (Article 31(2)). Additionally, investment firms and market operators operating an MTF (or OTF) must supply without undue delay the relevant information to the authority responsible for the investigation and prosecution of market abuse, and provide full assistance to that authority (Article 31(3)). V.7.2.4 Transparency Requirements MTFs (and OTFs) are subject to the same transparency rules that apply to RMs, albeit that their business model means that they are more exposed to the constraints on dark trading (section 11). V.7.2.5 Admission to Trading MTFs (and OTFs) are not subject to detailed admission-​to-​trading rules, reflecting their characterization under MiFID II as secondary market trading-​services providers (and not, by contrast with RMs, as primary/​issuance markets).245 Investment firms or

244 These requirements are broadly similar to the RM access regime, save that RMs are required to adopt rules specifying the obligations of members or participants. 245 Although MTFs in the form of SME Growth Markets are exceptions in this regard and are subject to admission conditions. See further Ch II section 8.

488  Order Execution Venues market operators are subject only to the obligation to establish transparent rules regarding the criteria for determining the financial instruments that can be traded under their systems; they must, however, provide, or be satisfied that there is access to, sufficient publicly available information to enable users to form an investment judgment, taking into account the nature of the users and the types of instrument traded (Article 18(2)).246

V.8  Authorization and Ongoing Regulation of Trading Venues: Organized Trading Facilities The OTF regime is, in nearly all respects, the same as that which applies to MTFs, as outlined above. As discretionary venues, however, OTFs are subject to conditions (Article 20) on how discretion can be exercised and on the extent to which they can engage in proprietary trading, as discussed in section 5.4.

V.9  Authorization and Ongoing Regulation of OTC Execution Venues: Dealing on Own Account V.9.1  Systematic Internalizers The SI venue sits within the OTC/​bilateral space and accordingly does not trigger the MiFID II/​MiFIR regime for multilateral trading venues. SIs, as investment firms, and as regards their ‘internalization’ activities (dealing on own account by executing client orders), are subject to the authorization, organizational, and conduct rules that apply to investment firms under MiFID II and to the parallel prudential regime that applies under the IFD/​IFR and CRD IV/​CRR regime (Chapter IV). Similarly, they benefit from MiFID II passporting rights (Chapter IV). SIs, as investment firms, are also subject to the array of specific requirements which apply to trading practices generally (including with respect to algorithmic trading and short selling), discussed in Chapter VI. Classification as an SI is of pivotal importance, however, as it subjects the investment firm, as regards its internalization activities, to specific pre-​trade transparency requirements; the OTC sector generally is otherwise dark pre-​trade. Like all investment firms, SIs are subject to post-​trade transparency requirements (section 11).

246 Investment firms and market operators operating MTFs and OTFs are also required to comply immediately with any instructions from their NCAs to suspend or remove a financial instrument from trading (Art 18(9)). This obligation may arise from the regime governing the suspension or removal of a financial instrument from RMs (Art 52) which requires the parallel suspension or removal of the relevant instrument from other trading venues and SIs that trade the instrument in specified circumstances (including where the RM suspension/​removal is related to market abuse).

V.10  Shrinking the OTC Space: The Share Trading Obligation  489

V.9.2  Dealing on Own Account Investment firms who deal on own account, but who do not fall within the SI (or other) classification, are not subject to venue-​like requirements under MiFID II/​MiFIR, although post-​trade transparency requirements apply (section 11).247 These firms are subject to the MiFID II authorization, organizational, and conduct regimes (although in practice, many conduct rules are dis-​applied where the trades are between eligible counterparties) and benefit from MiFID II passporting rights, and are also subject to the prudential requirements that apply under the IFD/​IFR and CRD IV/​CRR regime (Chapter IV). These firms, like SIs, are also subject to the array of specific requirements which apply to trading practices generally (including with respect to algorithmic trading and short selling), discussed in Chapter VI.

V.10  Shrinking the OTC Space: The Share Trading Obligation MiFID I was generally facilitative of OTC trading,248 but MiFID II/​MiFIR is significantly more prescriptive, as is exemplified by the MiFIR Share Trading Obligation (STO) (Article 23). While the STO has had material market-​shaping effects, it was not among the more contested elements of the MiFID II/​MiFIR negotiations.249 Since its coming into force, however, its market effects have brought sharp policy and political focus to bear. Article 23(1) (the STO) in effect requires that all trading in shares be executed on organized venues: an investment firm must ensure the trades it undertakes in ‘shares admitted to trading on a regulated market or traded on a trading venue’ must take place on an RM, MTF, SI, or a third country trading venue which is assessed by the Commission as equivalent, as appropriate. The only exceptions are where the trades are ‘non-​systematic, ad hoc, irregular, and infrequent’, or are carried out between eligible and/​or professional counterparties and do not contribute to the price discovery process.250 Similarly, an investment firm that operates an ‘internal matching system’, which executes client orders (in shares but also in depositary receipts, ETFs, certificates, and other similar financial instruments) on a multilateral basis (such as a Broker Crossing System/​Network which supports ‘internal 247 Under MiFID II Art 1(7), all transactions in financial instruments which are not concluded on multilateral systems or SIs must be in compliance with the MiFIR post-​trade transparency regime. 248 In its 2010 MiFID I Review Communication, the Commission described the MiFID I regime as not prescriptive about where trades were executed and as providing investors with flexibility and choice about where and how they wished to execute trades: n 83, 9. It similarly characterized MiFID I as neutral as to where a trade was executed. 249 All the institutions, if to different degrees, supported a contraction of OTC trading. The Commission argued that the creation of the OTF should ‘substantially decrease’ the weight of OTC trading in non-​equities but also in equities (2011 MiFID II/​MiFIR Proposals IA, n 64, 36–​7), while the European Parliament took a maximalist approach, calling for all trades in non-​equity instruments, bar large ad hoc professional trades, to be executed on organized venues (RMs, MTFs, OTFs, and SIs), and for all equity trading to take place on RMs, MTFs, and SIs only. The Council’s approach was more liberal, but it nonetheless sought to ensure that as much trading as possible took place on open, transparent, and regulated platforms (Cyprus Presidency MiFID II/​MiFIR Progress Report, n 104, 5. 250 RTS 1 Art 2 amplifies when transactions do not contribute to the price formation process. The extent to which OTC trades do not shape price formation has, since 2018, increasingly come to shape the OTC/​trading venue debate, prompting ESMA to call for a more consistent approach to how this concept, which is used elsewhere in the order execution regime (including in the ‘negotiated trade’ waiver from pre-​trade transparency), is defined: see n 321.

490  Order Execution Venues crosses’ between client orders), must ensure it is authorized as an MTF and complies with all relevant provisions (Article 23(2)). This prescriptive approach, designed to minimize OTC equity trading, represented at the time a major shift from the MiFID I era as regards regulatory design. In practice, it has had transformative impact, being associated with a reduction in OTC share trading, including by, in effect, prohibiting share trading on Broker Crossing Systems/​Networks.251 It has also, however, led to a deeper embedding of SIs in share trading and to continued related contestation as to the organization of share trading between SIs and trading venues (discussed further in section 11).252 The STO has also generated contestation as regards its reach over shares traded on EU venues and that are also traded on third country trading venues, particularly where a third country trading venue is not ‘equivalent’ (and so is not an eligible venue for the STO), but is a major liquidity pool for a share. The practical difficulties the STO can generate in such circumstances, including for the achievement of best execution, came into sharp focus with Brexit.253 Reform has been quick to follow. Reflecting ESMA’s assessment of the STO for the MiFID II/​MiFIR Review,254 the 2021 MiFIR 2 Proposal suggests that the STO will be recast to reflect the Brexit-​related soft law clarifications made by ESMA, as outlined below. The absence of a temporary/​transitional ‘equivalence’ decision for UK trading venues (by contrast with the transitional arrangements adopted for UK CCPs)255 had raised the prospect of relevant share trading by EU investment firms on UK venues being repatriated to the EU, by virtue of the STO, at the end of the UK’s transition period, as happened in practice.256 But it also generated some uncertainty, and the risk of related market disruption,257 as to which specific shares, traded on EU trading venues but also on UK trading venues, were subject to the STO, and as to how potential overlaps between the STO and any related UK requirements could be avoided. ESMA sought to clarify the scope of the STO as regards shares traded in the EU and also in the UK through soft law which, in effect, interpreted the STO exemption for ‘non-​systematic, ad hoc, irregular, and infrequent’ trades as allowing the STO to be lifted from share trading which was not material in the EU. ESMA’s related solution was to rely on the International Securities Identification Number (ISIN), which identifies all securities including through a nationality identifier, as a means 251 By requiring that internal matching systems operate as MTFs, Art 23 in effect prohibited OTC share trading through such systems: 2020 Oxera Report, n 17, 172–​3. 252 ESMA, MiFID II/​MiFIR Review Report (Equity Transparency Report, the Double Volume Cap, and the Share Trading Obligation) (2020) 42–​3. ESMA associated the STO with the significant growth post-​2018 in SIs registered for share trading and with greater volumes of liquid share trading on SIs. Given the wider level playing-​ field and transparency challenges associated with the growth of the SI segment on MiFID II/​MiFIR’s coming into force, ESMA also considered whether SIs should be removed as an eligible execution venue for the STO but, and reflecting also a lack of industry support, did not propose any change. 253 As well as with the 2020 lapse of Swiss trading venues’ equivalence status. See further Chapter X section 4. 254 The Commission did not mandate ESMA to address Art 23 under the MiFID II/​MiFIR Review, but given significant market concern over the reach of Art 23, and the practical difficulties generated by Brexit, ESMA consulted on the scope of Art 23 and how its third country reach could be clarified: 2020 ESMA Equity Transparency Report, n 252, 37–​42. 255 See further Ch X section 11.3. 256 The end of the UK’s transition period saw a significant movement of share trading from London to the EU (mainly Amsterdam) in January 2021. Almost €6 billion of share dealing in EU companies moved from the UK to EU trading venues, representing a major shift in trading patterns, with some venues reporting that nearly all euro-​ denominated share trading had shifted over the New Year: Stafford, P, ‘EU Share Trading Flees London on First Day after Full Brexit’, Financial Times, 4 January 2021. The impact of the STO is discussed further as regards the third country regime in Ch X section 11.3. 257 The UK authorities warned of the potential for market disruption from the related fragmentation of liquidity (eg, Bank of England: Bank of England, Financial Stability Report (2019) 6).

V.11  Transparency Regulation  491 for identifying such non-​material trading. Its advised accordingly that those shares traded on an EU trading venue and identified by an EU ISIN, as well as those with an ISIN from Iceland, Liechtenstein, or Norway (together, EEA ISINs), were subject to the STO (leading to the repatriation of trading in such shares by EU investment firms to EU trading venues where these shares were also traded in the UK); advised that shares traded on an EU trading venue but with a GB ISIN fell outside the STO; and clarified that shares with an EEA ISIN would nonetheless fall outside the STO where they traded in pounds sterling (GBP), given the low levels of trading by EU investment firms in such shares.258 ESMA’s MiFID II/​MiFIR Review recommendation that this approach be formalized by means of revisions to Article 23259 was adopted by the 2021 MiFIR 2 Proposal, evidencing further ESMA’s influence on the development of MiFID II/​MiFIR.260 The Proposal, if adopted, would revise Article 23 to apply the STO to EU investment firm trades in shares with an EEA ISIN (instead of, as currently, to trades in shares admitted to an RM or traded on a traded venue).

V.11  Transparency Regulation V.11.1  The Transparency Framework V.11.1.1 Competitive Order Execution and the Transparency Regime The facilitation of competitive order execution remains (despite the restrictions placed on OTC trading by the Share Trading Obligation (STO)) a cornerstone of EU venue regulation, being associated with enhanced investor choice, a diversity of liquidity providers that can meet different liquidity needs, and with deeper, more liquid, and more integrated markets. This animating principle drives the priority given to ensuring a level regulatory playing-​ field between competing order execution venues, having due regard to their functionality. The EU’s transparency rules, while in service of the traditional objectives of transparency 258 ESMA, Public Statement (Impact of Brexit on the Trading Obligation for Shares), 19 March 2019, initially updated 29 May 2019 (to exclude all GB ISIN shares), and finally updated 28 October 2020 (regarding the currency clarification). The currency clarification reflected ESMA’s position that third country trading in a local currency in EU shares (traded also on a trading venue in the EU) was mainly designed for domestic third country investors who did not have access to EU trading venues, and so did not undermine the STO (in practice, less than 1 per cent of EU total trading activity was accounted for by EEA ISIN shares traded on a UK venue in GBP, and so was likely to fall within the exemption for non-​systematic, ad hoc, irregular and infrequent trading in the EU). The updates reflected difficult engagement with the UK Financial Conduct Authority, with the FCA favouring an approach based on applying the STO only where large liquidity pools in the relevant share operated in the EU, as well as challenges relating to the reciprocal application of the STO and of the new UK version (which had yet to be finalized as ESMA adopted its approach). ESMA’s initial March 2019 statement brought GB ISIN shares within the STO where they had a liquid market in the EU. Following FCA concern that this could lead to overlap between the (to-​ be-​adopted) UK and EU STOs and disrupt liquidity (FCA, Public Statements 19 March 2019 and 29 May 2019), this was modified by ESMA to exclude GB ISINs (May 2019) and subsequently also EEA ISINs traded in GBP (October 2019). ESMA/​FCA relations were strained over this period, as reflected in Chair Maijoor underlining that, while ESMA had made adjustments to its approach in May 2019 to exclude GB ISINs and in response to UK concerns that otherwise the UK STO would overlap with the EU STO, the UK had yet to clarify the scope of the UK obligation, although clarification was important for EU market participants. The scope of the UK STO was finally confirmed in November 2020. 259 While there was some market enthusiasm for a more radical approach, including the abolition of the STO, ESMA sought only to clarify the scope of Art 23, underlining that the ISIN-​based approach was the least complex way to do so: 2020 ESMA Equity Transparency Report, n 252, 41. 260 Albeit that the Brexit ‘fix’ was developed in close cooperation with the Commission: 28 October 2022 Updated Public Statement, n 258.

492  Order Execution Venues regulation (primarily the support of liquidity and price formation and of supervisory market monitoring), have a key role to play in supporting competitive order execution.261 They are designed to level the regulatory playing-​field between functionally similar venues as regards transparency regulation, by means of calibrated requirements that are sensitive to different financial instruments and to different trading functionalities, and that are designed to mitigate any related liquidity risks. They are also designed to mitigate the fragmentation risks associated with competitive order execution: the trade transparency data that is produced under the transparency rules should have the effect of tying together the different liquidity providers and venues, across different asset classes, that operate in the EU’s competitive, but thereby also fragmented, order execution market, and accordingly support liquidity and price formation. The transparency rules serve a further and related function in that, like the venue classification regime generally and the STO, they are designed to tilt trading, while operating in a competitive order execution market generally, towards lit, organized venues, by applying transparency requirements widely to different venues and asset classes. The debate on the optimal organization of competitive order execution in the EU, in particular as regards the balance between dark (primarily bilateral/​OTC) and lit (primarily multilateral/​organized) trading, and on the related role of transparency regulation, is showing little sign of abating, some twenty years on from the pathbreaking MiFID I reforms.262 It is, however, clear that it can be difficult for regulation to capture the sometimes intricate political compromises embedded in MiFID II/​MiFIR’s articulation of competitive order execution and in its supporting transparency regime, to ensure a regulatory level playing-​field, and to guard against unexpected or unintended outcomes, as regards transparency levels and liquidity levels. Shortly after MiFID II/​MiFIR’s coming into force, the MiFID II/​MiFIR Review identified weaknesses and anomalies in the transparency regime that supports competitive order execution and a series of related reforms have been proposed by the 2021 MiFIR 2 Proposal.

V.11.1.2 The Transparency Rulebook The transparency regime is complex, highly segmented, and finely calibrated. It is also multi-​layered. At its core are the foundational legislative rules, of often considerable technical complexity and some ambiguity, set out in MiFIR. These are amplified and calibrated by a suite of administrative rules of fine granularity and strong quantitative orientation, chief among them RTS 1 and RTS 2, which govern equity and non-​equity transparency,

261 For recent reviews of the MiFID II/​MiFIR transparency reforms see, eg, Siri and Gargantini, n 3; Busch and Gulyás, n 3; and Schmies C and Sajnovits, A, Data Reporting: Market Structures and Regulatory Framework, EBI WP Series 2020-​7 (2020), available via . A predominantly finance-​oriented literature has examined and modelled the impact of MiFID II/​MiFIR (and its transparency requirements) on market structure. See, eg, Johann, T et al, Quasi-​Dark Trading: The Effects of Banning Dark Pools in a World of Many Alternatives, SAFE WP No 253 (2019). 262 eg, the 2020 High Level Forum on CMU did not address the organization of order execution in the EU, noting different views on the relative desirability of competition between a diversity of venues: High Level Forum on the Capital Markets Union, Final Report (2020) 17. For a positive analysis, suggesting that the fragmentation of order execution across different venues has not led to a contraction in liquidity, and noting the role dark trading (still a significant component of EU trading) played in managing the risks to traders from the high volatility generated by the Covid-​19 pandemic, see 2020 Oxera Report, n 17.

V.11  Transparency Regulation  493 respectively.263 Also, a thicket of explanatory ESMA soft law has encrusted these rules,264 at the core of which is the lengthy MiFID II/​MiFIR Transparency Q&A. ESMA was the primary architect of the regime’s administrative rules and it continues to develop related soft law. ESMA also sits at the centre of the immense data-​hub, under construction since 2018, that powers the application of the transparency regime. The Financial Instruments Transparency System (FITRS), constructed by ESMA, supports the transparency regime by collecting, storing, and processing the data necessary for ESMA to perform the regular updating transparency calculations which determine how the transparency rules apply.265 ESMA has also developed a related system which allows it to carry out the trading-​volume-​related calculations required for the MiFIR equity market transparency regime’s ‘double volume cap mechanism’, and to publish the related trading volume caps (the DVCM system). These databases are supported by the massive FIRDS data system, hosted and operated by ESMA, which contains the detailed ‘Financial Instrument Reference Data’, reported by trading venues, SIs, and other data providers under MiFIR, which collects the immense (and changing) mass of FIRDS data from reporting entities, and which is updated daily (section 13.2). Through these different capacities, ESMA has become something of a steward of the transparency system, monitoring its development and identifying reforms, including by means of its data-​rich reports which informed the MiFID II/​MiFIR Review and the 2021 MiFIR 2 Proposal. The following sections examine the main features of the transparency regime.

V.11.2  The Equity/​Equity-​like Markets V.11.2.1 RMs, MTFs, and OTFs a. Pre-​trade Transparency Trading venues (RMs, MTFs, and OTFs), as multilateral venues of central importance to price formation, are subject to the full weight of the transparency regime generally, subject to some calibrations as regards how it applies to different instruments and trading systems, and to the availability of waivers which can, in specified circumstances, lift pre-​trade transparency requirements. MiFIR brought major change to the MiFID I equity market transparency regime for trading venues by extending the range of equity instruments subject to transparency requirements (from shares to a wide range of equity-​like instruments); and by restricting the

263 ESMA Chairman Maijoor underlined that MiFIR was not designed to provide full transparency but the ‘right amount’ that contributed to efficient price formation and to a level playing-​field between execution venues, while avoiding market impact, and noted that ‘ESMA has been in charge of the calibration of the transparency regime, a complex exercise that took us several years to prepare’: ESMA Chair, Speech, 3 October 2018. 264 Including Opinions designed to address emerging arbitrage risks (such as the 2019 Opinion on Frequent Batch Auctions) and NCA-​oriented measures designed to support supervision (such as the 2019 Supervisory Briefing on Commodity Derivatives Transparency, designed to address inconsistencies in how the MiFIR transparency rules were being applied to commodity derivatives). 265 NCAs were, originally, solely charged with collecting the data and the related calculations (Art 22) but, with the exception of the Polish NCA, delegated these competences to ESMA. The 2019 ESA Reform Regulation (Regulation (EU) 2017/​2175 [2019] OJ L334/​1) revised Art 22 to empower ESMA to request the relevant data and carry out the related calculations.

494  Order Execution Venues waivers which can lift pre-​trade transparency requirements for trading venues, in order to limit the growth of ‘dark pools’ on trading venues. The pre-​trade equity transparency rules for trading venues are set out at a principles-​ based level in MiFIR Articles 3–​4, but the operative requirements are contained in a detailed RTS (RTS 1).266 The foundational MiFIR obligation requires market operators and investment firms operating a trading venue to make public current bid and offer prices and the depth of trading interest at those prices which are advertised through their systems for shares, depositary receipts, ETFs, certificates, and similar financial instruments traded on a trading venue; the transparency requirement also applies to actionable indications of interests (Article 3(1)).267 The inclusion of ETFs in the pre-​trade equity transparency regime has been associated with significant market change. Prior to MiFIR coming into force in 2018, ETF trading was largely non-​transparent and OTC, but the reforms have been associated with a significant shift in ETF trading on to transparent organized venues, albeit that the trading venue waiver system has limited the degree of ETF transparency in practice.268 Reflecting the calibration which is the distinguishing feature of the transparency regime, the pre-​trade equity transparency requirements are calibrated to different types of trading system, including order-​book, quote-​driven, hybrid, and periodic auction trading systems (Article 3(2)). RTS 1 sets out in granular detail how the transparency rules apply to these different trading systems.269 The pre-​trade equity transparency requirements for trading venues have proved largely uncontroversial, as they reflect the precursor MiFID I regime as well as market practice. Nonetheless, some difficulties have arisen in setting the regulatory perimeter for the pre-​ trade equity transparency regime, and in ensuring a level playing-​field as new forms of trading system have developed. ESMA soft law and administrative rule revisions have, however, accommodated adjustments.270 b. Pre-​trade Transparency Waivers The waiver system, however, has proved to be more contested (Article 4). The extent to which trading venue ‘dark pool’ trading (which is not pre-​trade transparent) should be accommodated through waivers has long attracted sharp political contestation (reflecting the trading venue business and competitive advantage at stake) which has shaped the complex waiver system. Under MiFID I, dark pool share trading within trading venues was permitted in relation to four pre-​trade transparency waivers, the reference price, negotiated trades, order management facility, and large-​in-​scale waivers, all of which supported the operation of dark pools. These waivers were designed to lift pre-​trade 266 RTS 2017/​587 [2017] OJ L87/​387. 267 An actionable indication of interest is a message from one member or participant to another within a trading system in relation to available trading interest, and that contains all necessary information to agree on a trade: MiFIR Art 2(1)(33). 268 ESMA, Consultation Paper, MiFID II/​MiFIR Review Report on the Transparency Regime for Equity and Equity-​Like Instruments, the Double Volume Cap Mechanism, and the Trading Obligation for Shares (2020) 22. 269 It specifies, eg, the features of different trading systems (continuous auction order book trading systems; quote-​driven trading systems; periodic auction trading systems; request for quote trading systems; and other trading systems) and the related transparency information to be made public. 270 eg, the rise of ‘frequent batch auctions’ (a new form of periodic auction trading system) led to an ESMA Opinion on how the transparency rules apply, in order to manage regulatory arbitrage risks and protect transparency (ESMA, Opinion on Frequent Batch Auctions and the Double Volume Cap Mechanism (2019)), and to related RTS 1 reform proposals.

V.11  Transparency Regulation  495 transparency requirements in specified circumstances where the risks of prejudice to price formation were regarded as limited, were a waiver to apply, but the liquidity and position risks were regarded as high, were the relevant orders to be exposed. Over the MiFID II/​ MiFIR negotiations, the extent to which trading venue dark pools for equity/​equity-​like instruments, supported by such waivers, should be permitted emerged as one of the most contested elements of the Council negotiations. Sharp differences arose between those Member States seeking to expose as much equity trading as possible to the price-​formation process, and those concerned to protect the specialist liquidity and trading needs of institutional investors in particular.271 The large-​in-​scale waiver was (and remains) uncontroversial, given its concern to protect large orders from the market impact risks of being exposed to the market under pre-​trade transparency requirements, the traditional objective of waivers in this area. By contrast, the negotiated trades and reference price waivers, which were (and are) more associated with dark pools, provoked difficult Council negotiations,272 reflecting earlier clashes between NCAs as to whether these waivers prejudiced price formation.273 The compromise achieved was to continue to provide all four MiFID I waivers; to confer ESMA with oversight powers over NCAs’ approval of trading venues’ waiver use; and to impose more restrictive conditions on the reference price and negotiated trades waivers and apply a cap to their use, under the novel Double Volume Cap Mechanism (DVCM).274 The waiver system is NCA-​based (trading venues must have NCA approval to use a waiver) but is overseen by ESMA. Under Article 4, NCAs may waive pre-​trade transparency requirements for four types of trading systems. The controversial reference price waiver (Article 4(1)(a)) is available for systems which match orders based on a trading methodology by which the price of the equity/​equity-​like instrument in question is derived from a trading venue where the instrument was first admitted to trading, or the ‘most relevant market in terms of liquidity’, where that reference price is widely published and regarded by market participants as a reliable reference price. The use of this waiver is subject to a cap under the DVCM, outlined later in this section. The negotiated trades waiver (Article 4(1)(b)) is available for systems that formalize negotiated transactions that are concluded according to the conditions set by the waiver (which relate to how the price is formed). This waiver is also subject to the DVCM cap. In addition, for this waiver trading venues are subject to specific obligations relating to the prevention of market abuse and of circumvention of MiFID II/​MiFIR. The large-​in-​scale waiver (Article 4(1)(c)) is the workhorse of the waiver system. The most heavily used waiver,275 and also the least contentious, it is a classic pre-​trade transparency waiver in that it applies to orders that are large-​in-​scale compared with normal market size, and so is designed to protect such large orders from the market impact risk generated by exposing the orders. Finally, the order management facility 271 As waivers tended to be used in only a small number of Member States, reflecting the concentration of different types of specialist trading in particular financial markets, the risks for these Member States were more significant were waivers to be restricted. Political tensions were, accordingly, significant. The contested reference price waiver, eg, was only available in four Member States at the time of the negotiations: 2010 CESR Equity Market Consultation, n 85, 10. 272 The Commission and several Member States sought to limit the waiver regime to the large-​in-​scale waiver only, albeit in the face of significant opposition: Danish Presidency MiFID II/​MiFIR Progress Report, n 104, 6. 273 2010 CESR Equity Market Consultation, n 85, 11 and ESMA, Waivers from Pre-​Trade Transparency. CESR Positions and ESMA Opinions (2012). 274 The agreement on waivers was regarded by the Council as a major element of its MiFID II/​MiFIR agreement and as a significant limitation on dark pool trading: Irish Presidency Press Release, 17 June 2013. 275 ESMA, Annual Report on the Application of Waivers and Deferrals (2021).

496  Order Execution Venues (OMF) waiver has proved similarly uncontroversial (Article 4(1)(d)). It relates to orders held in an OMF which are subsequently exposed and subject to the pre-​trade transparency regime and so does not significantly effect price formation. The operational detail of the waiver system is governed by RTS 1.276 The DVCM, which was at its adoption and remains controversial,277 limits the volume of trading that can take place under the reference price and negotiated trades waivers (the most contested waivers), in order to support price formation (Article 5). It limits the percentage of trading in a financial instrument carried out on a trading venue under these waivers to 4 per cent of the total volume of trading in that financial instrument on all trading venues across the EU over the previous twelve-​month period; and overall EU trading in the financial instrument, and carried out under these waivers, must be limited to 8 per cent of the total volume of trading in the instrument on all trading venues across the EU over the previous twelve-​month period. The DVCM does not apply in specified circumstances, linked to supporting liquidity. Where the trading volume exceeds the 4 per cent limit in relation to trading on a particular venue (based on data provided by ESMA), the NCA that authorized the use of the waivers must suspend their use (as regards the relevant instrument)_​ for six months (Article 5(2)). Where the 8 per cent limit for all EU trading is exceeded, all NCAs must suspend the waivers for six months (Article 5(3)). The technical modalities of the DVCM are governed by RTS 3.278 The DVCM was first activated in March 2018, leading to the temporary prohibition by NCAs of the trading of shares of hundreds of EU firms under these waivers,279 and has been in operation since then. Reflecting their political sensitivity, all NCA waiver approvals for trading venues are subject to an ESMA notification/​review process.280 The notification/​review procedure (Article 4(4)) is based on the relevant NCA notifying ESMA of its proposed waiver decision and on ESMA issuing a non-​binding opinion as to the decision’s compliance with Article 4.281 This process also supports the annual reporting on waivers required of ESMA. In practice, the notification/​review system appears to be working without material frictions. From the outset, ESMA/​NCA relations appeared to be collaborative. Given the very large number of waiver opinions required of ESMA prior to MiFIR coming into force, and in the absence

276 RTS 1 covers the calculation of ‘the most relevant market in terms of liquidity’ (which governs the reference price waiver); the specific characteristics of ‘negotiated trades’ for that waiver to apply; and the type of orders that can be held in an OMF for the purposes of that waiver. RTS 1 also covers the technical calculations relating to ‘large-​in-​scale’ for the purposes of the large-​in-​scale waiver. Whether an order is ‘large-​in-​scale’ is calculated by reference to the RTS’s specification of the ‘normal market size’ for different equity instruments, measured by means of an average daily turnover metric. eg, for shares of ‘average daily turnover’ of less than €50,000 the minimum size of a large-​in-​scale order is €15,000 (Art 7 and Annex II, Table 1). The ETF large-​in-​scale metric is different, being specified as orders equal or larger than €1 million (Art 7(2)). 277 The cap was fiercely resisted by segments of the industry as exposing institutional traders unnecessarily to the risks of lit trading, increasing market impact costs (particularly given the increased risk of exposure to algorithmic traders), and increasing the cost of trading and reducing returns across the EU: Loven, P, ‘Proposed EU Regulation Could Risk Savings’, Financial Times Fund Management Supplement, 17 June 2013. 278 RTS 3 2017/​ 577 [2017] OJ L87/​ 174 covers the reporting and data modalities that support ESMA’s calculations. 279 More than ¾ of the composition of the FTSE-​100 was affected by the temporary trading prohibitions which followed ESMA’s first 7 March 2018 assessment of trading volumes: Stafford, P, ‘Hundreds of European Stocks Barred from Dark Pools’, Financial Times, 7 March 2018. 280 This process formalizes the previous CESR-​based informal review process which ESMA had continued to use by means of its supervisory convergence powers. 281 The process provides for binding mediation by ESMA where other NCAs disagree with the waiver decision. It also governs the withdrawal of waiver approvals, the conditions for which include that the waiver is being used to circumvent MiFIR (Art 4(5)).

V.11  Transparency Regulation  497 of transitional procedures,282 ESMA and the NCAs agreed on an expedited process under which NCAs were to notify ESMA of their proposed waiver decisions but, to avoid a bottleneck of waiver decisions awaiting ESMA opinions, were to grant waiver approvals based on their own assessment of MiFIR compliance. ESMA, in order to support supervisory convergence, also published a Q&A which addressed key issues ESMA had identified in the related NCA notifications and it warned that any waiver decisions notified by NCAs to ESMA which did not include essential information or which did not comply with the Q&A would not be eligible for the expedited process.283 Since then, the process seems to be working smoothly.284 Although ESMA does not publish its waiver opinions, its annual review of the waiver system suggests that it is rare for ESMA to find that an NCA waiver decision is not in compliance with MiFIR and, where it does, the waiver decision is typically adjusted by the NCA or withdrawn.285 ESMA has alongside adopted an Opinion that outlines the considerations on which its waiver opinions are based and that is designed to provide guidance. It also underlines ESMA’s stewardship of the waiver process: in practice, a high degree of standardization appears to have been imposed on how the waivers are applied by NCAs.286 The concern of those Member States who, over the MiFIR negotiations, had sought a binding approval power for ESMA, given their concerns that a soft review power would be insufficient to drive standardization in how use of the waivers by trading venues is approved by NCAs, does not appear to have materialized. While the ESMA oversight process appears to be working well, the waiver system has been less successful in limiting waiver-​based trading. The DVCM caps have been associated with an increase in lit trading and with deeper liquidity in the relevant instruments subject to a DVCM suspension,287 but they have also been associated with an increased volume of trading under the large-​in-​scale waiver,288 and with arbitrage.289 Waiver use generally has remained significant,290 including through combinations of waivers designed to maximize dark trading opportunities.291

282 ESMA estimated that some 700 waiver opinions were required of it prior to MiFIR’s coming into force: ESMA, Public Statement, 28 September 2017. 283 n 282. 284 As at end December 2021, ESMA had issued 1,112 opinions since 2018, 386 relating to equity waiver decisions and 726 relating to non-​equity waivers decisions (this latter system is noted below): ESMA, Opinion (Assessment of Pre-​Trade Transparency Waives for Equity and non-​Equity Instruments), 23 March 2022. 285 ESMA’s 2021 report on waivers and deferrals, eg, reported that of the twenty-​nine opinions issued by it, only two found non-​compliance, following which one waiver decision was withdrawn and the other was adjusted by the relevant NCA: ESMA, Annual Report on the Application of Waivers and Deferrals (2021). 286 2022 Waiver Opinion, n 284. 287 ESMA found that the first imposition of the DVCM in March 2018 led to a 7 per cent increase in lit trading: 2020 ESMA Equity Transparency Report Consultation Paper, n 268, 56. ESMA also found that liquidity in lit markets for the suspended instruments also improved: at 63–​7. 288 2020 ESMA Equity Transparency Report Consultation Paper, n 268, 14 and 58. 289 2020 ESMA Equity Transparency Report Consultation Paper, n 268, 56, evidencing the correlation between the DVCM and the growth of frequent batch auctions. ESMA subsequently suggested refinements to RTS 1. 290 Although the impact of Brexit means that the data is currently transitional. In its 2021 annual report on waivers ESMA reported that ETF trading represented the largest proportion of dark trading (at 39.25 per cent of EEA-​30 ETF turnover). Share trading under waivers represented 2.65 per cent, depositary receipts 2.94 per cent, and other equity instruments 4.81 per cent. The impact of Brexit is significant. The data for 2020 and 2019 for the EEA-​31, respectively is: 56.39 and 61 per cent (ETFs); 28.89 and 29.56 per cent (shares); 28.07 and 33.34 per cent (depositary receipts); and 34.36 and 35.29 per cent (other). Waivers were most heavily used by MTFs (72 per cent of all waiver trading, reflecting the dominance of MTFs in ETF trading). ESMA also reported on increasing use of waivers, primarily the OMF and large-​in-​scale waivers: 2020 ESMA Equity Transparency Report Consultation Paper, n 268, 28. 291 ESMA suggested accordingly that combinations of waivers be prohibited, but resiled from this position following significant market concern that this would lead to trading venues running separate order books which would fragment liquidity: 2020 ESMA Equity Transparency Report, n 252, 11–​13.

498  Order Execution Venues In its MiFID II/​MiFIR Review report, ESMA identified the waiver system as in need of simplification, given its complexity, but also of review, in order to improve transparency levels.292 Its proposed reforms were primarily directed to making large trades with price impact risk the focus of the waiver system: ESMA proposed limiting the reference price waiver to larger trades with price impact; and also increasing the large-​in-​ scale threshold for ETF trading under the large-​in-​scale waiver, given the scale of waiver trading in the ETF market.293 ESMA’s conclusion on the contested DVCM was that it was useful in supporting transparency, but that it was overly complex in applying a 4 per cent cap to trading venues;294 it accordingly called for a single 7 per cent cap tied to EU waiver trading. The Commission’s 2021 MiFIR 2 Proposal broadly followed ESMA’s approach:295 it linked the reference price waiver to a size criterion; and recast the DVCM into a single 7 per cent of total EU waiver trading (under the reference price and negotiated trades waivers) cap. The fate of the Proposal remains to be seen. The earlier and highly contested MiFID II/​MiFIR negotiation process does not augur well for easy resolution. The Proposal, if adopted, would, however, inject a welcome degree of coherence into the waiver system by focusing it on the traditional waiver objective of protecting large trades from market impact. The waiver system would also thereby become more streamlined and less complex and so less prone to arbitrage and less costly to administer. Whatever the outcome, ESMA’s evidenced capacity to gather and interrogate complex market data in support of regulatory reform marks a significant departure from the MiFID II/​MiFIR development era when the market impact of transparency rules was only poorly quantified. c. Post-​trade Transparency The pre-​trade equity transparency system for trading venues is mirrored by the significantly less contentious post-​trade system (which poses less liquidity risks). The high-​level MiFIR obligation requires market operators and investment firms operating a trading venue to make public the price, volume, and time of transactions executed in respect of shares, depositary receipts, ETFs, certificates, and other similar equity-​like instruments traded on a trading venue (Article 6(1)). The required disclosures are governed by RTS 1.296 The post-​trade regime has not generated significant difficulties in practice, albeit that (as also with the pre-​trade regime) data quality and distribution remain major concerns and are

292 ESMA found that while waivers should be the exception, they had become the norm, and that many trading venues were setting up complex systems to reduce their exposure to pre-​trade transparency requirements: 2020 ESMA Equity Transparency Report, n 252, 11–​13. 293 2020 ESMA Equity Transparency Report, n 252. ESMA’s initial proposals were more radical, suggesting a removal of the reference price and negotiated trades waiver (but a related increase in the thresholds applicable to the large-​in-​scale waiver). But it faced significant industry opposition, in part given a lack of experience with, and data on, the transparency regime since 2018. 294 ESMA argued that the 4 per cent trading venue cap only had the effect of redistributing trading to other dark venues. 295 As restricting the large-​in-​scale waiver for ETFs did not require legislative change but an adjustment to the RTS 1 thresholds, ESMA proposed related reforms to RTS 1: ESMA, Review of RTS 1 and RTS 2. Consultation Paper (2021). 296 RTS 1 covers the extensive disclosures required in the related trade report (including the ISIN, date and time, price, currency, quantity, and execution venue), the different symbols and formats to be used, and the required flags which indicate the transaction type (ie, non-​price forming, reference price transaction, negotiated transaction, illiquid transaction, and cancellation).

V.11  Transparency Regulation  499 being addressed through the Consolidated Tape reform under the 2021 MiFID III/​MiFIR 2 Proposals (section 12.4). d. Deferred Publication In parallel with the pre-​trade waiver system, the post-​trade regime permits the deferred publication of post-​trade data, in order to protect certain transactions from liquidity and position risk (Article 7(1)). This system is less articulated than the pre-​trade waiver system, as the liquidity risks are less acute post-​trade and, relatedly, the political context is less sensitive. NCAs are empowered to authorize market operators and investment firms operating a trading venue to provide for deferred publication of transaction details, based on transaction type or size. In particular, NCAs may authorize deferred publication by trading venues in respect of transactions that are large-​in-​scale as compared with the normal market size of that share or equity-​like instrument. Market operators and investment firms must obtain the NCA’s prior approval for deferred publication, and must clearly disclose these deferral arrangements to market participants and to the public. ESMA does not, by contrast with the pre-​trade waiver system, review NCA post-​trade deferral decisions, but monitors deferral practices generally and, where an NCA disagrees with a deferral determination by another NCA, the NCA can refer the matter to ESMA binding mediation. RTS 1 governs the technical modalities.297 By contrast with the waiver system, the deferral system has not prompted significant concern, with ESMA’s MiFID II/​MiFIR Review report finding that MiFIR had delivered its objectives in this regard, as in practice only a small portion of large trades were subject to deferred publication.298

V.11.2.2 The Bilateral/​OTC Segment a. Pre-​trade Transparency and SIs In the OTC segment, only SIs are subject to pre-​trade transparency requirements for equity/​equity-​like order execution. The complex rules reflect the fraught 2004 MiFID I negotiations, the outcome of which was an SI-​specific pre-​trade transparency requirement for shares (only) which sought to ensure functionally equivalent treatment of RMs, MTFs, and SIs, but also to reflect the position risks undertaken by SIs. Additional refinements were introduced by MiFIR to increase transparency and limit regulatory arbitrage risks. Chief among these were a more granular specification of when an investment firm’s trading activities require it to be regulated as an SI (section 5.5); the inclusion of SIs as an eligible execution venue for the STO (section 10); and, the concern of this section, enhanced pre-​trade transparency requirements, extending from shares to equity-​like financial instruments.

297 RTS 1 sets out the specific times of the deferral periods permitted, related to liquidity (expressed as average daily turnover), and the minimum qualifying size of transactions eligible for deferral, calibrated to shares (Annex II, Table 4), ETFs (Table 5), and certificates and other instruments (Table 6). eg, for shares with average daily turnover of equal or greater than €100 million, the minimum qualifying size of transaction and related time deferral is €10 million and sixty minutes, €20 million and 120 minutes, and €35 million and end of trading day. For the least liquid shares (turnover less than €50,000), the minimum qualifying sizes are €7,500, €15,000, and €25,000 with the same ladder of increasing time delays. 298 2020 ESMA Equity Transparency Report, n 252, 30–​2, noting that the proportion of share and depositary receipt transactions subject to deferred publication represented a ‘satisfying outcome’, albeit reporting that a significant volume of ETF trades was deferred (ESMA proposed accordingly to revise RTS 1 to tighten the criteria for ETF deferred publication).

500  Order Execution Venues The foundational obligation requires SIs to publish pre-​trade ‘firm quotes’ with respect to shares, depositary receipts, ETFs, certificates, and other similar instruments traded on a trading venue, for which they are registered as SIs (Article 14(1)). Two important qualifications, designed to protect SIs’ proprietary capital and to mitigate position risk, apply which have, in practice, limited the application of the pre-​trade transparency requirements. First, the quoting (or pre-​trade) obligation applies only where there is a ‘liquid market’ in the relevant instrument(s) (Article 14(1)). A ‘liquid market’ for these purposes is defined by reference to three criteria: free float, and average daily number of transactions and average daily turnover in the relevant instrument (Article 2(1)(17)(b)).299 These criteria are, in practice, assessed by ESMA which produces the related data annually in order to support the application of the pre-​trade rules by SIs. Where the market in the relevant instrument is not liquid (increasing the risk to the SI of moves against its trading position), SIs are to disclose quotes to their clients on request. In practice, the liquidity condition limits the population of shares subject to SI pre-​trade transparency.300 Second, the quoting obligation only applies when the SI is dealing in sizes up to ‘standard market size’ (SMS) for the relevant financial instrument; an SI dealing in sizes above the SMS for the instrument is not subject to the pre-​trade transparency regime (Article 14(2)). The SMS concept, a device for representing the average value of transactions in the relevant instrument and so for capturing liquidity and position risk, accordingly serves as a second limiting factor on the SI pre-​trade transparency obligation.301 In practice, many SI transactions, being of larger size than the SMS, fall outside the pre-​trade regime.302 Further, the minimum quote size for a particular instrument is tied to a low minimum of at least 10 per cent of the SMS of the instrument in question, further limiting the extent to which SI trading is transparent as to the levels of trading interest.303 SI quotes must also include firm bid and offer prices which reflect the prevailing market conditions for the relevant instrument. (Article 14(3)). SI quotes must be made public (in a manner which is easily accessible to other market participants on a reasonable commercial basis) on a regular and continuous basis during normal trading orders; quotes may be updated at any time and may be withdrawn where exceptional market conditions exist (Article 15(1)). The limitations of the SI pre-​trade quoting obligation led ESMA to propose a series of refinements in its MiFID II/​ MiFIR Review report, chief among them increasing the minimum quoting size from 10 per cent of SMS to twice the SMS.304 This reform was adopted by the Commission in its 2021 299 Delegated Regulation 2017/​567 amplifies in detail how these criteria are to be used to assess liquidity for shares, depositary receipts, ETFs, and certificates. A market in a particular share, eg, is liquid where the free float is not less than €100 million (share admitted to a RM) or €200 million (MTF); the average daily number of transactions is not less than 250; and the average daily turnover is not less than €1 million. Additional modalities set out in the Regulation govern how, eg, the free float is calculated. 300 ESMA’s March 2022 annual transparency calculations report, eg, reported that 1,200 liquid shares and 976 liquid equity-​like instruments were subject to the transparency regime: ESMA, Press Release 1 March 2022 (the 2021 figures were 1,432 and 982, respectively). 301 The SMS calculation is governed by RTS 1 (Art 11 and Annex II, Table 3). It is based on the principles set out in MiFIR Art 14(3)–​(7) (which relate SMS to the average value of transactions (AVT)) and sets out how AVT is to be calculated. 302 2020 ESMA Equity Transparency Consultation Paper, n 268, 47–​51. 303 ESMA reported that in practice the 10 per cent of SMS minimum quoting obligation had led to very small quoting sizes in the majority of cases, typically of €1,000 or €2,000: 2020 ESMA Equity Transparency Consultation Paper, n 268, 51. 304 ESMA also indicated that it would seek to revise RTS 1 to increase the SMS bands: 2020 ESMA Equity Transparency Report, n 252, 27–​9. ESMA’s original proposals were more wide-​ranging, including extending the quoting obligation to illiquid shares, but were scaled back following market feedback, including as to the pressure that extending the obligation to illiquid shares could place on SIs’ proprietary inventories.

V.11  Transparency Regulation  501 MiFIR 2 Proposal, which also proposed a significant expansion of the SI transparency obligation by extending its application from dealing in sizes below the SMS, to below dealing in sizes up to twice the SMS. The SI rules (under Articles 15 and 17) also address the order execution process as regards SI quotes,305 given the risks to clients from bilateral order execution. These requirements address the extent to which an SI can offer price improvement (or offer different quotes to those published) and can manage access to its quotes (to mitigate position risks). Since MiFID I, SIs have also been subject to an ‘order routing obligation’ regarding shares (now MiFID II Article 28(2)). Client limit orders—​or an order to buy or sell a financial instrument at a specific price limit or better and for a specified size (MiFID II Article 4(1) (14))—​are generally, although not universally, regarded as an important source of liquidity and price information. Failure by an SI to disclose such share orders (which might otherwise contribute to price formation on the price-​forming central order book of a multilateral venue) might damage price formation by concealing the real level of trading interest in a share. Market forces should ultimately ensure that limit orders are directed to the venue on which they are most likely to be filled in time. Nonetheless, MiFID II (Article 28(2)) intervenes to provide some protection for these orders and to enhance transparency, through a form of order-​routing arrangement. In a rule inspired by US securities regulation,306 and designed to support market efficiency,307 where a client limit order in respect of shares admitted to trading on an RM or traded on a trading venue is not immediately executed under ‘prevailing market conditions’, all investment firms (including SIs) must (unless expressly instructed otherwise by the client) ‘take measures to facilitate’ the earliest possible execution of the order by making the order public immediately in a manner that is easily accessible to other market participants.308 Member States may decide that this requirement is met by the firm transmitting the order to a trading venue.309 b. Post-​trade Transparency and Deferrals: SIs and Investment Firms All investment firms, including SIs, are subject to the MiFIR post-​trade transparency regime for equity/​equity-​like instruments (Article 20). Investment firms which, either on own account or on behalf of clients, conclude transactions in shares, depositary receipts, ETFs, certificates, and other similar financial instruments traded on a trading venue must make public the volume and price of those transactions and the time at which they are concluded; the data required corresponds to the post-​trade equity/​equity-​like data required of trading venues under MiFIR Article 6, as do the deferrals available (MiFIR Article 20(2)). In practice, levels of deferred reporting are high in this segment,310 but, aside from the prevailing difficulties related to the quality of market data and its distribution and which are

305 These MiFIR requirements are amplified by Delegated Regulation 2017/​567. 306 Under the US SEC’s Limit Order Display Rule, dealers must display limit orders where they are placed at a price superior to the dealers’ quotes. 307 The Commission argued that the rule represented an important safeguard for overall market efficiency given the growing preponderance of limit orders and their importance as a source of price-​relevant information: 2002 Commission MiFID I Proposal, n 83, 21. 308 The obligation is amplified, but to a limited extent and in relation to the publication process, by Delegated Regulation 2017/​565 Art 70. 309 NCAs may waive this obligation where the order is large-​in-​scale compared with normal market size. 310 ESMA has reported that 35 per cent of OTC transactions benefit from deferred reporting, as compared to 15 per cent of trading venue transactions: 2020 ESMA Equity Transparency Report, n 252, 32.

502  Order Execution Venues addressed by the 2021 MiFIR 2 Proposal, there have been few serious difficulties with the deferral system.

V.11.2.3 Impact and the MiFID II/​MiFIR Review The MiFIR equity/​equity-​like transparency system represents the most recent attempt by the EU to address the organization of equity trading in the EU and related levels of transparency. It is considerably more muscular than its MiFID I predecessor: the restrictions on the trading venue waivers, particularly the swingeing DVCM, are expressions of a political concern to limit the volume of dark equity trading on trading venues; while the finessed SI regime has been designed to limit arbitrage and to ensure OTC equity trading comes within the SI regime and its transparency requirements when the conditions are met. Nonetheless, initial experience since its coming into force in 2018 suggested that the regime has struggled to increase equity market transparency. Early evidence, including ESMA’s reports for the MiFID II/​MiFIR Review, suggested that while the first three years or so of the regime’s operation saw an increase in transparency in some instruments (notably ETFs, which came within the equity transparency regime for the first time with MiFIR), and while share trading in some dark pools on trading venues decreased (reflecting the impact of the DVCM), significant volumes of equity/​equity-​like trading were not pre-​trade transparent311 and the trend appeared to be towards a decrease in transparency.312 As regards trading venues, for example, ESMA’s 2021 review of EU securities markets found that while trading venues accounted for some 80 per cent of equity/​ equity-​like trading (typically EU trading venue trading has accounted for some 60 per cent of trading; this sharp increase reflected the volume of OTC equity trading that takes place in the UK and that is now excluded from EU reporting), significant trading volumes on trading venues were dark, being carried out under pre-​trade transparency waivers.313 The SI regime was similarly reported as posing transparency challenges. While the equity SI segment had grown,314 SI transparency remained limited.315 Also, SI share trading volumes remained high and were increasing,316 an increase associated with regulatory factors, 311 ESMA’s 2020 assessment for the MiFID II/​MiFIR Review was that the overall objective of the regime had not been achieved as regards the promotion of market transparency and of a robust price formation process: 2020 ESMA Equity Transparency Consultation Paper, n 268, 28–​31. ESMA’s Final Report similarly underlined the failure of the equity/​equity-​like regime to achieve its goals, in particular given the impact of the trading venue waivers: 2020 ESMA Equity Transparency Report, n 252, 7. 312 2020 Oxera Report, n 17, reporting on a drop from lit equity trading representing 40 per cent of trading before MiFID II to 35 per cent in 2018 and to 33 per cent in the first half of 2019. 313 Some 39 per cent of ETF trading, eg, was carried out under trading venue waivers, although only 3 per cent of share trading was: 2021 ESMA EU Securities Markets Report, n 122, 4 and 21. 314 Shortly after MiFID II/​MiFIR came into force, it emerged that market participants were shifting their business models from trading-​venue-​based dark pools (given the impact of the waiver restrictions) to SIs, with Goldman Sachs, JP Morgan, and Barclays among the major banks establishing SIs: Stafford, P, ‘Dark Pool Trading Flourishing after MiFID II Delay’, Financial Times, 19 January 2018. Relatedly, in 2017, prior to MiFID II/​MiFIR coming into force, ten SIs were registered in the EU; by 2019, this had increased to seventy-​two (including nineteen in the UK). 315 ESMA reported over the MiFID II/​MiFIR Review that while MiFID II/​MiFIR had increased the importance of SIs as an execution venue, it had fallen short as regards transparency, as the majority of SI equity trading was not pre-​trade transparent: 2020 ESMA Equity Transparency Report, n 252, 49–​50. 316 ESMA reported over the MiFID II/​MiFIR Review that the SI (and OTC) proportion of share trading had continued to increase from 2018, in most share liquidity profiles (from least to most liquid) apart from the most liquid shares, and represented a ‘high’ proportion at 30 per cent of share trading: 2020 ESMA Equity Transparency Report Consultation Paper, n 268, 16–​21. Similarly, 2020 Oxera Report, n 17, 172–​3, reporting on increases in SI trading from 2018.

V.11  Transparency Regulation  503 including the inclusion of SIs as venues for the STO and the more limited pre-​trade transparency regime applicable to SIs.317 Relatedly, arbitrage risks had been generated,318 with the SI segment remaining a persistent focus of industry contestation.319 The challenges faced by the equity/​equity-​like transparency regime since 2018 are not unexpected. They also underline the difficulties in constructing regulatory articulations for political compromises, in a field of immense technical and operational complexity, and in a setting where liquidity risks and arbitrage opportunities are significant. The regime is, however, showing some capacity for adjustment. The 2021 MiFIR 2 Proposal, informed by ESMA’s extensive reviews and consultations, is likely to bring legislative reform, while soft law and administrative rule revisions are calibrating the regime.320 A degree of permanent instability in the rulebook may therefore be the price for more refined rules. It is also clear that ESMA has become a decisive technocratic influence on the equity/​equity-​like transparency regime. In this regard, its appetite for constructing an empirical foundation for the longstanding debate on the optimal relative proportions of trading venue/​OTC trading augurs well for a highly contested corner of regulatory policy becoming, to some extent at least, more a function of data than of politics.321

V.11.3  The Non-​equity Markets V.11.3.1 RMs, MTFs, and OTFs a. Pre-​trade Transparency The application of harmonized transparency requirements (pre-​and post-​trade) to the non-​ equity markets was one of the flagship MiFID II/​MiFIR reforms. While directed to similar ends, and drawing on similar devices, as the equity transparency regime, the non-​equity transparency regime is significantly more calibrated and qualified, reflecting its novelty and its greater market impact. Previously, transparency requirements for non-​equity trading were variable across trading venues, while the OTC non-​equity markets were largely dark. The reforms were therefore designed to materially increase transparency levels and support price formation in the non-​equity markets. The liquidity risks of this major reform to trading in the non-​equity markets were significant, particularly as regards pre-​trade requirements. In non-​equity asset classes, liquidity is thinner than in equity asset classes and can be shaped by asset-​specific trading patterns. 317 2020 Oxera Report, n 17, 172–​3. 318 See section 5.5 on the difficulties generated by SI networks. 319 The MIFID II/​MiFIR Review, in a relitigation of legacy battles, saw some market participants concerned as to continued growth in SI equity trading, and particularly the volumes of retail orders internalized by SI, but others regarding the SI segment as critical for a well-​functioning and efficient market: 2020 ESMA Equity Transparency Report, n 252, 6. 320 eg, ESMA, through the MiFID II/​MiFIR Review process, proposed adjustments to RTS 1, in particular as regards ETF transparency requirements, and earlier adopted soft law to address the arbitrage risks posed by the emergence of frequent batch auctions. 321 ESMA suggested that the different views on whether the volume of OTC trading was ‘too high’ or, alternatively, inaccurately inflated by trades which were not price forming (one leading industry report suggested in 2021 that the volume of OTC/​SI trading was inflated as it included technical trades which were not price forming: AFME, The Landscape for European Equity Trading and Liquidity (2021)), originated from different understandings of whether trades were price forming or not and related inconsistent reporting, and called for a more consistent approach to non-​price forming trades: 2021 ESMA Consultation Paper on RTS 1 and 2, n 295.

504  Order Execution Venues Bond trading, for example, is often concentrated around issuance as bonds are typically held to maturity, although trading patterns vary in accordance with, for example, a bond’s yield, rating, and type of issuer; bond liquidity can, accordingly, be thin, position risk high, and transparency requirements disruptive. Relatedly, much of bond trading is dealer-​based, so pre-​trade transparency requirements can generate elevated risks to the dealing positions of liquidity providers.322 More generally, the non-​equity market is characterized by heterogeneous market segments (from the massive interest rate derivatives market to the multi-​ asset-​class bond market which includes corporate, covered, and sovereign bonds)323 and by a great diversity of trading methods. Liquidity risks, position risks, and so the implications of transparency requirements accordingly vary across the market. Concern as to the potentially disruptive impact of the reforms on liquidity, unless the reforms were finely tuned to the risks of different asset classes and trading methods, was therefore widespread and significant.324 The non-​equity transparency requirements have, however, been amplified by a calibrating administrative rulebook (RTS 2)325 of unprecedented complexity, technicality, and quantitative orientation. The development of these rules required an immense data-​ gathering and market consultation exercise of ESMA,326 but was also shaped by institutional positioning on how the liquidity/​transparency trade-​off associated with the reforms was to be managed. In a determinative intervention, the Commission, which otherwise supported ESMA’s approach to the calibration of the legislative requirements, introduced a phasing-​in mechanism, outlined below, which has led to the impact of the reforms on non-​ equity market transparency levels being minimal.327 The foundational pre-​trade transparency requirement, as regards non-​equity asset classes and for trading venues, is set out in MiFIR Article 8. It requires market operators and investment firms operating a trading venue to make public current bid and offer prices and the depth of trading interests at those prices (including with respect to actionable indications of interest) for bonds, structured-​finance products, emission allowances, derivatives ‘traded on a trading venue,’328 and package orders329 (Article 8(1)). A hedging exemption, designed to avoid disruption to commercial hedging activities, lifts the obligation for derivative transactions of non-​financial counterparties, which are objectively measurable as reducing risks relating to the commercial activity or treasury financing activity of the non-​ financial counterparty or its group. The transparency requirements applicable are calibrated to reflect the array of different systems operating in the non-​equity markets, including the 322 As was acknowledged by the Commission in its 2011 MiFID II/​MiFIR Proposals IA: n 64, 12. 323 In 2018, 78 per cent of the notional trading amount of non-​equity trading volumes related to interest rate derivatives, followed by bonds (corporate and sovereign) (17 per cent). As regards the numbers of transactions, a more balanced profile obtains (commodity derivatives at 43 per cent; interest derivatives at 24 per cent; bonds at 14 per cent; securitized derivatives at 12 per cent; and equity derivatives at 4 per cent): ESMA, MiFID II/​ MiFIR Review Report on the Transparency Regime for non-​Equity Instruments and the Trading Obligation for Derivatives. Consultation Paper (2020) 18. 324 See, eg, European Systemic Risk Board (ESRB), Market Liquidity and Market Making (2016). 325 RTS 2017/​583 [2017] OJ L87/​229. 326 The process can be traced in ESMA’s mammoth preparatory and consultative documents on the transparency regime (generally), chiefly ESMA/​2014/​548 and ESMA/​2014/​1570, and in ESMA’s final proposals to the Commission (ESMA/​2015/​1464). 327 In response to the Commission’s revision (Commission Letter to ESMA, 20 April 2016), ESMA suggested an automatic phase-​in approach, but this was not taken up: ESMA Opinion, 2 May 2016. 328 On this concept see section 4.2. 329 Package orders are a form of derivatives transaction linked to physical delivery obligations. This form of trading pattern was not initially addressed by MiFID II/​MiFIR but was brought within scope by a 2016 ‘Quick Fix’ legislative revision (n 111).

V.11  Transparency Regulation  505 order-​book, quote-​driven, hybrid, and periodic auction trading mechanisms familiar from the Article 3 equity obligation, but also including voice broking systems, in an accommodation of trading practices in the non-​equity markets (Article 8(2)). The operative detail of the transparency reporting required, calibrated to the relevant trading system, is amplified by RTS 2.330 b. Pre-​trade Transparency Waivers The Waiver System  The waiver system, which was contested over the MiFID II/​MiFIR negotiations,331 is of pivotal importance to the pre-​trade non-​equity regime for trading venues. It determines the extent to which the pre-​trade transparency rules for non-​equity asset classes apply to trading venues, and so is one of the major regulatory levers used to moderate and manage the liquidity risks associated with imposing transparency requirements on non-​equity asset classes. Given the underpinning objective of the transparency regime to support lit multilateral trading, the waiver system also supports trading in moving to transparent trading venues from OTC execution venues by protecting such trading from liquidity risks. Under Article 9, NCAs may approve waivers for trading venues from the pre-​trade transparency requirements in three circumstances: (i) as under the equity regime, with respect to orders which are large-​in-​scale compared with normal market size, and with respect to orders held in a trading venue’s order management facility pending disclosure;332 (ii) with respect to actionable indications of interest in request-​for-​quote and voice-​trading systems that are above a ‘size specific to the instrument’ (the ‘SSTI’), which would expose liquidity providers to undue risk and takes into account whether the relevant market participants are retail or wholesale investors;333 and (iii), the most significant waiver, with respect to derivatives not subject to the Derivatives Trading Obligation (DTO) (and so less liquid)334 and with respect to other financial instruments for which there is not a ‘liquid market’.335 As 330 RTS 2 (Art 1 and Annex I) specifies the features of the different trading systems addressed (continuous auction order book; quote-​driven; periodic auction; request-​for-​quote; voice trading; and other systems) and the pre-​ trade disclosures required as regards each system. The quote-​driven (dealer) system requirement, eg, is, for each financial instrument, the best bid and offer by price of each market-​maker in the instrument, together with the volumes attaching to those prices. The relevant quotes must represent binding commitments to buy and sell and indicate the price and volume of the instruments in which the registered market-​makers are prepared to buy and sell, although in exceptional market conditions indicative or one-​way prices may be allowed for a limited time. 331 eg, the Commission, France, and Italy all recorded different objections, on the final adoption of MiFIR, on how the waivers had limited the scope of the non-​equity regime: 7 May 2014, Council Document 9344/​14, Annex. 332 RTS 2 governs the operation of these waivers, including as regards how ‘large-​in-​scale’ orders are assessed and the features of order management facilities. 333 This waiver is designed to support trading moving from OTC venues to trading venues: n 323, 13. Added during the Council negotiations, it was contentious, with Member States divided as to its appropriateness: Cyprus Presidency MiFID II/​MiFIR Progress Report, n 104, 5. 334 The derivatives DTO is outlined in Ch VI. 335 The ‘liquid market’ device recurs across the non-​equity regime, governing how the waiver and deferral regimes for non-​liquid markets apply and also governing the extent of the pre-​trade obligation for SIs (which applies only in liquid markets). For the purpose of these provisions, a ‘liquid market’ is a market for a financial instrument or a class of financial instruments where there are ready and willing buyers and sellers on a continuous basis, assessed according to specified criteria, and taking into consideration the specific market structures of the particular financial instrument or of the particular class of financial instruments (Art 2(1)(17)(a)). The criteria cover: the average frequency and size of transactions over a range of market conditions, having regard to the nature and life-​ cycle of products within the class of financial instruments; the number and type of market participants (including the ratio of market participants to traded instruments in a given product); and the average size of spreads, where applicable. The calculation of when a particular asset class is not liquid for the purposes of the trading venue waivers (Art 9) and deferrals (Art 11) is governed by the different metrics applicable under RTS 2, noted below.

506  Order Execution Venues with the pre-​trade equity system, while these waivers for trading venues are NCA-​approved, ESMA exercises an oversight role (Article 9(2) and (3)).336 The liquidity and SSTI waivers, as the most significant and also contentious waivers, are outlined in the following sections. The Liquidity Waiver  The extent to which the non-​equity pre-​trade transparency regime for RMs, MTFs, and OTFs applies in practice is in large part a function of the liquidity waiver (i.e. the waiver for instruments for which there is not a liquid market) which is the most commonly used waiver.337 The operation of the liquidity waiver is highly calibrated by RTS 2 as regards the different non-​equity asset classes and by reference to three methods for reviewing liquidity status: regular instrument-​by-​instrument reviews; regular asset-​class-​based reviews; and static determinations of liquidity status for certain asset classes that are fixed by RTS 2.338 For the most part, the liquidity assessment system is dynamic, requiring regular ESMA calculations and reporting as regards liquidity status. Relatedly, ESMA now sits at the centre of an immense data-​hub (powered by the Financial Instruments Transparency Reporting System (FITRS)) on the instruments traded in the EU. The RTS 2 liquidity assessment for bonds, the most sensitive and fine-​grained of the different liquidity assessments, has become somewhat totemic as a bellwether for the operation of the non-​equity transparency regime more generally.339 The liquidity assessment (by ESMA) happens quarterly, on an exhaustive, instrument-​by-​instrument basis (termed the ‘instrument by instrument dynamic approach)340 and in accordance with three criteria. A bond is determined not to have a liquid market if it does not meet one or all the following thresholds on a cumulative basis: ‘average daily notional amount’ of €100,000; average daily number of trades of either fifteen, ten, seven, or two, depending in each case on the phasing of the exemption, with fifteen in the first phase and two in the final fourth phase; and percentage of days traded over the period considered of 80 per cent.341 The average daily number of trades accordingly operates as a ratchet, narrowing the exemption over time and in step with market liquidity conditions.342 336 NCA/​ESMA relations appear smooth, with only a very small number of NCA waiver decision notifications generating a negative ESMA opinion (11 of 338 reviewed notifications in 2018 (ESMA, MiFID II/​MiFIR Review Report on the Transparency Regime for non-​Equity Instruments and the Trading Obligation for Derivatives. Consultation Paper (2020) 24); and fifteen of 127 reviews in 2020 (2021 ESMA Waivers and Deferrals Report, n 143, 34)). 337 In 2018, the liquidity waiver accounted for 76 per cent of notional trading volume carried out under the waivers (followed by the large-​in-​scale waiver at 15 per cent): 2020 ESMA Non-​equity Transparency Consultation Paper, n 323, 25. 338 The liquidity assessment framework is primarily set out in RTS 2 Art 13 and is operationalized by RTS 2 Annex III. Annex III sets out the quantitative metrics and thresholds which govern the liquidity status of different asset classes (some qualitative criteria apply to certain asset classes) and is based on thirteen detailed Tables which extend across nearly 100 pages of the OJ ([2017] L87/​229, 256–​342)). 339 Different calculation models apply to other asset classes under RTS 2. eg, securitized derivatives and certain specified equity derivatives are subject to a static (fixed) determination as to their liquidity status (in both cases, they are determined to be liquid) as are foreign exchange derivatives (determined to be illiquid). The liquidity of most other instruments is determined annually and on an asset class basis (by ESMA and through FITRS). 340 The assessment is supported by the massive FIRDS database (Financial Instrument Reference Data System) which collates reference data on all instruments traded in the EU and which facilitates the transparency-​ related FITRS. 341 RTS 2 Art 13(1)(b) and Annex III Table 2.1. The calculation method for ‘average daily notional amount’ is specified. Issuance-​based criteria, segmented by different bond types, are used to assess the liquidity status of newly admitted instruments, pending the full quarterly assessment. 342 The phase-​in was added by the Commission as RTS 2 was developed. ESMA’s concerns as to its impact were clear from the outset, with ESMA Chair Maijoor warning in 2018 that, even when the data issues which were complicating the liquidity calculations were addressed, the number of liquid bonds would be ‘modest given

V.11  Transparency Regulation  507 The operation of the liquidity exemption for bonds has not been straightforward as it depends on the quality of the market data supplied to ESMA through the MiFID II/​MiFIR reporting system, which remains a work-​in-​progress (section 12). It has also been complicated by Brexit. Given the importance of the UK market to non-​equity trading, its exclusion from the related reporting requirements complicated ESMA’s data collection and interrogation. Further, the UK’s withdrawal, by reducing the pool of liquid bonds trading in the EU, increased liquidity risks. It is clear, however, that, as a consequence of the design of the liquidity exemption for bonds, only a very limited population of bonds are subject to full pre-​trade transparency. ESMA’s first May 2018 assessment (which was delayed given data collection difficulties) led to 220 bonds of the circa 71,000 bonds assessed being deemed liquid and subject to the pre-​trade rules.343 By August 2022, 838 of the circa 128,000 bonds assessed were deemed to be liquid.344 The exemption is slowly being narrowed. ESMA is required annually to assess whether the ‘average daily number of trades’ metric should be moved to the next phase (and so reduced), given the evolution of trading volumes and other relevant factors.345 Reflecting strong market support, ESMA’s 2020 assessment recommended moving the metric to phase 2 (and thereby reducing the number of trades to ten), to make progress towards a more transparent trading environment, albeit that this change would have had only a marginal impact on transparency, increasing the number of liquid bonds by only some 50 per cent.346 Accepted by the Commission, the change came into force by means of a revision to RTS 2. ESMA’s 2021 assessment was similar, recommending a move to phase 3 (and a further reduction in the ‘average daily number of trades’ metric to seven), albeit this time in the face of some industry opposition, given Covid-​19 and Brexit-​related uncertainties.347 Progress is, accordingly, slow and bond market transparency remains limited. ESMA considered whether a full review of the liquidity exemption was necessary as part of the MiFID II/​ MiFIR Review, but the scale of the impact assessment required led it to undertake additional work prior to making any material recommendations. The SSTI Waiver  The SSTI waiver has also, and reflecting the fractious negotiations that attended its adoption, proved contentious.348 It is available for actionable indications of interest in request-​for-​quote and voice-​trading systems that are above a ‘size specific to the instrument’ (the ‘SSTI’), which would expose liquidity providers to undue risk and takes into account whether the relevant market participants are retail or wholesale investors. Some degree of transparency is provided, as the market operator or investment firm must make public at least indicative pre-​trade bid and offer prices which are close to the price the clear political direction to have a cautious start’ and noting that ‘we would have preferred a more ambitious start’: Speech, 21 June 2018. 343 ESMA, Press Release, 2 May 2018. 344 ESMA, Press Release, 1 August 2022. An increasing number of bonds is, however, being reviewed over time, reflecting improvements in data reporting from execution venues, particularly SIs. ESMA’s original design for RTS 2 was based on some 2 per cent of bonds in the EU becoming subject to the transparency regime. 345 RTS 2 Art 17. 346 ESMA, MiFID II/​MiFIR Annual Report under RTS 2 (2020). The first (2019) assessment was postponed because of Brexit uncertainties. 347 ESMA, MiFID II/​MiFIR Annual Report under RTS 2 (2021). The Commission accepted ESMA’s assessment, and the change, which led to a 40 per cent increase in the number of liquid bonds, came into force in January 2022. The 2022 review was postponed to 2023 to accommodate changes wrought by the MiFID II/​MiFIR Review. 348 ESMA recommended that it be withdrawn, a proposal taken up by the Commission in the 2021 MiFIR 2 Proposal (as noted below).

508  Order Execution Venues of the trading interests advertised through the relevant system (Article 8(4)).349 The SSTI waiver has been amplified by RTS 2 which governs the SSTI calculation, using a percentile metric. Like the ‘average number of daily trades’ metric for the liquidity waiver, this percentile is subject to a phase-​in, over four phases, which steadily narrow the scope of the exemption by increasing the size at which it applies. Progress has also been slow here. While the SSTI calculation has moved to phase 3 for bonds, following ESMA’s 2020 and 2021 reviews,350 it has yet to move from phase 1 for other instruments given ongoing difficulties with data quality.351 The NCA Suspension Power  The extent to which the liquidity risks engaged by the new non-​equity pre-​trade transparency regime for trading venues preoccupied the legislative process is underlined by the exceptional power given to NCAs to suspend pre-​trade transparency requirements where liquidity is compromised (Article 9(4)). As the pre-​trade regime does not apply to illiquid instruments, liquidity risks should not, however, become elevated to the point of needing NCA intervention. Nonetheless, the NCA responsible for supervising one or more trading venues on which a class of bond, structured-​finance product, emission allowance, or derivative is traded may, where the liquidity of the class of financial instrument falls below a ‘specified threshold’, temporarily suspend pre-​trade transparency requirements; the suspension is valid for an initial period not exceeding three months and may be renewed for further three-​month periods if the grounds for suspension continue to be applicable. The applicable metrics are governed by RTS 2, which is designed to ensure that, while any suspension decision is for the NCA, it is only taken where there has been a significant decline in liquidity across all venues in the EU for the financial instrument.352 ESMA is closely engaged with any suspension: the relevant NCA must notify ESMA before it takes action (whether to suspend or renew a suspension) and ESMA must issue an opinion to the NCA as soon as is practical on whether the suspension is justified. In an indication that the non-​equity pre-​trade transparency regime for trading venues was much less disruptive and impactful than predicted, the suspension had yet to be activated by any NCA by the late 2021 adoption of the MiFID III/​MiFIR 2 Proposal, notwithstanding the market disruption associated with the pandemic in early 2020.353 c. Post-​trade Transparency The post-​trade non-​equity transparency regime for trading venues follows the parallel equity regime and requires that market operators and investment firms operating a trading venue make public the price, volume, and time of transactions (Article 10(1)). The details of this regime (which also applies to SIs and investment firms) are governed by RTS 2.354

349 This disclosure obligation reflects the significant Council controversy which attended the availability of the request-​for-​quote/​voice trading waiver. 350 2021 ESMA RTS 2 Report (n 347). The phase 3 change came into force in January 2022. 351 2021 ESMA RTS 2 Report (n 347). 352 RTS 2 Art 16 specifies the relevant metrics. 353 In its 2020 review ESMA considered proposing its removal, particularly given the alternative tools available to trading venues and NCAs, such as trading suspensions, but did not proceed given market concern: 2020 ESMA Non-​Equity Transparency Report, n 129. 354 RTS 2 Art 7 and Annex II. As under the equity regime, extensive details are specified regarded the content of the required trade reports, the fields in which data is presented, and the different required flags which indicate how a transaction was executed.

V.11  Transparency Regulation  509 d. Deferred Publication A deferred publication regime, designed to manage price impact and liquidity risks, applies as regards the post-​trade requirements, and is similar in design to the pre-​trade waiver system (Article 11). NCAs are empowered to authorize market operators and investment firms operating a trading venue to provide for deferred publication of the details of transactions, based on the size or type of the transaction. By contrast with the pre-​trade waiver system, NCA decisions are not subject to ESMA oversight.355 In particular, NCAs may authorize deferred publication in respect of transactions that are large-​in-​scale compared with normal market size for the instrument in question or for that class of instrument (akin to the large-​in-​scale pre-​trade waiver); are related to an instrument or class of instrument for which there is not a liquid market (akin to the pre-​trade liquidity waiver); or are above a size specific to the instrument which would expose liquidity providers to undue risk, and which size takes into account whether the relevant market participants are retail or wholesale investors (akin to the pre-​trade SSTI waiver). In addition, a widely cast discretionary power allows NCAs to suspend post-​trade obligations where liquidity falls below a specified threshold (Article 11(2)). The conditions under which these deferrals operate are governed by RTS 2.356 Liquidity risks are further addressed by Article 11(3), which empowers NCAs to require or allow different disclosures in conjunction with the authorization of a post-​trade deferral.

V.11.3.2 The Bilateral/​OTC Segment a. Pre-​trade Transparency and SIs In an effort to increase non-​equity pre-​trade transparency in the OTC segment, MiFIR also subjects SIs to pre-​trade transparency requirements governing their pre-​trade quotes in bonds, structured-​finance products, emission allowances, and derivatives traded on a trading venue (for which the firm is an SI) (Article 18). The SI non-​equity regime incorporates the major features of the SI equity/​equity-​like regime but is more calibrated to liquidity risk. The regime is, in consequence, complex and its difficulties are compounded by the absence of clarifying administrative rules.357 Like the equity/​equity-​like SI regime, the design of the regime is based on specifying the conditions which trigger the pre-​trade transparency/​quoting obligation and so the regime does not include waivers. The foundational obligation requires SIs to make public firm quotes in the non-​equity instruments for which they are SIs, and for which there is a ‘liquid market’,358 but only when three additional conditions, designed to protect SIs’ liquidity positions, are met: when they are prompted for a quote by a client of the SI (Article 18(1)); when the SI agrees to provide a quote (Article 18(1)); and where the SI deals in sizes which do not pose undue liquidity risk (this condition is tied to the ‘size specific to the financial instrument’ (SSTI) concept 355 Its application is characterized by significant diversity across NCAs as regards the use of different deferral time periods: 2021 ESMA Waivers and Deferrals Report, n 143. The 2021 MiFIR 2 Proposal seeks to introduce a fixed set of harmonized deferral periods. 356 RTS 2 Arts 8–​11. The related metrics follow those applicable to the pre-​trade waiver system, but the thresholds governing the large-​in-​scale and SSTI deferrals are higher, making the post-​trade deferrals more restrictive than the pre-​trade waivers. 357 ESMA has described the regime as ‘complex and difficult to understand’ and supports its application through the MiFID II/​MiFIR Transparency Q&A (section 7 addresses the SI regime and is primarily concerned with the non-​equity rules). 358 Defined under Art 2(1)(17)(a). See n 335.

510  Order Execution Venues (Article 18(10)).359 The quote offering and execution process is also addressed, in order to allow the SI to manage position and liquidity risk, but also to protect investors from the elevated risks that arise in a bilateral order execution context. The relevant requirements are based on those applicable to equity/​non-​equity SIs but are calibrated further to reflect liquidity risks. In practice, while there has been a significant increase in SIs for non-​equity instruments since MiFID II/​MiFIR coming into force in 2018,360 this market is currently characterized by bilateral relationships between SIs and client firms and not by competitive public quoting. ESMA has reported that these SIs typically provide bespoke quotes, for clients, for large trades in low liquidity instruments, where no pricing is available, and for complex trading strategies or where markets are volatile.361 b. Post-​trade Transparency and Deferrals: SIs and Investment Firms All investment firms (including SIs) which, either on own account or on behalf of clients, conclude transactions in bonds, structured-​finance products, emission allowances, and derivatives traded on a trading venue must make public (through an Approved Publication Arrangement—​see section 12) the volume and price of those transactions and the time at which they were concluded (Article 21(1)). The data which must be published replicates that required of trading venues as regards non-​equity post-​trade transparency data (Article 21(3)). Deferrals are provided for by Article 21(4) and follow a similar regime as applies to trading venues.

V.11.3.3 Impact and the MiFID II/​MiFIR Review The non-​equity transparency regime was at the time of its negotiation and adoption (and remains) freighted with concern as to its potentially prejudicial impact on liquidity. Accordingly, while it was designed to be transformative in enhancing transparency in the EU non-​equity market, it was also designed to be carefully calibrated by administrative rules to manage the related liquidity risks. Initial evidence suggests that the regime has been a qualified success. It has not generated the disruption feared at the time of the adoption of MiFID/​MiFIR; the RTSs governing its application, and particularly RTS 2, emerged from a process characterized by extensive consultation and data assessment; and it has led to the emergence of a gradually strengthening stream of data on the non-​equity markets. It has not, however, led to a significant enhancement of transparency in non-​equity markets. The concern to protect liquidity appears to have trumped the animating objective of enhancing transparency. ESMA’s 2020 assessment for the MiFID II/​MiFIR Review found that the potential risks to liquidity had not crystallized, but reported on market concern as to the level of transparency achieved.362 ESMA relatedly reported that non-​equity trading 359 See section 11.3.1 on the SSTI. 360 Of the 222 SIs registered in 2020, 137 were registered for non-​equity instruments, primarily bonds: ESMA, MiFIR Report on Systematic Internalizers in Non-​equity Instruments (2020) 9. 361 ESMA’s 2020 review found, eg, that SI clients rarely traded on the basis of published quotes, with trades usually based on bespoke quotes and the access to quotes rules accordingly of limited value: 2020 ESMA SI Non-​equity Report, n 360, 9. 362 2020 ESMA Non-​equity Transparency Consultation Paper, n 323, 19, reporting on market concern that the regime was not providing sufficient transparency given the high proportion of illiquid instruments and the wide use of waivers. Its Final Report similarly noted that all market participants appeared to share the view that MiFIR

V.12  Data Distribution and Consolidation  511 on OTC/​SI venues (on which pre-​trade transparency is low)363 was significant, accounting for some 30 per cent of non-​equity trading volumes,364 although trading patterns varied by asset class: bonds were primarily traded OTC, mainly through SIs;365 interest rate and commodity derivatives, and emission allowances, were primarily traded on RMs; and equity derivatives were primarily traded on OTFs.366 ESMA similarly found that trading venues had not become significantly more transparent as regards non-​equity trading: the impact of waivers, and notably the liquidity waiver, had been significant in keeping pre-​trade transparency levels low, particularly as regards bond trading.367 Post-​trade transparency levels were very limited, reflect the impact of the deferrals available for illiquid instruments.368 In response, ESMA recommended a series of reforms, including to simplify the trading venue waiver and deferral systems and to enhance transparency.369 Chief among its proposals was the removal of the SSTI waiver, which ESMA regarded as being overly complex, as favouring request-​for-​quote and voice-​trading systems, and as limiting transparency.370 ESMA also recommended a significant tightening of the deferral system. The 2021 MiFIR 2 Proposal followed suit, proposing the removal of the SSTI waiver and restrictions to the deferral system. While the goal of enhanced non-​equity market transparency seems some way off, this incremental, technocratically informed approach to the refinement of the regime may, particularly if the 2021 Proposal succeeds in improving data quality through a consolidated tape (section 12.4), offer the most low-​risk way forward.

V.12  Data Distribution and Consolidation V.12.1  Enhancing the Data Framework If transparency requirements are to support liquidity and price formation, the transparency data must be of high quality, but it must also be distributed efficiently across the market at reasonable prices.371 In the EU’s competitive order execution market, this is all the more important as the distribution of high-​quality data acts as a means for drawing together had failed to achieve meaningful transparency for the non-​equity markets: 2020 ESMA Non-​equity Transparency Report, n 129, 10. 363 Pre-​trade transparency requirements do not apply to investment firms generally, while SIs do not, in practice, engage in trading practices that bring them within the scope of pre-​trade regime to any significant extent, as noted previously. 364 2020 ESMA Non-​equity Transparency Consultation Paper, n 323, 20. 365 SI and OTC trading accounted for 56 per cent and 10 per cent respectively of bond trading volumes in 2020: 2021 ESMA Securities Markets Report, n 122, 27. 366 2020 ESMA Non-​equity Transparency Consultation Paper, n 323, 21. 367 Bonds accounted for 68 per cent of trading under waivers in 2018 (2020 ESMA Non-​equity Transparency Consultation Paper, n 323, 26) and 69 per cent in 2020 (2021 ESMA Waivers and Deferrals Report, n 143, 44–​5). 368 2020 ESMA Non-​equity Transparency Report, n 129, 34. 369 2020 ESMA Non-​equity Transparency Report, n 129. 370 ESMA considered, but did not propose, that the liquidity waiver be revised, given the empirical complexities and persistent data uncertainties. Reflecting the legacy debate in this area, the OTC/​investment firm segment was significantly more opposed to such a reform than the trading venue segment: 2020 ESMA Non-​equity Transparency Report, n 129, 17–​18. 371 A considerable policy, industry, and academic (primarily finance) literature considers the design of data distribution for financial markets. This short outline covers only the major features of the MiFID II/​MiFIR model.

512  Order Execution Venues different liquidity pools. The regulation of data quality and data distribution has, accordingly, long formed part, if a troublesome part, of the EU transparency regime. MiFID II/​MiFIR was designed to drive significant enhancements to the quality and distribution of transparency-​related data (or trade reports), in response to the serious weaknesses that the MiFID I Review had identified as regards the poor quality and high cost of transparency data, and as regards inefficiencies in the distribution and consolidation of such data. MiFID II/​MiFIR did not adopt price-​related or infrastructure reforms, but instead adopted a multi-​layered approach designed to prompt market change. It required, inter alia, market operators and investment firms operating trading venues to unbundle their trading data feeds by offering pre-​and post-​trade transparency data separately, and it also imposed a ‘reasonable commercial basis’ condition on data sales. In addition, the OTC sector, data feeds from which had been partial and at times unreliable, became subject to an obligation to report post-​trade data through an ‘Approved Publication Arrangement’ (APA). In addition, a new regulatory regime was put in place for ‘Data-​reporting Services Providers’ of different hue (including APAs) to support data distribution. MiFID II/​MiFIR also sought to support the consolidation of post-​trade data by establishing a regulatory regime within which different ‘Consolidated Tape Providers’ were to compete to consolidate data from trading venues and other data providers in the form of real-​time, consolidated data feeds.372 In so doing, it sought to emulate the US market and its well-​established consolidated tape system.373 These reforms did not deliver material enhancements, with the data quality/​data distribution system emerging as the weakest element of MiFID II/​MiFIR in practice. While regulation can be implicated in this failure, it also reflects the stickiness of the commercial considerations faced by data providers and users, the scale of the data variability prior to MiFID II/​MiFIR and so the novelty of the new reporting obligations, and the complexities of the infrastructure design and pricing issues in this area. Early indications of difficulties emerged as ESMA began to engage with the initial transparency calculations required under the MiFID II/​MiFIR transparency regime (through its FITRS system, which relies on data feeds from trading venues, SIs, and APAs) but faced significant challenges from incomplete and poor-​quality data.374 A significant reform programme followed. The first set of reforms were institutional, moving the NCA-​ based supervision of Data-​ reporting Services Providers to ESMA (under the 2019 ESA Reform Regulation). The second set of reforms, proposed under the 2021 MiFID III/​MiFIR 2 Proposals, are significantly more ambitious and infrastructure-​ oriented. In particular, and in a rejection of the organic, industry-​led approach adopted

372 Council negotiations on the consolidation model for transparency data proved contentious, with some Member States in favour of a single provider and others supportive of a commercially driven model under which multiple providers could compete: Cyprus Presidency MiFID II/​MiFIR Progress Report, n 104, 10. 373 The US consolidated tape system, which is supported by federal legislation and SEC rules (including Regulation National Market System (NMS)), covers pre-​and post-​trade data for listed shares and bonds, regardless of execution venue (off-​exchange trades are reported to the tape through trade reporting facilities). 374 ESMA’s regular quarterly reports on bond liquidity status, and its annual reports on trading activity data to support SIs as regards their transparency obligations, from the outset referred to persistent difficulties with data quality. Over time, data quality has improved, evidenced, eg, by the increasing number of bonds now subject to the quarterly ESMA liquidity assessment.

V.12  Data Distribution and Consolidation  513 under MiFID II/​MiFIR, they are more interventionist as regards the construction of consolidated tapes for different asset classes.

V.12.2  Data Publication The distribution/​publication requirements governing transparency data are based on the MiFIR publication requirements, as amplified by detailed administrative rules. In the trading venue segment, and with respect to pre-​trade equity/​equity-​like transparency data, the market operator or investment firm operating the trading venue must make the relevant data available to the public on a continuous basis during normal trading hours (Article 3(1)). Similarly, pre-​trade non-​equity data must be made available to the public on a continuous basis during normal trading hours (Article 8(1). With respect to post-​trade equity/​equity-​like, and also non-​equity, transparency data, details of these transactions must be made public as close to real time as technically possible (Article 6(1) and 10(1)). In each case, market operators and investment firms operating a trading venue must make transparency data available free of charge fifteen minutes after the publication of the information; before that, all trade data required under MiFIR Articles 3–​11 must be available on a ‘reasonable commercial basis’ (Article 13). Market operators and investment firms must also unbundle their data, in an effort to reduce costs and support data consolidation, by offering pre-​and post-​trade transparency data separately (Article 12). In the bilateral OTC segment, SIs must make their pre-​trade equity/​equity-​like and non-​ equity quote data public in a manner which is easily accessible to other market participants on a reasonable commercial basis (Articles 15(1) and 18(8)). The post-​trade transparency data required of all investment firms (including SIs) must be published through an APA (Article 21(1)),375 in a significant change from MiFID I which allowed investment firms to report through proprietary channels—​a concession which became associated with the poor quality of OTC data. In addition, to support data distribution, market operators and investment firms operating a trading venue must give access, on reasonable commercial terms and on a non-​discriminatory basis, to the arrangements they employ for making transparency data public to those OTC investment firms which are required to make public pre-​ trade transparency data for equity/​equity-​like instruments and for non-​equity instruments (Article 3(3) and 8(3)) (SIs) and post-​trade data (all investment firms) (Article 6(2) and 10(2)). An extensive administrative rulebook, supported by ESMA soft law, amplifies this framework system, including as regards the ‘reasonable commercial basis’ condition applicable to data sales.376

375 Each transaction must be made public once through a single APA to avoid duplication and confusion. 376 The ‘reasonable commercial basis’ condition (for data not made available to the public free of charge) is addressed by Delegated Regulation 2017/​565 (Data-​reporting Services Providers) and Delegated Regulation 2017/​ 567 (trading venues and SIs). The rules are based on general principles related to, inter alia, the price being based on cost (and a reasonable margin), offered on a non-​discriminatory basis to all clients, and charged according to the use made by the individual end-​user, and also include reporting obligations relating to pricing policy. Following its MiFID II/​MiFIR Review assessment of the data landscape, ESMA adopted extensive Guidelines that amplify these principles in some granular detail including, eg, as regards the accounting methodologies supporting cost-​based pricing and how discounts are to be addressed: ESMA, MiFID II/​MiFIR Obligations on Market Data (2021).

514  Order Execution Venues

V.12.3  The Regulation of Data-​reporting Services Providers (DRSPs) The transparency data distribution/​publication process is supported by Data-​reporting Services Providers (DRSPs) of varying type, but in particular by the Approved Publication Arrangements (APAs) through which investment firms are required to publish their post-​ trade data. The regulatory scheme governing these DRSPs was originally contained in MiFID II, but has been transferred to MiFIR in order to support the 2022 transfer of supervision of DRSPs from NCAs to ESMA.377 The transfer of supervisory powers over DRSPs from NCAs to ESMA was relatively uncontested when it was proposed over the 2017 ESA Review, reflecting the cross-​border nature of, and limited systemic risk (and thereby limited fiscal risk to Member States) associated with, the sector. It also reflects the significant degree of political and institutional experience by then with ESMA as a direct supervisor (of rating agencies and trade repositories). The transfer of power was not, however, auspicious. The required administrative rules specifying which DRSPs qualified for a derogation from ESMA supervision and so would remain under NCA supervision, had not been published by the time the transfer came into force on 1 January 2022,378 requiring ESMA to adopt a ‘pragmatic supervisory approach’, based on its best estimate of which providers would remain under NCA supervision.379 MiFIR accordingly addresses the authorization, organizational, and operational (including as regards publication modalities) requirements380 for Approved Publication Arrangements (APAs),381 Approved Reporting Mechanisms (ARMs),382 and Consolidated Tape Providers (CTPs).383 The provision of these services as a regular occupation or business is subject to authorization by ESMA (Article 27b(1)), unless, in the case of APAs and ARMs only, a derogation is in place allowing for NCA supervision; in this case the entity is authorized (and supervised) by the relevant NCA in place of ESMA.384 These entities must otherwise provide their services under the supervision of ESMA (Article 27b(4)).385 Authorization (which supports a passport for data-​reporting services (Article 27c(3)) is governed by light-​touch procedures and requirements (Articles 27c-​f ) which require the entity to provide a programme of operations and organizational structure and to comply 377 The legal transfer was achieved by the 2019 ESA Reform Regulation which revised the regime to provide for direct ESMA supervision (save for certain DRSPs, subject to a derogation, which remain under NCA supervision) and to move it accordingly to MiFIR (via the new MiFIR Title IVA). 378 The reform empowered the Commission to adopt administrative rules to identify those DRSPs who would continue to be supervised by NCAs on account of their ‘limited relevance for the internal market’. The Delegated Regulation, which specifies how the cross-​border and scale criteria apply, was adopted in December 2021 but not published until March 2022. 379 ESMA announced that it would take over supervision only of those actors likely to fall under its jurisdiction, given the derogation criteria previously published in draft form, and encouraged NCAs to continue supervising other actors: ESMA, Public Statement, 14 December 2021. 380 The MiFIR framework is amplified in detail by Delegated Regulation 2017/​571 [2017] OJ L87/​126. 381 An APA is a person authorized to provide the service of publishing post-​trade reports on behalf of investment firms under MiFIR: Art 2(1)(34). 382 An ARM is a person authorized to provide the service of reporting details of transactions to NCAs or ESMA on behalf of investment firms: Art 2(1)(36). 383 A CTP is a person authorized to provide the service of collecting trade reports and consolidating them into a continuous electronic live data-​stream, providing price and volume data per financial instrument: Art 2(1)(35). 384 An investment firm or market operator of a trading venue can also provide these data-​reporting services, subject to prior ESMA verification of its compliance with the DRSP regime. Such services must be included in their firm or operator authorization (Art 27b(2)). 385 Including relevant investment firms or market operators providing data-​reporting services and as regards these services.

V.12  Data Distribution and Consolidation  515 with governance requirements which are similar to those which apply to RMs and investment firms. Specified ongoing requirements apply to each of APAs, CTPs, and ARMs;386 these entities will also be subject to the DORA regime as regards the digital operational resilience of network and information systems.387 APAs, the channel for OTC post-​trade transparency reporting, are subject to distinct distribution and organizational requirements reflecting their importance in transparency data distribution (Article 27g). As is the case with trading venues, APAs must make the transparency data they publish available as close to real time as technically possible, on a reasonable commercial basis; it must be available free of charge after fifteen minutes. APAs must additionally be able to efficiently and consistently disseminate such information in a way that ensures fast access to the information on a non-​ discriminatory basis and in a format that facilitates the consolidation of the information with similar data from other sources. Data integrity requirements are imposed: the APA must have sound security mechanisms designed to guarantee the security of the channels through which information is transferred, minimize the risk of data corruption and unauthorized access, and prevent information leakage prior to publication. The APA must also maintain adequate resources and have appropriate back-​up facilities, and have systems in place for checking trade reports. The APA must further operate and maintain effective administrative arrangements to prevent conflicts of interests with its clients. The CTP regime (Article 27h), which currently applies only to post-​trade equity/​equity-​ like trade reports, is, as currently structured, designed to support the consolidation of transparency data by setting the regulatory parameters for new consolidation channels, but relying on the market to produce the relevant providers. It requires CTPs to have adequate policies and arrangements in place to collect post-​trade equity/​equity-​like transparency data (from all RMs, MTFs, OTFs, and APAs; CTPs are accordingly required, under the current regime, to cover all equity/​equity-​like instruments traded in the EU), consolidate it into a continuous electronic data stream, and make it available to the public as close to real time as technically possible, on a reasonable commercial basis. Organizationally, the CTP must comply with the same data security and other organizational requirements as apply to APAs. No CTP emerged, however, following the 2018 implementation of MiFID II/​ MiFIR, reflecting the failure of the regulatory regime to address the commercial and regulatory risks faced by potential CTPs in accessing data from trading venues or APAs, or to adequately minimize the data quality frictions faced by any entity seeking to consolidate data streams. Major reforms to the CTP framework are expected following the 2021 MiFID III/​MiFIR 2 Proposal. The ARMs through which MiFIR Article 26 transaction reports can be provided (see section 13.2 on transaction reporting) are subject to a discrete organizational regime (Article 27i) which requires the ARM to have adequate policies and arrangements in place to report the information required under Article 26 as quickly as possible, and no later than the close of the working day following the day on which the relevant transaction took place; to have administrative arrangements to prevent conflict of interest; to have data security

386 These are amplified by Delegated Regulation 2017/​571 which covers, inter alia, governance, conflicts-​of-​ interest management, outsourcing, business continuity, testing and capacity, data security, error correction, and a series of requirements relating to how data is published. 387 See n 217.

516  Order Execution Venues arrangements in place; and to have systems in place for checking transaction reports and for detecting and correcting errors or omissions caused by the ARM. ESMA’s supervisory and enforcement powers are specified in detail in accordance with the template originally developed for ESMA’s direct supervision of rating agencies and which is now well-​tested, including by its extension to trade repositories.388

V.12.4  The 2021 MiFID III/​MiFIR 2 Proposal and the Consolidated Tape Reform The failure of the MiFID II/​MiFIR framework to support better data quality and more efficient data distribution became quickly apparent.389 Data quality was slow to improve and, as regards distribution, no CTP emerged and the projected reduction in the cost of data provided by trading venues did not materialize.390 ESMA’s 2019 review was bleak, concluding that MiFID II/​MiFIR had not delivered on its objective to reduce the cost of data, and calling for more stringent regulation and supervision in this regard, but not price controls.391 ESMA also addressed equity market data consolidation, reporting on the fragmentation of data distribution into multiple proprietary feeds;392 and relating the failure of a CTP to materialize to the limited commercial rewards for running an equity CTP, the strict regulatory requirements, competition from non-​regulated data vendors, and insufficient data quality (particularly as regards the SI/​OTC sectors). It supported the development of an equity CTP, however, as a means for mitigating fragmentation risks393 and identified high quality data (particularly OTC data), the mandatory contribution of data from trading venues and APAs, a CTP/​data providers revenue-​sharing model, and strong governance as conditions precedent for an equity CTP to emerge. Reform of data consolidation (which was drawn into the CMU agenda394 and which also became associated with strengthening EU corporate bond markets and with the international role of the euro)395 subsequently emerged as the centre-​piece of the 2021 MiFID III/​MiFIR 2 Proposals. The Commission took a wide-​angled lens to the reforms, relating them to, inter alia, the need to address incomplete transparency, across different execution venues and as regards equity, bond, and derivative asset classes; risks to the achievement of best execution; and inefficiencies in portfolio valuation and index construction, to the potential detriment of small issuers in particular.396 388 See further Ch VII on the rating agency template for ESMA supervision and enforcement. 389 Shortly after MiFIR’s implementation, ESMA noted reports of substantial increases in the price of data: ESMA Chair Maijoor, Speech, 21 June 2018. 390 The persistent difficulties have been extensively examined. See, eg, ESMA, MiFID II/​MiFIR Review Report No 1 (2019), and Market Structure Partners, Study on the Creation of an EU Consolidated Tape for the European Commission (2020). 391 n 390. 392 ESMA reported that 67 RMs, 111 MTFs, and 17 APAs provided trade reports to FITRS. 393 ESMA also noted the support a CTP could give to best execution and, more generally, to CMU: 2019 ESMA MiFID II/​MiFIR Data Report, n 390, 47. 394 The Commission’s 2020 CMU Action Plan called for the establishment of an equity CTP to support competitive order execution: COM(2020) 590 13–​14. 395 Commission, The European Economic and Financial System: fostering openness, strength, and resilience (COM(2021) 32) 8, associating a CTP with increasing market depth for euro-​denominated debt securities. 396 The 2021 MiFIR 2 Proposal estimated the costs of incomplete visibility across all equity liquidity pools, eg, as in the region of €10.6 billion annually: n 5, 2.

V.12  Data Distribution and Consolidation  517 The CTP reforms397 are designed to enhance commercial incentives for CTP construction by providing for a more accommodating regulatory framework; they are based on a single CTP being constructed for each asset class.398 Their main aim is to support the construction of such CTPs by, first, imposing a mandatory obligation on trading venues, SIs, and APAs to provide trade data to CTPs free of charge and also imposing a revenue-​sharing model for the share CTP (given the value of equity data to trading venues); and, second, ensuring that the data provided to CTPs is of high quality and in a format that supports consolidation. Assuming the CTP sector then develops, the reforms would require ESMA to select (three months after the reforms coming into force), through a competitive process, an authorized CTP for each asset class within the scope of the new regime. The selection/​ authorization would be for an initial five-​year period and in relation to post-​trade data only, although the reforms envisage that the CTP for shares could cover pre-​trade data after the initial five-​year period. Extensive and complex reforms have accordingly been proposed to MiFID II/​MiFIR (primarily MiFIR). At the core of the CTP reforms399 is the proposed new obligation for ‘market data contributors’400 to (and with regard to shares, ETFs, and bonds traded on a trading venue, and also OTC derivatives subject to the CCP clearing obligation)401 provide the CTP in question with the ‘market data’ (in a harmonized format and through a high quality transmission protocol) needed for the CTP to be operational; the Proposal envisages that this ‘market data’ be provided free of charge, save as regards share data, in relation to which a revenue participation model is proposed (MiFIR new Article 22a). The pivotal notion of ‘market data’ is related to ‘core market data’402 but is to be amplified, including as regards data quality, by administrative rules to be developed by the Commission, with advice (as is usual) from ESMA but also from a new expert stakeholder group (MiFIR new Article 22b). The reforms also reconstruct the MiFIR regulatory regime for CTPs, addressing, in detail, the criteria governing the ESMA CTP selection process (new Article 27da)403 and imposing new organizational and reporting requirements on

397 Which follow the exclusive, independent CTP model recommended by the Market Structure Partners Report (n 390). 398 The Commission also considered: a self-​aggregation model (under which market participants would collect and aggregate data for their own use); competing CTPs; exchange-​operated CTPs (under which each trading venue would become the exclusive consolidator for instruments admitted on the venue); and a concentration-​ based model (a reversion to the ISD model under which all trading in specified asset classes is concentrated on specified platforms). It concluded that an ESMA-​selected, single, independent CTP for each asset class was the most efficient approach. 399 A CTP is re-​defined as a person authorized under MiFIR to provide the service of collecting market data for shares, ETFs, bonds, or derivatives from ‘market data contributors’ and of consolidating this data into a continuous electronic live data stream that provides ‘core market data’ per share, ETF, bond, or derivative, and of providing this data to users of market data. 400 In effect, all entities subject to the transparency regime: trading venues, investment firms (including SIs), and APAs. 401 The Proposal accordingly has a wide reach. Concerns as to a lack of transparency in OTC derivatives markets, in particular, drove the reforms, with the Commission highlighting that while some 85 per cent of the notional value of derivatives traded in the EU was traded OTC, there was no consolidated feed of post-​trade data: 2021 MiFIR 2 Proposal, n 5, 2. 402 Broadly, transparency-​related data, including best bid and offer prices and volumes and transaction prices and volumes, but also including the more detailed disclosures covered by the transparency regime’s administrative rules including, eg, auction information, identifier codes, and time records. 403 Including as regards CTP governance, technical specifications, and fees to be charged. The selection process for the share CTP additionally addresses the revenue participation scheme proposed by the CTP.

518  Order Execution Venues CTPs. If the reforms do not lead to CTPs developing, an ESMA-​based, public CTP solution is envisaged, albeit that this backstop solution is tentatively expressed.404 Also, the proposed reforms address data distribution more generally, including by means of a new delegation for administrative rules on when data is made available on a ‘reasonable commercial basis’. Data quality and distribution have long been an Achilles heel of the transparency regime. The difficulties are many and complex and are not always amenable to a straightforward regulatory solution, in particular given the disruptive power of technology in this sphere, while industry interests are longstanding, significant, and polarized between the sellers of data and users. The MiFID III/​MiFIR 2 Proposal, by seeking to reorder commercial practices and incentives regard the distribution and pricing of data, marks a step-​change in the EU’s approach. It also underlines the strengthening operational capacity of the EU. ESMA provided extensive technical support to the development of the reforms, but it also gave the Commission the capacity to, at least, consider constructing an ESMA-​based, public good CTP. While any such exercise would be freighted with political, technical, and legal complexity, that such a reform is even being mooted underlines the transformation in the institutional setting of EU financial markets regulation since the financial crisis. Predicting how this major reform will fare is a perilous business, not least given the scale of the operational challenge, the commercial sensitivities, and the related industry and so political interests at stake.405 Market re-​design is, however, a recurrent feature of the MiFID story and, viewed in this light, the market for data is the next evolutionary step for EU venue policy. There is also a wider lesson. While the regulation of data quality and distribution has a humdrum quality, failure to address the deep-​seated market failures here could have significant implications for foundational political decisions: achievement of the EU’s political commitment to a competitive order execution market, in which pools of liquidity are tied together through different regulatory mechanisms, chief among them transparency rules, depends in large part on the quality and distribution of transparency data.406

V.13  Supervision and Enforcement V.13.1  The MiFID II Framework Investment firms operating as bilateral venues, such as SIs, are supervised as regards their MiFID II/​MiFIR compliance under the NCA-​based MiFID II supervisory framework for investment firms (Chapter IV). The MiFID II framework is bolstered by MiFIR, which 404 The reforms include a revised MiFIR review clause which requires that, if no CTP has emerged through the ESMA selection process within one year of the reform coming into force, the Commission is to review the framework and may accompany that review, where appropriate and having consulted ESMA, with a legislative proposal setting out how ESMA should provide a consolidated tape. 405 Initial reaction was not auspicious, with the reforms facing criticism from trading venue and OTC segments alike, including as regards costs, revenue-​sharing, and the risks of such a complex ‘experiment’: Stafford, P, ‘Brussels Criticised over Plan for Capital Markets Databases’, Financial Times, 29 November 2021. ESMA was also wary: Noonan, L, ‘EU Securities Regulator Warns it Could ‘Struggle’ to Run Live Trading Databases’, Financial Times, 8 July 2022. 406 Bearing out the insight that ‘details matter’ and that slow progress on data standardization in financial markets governance can have ‘first order’ effects: Judge, K and Berner, R, ‘The Data Standardization Challenge’ in Arner, D et al, Systemic Risk in the Financial Sector: Ten Years after the Great Crash (2019).

V.13  Supervision and Enforcement  519 requires that NCAs must monitor the activities of investment firms to ensure that they act honestly, fairly, and professionally, and in a manner which promotes the integrity of markets (Article 24). The supervision of multilateral trading venues (whether operated by market operators or investment firms) is also governed by the MiFID II framework, although the harmonized suite of powers which must be available to NCAs under MiFID II is calibrated to reflect the particular concerns of venue supervision. First, the specified NCA powers must be available in relation to RMs and their market operators, as well as in relation to investment firms. Second, several NCA powers are expressly targeted to venue regulation, including the powers to require information relating to commodity derivative positions (Article 69(2)(j)); require the suspension of trading in a financial instrument (Article 69(2)(m)); require the removal of a financial instrument from trading (whether on an RM or under other trading arrangements) (Article 69(2)(n)); request any person to take steps to reduce the size of a position or exposure (Article 69(2)(o)); and limit the ability of any person from entering into a commodity derivative (Article 69(2)(p)).407 In addition, specific MiFIR supervisory reporting requirements support the venue regime. MiFIR requires investment firms to keep at the disposal of the NCA, and for at least five years, records regarding all orders and transactions in financial instruments carried out, on own account or on behalf of clients (Article 25(1)). Similarly, all trading venues are required to keep at the disposal of the NCA, and for at least five years, relevant data relating to orders in financial instruments which are advertised through their systems (Article 25(2)). In addition, investment firms are subject to daily transaction reporting requirements (Article 26). These recording and daily transaction reporting obligations are keystone supervisory tools for monitoring market efficiency, transparency, and integrity.408 The Article 26 daily reporting obligation, in particular, is a pivotal reporting obligation and is outlined in the following section.

V.13.2  Transaction Reporting V.13.2.1 MiFIR Article 26 The transaction reporting obligation (MiFIR Article 26) applies to investment firms but, and reflecting the importance of the obligation, trading venues are required to report details of transactions within the scope of Article 26 where these transactions are executed through their systems by firms not within the scope of MiFID II/​MiFIR (Article 26(5)). Trading venues may also report on behalf of MiFID II/​MiFIR investment firms (Article 26(7)). The Article 26 transaction reporting obligation is a keystone supervisory reporting requirement. It requires investment firms which execute transactions in financial instruments to report complete and accurate details of such transactions to their NCA as quickly as possible, and no later than the close of the following day. Its centrality to market monitoring is reflected in the NCA of the ‘most relevant market in terms of liquidity’409 also receiving the

407 See further Ch VI section 2.5 on position management. 408 See further Ch VIII section 9.2 on Art 25 and market abuse monitoring. 409 The determination of this market is governed by RTS 2017/​590 [2017] OJ L87/​449 Art 16 and is related to turnover.

520  Order Execution Venues Article 26 reports. The reporting obligation applies widely to: financial instruments which are admitted to trading or ‘traded on a trading venue’410 (or for which a request for admission to trading has been made); financial instruments where the underlying is a financial instrument traded on a trading venue; and financial instruments where the underlying is an index or basket composed of financial instruments traded on a trading venue (Article 26(2)).411 As the obligation applies regardless of whether the transaction is carried out on the trading venue, the effect of Article 26 is to require the reporting of all OTC transactions (as well as on-​trading-​venue transactions), unless the value of the instrument in question does not depend to some extent on or influence instruments which are admitted to trading. The content of the transaction reports required under Article 26 is (unusually) subject to detailed legislative specification (Article 26(3)) and must include (in addition to names and numbers of financial instruments, quantities, prices, and times of transactions), inter alia, a designation identifying the clients involved; identifying the person and algorithm within the firm responsible for execution; identifying the applicable transparency waiver under which a trade has taken place (where relevant); identifying whether the transaction is a short sale under the 2012 Short Selling Regulation;412 and, for an OTC transaction in an instrument subject to the Article 26 reporting obligation (ie one not executed on a trading venue), identifying the type of transaction (Article 26(3)). The transaction reporting obligation can be met by direct reporting by the relevant investment firm, reporting through an ARM (see section 12), or reporting through the trading venue on which the transaction is completed (Article 26(7)).413 Transaction reporting can also be carried out by EMIR trade repositories (in order to avoid the imposition of double reporting obligations on firms with respect to derivatives transactions; see Chapter VI on trade repositories).

V.13.2.2 Administrative Amplification, the FIRDS System, and ESMA The content of the Article 26 transaction reports is specified in granular detail by an RTS414 which covers, inter alia, data content, standards, and formats;415 the (widely cast) ‘transactions’ subject to the reporting obligation; the different codes to be deployed, including the legal entity identifiers (LEIs) used to identify legal persons associated with a transaction;416 and reporting arrangements.417 Also, a distinctly practical set of ESMA Guidelines operate

410 On this widely cast perimeter concept see section 4.2. 411 The reporting obligation applies irrespective of whether or not the transaction is actually carried out on the trading venue, in part to ensure the reporting regime dovetails with the market abuse regime which applies to a wide range of venues (Ch VIII). 412 Regulation (EU) No 236/​2012 [2012] OJ L86/​1. See Ch VI section 3. 413 Where transactions are reported directly to the NCA by a trading venue or ARM, the firm is not responsible for failures in the reporting which are attributable to the venue or ARM, but must take reasonable steps to verify the completeness, accuracy, and timeliness of reports submitted on its behalf. 414 RTS 2017/​590 [2017] OJ L87/​449. 415 Detailed tables set out the immensely detailed content required including as regards the execution venue, the executing entity, buyer, seller, transaction, instruments, traders, algorithms, transparency waivers, and type of trade (including whether short sale, OTC, or securities financing transaction). 416 The LEI is an international standard (alpha/​numeric code) used to identity the type of legal entity participating in a financial transaction and identifies, eg, the investment firm, execution venue, and client, where they are legal persons, and the issuer of the instrument. While the LEI is a global standard, ESMA was instrumental in its application to EU financial markets. See, eg, ESMA, Supervisory Briefing—​Legal Entity Identifier (2017). 417 Including the standards applicable to the relevant systems operated by investment firms and trading venues and which generate and submit reports: Art 15.

V.13  Supervision and Enforcement  521 as a ‘how to’ manual, explaining and illustrating in fine detail how transaction reports are to be constructed.418 The transaction reporting system is supported by the related ‘Financial Instruments Reference Data System’ (FIRDS). This system, which collates financial-​instrument-​specific data, derives from the MiFIR Article 27 obligation on trading venues419 to provide NCAs with identifying ‘reference data’ for the instruments admitted to trading or traded on the trading venue.420 FIRDS is governed by a highly detailed RTS421 which specifies the content, standards, form, and format of financial instruments reference data and the timescales governing its reporting to NCAs; specifies NCAs’ monitoring obligations, including as regards data quality; and imposes standards as regards the submission of the reference data to NCAs. The Article 26 transaction reporting system, as supported by FIRDS, is a creature of operations and technical specification, but it also the lifeblood of the supervisory system, pumping transaction data, on a daily basis, from investment firms to NCAs and supporting NCA oversight of the massive volume of daily trading activity in the EU. ESMA is integral to the Article 26 transaction reporting system in a number of ways. In particular, it hosts and operates the vast and intricate FIRDS database which supports the transaction reporting system.422 ESMA’s construction of the FIRDS database constituted at the time the first major delegation of powers from NCAs to ESMA. NCAs were, under MiFIR, originally charged with collecting the relevant reference data and transmitting it onward to ESMA, which was charged with making the data publicly available, and with collating it for NCA access. NCAs, however, delegated the reference data collection competence to ESMA, in a material indication at the time of ESMA’s growing capacity and influence.423 Alongside, the ESMA-​hosted Transaction Reporting Mechanism (TREM) supports the exchange of Article 26 transaction reports between NCAs. And overall, the different technical interfaces of the Article 26 reporting ecosystem (from investment firms’ data collection and reporting systems, to NCAs’ interfaces with firms, to the ESMA-​hosted systems) operate under ESMA-​developed technical protocols and standards.424 The Article 26 transaction reporting system also saw ESMA engage in one of its first significant exercises of 418 ESMA, Guidelines on Transaction Reports, Order Record Keeping and Clock Synchronization under MiFID II (2017). The lengthy Guidelines (which run to nearly 300 pages) have a distinctly practical orientation, setting out, for different ‘blocks’ (ie, a block for the ‘buyer’), how different transaction orders should be reported on, and also populating the relevant report fields. 419 In specified circumstances SIs may be required to report. 420 In practice, the Art 26 transaction-​specific data is combined by NCAs for, oversight purposes, with the financial instrument reference data available through FIRDS. 421 RTS 2017/​585 [2017] OJ L87/​368. Reference data reporting requirements also apply under the Market Abuse Regulation (Regulation (EU) No 596/​2014 [2014] OJ L173/​1) (Art 4) which similarly requires trading venues (RMs, MTFs, and OTFs) to provide reference data on financial instruments admitted to the venue (see Ch VIII). The MAR reference data requirements are specified in RTS 2016/​909 [2016] OJ L153/​13. The MiFIR and MAR requirements are designed to be aligned to the greatest possible extent (albeit that they are not identical) and are both reported through FIRDS. 422 Shortly after its construction, FIRDS was processing some seven million records a day: ESMA Executive Director Ross, Speech, 27 June 2018. The scale of the FIRDS system, and of ESMA’s related technical capacity, is evident from the highly detailed and regularly updated ‘reporting instructions’ and access protocols which apply. See, eg, ESMA, Reporting Instructions. FIRDS Reference Data System (2020) and ESMA, Financial Instruments Reference Data System. Instructions on Access (2022). 423 Not all NCAs delegated reference data collection functions to ESMA: Board of Supervisors, Minutes, 17 December 2014, reporting on the non-​participation of the Bulgarian NCA. NCAs who have not delegated collection functions must transmit the reference data to ESMA for inclusion in the FIRDS system. 424 See ESMA, Technical Reporting Instructions—​MiFIR Transaction Reporting (2017).

522  Order Execution Venues ‘supervisory forbearance’ action. Days before MiFID II/​MiFIR came into force in 2018, ESMA announced an informal six-​month transitional period to allow market participants to acquire the LEI codes required for transaction reporting, following evidence of a lack of industry preparedness,425 and thereby claimed a soft power to informally suspend the application of binding rules.426 As outlined in Chapter I, forbearance action provides a functional solution where administrative rules cannot be nimbly revised, but it also generates legitimation risks.427 The technical character of the Article 26 transaction reporting system therefore belies its wider institutional significance in EU financial markets governance.

V.13.3 Supervisory Coordination, Cooperation, and Convergence NCA coordination and cooperation as regards the venue regime operates under MiFID II’s supervisory coordination and cooperation arrangements generally. These are, however, calibrated to the venue context, in particular to mitigate the risks to supervisory effectiveness from the fragmentation of order execution across different venues. Specific supervisory coordination requirements apply, for example, to the supervision of trading venues’ remote access arrangements (MiFID II Article 79). In a derogation from the otherwise dominant home-​country control principle, shared supervisory arrangements are provided for (Article 79(2)): where, taking into account the situation of the securities markets in the host Member State, the operations of a trading venue that has established arrangements in a host Member State have become of ‘substantial importance’ for the functioning of securities markets and the protection of investors in the host Member State, the home and host NCAs must establish proportionate cooperation arrangements.428 Host NCA precautionary powers are also provided for (Article 86(3)). Further, a distinct cooperation regime applies with respect to NCAs’ position management powers (Chapter VI). In addition, and reflecting the array of financial instruments within the scope of the venue regime, NCAs must report to and cooperate with the relevant public oversight bodies in emission allowances markets and agricultural commodities markets (Article 79(6) and (7)). NCA supervision and cooperation/​coordination is framed by ESMA’s extensive supervisory convergence measures which, alongside its extensive and often operationally oriented Guidelines and Q&As,429 include horizon-​scanning activities relating to venue risks.430 It is the direct operational quality of ESMA’s engagement, however, that makes its convergence role distinct as regards the venue regime. Its oversight role as regards NCAs’

425 ESMA, Public Statement (LEI Requirements), 20 December 2017. The sharp increase in demand for LEIs for clients and also issuers had led to bottlenecks in the supply of LEIs and to related infrastructure challenges for firms and trading venues. The suspension allowed trading venues to use their codes for issuers and allowed investment firms to provide services (triggering Art 26 reports) for clients who did not have LEIs, as long as the investment firm acquired from the client, prior to providing the services, the relevant documentation to acquire the code. 426 NCAs were relatedly required to revise the ‘validation rules’ governing their transaction reporting systems. 427 The LEI ‘suspension’ was, accordingly, subject to conditions and monitored by ESMA. The transitional period ended in June 2018: ESMA, Public Statement (LEI Requirements), 20 June 2018. 428 These arrangements are amplified by ITS 2017/​988 [2017] OJ L149/​3. 429 Including the ESMA Guidelines on market data (2021) and on the management body of market operators and data reporting services providers (2017), as well as the more manual-​like Guidelines on transaction reporting (2016, revised 2017) and on trading halts (2017); and the MiFID II/​MiFIR Q&A on Market Structure Topics and the MiFID II/​MiFIR Q&A on Transparency Topics. 430 ESMA, eg, identified venue outages, where trading systems fail and are suspended, as of supervisory concern. Alongside potential legislative reform, it identified best practices and called for closer industry cooperation, in particular as regards the re-​routing of trades to other venues: ESMA, MiFID II/​MiFIR Review on Algorithmic Trading (2021) 70–​6.

V.14  Post-trading and the Settlement Process  523 approval of transparency waivers, its pivotal role in operationalizing the transparency system through its transparency calculations and related databases, and its construction of an immense trading/​transaction datahub, which includes the FIRDS and TREM transaction reporting systems as well as the FITRS and DVCM transparency-​related systems, all strengthen ESMA’s technical capacity as regards venue regulation and, thereby, its capacity to shape and coordinate NCA supervision.

V.14  Post-​trading, the Settlement Process, and the Central Securities Depositories Regulation ‘Post-​trading’ relates to the process through which ownership in a financial instrument is transferred from the seller to the buyer, in return for payment, and involves a number of stages, typically confirmation, clearing, and settlement.431 It starts with confirmation (or verification), during which the positions of the trading parties are confirmed and the parties’ settlement instructions, for the completion of the transaction, are matched, typically by the relevant trading venue or its participants. The subsequent clearing process, which is discussed in Chapter VI as a key element of the EU’s regulation of derivatives trading, is concerned with establishing overall mutual positions and with matching contracts prior to settlement: positions are typically not dealt with individually in the post-​trade process but are pooled, in order to minimize the volume of funds and securities that must be transferred, and in order thereby to establish net positions. Clearing can happen through a central clearing counterparty (CCP), which becomes a counterparty to every transaction it clears and which, taking on the related counterparty credit risk, sets off transactions, leaving the net positions which remain for settlement. During the final settlement stage, the subject of this section, cash and securities are transferred through reciprocal cash and securities book-​keeping, or transaction processing, mechanics (the simultaneous ‘delivery versus payment’ process) which ensure that the trading bargain is completed. The settlement process typically occurs through accounts maintained within central securities depositaries (CSDs). CSDs are systemically significant infrastructures that play a central role in the post-​trade process by, in the primary markets, arranging for the dematerialization (transfer to electronic form) and immobilization within the CSD of financial instruments when first issued (thereby allowing their subsequent electronic transfer);432 and by, in the secondary markets, providing accounts through which the settlement of subsequent transactions in these instruments takes place.433 431 The technical and operational procedures, risks, and regulatory responses, and the private law property and security rights, related to post-​trading are outside the scope of this chapter, which focuses on the initial order execution process and on the related venues. The central clearing counterparty (CCP) regime for derivatives clearing is covered in outline in Ch VI, however, given its importance to the regulation, supervision, and organization of trading in the OTC derivatives markets, and the settlement process is noted in brief in this section. On the post-​trade process generally and the background to the EU’s approach see, eg, Gullifer, L and Payne, J (eds), Intermediation and Beyond (2019) and Conac, P-​H, Segna, U, and Thévenoz, L, Intermediated Securities: The Impact of the Geneva Securities Convention and the Future European Legislation (2012). 432 The dematerialization of securities allows for their electronic transfer and is associated with more secure, efficient, and timely settlement. 433 CSDs typically (and under the CSD Regulation must) establish electronic ‘book entries’ for issues of securities and, on an ongoing basis, ensure that the number of securities issued in a particular issue matches the total number in circulation and recorded in book entry accounts. A particular issue of securities is accordingly first ‘dematerialized’ and ‘immobilized’ within the CSD (the issuer CSD) and subsequent transactions in that issue

524  Order Execution Venues CSDs and the settlement process are regulated by the 2014 Central Securities Depositories (CSD) Regulation,434 an infrastructure measure which, like MiFID II/​MiFIR, has a financial stability orientation that reflects its financial-​crisis-​era genesis435 (MiFID II also addresses settlement in that it imposes on trading venues a high-​level obligation to have in place effective arrangements to facilitate settlement (Articles 18 and 47)). The CSD Regulation supports a massive volume of settlement activity in the EU,436 including by supporting the ‘Target2-​Securities’ (T2S) platform, a Eurosystem initiative which provides a single technical platform for the settlement of securities in the EU and in which CSDs participate. The Regulation lays down uniform requirements for the settlement of financial instruments in the EU, and rules on the organization and conduct of CSDs, to promote safe, efficient, and smooth settlement (Article 1). It has two main purposes. First, it captures the core functionality of CSDs and establishes a related regulatory regime for their authorization and ongoing regulation. A CSD is a legal person that operates a securities settlement system and also provides at least one of the core CSD services specified by the Regulation: arranging for the recording of securities issues in book entries; and the safekeeping of securities through accounts (Article 2(1)(1)).437 Second, it regulates the securities settlement process generally, and thereby supports T2S, by imposing minimum operational requirements in order to enhance the security and stability of settlement. The adoption of the CSD Regulation in 2014 as the financial-​crisis-​era reform period closed marked a step change in the governance of the settlement process in the EU. The Regulation was designed to address the long-​identified and longstanding costs, stability risks, and obstructions to cross-​border transactions associated with the fragmentation of settlement across nationally based and -​regulated CSDs.438 Its adoption followed a lengthy period of experimentation with the complex legal, technical, and operational challenges raised by the governance of settlement systems and by cross-​border settlement in particular.

are settled ‘at the top level’ between members of the CSD, usually financial institutions, via electronic cash and securities account entries. The CSD accordingly sits at the top of the chain (holding ‘top tier’ accounts for the relevant securities), with all relevant cash and securities holdings relating to the issue held in the CSD’s accounts. The CSD market is nationally based in the EU. Two International CSDs or ICSDs (within the Euroclear group and the Clearstream group) originally developed as specialists in eurobonds (bonds denominated in a currency different from that of their issuance) but have since evolved to settle a wide range of financial instruments. 434 Regulation (EU) No 909/​2014 [2014] OJ L257/​1. Settlement through CSDs is also supported by the 1998 Settlement Finality Directive which deals with insolvency risk within settlement systems (Directive 98/​26/​EC [1998] OJ L166/​145) and by the 2002 Financial Collateral Directive (Directive 2002/​47/​EC [2002] OJ L168/​43) which harmonizes the receipt and enforcement of financial collateral. Legal uncertainty risks relating to the cross-​ border exercise of ownership rights, particularly for shareholders, remain significant. While the 2015 CMU Action Plan contained a commitment to addressing these uncertainties, progress on the related Securities Law Directive is slow. Relatedly, the 2020 CMU Action Plan committed to enhancing shareholders’ rights by strengthening their ability to exercise their ownership rights. 435 The CSD Regulation has not, by comparison with EMIR and MiFID II/​MiFIR been widely examined. For a leading review see Ferran, E and Hickman, E, ‘The Roles and Risks of European Central Security Depositories’ in Saguato and Binder, n 3. 436 As at mid-​2022, 26 CSDs were authorized in the EU. The 2019 data give a sense of the scale of their systemic importance: these CSDs dealt with 420 million delivery instructions, representing over €53 trillion of securities and a turnover of over €1,120 trillion: 2022 CSD Regulation Reform Proposal (COM(2022) 120) 1. 437 In practice, most CSDs provide both services. 438 One of the earliest reviews was by the 2001 Lamfalussy Report, which identified the major inefficiencies in the EU’s post-​trade regime and called for an industry-​led restructuring: Final Report of the Committee of Wise Men on the Regulation of European Securities Markets (2001) 16–​17.

V.14  Post-trading and the Settlement Process  525 The seminal 2001 and 2003 Giovannini Reports for the Commission,439 which identified the costs, risks, and distortions associated with the EU’s fragmented settlement systems, set a pioneering reform agenda, but progress was slow and sporadic,440 including a failed effort at a market-​based approach.441 Although some progress had been made, if slowly, prior to the financial crisis,442 the financial crisis reset the policy agenda. Securing the resilience and stability of post-​trade infrastructures, enhancing the security and efficiency with which cross-​border transactions were concluded, and ensuring the resilience of increasingly close interlinkages between CSDs as cross-​border transactions increased, became policy priorities. The Commission’s 2012 proposal of a new harmonized regime governing CSDs and the settlement process followed.443 The Regulation reflects the classic regulatory and liberalization concerns of EU financial markets regulation, being designed to enhance the stability of the settlement process in the EU, but also to promote competition between CSDs.444 It is wide-​ranging, applying beyond CSDs to impose obligations on parties in the securities settlement chain generally, particularly the new settlement discipline requirements, and is articulated in some technical detail. As regards the securities settlement process generally, a series of harmonized obligations are imposed to enhance its security and efficiency. The Regulation mandates the dematerialization of securities, imposing an obligation on EU issuers of transferable securities admitted to trading or traded on trading venues to arrange for such securities to be represented in a book entry form (and so to be capable of being settled electronically) (Article 3); in effect, the Regulation mandates the use of CSDs for the issuance of securities.445 It also requires participants in settlement systems to meet the specific intended settlement date for the instrument in question and establishes a minimum settlement period (Article 5).446 The contested ‘settlement discipline system’ (Articles 6–​8),447 which is designed to minimize ‘settlement fails’ that can disrupt trading,448 addresses the prevention of settlement fails and also how they are to be addressed when they arise, imposing reporting obligations but also 439 Giovannini Group, Cross-​border Clearing and Settlement Arrangements in the European Union—​First Report (2001) and Cross-​border Clearing and Settlement Arrangements in the European Union—​Second Report (2003). The reports set out the main barriers to efficient pan-​EU settlement (and clearing) (technical issues, taxation, and lack of legal certainty) and a related action plan. 440 For a financial-​crisis-​era review see Expert Group on Market Infrastructure, Report (2011). 441 Which reached its apotheosis with the Commission’s support of a remedial industry Code of Conduct (European Code of Conduct for Clearing and Settlement (2006)) which addressed price transparency, access rights, and governance. 442 One MiFID I Review study on the costs of trading and post-​trading found that CSD costs had decreased by 25 per cent (equities) and 35 per cent (bonds): 2011 Oxera Report, n 75. 443 COM(2012) 73. 444 The Commission explained the Regulation’s purpose as to increase the safety of settlement, in particular for cross-​border transactions; to increase the efficiency of settlement by introducing an internal market for CSD services; and to increase the safety of CSDs by applying high prudential requirements: Commission FAQ on the CSD Regulation, Memo, 16 April 2014. 445 All newly issued securities were to be in book entry form by January 2023 and all securities by January 2025. 446 For transactions in transferable securities executed on trading venues, the intended settlement date must, unless an exemption applies, be no later than on the second business day after the trading takes place (T +​2). This requirement led to a reduction in settlement times as T +​3 applied in some instances. 447 The complex and highly technical rules relating to settlement discipline are set out in RTS 2018/​1229 [2018] OJ L230/​1 which came into force in February 2022. 448 ESMA’s half-​yearly TRV Reports cover settlement trends. ESMA had, up to 2022, noted significant stress on the settlement system only in relation to the market turmoil in early 2020 as the pandemic deepened. Settlement fails in equity transactions peaked at 14 per cent (by value) over the height of the market turmoil in 2020, but subsequently fell back to 9 per cent in the first half of 2021, albeit that fail levels remained higher than their pre-​ pandemic levels: ESMA, TRV No 2 (2021) 17.

526  Order Execution Venues cash penalties and ‘mandatory buy-​in’ arrangements for settlement fails.449 The Regulation additionally applies reporting requirements to ‘settlement internalizers’, typically regulated entities, who settle transactions outside a securities settlement system (Article 9). As regards CSDs, the Regulation addresses their authorization and regulation and the related passporting rights which are designed to strengthen the cross-​border settlement system. At the core of the regime is the requirement for all CSDs to be authorized by their home NCA in accordance with the Regulation’s requirements. Authorized CSDs are subject to an extensive ongoing regulation regime, including as regards organization,450 conduct,451 the security and integrity of the settlement process, and prudential risk management.452 The Regulation also regulates the establishment of links between CSDs to support settlement;453 and confers and regulates CSD access rights, including as regards issuer access to CSDs, access between CSDs (where a CSD becomes a participant in another CSD, subject to the requirements governing CSD links), and access between CSDs and other market infrastructures.454 These provisions sit alongside the intricate and related MiFID II/​MiFIR provisions governing access (including by investment firms) to and between CCPs, settlement systems, trading venues, and benchmarks.455 Reflecting the structure of the CSD market, the Regulation also provides for a specific, prudentially oriented authorization and regulatory system for CSDs engaged in banking-​like services (such as the provision of payment services, deposit-​holding functions, and cash credit services). The NCA supervisory framework (which includes a CSD-​specific Supervisory Review and Evaluation Process (SREP)) is specified in detail, reflecting the systemic significance of CSDs but also the heightened risk that attends cross-​border, passported CSD provision, and the construction of links between CSDs and other market infrastructures. Like MiFID II/​MiFIR, the CSD Regulation is a measure of marked operational complexity and has required extensive amplification through often highly technical administrative rules456 and soft law.457 Also like MiFID II/​MiFIR, the translation of certain of its 449 A ‘buy-​in’ mechanism provides a buyer of securities, where settlement fails, with a contractual right to acquire the security elsewhere, cancel the original trade, and settle any differences from the net costs of the original transaction and the buy-​in transaction. The scope of the CSD Regulation buy-​in requirement, and its mandatory nature, generated significant industry concern given the scale of the operational changes involved and the potential liquidity risks. In November 2021, the Commission confirmed an indefinite suspension of the requirement, pending further review. The Commission’s 2021 review of the Regulation had reported on market concern that the mandatory buy-​in requirement was unclear, could reduce liquidity, increase costs, and place EU CSDs at a competitive disadvantage to third country CSDs not subject to such requirements: COM(2021) 348 5–​6. The subsequent 2022 CSD Regulation Proposal proposed a series of ameliorations, as noted below. 450 Including as regards general principles and governance, record-​keeping, and outsourcing requirements. The DORA regime will also apply to CSDs. 451 Including as regards engagement with system participants and transparency obligations. 452 Including as regards the management of legal, general business, and operational risk, the CSD’s investment policy, and capital requirements. 453 CSD links are used to allow the transfer of financial instruments between CSDs, particularly to support settlement in securities issued in another jurisdiction and held in that other jurisdiction’s CSD. 454 CCPs and trading venues are to provide transaction feeds on a non-​discriminatory and transparent basis to a CSD on request by the CSD, subject to a reasonable commercial fee. Conversely, CSDs are required to provide access to their settlement systems on a non-​discriminatory and transparent basis to a CCP or trading venue, subject to a reasonable commercial fee (Art 53). 455 The negotiations on the access rights were difficult, with Member States taking different views on the extent to which access should be liberalized: Cyprus Presidency MiFID II/​MiFIR Progress Report, n 104, 11. 456 The main administrative rules address the penalty rates for the cash penalties required as part of the settlement discipline system (Delegated Regulation 2017/​389 [2017] OJ L65/​1); the settlement internalization rules which govern settlement outside a CSD (RTS 2017/​391 [2017] OJ L65/​44); the settlement discipline system (RTS 2018/​1229 [2018] OJ L230/​1); the prudential regulation of CSDs (RTS 2017/​390 [2017] OJ L65/​9); and the authorization and regulation of CSDs (RTS 2017/​392 [2017] OJ L65/​48). 457 ESMA’s supporting soft law includes eight separate sets of Guidelines and an extensive Q&A.

V.14  Post-trading and the Settlement Process  527 core principles into the structural market change sought has not been straightforward.458 The ‘mandatory buy-​in’ element of the settlement discipline system, in particular, generated significant industry contestation, including as to its potentially prejudicial impact on liquidity.459 And like MiFID II/​MiFIR, it is proving to be a dynamic regime which has yet to settle. The Commission’s 2021 review of the Regulation was broadly positive, finding that it was achieving its objectives as regards enhancing the efficiency of settlement and the soundness of CSDs, and was not in need of major reform, but it committed to a further review, particularly as regards the CSD passport and the mandatory buy-​in system.460 The subsequent 2022 Proposal,461 which forms part of the 2020 CMU Action Plan, proposed a series of refinements, chief among them adjustments and ameliorations to the mandatory buy-​in system,462 liberalization of the passporting regime,463 and a requirement for coordinating colleges of supervisors, designed to support information exchange, where a CSD engages in passporting activity or is part of a group comprised of two or more CSDs authorized in at least two Member States. Of strongly operational orientation, and concerned to moderate the impact of the Regulation, the Proposal illustrates the increasingly technical, and technocratically informed, quality of EU financial markets regulation.

458 The 2020 High Level Forum Report on CMU highlighted that CSD services remained fragmented across national markets and called for reforms: n 262, 16 and 77–​8. 459 n 449. 460 n 449. 461 n 436. 462 The Proposal suggested a series of reforms, including that the buy-​in requirement not apply where the ‘fail’ is not attributable to the counterparties to the transaction, a phasing-​in system (based on monitoring market conditions), and a suspensive mechanism through which the Commission could suspend the buy-​in requirement for particular classes of financial instruments or transactions where serious threats to financial stability or to the orderly functioning of markets arose (akin to that already available as regards the EMIR CCP clearing obligation). 463 It changes the current passporting regime from a system which accommodates host NCA veto (Art 23(6)), to one based on notification (and so aligns the regime more closely with that in operation across the single rulebook).

VI

TRADING VI.1 Introduction VI.1.1  Regulating Trading This chapter is concerned with trading (order execution) in financial instruments. Regulation of the trading process has long been associated with the support of market efficiency and efficient resource allocation, and with the related protection of liquidity and the facilitation of risk management.1 It has also long been associated, particularly in the brokerage context, with investor protection, given the significant agency risks, including with respect to conflicts of interest, which can arise, as the 2021 Gamestop/​‘meme-​stock’ episode suggested as regards payment-​for-​order-​flow risks.2 Trading, and particularly proprietary dealing, can also, however, generate systemic risks to financial stability, particularly where solvency and liquidity risks are passed down through chains of counterparties.3 But it was not until the financial-​crisis era that the regulation of trading closely engaged with financial stability risks particularly, as noted below, in derivatives markets. The swingeing reforms which followed have since been associated with the relative resilience of the trading process internationally in the face of a series of subsequent disruptions, including the acute volatility, and related pressure on liquidity, unleashed by the Covid-​19 pandemic in 2020. The pandemic and, subsequently, the volatility in certain energy derivatives markets following the Russian invasion of Ukraine in early 2022 did, however, sharpen the post-​ financial-​crisis era focus on the risks posed by non-​bank financial intermediation and on related trading risks, including as regards the heavy dependence in certain bond markets on dealer-​based liquidity and the related risks of an abrupt reduction in dealing capacity (as happened over 2020); and as regards the capacity of margin to manage risks in derivatives trades in times of acute volatility (given the liquidity strains, consequent on the increased margin requirements imposed in response to volatility in energy derivatives markets, that emerged in 2022).4

1 See, eg, Amihud, Y and Mendelson, H, ‘Asset Pricing and the Bid Ask Spread’ (1986) 17 JFE 223 and Levine, R, ‘Financial Development and Economic Growth: Views and Agenda’ (1997) 35 J of Econ Lit 685. 2 See section 2.2. 3 For an early perspective see Franks, J and Mayer, C, Risk, Regulation and Investor Protection. The Case of Investment Management (1989) 158. 4 The series of reports from the international standard-​setting bodies that followed the period of elevated volatility in 2020 as the Covid-​19 pandemic deepened found that the regulatory framework was resilient and had proved robust in the face of a significant test. They suggested, however, a series of reforms, primarily as regards the financial stability risks posed by non-​bank financial intermediation, and including in relation to trading risk management: eg, FSB, Enhancing the Resilience of Non-​Bank Financial Intermediation. Progress Report (2022) and FSB, Lessons Learnt from the Covid-​19 Pandemic from a Financial Stability Perspective (2021). On non-​bank financial intermediation see further Ch III section 3.2.1.

530 Trading Much of the international financial-​crisis-​era financial stability agenda as regards trading focused on derivatives trading. The systemic instability which can flow from trading positions in derivatives, and from related poor risk management, was laid bare by the disruption that the over-​the-​counter (OTC) derivatives markets, in particular for credit derivatives, experienced over the crisis. Major reforms followed, chief among them the central clearing counterparty (CCP) clearing obligation, the related obligation to trade certain derivatives on trading venues, and rules governing risk management in bilaterally cleared transactions, including margin and collateral requirements. Relatedly, the crisis-​era agenda pulled financial institutions’ ‘trading books’ (broadly, their trading activities) more fully into prudential regulation, including by means of capital, liquidity, and risk management requirements. It also led to a sharper focus on the risks posed by non-​bank financial intermediation, including as regards the securities financing transactions that support trading activities but that can generate liquidity and solvency risks, and to related regulatory reform. These reforms all now form part of the EU trading ‘rulebook’, alongside the organizational and conduct rules relating to the order execution process which have been a part of EU financial markets regulation since the 2004 Markets in Financial Instruments Directive I (MiFID I).5 The financial stability agenda also led, in some jurisdictions internationally, to trading being drawn into structural reform of the banking sector, by means of reforms designed to address the ‘too big to fail’ subsidy enjoyed by systemically significant banks which carry out household/​commercial deposit-​taking and lending functions alongside wholesale market intermediation. Ring-​fencing and similar structural reforms, designed to reduce incentives for risk-​taking by taking trading and other riskier activities outside the scope of deposit protection and of the implicit ‘too big to fail’ subsidy, followed,6 albeit not in the EU.7 Alongside these stability-​oriented reforms, the EU reform agenda took an idiosyncratic turn, and tilted towards cooling speculation.8 This is most evident in the short selling regime adopted in 2012 and in the failed 2011 proposal for a financial transactions tax,9 but 5 Directive 2004/​39/​EC [2004] OJ L145/​1. 6 The US led the way with the highly contested ‘Volcker Rule’ (2010 Dodd-​Frank Act s 619), which prohibits specified banking entities from engaging in short-​term proprietary trading (market-​making and hedging activities are permitted), and from acquiring or retaining any equity, partnership, or other ownership interest in or sponsoring a hedge fund or private equity fund. It was refined as regards its impact on fund investments in 2020. See, eg, Schwarcz, S, ‘Ring-​Fencing’ (2013) 87 So Cal LR. 7 In 2014, and following the report of the Liikanen Group (High-​level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report (2012)), the Commission presented a report for ‘ringfencing’ proprietary trading and the taking of positions in hedge funds, by means of a prohibition on such activities taking place within the same banking group (the Proposal addressed large, systemically significant groups): COM(2014) 43. The Proposal did not gather sufficient political support and, also given cognate reforms in support of financial stability, including the Banking Union supervision/​resolution reforms and the reforms to bank prudential regulation generally, was abandoned in 2017 (COM(2017) 650). For an examination of the political economy of the Proposal see Quaglia, L and Spendzharova, A, ‘The Conundrum of Solving ‘Too Big to Fail’ in the European Union: Supranationalization at Different Speeds’ (2017) 55 JCMS 1110. On the Proposal and the foundational Liikanen Report see, eg, Binder, J-​H, To Ring-​Fence or Not, and How? Strategic Questions for Post-​Crisis Banking Reform in Europe (2014), available via . 8 The European Parliament’s crisis-​era suspicion of trading in derivatives is indicative of this dynamic, eg, European Parliament, Resolution on Derivatives Markets: Future Policy Actions, 15 June 2010 (P7_​TA(2010) 0206), calling on the Commission to look into ways of significantly reducing the overall volume of derivatives so that the volume was proportionate to the underlying securities. 9 COM(2011) 594. The proposal was withdrawn following its failure to garner the required unanimity support from the Member States. Subsequently, a 2013 Proposal (COM(2013) 72) sought to progress the reform under the ‘enhanced cooperation procedure’ (the UK’s challenge to the validity of the Council’s authorization of enhanced cooperation failed: Case C-​209/​13 UK v Council (ECLI:EU:C:2014:283)). Eleven Member States originally joined the process (now ten, following the withdrawal of Estonia), but progress has been slow, although Germany

VI.1 Introduction  531 is also reflected in the 2014 reforms to algorithmic trading. It is not unexpected that the financial crisis pulled the trading process more generally into the regulatory net; benign shareholders, traders, and risk managers can quickly become recharacterized as speculators and predators as the economic effects of crisis spread.10 The crisis era relatedly prompted a concern to monitor and manage financial innovation, and generated some scepticism as to the benefit of ever higher levels of market intermediation, of greater market completeness achieved through the use of derivatives, and, of speculative trading activities.11 The 2009 Turner Review (UK), for example, called for regulatory policy to balance the benefits of market completion and market liquidity with the drawbacks of instability,12 while French regulatory policy also underlined the risks of socially inefficient speculation.13 The EU’s crisis-​era trading reforms reflected this concern to support ‘productive’ financial markets, but they were also coloured, in places, by some scepticism toward perceived ‘excessive’ speculation, reflecting longstanding suspicion of freebooting market capitalism in some Member States, as well as the fiscal impact of turmoil in the EU’s sovereign debt markets.14 Since the financial-​crisis era, trading regulation has been one of the quieter corners of financial markets regulation internationally. The protracted development of the derivatives markets reforms and also of the trading book prudential regulation reforms has, however, meant that, more than a decade from the financial crisis, some reforms are still coming into force. Further, the continued focus by the EU (and by the international standard-​setting bodies, particularly the Financial Stability Board (FSB)) on the risks posed by non-​bank financial intermediation, and particularly on related risks to financial stability where volatility is elevated, has kept the resilience of the regulatory scheme supporting derivatives trading in particular under scrutiny.

VI.1.2  Regulating Trading and the EU: A Distinct Setting The EU order execution or trading regime, primarily applicable to investment firms,15 is significantly wider and deeper than its pre-​financial-​crisis precursor. It applies, for example, to a wider range of financial instruments, notably derivatives; imposes more extensive supervisory reporting and disclosure requirements, including as regards short selling, securities financing transactions, and derivatives transactions; applies more demanding risk management requirements, including the CCP clearing and trading obligations that apply in the derivatives markets; and deploys more intrusive tools, notably the tools that national presented a revised proposal in 2019 and a further proposal was suggested by Portugal in 2021. Since then, some Member States have adopted similar taxes, including France, Italy, and Spain. 10 Hill, J, ‘Why did Australia Fare so Well in the Global Financial Crisis’ in Ferran, E, Moloney, N, Hill, J, and Coffee, J, The Regulatory Aftermath of the Global Financial Crisis (2012) 203. 11 On the related debate on the ‘dark side of liquidity’ and its leading proponents, including Keynes in the 1930s and Tobin in the 1970s, see O’Hara, M, Liquidity and Financial Market Stability, National Bank of Belgium WP No 55 (2004), available via . 12 UK Financial Services Authority (FSA), The Turner Review. A Regulatory Response to the Global Financial Crisis (2009). 13 Authorité des Marchés Financiers (AMF), What are the Priorities for Financial Markets? (2011). 14 Illustrated, eg, by European Parliament, Resolution on Innovative Financing at a Global and European Level, 8 March 2011 (P7_​TA(2011) 0080). 15 And also credit institutions carrying out investment services/​activities. On the investment firm/​credit institution perimeter see Ch IV section 5.

532 Trading competent authorities (NCAs) and the European Securities and Markets Authority (ESMA) can deploy as regards short selling and in the commodity derivatives markets. This regime is split across a number of measures which developed and were adopted over different stages of the financial crisis and post-​financial-​crisis eras. The 2014 MiFID II/​MiFIR provides the over-​arching regulatory framework (section 2).16 It is supported by the 2019 Investment Firm Directive and Investment Firm Regulation (IFD/​IFR) and the 2013 Capital Requirements Directive IV/​Capital Requirements Regulation (CRD IV/​CRR) (as revised in 2019)17 regime as regards the prudential regulation of investment firms. The 2012 Short Selling Regulation,18 one of the first crisis-​era measures, addresses short selling practices (section 3). The 2015 Securities Financing Transactions Regulation,19 a post-​crisis measure and of a financial stability orientation, addresses securities financing transactions, primarily as regards supervisory reporting and market disclosure (section 4). The 2012 European Market Infrastructure Regulation (EMIR),20 like MiFID II/​MiFIR a cornerstone of the crisis-​era reform agenda, is the pivotal measure governing trading in the derivatives markets, although these markets are addressed across the ‘trading rulebook’, including by MiFID II/​MiFIR and as regards the Derivatives Trading Obligation (section 5).21 The EU ‘trading rulebook’ discussed in this chapter is of great breadth, capturing a wide range of financial instruments, trading practices, and counterparties. It is also muscular. The prohibition on ‘uncovered’ short sales and the powers of NCAs (and of ESMA) to restrict or prohibit short selling (Short Selling Regulation), the position limits placed on commodity derivatives under MiFID II//​MiFIR, and the CCP clearing obligation, the bilateral clearing margin requirements, and the Derivatives Trading Obligation (EMIR and MiFID II/​MiFIR), all have market-​shaping effects and can be liquidity-​constraining. But the rulebook is also infused with moderating mechanisms, such as suspensive powers (including the power of the Commission to suspend the CCP clearing obligation; and the powers of NCAs to suspend the prohibition on ‘uncovered’ sovereign debt credit default swaps) and adjustments (such as the many phase-​ins that have accompanied the EMIR regime), designed to support liquidity. These moderating mechanisms are supported by the now massive data-​set on trading which has been constructed since the crisis-​era reforms, including on net short positions (Short Selling Regulation), securities financing transactions (Securities Financing Transactions Regulation), and derivatives (EMIR), much of which is hosted through trade repositories and at the centre of which sits ESMA. This data-​set 16 Markets in Financial Instruments Directive II 2014/​65/​EU [2014] OJ L173/​349 (MiFID II) and Markets in Financial Instruments Regulation (EU) No 600/​2014 [2014] OJ L173/​84 (MiFIR). On the evolution of MiFID II/​ MiFIR see Ch IV. 17 Directive (EU) 2019/​2034 [2019] OJ L314/​64 (IFD) and Regulation (EU) 2019/​2033 [2019] OJ L314/​1 (IFR); Directive 2013/​36/​EU [2013] OJ L176/​338 (Capital Requirements Directive IV (CRD IV)) and Regulation (EU) No 575/​2013 [2013] OJ L176/​1 (Capital Requirements Regulation (CRR)) (revised in 2019 by Directive (EU) 2019/​ 878 [2019] OJ L150/​253 (CRD V) and Regulation (EU) 2019/​876 [2019] OJ L150/​1 (CRR 2); the revised regime is referred to in this chapter as CRD IV/​CRR). 18 Regulation (EU) No 236/​2012 [2012] OJ L86/​1. On its development see section 3. 19 Regulation (EU) 2015/​2365 [2015] OJ L337/​1. On its development see section 4. 20 Regulation (EU) No 648/​2012 [2012] OJ L201/​1. On its development see section 5. 21 Trading is also supported by the weight of rules which govern market efficiency and integrity generally, including the rules governing the prohibition of market abuse and insider dealing considered in Ch VIII, the reporting rules which require disclosure of ownership of certain equity positions (Ch II section 5.8), and the MiFID II/​MiFIR requirements governing the venues on which order execution takes place, including trade transparency rules and also transaction reporting requirements (Ch V). Inevitably, there is some overlap between the coverage of Chs V and VI, in particular as regards order execution venues. eg, the trade transparency rules discussed in Ch V include the transparency rules which govern bilateral trades away from organized venues in the OTC markets.

VI.2  MiFID II/MiFIR: The Regulation of Trading  533 supports supervision, but it also supports review and adjustment of the trading rulebook. Relatedly, the trading rulebook is dynamic (the position limits regime and the CCP clearing obligation, for example, have been adjusted in light of market practice) and so is showing some capacity to adapt. Notably, the acute volatility and disruption to pricing mechanisms in energy and energy derivatives markets which followed Russia’s invasion of Ukraine in February 2022 led to a targeted suite of actions under the Commission’s related work-​plan (noted below in this chapter). The ‘trading rulebook’ is more heavily tilted towards EU operationalcoordination and intervention than other elements of the single rulebook. The EMIR regime places CCP supervision within a distinct institutional framework, with NCA, college of supervisor, and ESMA components. ESMA is the exclusive supervisor of EMIR trade repositories. The Short Selling Regulation (as regards short-​selling-​related intervention) and MiFID II/​MiFIR (as regards position limits) empower ESMA to review NCA action but also empower ESMA to take direct, executive action, in exceptional circumstances. Relatedly, ESMA’s technocratic imprint on the trading rulebook is marked. The channels through which it exerts influence are many, including its construction of a burgeoning soft law ‘rulebook’ composed of often granular Guidelines and Q&As; its empirical review of, and advice to the Commission on, whether classes of derivatives should be subject to the CCP clearing obligation and to the Derivatives Trading Obligation and on whether those obligations should be suspended; its use of ‘supervisory forbearance’ techniques to moderate the impact of binding rules, in particular under the EMIR regime; its oversight over and interrogation of the now vast data-​set on trading; and its intensifying influence on legislative reform by means of the extensive and empirically informed reports it provides to the Commission on review of legislation. So far, the ‘trading rulebook’ has not experienced undue strain. As noted below in this chapter, the periods of acute volatility associated with the Gamestop/​meme-​stock episode, the Covid-​19 pandemic, and Russia’s invasion of Ukraine did not expose significant weaknesses. But the exemptions, calibrations, and technical adjustments that strongly characterize this regime underline its capacity to generate unintended effects and the need for nimble response.

VI.2  MiFID II/​MiFIR: The Regulation of Trading VI.2.1  The MiFID II/​MiFIR and IFD/​IFR/​CRD IV/​CRR Framework MiFID II/​MiFIR, as supported by the parallel IFD/​IFR and CRD IV/​CRR prudential regime, governs the trading process generally. The MiFID II/​MiFIR regime, although based on its MiFID I precursor, is significantly wider in reach, reflecting the financial-​crisis-​era concern to close regulatory gaps and to address the stability risks associated with financial markets.22 Similarly, the recent enhancement and intensification of risk management and capital requirements for trading activities, under the prudential regime for investments firms and particularly through the 2019 CRD V/​CRR 2 reforms to CRD IV/​CRR 22 The final MiFID II/​MiFIR trilogue (Commission/​Council/​European Parliament) negotiations, in particular, saw more intrusive regulation imposed, particularly with respect to algorithmic trading, market-​making, and position management.

534 Trading and through the 2019 IFD/​IFR, is designed to contain the risks posed by trading, and in particular dealing, and which had not previously been captured fully by the EU’s prudential requirements. The investment services and activities governed by MiFID II/​MiFIR cover the reception and transmission of orders, the execution of orders on behalf of clients (broking), and dealing on own account (unless an exemption is available),23 in each case in MiFID II/​ MiFIR ‘financial instruments’.24 The conduct of these activities and the provision of these services accordingly requires authorization under MiFID II and is subject to its organizational requirements (including conflict-​of-​interest management requirements) and conduct rules (including as regards fair treatment and disclosure) (Chapter IV),25 as well as to the trade transparency reporting and supervisory transaction reporting required by MiFIR (Chapter V). The CRD IV/​CRR and IFD/​IFR prudential rulebooks also apply and include capital requirements for firms’ ‘trading books’, as well as liquidity, risk management, and supervisory reporting/​disclosures requirements (Chapter IV). In addition, the MiFID II conduct regime for investment firms contains several requirements specific to order execution, which have been subject to detailed amplification,26 and which are discussed in the following section.27

VI.2.2  The Order Execution Process VI.2.2.1 Best Execution and Payment-​for-​order-​flow The MiFID II Article 27 ‘best execution’ requirements are of central importance in the MiFID II order execution regime. Best execution requirements are a form of conduct regulation. They address the agency risks of brokerage services, in particular the conflict-​ of-​interest risks to which the order-​routing decisions made by brokers can be subject to, given commission and other incentives. They can broadly be regarded as requiring execution intermediaries to seek the ‘best possible result’ for their clients.28 Best execution requirements also support market efficiency more generally, particularly where trading is fragmented across competitive order-​execution venues, as they require intermediaries to tie together execution data from different venues, and thereby support the price formation process. Best execution rules can, however, pose formidable design challenges.29 While the ‘best possible result’ is often associated with price, best execution obligations should reflect the range of factors that shape execution outcomes, including the impact of trading costs, 23 On the dealing exemptions see Ch IV section 6.1. Own-​account dealing in commodity derivatives benefits from a specific exemption broadly designed to protect commercial hedging activities (Art 2(1)(j)). 24 See Ch IV section 5.3 on the scope of ‘financial instruments.’ 25 Where a transaction is between eligible counterparties, the MiFID II conduct regime does not apply and investment firms are subject only to an obligation to act honestly, fairly, and professionally, and to communicate in a way that is fair, clear, and not misleading, taking into account the nature of the eligible counterparty and its business: Art 30. See further Ch IV 6.2. 26 Primarily by Delegated Regulation 2017/​565 [2017] OJ L87/​1 (best execution and order handling); RTS 2017/​ 575 [2017] OJ 87/​152 and RTS 2017/​576 [2017] OJ L87/​166) (best execution reporting); RTS 2017/​578 [2017] OJ L87/​183 (market-​making); RTS 2017/​589 [2017] OJ L87/​417 (algorithmic trading); and RTS 2022/​1302 [2022] OJ L197/​52 (position limits). Also, derivatives trading is addressed by a suite of rules considered in section 5. 27 These requirements are dis-​applied from trades between eligible counterparties. 28 Macey, J and O’Hara, M, ‘The Law and Economics of Best Execution’ (1997) 6 J Fin Intermed 193. 29 For a recent analysis see Krüger Andersen, P, ‘Time to Reduce Complexity in a Data-​Driven Regulatory Agenda—​Perspectives on the MiFID II Best Execution Regime’ (2020) 17 ECFR 692.

VI.2  MiFID II/MiFIR: The Regulation of Trading  535 the importance of speed of execution (particularly where market impact costs arise), the depth of liquidity and market structure, the nature of the financial instrument (the best execution obligation engages differently with equity transactions as compared with those in customized derivatives), and the nature of the order.30 They can also be challenging to meet in a competitive order execution market where execution data is fragmented. Reflecting these challenges, the MiFID II best execution regime continues to evolve (as noted below), but it remains based on the principles established by MiFID I. Prior to MiFID I, best execution regulation was not well developed across the EU, given the impact of the ‘concentration rule’ which, in the Member States where it applied, required retail orders to be routed through the local central stock exchange and which, in effect, delivered a form of best execution by requiring the pooling of liquidity on exchanges. MiFID I subsequently imposed a harmonized best execution obligation as a mitigant against the fragmentation and also conflict-​of-​interest risks generated by MiFID I’s introduction of a competitive order execution model (see Chapter V).31 While a novelty at the time, and requiring significant amplification,32 the MiFID I best execution obligation was regarded as broadly successful and was not significantly reformed by MiFID II. The MiFID II reforms were primarily concerned with supporting the achievement of best execution by requiring additional reporting on execution quality. The MiFID II best execution regime (Article 27) is based on a widely cast best execution obligation which is buttressed by related execution policy, execution-​policy-​monitoring, execution data collection, and disclosure requirements (Article 27(1)).33 Under Article 27(1), investment firms must take all ‘sufficient’34 steps when executing orders35 to obtain the ‘best possible result’ for their clients, taking into account price, costs, speed, likelihood of execution and settlement, size, nature, and other relevant considerations,36 which can

30 Ferrarini, G, ‘Contract Standards and the Markets in Financial Instruments Directive’ (2005) 1 Euro Rev Contract L 19, 38. 31 See Ferrarini, G, ‘Best Execution and Competition Between Trading Venues—​MiFID’s Likely Impact’ (2007) 2 CMLJ 404. The Commission described the new best execution rule as ‘central to the structure and logic of the Directive. [Best execution obligations] not only form a fundamental element of investor protection, but are also necessary to mitigate possible problems associated with market fragmentation’: Commission, Background Note to the Draft Commission Directive, February 2006, 24 32 Primarily by the administrative 2006 Commission MiFID I Directive (Directive 2006/​73/​EC [2006] OJ L241/​ 26) but also by CESR and, unusually, Commission soft law (CESR, Best Execution under MiFID. Questions and Answers (2007); and Commission, Working Document ESC/​07/​2007, Commission Answers to CESR Scope Issues under MiFID and the Implementing Directive). 33 Administrative rules amplify the best execution criteria and best execution requirements (Delegated Regulation 2017/​565) and the execution reporting requirements (RTS 2017/​575 and RTS 2017/​576). 34 The MiFID II Proposal applied a ‘reasonable’ standard but the European Parliament inserted a higher ‘necessary’ standard: MiFID II, Parliament Negotiating Position, 28 October 2012 (P7_​TA (2012) 0406) Art 27(1). ‘Sufficient’ was the compromise solution. 35 Article 27 applies to the execution of orders and not, directly, to the related services of portfolio management and reception/​transmission of orders, although these MiFID II services also engage execution venue decisions. In an administrative solution developed earlier for the MiFID I obligation, the best execution requirements are applied to such services through the operation of the Art 24 fair treatment requirement. Delegated Regulation 2017/​ 565 provides that, in providing such services, the relevant firm must comply with Art 24 and, in so doing, take all sufficient steps to obtain the best possible result for clients taking into account the Art 27 best execution factors, establish a related policy, and follow disclosure and monitoring obligations similar to those applicable under Art 27: Art 65. 36 Delegated Regulation 2017/​565 specifies that in determining the relative importance of these factors, firms must take into account the client’s characteristics (including its classification as retail or professional) and the characteristics of the order, financial instrument, and execution venue: Art 64.

536 Trading include whether the order is traded OTC.37 Relatedly, investment firms must establish and implement ‘effective arrangements’, including an order-​execution policy,38 to allow them to obtain the ‘best possible’ result in accordance with Article 27(1) (Article 27(4)). Best execution is therefore a function of the construction and application of pre-​defined processes, rather than of a particular price benchmark, as is underlined by the obligation on the firm to monitor its best execution policy and related execution arrangements (Article 27(7)), to demonstrate to clients, on request, that their orders have been executed in accordance with the policy (Article 27(8)), and to demonstrate compliance with Article 27 to NCAs (Article 27(8)). The firm is further subject to an obligation, designed to support client monitoring, to provide clients with appropriate information on its order-​execution policy which explains clearly, in sufficient detail, and in a way that can easily be understood by clients, how orders will be executed (Article 27(5)).39 The best execution obligation reflects client autonomy: where there is a ‘specific instruction’ from the client, the firm must execute the order following the specific instruction (Article 27(1)). Some prescription is, however, imposed on the firm’s execution policy (and thereby on the firm’s execution practices) by Article 27(5), which requires that the policy, to which clients must consent (Article 27(5)), must include, in respect of each class of financial instrument, information on the different venues where the investment firm executes its client orders, and on the factors affecting the choice of execution venue. The firm must also at least include in its policy those venues that enable the firm to obtain, on a ‘consistent basis’, the ‘best possible’ result for the execution of client orders. In a muscular intervention which privileges trading on organized venues, but which reflects the MiFID II/​MiFIR concern to promote trading on organized venues (Chapter V), the firm must inform clients where the policy provides for client orders being executed outside a MiFID II/​MiFIR ‘trading venue’, and obtain the ‘prior express consent’ of clients before executing orders outside a trading venue (Article 27(5)).40 The more elaborate and complex the best execution policy, however, the greater the likelihood of costs being passed on to clients; the cost burden for retail clients, in particular, where extensive search costs are imposed on firms, could become significant. The MiFID I regime therefore established a price benchmark for best execution in the retail markets, which was incorporated within MiFID II. Under Article 27(1), the best possible execution result for retail clients is to be determined in terms of the ‘total consideration’, representing the price of the financial instrument and the execution costs (including all expenses, including clearing and settlement fees, incurred by the client directly related to order execution). Conflicts of interest, including those arising from the payment-​for-​order-​flow arrangements implicated in the Gamestop saga (noted below), are expressly addressed: the firm must not receive any remuneration, discount, or non-​monetary benefit for routing client orders to a particular venue where that benefit would be in breach of the MiFID II 37 Relatedly, when executing orders or taking orders to deal in OTC products, including bespoke products, the firm must check the fairness of the price, by gathering market data used in the estimation of the price and, where possible, by comparing with similar or compatible products: Delegated Regulation 2017/​565 Art 64(4), 38 Which must be regularly reviewed, along with relevant execution arrangements: Art 27(7). 39 The disclosures required are specified in detail by Delegated Regulation 2017/​565 Art 66 (including as to the list of venues, how the execution criteria are weighed, factors for venue selection, and disclosures regarding execution outside trading venues). Specific requirements apply to retail clients who must be provided with a summary of the policy: Art 66(9). 40 On MiFID II/​MiFIR ‘trading venues’ see Ch V.

VI.2  MiFID II/MiFIR: The Regulation of Trading  537 conflict-​of-​interest rules (Article 27(2)).41 Similarly, where, in accordance with the firm’s execution policy, there is more than one execution venue for a particular transaction, and in order to assess and compare the potential execution outcome for the client, the firm’s commission and costs must be taken into account in the assessment (Article 27(1)). MiFID II also experimented with two new forms of execution-​data reporting requirement, designed to support best execution: one firm-​oriented and directed to supporting client choice and client monitoring; and one venue-​oriented and directed to support firms in achieving best execution. As regards the first, firms must annually disclose execution quality reports, covering the top five venues in terms of trading volume where they executed client orders in the preceding year, and as regards the quality of execution obtained, by reference to each class of financial instrument engaged (Article 27(6)).42 This reporting obligation has experienced some difficulties, but it remains part of the best execution architecture.43 The second reporting obligation has proved significantly more troublesome. MiFID II requires an execution venue to makes publicly available—​without charge—​data relating to the quality of execution of transactions on that venue, on at least an annual basis, and including details on price, costs, speed, and likelihood of execution (Article 27(3)).44 While this reform was welcomed at the time of its adoption,45 in practice it became associated with excessive costs and insufficient benefits.46 In a reflection of the degree of agility that can now be associated with the MiFID II/​MiFIR rulebook, the reporting requirement was initially suspended by the 2021 MIFID II ‘Quick Fix’ package of pandemic-​related alleviations;47 and the 2021 MiFID III Proposal subsequently proposed its removal.48 The 41 Delegated Regulation 2017/​565 amplifies this requirement by providing that such third-​party payments can only be received where they are in compliance with the MiFID II Art 24 conflict-​of-​interest management requirements and that clients must be informed about the inducements a firm may receive from venues: Art 66(6). MiFID II Art 24(9) prohibits the payment of commissions unless their payment enhances the quality of the relevant service and does not impair compliance with the core MiFID II Art 24(1) fair treatment obligation. On Article 24 see further Ch IX section 4.10. 42 The content required is specified by RTS 2017/​576. 43 ESMA’s MiFID II/​MiFIR Review assessment of these reports found that they were little used by retail clients, could be difficult to access, and had data quality weaknesses, but also reported on good practices as well as on some NCA support for the reports as a means of providing greater transparency on execution quality: ESMA, Review of the MiFID II Framework on Best Execution Report (2021) 9–​10. The UK authorities, however, removed the requirement, and the parallel execution venue reporting requirement, as part of the UK’s post-​Brexit reassessment of EU requirements. 44 The extensive data required was amplified by RTS 2017/​575 which specified the required reports in granular detail. 45 In justification, the Commission suggested that data relating to, eg, speed of execution and number of orders cancelled prior to execution was relevant to the assessment of best execution: 2011 MiFID II Proposal (COM(2011) 656/​4) 8. This reform received strong support from the Member States and from the buy-​side: 2011 MIFID II/​MiFIR Proposals Impact Assessment (IA) (SEC(2011) 1226) 55. 46 ESMA’s 2021 review identified a series of difficulties, including in relation to poor data quality, a lack of standardization, difficulties in accessing the reports, and a lack of clarity: n 43, 9–​10. 47 The Commission reported that the reports, which were costly to prepare, were rarely used by investors, with the buy-​side sector receiving relevant data on best execution through other means, such as meetings with their brokers: 2020 MiFID Quick Fix Proposal (COM(2020) 280) 9. ESMA had earlier suggested that NCAs apply supervisory forbearance as regards the preparation of these reports (and also the execution quality reports required of investment firms) given the exceptional conditions engendered by the pandemic and the strains on the industry: ESMA, Covid-​19: Clarification of Issues Relating to the Publication of Reports by Execution Venues and Firms as Required by RTS 27 and 28 (2020). The suspension was achieved by Directive (EU) 2021/​338 [2021] OJ L68/​14. 48 COM(2021) 726. The potential gap between the end of the Quick Fix suspension period (February 2023) and the coming into force (if agreed) of the MiFID III Proposal’s removal of the obligation, led ESMA (which had, in its 2021 review, called for a more simplified venue reporting system, not its abolition) to call on NCAs to exercise supervisory forbearance over any transitional period as regards the reports: ESMA, Application of the Temporary Suspension of the Obligation to Produce RTS 27 Reports (2021). On supervisory forbearance see Ch I section 6.

538 Trading reform is, in some respects, a story of the EU’s increasing capacity to manage technical and operational complexity, but it also speaks to the challenges faced by firms in achieving best execution in a market still characterized by a fractured data reporting system (see further Chapter V). The scale and speed of technological innovation in the trading/​brokerage process, and in particular the development of low-​cost/​zero commission online trading apps, has placed further pressure on best execution as a tool for supporting investor protection and market efficiency. The early 2021 US equity market Gamestop/​’meme-​stock’ volatility spike focused attention on a multitude of equity market regulatory design issues.49 These included best execution requirements, given the extent to which low-​cost/​zero commission online brokerage/​trading apps can be funded through ‘payment-​for-​order-​flow’ arrangements.50 Under these funding arrangements, the brokerage firm providing the low-​cost/​zero commission trading app is paid a fee, by the relevant venue, for directing its order flow to that venue, most usually a specialized investment firm. The practice therefore raises conflict-​of-​ interest risks, as the price achieved by the retail investor may be poorer as a result. It also generates the risk of misleading disclosures being provided as regards the real costs engaged by use of the app. In the EU, the combined effect of the MiFID II Article 27 best execution obligation, the requirement to take all appropriate steps to identify, prevent, or manage conflicts of interest (Article 16(3) and Article 23), the prohibition on receipt of commission in relation to the provision of investment services, unless the commission enhances the quality of the service (Article 24(9)), and the foundational obligation to act in the best interests of the client (Article 24(1)), renders payment-​for-​order-​flow arrangements difficult, although not impossible, to structure.51 The Gamestop episode, however, drew close political and technocratic attention to EU firms’ compliance with these rules,52 as well as 49 Coordinated action by retail investors (primarily via the Reddit social media platform) against short hedge fund positions in Gamestop led to the Gamestop price soaring. It also led to one of the brokerage/​trading apps widely used by the Reddit community (Robinhood) coming under pressure from margin calls relating to these open equity positions and subsequently suspending trading. While the Gamestop share price subsequently stabilized, the fracas (and similar volatility in other ‘meme stocks’: ‘meme stocks’ are those which become associated with social-​media-​related mass trading campaigns) led to a sharp focus on a range of related, primarily retail-​ market-​oriented, issues, including as to the operation of market manipulation prohibitions, the dynamics of short selling, the behavioural dynamics of online trading, and the implications of coordinated retail investor trading for market efficiency. From the extensive literature Gamestop generated, and for a wide-​angled analysis see Macey, J, ‘Securities Regulation and Class Warfare’ (2021) Co Bus LR 796. The episode is noted in this Ch in relation to payment-​for-​order-​flow practices and as regards short selling, and in Ch IX in relation to retail market regulation. 50 At the time of writing, the US Securities and Exchange Commission (SEC) was considering a range of potential reforms to retail market order handling, in the wake of Gamestop and recent market changes, and given concerns as to a lack of competition in retail market execution, including as regards the introduction of a best execution rule (best execution is a function of the self-​regulatory industry bodies in the US, not SEC regulation); enhanced transparency on order execution data; and, the reform likely to generate most contestation, ‘order by order competition’ which would seek, through auction-​related reforms, to ensure greater competition in the execution of retail orders (currently carried out, in very large part, by a small number of wholesale dealers/​off-​exchange venues). The SEC is also examining conflict-​of-​interest risk in payment-​for-​order-​flow: Gensler, G (SEC Chair), Remarks (Piper Sandler Conference), 8 June 2022. Initial industry reaction has been critical, with concern, eg, as to unintended effects and the lack of empirical grounds for reform: Megaw, N and Darbyshire, M, ‘SEC Chief Launches Review of ‘Uneven’ US Equities Market’, Financial Times, 9 June 2022. 51 ESMA’s view is that, given the multiple requirements that apply, and the serious investor protection concerns driving from the elevated conflict-​of-​interest risk, it is ‘in most cases unlikely’ that payment-​for-​order-​flow practices are MiFID II-​compliant, although it cannot be conclusively determined that its use is ‘entirely incompatible’ with MiFID II: ESMA, Final Report on the Commission Mandate on Certain Aspects relating to Retail Investor Protection (2022) 50. 52 At the time of the Gamestop episode, ESMA issued a Public Statement stating its view that, in light of the potential for conflicts of interests, and the operation of the MiFID II conflict-​of-​interest management and best execution requirements, payment-​for-​order-​flow ‘raises serious investor protection concerns. . . .[and] in most cases it is

VI.2  MiFID II/MiFIR: The Regulation of Trading  539 supervisory attention.53 Notwithstanding the MiFID II restrictions on payment-​for-​order-​ flow, the episode can also be in part associated with the Commission’s 2021 proposal of a complete prohibition on investment firms receiving a fee, commission, or non-​monetary benefit for forwarding client orders to a third party for execution,54 although this proposal is also designed to support transparency in the equity markets more generally.55 While supported by ESMA,56 it is a potentially controversial reform, given the strict conditions already imposed by MiFID II on payment-​for-​order-​flow, conflicting evidence on whether order execution venues using payment-​for-​order-​flow achieve better execution returns,57 and some industry concern that a prohibition could limit brokerage firms’ capacity to provide low-​cost access to trading.58

VI.2.2.2 Order Handling The MiFID II conduct regime also includes rules governing the order handling process (Article 28). Investment firms must implement procedures and arrangements which provide for prompt, fair, and expeditious execution of client orders, relative to other client orders and the trading interests of the firm. Article 28 also imposes a time-​priority rule which requires firms to execute otherwise comparable orders in accordance with the time of their reception. These requirements, which have been amplified by administrative rules,59 are designed to enhance confidence in the impartiality and quality of execution services in a

unlikely that payment-​for-​order-​flow could be compatible with MiFID II’: ESMA, Public Statement (Warning on Payment-​for-​Order-​Flow), 13 July 2021. This intervention came amidst considerable attention from the European Parliament, which held a hearing on Gamestop at which ESMA and the Commission underlined how MiFID II limited the potential for payment-​for-​order-​flow arrangements: ESMA Chair Maijoor, Introductory Statement (ECON Exchange of Views in Relation to Gamestop Share Trading and Related Phenomena), 23 February 2021. Earlier, on the eve of MiFID II coming into force, the UK authorities had taken a similar view that the MiFID II conflict-​of-​interest rules, together with its fair treatment requirements, restricted payment-​for-​order-​flow: UK FCA, Dear CEO Letter (Payment for Order Flow), 13 December 2017. 53 ESMA requested NCAs to prioritize payment-​for-​order-​flow in their supervisory activities for 2021/​ 2022: 2021 Public Statement, n 52. 54 MiFIR II Proposal COM(2021) 272, MiFIR new Art 39a. The reform proposes that investment firms acting on behalf of clients shall not receive any fee or commission or non-​monetary benefit from any third party for forwarding client orders to such third party for their execution. 55 The proposed prohibition also seeks to prevent investment firms from channelling their order flow (primarily, in practice, high volume retail equity order flow) to high frequency algorithmic traders for execution, and thereby to incentivize the flow of orders to trading venues which are, under MiFIR, pre-​trade transparent: 2021 MiFIR II Proposal, n 54, 16. See further on the transparency regime Ch V. 56 ESMA supported the full prohibition given that payment-​for-​order-​flow could not conclusively be prohibited under MiFID II, and given that the conflict-​of-​interest risk it generated could lead to firms’ choosing the venue offering the highest payment rather than the venue offering the best possible outcome for the client: 2022 ESMA Retail Market Report, n 51, 49–​52. 57 The evidence presented by ESMA as to the impact of payment-​for-​order-​flow on execution prices was not conclusive. While studies from the Dutch and Spanish NCAs suggested worse prices were achieved, a German study under development suggested stronger prices were the outcomes: n 51, 52. 58 As outlined in ESMA’s examination: n 51, 50–​2. 59 Delegated Regulation 2017/​565 specifies general principles governing order allocation (as regards accurate record-​keeping and allocation, the sequential execution of comparable orders, and an obligation to inform retail clients about any material difficulties relevant to the order’s execution); prohibits, in a market-​integrity-​oriented rule, the misuse of order-​related information; and addresses conflict-​of-​interest management in the aggregation and allocation of orders: Arts 67–​9. While settlement is typically carried out through Central Securities Depositories (Ch V), the rules also specify that where settlement in internalized within a firm, all reasonable steps must be taken to ensure that client financial instruments/​funds are prompted and correctly delivered to the appropriate client account: Art 67(2).

540 Trading competitive trading environment, particularly where retail orders are ‘internalized’ by investment firms.

VI.2.3  Algorithmic Trading and High Frequency Trading Algorithmic trading and high-​frequency algorithmic trading (HFT), both forms of trading that are based on automated, algorithm-​based technology, are now established institutional features of the EU financial market, with liquidity provision by such trading now part of the EU’s market microstructure.60 MiFID II/​MiFIR has, since its 2014 adoption, shown some dynamism and agility in responding to the impact of this trading, particularly as regards the implications for market structure and transparency.61 Earlier, the introduction by MiFID II of discrete regulatory requirements governing investment firms engaging in algorithmic trading and HFT62 was a major reform, which reflected the financial-​crisis-​era concern as to the potential risks that HFT, in particular, posed to market stability and efficiency. This reform was something of an experiment in regulatory design at the time, but the 2020 MiFID II/​MiFIR Review suggested that the regime has performed well, coping with periods of high volatility and not prejudicially impacting on the liquidity provided by this form of trading.63 While the regime for algorithmic trading and HFT is now relatively stable, its adoption was accompanied by an intense debate on whether and how algorithmic trading and, in particular, HFT, should be regulated.64 HFT is a form of algorithmic trading (automated trading based on sophisticated computer technology which dictates trading decisions and which takes advantage of arbitrage opportunities) which takes place at a very speed. It is a function of algorithms that deploy high frequency orders (which are open often for less than a second) to take advantage of very short duration arbitrage opportunities; a range of techniques are used, including ‘co-​location’ in, and ‘direct’/​‘sponsored’ electronic access to, trading venues.65 A feature of EU market microstructure generally, HFT is often engaged in by specialist dealers and to implement particular trading strategies (such as arbitrage, 60 See, eg, Oxera, Primary and Secondary Markets in the EU (2020) and ESMA, MIFID II/​MiFIR Review Report on Algorithmic Trading (2021). ESMA reported that while algorithmic and high frequency trading had both increased (with in the region of 40–​60 per cent of participants on large trading venues engaging in algorithmic trading), and had extended from the more mature equity and interest rate segments to other asset classes, the incidence varied by asset class. HFT accounted for some 60 per cent of equity trading over 2018–​2019, eg, but, in the bond segment, there was little HFT, although algorithmic trading in bonds had experienced a dramatic spike from being immaterial to accounting for 80 per cent of trading in Q3 2019: at 18–​21. 61 See, eg, the reforms made to the treatment of Systematic Internalizers to address related arbitrage risks (Ch V section 5.5). 62 Parallel requirements were introduced for trading venues: Ch V. 63 ESMA’s wide-​ranging review did not suggest material revisions to the investment firm requirements, finding that they had, overall, worked well: n 60. For a critical perspective, calling for the regime to extend to simpler automated/​algorithmic systems used in order routing systems see Martins Pereira, C, ‘Unregulated Algorithmic Trading: Testing the Boundaries of the European Union Algorithmic Trading Regime’ (2020) 6 J of Fin Reg 270. 64 For a review of the debate see Woodward, M, ‘The Need for Speed: Regulatory Approaches to High Frequency Trading in the United States and the European Union’ (2017) 50 V J I’ntl L 1359. 65 Co-​location involves the firm/​trader’s servers being located within the trading venue in question. Direct electronic access involves a firm/​trader connecting directly to a trading venue through a member or participant firm; such arrangements are termed ‘sponsored access’ where the trader does not place the order through the firm’s trading infrastructure. The MiFID II approach is to term both forms of sponsored and direct access as direct electronic access and to treat both forms in broadly the same manner (MiFID II Art 4(1)(41)). Most EU HFT activity is in the form of co-​location.

VI.2  MiFID II/MiFIR: The Regulation of Trading  541 market-​making, or short-​term/​news-​driven directional strategies).66 Its risks and benefits have been well charted. It can bring significant benefits to markets in the form of deeper liquidity (high frequency traders have come to act as liquidity providers by providing continuous ‘two-​way’ (buy and sell) liquidity on major electronic order books and also by supporting dealers); narrower spreads; stronger price discovery; and better price alignment across venues.67 But it can also increase price impact costs for large trades and, thereby, increase volumes of dark trading;68 deepen volatility where HFT liquidity providers withdraw in volatile conditions;69 and, through operational failures, threaten orderly trading.70 While the debate on the merits of algorithmic trading and HFT has since receded and such trading is now a key source of liquidity in the EU market,71 it was, at the time of MiFID II’s development, raging.72 The strong association between algorithmic trading/​HFT and stability and liquidity risks, as well as the prevailing crisis-​era scepticism as to the value of financial market innovation, made algorithmic and HFT natural targets for reform. The first salvo was fired by ESMA, which adopted guidelines on automated trading environments in 2011,73 but the MiFID I Review led to MiFID II establishing a targeted legislative regime for algorithmic trading generally,74 which has been amplified by administrative rules.75 At the core of the MiFID II regime are the operational requirements for investment firms as regards ‘algorithmic trading’ generally (Article 17): algorithmic trading is defined broadly as trading in MiFID II financial instruments where a computer algorithm automatically determines individual parameters of orders (such as whether to initiate the order, the timing, price, or quantity of the order, or how to manage the order after its submission), with limited or no human intervention (Article 4(1)(39)).76 Additional reporting requirements apply to the subset of ‘high frequency algorithmic trading’,77 but the main purpose of this separate

66 See further Hagströmer, B and Nordén, L, ‘The Diversity of High Frequency Traders’ (2013) 16 J of Fin Markets 741. 67 eg, and from an extensive literature, Hendershott, T, Jones, C, and Menkveld, A, ‘Does Algorithmic Trading Improve Liquidity’ (2011) 66 J Fin 1. 68 The MiFID II concern to increase the volume of lit trading in the EU was in part driven by concerns that increased HFT activity was driving greater demand for dark trading for large trades. See further Ch V. 69 eg, Grob, S, ‘The Fragmentation of the European Equity Markets’ in Lazzari, V (ed), Trends in the European Securities Industry (2011) 127. 70 During a twenty-​minute period starting at 2:40 pm, over 20,000 trades, across more than 300 securities, were executed at prices which were some 60 per cent away from the 2:40pm prices. While the subsequent SEC/​CFTC Report identified a series of causes, it highlighted the impact of an automated ‘Sell Algorithm’ which executed trades in some 75,000 derivative contracts. SEC and CFTC, Findings Regarding the Market Events of 6 May 2010 (2010). 71 n 60. ESMA’s 2021 review found that market stakeholders were broadly positive as to the impact of algorithmic trading and HFT on market quality: n 60. 72 From the crisis-​era debate see, eg, Brogaard, J, Hendershott, T, and Riordan, R, High Frequency Trading and Price Discovery, ECB WP Series No 1602 (2013); Benos, E and Sagade, S, High-​frequency Trading Behaviour and Its Impact on Market Quality, Bank of England WP No 469 (2012); and Angel, J, Harris, L, and Spatt, C, ‘Equity Trading in the 21st Century’ (2011) (1) Q J of Fin 1. 73 ESMA, Guidelines on Systems and Controls in an Automated Trading Environment for Trading Platforms, Investment Firms and Competent Authorities (2011). ESMA’s Guidelines built on earlier CESR work, including CESR, Microstructural Issues of the European Equity Markets (2010). 74 The Commission, Council, and European Parliament were all in agreement on the need to bring algorithmic trading and HFT within the regulatory net, but the negotiations were contentious, with the Parliament adopting a more restrictive approach than the Council and prevailing, for the most part. 75 Primarily Delegated Regulation 2017/​565 (definitions) and RTS 2017/​589 (operational requirements for investment firms). 76 Delegated Regulation 2017/​565 Art 18 specifies where a system has no or limited human intervention. 77 High frequency algorithmic trading is defined as any algorithmic trading technique characterized by: infrastructure intended to minimize network and other types of latencies (including at least co-​location,

542 Trading definition is to ensure that own-​account dealers, who engage in high frequency trading, do not benefit from the MiFID II/​MiFIR exemption for certain own-​account dealers (Article 2(1)(d) and (j)) and come within the regulatory net.78 A firm engaging in algorithmic trading is, under Article 17, subject to a targeted operational regime which requires it to have in place effective systems and risk controls, suitable to the business operated, to ensure that its trading systems are resilient and have sufficient capacity, are subject to appropriate trading thresholds and limits, and prevent the sending of erroneous orders or the systems otherwise functioning in a way that may create or contribute to a disorderly market. Effective systems and risk controls must be in place to ensure the trading systems cannot be used for a purpose contrary to the EU’s market abuse regime or contrary to the rules of a trading venue to which the firm is connected. The firm must also have in place effective business continuity arrangements to deal with trading system failures and must ensure its systems are fully tested and properly monitored to ensure compliance with MiFID II. Specific conditions (Article 17(3)), designed to protect market efficiency and avoid a sudden withdrawal of liquidity, apply where the firm engages in algorithmic trading pursuing a market-​making strategy.79 In these circumstances, the firm must engage in market-​making continuously during a specified proportion of the trading venue’s trading hours, except under exceptional circumstances, with the result of providing liquidity on a regular and predictable basis to the trading venue. The firm must also enter into a binding written agreement with the trading venue (which at least specifies the obligations of the firm with respect to market-​making) and have in place effective systems and risk controls to ensure it can at all times fulfil its market-​making obligations. These conditions apply taking into account the liquidity, scale, and nature of the specific market, and the characteristics of the instruments traded. Article 17 also imposes specific controls on firms which, as members of trading venues, support direct electronic access80 by their clients (in effect, high frequency traders) to these venues (Article 17(5)). These controls, inter alia, require that effective systems and controls are in place, that clients are subject to

proximity hosting, or high speed ‘direct electronic access’ techniques (n 80)); system determination of order initiation, generating, routing, or execution, without human intervention for individual trades or orders; and ‘high message intraday rates’ which constitute orders, quotes, or cancellations: Art 4(1)(40). Delegated Regulation 2017/​565 Art 19 specifies that a ‘high message intraday rate’ constitutes at least two messages per second with respect to any single financial instrument traded on a trading venue, and at least four per second with respect to all financial instruments on a trading venue. Despite its specificity, and the pace of technological innovation, this definition has proved robust with little market concern as to its operation: 2021 ESMA Algorithmic Trading Report n 60. 78 The Art 17 regime also applies to members or participants of RMs or MTFs who are not required to be authorized under MiFID II by virtue of the exemptions for insurance undertakings, collective investment undertakings, and certain energy market participants (Art 1(5)) (save for the direct electronic access requirements which are disapplied). 79 A firm pursues a market-​making strategy when, as a member or participant of one or more trading venues, its strategy, when dealing on own account, involves posting firm, simultaneous two-​way quotes of comparable size, and at competitive prices, relating to one or more financial instruments on a single trading venue or across different trading venues, with the result of providing liquidity on a regular and frequent basis to the overall market: Art 17(4). 80 Defined as an arrangement whereby a member or participant of a trading venue permits a person to use its trading code so the person can electronically transmit orders relating to a financial instrument directly to the trading venue (whether or not the person in question uses the infrastructure of the member or participant or any connecting system provided by the member or participant): Art 4(1)(41). The regime does not accordingly differentiate between direct and sponsored access.

VI.2  MiFID II/MiFIR: The Regulation of Trading  543 pre-​set trading and credit controls, that client trading is monitored, and that risk controls apply to prevent client trading that could generate risks for the firm or create or contribute to a disorderly market—​direct electronic access without such controls is prohibited. Firms are also responsible for ensuring that these clients comply with MiFID II and the rules of the relevant trading venue and must monitor transactions to identify breaches of rules. NCAs do not approve the highly complex models used for algorithmic trading, but extensive reporting requirements apply as regards algorithmic trading practices and their governance (Article 17(2)).81 These governing principles have been amplified in some technical and operational detail by RTS 2017/​589.82 It has proved, despite some concerns as to its impact on liquidity provision, to have worked well and to be appropriately calibrated to the automated trading/​HFT environment.83

VI.2.4  Market-​making The sensitivity towards liquidity which shapes how MiFID II/​MiFIR regulates trading and also order execution venues is evidenced by the specific treatment, by Article 17, of algorithmic trading which pursues a market-​making strategy, but also by MiFID II’s discrete treatment of market makers.84 Reflecting their pivotal importance to market liquidity and stability, firms engaging in market-​making activities do not qualify for the MiFID II exemption for own-​account dealers (Article 2(1)(d)), and so fall within MiFID II/​MiFIR and are subject to its organizational and conduct requirements, as well as to its post-​trade transparency requirements (and to the parallel prudential regulation regime). Also, specific rules apply, albeit at the trading venue level, requiring trading venues to enter into market-​ making agreements with firms which ensure that liquidity is provided to the market on a regular and predictable basis.85 Similarly, multilateral trading facilities (MTFs) and organized trading facilities (OTFs)86 must have at least three materially active members or users, each having the opportunity to interact with all the others with respect to price formation (Article 18(7)).

81 In addition, where a firm engages in high frequency algorithmic trading, it must store, in an approved form, accurate and time-​sequenced records of all its placed orders and make them available to the NCA on request (Art 17(2)). 82 n 26. An extensive, operationally oriented measure it covers, inter alia, compliance, staffing, IT outsourcing, system testing, ongoing self-​assessment and validation, system resilience (including ‘kill’ functionalities for cancelling unexecuted orders in emergency conditions), surveillance, business continuity, pre-​and post-​trade controls, direct electronic access, and order recording. 83 ESMA’s 2021 review did not identify major difficulties or stakeholder concerns and did not propose substantial reforms: n 60. 84 A market-​maker is a person who holds himself out on the financial markets on a continuous basis as being willing to deal on own account by buying and selling financial instruments against his proprietary capital at prices defined by him: Art 4(1)(7). The Short Selling Regulation definition of a market-​maker is significantly more articulated and widely cast, reflecting its function as a device for exempting market-​making activities, which typically include short selling, from the scope of the Regulation (see section 3). 85 Arts 48(2) and Art 18(5). See further Ch V section 6. 86 An organized trading facility (OTF) is a form of MiFID II/​MiFIR trading venue, as outlined in Ch V.

544 Trading

VI.2.5  The Commodity Derivatives Market and Position Management VI.2.5.1 The Commodity Derivatives Trading Agenda, MiFID II/​MiFIR, and the 2021 Quick Fix Reforms Among the more material of the MiFID II/​MiFIR reforms was the adoption of a new ‘position management’ regime governing trading in commodity derivatives,87 composed of NCA-​imposed position limits, requirements for trading venues to apply position management controls, and supervisory reporting on positions held.88 Controversial at the time of its adoption, particularly as regards its interventionist imposition of position limits, the reform proved to be one of the more short-​lived elements of MiFID II/​MiFIR: the position management regime was extensively revised by the 2021 MiFID II Quick Fix Directive, some three years after its coming into force in 2018, and further reform to the commodity derivatives regime more generally may follow in response to the elevated volatility in energy derivatives markets in 2022.89 The 2014 MiFID II/​MiFIR reforms reflected the financial-​crisis-​era widening of the regulatory perimeter around EU financial markets regulation, and the G20 reform agenda’s concern to address more lightly regulated and non-​regulated sectors, but there were also specific factors at play. Prior to and over the global financial crisis, international policy concern intensified as to the potentially destabilizing impact of trading in commodity derivatives on commodity prices. This trading became associated with increasing commodity prices and price volatility, technical difficulties with pricing dynamics on commodity markets, and threats to market integrity,90 and was drawn into the financial crisis reform agenda. The September 2009 Pittsburgh G20 Summit committed to improving the regulation, functioning, and transparency of financial and commodity markets to address excessive commodity price volatility,91 and an International Organization of Securities Commissions (IOSCO) reform agenda followed.92 The EU’s reform agenda included the general reforms to derivatives markets trading under EMIR (section 5), but also the specific MiFID II/​ MiFIR reforms to commodity derivatives trading, which had two dimensions: first, MiFID 87 On the definition of commodity derivatives see Ch IV section 5.3. 88 The commodity derivatives regime is addressed here in outline only given the specific features of commodity derivatives markets, which are shaped by trading in underlying commodities. See further Ch IV section 6.1 on the exemptions for commodity derivatives dealers from MiFID II/​MiFIR. 89 Directive (EU) 2021/​338 [2021] OJ L68/​14 (the MiFID II Quick Fix Directive). Further reforms (alongside the exceptional temporary alleviations adopted in Autumn 2022 as regards the collateral which can be used to meet CCP margin requirements under EMIR: n 368) were likely at the time of writing in response to the disruption in energy markets which followed the Russian invasion of Ukraine, including as regards trading halts, reporting on commodity derivatives trading, and the ‘ancillary activities’ MiFID II exemption which takes qualifying commodity dealers outside MiFID II (see Ch IV section 6.1): ESMA, Letter to the Commission (Excessive Volatility in Energy Markets), 22 September 2022 and Commission, Facing the Energy Crisis in the EU: work streams relating to the financial system (2022). 90 eg, from an EU perspective, Commission, Public Consultation on the Markets in Financial Instruments Directive Review (2010) 37–​9, Commission, Tackling the Challenges in Commodity Markets and Raw Materials (COM(2011) 25), and Commission, A Better Functioning Food Supply Chain in Europe (COM(2009) 591). From the extensive literature on commodity and commodity derivatives market interlinkages at the time of the reforms see, eg, Nissanke, M, ‘Commodity Market Linkages in the Global Financial Crisis: Excess Volatility and Development Impacts’ (2012) 48 J of Development Studies 732 and Gutierrez, L, ‘Speculative Bubbles in Agricultural Commodity Markets’ (2012) European Rev of Agricultural Economics 1. More recently, and for a political economy perspective, see Engel, J, ‘The Politics of Commodity Derivatives Reform in the EU and USA’ in Avgouleas, E and Donald, D (eds), The Political Economy of Global Financial Regulation (2019) 310. 91 Pittsburgh G20 Summit, September 2009, Leaders’ Statement, Strengthening the International Financial Regulatory System, para 12. 92 eg IOSCO, Principles for the Regulation and Supervision of Commodity Derivatives Markets (2011).

VI.2  MiFID II/MiFIR: The Regulation of Trading  545 II/​MiFIR tightened the exemptions previously available for commodity derivatives dealers, albeit that the 2021 Quick Fix reforms liberalized these exemptions (Chapter IV); and second, MiFID II/​MiFIR put in place a new position management regime, with position limits, position management, and position reporting elements (this section). The position limits proved to be the most contested element. The position limits regime required NCAs to put in place position limits on the size of a net position which a person could hold at all times in individual MiFID II/​MiFIR-​scope commodity derivative contracts traded on a trading venue and in economically equivalent contracts traded OTC, applicable to all such positions held by that person or held on its behalf at an aggregate group level; NCAs were also required to put in place limits on total overall trading in each such individual contract (MiFID II Article 57). These limits, a novelty for EU financial markets regulation, were designed to prevent market abuse and to support orderly pricing and settlement conditions, including as regards convergence between the prices of derivatives and those on the relevant underlying commodity market, without prejudicing price formation for the underlying commodity. A hedging exemption was available, but only in relation to positions held by or on behalf of a non-​financial entity which were objectively measurable as reducing risks directly relating to the commercial activity of the entity. The limits were to be set by NCAs in accordance with the criteria and methodology set out in RTS 2017/​591:93 it set out the criteria for adopting and adjusting limits for liquid contracts; and also established de minimis, quantitatively oriented limits for new and less liquid commodity derivatives (the latter were to be applied by NCAs pending their adoption of bespoke limits for such contracts). Reflecting the novelty of the regime and the need for convergence as it developed, but also its political salience, NCAs were subject to ESMA oversight in the form of a requirement for ESMA to issue an opinion on an NCA’s proposed limits and for NCAs to explain any adoption of limits contrary to an ESMA opinion. ESMA was also empowered with exceptional intervention powers (MiFIR Article 45). Alongside the position limits regime, trading venues were to put in place position management controls (MiFID II Article 57) and supervisory reporting requirements were imposed for trading venues and investment firms (MiFID II Article 58). Highly contested at the time of its adoption,94 this framework was given an early overhaul by the 2021 MiFID II Quick Fix Directive, most significantly as regard the novel position limits regime.95 The position limits regime had proved complex, requiring extensive ESMA amplification,96 and inflexible, struggling to respond to rapidly changing patterns of demand and liquidity on commodity derivatives markets (given the need for NCA action and for ESMA review before a position limit could be adjusted). ESMA’s 2020 MiFID II/​MiFIR

93 RTS 2017/​591 [2017] OJ L87/​479 (since repealed). 94 Position limits were strongly resisted by market participants as being arbitrary and as not reducing volatility. They were supported, however, by the EU institutions (albeit with some disagreement as to where the power to set position limits should be located (whether at NCA or trading venue level), and as to the extent to which limits should be governed by EU rules), and in particular by the European Parliament which saw them as a means for reducing speculation and volatility. 95 By way of illustration, ESMA’s MiFID II/​MiFIR Review of the regime noted that in 2020, the US CFTC, which has long experience in regulating commodity derivatives markets, had only nine positions limits in place for physically settled agriculture futures: ESMA, MiFID II/​MiFIR Review Report on Position Limits and Position Management (2020) 28. EU NCAs, however, were required to put in place limits for all MiFID II/​MiFIR-​scope commodity derivatives. 96 Through a discrete Q&A: ESMA, Q&A on MiFID II/​MiFIR Commodity Derivatives Topics.

546 Trading Review assessment identified a series of difficulties97 and recommended that the position limits regime be restricted to only ‘critical or significant contracts’. This was to allow the position limits regime to be better targeted, to focus on mature commodity derivative contracts that served as benchmarks and were important for price formation, and to allow new and nascent commodity derivatives markets to develop without limit-​based restrictions on liquidity providers.98 In addition, ESMA recommended a series of refinements to the position limits regime, including the extension, in the interests of supporting liquidity, of the hedging exemption to include financial entities. ESMA also called for greater harmonization as regards the position management action to be taken by trading venues, given significant divergences across trading venues in how they approached position management. ESMA’s proposals were given speedy institutional backing, being adopted, almost in their entirety, in the Commission’s 2020 MiFID II Quick Fix Proposal.99 The Commission placed the reforms in the context of the EU’s recovery from the Covid-​19 pandemic, relating them to the strains the position limits system had placed on the ability of energy markets to respond to the rapidly changing structure of demand over the pandemic (the pandemic had given rise to a need for real-​time adjustments to position limits in the related derivatives markets, but the formalities that attended NCAs’ adjustment of position limits and the ESMA review process imposed obstructions). The Proposal was also related to the need to support the development of euro-​denominated energy derivatives trading venues.100 The Proposal included, however, all agricultural commodity derivatives, and not only those designated as significant or critical, within the scope of the new position limits regime. The revised regime, adopted in 2021,101 accordingly retains the position limit system but applies it only to agricultural commodity derivatives and to ‘critical or significant’ derivatives; retains position management requirements for trading venues (for all commodity derivatives) but seeks greater convergence in how these requirements are applied; and retains the position reporting system for all commodity derivatives.102 97 n 95. Market participants reported that the limits had little positive impact but were constraining the development and growth of new commodity derivatives markets (particularly the de minimis limits applicable to new or less liquid derivatives contracts which hindered liquidity providers in holding large positions in these contracts) and called for the limits to be applied only to well-​developed, mature, key benchmark contracts that had a role in price formation. 98 n 95, 26–​8. ESMA concluded that while it fully supported the EU’s commitment to improving the regulation, functioning, and transparency of commodity derivatives markets, the case for position limits to be applied to every individual contract had yet to be made; and that while that its proposed reform would be a substantial one, it would be to the benefit of more efficient markets. 99 COM(2020) 280. 100 The Commission reported that liquidity providers in the developing energy derivatives trading venues in the EU were primarily in the form of large counterparties who were, because of the position limits regime, required to reduce their positions, and so limited in their capacity to support these markets: SWD(2020) 120, 28–​32. The reforms have been associated with an attempt to reduce the EU’s dependence on oil benchmarks priced in US $ and to accommodate trading in euro-​denominated alternatives, including natural gas: Stafford, P, ‘MiFID II Review Aims to Boost Euro Trading in Commodity Derivatives’, Financial Times, 17 February 2020. 101 The negotiations proved to be the most complex of the Quick Fix package, with the Parliament wary of reducing the scope of the position limits regime: Norton Rose Fulbright, European Legislators Start MiFID ‘Quick Fix’ Trilogue Negotiations (8 December 2020). The respective definitions of ‘agricultural commodity derivatives’ and ‘significant and critical derivatives’ accordingly evolved over the course of the negotiations, becoming more tightly specified. 102 Excluding, following ESMA’s advice, securitized commodity derivatives. Securitized derivatives are already subject to, in effect, notional position limits in that each issue is separately registered within a Central Securities Depository and can only be increased in line with a regulated approval process (by contrast, the size of open positions in commodity derivatives generally is almost limitless). Further, these derivatives are often purchased by retail investors and held in small positions, further reducing their capacity to drive price distortions or market abuse: n 95, 24–​6.

VI.2  MiFID II/MiFIR: The Regulation of Trading  547 These reforms are technical and are directed to a relatively small segment of the EU trading landscape.103 They are nonetheless revealing. They bear ESMA’s imprint and are a testament to its expanding influence. They evidence the persistence of the MiFID II/​MiFIR policy concern to support organized venue trading, evident from the reforms’ calibration of the position limits regime to facilitate the emergence of new commodity derivative trading venues (by accommodating liquidity providers to such venues who take on large positions). More generally, the reforms illustrate the complexities and uncertainties associated with novel and largely untested reforms (such as the original position limits regime) that intervene in market structure and trading practices, but the EU’s increasing capacity and appetite for adjustment. The main features of the position management regime, which applies widely to all persons, including those exempted from MiFID II/​MiFIR,104 are noted below.

VI.2.5.2 Position Limits and Position Management Under the revised position limits regime, NCAs must set and apply limits on the size of a net position which a person can hold at all times in ‘agricultural commodity derivatives’105 and in ‘critical or significant’106 commodity derivatives that are traded on trading venues and in economically equivalent OTC contracts; these limits apply to all positions held by the person and also on that person’s behalf at an aggregate group level (Article 57(1)). The limits, which must specify clear quantitative thresholds for the maximum size of position,107 are to be set in order to prevent market abuse and to support orderly pricing and settlement conditions, and in accordance with the calculation methodology set out in the relevant administrative rules (Article 57(1) and (2)).108 The original hedging exemption for non-​financial entities applies, as well as three new exemptions: a hedging exemption for financial entities;109 a liquidity-​oriented exemption for market makers, directed to all positions held by financial and non-​financial counterparties that are objectively measurable as resulting from transactions entered into to fulfil obligations to provide liquidity on a trading venue; and all securitized derivatives110 (Article 57(1)).111 In addition, NCAs must set total 103 Some sixty or so liquid commodity derivative contracts (primarily in the energy sector, followed by freight and agriculture) are subject to position limits, while eight trading venues specializing in commodity derivatives, eg, currently apply position management controls: ESMA, Register on Liquid Commodity Derivatives, and Register on Position Management Controls. 104 Set out in MiFID II Arts 57 and 58, the position management regime applies to persons otherwise exempted from MiFID II (Art 1(6)). 105 Defined by reference to Common Agricultural Policy-​related legislation (Art 4(1)(59)). 106 Reflecting ESMA’s advice as well as feedback to the Commission’s consultation, a commodity derivative is ‘critical or significant’ where the sum of all net positions of end position holders constitutes the size of their open interest (an ‘open interest position’ relates to the total of all futures and options contracts held), and is at a minimum of 300,000 ‘lots’ on average over a one-​year period (a ‘lot’ is the metric used to capture the standard quantity measure for transactions in the relevant derivatives market). This metric is designed to ensure that only derivative contracts which act as price benchmarks come within the position limits regime: Quick Fix Proposal, n 99, 11. ESMA is to establish a list of those commodity derivatives that are ‘critical or significant’: Art 57(3). The Proposal envisaged that an RTS establish the criteria governing such derivatives, but a more prescriptive, list-​based approach was adopted over the negotiations. 107 All NCA position limits must also be transparent and non-​discriminatory, specify how they apply, and take account of the nature and composition of market participants and how they use commodity derivative contracts: Art 57(9)). 108 On the rules, adopted as RTS 2022/​1302, see ESMA, Final Report, Technical Standards for Commodity Derivatives (2021). 109 The extension is designed to facilitate commercial groups which, prior to MiFID II, had established financial entities to provide their hedging needs. 110 See n 102. 111 The modalities of these exemptions are governed by RTS 2022/​1302.

548 Trading trading limits for each ‘critical or significant’ commodity derivative or agricultural commodity derivative, traded on trading venues (and including economically equivalent OTC contracts), and subsequently adjust these limits to respond to significant market change (Article 57(4)).112 NCAs can subsequently impose more restrictive position limits than those established ex-​ante, but only in exceptional cases, where the action is objectively justified and proportionate, taking into account the liquidity and the orderly functioning of the specific market (Article 57(13)). They must also be empowered generally to take specific supervisory/​enforcement position-​management action to require or demand the provision of information from any person regarding the size and purpose of a position or exposure entered into via a commodity derivative, and any assets or liabilities in the underlying market (Article 69(2)(j)); and to limit the ability of any person from entering into a commodity derivative (Article 69(2)(p)). NCAs must further be empowered to request any person to take steps to reduce the size of a position or exposure (whether or not in commodity derivatives) (Art 69(o)). ESMA is injected into the process for setting position limits, being charged with issuing an opinion on the compatibility of an NCA’s limits with the objectives of Article 57 and with the position limits calculation methodology (Article 57(5)).113 ESMA must also monitor, at least annually, how NCAs have applied the administrative rules governing the position limits calculation methodology (Article 57(7)). Trading venues are brought into the position management system by means of an obligation to have in place position-​management powers and controls (Article 57(8)–​(10)). These powers, which must be applicable to all commodity derivatives traded on the venue, must include, at least, powers for the trading venue to: monitor the open interest positions of persons; access information relating to positions; require the termination or reduction of a position, on a temporary or permanent basis, and to act unilaterally where the position holder does not comply; and, where appropriate, require a person to provide liquidity to the market, at an agreed price and volume on a temporary basis, with the intent of mitigating the effects of a large or dominant position. While these requirements have proved less troublesome than the NCA-​based position limit system, trading venues have adopted different approaches114 and, reflecting how the arc of EU financial markets regulation continually bends towards harmonization, the 2021 MiFID II Quick Fix Directive adopted a mandate for amplifying RTSs.115

112 A coordination-​based system, refined and amplified by the Quick Fix reforms to reflect the new scope of the limits regime, governs how these limits are to be applied by NCAs where the ‘same’ derivative (based on the same underlying and sharing the same characteristics) is traded on a trading venue in more than one jurisdiction. This system is based on the limit being set by the NCA of the trading venue with the largest volume of trading, but consulting with other NCAs, and ESMA exercising its binding mediation powers in the case of disputes (Art 57(6)). 113 An NCA must modify its limits in accordance with the opinion or provide ESMA with a justification as to why change is not considered necessary; where an NCA imposes limits contrary to an ESMA opinion, it must immediately publish on its website its reasons for doing so. Similarly, where an NCA imposes more restrictive position limits in exceptional cases, ESMA must offer an opinion as to whether the limits are necessary; where an NCA imposes limits contrary to the opinion, it must immediately publish its reasons on its website (Art 57(13)). 114 In practice, only a small number of specialist trading venues come within these requirements, with only eight trading venues currently reporting on position management controls in ESMA’s register: ESMA, Position Management Controls in Place at Commodity Derivatives Trading Venues. 115 ESMA acknowledged the need to allow trading venues to calibrate their controls to the features of the contracts traded on the venue, but concluded that a more convergent approach was needed: n 95, 34–​8.

VI.2  MiFID II/MiFIR: The Regulation of Trading  549 Finally, a position reporting regime applies to commodity derivatives, as well as to emission allowances and related derivatives. Introduced by MiFID II, it was not revised by the Quick Fix reform, save to disapply it from securitized derivatives (Article 58).

VI.2.5.3 ESMA’s Powers ESMA has been inserted into the operation of the commodity derivatives regime, primarily by means of its review of NCA position limits (MiFID II Article 57(5)) and, secondarily, by means of its exceptional direct powers of intervention (MiFIR Article 45); these competences and powers are similar to those that it is conferred with under the Short Selling Regulation. Of these two powers, more evidence is available on how ESMA deploys its review/​ opinion power, which must be exercised whenever an NCA proposes a position limit; the intervention power has yet to be deployed. The evidence which is available on the opinion power suggests that ESMA follows a technically rigorous approach,116 albeit one that is sensitive to the complexity of what was, at the time of the adoption of MiFID II, a new form of supervisory decision-​making. As the NCA position-​limit-​setting process intensified prior to MiFID II/​MiFIR coming into force, ESMA recognized that setting position limits was a ‘new and technically challenging’ task for NCAs, which required the gathering and examination of large volumes of complex data, and which could only have been undertaken at a late stage prior to MiFID II/​MiFIR coming into force, given the delays in adopting the related RTS governing how limits are set.117 ESMA and NCAs accordingly agreed that (as with the MiFIR equity pre-​trade transparency waivers)118 NCAs would publish their limits ahead of the relevant ESMA opinion, but that NCAs would modify their opinions, where necessary, in accordance with the subsequent ESMA opinion, or provide explanations.119 The ESMA/​NCA relationship as regards position limit setting is unlikely to avoid contestation, but there is little sign of disruptive conflict so far.120 The opinion power has, however, a potentially far-​reaching, sedimentary effect in that it strengthens ESMA’s technocratic capacity as regards the commodity derivatives markets, and its related ability to shape how the regime develops, as is clear from the deep imprint it has left on the legislative scheme by means of the 2021 Quick Fix reforms which were largely based on its recommendations. ESMA has also been conferred (by MiFIR Article 45) with temporary powers to intervene in the commodity derivatives markets, which powers reflect those conferred on NCAs under MiFID II Articles 57 and 69 (as noted above).121 ESMA’s powers are similar

116 Evident in the first set of ESMA opinions, which related to limits adopted by the French NCA (ESMA70-​155-​ 993/​983/​and 988, related to commodity derivative positions on rapeseed, milling wheat, and corn). The opinions were positive but were technically detailed and suggested an intention to apply the review power purposefully. A similar observation can be made of ESMA’s second swathe of (October 2017) opinions which addressed a range of UK FCA position limits. While all the opinions were positive, they suggested close engagement with the factual context and with the FCA’s reasoning. 117 ESMA, Public Statement, 28 September 2017. 118 See Ch V section 11.2. 119 n 117. 120 Albeit that ESMA’s related register reports that limits for some sixty or so commodity derivatives contracts have been subject to review since the coming into force of MiFID II/​MiFIR: ESMA, List of Liquid Commodity Derivatives Contracts. 121 ESMA’s powers are not specific to commodity derivatives but apply to all derivative positions, although the regime focuses on the risks and features of commodity derivative markets.

550 Trading in design to the exceptional powers of intervention conferred on ESMA in relation to short selling (section 3), and product intervention (Chapter IX). Where the relevant threshold conditions are met, ESMA must take one or more of the following measures: directly request all relevant information regarding the size or purpose of a position or exposure entered into via a derivative from any person; require any such person to reduce the size of or to eliminate a position or exposure; and ‘as a last resort’ limit the ability of a person to enter into a commodity derivative (this last power applies to commodity derivatives only). These measures all take precedence over any related measure adopted by an NCA. ESMA ‘shall take a decision’ only if the measure addresses a threat to the orderly functioning and integrity of financial markets, including commodities derivatives markets, or to the stability of the whole or part of the financial system in the EU; and an NCA or NCAs has not taken measures to address the threat, or the measures taken have not sufficiently addressed the threat. ESMA must also ensure that the measures taken meet a set of further conditions.122 Granular administrative rules specify further the conditions which apply to these powers.123 Measures can only be temporary in nature and ESMA must also notify the relevant NCAs before imposing or renewing any measures. ESMA has yet to take action under Article 45. These powers serve different objectives to its parallel short selling and product intervention powers, being designed to reflect the pricing and stability risks specific to commodity derivatives markets,124 and were shaped by different political/​institutional interests as well as by different technical, context-​specific requirements. But, like its other intervention powers, and as discussed further in Chapter IX as regards product intervention, they are novel and contestable, designed to apply temporarily in exceptional circumstances, with potentially far-​reaching and unforeseen effects, and with the capacity accordingly to strengthen significantly ESMA’s technocratic position. Relatedly, they generate legitimation risks as well as reputational risks for ESMA. That ESMA has yet to exercise the Article 45 power is a function, of course, of market conditions. Nonetheless, and given its purposeful deployment of other channels of influence in this area, including soft law,125 its opinion power, and its shaping of legislative reform, it also suggests a sensitivity to the risks associated with its exceptional intervention powers, and a preference to use softer modes for exerting influence.

122 The action must ‘significantly address’ the threat to the orderly functioning and integrity of financial markets, including commodity derivatives markets, or to the stability of the EU financial system (or part thereof), or significantly improve the ability of NCAs to monitor the threat; not create a risk of regulatory arbitrage; and not have the following detrimental effects on the efficiency of financial markets, disproportionate to the benefits of the measure—​reduce liquidity in financial markets, restrain the conditions for reducing risks directly related to the commercial activity of a non-​financial counterparty, or create uncertainty for market participants. ESMA must also consult with the Agency for the Cooperation of Energy Regulators (ACER) where the action relates to wholesale energy products, and with the public bodies responsible for the oversight, administration, and regulation of physical agricultural markets where the measure relates to agricultural commodity derivatives. 123 Delegated Regulation 2017/​567 [2017] OJ L87/​90 Art 22. 124 The governing conditions also refer to delivery arrangements for physical commodities. 125 Notably the extensive Q&A on MiFID II/​MiFIR Commodity Derivatives Topics.

VI.3  The Regulation of Short Selling  551

VI.3  The Regulation of Short Selling VI.3.1  Short Selling Regulation and the EU Short selling is a trading practice that allows traders to profit from drops in the prices of financial instruments. It involves the selling of a security (typically a share) which the seller does not own with the objective of buying the security prior to the delivery date, on the assumption that the price of that security will decline before the security must be delivered. Where a short sale is ‘uncovered’ the seller does not borrow the security or enter into an agreement to secure its availability;126 uncovered short sales are prohibited in the EU, as discussed below in this section. Short sales carry the risk that prices do not decline and the short seller is required to acquire the ‘shorted’ security at a higher price to cover the short position.127 Short selling can also be carried out through credit default swaps (CDSs) which fulfil similar economic functions to short sales in that they pay the CDS buyer a fee on a decrease in value of the covered (reference) security (corporate and sovereign bonds).128 A discrete regime applies to short selling under the 2012 Short Selling Regulation.129 It addresses short selling in shares but also short selling and CDS transactions in sovereign debt, reflecting the febrile political and market conditions that shaped the Regulation’s adoption as euro area sovereign debt markets roiled and the financial crisis deepened. The Regulation is the fulcrum of the EU’s short selling ‘rulebook’, but it is supported by a series of cognate measures, including the Market Abuse Regulation, the MiFIR financial transaction reporting regime (which requires flagging of completed short sales), and the panoply of conduct and prudential rules which apply to the trading/​dealing process generally under MiFID II and the IFD/​IFR and CRD IV/​CRR rulebook. Short selling is a well-​established trading strategy that supports liquidity and price formation by feeding informed negative sentiment through to pricing and by providing incentives to fine-​tune price discovery,130 including incentives to monitor firms for abusive behaviour.131 Typically engaged in by financial institutions, and associated in particular with specialist hedge funds, short sale strategies, including the use of CDSs, allow short 126 A ‘covered’ short sale therefore has a number of stages, including the borrowing of the shares (to be provided to the buyer at settlement) by the short seller, the shorting of the shares by the short seller, the purchase of the same number of shares to be returned to the original lender, and the return of the shares to the original lender. For a policy-​oriented review see FSA, Discussion Paper 09/​1, Short Selling (2009) and IOSCO, Regulation of Short Selling (2009). 127 The risks are heightened as the investment firms which lend securities for short sales typically require short sellers to post collateral to cover a proportion of the shorted position. Increases in prices can therefore mean that short sellers must either post additional collateral or exit the position (which can mean the short seller has to buy the shorted security at a higher price than the sale price to cover the position). 128 Accordingly, a seller of a CDS takes, in effect, a leveraged long position in the underlying reference bond, while a purchaser of a CDS takes a short position in the bonds: IOSCO, The Credit Default Swap Market (2012) 4. 129 Regulation (EU) No 236/​2012 [2012] OJ L86/​1. For an assessment of the Regulation see Payne, J, ‘The Regulation of Short Selling and its Reform in Europe’ (2012) 13 EBOLR 413. The main elements of the legislative history are: Commission Proposal COM(2010)482, IA SEC(2010) 1055; Parliament Resolution adopting a Negotiating Position, 5 July 2011 (T7-​0312/​2011) (ECON Report A7-​055/​2011); and Council General Approach, 11 May 2011 (Council Document 10334/​11). The ECB opinion is at [2011] OJ C91/​1. 130 For a pandemic-​related assessment, showing how short sellers incorporated assessments of the extent to which governments would have the fiscal flexibility to support relevant issuers, see Greppmair, S, Jank S, and Smajlbegovic, E, On the Importance of Fiscal Space: Evidence from Short Sellers During the Covid-​19 Pandemic, Deutsche Bundesbank Discussion Paper No 29/​2021. 131 The prohibition by the German NCA of short selling in Wirecard accordingly drew intense criticism in light of the subsequent emergence of the fraud, as noted below.

552 Trading sellers to profit from speculating correctly against the current direction of trading, support hedging and risk management by allowing the balancing of long and short positions, and facilitate market-​making by allowing market makers to meet buy orders that their proprietary inventory cannot cover and thereby respond to buying pressure.132 In times of acute market volatility, and when prices are spiralling downwards, short sellers, who profit when markets fall, can become a lightning rod for societal concern, including as to inequitable patterns of wealth distribution and as to the relative power of market professionals and retail investors. The January 2021 Gamestop/​‘meme-​stock’ episode saw mass buying (‘long’) campaigns by retail investors, coordinated through social media channels, targeted against shares with significant net short positions. The scale of this coordinated long trading led to exponential price increases in shares in which there were significant short positions and, in part because of the ‘short squeezes’ thereby generated,133 to major losses for some hedge funds holding short positions.134 It also saw the perennial debate on the benefits and risks of short selling folded into a wider debate on the sources of power in financial markets.135 But while the Gamestop episode became associated with a David v. Goliath style victory for retail investors over hedge funds, it also generated concern as to potentially prejudicial changes to the dynamics of short selling were short positions to become systematically exposed to social-​media-​driven campaigns, short sellers to sustain heavy losses, and a curtailing of productive short selling activity to follow.136 Over a decade earlier, the chaos in financial markets as the financial crisis deepened over 2008–​2009 led to emergency curbs on short selling that were subsequently assessed to be of little value and to have damaged liquidity and constrained price formation.137 More recently, the deepening 132 From an extensive literature see Howell, E, ‘Short Selling Restrictions in the EU and the US: a comparative analysis (2016) 16 JCLS 333 and Avgouleas, E, ‘A New Framework for the Global Regulation of Short Sales: Why Prohibition is Inefficient and Disclosure Insufficient’ (2010) 16 Stanford J of Law, Business and Finance 376. On CDSs, see Partnoy, F and Skeel, D, ‘The Promise and Perils of Credit Derivatives’ (2007) 75 U of Cincinnati LR 1019, identifying the hedging benefits of CDSs, their potential for bringing greater liquidity into credit markets by allowing banks to hedge their exposure more effectively, and their information transmission function as regards corporate performance. 133 A ‘short squeeze’ occurs where short positions are exposed to price increases in the shorted instrument, the holders of the short positions need to purchase the shorted instrument to close out the positions in a rising market, but thereby increase upward pressure on the price, and place further pressure on the short positions. 134 The January 2021 meme-​stock phenomenon, which affected more than 100 issuers, has been extensively examined in the policy and scholarly literature as regards its implications for short selling. In the totemic case of Gamestop, in which there were significant short positions (in the region of 100 per cent of outstanding shares over 2019-​early 2021), it became the subject of a targeted social media campaign (coordinated in the main through Reddit) against Gamestop’s short position holders (fuelled by positive market sentiment following a change in the Gamestop board) which led to a 2,700 per cent increase in its share price over 8 January–​28 January. This exponential increase led to major short position holders being required to cover their positions by purchasing shares as the price increased. This action further increased the share price and lead to a ‘short squeeze’ as short position holders scrambled to cover their positions as the price kept soaring. While associated with the ‘defeat’ of short sellers, retail investors who purchased during the frenzy also sustained losses when the price stabilized. For a policy-​oriented review see SEC, Staff Report on Equity and Market Options Market Structure in Early 2021 (2021). 135 See, eg, Angel, J, Gamestonk: What Happened and What to do About it, Georgetown McDonough School of Business Research Paper (2021), available via , Loewenstein, M, ‘Short Squeeze, Gamestop, the Common Law and a Call for Regulation, U of Colorado Law Legal Studies Paper Research Paper No 22-​3, available via https://​ssrn.com/​abstr​act=​4001​978>, and Macey, n 49. 136 One major short seller (Citron Research) announced after the January 2021 turmoil that it would cease its voluntary publication of its short selling reports. For a contemporaneous analysis see Smith, I and Wigglesworth, R, ‘Gamestop’s Wild Ride: how Reddit traders sparked a ‘short squeeze’, Financial Times, 29 January 2021. The SEC’s review was cautious, reporting that it was not clear from the evidence that a disruptive ‘short squeeze’ had occurred that required remediation, albeit that it noted the benefits of enhanced reporting on short sale activity: n 134. 137 The extensive literature, primarily of an economics/​finance orientation, on the crisis-​era prohibitions found that the restrictions typically contributed to volatility (including in weakened financial institutions), negative pricing spirals, and a contraction of liquidity. See eg: Beber, A et al, Short Selling Bans and Bank Stability, ESRB WP

VI.3  The Regulation of Short Selling  553 of the Covid-​19 pandemic in early 2020 and related acute market volatility saw some EU NCAs take action to restrict short selling, an intervention that became associated with a concern to ‘do something’ as markets roiled and short sellers profited.138 The challenge for regulation is considerable. Short selling is an important conduit for pricing information and, thereby, for monitoring issuers, facilitates market-​making and, thereby, liquidity, and supports risk management; restricting it can damage market quality. There are, however, risks associated with short selling which range from the more tractable risks relating to settlement failure where the short seller does not deliver the shorted securities,139 through to the risks of manipulative conduct, and on to the more contestable risks related to orderly trading and, in extremis, financial stability where, in conditions of acute market volatility, downward pricing spirals develop, particularly in securities of financial institutions, amplified by short selling. Further, poor supervisory transparency on the scale of shorting activity can hobble regulators in assessing the scale and location of risks to financial stability, market efficiency, and market integrity, while limited public disclosure of shorting activity can hinder price formation,140 albeit that public disclosure also generates risks that short sellers’ positions are exposed, with potentially detrimental effects on short sellers’ incentives to carry out short strategies. The regulatory tool-​box for short sales reflects the contestability of the risks engaged. It includes less intrusive supervisory reporting requirements regarding short positions and more intrusive public disclosure obligations; operational conditions on the execution of short sales (including the ‘locate’ rules used to require short sellers to have made arrangements to secure the sorted securities in advance and which address ‘uncovered’ short sales);141 and the controversial prohibitions on short sales which, in effect, substitute the regulator’s determination as to what is normal pricing activity for the market’s.142 64/​2018 and 2020 (2020), Klein, A, Bohr, T, and Sikles, P, ‘Are Short Sellers Positive Feedback Traders? Evidence from the Global Financial Crisis’ (2013) 9 J of Financial Stability 337, and Beber, A and Pagano, M, ‘Short Selling Banks around the World: Evidence from the 2007–​09 Crisis’ (2013) 68 J Fin 343. 138 The March 2020 imposition of prohibitions on short selling by six NCAs was criticized as theoretically and empirically unsound, and explained as a reaction to a perceived need to be ‘seen to act’: Enriques, L and Pagano, M, ‘Emergency Measures for Equity Trading: The Case Against Short-​Selling Bans and Stock Exchange Shutdowns’ in Gortsos, C and Ringe, W-​G (eds), Global Pandemic Crisis and Financial Stability (2020), available via , and Siciliano, G and Venturozzo, M, ‘Banning Cassandra from the Market? An Empirical Assessment of Short-​Selling Banks During the Covid-​19 Crisis’ (2020) ECFR 386. 139 Albeit that settlement risks rarely crystallize on a large scale and were not associated with the Gamestop episode. While there was an increase in settlement fails (‘fails to deliver’) in January 2021, these were not directly associated with short selling: SEC, n 134, 29. Earlier, settlement fails were not strongly associated with the financial crisis era (2010 Short Selling Proposal IA, n 129, 26–​7). 140 In developing the proposal for the Short Selling Regulation, the Commission struggled to estimate the volume of short selling in the EU market and drew mainly on proxy evidence from the UK (based on securities lending data) and from Spain, in estimating the volume of short sales in shares at approximately 1–​3 per cent of EU market capitalization: 2010 Short Selling Proposal IA, n 129, 11–​13. By contrast, US reporting was more extensive. At the time, some 50 per cent of total listed equity trading volume in the US market was thought to represent orders marked as short orders under the US ‘flagging’ regime: SEC Release No-​64383, Short Sale Reporting Study Required by Dodd-​Frank Act, 3. 141 ‘Locate’ rules, which require that the short seller has made arrangements to locate and secure the shorted security in question (locate rules may, variously, require that the security is reserved for the short seller or that best/​ reasonable efforts are made to ensure that the security is available) are associated with the reduction of settlement risk and of market disruption risk (in that an economic linkage exists between the demand for short selling activity and the supply of the related securities): IOSCO, Regulation of Short Selling (2009) 7–​8. 142 The US market has long been a laboratory for short selling rules, with short selling regulation a feature of US securities regulation since 1938. The US regime, set out in Regulation SHO, includes ‘locate rules’, ‘close out’ rules, which require broker/​dealers who participate in clearing systems to close out failures to deliver for a short sale transaction within the required time frame, circuit-​breaker rules for trading venues (which automatically halt

554 Trading In the EU, regulation now takes the normative position, frequently articulated by ESMA,143 that short selling, while valuable, can generate risks to the orderly functioning of markets and to financial stability. Prior to the financial crisis, however, the regulation of short selling was not common in the EU. The financial crisis led to the adoption of the totemic 2012 Short Selling Regulation, the poster child for the interventionist turn that EU financial markets regulation took over the crisis. It imposes supervisory reporting requirements as regards net short positions as well as public disclosure requirements, prohibits ‘uncovered’/​‘naked’ short sales and applies related ‘locate’ rules, and provides for exceptional intervention powers, including to curb short selling, for NCAs and, in a precedent-​setting reform, ESMA.

VI.3.2  The Evolution of the Short Selling Regulation VI.3.2.1 Regulating Short Sales and the Financial Crisis The Short Selling Regulation is redolent of the financial-​crisis era. Short selling regulation underwent something of a transformation over the financial crisis as financial market regulators worldwide turned to it as a means for supporting financial stability.144 These regulators, who had traditionally relied heavily on disclosure tools,145 had little experience of, and a limited tool-​box for dealing with, the massive instability which shook financial markets in autumn 2008.146 However counterintuitive for regulators who traditionally had not intervened heavily in trading, trading-​related regulation was one of the very few tools which could be quickly deployed to support financial stability—​however blunt and ineffective a tool it subsequently turned out to be.147 In the US, the SEC imposed a temporary prohibition on short sales in the shares of 799 financial institutions on 18 September 2008,148 while, on the same day in the UK, the (then) Financial Services Authority (FSA) announced a temporary prohibition on short sales in the shares of thirty-​two financial institutions and the imposition of related reporting requirements,149 and similar action was taken by different NCAs across the EU (noted below). Short selling did not ultimately become a major priority short-​selling when prices fall below a set threshold in a set time) and transparency rules, including with respect to the flagging of short sales. 143 ESMA has consistently articulated this view in the sequence of opinions it has adopted since 2012 on NCAs’ short selling curbs, as well as in its first exercise, in March 2020 and in response to the pandemic, of its exceptional intervention powers: ESMA, Decision 16 March 2020, 6, noting that ‘while short selling at other times may service positive functions in terms of determining the correct valuation of issuers, in current market circumstances it poses an additional threat to the orderly functioning and integrity of markets’. 144 Albeit that the turn to using short selling for stability purposes was also associated with the need to be ‘seen to act’: Enriques, L, ‘Regulators’ Response to the Current Crisis and the Upcoming Reregulation of Financial Markets: One Reluctant Regulator’s View’ (2009) 30 U Pa JIL 1147 (similarly, as regards NCAs’ action over the pandemic, Enriques and Pagano, n 138). 145 Hu, H, ‘Too Complex to Depict? Innovation, “Pure Information” and the SEC Disclosure Paradigm’ (2012) 90 Texas LR 1601, examining the crisis-​era reliance on short selling regulation as a major departure for disclosure-​ based regulators. 146 IOSCO, Mitigating Systemic Risk. A Role for Securities Regulators (2011). 147 See the discussions at n 137. 148 The prohibition followed a 15 July 2008 temporary prohibition by the SEC of uncovered short sales in 19 financial institutions, in response to the destabilizing effect of rumours. 149 The prohibition (on net positions in excess of 0.25 per cent of the issued share capital) extended to uncovered and covered sales and to related transactions through derivatives. See Marsh, I and Payne, R, ‘Banning Short Sales and Market Quality’ (2012) 36 J of Banking and Finance 1975.

VI.3  The Regulation of Short Selling  555 for the G20-​led reform agenda, although IOSCO subsequently adopted principles on the effective regulation of short selling which did not attract significant political traction.150 Short selling remained on the EU agenda, however, and became the subject of a highly politicized negotiation shaped by the impact of short selling and CDS trades on the troubled sovereign debt market. Three proximate drivers can be identified for the 2012 Short Selling Regulation: concerns as to regulatory fragmentation and related arbitrage risks consequent on the unilateral prohibitions on short sales adopted by the Member States/​NCAs in autumn 2008; concerns in some Member States, and particularly in the European Parliament, as to perceived excessive speculation; and concerns, notably among the French and German governments, as to CDS-​ fuelled speculation in the sovereign debt markets and as to the consequent pressure on the stability of the euro area and on Member States’ ability to raise funds and manage deficits. Short selling erupted on to the EU regulatory agenda in autumn 2008 when several Member States imposed restrictions of varying types on short sales, ranging from reporting requirements, to prohibitions on uncovered short sales, to outright prohibitions, in an effort to shore up financial stability.151 The initial EU response, via the Committee of European Securities Regulators (CESR), was in the form of soft law recommendations for net short position supervisory reporting and for public disclosure,152 but political and market conditions intervened in spring 2010 to place binding legislative measures on the agenda. Turmoil in the Greek sovereign debt market fuelled political concerns that speculation in sovereign debt CDSs—​in effect, speculation on the likelihood of default—​was prejudicing the stability of Member State sovereign debt markets and of the euro area, and damaging the ongoing, strenuous, and politically costly efforts to stabilize the euro area. In March 2010, France and Germany (supported by Luxembourg and Greece) called on the Commission to investigate the effect of speculative trading in CDSs on the sovereign bonds of Member States, to introduce transparency requirements, and to prohibit trades in uncovered CDSs.153 Ongoing instability led to Greece imposing prohibitions on short selling in April 2010.154 Germany’s prohibition of short selling and CDS transactions in May 2010155 materially ratcheted up the political tensions156 and the pressure for intervention.157 It also exposed differences 150 IOSCO adopted four principles: that short selling should be subject to appropriate controls to reduce or minimize potential risks to the orderly and efficient functioning of markets and the stability of markets; that short selling should be subject to a reporting regime (to markets or to regulators); that an effective compliance and enforcement system apply; and that any rules adopted allow for appropriate exemptions: n 141. 151 For a list of the restrictions in place at September 2010 (the majority of which were imposed in autumn 2008) see 2010 Short Selling Proposal IA n 129, Annex 3. For an examination of the French, German, and UK action see Payne, n 129. 152 CESR, Model for a Pan-​European Short Selling Disclosure Regime (2010). CESR recommended supervisory reporting to NCAs where a short position amounted to 0.1 per cent of the issuer’s share capital and public disclosure at 0.2 per cent, as well as disclosure at specified incremental steps thereafter. 153 Peel, Q, ‘Call for Ban on CDS Speculation’, Financial Times, 11 March 2011. 154 The Greek regulator banned the short selling of shares listed on the Athens Exchange; while this ban was lifted in August 2010, it was immediately replaced by a ban on uncovered short sales and subsequent measures followed. 155 The prohibition applied to shares of the ten most significant financial institutions in Germany, euro-​area sovereign debt, and sovereign debt CDSs: BaFIN Quarterly 2/​2010, 3. 156 Germany’s action was widely linked to the domestic political agenda and concerns as to the cost of the euro-​area bailout: Barber, T and Wiesmann, G, ‘Berlin Makes Shock Moves without Allies’, Financial Times, 20 May 2010. 157 German Finance Minister Schauble was reported as stating that the markets were ‘really out of control’ and that effective regulation was needed: Barber, T, Hall, B, and Wiesman, G, ‘German Curbs Raise Tensions in Europe’, Financial Times, 5 May 2010.

556 Trading between the Member States as to the optimal approach to short selling (France, in particular, was critical of Germany’s unilateral approach), increased tensions between Member States as global equity markets and the value of the euro tumbled in the wake of Germany’s action, and generated a call for greater coordination from the FSB. In this febrile environment, the Commission engaged in a short consultation158 before publishing in September 2010 a Proposal for a short selling regime which was strongly influenced by the prevailing political climate.159 The Proposal, which was in part designed as a response to the then recently reformed US regime,160 proposed a new transparency regime for net short position in shares but also short sovereign debt positions; prohibitions on uncovered short sales in shares and on uncovered sovereign debt short sales (but not uncovered sovereign CDS transactions); and direct intervention powers for NCAs and for ESMA. Over the difficult negotiations which followed most contestation was generated by the treatment of sovereign debt and by the different positions of the Council and the Parliament, although ESMA’s novel intervention powers also proved controversial. While the industry warned of the risks of restricting CDS transactions,161 the Parliament, which was concerned as to speculation in the sovereign debt markets, introduced a prohibition on uncovered sovereign CDS trades, a revision that quickly became a major point of contention with the Council.162 Internal Council negotiations proved very difficult, with the Council split between the Member States (the majority) opposed to intervention in the sovereign debt market, given the potential damage to the ability of Member States to raise finance (the most vehement opponents were reportedly the Netherlands, Poland, Italy,163 the UK,164 and Luxembourg), and the minority of Member States (including France and Germany) concerned to quell speculation in sovereign debt.165 A negotiating position was finally reached by the Council in May 2011 which included a provision providing for a temporary suspension of the prohibition on uncovered short sales in sovereign debt, and on uncovered sovereign CDS transactions, where

158 Commission, Public Consultation. Short Selling. June 2010. The Consultation addressed, inter alia, transparency requirements, restrictions on uncovered short sales, emergency powers, and the appropriate scope of a harmonized regime. Although the consultation responses were generally supportive of a harmonized approach and concerned as to unilateral Member State action, they revealed a lack of support, particularly from the market, for restrictions on uncovered short sales, and only limited support for applying the regime to asset classes other than equity. 159 The IA drew, eg, heavily on the political concern in some Member States as to the potential impact of uncovered CDSs on the sovereign debt markets in justifying the Proposal: n 129, 5–​6, while Commissioner Barnier linked the Proposal with efforts to restrain any ‘wild west’ tendency in financial markets: Tait, N, ‘Brussels in Bid to Take “Wild West” Markets’, Financial Times, 16 September 2010. 160 2010 Short Selling Proposal IA, n 129, 34. 161 eg AFME, ISLA, and ISDA, Summary of the AFME, ISLA, and ISDA position on Short Selling (May 2011), expressing the concerns of three major investment banking trade associations. 162 The Council noted the Parliament’s determination not to allow the Council a veto over its position on uncovered sovereign CDSs and the view in some quarters in the Parliament that uncovered CDS transactions were riskier than lotteries: 3105th Council Meeting, 12 July 2011 (Council Document 12481/​2011). 163 Italy (whose sovereign debt came under repeated pressure over 2011) was concerned as to the impact of the Parliament’s uncovered sovereign debt CDS prohibition on its ability to manage its public debt: ‘EU Short Selling Talks Collapse amid Sovereign Debt Fears’, EurActiv, 22 September 2011. 164 The UK was opposed to any prohibition on uncovered sovereign CDSs and concerned in particular as to potential liquidity contractions in the sovereign debt market, pressure on sovereign borrowing costs, damage to the ability of the EU to recover from the financial crisis, and disruption to legitimate hedging activities: House of Commons, EU Committee, 20th Report of Sessions 2010–​2012, The EU Financial Supervisory Framework: An Update. 165 Baker & McKenzie, EU Politicians Debate Short Selling Regulation, March 2011.

VI.3  The Regulation of Short Selling  557 sovereign debt markets were disrupted. Very difficult trilogue negotiations followed,166 with tensions exacerbated by ongoing market turmoil and the different approaches taken by NCAs: on 11 August 2011—​as rumours regarding the health of French banks swept EU markets, borrowing costs increased, and emergency financing levels increased—​four Member States imposed or extended temporary prohibitions on short selling, which varied in scope,167 but the Netherlands NCA stated that a prohibition was not necessary, and the majority of NCAs did not act.168 Ultimately, the Council’s modifications to the Parliament’s ban on uncovered sovereign CDS transactions were accepted,169 allowing for agreement on the text in November 2011.

VI.3.2.2 From the Financial Crisis to Gamestop: Experience with the Short Selling Regulation The legislative passage of the Short Selling Regulation did not augur well for its future success. The empirical evidence which could have mitigated political risks and supported nuanced drafting was limited, particularly as regards CDS markets,170 while the European Parliament’s and Council’s extensive revisions to the Proposal were not subject to impact assessment. The amplifying administrative rulebook, however, albeit an early test for ESMA as a quasi-​rule-​maker, delivered much-​needed nuance and was based on empirical evidence and market practice to a materially greater extent than the Regulation. Similarly, ESMA’s soft law has provided a means for addressing opacities and ambiguities and for reflecting market practices.171 Allied legislative measures have enhanced the oversight of short selling, notably the MiFIR Article 26 financial transaction reporting system which requires the flagging of completed short sale transactions. Over the decade or so since its adoption, the Short Selling Regulation has proved to be resilient in practice. The 2021 Gamestop/​meme-​stock episode, which could have been significantly amplified on EU markets given that the EU, unlike the US, requires public disclosure of net short positions, did not have significant impact. There was little evidence of material ‘attacks’ on short positions, ‘short squeezes’, a subsequent reduction in short selling capacity, or of settlement fails relating to failures to cover short sales adequately.172 But while EU markets were broadly unscathed, the episode shaped the regulatory regime: the reduction in 2022 of the supervisory reporting threshold for net short positions from 0.2 per cent of issued share capital to 0.1 per cent of issued share capital, while mainly a legacy of the 166 The European Parliament was initially not prepared to accept any loosening of its prohibition on uncovered sovereign CDS trading, leading to the possibility of the trilogue negotiations failing and the measure proceeding to a second reading: ‘EU Short Selling Talks Collapse amid Sovereign Debt Fears’, EurActiv, 22 September 2011. 167 Belgium, France, Italy, and Spain. 168 Industry reaction to the series of uncoordinated prohibitions was hostile. The Managed Funds Association, eg, warned of the damage to risk management and of increased volatility: Letters to the Italian, Spanish, Belgian and German regulators, and to the ECB, the Council, the Commission, and ESMA, 13–​15 August 2011. 169 The Polish Presidency announcement on the successful completion of the trilogue negotiations noted the extensive negotiations and the significant difference between the institutions’ positions: Polish Presidency Communiqué on Short Selling, 19 October 2011. 170 The Commission’s IA was thinly evidenced and precautionary, particularly with respect to the sovereign debt and CDS measures. The Commission’s Impact Assessment Board supported the use of a precautionary model, however, given the lack of evidence. IAB Opinion, 31 August 2010 (Ref. Ares(2010) 549585). 171 Notably through the Q&A: ESMA, Q&A on the Regulation on Short Selling and Certain Aspects of Credit Default Swaps. 172 ESMA’s monitoring of the evolution of short positions in the most heavily shorted shares found that levels of short selling were not significantly affected over the early 2021 meme-​stock volatility spike: TRV No 2 (2021) 11. For a review see ESMA, Review of Certain Aspects of the Short Selling Regulation. Consultation Paper (2021).

558 Trading Covid-​19 pandemic, was also linked to what was identified as a need for careful monitoring of ‘short squeeze’ risks, given changes to retail investor trading patterns which could drive ‘short squeezes’ (section 3.6).173 Earlier, the curbs on short selling imposed by six NCAs in March 2020, in response to the pandemic-​related acute market volatility, generated not-​ unexpected controversy, but short selling practices were subsequently re-​established, and while the fractured response generated some market confusion, there was little sustained disruption (section 3.7). The Regulation and its administrative rules have also been remarkably stable, being reformed materially only in 2022, when the threshold for supervisory reporting on net short positions was reduced. The elements that were most heavily contested over the negotiations (the provisions relating to sovereign debt CDSs) have proved largely uncontroversial.174 The Regulation has, however, been the subject of a series of reviews which, if to different degrees, can be characterized as being empirically based (ESMA’s data-​sets have expanded over time as data flows from the Regulation’s reporting requirements have increased), sensitive to market practice (being accompanied by extensive consultations), and, for the most part, cautious in the recommendations made, auguring well for the resilience of future reforms. The Commission’s initial 2013 review,175 based on ESMA’s largely positive assessment,176 found that the Regulation had not generated significant problems, that market dynamics had not been prejudicially disrupted, and that the Regulation had made a positive impact in terms of greater transparency of short sales and reduced settlement failures. While it noted ESMA’s related proposals for reform, it decided against taking action, given in particular the limited empirical evidence available, and called for a second review of the Regulation by end 2016. Subsequently, difficulties with the operationally critical exemption for market-​ makers led to a 2016 ESMA peer review of NCA experience with ESMA’s 2013 Guidelines on the exemption,177 which shaped the subsequent Commission-​mandated ESMA review in 2017.178 While ESMA’s 2017 review was limited in scope (addressing the market-​making exemption, the short-​term (daily) prohibitions/​circuit-​breakers NCAs can impose on short 173 The increase was adopted by Delegated Regulation 2022/​27 [2022] OJ L6/​9. 174 ESMA’s initial 2013 review of the Regulation found that the highly contested prohibition on uncovered sovereign CDSs had not had a ‘compelling impact’ on the liquidity of the EU CDS market or on the related sovereign debt market, although a decline in activity in sovereign CDSs in a few EU Member States, and reduced liquidity in EU sovereign CDS indices, had occurred: ESMA, Technical Advice on the Evaluation of the Short Selling Regulation (2013). For an early positive assessment of the sovereign debt CDS measures see Juurikkala, O, ‘Credit Default Swaps and the EU Short Selling Regulation’ (2012) ECFLR 307. 175 Commission, Report from the Commission to the European Parliament and Council on the Short Selling Regulation (COM(2013) 885). The Art 45 review clause, in an indication of the contestation that had accompanied the Regulation, required the Commission to report on identified elements of the Regulation by June 2013. 176 ESMA’s main findings (in relation to only the first five months or so of the Regulation being in force) were broadly positive. As compared to a control group of US shares, it found a slight decline in the volatility of EU shares, mixed effects on liquidity (a decrease in bid-​ask spreads and no significant impact on traded volumes), but a decrease in price discovery effectiveness. It found that the thresholds for NCA supervisory reporting and for public disclosure in relation to net short positions in shares were appropriate, albeit that it recommended that the NCA supervisory reporting threshold for sovereign debt be revised, given very limited reporting and general market unhappiness with the reporting thresholds. As regards the restrictions on uncovered short sales in shares and in sovereign debt, it found a reduction in the incidence of settlement failure, and recommended some technical adjustments to the ‘locate’ rule. As outlined in section 3.4, ESMA also found that the exemption for market-​ making was problematic in practice, being restrictive in scope and unclear. ESMA also found that the (limited) NCA exercise of emergency powers under the Regulation had been necessary and appropriate. 177 ESMA, Peer Review Report on Compliance with the Short Selling Regulation as Regards Market-​Making Activities (2016). 178 ESMA, Technical Advice on the Evaluation of Certain Aspects of the Short Selling Regulation (2017).

VI.3  The Regulation of Short Selling  559 selling, and the supervisory reporting/​public disclosure regime on net short positions),179 it was broadly positive, finding that the supervisory reporting/​disclosure regime was providing sufficient disclosures on net short positions, although ESMA reported that the circuit-​breaker power was of limited value. ESMA also recommended a series of predominantly technical revisions, designed to remove frictions and respond to market practice, including that the exemption for market-​makers be clarified and liberalized. Subsequently, ESMA’s 2022 own-​initiative review of how the Regulation had performed over the pandemic and meme-​stock periods was also largely positive, albeit that it recommended a series of operational enhancements. These included, in light of the meme-​stock episode in particular and related concerns as to settlement risks where short sellers get caught by ‘short squeezes’, a tightening of the ‘locate’ rules (mainly as regards record-​keeping and sanctions);180 clarification of the procedural modalities governing NCAs’ exceptional powers of intervention, in light of the pandemic experience with these powers; and enhancements to the supervisory reporting and public disclosure obligations relating to net short positions (ESMA recommended that aggregated, per issuer, net short positions be disclosed on a two-​weekly basis and that a centralized reporting system, based in ESMA, be established).181 Overall, the Regulation has weathered its first decade well. It emerged more or less unscathed from the pandemic and meme-​stock periods of acute market volatility and has become established as a stable component of the single rulebook. Given the novelty of its public disclosure requirements relating to net short positions, its ‘locate’ rules, and its exceptional powers of intervention for NCAs and ESMA, and the risks these posed to short selling capacity, this outcome could not have been predicted with any certainty in 2012. It is also clear that the technocratic capacity provided by ESMA has mitigated the risks the Regulation posed. Responsive soft law, ESMA’s interrogation of the expanding data-​set on the evolution of trends in short positions and in short selling practices, and ESMA’s regular reviews have all supported the application of the regime in practice. The operational revisions suggested by ESMA in 2013, 2017, and 2022, however, suggest that frictions and costs persist in the regime, including as regards the pivotal exemption for market-​makers, which have yet to be fully addressed.

VI.3.3  The Short Selling Rulebook: Legislation, Administrative Rules, and Soft Law The Short Selling Regulation, despite its novelty and its potentially disruptive effects, has, over a decade on, not been materially revised, with only two revisions of note. First, the adoption of the Central Securities Depositaries (CSD) Regulation in 2014,182 and its 179 In an indication of the extent to which the regime had settled, there was much less engagement with the related consultation than with the earlier 2012/​2013 review. Only a small number of market participants responded, leading ESMA to emphasize the limited feedback provided: 2017 ESMA Short Selling Review, n 178, 6. 180 As regards the ‘meme-​stock’ episode, ESMA reported on an increase in the share settlement fail rate in January 2021, linked to failures to deliver shares in two issuers which had net short positions in excess of 10 per cent of share capital, acknowledged that the increase could be circumstantial, but suggested that a review of the locate rules could nonetheless be useful in reducing the risk of ‘short squeezes’: 2021 ESMA Review Consultation, n 172, 40–​1. 181 ESMA, Review of Certain Aspects of the Short Selling Regulation (2022). 182 Regulation (EU) No 909/​2014 [2014] OJ L257/​1.

560 Trading establishment of a securities settlement discipline system, which includes sanctions for settlement fails, obviated the need for the Regulation’s ‘buy in’ rules, which were designed to protect against settlement fails.183 Second, in 2022, the Regulation’s supervisory reporting threshold for reporting on net short positions was reduced from 0.2 per cent of the relevant issued share capital to 0.1 per cent, thereby rendering permanent ESMA’s emergency lowering of the reporting threshold over the pandemic (section 3.6). This stability can be in part associated with the extensive administrative rules that amplify the Regulation, chief among them Delegated Regulation 918/​2012,184 the major administrative measure, and RTS 826/​2012185 and RTS 919/​2012,186 which are primarily concerned with calculation methodologies and reporting requirements. Alongside, ITS 827/​2012 is, unusually for an ITS, of quasi-​regulatory importance in that it sets out the types of ‘covering’ arrangements which qualify under the Regulation’s ‘locate’ rule.187 Despite the novelty, at the time, of ESMA’s role in administrative rule-​making, the rule-​ making process, which amplified and calibrated the political compromises articulated by the Regulation, was characterized by a generally good working relationship between the Commission and ESMA,188 and by a concern to avoid overly burdensome rules,189 albeit that the limited empirical evidence available posed challenges.190 The administrative rules have, like the Regulation, proved to be resilient and have yet to be revised. ESMA’s supervisory convergence measures, chief among them the Short Selling Q&A191 and the 2013 Guidelines on the market-​making exemption192 have further specified how the myriad complexities of the Regulation apply in practice. In addition, ESMA, to a greater degree than in other single rulebook measures, is embedded in the practical application of the Regulation, a characteristic of the regime that has further mitigated the risks of it having unintended adverse consequences and that has, relatedly, strengthened ESMA’s influence on the regime and its capacity to adjust it. It acts as a central hub for supervisory reporting and for public disclosures on net short positions as well as for other disclosures,193 and, through its regular reports on the evolution of short 183 The since deleted Art 15 of the Regulation was designed to address the settlement risks associated with uncovered short sales and to establish basic standards related to settlement discipline. 184 Delegated Regulation 918/​2012 [2012] OJ L274/​1. 185 RTS 826/​2012 [2012] OJ L251/​1. 186 RTS 919/​2012 [2012] OJ L274/​16 187 ITS 827/​2012 [2012] OJ L251/​11. 188 Delegated Regulation 918/​2012, the main administrative measure, broadly reflects ESMA’s advice. One notable departure from ESMA’s advice, however, related to the highly contested question as to how correlation should be assessed in relation to whether a sovereign debt CDS is used for legitimate hedging purposes and so is ‘covered’ (and, accordingly, permitted under the Regulation as uncovered sovereign CDSs are prohibited). The Commission adopted a mixed quantitative and qualitative approach, although ESMA (and the market generally) supported a qualitative approach. The RTSs and ITS were adopted by the Commission without any changes to ESMA’s proposals. 189 This was particularly the case in relation to the notification thresholds for net short sovereign debt positions, as regards which the Commission was keen to avoid onerous reporting obligations which would provide information of only limited systemic relevance: Commission Delegated Regulation 918/​2012 IA (SWD(2012) 198) 34. 190 Both the Commission and ESMA noted the paucity of evidence available in relation to the appropriate threshold for reporting of net short sovereign debt positions, eg: Commission Delegated Regulation 918/​2012 Impact Assessment, n 189 4, 33. 191 n 171. 192 ESMA, Guidelines. Exemption for market-​making activities and primary market operations under the Short Selling Regulation (2013). 193 In outline, ESMA host links to the websites which hold public disclosures of net short positions (Art 9(4)); maintains the list of shares for which the principal trading venue is a third country and which accordingly fall outside the Regulation (Art 16(2)); maintains the list of exempted market makers and authorized primary dealers (Art 17(13)); and maintains a list of all related penalties and administrative measures applicable in the Member States

VI.3  The Regulation of Short Selling  561 selling trends, including through its Trends, Risks and Vulnerabilities (TRV) Reports, has increased transparency on the structure of short selling in the EU. Further, ESMA’s review of NCAs’ exercise of their exceptional powers of intervention over short selling puts it in a position of some political delicacy, but it also enhances transparency on how these exceptional powers operate and can be associated with some degree of convergence in how NCAs use them (section 3.7). And while its own, parallel exceptional powers of intervention have, over time, become less novel as ESMA has acquired similar exceptional powers under different legislative measures (see Chapter IX on its product intervention powers, for example), they remain powerful vectors for shaping the short selling regime. This is underlined by the translation of ESMA’s first (and so far only) exercise of its exceptional powers (its temporary widening of the Regulation’s supervisory reporting requirements for net short positions over the Covid-​19 pandemic) into the 2022 binding revision to the Regulation’s reporting threshold for net short positions.

VI.3.4  Setting the Perimeter: Scope and Exemptions VI.3.4.1  Scope The Short Selling Regulation194 is designed to lay down a common regulatory framework with regard to the requirements and powers relating to short selling and CDSs, and to ensure greater coordination and consistency between Member States (recital 2). Its objectives are to increase the transparency of short positions held in certain securities; ensure Member States have clear powers to intervene in exceptional situations to reduce risks to financial stability and to market confidence arising from short sales and from CDSs; ensure coordination between Member States and ESMA in adverse situations; reduce settlement and other risks linked with uncovered short selling; and reduce the risks to the stability of sovereign debt markets posed by uncovered CDS positions.195 Accordingly, it imposes two sets of obligations on market participants (first, a prohibition on ‘uncovered’ transactions; second, transparency requirements) and confers a range of powers on NCAs and ESMA. The scope of the Regulation is widely drawn. Its perimeter is set by the wide range of instruments subject to the Regulation, not by the market participants who, by holding short positions in these instruments, become subject to the Regulation.196 Under Article 1, the Regulation applies to three sets of instruments. First, it applies to MiFID II/​MiFIR financial instruments, where those instruments are admitted to trading on a ‘trading venue’ (defined as an RM or an MTF) in the EU; these instruments are in scope when traded outside these venues, as long as they are admitted to these venues (Article 1(1)(a)). Second, it applies to derivatives,197 where those derivatives relate to an Article 1(1)(a) instrument, or relate to (Art 41). In addition, ESMA receives aggregated supervisory information on net short positions from NCAs on a quarterly basis and can request additional information relating to short sales and CDSs from NCAs (Art 11) and from market participants (Art 28). 194 The short selling regime takes the form of a regulation in order to ensure uniform application and to allow for the conferral of powers on ESMA. The removal of divergence recurs as a major rationale for intervention in the Regulation’s recitals: eg, recitals 1, 2, and 5. 195 Commission, FAQ. Commission Delegated Regulation on Short Selling and CDSs. 5 July 2012. 196 The regime typically applies to ‘natural and legal persons’, termed ‘persons’ in this discussion. 197 As specified in MiFID II (see Ch IV section 5.3).

562 Trading an issuer of such an instrument, including when these instruments are traded outside a trading venue (Article 1(1)(b)). Finally, it applies to debt instruments issued by a Member State or the EU, and to Article 1(1)(b) derivatives that relate to, or are referenced to, debt instruments issued by a Member State or the EU (Article 1(1)(c)). The range of emergency powers which are conferred on NCAs and on ESMA in exceptional market conditions apply to financial instruments generally, regardless of where they are admitted to trading (Article 1(2)). While wide in reach, the regime is calibrated. It does not, save when exceptional circumstances arise, apply to financial instruments generally. Its provisions are generally directed to short sales198 of shares and of sovereign debt,199 and to sovereign CDSs.200 Two sets of obligations apply to these instruments: a trading rule which prohibits ‘uncovered’ short sales of shares and sovereign debt, and transactions in uncovered sovereign CDSs; and a supervisory reporting/​public disclosure rule in relation to net short positions. In neither case is the domicile or establishment of the person entering into the relevant transaction determinative; the scope of the obligation is dictated by whether the related instruments are within the scope of the Regulation.

VI.3.4.2 The Market-​making Exemption Market-​making and related activities are exempted from the Regulation (Article 17) in order to ensure that liquidity, and the related ability of market-​makers to take short positions, is not prejudiced. The broadest market-​making exemption is available for transactions performed due to ‘market-​making activities’: these activities are exempted from the supervisory reporting and public disclosure obligations relating to net short positions; and from the prohibition on uncovered transactions (Article 17(1)). To benefit from this broadly cast exemption, the market-​maker must come within the classes of market-​maker identified in the Regulation;201 be a member of an in-​scope trading venue or an equivalent third country market where it deals as principal in a financial instrument (whether traded on or outside a trading venue);202 and act in any one of three identified capacities 198 A short sale in relation to a share or debt instrument is defined broadly as any sale of the share or debt instrument which the seller does not own at the time of entering into the agreement to sell, including a sale where, at the time of entering into the agreement to sell, the seller has borrowed or agreed to borrow the share or debt instrument for delivery at settlement: Art 2(1)(b). Three forms of transaction are excluded: a sale by either party under a repurchase agreement where one party has agreed to sell the other a security at a specified price with a commitment from the other party to sell the security back at a later date at another specified price; a transfer of securities under a securities lending arrangement; and entry into a future contract or other derivative contract, where it is agreed to sell securities at a specified price at a future date. The nature of ‘ownership’ for the purpose of the short sale definition has been amplified by Delegated Regulation 918/​2012 Art 3. 199 Sovereign debt is defined as a debt instrument issued by a sovereign issuer (Art 2(1)(f)). A sovereign issuer is widely defined as including the EU, a Member State (including a government department, agency, or SPV (special purpose vehicle) of the Member State), a member of the federation in the case of a federal Member State, an SPV for several Member States, an international financial institution established by two or more Member States which has the purpose of mobilizing funding and providing financial assistance to the benefit of its members that are experiencing or threatened by severe financing problems, and the European Investment Bank: Art 2(1)(d). 200 A CDS is defined as a derivative contract in which one party pays a fee to another party in return for a payment or other benefit in the case of a credit event relating to a reference entity and of any other default relating to that derivative contract which has a similar economic effect (Art 2(1)c). A sovereign CDS is one where a payment or other benefit is paid in the case of a credit event or default relating to a sovereign issuer (Art 2(1)(e)). 201 Including investment firms, credit institutions, and third country entities. 202 Although the actor in question must be a member of a trading venue or third country market, the actor is not required to conduct its market-​making activities on that venue/​market or to be recognized as a market maker on that venue/​market: 2013 ESMA Market-​Making Guidelines, n 192, 7. The restriction of the exemption to members of a trading venue has, however, limited the availability of the exemption for OTC market-​making activities and, as

VI.3  The Regulation of Short Selling  563 (Article 2(1)(k)).203 The exemption applies only in relation to market-​making activities and does not cover own-​account dealing generally by the actor in question.204 With specific reference to market-​making in sovereign debt, ‘authorized primary dealers’205 are exempted from supervisory reporting in relation to net short positions, and from the prohibition on uncovered short sales of sovereign debt and on uncovered sovereign CDSs (Article 17(3)). The relevant home NCA must be notified of use of the exemption, and is empowered to prohibit reliance on an exemption where it considers the related conditions are not met (Article 17(5)–​(8)). The NCA may also request information relating to short positions held or activities conducted under the exemption (Article 17(11)). The market-​making exemption has not been amplified by administrative rules, but ESMA adopted detailed Guidelines in 2013 designed to provide clarification on its scope.206 These Guidelines were at the time, and remain, controversial, with five NCAs, including the NCAs of the (then, pre-​Brexit) largest financial markets in the EU (of the UK, France, and Germany) recording their non-​compliance in the first year of the Guidelines’ operation.207 While their reasons varied, there was strong NCA disagreement with the limitations which the Guidelines imposed with respect to market-​makers’ trading venue membership.208 ESMA’s subsequent 2016 peer review of the Guidelines underlined the extent of NCA disagreement with aspects of the Guidelines.209 In its related 2017 review of the Regulation, which, at the request of the Commission, considered the market-​making exemption, ESMA recommended that legislative revisions clarify and liberalize the exemption, including as regards trading venue membership, but action has yet to follow.210 While the scope difficulties noted below (n 210), has been identified by ESMA as in need of reform. The equivalence criteria for third country markets are set out in Art 17(2) (the notion of equivalence and how it is used by the EU as regards third countries is discussed in Ch X). 203 The firm can post simultaneous two-​way quotes of comparable size and at competitive prices, with the result of providing liquidity on a regular and ongoing basis to the market; it can, as part of its usual business, fulfil orders initiated by clients or in response to clients’ requests to trade; or it can hedge positions arising from the fulfilment of the latter two tasks. 204 Short Selling Regulation recital 26. 205 Defined as a person who has signed an agreement with a sovereign issuer or who has been formally recognized as a primary dealer by or on behalf of a sovereign issuer and who, in accordance with the agreement or recognition, has committed to dealing as principal in connection with primary and secondary market operations relating to debt issued by that issuer: Art 2(1)(n). 206 The Guidelines provide, eg, that the exemption applies on a financial-​instrument-​basis and that the conditions which apply to the market-​making exemption must accordingly be met in relation to each financial instrument in respect of which exemption is sought, reflecting Commission advice to this effect: at 7. 207 Since then, further NCAs have recorded their non-​compliance, with seven recording non-​compliance in 2021: ESMA. Guidelines Compliance Table—​Guidelines on the Exemption for Market-​making Activities (2021). 208 The UK, eg, argued that while the exemption requires trading venue membership, it does not, contrary to ESMA’s view as outlined in the Guidelines, expressly require that the financial instrument in respect of which the market-​making exemption is sought must be traded on the trading venue where the actor seeking exemption is a member. The German NCA similarly rejected ESMA’s interpretation, arguing that it could take market-​making in sovereign CDSs outside the exemption, as these instruments are often not admitted to trading venues. The other non-​compliant NCAs related their reasons to the lack of a level playing field given other NCAs’ non-​compliance (France, Ireland, Italy, and Spain). 209 ESMA, Peer Review Report on Compliance with the Short Selling Regulation as regards Market Making Activities (2016). The review followed Commission concern that the reasons given by NCAs in explaining their non-​compliance with the Guidelines suggested some doubts as to the extent of NCA compliance with the market-​ making exemption more generally. 210 ESMA recommended, inter alia, that the Regulation specify more widely and in more detail the coverage of qualifying market-​making activities, and that the trading venue membership requirement not apply where the instruments in relation to which the exemption is sought are only traded OTC. It also proposed a tightening of the exemption by means of a new reporting obligation for market makers: 2017 ESMA Review, n 178.

564 Trading remain unresolved, ESMA’s repeated efforts, through Guidelines, peer review, and the proposal of legislative reforms, to clarify the operation of the exemption, which is a critical device for fixing the perimeter of the Short Selling Regulation, underscore the pivotal role it has come to play in managing the operational challenges the Regulation has generated.

VI.3.5  Restricting Short Sales: The Uncovered Short Sales Prohibition and ‘Locate’ Rules VI.3.5.1 The Prohibition At the core of the Regulation is the prohibition on ‘uncovered’ short sales of shares and of sovereign debt and on transactions in uncovered sovereign CDSs (Articles 4 and 12–​13). The conditions which govern whether transactions are ‘covered’ (ie the rules requiring that the shorted securities are, in some way, ‘located’), and so outside the prohibition, were the subject of intense negotiations, becoming a focal point for the wider debate on the legitimacy and efficacy of short sales, particularly short sales achieved through sovereign CDSs. The resulting regime is complex and technical, as it is designed to balance between the need to protect longstanding market hedging and risk-​management practices, and the need to reflect the strong political concern, particularly in the European Parliament, to prohibit uncovered short sales and uncovered sovereign CDS transactions. In practice, the rules have not experienced undue strain.211 The locate rules are also supported by the ‘settlement discipline’ requirements since adopted under the 2014 CSD Regulation, in an indication of the increasingly intricate but also holistic character of the single rulebook.212 VI.3.5.2 Uncovered Short Sales in Shares and the ‘Locate’ Rule Under Article 12, a natural or legal person may enter into a short sale of a share admitted to trading on a trading venue only where one of three sets of conditions, designed to ensure the sale is ‘covered’, is met. These conditions have been subject to detailed amplification by ITS 827/​2012. A short sale is covered where the person has borrowed the share or has made alternative provisions resulting in a similar legal effect (Article 12(1)(a)). A short sale is also covered where the person has entered into an agreement to borrow the share or has another ‘absolutely enforceable claim’ under contract or property law to be transferred ownership of a corresponding number of securities of the same class, so that settlement can be effected when it is due (Article 12(1)(b)). ITS 827/​2012 specifies the range of agreements and claims which can be employed (futures and swaps; options; repurchase agreements; standing agreements and rolling facilities; agreements relating to subscription rights; and other claims or agreements) and the conditions which these agreements must meet (Article 5). 211 The increased risk of settlement fails exposed by the Gamestop episode led ESMA to consider recommending a tightening of the rules to mitigate the risk of ‘short squeezes’: 2021 ESMA Review Consultation, n 172, 39–​48. Its final review did not, however, suggest material changes, proposing that records be kept (for five years) regarding compliance with the locate arrangements, in order to support NCA monitoring; and, relatedly, that the Regulation’s administrative sanctioning regime be tightened so that specific sanctions, based on those applicable under the market abuse regime, apply to ‘locate’ rule breaches (at 41–​8). 212 Ch V section 14 (albeit that the pivotal ‘mandatory buy-​in’ rules have yet to come into force).

VI.3  The Regulation of Short Selling  565 Finally, and significantly in terms of market practice, a short sale is covered where the (highly contested)213 ‘locate rule’ is met: the person has an arrangement with a third party under which that third party has confirmed that the share has been located and has taken ‘measures’ vis-​à-​vis third parties necessary for the person to have a ‘reasonable expectation’ that settlement can be effected when it is due (Article 12(1)(c)). ITS 827/​2012 sets out the three permissible forms of locate arrangements and measures and the related confirmations required (Article 6).214 The standard requirement is that the third party (i) confirms, prior to the short sale being entered into by the person, that it considers it can make the share available for settlement in due time, taking into account the amount of the possible sale and market conditions, and indicates the period for which the share is located (the ‘locate’ confirmation), and (ii) confirms, prior to the short sale being entered into, that it ‘has at least put on hold’ the requested number of shares for the person (the ‘put on hold’ confirmation) (Article 6(2)). Lighter requirements apply to confirmations relating to intra-​day short sales (Article 6(3)) and short sales of liquid shares (Article 6(4)).215 ITS 827/​2012 also specifies the third party with whom these arrangements can be made (Article 8); in effect, the third party must be a legally separate entity from the short seller.

VI.3.5.3 Uncovered Short Sales in Sovereign Debt and the ‘Locate’ Rule Similar but lighter rules govern whether a short sale in sovereign debt is covered, and so permitted, although an exemption regime applies which reflects significant Member State concern as to the potential damage to the sovereign debt market. Under Article 13, a short sale of sovereign debt may only be carried out where the sale is covered, in that it meets one of three conditions. First, the relevant person must have borrowed the sovereign debt or have made alternative provisions resulting in a similar legal effect (Article 13(1)(a)). Second, the person must have entered into an agreement to borrow the sovereign debt or have another absolutely enforceable claim under contract or property law to be transferred ownership of a corresponding number of securities of the same class so that settlement can be effected when it is due (Article 13(1)(b)). Finally, a ‘locate rule’ applies, in that the sale is covered where the person has an arrangement with a third party under which the third party has confirmed that the sovereign debt has been located or otherwise has a reasonable expectation that settlement can be effected when it is due (Article 13(1)(c)).216 The restrictions on uncovered short sales of sovereign debt are lighter than those which apply to shares, in order to reflect concern as to the potential detriment a limited interpretation of ‘covered’ could cause to Member States’ management of their budget deficits.217 ITS 827/​2012, in amplifying Article 13, accordingly seeks to preserve

213 The Commission and European Parliament took a restrictive approach to the locate rule, requiring that the locate confirmation confirm both that the third party in question had located the securities and that the securities were reserved for lending. The Council’s more facilitative approach prevailed in the Regulation as finally adopted. 214 The different arrangements are based on EU market practice as well as on the US regulatory framework for short sales: Commission FAQ, Short Selling Technical Standards, 29 June 2012. 215 In particular, the third party must provide the locate confirmation, but need only confirm that the share is easy to borrow or purchase in the relevant quantity, taking into account market conditions (the ‘put on hold’ confirmation does not accordingly apply). 216 This requirement is lighter than the parallel requirement as regards shares, which requires that related measures be taken: Art 12(1)(c). 217 As was acknowledged by the Commission: 2012 Commission FAQ, Short Selling Technical Standards, n 195.

566 Trading liquidity in the sovereign debt markets and adopts lighter requirements than those applicable to shares as regards the related conditions that apply.218 The requirement for sovereign debt short sales to be covered can be temporarily suspended by the relevant NCA,219 where it determines that liquidity has become restricted in that it has fallen below the relevant threshold, set in accordance with the Regulation (Article 13(3) and (4)). Given the sensitivity of this suspension, its operation has been specified in some detail by Delegated Regulation 918/​2012. The relevant NCA must notify other NCAs, and also notify ESMA, which must issue an opinion within 24 hours on the proposed suspension and its compliance with the related conditions (Article 13(3)). ESMA is accordingly required to opine, in a likely charged and time-​pressured environment, on the validity of potentially highly controversial decisions by NCAs. The suspension is valid for an initial period not exceeding six months, although it may be renewed for an additional six-​month period if the qualifying liquidity conditions continue to prevail (Article 13(3)).

VI.3.5.4 Uncovered Sovereign CDSs Most controversy over the negotiations attended the Regulation’s prohibition of uncovered sovereign CDSs. Accordingly, a complex regime governs when a sovereign CDS is ‘covered’, and so permitted, which is designed to protect legitimate hedging activities. Under Article 14(1), a natural or legal person may only engage in a sovereign CDS transaction where the transaction does not lead to an uncovered sovereign CDS position. Whether or not a sovereign CDS is covered, and so permitted, is a function of whether the CDS is deployed for the hedging purposes which the Regulation permits. Two forms of hedging are permitted: hedging against the risk of default of the sovereign issuer, where the person in question has a long position in the debt of the issuer to which the CDS relates; and hedging against the risk of a decline of the value of the sovereign debt, where the person holds assets or is subject to liabilities, including but not limited to financial contracts, a portfolio of assets, or financial obligations, the value of which is correlated to the value of the sovereign debt (Article 4). The second of these two hedges—​the ‘proxy hedge’—​is of central importance to hedging and risk management in the sovereign CDS market. The boundary between legitimate and illegitimate proxy hedges is, however, a difficult one to establish and police, given the complexities related to, for example, the extent to which the relevant exposures should be correlated with the CDS,220 as well as the dynamism of the exposures, which can change in value over time, affecting the coverage of the hedge. Accordingly, a complex regime, designed to ensure consistency in supervisory and market practice, governs the extent to which the CDS is correlated to the proxy hedged assets or liabilities, under Delegated Regulation 918/​2012 (Articles 14–​20). In essence, under Delegated Regulation 918/​2012, four major conditions govern whether the sovereign CDS is covered, in that it relates to a legitimate proxy hedge. First, the assets or liabilities must be in the sovereign Member State; despite significant market opposition, 218 In essence, the locate regime for sovereign debt does not require that the securities are placed on hold by the third party. In the standard arrangement, the third party, prior to the sale being entered into, must confirm that it considers that it can make the sovereign debt available for settlement in due time, in the amount requested by the person, taking into account market conditions, and indicate the period for which the sovereign debt is located (Art 7(1)). 219 The NCA of the Member State which has issued the debt: Art 2(1)(j)(i). 220 A generous approach to correlation could lead to almost any hedge being deemed as ‘covered’: 2012 Delegated Regulation 918/​2012 IA, n 189, 8.

VI.3  The Regulation of Short Selling  567 cross-​border proxy hedges are not permitted save to a very limited extent and in relation to cross-​border, group-​related assets and liabilities (Article 15). Second, the hedged assets and liabilities must come within the scope of those assets and liabilities specified as qualifying for the proxy hedge (set out in Article 17). Third, a proportionality requirement applies in that the CDS position must be proportionate to the size of the exposures hedged—​although a ‘perfect hedge’ is not required, given the potential volatility of the exposures hedged, and the difficulties in exactly capturing the risks in question; limited over-​provisioning is permitted (Article 19). Finally, the nature of the correlation assessment used to ensure the exposures are correlated to the CDS is specified; a quantitative or qualitative assessment may be used (Article 18).221 Under the quantitative element, there must be a correlation co-​efficient of at least 70 per cent between the price of the assets or liabilities hedged and the price of the sovereign debt;222 the 70 per cent correlation requirement is deemed to be met in specified circumstances, which provide a safe harbour.223 Under the qualitative element, a ‘meaningful correlation’ (based on appropriate data and not just on evidence of a merely temporary dependence) must be shown.224 A person entering into a sovereign CDS position must, on the request of the NCA, demonstrate compliance with the applicable conditions (Article 16). As with the prohibition on uncovered sovereign debt short sales, the prohibition on uncovered sovereign CDSs may be suspended in exceptional circumstances, designed to capture situations in which the Member States’ ability to raise funds might be compromised (Short Selling Regulation Article 14(2)). An NCA may suspend the prohibition225 where it has objective evidence for believing that its sovereign debt market is not functioning properly and that the prohibition might have a negative impact on the sovereign CDS market, especially by increasing the cost of borrowing for sovereign issuers or by affecting sovereign issuers’ ability to issue new debt. Any such decision by the NCA must be based on the specified indicators relating to: a high or rising interest rate on the sovereign debt; a widening of interest rate spreads on the sovereign debt compared to the sovereign debt of other issuers; a widening of the sovereign CDS spreads as compared to the sovereign debt’s own curve and compared to other sovereign issuers; the timeliness of the return of the price of the sovereign debt to its original equilibrium after a large trade; and the amount of sovereign debt that can be traded.226 As with the suspension regime for uncovered sovereign debt short sales, ESMA must be informed and provide an opinion within twenty-​four hours and other NCAs must be informed. The suspension applies for an initial twelve-​month period but can be extended subsequently for six-​month periods. Additionally, where a suspension applies, 221 The Commission considered the relative merits of qualitative and quantitative approaches in some detail and despite ESMA’s support for a qualitative approach, chose a mixed approach: 2012 Commission Regulation 918/​ 2012 IA, n 189, 22–​3 and 26–​31. 222 The correlation is assessed in relation to the price of the assets or liabilities, and the price of the sovereign debt, calculated on a historical basis using data for at least a period of 12 months of trading days immediately preceding the date when the CDS position was taken out: Art 18(1)(a). 223 The 70 per cent condition is met where the exposure being hedged relates to: an enterprise which is owned, majority owned, or has its debts guaranteed by the sovereign issuer; a regional, local, or municipal government of the Member States; an enterprise whose cash flows are significantly dependent on contracts from a sovereign issuer; or a project which is funded, significantly funded, or underwritten by a sovereign issuer, such as an infrastructure project: Art 18(2). 224 Art 18(1)(b). The time frame for the calculation of the correlation is specified. 225 Any uncovered sovereign CDS positions created over the suspension period can be held until maturity: Art 46(2). Reporting requirements also apply under Art 8. 226 NCAs may also use other indicators.

568 Trading natural or legal persons holding an uncovered position in a sovereign CDS must notify the relevant NCA227 where the position reaches or falls below the reporting thresholds for sovereign debt (section 3.6) (Article 8).

VI.3.6  Transparency of Net Short Positions: Supervisory Reporting and Public Disclosure VI.3.6.1 The Transparency Regime These restrictions are accompanied by transparency requirements in relation to net short positions. These take two forms. First, holders of net short positions are subject to NCA/​supervisory reporting obligations designed to enhance NCAs’ ability to monitor short selling activities for financial stability, orderly trading, and market integrity risks that might arise, including through the emergence of ‘short squeezes’.228 Supervisory reporting on short sale activity sits at the less interventionist end of the regulatory spectrum as, being private, it does not generate risks to short sellers’ positions or constrain net positions, although it can have a ratchet effect, driving more interventionist supervisory action. Nonetheless, the threshold at which the reporting obligation applies requires careful calibration to avoid inefficient over-​reporting or, conversely, under-​reporting which obscures the scale of short positions and undermines the purpose of this form of reporting. Public disclosure requirements regarding net short positions also apply, designed to enhance pricing mechanisms by providing disclosure to the market on short positions and so on negative sentiment. These obligations, a novelty at the time of their adoption,229 are more interventionist than the supervisory reporting requirements as, in practice, they place non-​ binding/​soft constraints on the taking of short positions: they create incentives for short sellers to hold positions short of the reporting threshold, in order to avoid exposing short positions to the market and to the risk of market reaction. They can, therefore, be characterized as soft substitutes for short selling bans. Nonetheless, they are non-​binding, their impact depends on the trading strategy and net positions of the relevant position holder, and they have more incremental effects than prohibitions, shaping how positions are formed over time.230 Public disclosure requirements require careful fine-​tuning as they can, accordingly, distort short sellers’ incentives to enter into short sales and thereby disrupt liquidity and price formation; they can also generate herding effects, similarly distortive of price formation, where short positions generally are increased in response to disclosure of the positions held.231 227 The NCA of the relevant sovereign: Art 2(1)(j). 228 ESMA has reported that NCAs use supervisory reports on net short positions as, as regards specific shares, indicators of potentially over-​valued or volatile shares or shares that could suffer a ‘short squeeze’; to monitor trends in specific shares and sectors affected by net short positions; and, in aggregate, to monitor whether market conditions are deteriorating: ESMA, Opinion, 13 May 2021. 229 Public disclosure of net short positions is not, eg, required in the US. The disclosure regime was, nonetheless, significantly less controversial over the Regulation’s negotiations than the rules on uncovered transactions, in part given experience with CESR’s 2010 soft standards for disclosure and reporting (albeit that these standards covered only shares). 230 On the transformative effects of public reporting of net short positions see ESMA, TRV No 1 (2018) 61. 231 ESMA has found some evidence of positions being held below the public reporting threshold in order to avoid public disclosure, as well as some evidence of herding effects: ESMA, TRV No 1 (2018) 60–​7. Similar effects were identified in Copenhagen Economics, Market Impact of Short Sale Position Disclosures (2021) and in Jank,

VI.3  The Regulation of Short Selling  569 As outlined below, the thresholds that govern supervisory reporting and public disclosure under the Regulation are supported by review mechanisms that allow for adjustment and refinement in light of market experience. The Regulation does not impose an order flagging requirement. ‘Flagging’ rules require that short sale orders are ‘marked’, as the order is placed, and that aggregate daily reports on short positions, based on the marking of orders, are filed with the regulator. Although such a requirement was originally supported by the Commission and European Parliament, it was opposed by the Council and not pursued given, inter alia, concerns as to the data quality risks inherent in order flagging.232 Since then, the MiFIR Article 26 transaction reporting obligation has required post-​trade disclosure of short sale transactions, but these disclosures are less informative than order-​based disclosures on open short positions.

VI.3.6.2  Shares The share transparency requirements apply in relation to net short positions in shares, or to the position remaining after deducting the long position held in relation to the issued share capital233 from any short position held in relation to the share capital (Article 3(4)). An expansive approach has been adopted to the net short position assessment (and thereby to the transparency regime), designed to capture the building of positions through derivatives: a short position in shares is one which results from either a short sale of a share issued by a company or from a transaction which creates or relates to a financial instrument other than a share, where the effect (or one of the effects) of the transaction is to confer a financial advantage on the person entering into the transaction in the event of a decrease in the price or value of the share (Article 3(1)). A long position, conversely, arises from holding a share, or, similarly, from a transaction which creates or relates to a financial instrument other than a share, where the effect (or one of the effects) of the transaction is to confer a financial advantage on the person entering into the transaction in the event of an increase in the price or value of the share (Article 3(2)). Where a short or long position is held indirectly (including through an index, a basket of securities, or an exchange-​traded fund (ETF)), the person in question must determine whether the reporting requirement applies, acting reasonably having regard to publicly available information as to the composition of the relevant index or other vehicle.234 The administrative regime amplifies when a person ‘holds’ a share,235 and specifies how the calculation of net short positions is to be carried out,236 including with respect to when different entities in a group have long or short positions237 and in the asset management context.238 S, Roling, C, and Smajlbegovic, E, ‘Flying Under the Radar: The Effects of Short-​Sale Disclosure Rules on Investor Behaviour and Stock Prices’ (2021) 139 JFE 209. 232 CESR earlier warned of imperfections in flagging-​related data, that such data might simply replicate that already available from proxy sources, notably in relation to securities lending, while imposing significant costs, and that this data did not provide disclosure on aggregate individual short positions. 233 Defined as the total of ordinary and preference shares issued by the company, but not including convertible debt securities: Art 2(1)(h). 234 No person is required to obtain any real time information as to such composition from any person (Art 3(3)). 235 Delegated Regulation 918/​2012 Art 4 (linking the ‘holding’ of a share to owning the share and having an enforceable claim to be transferred ownership of the share). 236 Delegated Regulation 918/​2012 Arts 5 and 6. 237 Delegated Regulation 918/​2012 Art 13. 238 Delegated Regulation 918/​2012 Art 12.

570 Trading Two reporting obligations apply to net short positions in shares, in each case subject to a qualifying threshold: the lower in relation to supervisory NCA reporting; and the higher in relation to public disclosure. As regards supervisory NCA reporting, a person who has a net short position in relation to the issued share capital of a company that has shares admitted to trading on a trading venue (an RM or MTF) must notify the relevant NCA239 where the position reaches or falls below 0.1 per cent of the issuer’s share capital initially, and each 0.1 per cent above that (Article 5). The reporting threshold was initially set at 0.2 per cent, but was reduced to 0.1 per cent in 2022, following ESMA’s temporary lowering of the threshold in March 2020 (from 0.2 per cent to 0.1 per cent) to enhance supervisory monitoring of short sales at a time of intense pandemic-​related market volatility. Review of the original 0.2 per cent threshold was, from the outset, implied by Article 5, which empowered ESMA to issue an opinion to the Commission on adjusting the threshold, taking into account development in financial markets, and which empowered the Commission to modify the threshold, again taking into account developments in financial markets. The 0.2 per cent threshold remained in place until March 2020, when ESMA, exercising its powers of emergency intervention (section 3.7), lowered the threshold to 0.1 per cent as the Covid-​19 pandemic deepened, and kept this threshold in place, through repeated renewals of three months duration, for one year. Following ESMA’s subsequent 2021 review of the reduction, which found that the additional supervisory reporting had significantly strengthened NCA monitoring capacity, and that rendering the reduction permanent would therefore support market monitoring but also respond to structural market change by allowing for closer monitoring of when ‘short squeezes’ might arise on foot of retail investor trading,240 the Commission revised the Regulation to permanently decrease the Article 5 threshold from 0.2 per cent to 0.1 per cent.241 Whatever its merits (and supervisory reporting has significant attractions as a regulatory tool given the uncertainties associated with the regulation of short selling), the revision has the benefit of following a year of market-​based testing, during which it did not pose material difficulties. Public disclosure of net short positions in shares admitted to trading on a trading venue triggers at a higher level:242 disclosure is required where the position reaches or falls below the higher threshold of 0.5 per cent of the issued share capital, and each 0.1 per cent above that (Article 6).243 This threshold is also subject to ESMA review and Commission adjustment, but it has remained in place since 2012. The threshold has been associated with some price formation impacts,244 but it has not generated significant contestation. ESMA’s 2017 review found that the threshold, while associated with some herding effects and while creating incentives to keep net short positions below 0.5 per cent, supported meaningful 239 The determination of the relevant NCA is carried out according to the rules which govern the relevant NCA for the purposes of Art 26 transaction reporting under MiFIR. 240 ESMA, Opinion, 13 May 2021. 241 Delegated Regulation 2022/​27 [2022] OJ L6/​9. The Commission placed the reduction in the context of the more frequent recourse by NCAs to emergency measures, notably over the pandemic, but also the growing risk of retail investors being involved in ‘short squeezes’ (as highlighted by the meme-​stock turmoil). 242 The higher threshold reflects the potential risks to the position holder (who might become vulnerable to moves against the position once it is disclosed), as well as the herding risks which might generate market instability were trading to follow the direction of the disclosed positions to a significant extent. 243 Art 6 applies without prejudice to rules which may apply at national level, and in accordance with EU law, in relation to the disclosure of positions held in the context of takeover transactions: Art 6(5). 244 See n 231.

VI.3  The Regulation of Short Selling  571 transparency and did not require revision.245 ESMA’s 2021 review was similarly supportive, finding that the threshold had not generated price formation difficulties, or driven ‘short squeezes’ over the early 2021 period of meme-​stock volatility, and remained appropriate.246 These public disclosures may be strengthened in light of ESMA’s recommendation that, to build on the public disclosures available and enhance transparency, disclosure be made of aggregated, per issuer, net short positions on a two-​weekly basis, a recommendation which was broadly supported by market stakeholders as being informative,247 and which illustrates the increasing sophistication and density of the EU’s financial markets data infrastructure.

VI.3.6.3 Sovereign Debt Transparency requirements also apply to net short positions in sovereign debt, reflecting the distinct political conditions under which the Regulation was negotiated. A net short position in sovereign debt is the position remaining after deducting any long position held in the issued sovereign debt,248 and also after deducting any long position in debt instruments of a sovereign issuer, the pricing of which is ‘highly correlated’249 to the pricing of the given sovereign debt, from any short position held in relation to the same sovereign debt (Article 3(5)). The calculation of long and short positions in sovereign debt is to be made for each single, sovereign issuer, even if separate entities issue debt on behalf of the sovereign issuer (Article 3(6)). Sovereign CDSs referenced to the sovereign issuer must be included in the calculation.250 Otherwise, the calculation is as for shares (Article 3(1) and (2)).251 Article 7 imposes a supervisory reporting obligation as regards net short positions relating to sovereign debt (and, where relevant, sovereign CDSs).252 The relevant thresholds which trigger the reporting obligation were not set out in the Regulation, given the complexities,253 but were specified in Delegated Regulation 918/​2012 (Article 21). Sovereign debt is classified into three baskets for the purposes of determining which reporting threshold applies:254 an initial 0.1 per cent (of the total amount of outstanding sovereign 245 2017 ESMA Review, n 178, 51–​3. ESMA noted that while there was a risk of price formation being disrupted, this was limited given the evidence of short sellers holding positions above the 0.5 per cent threshold, and that the threshold represented an appropriate trade-​off between increasing transparency and allowing short sellers to trade profitably. There was also little evidence of market concern. 246 ESMA reported that while there had been concern about a parallel outbreak of ‘short squeezes’ in the EU, given the requirement for public disclosure of net short positions, this did not materialize, net short positions remained at moderate levels overall, and while the number of short sellers disclosing positions over 0.5 per cent declined somewhat over January to April 2021 (from 167 to 139), it was difficult to attribute this decline to net short position disclosure risks given the improving market conditions over this period: 2022 ESMA Review, n 181, 55–​9. 247 2022 ESMA Review, n 181, 53–​4. 248 Defined as the total of sovereign debt issued by a sovereign issuer that has not been redeemed: Art 2(1)(g). 249 See n 251. 250 A sale of a CDS is considered to represent a long position, and a purchase a short position: Delegated Regulation 918/​2012 Art 9(3). 251 The calculation of net short positions in sovereign debt has similarly been amplified by Delegated Regulation 918/​2012 Arts 8–​9, which address, inter alia, when sovereign debt of another issuer is ‘highly correlated’ and so included in the calculation of the related long position. 252 Where an NCA suspends the prohibition on uncovered sovereign debt as an exceptional measure (Art 14), a person holding an uncovered position in a sovereign CDS becomes, under Art 8, subject to the supervisory reporting requirements applicable to sovereign debt under Art 7. 253 Including in relation to a lack of data, the practical difficulties generated by frequent new issues of sovereign debt and the maturing of issues, differing levels of liquidity in different sovereign debt markets, and the danger of over-​reporting where thresholds are set at too low a level. 254 The classification is based on the need to ensure that the thresholds do not lead to over-​reporting of positions of minimal value, to reflect, accordingly the total amount of each sovereign’s debt and the average size of the related

572 Trading debt, regardless of different issues) and a subsequent 0.05 per cent threshold applies where the total amount of outstanding issued sovereign debt is between 0 and 500 billion euro; where the outstanding debt is above 500 billion euro, or where there is a liquid futures market for the particular sovereign debt, an initial 0.5 per cent and subsequent 0.25 per cent threshold applies. ESMA places Member States’ sovereign debt in one of these three baskets (0–​500 billion euro, 500 billion euro +​, and liquid futures market) and publishes the particular monetary amounts, in relation to Member States’ sovereign debt, to which the reporting obligation attaches.255 Public disclosure is not required, given the potential for damage to liquidity, particularly in markets which are under liquidity pressure.

VI.3.6.4 Dissemination and ESMA as a Data-​hub The modalities of the supervisory reporting and public disclosure processes are governed by Article 9 and its administrative rules. Under Article 9(1), the supervisory report or public disclosure must set out details of the identity of the person, the size of the relevant position, the issuer in question, and the date on which the position was created, changed, or ceased to be held. The public disclosures (for net short positions in shares) must be made in a manner which ensures fast access to the information on a non-​discriminatory basis and the information must be posted on a website operated or supervised by the relevant NCA; ESMA hosts links to these websites (Article 9(4)). The administrative regime specifies further the content of the supervisory NCA reports, the means through which public disclosure can be made in relation to shares, and the format in which the NCA reports are to be made.256 The reporting obligations have had the effect of ESMA becoming a data-​hub as regards net short positions. While NCAs must provide information in summary form to ESMA, on a quarterly basis, on net short positions relating to shares and sovereign debt (and uncovered sovereign CDS as relevant)257 (Article 11(1)),258 in practice, NCAs and ESMA have developed reporting channels that allow for daily reporting to enhance ESMA’s monitoring capacity.259 ESMA may also request, at any time and in order to carry out its duties under the Regulation, additional information from NCAs on net short positions related to shares, sovereign debt, or uncovered sovereign CDSs (Article 11(2)). Operational enhancements can be expected in the form of a centralization of net short position reporting, which would reflect the already significant centralization of trading-​related reporting within ESMA.260 positions, and to reflect the relative liquidity of each sovereign’s debt: Art 21(5) and Short Selling Regulation Art 7(3). 255 The monetary amounts are reviewed on a quarterly basis by ESMA to reflect changes in the total amount of outstanding debt, while the placing of Member States within particular baskets is reviewed annually: Delegated Regulation 918/​2012 Art 21(3) and (9). ESMA maintains a public register of the relevant monetary amounts, updated quarterly. 256 RTS 826/​2012 Art 2 and ITS 827/​2012 Arts 2 and 3. 257 n 252. 258 The format and content of these reports is specified in RTS 826/​2012 Arts 4 and 5 and ITS 827/​2012 Arts 3 and 4. 259 These were developed over the pandemic to facilitate pan-​EU monitoring: 2021 ESMA Review Consultation, n 172, 64. 260 ESMA recommended that the relevant supervisory reports and public disclosures be made directly to it, allowing for the development of a centralized supervisory reporting and public disclosure system for net short positions (2022 ESMA Review, n 181, 55–​8). Such a system would dovetail with the commitment to build a European Single Access Point for capital markets data (Ch II section 7.3).

VI.3  The Regulation of Short Selling  573

VI.3.7  Intervention in Exceptional Circumstances VI.3.7.1 NCA Powers The Regulation also confers a series of wide-​ranging powers of intervention, designed to address exceptional or emergency conditions, and subject to extensive conditionality and proceduralization, on NCAs and on ESMA. The NCA powers are triggered when there are adverse events or developments which constitute a serious threat to financial stability or to market confidence in the Member State concerned, or in one or more other Member States,261 and the measure in question is necessary to address the threat and will not have a detrimental effect on the efficiency of financial markets which is disproportionate to its benefits; the NCA’s determination in this respect is reviewed by ESMA. Where these threshold conditions are met, the NCA may require persons who have net short positions in relation to a specific financial instrument or class of financial instruments to notify to it, or to disclose to the public, details of the position where the position reaches or falls below a threshold fixed by the NCA (Article 18); the NCA may provide for exceptions, including in relation to market-​making and primary market activities.262 The NCA may also require persons engaged in the lending of a specific financial instrument or class of financial instrument to notify any significant change in the fees requested for such lending (Article 19). More interventionist action is envisaged by the totemic Article 20 power (the prohibition power) which empowers the NCA to prohibit or impose conditions relating to persons entering into a short sale or a transaction other than a short sale which creates, or relates to, a financial instrument, and the effect (or one of the effects) of that transaction is to confer a financial advantage on the person in the event of a decrease in the price or value of another financial instrument.263 Similarly, Article 21 empowers the NCA to restrict the ability of persons to enter into sovereign CDS transactions or to limit the value of sovereign CDS transactions.264 A one-​day ‘circuit-​breaker’ power, which is not subject to the Articles 18–​21 threshold/​ qualifying conditions, allows for the temporary restriction by NCAs of short sales in financial instruments, in the case of a ‘significant’ fall in price, and is designed to prevent disorderly declines in the value of specific financial instruments (Article 23).265 The Regulation 261 The nature of these adverse events or developments is amplified by Delegated Regulation 918/​2012 Art 24 which (in outline) identifies any act, result, fact, or event that is or could reasonably be expected to lead to: serious financial, monetary, or budgetary problems which may lead to financial instability concerning a Member State or bank and other financial institution deemed important to the global financial system; a rating action or default by any Member State or bank and other financial institution deemed important to the global financial system; substantial selling pressures or unusual volatility causing significant downward spirals in any financial instruments related to any bank and other financial institution deemed important to the global financial system; any relevant damage to the physical structures of important financial issuers, market infrastructures, clearing and settlement systems, and supervisors; and any relevant disruption in any payment system or settlement process. 262 This power does not apply where the financial instrument is already subject to transparency requirements under the Regulation: Art 18(2). 263 The NCA may apply the restriction to all financial instruments, financial instruments of a specific class, or a specific financial instrument, and may provide for exceptions (including in relation to market-​making and primary dealing activities). 264 As under Art 20, the NCA may apply the restriction to all sovereign CDS transactions of a specific class, or to specific sovereign CDS transactions, and may provide for exceptions (including in relation to market-​making and primary dealing activities). 265 The circuit-​breaker power is designed to empower NCAs to slow a negative price spiral without needing to show, at the same time, the exceptional, emergency conditions on which emergency intervention is otherwise dependent.

574 Trading specifies that a fall in value of 10 per cent amounts to a significant fall in value for a liquid share, while the required fall in value for illiquid shares and other financial instruments is governed by Delegated Regulation 918/​2012.266 The thresholds are set at levels designed to ensure that NCAs are not required to repeatedly and unnecessarily consider whether Article 23 ‘circuit-​breaker’ action should be taken.267 Temporal and procedural requirements apply. The Article 18–​21 restrictions may only be valid for an initial period of three months, which may be extended by further three-​month periods (Article 24), while the Article 23 circuit-​breaker power is short term, applicable in daily increments.268 Any exercise of power under Articles 18–​21 and also Article 23 must be disclosed on the NCA’s website and notified to the other NCAs (Article 26). In an indication of the sensitivities, an exercise of Article 18–​21 powers also requires consent from the ‘relevant NCA’ where the instrument trades on multiple venues. ESMA is also engaged, in order to support supervisory convergence in a highly sensitive area. Any proposed use of the Articles 18–​21 and 23 powers (and any renewal of related decisions) must be notified to ESMA (Article 26). Further, ESMA must review any proposed Article 18–​21 measures: ESMA must issue and publicly disclose an opinion on whether it considers the proposed measure269 necessary to address the relevant exceptional circumstances (Article 27(2)).270 An NCA can choose to take action contrary to the ESMA opinion, but must publicly explain its reasons for doing so; ESMA may also consider whether exercise of its exceptional Article 28 intervention powers (discussed later in this section) is then warranted. ESMA is less engaged with the Article 23 circuit-​breaker power, reflecting its time-​ sensitive nature. ESMA must, however, be notified and is required to support coordination where the instrument in question is traded in a number of venues across the Member States (the NCAs of those other venues must be notified by ESMA, and where disagreement arises between the NCAs concerned, ESMA must mediate between the NCAs, failing which ESMA can impose a decision in relation to the treatment of the instrument concerned).271 In practice, the circuit-​breaker power has not been regularly used, but it has experienced operational frictions which have led to ESMA suggesting that only one NCA, the NCA of the most relevant market in terms of liquidity, be empowered to use circuit-​breakers and that any such action apply to all trading pan-​EU and not be subject to a veto from other NCAs.272

266 Delegated Regulation 918/​2012, Art 23. 267 Delegated Regulation 918/​2012 IA, n 189, 14. 268 Article 23 restrictions must initially be imposed for not more than the trading day following the day on which the fall in price occurred and can only be extended for a further two days, and only where a further significant fall in value has occurred (Art 23(2)). 269 ESMA must also review the relevant measures regularly and at least every three months. 270 The opinion must state whether ESMA considers that adverse events or developments have arisen which constitute a serious threat to financial stability or market confidence in one or more Member States, whether the measure is appropriate and proportionate to address the threat, and whether the proposed duration is justified: Art 27(2). The opinion must also state if ESMA considers that the taking of any measures by other NCAs is necessary. 271 Very tight deadlines apply to notification and mediation under Art 23(4) which are designed to ensure agreement is reached by midnight on the day on which the NCA makes the restriction decision. 272 This recommendation was made in the 2017 and 2022 ESMA reviews and reflects ESMA’s concern as to the difficulties in resolving disputes in the short twenty-​four-​hour timeframe.

VI.3  The Regulation of Short Selling  575

VI.3.7.2 ESMA Powers The precedent-​setting political decision to confer binding intervention powers on ESMA in relation to short selling was taken prior to the adoption of the Short Selling Regulation and during the negotiations on the foundation Regulations for the European Supervisory Authorities (ESAs). At the instigation of the European Parliament, an enabling clause was added to the ESAs’ founding Regulations which permits the ESAs to temporarily prohibit or restrict financial products or services, once the specific power is conferred in the relevant legislation.273 A specific power to this effect was conferred under the Short Selling Regulation (Article 28), which has the effect of empowering ESMA in a highly sensitive area. ESMA has a range of powers, however, in relation to short selling, which range from facilitation of NCA action to direct action. Under Article 27, ESMA is to perform a coordination and facilitation role in relation to emergency (Articles 18–​21 and 23) measures taken by NCAs and is to ensure a consistent approach is taken by NCAs. As noted above, ESMA is also required to provide an opinion on Article 18–​21 NCA action and can facilitate mediation in the case of disputes between NCAs in relation to Article 23 NCA action. ESMA is further empowered to conduct an inquiry (on its own initiative, or at the request of the Council, the Commission, the European Parliament, or one or more NCAs) into a particular issue or practice relating to short selling or into the use of CDSs, in order to assess whether potential threats to financial stability or market confidence in the EU are engaged (Article 31). Attracting most contestation, and in what was, at the time, a precedent-​setting extension of its powers, ESMA is also empowered, subject to strict conditionality, to take direct action with respect to short selling (Article 28). Where the relevant threshold conditions are met, ESMA must either: require persons who have net short positions in relation to a specific financial instrument or class of financial instrument to notify an NCA or to disclose to the public details of any such position; or prohibit or impose conditions on the entry by persons into a short sale or a transaction which creates, or relates to, a financial instrument (other than sovereign debt or derivatives related to sovereign debt, including CDSs) where the effect (or one of the effects) of the transaction is to confer a financial advantage on such person in the event of a decrease in the price or value of another financial instrument (Article 28(1)).274 These measures, which are valid for three months in the first instance,275 prevail over any previous measure taken by an NCA under Articles 18–​21 and 23 (Article 28(11)). Before ESMA can act, stringent threshold conditions must be met. The measures must address a threat to the orderly functioning and integrity of financial markets or to the stability of the whole of part of the financial system in the EU, and there must be cross-​border implications (Article 28(2)).276 It must also be the case that no NCA has taken measures 273 In the case of ESMA, ESMA Regulation Art 9(5) (as finessed by the 2019 reforms to the ESA Regulations). 274 As with the parallel NCA powers, the measures may apply in particular circumstances or be subject to exceptions, including in relation to market-​making activity and primary market activities. 275 The measure can be renewed for subsequent three-​month periods, subject to the Art 28 conditions and procedural requirements being met: Art 28(10). 276 This condition has been amplified by Delegated Regulation 918/​2012 Art 24(3), which is similar to Art 24(1) of the Delegated Regulation, which specifies the nature of the threats which can lead to Art 18–​21 NCA action (n 261). The conditions differ, however, in that they are related to threats concerning a Member State, or the financial system within a Member State, and do not extend to banks and other financial institutions deemed important to the global financial system; and also in that they do not include the Art 24(1) condition relating to substantial selling pressures or unusual volatility in financial instruments related to banks or important financial institutions.

576 Trading to address the threat, or that one or more NCAs have taken measures but they do not adequately address the threat (Article 28(2)). In addition, before taking action, ESMA must take into account the extent to which the measure: significantly addresses the threat to the orderly functioning and integrity of financial markets or to the stability of the whole of part of the financial system in the EU, or significantly improves the ability of NCAs to monitor the threat; does not create a risk of regulatory arbitrage; and does not have a detrimental effect on the efficiency of financial markets, including by reducing liquidity in those markets or creating uncertainty for market participants that is disproportionate to the benefits of the measure (Article 28(3)). A number of procedural notification requirements must be met. The European Systemic Risk Board (ESRB) and, where relevant, ‘other relevant authorities’277 must be consulted before ESMA acts (or decides to renew a measure) (Article 28(4)). The NCAs concerned278 must also be notified at least 24 hours in advance of ESMA action,279 and public disclosure made280 in relation to any Article 28 decision or a renewal of a decision (Article 28(5)–​(9)). ESMA’s direct powers of intervention were contested over the negotiations on the Regulation. While the European Parliament supported powers of intervention for ESMA as regards the sovereign debt and CDS markets,281 these proposed powers proved highly contentious during Council negotiations, given the potential impact of any such intervention on a Member State’s borrowing costs, and were not supported. In addition, some Member States were of the view that the short selling powers conferred a wide discretion on ESMA, potentially in breach of the Court of Justice’s Meroni ruling, which prohibits any delegation of powers from an EU institution which involves the exercise of wide discretion by the delegate.282 In June 2012 the UK launched a challenge to the Article 28 power based on a series of grounds, chiefly relating to the power’s breach of the conditions which apply to the delegation of powers to ESMA. In January 2014 the Court rejected the challenge, finding that ESMA’s executive discretion was appropriately confined, and underlining the importance of the power in supporting financial stability as well as the technical capacity which ESMA brought to EU financial system governance.283

VI.3.7.3 Experience with the Exceptional Powers of Intervention: NCAs a.  Overview The Regulation’s rules on the transparency of net short positions, and its prohibitions on uncovered short sales, have, despite their novelty at the time of their adoption and related concerns as regards their impact on the sovereign debt markets in particular, proved to be workable in practice and are largely uncontested. The emergency/​prohibition powers, however, continue to attract controversy.284 Nonetheless, it is now clear, a decade or so on, 277 Undefined, but designed to capture, eg, authorities responsible for non-​financial commodities markets, where necessary (recital 33). 278 Not defined, but presumably the NCAs of the major venues and markets affected by the ESMA action. 279 Although a shorter notification period is permissible in exceptional circumstances. 280 The disclosure (on ESMA’s website) must specify the relevant measure(s) and include the reasons why ESMA is of the opinion that it is necessary to impose the measure(s) and the related supporting evidence. 281 European Parliament Press Release, Crack Down on Short Selling and Sovereign Debt Speculation (Ref 201110181PR29720), noting the Council’s refusal to accept the Parliament’s position. 282 Case 9-​56 Meroni v High Authority (ECLI:EU:C:1958:7). 283 Case C-​270/​12 UK v Council and Parliament (ECLI:EU:C:2014:18). See further Ch I section 6. 284 Analysis of the prohibitions, primarily from an economics/​finance perspective, tends to tilt towards scepticism as to the value of the prohibitions over the financial-​crisis and Covid-​19 pandemic periods, given

VI.3  The Regulation of Short Selling  577 that they are not ‘paper tigers’ and that they form an established part of the tool-​kit of exceptional powers that certain NCAs use in conditions of acute market stress (and it is also now clear that other NCAs do not contest their use). Care must be taken in drawing general conclusions given that these powers operate in exceptional and fact-​specific circumstances, and that their use is shaped by local context and regulatory traditions, but a few observations can be hazarded. The powers have been used by NCAs in a minority of Member States, primarily but not entirely those associated with most market instability over the financial-​crisis era: Austria (2020); Belgium (2020); France (2020); Greece (2012–​2013; 2015–​2016; 2020); Italy (2014; 2016; 2020); and Spain (2012; 2017; 2020).285 They have, in addition, been used once in Germany, the much criticized but idiosyncratic February 2019 prohibition of short selling in Wirecard; otherwise, Germany has been associated with a more sceptical stance as regards the curbing of short selling.286 Their use remains exceptional, with only sixteen instances of these powers being used over 2012–​2022 (excluding exercises of the short-​term, intra-​day circuit-​breaker power),287 and with Greece accounting for a significant proportion of these. Further, before the Covid-​19 pandemic period, their use was confined to specific issuers, or groups of issuers, primarily financial institutions, and associated with financial stability. It was only with the pandemic-​related March 2020 series of prohibitions that market-​wide prohibitions, oriented towards supporting orderly trading and financial stability, were introduced. It is also clear that, while short selling prohibitions are a function of individual NCA action, and accordingly apply in a fragmented manner across the EU, coordination has improved since the adoption of the Regulation. For example, NCAs are required to obtain consent from the other NCAs impacted by a proposed prohibition, but consent has never been withheld, in an indication of some degree, at least, of intra-​NCA trust on how the prohibitions are applied and also of the appropriateness, accordingly, of the Regulation’s conditions. The evidence also suggests that ESMA has been careful in exercising its oversight role over NCA action. It is tempting to read into ESMA’s support, since 2012, of all but one of the NCAs’ prohibition proposals, some ESMA reticence as regards robust oversight of NCA action; this is all the more the case as the reasoning in the NCAs’ proposals for action and in ESMA’s reviews can lean towards assertion, reflecting the precautionary nature of the interventions proposed, as well as the uncertainty which attends these interventions. Due account must be given, however, to the limits of what ESMA oversight can achieve, given

distortions to liquidity and market efficiency (nn 137 and 138). For a review see Langenbucher, K and Pelizzon, L ‘Short Selling—​On Ethics, Politics and Culture’ (2021) ZBB 301. 285 It has been suggested that short selling prohibitions tend to cluster in Member States with more recently developed capital markets and with lower regulatory tolerance for market volatility: Langenbucher and Pelizzon, n 284. 286 The Bundesbank was reported as not being supportive of the German NCA’s (BaFIN) proposal to prohibit short selling in Wirecard (Storbeck, O, ‘BaFin Ignored Bundesbank Concerns over Wirecard Short Selling Ban’, Financial Times, 24 November 2020), while the absence of prohibitions on short selling in Germany over the Covid-​19 pandemic was regarded as significant: Stafford P, Fletcher, L, and Smith, R, ‘Regulators across Europe Clash over Bans on Short Selling’, Financial Times, 31 March 2020. 287 The circuit-​breaker power is only rarely used (it was, however, used by NCAs in Belgium, France, Italy, and Spain in immediate advance of their issuing prohibitions on short selling in March 2020), is seen as of little value by market participants, and its benefits were doubted by ESMA in its 2017 review.

578 Trading the highly charged circumstances in which these powers are typically exercised, the related legitimacy risks to ESMA, the short time window for ESMA review, and the importance of local context to NCA action. Nonetheless, the constraints imposed by the requirement for NCAs to provide ESMA with a justification, against the legislative conditions, for the proposed intervention, the need for consent from other NCAs where the affected instruments are traded on multiple trading venues, and the transparency associated with ESMA’s review, impose some degree of discipline, increase transparency, and reduce the risk of capricious NCA action. b. NCA Action Three sets of prohibitions can be identified: the 2012–​2017 prohibitions relating to the financial crisis and to associated bank sector restructuring and imposed by the NCAs of Greece, Italy, and Spain; the February 2019 prohibition by the German NCA on short selling in Wirecard; and the pandemic-​related March 2020 prohibitions imposed by six NCAs to support orderly trading and financial stability. A short account of the experience follows. As regards the first set, the NCAs of three Member States took action. In 2012, the Spanish NCA extended a general prohibition on short selling, which had originally been imposed prior to the coming into force of the Short Selling Regulation, at the height of the euro area turbulence.288 Subsequently, in 2017, it imposed a targeted prohibition on short selling as regards one bank, related to that bank’s restructuring.289 In both cases ESMA supported the actions. The Italian NCA imposed prohibitions in 2014 and in 2016 on the short selling of specific bank instruments, on foot of significant selling pressure on the relevant banks, related to supervisory/​restructuring action; ESMA also supported these actions.290 The Greek NCA imposed a series of prohibitions that responded to ongoing instability in its banking market, all bar one of which were supported by ESMA. A first set of prohibitions on short selling in financial instruments generally, and also in securities of specific banks, was notified by the Greek NCA to ESMA over 2012–​2013 and supported by ESMA.291 A second set of prohibitions on short selling in financial instruments generally, and also in relation to securities of specific banks, was notified by the NCA to ESMA over 2015–​2016 and were all, bar one, supported by ESMA.292 In all these cases, the political and NCA sensitivities were acute. The different prohibitions were notified to ESMA either during the euro area turbulence over 2012–​2013; or responded to major disruption experienced by individual banks, either in relation to 288 Reviewed in ESMA/​2012/​715. 289 In June 2017, the Spanish NCA (the CNMV) notified a short selling ban on the shares of a Spanish bank which had experienced steep price falls during the Spanish banking market turbulence which had broken out at that time, and which was related to the resolution of the major Spanish bank Banco Popular. Reviewed in ESMA70-​146-​10. 290 The Italian NCA (CONSOB) notified ESMA in July 2016 of its proposal to impose a short selling prohibition on Monte dei Paschi di Siena bank following supervisory action requiring a reduction in the bank’s non-​performing loan exposure, and subsequent severe selling pressure on the bank’s shares. ESMA supported CONSOB’s determination that there was a serious threat to market confidence and financial stability in Italy and that the measure was proportionate and appropriate; ESMA also supported subsequent renewals (ESMA/​2016/​431 and ESMA/​ 2016/​1078). In October and November 2014, ESMA supported the original imposition and subsequent renewal by CONSOB of a short selling prohibition on the shares of two Italian banks, following the restructuring the banks required after the significant shortfall in their capital positions exposed by the 2014 ‘Comprehensive Assessment’ (stress test) of banks entering Banking Union (ESMA/​2014/​1355 and ESMA/​2014/​1312). 291 ESMA/​2013/​542, ESMA/​2013/​149, and ESMA/​2012/​717. 292 The different measures are reviewed in ESMA/​2016/​28.

VI.3  The Regulation of Short Selling  579 EU-​level resolution action/​EU-​level stress testing/​remedial action (in the case of the Italian and Spanish NCA actions), or EU-​led restructuring (in the case of the Greek NCA action). ESMA tread carefully amidst the EU level and national sensitivities, supporting NCA action in all but one case. While the lack of ESMA/​NCA contestation might suggest a hands-​off ESMA posture, ESMA’s approach became more technically sophisticated, data-​ informed, and challenging over time. ESMA’s reasoning is significantly more articulated in its 2016 and 2017 opinions on the Italian and Spanish NCAs’ notified actions, for example, as compared to its initial 2012–​2013 opinions, which simply recorded the NCAs’ reasoning and briefly noted compliance with the requirements of the Short Selling Regulation. An increasing appetite for challenge can also be detected. In its 2016 opinion on the Italian NCA’s proposed action, for example, ESMA queried the potential disruption which could arise from the NCA’s decision not to exempt market-​makers from the prohibition;293 while it adopted its first negative opinion in 2016, when it decided not to support action by the Greek NCA. The intrusive nature of this only (to date) negative ESMA opinion should not be overplayed, however, as it formed the last of a series of ESMA opinions which had previously supported a chain of Greek NCA prohibitions, and as the refusal related to a renewal of a previously ESMA-​supported prohibition and so was more a function of timing than of principle.294 A step-​change occurred over the Covid-​19 pandemic when six NCAs (of Austria, Belgium, France, Greece, Italy, and Spain), all supported by ESMA, applied prohibitions on a market-​wide basis, and on more precautionary and speculative grounds, for a two-​month period from March to May 2020.295 In the case of the proposed prohibitions by the NCAs of Austria, Belgium, France, and Spain, the measures were based on almost identical (and presumably coordinated) reasoning, and were all supported by data on the sharp drops in the main relevant market indices. The four NCAs all identified three risks to market confidence (a lack of clear information relating to the impact of the pandemic on issuers and related risks to price formation; heightened risks of dissemination of disinformation, including through social media, and related risks to price formation; and the similarity of the pandemic, in terms of its effects, to the natural disasters which can ground a case for the imposition of a short selling prohibition under the Regulation),296 which could, given the growth in short positions, destabilize markets and potentially prejudice financial stability (albeit that all the NCAs noted that there was as yet no evidence of impact on financial stability).297 In all four cases, the terms of the prohibitions were almost identical, applying to all shares traded on identified regulated markets (RMs) and MTFs, and with exclusions for specified 293 ESMA/​2016/​1078, para 18. 294 ESMA/​2016/​28. ESMA disagreed with the extension, finding that the relevant bank subject to the prohibition (Attica Bank) was a small bank within the Greek market and did not pose material risk to the pan-​EU banking market; that the risks posed to financial stability had become much less acute since a recent share capital increase; and that while there was a risk of increased volatility as the new shares had not yet commenced trading, the trading data did not indicate significant downward pressure on prices. The risk that falling Attica Bank share prices would endanger the orderly functioning and integrity of the whole Greek market was ‘not evident’ and it was not appropriate or proportionate to renew the measure accordingly. 295 The proposed measures were notified over 16–​18 March 2020 and were supported by ESMA over 17–​23 March 2020. Five of the six NCAs applied the relevant prohibition for one month, in the first instance, with the Italian NCA putting the relevant prohibition in place until June. Following a series of renewals, the prohibitions were lifted by all NCAs, including the Italian NCA, by 20 May 2020. 296 See n 261 on the conditions. 297 The cases are set out in ESMA70-​155-​9581 (France); ESMA70-​155-​9604 (Austria); ESMA70-​155-​9556 (Spain); and ESMA70-​155-​9590 (Belgium).

580 Trading index-​related instruments and for market-​makers. ESMA supported all four proposals in similar terms, recognizing an increased vulnerability in EU financial markets, and supporting the relevant NCA reasoning as evidencing the Short Selling Regulation conditions. ESMA also found the measures to be appropriate and proportionate, noting that limiting the restrictions to specific issuers or sectors might not achieve the desired outcomes; that the restrictions would not have a detrimental effect on market efficiency disproportionate to the benefits; that short-​term intraday measures (circuit-​breakers adopted under Article 23) would not address the threat to market confidence; and that the measures provided for exemptions for market-​makers and index-​related instruments. The Italian NCA’s proposal, while very similar in scope, was more narrowly justified, being related to evidenced high price volatility, downward pressure on pricing, and an increase in net short positions, and the related need for a prohibition to minimize the risk of a loss of market confidence; it was supported by ESMA in similar terms.298 Finally, the Greek NCA’s proposal,299 also of similar scope, was similarly based on high price volatility and downward pricing pressure (although the NCA did not observe significant increases in short positions) and the related need to protect the market from unusual price volatility; the Greek NCA also justified the proposed prohibition by specific local conditions, linking the need for the prohibition to the comparatively illiquid nature of the Greek capital market, and the risk that a failure to address the heightened volatility could hinder the market in recovering from the significant crisis it had experienced in recent years. ESMA supported the measure in similar terms as it did the other proposals, albeit also calling in aid the specific circumstances associated with the Greek capital market. The pandemic-​related prohibitions provided a test for the Regulation in conditions of widespread volatility. Given that only six NCAs took action, albeit that markets across the EU were experiencing similar conditions,300 the conditions precedent for NCA action can be regarded as accommodating different NCA interpretations and as leading, relatedly, to a lack of convergence across the EU. Similarly, some confusion at the outset as to the exact scope of the different prohibitions’ coverage generated market concern as to the risks and costs faced by market participants in picking their way across a fragmented landscape.301 The fractured NCA response, however, is an inevitable consequence of a system based on local NCA discretion and designed to accommodate different NCA perspectives on the management of short selling risks, in conditions of prevailing uncertainty.302 Nonetheless, the coordinated nature of the six sets of prohibitions, which were very similar in timing and in design, as well as the absence of any NCA veto of the measures, limited the potential for market uncertainty and indicates stronger coordination by NCAs. Similarly, ESMA’s 298 ESMA70-​155-​9565. 299 ESMA70-​155-​9587. 300 A subsequent clarification by BaFIN (the German NCA) that the prohibitions imposed by other NCAs did not apply to certain indices was interpreted as indicating that it did not see a need for the prohibitions: Stafford et al, n 286. The UK FCA, outside the EU but overseeing similar turmoil on UK trading venues, noted that it had never imposed a prohibition under the Regulation and would apply a high bar to any such decision, and that short selling contributed to open markets that operated with integrity by supporting effective price formation, enhancing liquidity, and enabling risk management: FCA, Statement on Short Selling Banks and Reporting, 17 March 2020. 301 Stafford et al, n 286. 302 Further, net short positions in those Member States which ultimately imposed prohibitions were more than double the levels in other Member States, suggesting that a lack of convergence was not unexpected: ESMA, TRV Report No 2 (2020) 22.

VI.3  The Regulation of Short Selling  581 expeditious review of the prohibitions and its unambiguous and purposeful support of the different measures, provided, at the least, regulatory certainty in conditions of extreme volatility. The ESMA review process also led to greater convergence in how the prohibitions applied.303 The experience underlines, nonetheless, the persistent contestation that attends this form of exceptional intervention. While ESMA’s subsequent 2022 review of the prohibitions was supportive,304 finding that while the prohibitions constrained liquidity (primarily in large capitalization shares) they also reduced price volatility,305 and while levels of net short positions had normalized by the end of 2020,306 the effectiveness of the prohibitions was contested.307 One outcome augurs well, however. ESMA’s 2022 review led to it proposing a series of operational enhancements which, if adopted, would minimize the uncertainty risks attendant on a regime that is based on NCAs’ local discretion.308 The February 2019 imposition by the German NCA of a prohibition on short selling in Wirecard, following steep drops in its share price over January and February 2019, is something of an outlier and caution is needed in interpreting its implications for the Regulation more generally. The prohibition, based on potential detriment to market confidence,309 faced intense criticism in light of the subsequent uncovering of the massive Wirecard fraud.310 Relatedly, ESMA’s support of the prohibition, albeit somewhat nuanced, was queried.311 While ESMA did not publicly comment on the short selling ban after the

303 The ESMA review process led to greater alignment across the prohibitions, in particular as regards the treatment of indices: ESMA, ESMA Issues Positive Opinions on Short Sell Bans by Austrian FMA, Belgian FSMA, French AMF, Greek HCMC, and Spanish CNMV, 15 April 2020. 304 The bans also garnered some market support, including from Euronext, trading on which was affected: Stafford, P, ‘Euronext Chief Backs Short Selling Ban’, Financial Times, 27 March 2020. 305 2022 ESMA Review, n 181, 12–​13. 306 After removal of the bans, short selling activity slowly built up again in the relevant Member States: ESMA, TRV No 1 (2021) 14–​15. 307 ESMA reported in its 2022 review that most respondents were ‘very critical’ of the prohibitions; ESMA’s response was that it was ‘no surprise’ that there were very different and divergent opinions but that the prohibitions supported NCAs in addressing financial stability risks: n 181, 12–​14 and 60. From the academic literature see Siciliano and Ventoruzzo (n 138), finding that shares subject to the prohibitions displayed higher information asymmetry and lower liquidity as compared to other shares and, similarly, Della Corte P et al, The Double-​Edged Sword of the 2020 European Short Selling Banks (2020), available via . 308 ESMA recommended a series of refinements including as regards clarifying which NCA is competent to impose a prohibition and, relatedly, which NCAs must consent prior to NCA action, and as regards excluding indices, baskets, and ETFs from the scope of prohibitions, given confusion in March 2020 as to the extent to which these instruments were covered by the bans: n 181. 309 As outlined in ESMA’s Opinion (ESMA70-​146-​19), the prohibition, which was imposed from 18 February 2019, was linked by BaFIN to severe falls in the Wirecard share price (of 40 per cent between 30 January and 15 February); the coincidence between the price falls, increased net short positions, and negative news stories; concern as to potential market manipulation; and the risk of a related loss of confidence in price formation generally and in the German market. This interpretation does, however, require an elastic interpretation of the Regulation’s market confidence criteria, given that the prohibition applied to one issuer only, and that the manipulation risk could have been dealt with via a trading suspension. See Langenbucher, K et al, What are the Wider Supervisory Implications of the Wirecard Case? Study for the European Parliament ECON Committee (2020), calling for tighter conditions on NCAs’ prohibition powers. 310 For a review of BaFIN’s actions see Jakubeit, R, The Wirecard Scandal and the Role of BaFin, Luiss Working Paper 5/​2021 (2021). Subsequent legal action by Wirecard shareholders against BaFin as regards the ban failed. 311 ESMA70-​146-​19. ESMA supported BaFIN’s reasoning and suggested that the market manipulation concerns deserved further investigation. It did, however, note that the increased selling pressure on Wirecard shares, and the opening and increase of net short positions, could be justified by press reports, although the fact pattern ‘raise[d]‌reasonable questions about the possibility of coordinated action aimed at manipulating the market’ (at 5). Subsequent reporting suggested that ESMA had not been in receipt of full information on Wirecard’s status: Storbeck, n 286.

582 Trading emergence of the fraud,312 some discomfort might be implied from its subsequent underlining of the limits of its capacity to review short selling bans, given the 24-​hour response period mandated by the Regulation, and its recommendation of legislative reforms to clarify that, given the time constraints, ESMA can only use information provided by the relevant NCA in reviewing NCA action.313

VI.3.7.4 Experience with the Exceptional Powers of Intervention: ESMA By contrast, ESMA’s exercise of its exceptional powers of intervention has been much less contentious. These powers were not exercised until 16 March 2020, in the teeth of the pandemic-​ related market volatility, and then only in relation to supervisory reporting, the least intrusive of the powers available to ESMA. ESMA imposed a short-​term reduction, for three months, of the threshold at which supervisory reporting on net short positions is required: from 0.2 per cent of issued share capital to 0.1 per cent.314 In a Decision which addressed the different legislative and administrative conditions precedent which apply to ESMA intervention, including as regards the absence of adequate NCA action,315 ESMA justified the intervention in general terms. It argued that the pandemic was posing a serious threat, on a pan-​EU basis, to the orderly functioning and integrity of financial markets and to financial stability, given the related severe price falls (including in financial institutions’ securities) that threatened to undermine the price formation mechanism and to threaten the integrity and orderly functioning of markets;316 and that the build-​up of short positions, and the execution of short sales, could accelerate price volatility and amplify these threats. The reduction in the reporting threshold was required, as a preliminary measure, to improve the capacity of NCAs and ESMA to assess developments and to react if appropriate, by means of the ‘best possible data set’.317 The Decision was subsequently renewed in June, September, and December, before expiring a year later in March 2021. ESMA’s subsequent 2021 review of the temporary reduction reported that its implementation had been smooth. It also called for the reduction to be made permanent given the limited costs of such a reduction,318 the material strengthening of NCAs’ market monitoring capacity that would follow,319 and the need for enhanced monitoring capacity given ongoing economic uncertainty as well as structural market change in the form of increased retail investor activity which could increase the potential for ‘short

312 It was not covered in ESMA’s peer review of the supervision of Wirecard as regards the disclosure of financial information: ESMA, Fast Track Peer Review on the Application of the Guidelines on the Enforcement of Financial Information by BAFIN and FREP in the Context of Wirecard (2020). 313 2022 ESMA Review, n 181, 25–​6. 314 ESMA Decision, 16 March 2020. 315 ESMA noted that while a small number of NCAs had (at that point) imposed intra-​day circuit breakers, such measures were temporary, no NCAs had adopted measures to increase their visibility on the evolution of net short positions, and the information received by NCAs was not sufficient under the current stressed market conditions: at 5. 316 ESMA referenced the 30 per cent drop in equity markets between 20 February and its Decision: at 3. 317 At 5. 318 ESMA suggested that less than 500 market participants would be subject to additional reporting requirements and that, given that supervisory reporting was not public, there would be no impact on trading strategies: 2021 ESMA Opinion, n 228. 319 Between March 2020 and June 2020, eg, the number of short positions reported on of between 0.1 per cent and 0.2 per cent of issued share capital represented 40 per cent of overall net short positions: 2021 ESMA Opinion, n 228.

VI.3  The Regulation of Short Selling  583 squeezes’. The reduction was subsequently made permanent by the Commission which supported ESMA’s stance (section 3.6). The permanent reduction in the supervisory reporting threshold followed a year’s experience with the new reporting threshold, review by ESMA, and Commission assessment. Nonetheless, the reduction indicates the stickiness of exceptional measures and underlines the need for care in the design of the applicable conditionality for such measures as well as for robust legitimation of ESMA action.320

VI.3.8  Supervision and Enforcement The Regulation, like all single rulebook measures, establishes a framework for supervision, requiring that NCAs be designated for the purposes of the Regulation (Article 32), addressing the required NCA powers (Article 33), and also addressing ESMA/​NCA cooperation, including in relation to on-​site inspections or investigations (Articles 35–​37). This framework is supported by ESMA’s supervisory convergence activities, which are significant in this area, including soft law adoption, peer review, and review of NCA action, and which are strengthened by the capacity ESMA draws from its collection and interrogation of data on net short positions and from its direct intervention powers. The Regulation’s enforcement regime is based on the less articulated model which prevailed prior to the enhancement of enforcement in later financial-​crisis-​era measures (and contrasts with, for example, MiFID II/​MiFIR). Accordingly, Member States are required only to establish rules on penalties and administrative measures which must be effective, proportionate, and dissuasive; they must also provide ESMA on an annual basis with aggregated information on penalties and administrative measures imposed (Article 41).

VI.3.9  Extraterritorial Reach The Regulation has significant extraterritorial effects, as its scope is determined by whether the instrument in question is within the scope of the Regulation.321 The Regulation specifies, for example, that the supervisory reporting and public disclosure requirements in respect of net short positions apply to persons domiciled or established in the EU or a third country (Article 10). The Regulation makes some accommodations for third country trading. The supervisory reporting and public disclosure obligations relating to net short positions in shares, and the prohibition on uncovered short sales of shares, do not apply to shares of a company admitted to trading on a trading venue in the EU, where the ‘principal venue’ (the venue 320 Although ESMA’s approach to exceptional intervention has, since 2012, been restrained, its 2022 review indicated some appetite for it having greater leeway to intervene, as it called for the conditions which govern its intervention powers to be aligned with those governing NCA action (save for those conditions specific to ESMA’s EU-​level role, and relating to prior NCA action, regulatory arbitrage, and cross-​border implications): 2022 ESMA Review, n 181, 29–​34. Any such reform could, in some respects, liberalize ESMA’s powers, including by removing the ESMA requirement that the relevant measure ‘significantly’ address the threat, and by adding ‘market confidence’ (available only to NCAs) as a justification. While there is a degree of untidiness in the mismatch between the ESMA and NCA sets of conditions precedent, the constitutional, legitimation, and political risks call for caution in any redesign. 321 Ch X considers the third country regime generally.

584 Trading for the trading of that share with the highest turnover) for the trading of the shares is located in a third country (Article 16(1)).322 The determination as to whether the principal trading venue for a share is outside the EU is the responsibility of the relevant NCA for the shares,323 and is carried out on a two-​yearly basis, in accordance with the administrative rules which govern how turnover is to be calculated.324 A list of exempted shares is maintained by ESMA. In addition, third country market-​makers benefit from the Article 17 market-​making exemption, but only where the Commission has made the related equivalence determination in relation to the legal and supervisory framework of the relevant third country in accordance with Article 17.325 The extraterritorial reach of the Regulation is reflected in the extensive obligations imposed on NCAs and on ESMA in relation to third country cooperation arrangements.326

VI.4  The Securities Financing Transactions Regulation VI.4.1  Securities Financing Transactions and the EU The ‘trading rulebook’, broadly conceived, also includes the 2015 Securities Financing Transactions Regulation (SFTR).327 The SFTR requires counterparties to specified securities financing transactions to report these transactions to trade repositories, and imposes specific transparency requirements on collective investment funds, in order to enhance the EU’s capacity to monitor financial stability risks, particularly as regards non-​bank financial intermediation. It accordingly forms part of the wider system of data-​requisition, collection, and storage that has, since the financial-​crisis era, transformed levels of transparency as regards trading in the EU financial market. The SFTR also has a more interventionist dimension: it imposes minimum standards on the reuse of financial instruments provided as collateral (under all such arrangements, not only securities financing transactions). The SFTR sits across interconnected areas of financial markets regulation and policy. Its primary purpose is to address non-​bank financial intermediation risk, and related risks to financial stability, by enhancing the EU’s supervisory oversight capacity, given that securities financing transactions are a channel through which non-​bank credit risk can be transmitted across the financial system. As outlined in Chapter III, the EU’s non-​bank financial intermediation agenda is concerned in particular with collective investment fund regulation, but the SFTR also forms part of the EU’s tool-​box for addressing non-​bank financial intermediation risks and was adopted as part of the EU’s related crisis-​era reform agenda. 322 In effect, for the principal trading venue to be outside the EU, more than 50 per cent of the turnover in the share must take place on the third country venue: 2021 ESMA Short Selling Review Consultation, n 172, 50. 323 Determined in accordance with the rules which determine which NCA is responsible in relation to Article 26 transaction reporting under MiFIR. 324 RTS 826/​2012 Art 6 and ITS 827/​2012 Arts 8–​11. 325 The equivalence framework is designed to ensure that the third country trading venue of which the market maker is a member complies with legally binding requirements equivalent to the rules which apply to trading venues in the EU, including in relation to venue supervision and transparency, the prevention of market abuse, issuer disclosure, and transaction reporting: Art 17(2). On the EU equivalence regime generally, see Ch X. 326 These include, under Art 38, that NCAs must, where possible, conclude cooperation arrangements with supervisory authorities of third countries concerning the exchange of information and the enforcement of obligations arising under the Regulation in third countries. ESMA is charged with coordination responsibilities. 327 Regulation (EU) 2015/​2365 [2015] OJ L337/​1.

VI.4  The Securities Financing Transactions Regulation  585 Also, and relatedly, the SFTR supports the orderly settlement of transactions (primarily addressed by the 2014 Central Securities Depositories Regulation (Chapter V)) and orderly trading and liquidity more generally and so is noted in outline in this chapter.328 Securities financing transactions encompass a broad range of transactions that can be used to raise funds, on a secured basis, against securities inventories. They are often associated with securities lending and securities repurchase (repo) transactions. Securities lending engages, broadly, a counterparty lending securities for a fee, and against a guarantee/​collateral, and is often used to support short selling and for settlement. A repo transaction is, broadly, constructed as a sale of an instrument, in which one party sells a financial instrument at a fixed price for cash, but commits to repurchase the instrument at a higher fixed price on a future date. The economic logic of the transaction is based on the seller and purchaser having, in effect, only temporary, use of the cash proceeds (the seller) and the instrument (the purchaser);329 the instrument acts, in practice, as collateral against the credit risk carried by the purchaser of the instrument who, in effect, lends funds to the seller against the instrument and can sell the instrument if the seller defaults.330 Repos accordingly operate as a form of short-​term, collateralized lending, and are an important channel for short-​term financing, allowing financial institutions (and particularly collective investment funds) to use their inventories of financial instruments to borrow funds and deploy leverage, on a short-​term basis, at lower rates, in the money markets. Securities financing transactions therefore widen and diversify credit supply channels and support liquidity, including by supporting short selling. Over and since the financial crisis, however, securities financing transactions have drawn regulatory attention given their capacity to lead to a build-​up of leverage outside the prudential framework governing bank lending,331 and their related capacity to amplify credit and liquidity risks, particularly where counterparty creditors engage in fire sales of instruments where counterparties default.332 Reflecting the international, FSB-​led reform agenda,333 the SFTR, which has been subject to extensive administrative amplification,334

328 For a comparative review of the EU and US securities financing transactions markets and of the EU regulatory response see Wu, S and Nabilou, H, ‘Repo Markets Across the Atlantic: Similar but Unalike’ (2019) 30 EBLR 513. For a US-​oriented analysis of the risks generated by securities financing transactions (in particular ‘repos’) and of the EU reform response see Saguato, P, ‘The Liquidity Dilemma and the Repo Market: A Two-​step Policy Option to Address the Regulatory Void’ (2017) 22 Stanford J of Law, Bus and Fin 85. The regulation of the repo market internationally has drawn the attention of political economists given the relative power of the industry which flows from the pervasive importance of the short-​term financing provided by repos. See, eg, Bran, B, ‘Central Banking and the Infrastructural Power of Finance: The Case of ECB Support for Repo and Securitization Markets’ (2020) 18 Socio-​Economic Review 395. 329 In the parallel ‘reverse repo’ (from the buyer’s perspective) one party purchases the instruments and agrees to sell them back for a return. 330 The price differential (the interest payment, in effect) is the return on the funds that are, in effect, lent to the seller (the ‘repo rate’). Repo transactions can be financed by the purchaser then repo-​ing/​selling the relevant (liquid) financial instrument. 331 SFT markets are vast. In 2020, eg, the EU repo market represented some €8.3 trillion: ESRB, EU Non-​Bank Financial Intermediation Risk Monitor No 6 August (2021) 58. 332 For a crisis-​era review see FSB, Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos (2013). 333 n 332. The FSB recommended a series of reforms relating to stronger transparency, reuse of instruments, and clearing. 334 It has been amplified by nine sets of administrative rules which specify the technical modalities of the regime, including as regards the registration of the trade repositories to which the required reports are made, and as regards the content and format of the reports. ESMA has also adopted related soft law, including the SFTR Q&A and three sets of Guidelines on the reporting process.

586 Trading was adopted as part of the EU’s non-​bank financial intermediation agenda and in order to enhance the transparency and resilience of the securities financing transactions market.

VI.4.2  The Regulation The core reporting obligation requires all ‘counterparties’ to ‘securities financing transactions (SFTs)’ to report the details of any SFT they have concluded (the obligation applies over the lifecycle of an SFT, applying to modifications/​terminations thereto) to an EU registered (or third country recognized) trade repository,335 no later than the working day following the conclusion, modification, or termination of the relevant transaction (Article 4(1)). The Regulation accordingly borrows the trade repository technology from EMIR, placing trade repositories, which are exclusively registered and supervised by ESMA under the SFTR framework (Articles 5–​12),336 at the heart of its reporting framework. The detailed content of the reports to be provided to trade repositories, and their format and the frequency of reporting, is specified by administrative rules which have constructed a granular reporting regime.337 Trade repositories then store and disseminate this data: they are required to regularly, and in an easily accessible form, publish aggregate positions by type of SFT (Article 12(1)); and they must also ensure ‘direct and immediate’ access to the details held on SFTs to specified entities, to enable those entities to fulfil their responsibilities and mandates (essentially, these entities are supervisory authorities) (Article 12(2)).338 The related data collection, verification, aggregation, comparison, and publication obligations imposed on trade repositories (Article 12(5)) have been amplified by administrative rules.339 In addition, counterparties must keep a record of any SFT they have concluded, modified, or terminated for at least five years following the termination of the transaction (Article 4(4)). The Regulation has a wide reach. Counterparties are widely defined,340 and include counterparties established in the EU (including all of an EU counterparty’s branches, wherever located), as well as third country counterparties if the SFT is concluded in the course of the operations of a counterparty’s EU branch (Article 2(1)).341 Similarly, SFTs are broadly defined, covering repurchase transactions, securities or commodities lending/​securities or 335 A trade repository is a legal person that centrally collects and maintains records on securities financing transactions (Art 3(1)). See section 5 on EMIR and trade repositories. 336 Or recognized by ESMA in the case of third country TRs. See Ch X section 9.3. 337 The content of the reports is governed by RTS 2019/​356 [2019] OJ L81/​1. The reports are tailored to different types of SFT and build on the approach adopted by, and are designed to be aligned with, the derivatives reports required to be submitted to trade repositories under EMIR. 338 Delegated Regulation 2019/​357 [2019] OJ L81/​22 specifies the details to be provided to, and different levels of access enjoyed by, supervisory authorities (ESMA, eg, has full access but NCAs have access depending on their role. ie, NCAs of trading venues have access to the SFT data held relating to SFTs executed on those trading venues). 339 Delegated Regulation 2019/​358 [2019] OJ L81/​30. 340 Counterparties cover ‘financial counterparties’, widely defined as including authorized investment firms, credit institutions, insurance undertakings, UCITSs and alternative investment funds (and their managers as relevant), authorized occupational pension schemes, authorized CCPs, authorized CSDs, and their third country counterparts; and also ‘non-​financial counterparties’, defined as any undertaking established in the EU or a third country, other than a financial counterparty (Art 3(2)–​(4)). 341 The European System of Central Banks, the Bank for International Settlements, and public bodies managing public debt are exempted from the reporting and reuse requirements in order to protect their discretionary monetary/​financial stability activities.

VI.4  The Securities Financing Transactions Regulation  587 commodities borrowing, buy-​sell back transactions/​sell-​buy back transactions (similar in design to repos), and margin lending transactions (Article 3(11)).342 Counterparties may, however, delegate reporting to another entity (Article 4(2)), while small and medium-​sized enterprises (SMEs) benefit from an alleviation in that where a financial counterparty enters into a transaction with an SME, the financial counterparty must report for both parties (Article 4(3)).343 The use by collective investment funds of SFTs for portfolio management purposes is regulated under the EU’s collective investment management regime,344 but the SFTR alongside imposes supplementary transparency obligations, which apply in addition to the core SFTR reporting requirements, on UCITS management companies and investment companies (under the Undertaking for Collective Investment in Transferable Securities (UCITS) Directive), and on managers of alternative investment funds under the Alternative Investment Fund Managers Directive (AIFMD). These additional requirements are designed to enhance investors’ capacity to monitor the level of risk undertaken by funds and, in particular, to monitor the strategies used by funds to increase and deploy leverage through SFTs and ‘total return swaps’.345 These fund managers are required to provide aggregate disclosures on their use of SFTs (and also total return swaps) in their ongoing reports (annual and half-​year for UCITS managers; and annual for alternative investment fund managers) and to specify in their fund prospectuses which SFTs (and total return swaps) are used (Articles 13–​14).346 Finally, a series of requirements apply to the subsequent reuse of financial instruments received as collateral (whether or not in an SFT) (Article 15). These requirements are oriented to financial stability, given that reuse of collateral generates legal risks, as contractual claims on the assets build up, and creates multiple series of potentially opaque obligations that can amplify liquidity and credit risks, particularly in an insolvency.347 These requirements, which apply to all such collateral arrangements, and whether the collateral is taken under a title transfer or by way of a security interest, require that the ‘providing’ client 342 Each of these elements are further defined under Art 3(7)–​(10). 343 SME is defined in accordance with the 2013 Accounting Directive 2013/​34/​EU [2013] OJ L182/​19 (see Ch II). 344 In particular, collateral management and the use of repos by UCITSs is addressed by the administrative rules that amplify the UCITS Directive’s requirements regarding use of efficient portfolio management techniques and related risk management, as well as by ESMA Guidance, in particular the 2012 Guidelines on ETFs and other UCITS Issues which require that a UCITS should only enter into such an arrangement where it can recall, at any time, the assets subject to the arrangement. See further Ch III on the portfolio management rules that apply to UCITS funds. 345 A ‘total return swap’ is a derivative contract under which one counterparty transfers the total economic performance, including income, gains, and losses from price movements, and credit losses, of a reference obligation to another counterparty: Art 3(18). SFTs and total return swaps allow funds to deploy leverage to enhance returns, but they also elevate risks, in particular counterparty risks. 346 The disclosures required are specified in the Annex to the SFTR and include disclosures as regards the global amount of securities and commodities on loan as a proportion of lendable assets, the top ten counterparties for each type of SFT and total return swap, aggregate transaction data for each type of SFT and total return swap, and data on reuse of collateral (half-​yearly/​annual reports); as well as general descriptions of SFT and total return swap use, types of assets/​maximum proportion of assets under management/​expected proportion of assets under management that can be subject to SFTs and total return swaps, the criteria for selecting counterparties, acceptable collateral, and the risks associated with the use of SFTs and total return swaps (prospectus disclosures). 347 These requirements apply widely to counterparties engaging in reuse established in the EU (and all the counterparty’s branches, wherever located); and to those established in a third country, where the reuse is effected in the course of the operations of an EU branch of the counterparty, or the reuse concerns financial instruments provided under a collateral arrangement by a counterparty established in the EU or a branch in the EU of a counterparty established in a third country: Art 2(1).

588 Trading or counterparty be informed in writing by the ‘receiving’ counterparty of the risks and consequences of giving consent to a right of reuse as regards a security interest collateral arrangement or of concluding a title transfer collateral arrangement (as relevant); and that the providing client or counterparty give express prior consent to the collateral arrangement that includes the reuse right (in writing or in a legally equivalent manner). Any reuse must be in compliance with the terms of the collateral arrangement. A collateral transfer requirement also applies: the financial instruments in question must be transferred from the client or counterparty account to that of the entity reusing the financial instruments.

VI.4.3  Experience with the SFTR The requirement to report on SFTs under the SFTR was an international novelty.348 It brought major change to the EU financial market, and required significant operational adjustments, as was reflected in the phasing of its implementation. The first phase of reporting obligations activated in April 2020, but was postponed in response to the Covid-​19 pandemic to July 2020, and the reporting system did not come fully into force until January 2021.349 SFTR reporting is still developing, and while the first reporting cycle was informative,350 it suggested that the difficulties EMIR experienced with data quality would also, and unsurprisingly given the scale of the operational change, be a feature of the SFTR.351 SFTR reporting has been rolled into ESMA’s Data Quality Action Plan which, since 2014, has provided a systematic framework governing coordinated ESMA/​NCA efforts to support and enhance the quality of data reported through trade repositories (see section 5.10 on EMIR reporting). The SFTR does not substantively regulate trading and it does not seek to structure how SFTs are carried out. Its significance relates to the enhanced transparency it brings to the SFT market and to its related enhancement of supervisory capacity (including as regards 348 Saguato, n 328. 349 The SFTR (Art 33) provided for a phasing-​in of the Article 4 reporting obligations, following the coming into force of the related administrative rules governing the reports, tied to: twelve months from the rules coming into force for credit institutions and investments firms (and their third country counterparts); 15 months for CCPs and CSDs (and their third country counterparts); 18 months for investment funds, insurance companies, and occupational pension schemes (and their third country counterparts); and 21 months for non-​financial counterparties. With the relevant RTS coming into force in early 2019, this meant applications dates of 13 April 2020, 13 July 2020, 12 October 2020, and 11 January 2021, respectively. In March 2020, however, ESMA advised NCAs to exercise supervisory forbearance as regards the reporting obligations, between April and July 2020, in effect allowing investment firms and credit institutions more time to ensure compliance, given the severe disruption the pandemic was bringing to the already challenging exercise of ensuring SFTR readiness: ESMA, Public Statement, 26 March 2020. 350 By the end of the first six months of reporting (to December 2020), some two million open SFTs had been reported, the vast majority in the form of securities lending and borrowing transactions and repos. 90 per cent of these reports were submitted by investment firms and credit institutions (only 7 per cent of these initial SFT reports were submitted by UCITSs). By January 2021, however, the volume of reports had dropped very sharply to 250,000 open SFTs, in response to the exclusion of UK firms and their third country branches from the reporting obligation (EU branches of UK firms remain subject to the obligation): ESMA, EMIR and SFTR Data Quality Report 2020 (2021) 11–​12 and 21. The French NCA provided an initial and positive review, reporting on similar data for the French market (most reports relating to repos (80 per cent) and issuing primarily from investment firms and credit institutions, with only 2–​3 per cent of reporting from investment funds): AMF, Initial Analysis of SFTR Reporting Data (2021). 351 2021 ESMA Data Quality Report, n 350, 22, albeit that ESMA reported that the rejection rate for reports from trade repositories fell from 9 per cent in July 2020 to 2 per cent by January 2021.

VI.5 EMIR  589 oversight of short selling). It forms part of the wider trend since the financial-​crisis era to deploy regulation as a data-​requisition device in order to increase transparency over financial markets; this trend ties together the SFTR, the Short Selling Regulation (as regards net short positions), EMIR (derivatives transactions), and MiFIR II/​MiFIR (trade transparency data and transaction reports). Transformative in terms of the data now flowing to trade repositories on SFTs, it promises much in terms of the enhancement of supervisory oversight over non-​bank financial intermediation risks, but also over market integrity and efficiency generally.352 As with the EMIR regime on which the SFTR’s reporting requirements are based, much depends, however, on the capacity of trade repositories to ensure sufficiently high quality data, on ESMA’s capacity to drive convergence and consistency in data quality through its supervision of trade repositories, and on the capacity of ESMA and NCAs to interrogate and deploy the massive data-​set effectively.

VI.5  The European Market Infrastructure Regulation and the OTC Derivatives Market VI.5.1  The Regulation of OTC Derivatives Trading and the EU VI.5.1.1 The European Market Infrastructure Regulation: A Distinct Regime The EU ‘trading rulebook’ extends beyond MiFID II/​MiFIR trading venues to address trading in the OTC markets, as is exemplified by the Short Selling Regulation (section VI.3) and the MiFIR transparency rules (Chapter V). Trading venues remain, nonetheless, the fulcrum around which much of the trading rulebook is designed. For example, whether or not instruments are ‘traded on a trading venue’ acts as a form of perimeter control for much of the trading regime, and, as outlined in Chapter V, supporting the movement of trading from OTC venues to trading venues is an animating concern of EU law and policy in this area. A distinct set of rules, however, governs OTC trading in derivatives contracts353 specifically, under the European Market Infrastructure Regulation (EMIR).354 EMIR, a pillar of the EU’s financial-​crisis-​era reform agenda, is concerned with supporting transparency and risk management in the OTC derivatives markets. As regards transparency, it requires extensive reporting by counterparties to derivatives contracts to trade repositories (TRs); and puts in place the governing regime for TRs, providing the framework for their authorization and supervision by ESMA. As regards risk management, EMIR operates across two vectors. First, in order to reduce counterparty credit risk (which strongly characterizes derivatives transactions as this risk can persist for several years),355 it imposes a ‘clearing 352 The AMF has identified the uses of the SFTR data-​set as including the monitoring of stresses on specific underlying assets in the SFT market, deeper monitoring of net short positions, analysis of how SFTs are used by the investment fund industry, and analysis of significant movements in securities around key corporate actions (such as shareholder meetings): n 350. 353 The major classes of OTC derivative are interest rate (the largest segment), foreign exchange, commodity, equity, and credit (particularly CDS) derivatives. 354 Regulation (EU) No 648/​2012 [2012] OJ L201/​1. The main elements of the legislative history are: Commission Proposal COM(2010) 484 and IA (SEC(2010) 1058/​2): Parliament Negotiating Position, 7 May 2011 (T7-​0310/​ 2011) (ECON Committee report at A7-​022/​2011); and Council General Approach, 4 October 2011 (Council Document 15148/​11). The ECB Opinion is at [2011] OJ C571/​1. 355 Given the long time-​horizon over which the reciprocal obligations of the counterparties can be open, and the related risk that creditworthiness will fluctuate over that period and become compromised prior to the

590 Trading obligation’356 for specified derivatives contracts, requiring that these contracts be ‘cleared’ through central clearing counterparties (CCPs); and it puts in place the governing regime for CCPs, providing the framework for their authorization and supervision by NCAs, coordinated through ESMA. Second, for all other derivatives contracts not centrally cleared through CCPs (bilaterally cleared contracts), it imposes a series of obligations to reduce counterparty credit and also operational risk, including valuation and margin requirements. EMIR is, as outlined below, as regards its substantive content, supervisory architecture, dynamism, wider setting, and the innovation it has prompted, among the most complex and distinct measures in the single rulebook. As regards its substantive content, although EMIR is concerned with a specific market segment (OTC derivatives), it is nonetheless a sprawling measure that imposes wide-​ ranging requirements on trading counterparties generally, but that also regulates two infrastructures, TRs and CCPs. It is lengthy, highly technical, and granular, drilling deep into the complexities and intricacies of the OTC derivatives markets, but also into the governance of TRs and CCPs. It is amplified by an extensive administrative rulebook, second in scale only to its behemoth MiFID II/​MiFIR counterpart.357 Relatedly, ESMA’s reach over the regime is extensive, ranging from its determinative influence on the construction of the administrative rulebook, to its recommendation of the specific derivatives contracts that are subject to the CCP clearing obligation, and extending to its supervision of TRs, its coordination of NCA-​based CCP supervision through the ESMA CCP Supervisory Committee and, under the EMIR third country regime, its direct supervision of certain (‘Tier 2’) CCPs. The EMIR intricacies and complexities extend to its field of application, which has been calibrated and segmented by a range of exemptions and alleviations for different counterparties, based on their function but also on the scale of their derivatives exposure, and also for different types of derivatives contracts. Similarly, the EMIR implementation timeline has, given the scale of the market adjustment required, been adjusted on multiple occasions. As regards supervision, EMIR’s supporting supervisory architecture is the most byzantine in the single rulebook, being composed of NCA-​based components (the supervision of counterparties’ obligations under EMIR); ESMA-​based components (the supervision of TRs); and blended elements (NCA supervision of CCPs is coordinated through supervisory colleges, which include the European Central Bank (ECB), and through the novel ESMA CCP Supervisory Committee, established in 2020). Also, the ESRB monitors the systemic risk posed by CCPs to the EU market through risk reporting, albeit that it does not exercise supervisory powers.358

performance of obligations: Bliss, R and Steigerwald, R, ‘Derivative Clearing and Settlement: A Comparison of Central Counterparties and Alternative Structures’ (2008) 30 Economic Perspectives 22. 356 The clearing process is designed to reduce risk by establishing net mutual positions between the contracting parties prior to settlement. A bespoke definition applies under EMIR: n 460. 357 As outlined in section 5.3, the EMIR rulebook is composed of some thirty RTSs and seven delegated acts, alongside a host of implementing acts (concerned with equivalence and the third country regime) and a smaller number of ITSs (concerned with reporting formats and templates). The administrative rulebook is significantly less dense than its larger MiFID II/​MiFIR counterpart, however, as many of the RTSs are concerned with adjustments to the phasing-​in of EMIR’s application. 358 The ESRB includes CCPs in its quarterly assessments of systemic risk (through its Risk Dashboard). It also regularly examines the financial stability implications of CCP operation and supervision. eg, ESRB, The Macroprudential Use of Margins and Haircuts (2019) (which led to related ESMA Guidelines) and ESRB, Indicators for the Monitoring of Central Counterparties in the EU, Occasional Paper 18/​2018 (2018).

VI.5 EMIR  591 The dynamism of the EMIR legislative scheme, which is a function of the scale of its impact on derivatives markets and the need for agile adjustment, further attests to the regime’s distinctiveness and complexity.359 EMIR has been subject to legislative revision by sixteen separate measures since its 2012 adoption, albeit that of these only two brought significant reforms: the 2019 EMIR 2.1 reform (the ‘EMIR Refit’ which was concerned with streamlining the regime and rendering it more proportionate);360 and the 2019 EMIR 2.2 reform (which overhauled the supervisory framework).361 In addition, the 2021 CCP Recovery and Resolution Regulation now addresses the recovery and resolution of CCPs.362 EMIR’s wider legal and institutional setting is also complex and distinct. To take one example, EMIR, to a greater extent than other single rulebook measures, has multiple and intricate interactions with private law, particularly as regards ownership rights relating to the derivatives cleared through CCPs, as these derivatives are held through cascading layers of ownership.363 To take another, EMIR sits within a wider international reform agenda regarding derivatives markets, led by the FSB and the Basel Committee/​IOSCO.364 Further, its third country regime has become the poster-​child for the disruptions wrought by Brexit to the EU and UK financial markets: the systemic extent to which CCP clearing for the EU is, in effect, ‘off-​shored’ in the UK, where the vast bulk of euro-​denominated interest rate derivatives are cleared, represents a significant challenge in practice to the extent to which EMIR can act as a comprehensive platform for securing stability in the EU derivatives market.365 Finally, EMIR has proved, in the decade or so since its adoption, to be something of a crucible for innovation. Its introduction of the TR-​based reporting system, for example, has led to the construction of a vast data-​base which has materially enhanced regulatory sightlines on the derivatives markets,366 and which has also led ESMA to develop a data strategy governing the quality of the data reported by TRs.367 Rule-​making innovation has

359 While many of the revisions were designed to moderate EMIR’s impact, the level of change prompted ESMA to note that counterparties had been required to be adaptable, and to underline the importance of some stability in the regime, given the compliance costs: ESMA, Review of Clearing Thresholds in EMIR (2021) 1 and 24. 360 Regulation (EU) 2019/​834 [2019] OJ L141/​42. 361 Regulation (EU) 2019/​2099 [2019] OJ L322/​1. 362 Regulation (EU) 2021/​23 [2021] OJ L22/​1. 363 See Braithwaite, J and Murphy, D, ‘CCPs and the Law of Default Management’ (2017) 17 JCLS 291 and Braithwaite, J, ‘The dilemma of client clearing in the OTC derivatives market’ (2016) 17 EBOLR 355. 364 The related work-​streams included: the ‘Basel III’ work-​stream on capital requirements for non-​centrally/​ CCP cleared derivatives; the CPSS (now CPMI)-​IOSCO work-​stream on TR reporting (leading to, inter alia, its Report on OTC Derivatives Data Reporting and Aggregation Requirements (2012)); the CPSS (now CPMI)-​ IOSCO work-​stream on review of standards for financial market infrastructures (leading to its Principles for Financial Market Infrastructures (2012)); IOSCO’s work-​stream on CCP clearing requirements (leading to its Requirements for Mandatory Clearing (2012)); and initiatives from the OTC Derivatives Supervisors Group (ODSG). The international standards also include the IOSCO/​Basel Committee standards on margin for bilaterally cleared derivatives (Basel Committee/​IOSCO, Margin Requirements for Non-​Centrally Cleared Derivatives (2015)). 365 On the regulatory and policy challenges generated by the dominance of UK CCPs in the CCP clearing of interest rate derivatives (including euro-​denominated interest rate derivatives) see Thomadakis, A and Lannoo, K, Setting EU CCP Policy. Much More than Meets the Eye. CEPS-​ECMI Study (2021). The third country regime and Brexit is considered in Ch X sections 9 and 11. 366 Drawing on this data, ESMA now produces annual reports on the EU derivatives markets (see recently ESMA, EU Derivatives Markets (2021)). It also supports ESRB reviews (see for an early example ESRB, Shedding Light on Dark Markets: First Insights from the new EU-​wide OTC Derivatives Data Set (2016)). 367 For an examination of ESMA’s role in supervising TRs see Moloney, N, The Age of ESMA. Governing EU Financial Markets (2018) 272–​7.

592 Trading also followed. The disruption which would follow a CCP not being available to clear a derivative contract subject to the EMIR CCP clearing obligation has led to the adoption of a new system, adopted by the 2019 EMIR Refit Regulation, for suspending administrative rules, based on Commission suspensive action following a prior ESMA recommendation (section 5.6). To take a final example, the financial stability risks posed by CCPs has led to the construction of a novel and intricate supervisory cooperation regime, engaging NCAs and also national central banks (of issue of the currency of cleared instruments), coordinated through ESMA, under the 2019 EMIR 2.2 reform. Notwithstanding this complex and distinct setting, or perhaps because of it, the EMIR regime has proved resilient. Its first major test, the massive March 2020 market volatility associated with the outbreak of the Covid-​19 pandemic, saw EMIR prove to be robust, with CCP clearing obligations, margin requirements, and CCPs all proving resilient at a time of acute stress. The significant increase in volatility, in energy and energy derivatives markets in particular, which followed Russia’s invasion of Ukraine, however, led to acute liquidity pressure on certain non-​financial-​counterparty (NFC) members of CCPs as CCPs increased margin requirements to manage their exposures. A swift regulatory response followed, including the temporary expansion of the range of collateral eligible to meet margin requirements, suggesting some agility in the regulatory apparatus. 368 Given its now massive scale, its technical complexities, and its distinct market, institutional, and international setting, the EMIR regime can only be considered in overview in this section, which seeks to outline its main features and its distinct place in the single rulebook.369

368 On the pandemic experience see ESRB, Liquidity Risks Arising from Margin Calls (2020) and ESMA, Third EU-​Wide CCP Stress Test (2020). The assessment by the international standard-​setting bodies was, similarly, that the crisis-​era CCP reforms, and the imposition of margin requirements on bilateral clearing, had ensured that counterparty credit risk was not elevated and that financial market stability was secured, albeit that greater transparency on how margin requirements were set was called for: 2022 FSB Non-​Bank Financial Intermediation Progress Report, n 4, and Basel Committee, CPMI, IOSCO, Review of Margining Practices (2022). The increased volatility in energy derivatives markets following the Russian invasion of Ukraine led to, alongside enhanced monitoring of commodity derivatives markets by ESMA and a series of reviews (including of how margin is calculated by CCPs), specific reform through a temporary (twelve-​month) expansion of the range of collateral eligible to meet CCP margin requirements to include uncollateralized bank guarantees (for NFCs) and public guarantees (for all counterparties) (via a revision to the relevant RTS through C(2022) 7536). ESMA was supportive of the liberalization which was designed to alleviate the significant liquidity pressures which were leading some NFC CCP members (with fewer and less liquid assets available to meet margin requirements) to reduce their positions or leave them insufficiently hedged. It warned, however, of the need for any alleviations to be temporary and subject to appropriate conditionality, given that collateral and margin were fundamental to the resilience of CCPs, and to avoid shifting risk on to CCPs and so creating contagion channels to the financial system: ESMA, Final Report on Emergency Measures on Collateral Requirements (2022). Liquidity strain consequent on higher margin calls was observed globally but was not regarded as presenting material financial stability risks: FSB, Letter to G20 Finance Ministers and Central Bank Governors, 14 April 2022. 369 A now vast literature considers EMIR and the related international OTC derivatives market reform agenda, well exemplified by the emergence of new journals post-​crisis, such as the Journal of Financial Market Infrastructures. For recent reflections with an EU orientation see, eg, Murphy, D, Rules and Reasoning from Lehman to Covid (2022), the discussions in Binder, J-​H and Saguato, P (eds), Financial Market Infrastructures: Law and Regulation (2021), Nabilou, H and Asimakopoulos, I, ‘In CCP We Trust . . . Or Do We? Assessing the Regulation of Central Clearing Counterparties in Europe’ (2020) 15 CMLJ 70, Braithwaite J and Murphy, D, ‘Get the Balance Right: Private Rights and Public Policy in the Post-​crisis Regime for OTC Derivatives’ (2017) 12 CMLJ 480, Mc Vea, H, Central Counterparties and Sale and Repurchase Agreements: Regulating Financial Markets in the Light of Yet Another False Dawn’ (2017) 17 JCLS 111, and Marjosola, H, ‘Missing Pieces in the Patchwork of the EU Financial Stability Regime: the Case of Central Counterparties’ (2015) 52 CMLRev 1491.

VI.5 EMIR  593

VI.5.1.2 EMIR: Main Features and CCP Clearing EMIR is an infrastructure-​related measure which has brought transformative change to the structure and regulation of the OTC derivatives markets in the EU. It has two primary objectives. First, it is designed to reduce risk (primarily counterparty credit risk and operational risk) and to strengthen derivatives market resiliency through the counterparty-​ credit-​ risk-​ oriented CCP clearing obligation and related CCP risk-​ management requirements; and through the counterparty-​credit-​risk/​operational-​risk-​oriented risk-​ mitigation requirements for non-​centrally cleared (bilaterally cleared) derivatives, which are designed to strengthen the extent and quality of collateralization of bilaterally cleared transactions. Second, EMIR is designed to support supervisory oversight and also market discipline by means of extensive reporting by counterparties on derivatives trades to ESMA-​ supervised TRs. EMIR has a wide scope, applying to almost all users of derivatives, and catching financial counterparties but also non-​financial counterparties (NFCs), such as commercial firms which engage in derivative trading incidentally to hedge against commercial and treasury risks. It is accordingly calibrated (and was further adjusted in this regard by the 2019 EMIR Refit Regulation reform), including by means of exemptions from the pivotal CCP clearing obligation for small financial counterparties and for NFCs, and by means of specific alleviations, including phase-​in requirements, as regards the risk management requirements for bilaterally cleared derivatives. EMIR has strong market-​shaping effects. These derive in the main from its pivotal CCP clearing obligation, imposed on specified derivative contracts and on those counterparties subject to the CCP clearing obligation. Clearing in the OTC derivatives markets (or the establishing of mutual net positions and the related matching of contracts prior to settlement), which evolved as a means for managing counterparty credit risk, can happen in two ways: bilateral clearing; and central/​CCP clearing. Bilateral clearing involves the two counterparties to the derivative contract entering into a bilateral clearing arrangement which is supported by risk mitigation techniques, including collateralization; this method dominated prior to the financial crisis.370 By contrast, in CCP clearing (which, prior to the financial crisis, engaged only a small portion of the OTC derivatives markets;371 only a limited number of CCPs for OTC derivatives were then established in the EU),372 the CCP interposes itself between the two counterparties to the trade. Accordingly, the derivative contract between the counterparties is split into two offsetting transactions, each of which is 370 As the financial-​crisis-​era reforms evolved, an extensive literature emerged, canvassing the respective risks and benefits of bilateral and CCP clearing. See, eg, Duffie, D and Zhu, H, ‘Does a Central Clearing Counterparty Reduce Counterparty Risk?’ (2011) 1 Rev of Asset Pricing Studies 74; and Pirrong, C, The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information and the Sharing of Default Risk through a Central Counterparty, ISDA Discussion Paper Series No 1 (2011), available at . 371 The FSB reported that as at September 2010, in the OTC market, 31 per cent of interest rate derivatives, 13 per cent of CDSs, 0 per cent of equity derivatives, 20–​30 per cent of commodity derivatives, and 0 per cent of foreign exchange derivatives were cleared through CCPs. In the EU, the Commission’s ‘rough estimates’ suggested that 30 per cent of interest rate derivatives, 10–​15 per cent of CDSs, and 20–​30 per cent of commodity derivatives were cleared through CCPs. Foreign exchange derivatives were not cleared through CCPs: 2010 EMIR Proposal IA, n 354, 45. 372 The 2010 EMIR Proposal IA reported that 27 CCPs were established in the EU, but that only a small number cleared OTC derivatives: LCHClearnet (commodity, credit, and interest rate derivatives); European Commodity Clearing AG (commodity derivatives); NASDAQ OMX Stockholm AB (OTC derivatives); ICE Clear Europe (commodity and credit derivatives); Oslo Clearing (equity derivatives); and NOS Clearing ASA (commodity derivatives): n 354, 120.

594 Trading supported by the CCP, which becomes the legal counterparty to each transaction. CCP clearing supports the stability and resilience of the market in cleared derivatives through, first, ex-​ante centralization within the CCP of counterparty credit risk assessment (and the related assessment of margin and collateral requirements);373 and, second, in the case of a default, ex-​post replacement by the CCP of the trades of the failed counterparty and the application of pre-​set and orderly procedures (including multi-​lateral netting arrangements) to manage the default and the related ‘close-​out’ positions (CCP clearing thereby obviates the need for multiple actions by multiple counterparties in an default). CCP clearing accordingly reduces credit and operational risk and, as derivatives cleared through CCPs must be standardized, relatedly supports liquidity and, ultimately, financial stability. As CCPs thereby become highly concentrated sources of systemic risk, a series of techniques are deployed to buttress CCPs against failure. These include clearing member margin requirements, which form part of the ‘waterfall’ of CCP resources on which the CCP can call (these also include the CCP’s ‘default fund’ which, formed from clearing members’ contributions, provides for risk mutualization and the related incentivization of risk management by clearing members).

VI.5.2  The Evolution of EMIR VI.5.2.1 The Financial Crisis and EMIR The significant expansion in the reach of regulation over OTC derivatives markets374 was one of the defining features of the G20 crisis-​era reform programme.375 Prior to the financial crisis, OTC derivatives markets had expanded exponentially,376 but were largely unregulated: trading occurred outside regulated organized venues and often on a bilateral basis between counterparties; transactions were not subject to central/​CCP clearing requirements; and risk mitigation and reporting requirements were limited. The financial crisis exposed the very significant transparency and resilience risks which had been building up,377 notably through the massive increase in reliance on credit derivatives, and in

373 Margin in this context is the difference between the price of a trade at execution and guaranteed by the CCP and the expected price if the CCP had to replace the trade after a default by a member. Collateral is the asset provided by the member to the CCP and which represents the margin; it typically takes the form of highly liquid collateral, such as cash, gold, or government bonds. Margin takes two forms: ‘variation margin’, which is assessed on a daily basis, represents profits and losses on open positions, and is paid to or collected by the CCP on a daily basis; and ‘initial margin’, collected to ensure that sufficient funds are held on behalf of each clearing member to offset any losses incurred should the member default, between the last (marked-​to-​market) valuation of the position and the close out of the position. Margin requirements are designed to protect against defaults and, as a ‘defaulter pays’ mechanism which imposes costs on clearing members, to strengthen risk management incentives. EMIR (through its RTSs) defines initial and variation margin as regards CCP clearing and also for bilateral clearing. 374 Arguing for a more restrictive approach than that adopted over the financial-​crisis era, see Stout, L, Helwege, J, Wallison, P, and Pirrong, C, ‘Regulate OTC Derivatives by Deregulating Them’ (2009) 32 Regulation 3, arguing for OTC financial derivatives to be considered as non-​legally enforceable gambling contracts, unless the counterparties can prove the transaction has a legitimate hedging purpose. 375 For collections of studies, with an EU perspective, on the financial-​crisis-​era reform period see the Special Edition of the Banque de France’s Financial Stability Review on OTC Derivatives: New Rules, New Actors, New Risks, Issue 17, April 2013 and the Special Edition of the EBOLR on OTC Derivative Market Regulation, 13 (2013) Issue 3. 376 As widely reported in the major financial-​crisis-​era reports: eg, 2009 Turner Review, n 12, 81–​2. 377 See, eg, Commission, Ensuring Efficient Safe and Sound Derivatives Markets (COM(2009) 332) and ECB, Credit Default Swaps and Counterparty Risk (2009).

VI.5 EMIR  595 particular on CDSs, to manage exposures from asset-​backed securitization transactions.378 The March 2008 Bear Stearns collapse, the September 2008 default of Lehmans, and the September 2008 bailout of AIG379 triggered chaotic market disruption related to concerns as to the extent to which institutions globally were exposed to CDSs and to the related counterparty credit risk. The turbulence was driven by the features of the OTC derivatives markets generally and of the CDS segment in particular. The bilateral nature of the market meant that the market was largely opaque; the extent to which exposures were concentrated, and where they were concentrated, was not clear.380 But the extent of the interlinkages between counterparties to derivative contracts, and the degree of concentration of exposure risk among counterparties, transformed counterparty credit risk into systemic risk. Further, demands to post higher quality collateral to cover counterparty exposures as the creditworthiness of counterparties deteriorated added to the intense procyclical pressure in the market as the financial crisis deepened. It also became clear that OTC derivatives contracts were often under-​collateralized,381 and that, relatedly, operational risks were significant, particularly as regards asset segregation. In response, financial institutions, and particularly credit institutions, withdrew credit facilities, thereby aggravating the credit and liquidity contraction over autumn 2008. Reform quickly became a central element of the G20 reform agenda which committed to all ‘standardized OTC derivative contracts’ being traded on exchanges or ‘electronic trading platforms’, and cleared through CCPs, by the end of 2012; to OTC derivative contracts being reported to TRs; and to non-​centrally cleared contracts being subject to higher capital requirements.382 The related EU reform agenda extended beyond EMIR, including capital-​related reforms;383 position controls (including as regards short positions under the short selling regime, particularly with respect to sovereign CDSs—​see section 3—​and under the MiFID II/​MiFIR position-​management regime for commodity derivatives—​see section 2); MiFIR transparency requirements for the trading venues on which certain classes of OTC derivatives must now be traded (Chapter V); MiFIR transaction reporting requirements which capture transactions in a range of OTC derivatives (Chapter V); and a refined market abuse regime (Chapter VIII). More generally, the more intensive prudential regulation of investment firms and the imposition of more demanding risk-​management requirements (Chapter IV) can be associated with the financial-​crisis-​era policy concern to manage derivative-​related risks. Together, the financial-​crisis-​era reforms, and the subsequent 2019 378 Although the CDS segment represented only 7 per cent of the global OTC derivatives market, between 2005 and 2007 it had grown by 900 per cent: ECB, n 377, 4 and 13. 379 The AIG bailout was strongly associated with the systemic risks which its CDS exposures triggered. See Saunders, B, ‘Should Credit Default Swaps Issuers Be Subject to Prudential Regulation’ (2010) 10 JCLS 427. 380 The lack of transparency had two major impacts: it became difficult to evaluate collateral requirements for exposures; and market distrust, and the related liquidity contractions, intensified. Regulators also struggled in assessing the nature and location of risk: 2009 ECB Report, n 377, 4 and 11–​13. 381 An IMF study concluded that a large segment of the OTC market was under-​collateralized (by some $2 trillion): Singh, M, Collateral, Netting and Systemic Risk in the OTC Derivatives Market, IMF WP No 10/​99 (2010). 382 Pittsburgh G20 Summit, September 2009, Leaders’ Statement, Strengthening the International Financial Regulatory System. 383 The reforms (adopted under CRD IV/​CRR) are designed, inter alia, to address mark-​to-​market losses through a capital charge for credit valuation adjustment risk (the risk associated with a deterioration in the creditworthiness of a counterparty), to provide capital incentives to move bilaterally cleared OTC derivative transactions to CCP clearing, and to promote strong risk management and related hedging practices: 2011 Commission IA on CRD IV (SEC(2011) 950) paras 3.4–​3.5.

596 Trading reforms to investment firm prudential regulation, can reasonably be described as having led to a paradigm shift in the intensity with which OTC derivatives markets are regulated. EMIR, however, is at the heart of this shift. EMIR is one of the EU’s totemic financial-​crisis-​era measures. While the early stages of the EU reform agenda were concerned with the stability of the CDS segment, the reform agenda soon focused on the OTC derivatives markets generally.384 Supported by the European Council,385 this agenda was initially amplified in the Commission’s summer 2009 Communication and Consultation on derivatives market reform which set out the main elements of the reforms, including CCP clearing, risk mitigation, and reporting requirements.386 While industry action was also taken, with the industry committing to move more OTC derivative transactions on to CCPs,387 and significant progress was made with CDS clearing,388 the Commission warned that stronger regulatory incentives were required.389 Following Council and European Parliament support,390 and after some eighteen months of consultation391 and industry lobbying,392 the EMIR Proposal was presented in September 2010 (along with the Short Selling Proposal). The Proposal, which did not change materially over the negotiations, proposed a wide-​ranging CCP clearing obligation, applicable to OTC derivative transactions by financial counterparties and NFCs (moderated by a threshold mechanism for NFCs); risk mitigation requirements for bilaterally cleared OTC derivative contracts; and a reporting requirement for all OTC derivative contracts. These obligations were supported by authorization and supervisory regimes for CCPs and TRs. Over the negotiations, the scope of the regime became wider, but the different calibrations and exemptions were at the same time expanded and nuanced, with the main focus of the negotiations on how EMIR’s costs could be mitigated, particularly for NFCs. The Parliament sought to calibrate the Proposal more finely to reflect the costs faced by NFCs and, ultimately, end investors,393 but it also enhanced the Proposal’s provisions in relation to competition and access in the CCP market,394 and it strengthened ESMA’s role, including in relation to CCP colleges of supervisors. In the Council, the negotiations were coloured by the euro-​area/​internal market divide, with the UK concerned that EMIR would lead to a relocation of CCPs to the euro area. Following concessions to the UK designed to address its concerns as to euro-​area dominance (which included restrictions on the powers

384 Braithwaite, J, ‘The Inherent Limits of “Legal Devices”: Lessons for the Public Sector’s Central Counterparty Prescription for the OTC Derivatives Market’ (2011) 12 EBOLR 87. 385 European Council 18–​19 June 2009, Conclusions, para 18. 386 n 377. 387 By August 2009, seven CCPs for CDSs had launched globally or were due to: Braithwaite, n 384, 89. In the EU, nine major dealers committed to increasing their use of CCPs (Letter to EU Commissioner McCreevy, 17 February 2009). 388 Three new EU CCPs, eg, were established for CDS clearing. The industry’s ability to move to CCP clearing for CDSs relatively quickly reflected the high degree of standardization of CDSs, which was linked to their massive growth pre-​crisis: Partnoy and Skeel, n 132, 1032. 389 2009 Commission Consultation, n 377, 10. 390 2010 European Parliament Resolution, n 8 and ECOFIN Council: 2981st Meeting, 2 December 2009 (Council Document 16383/​09) 26–​30. 391 Consultations in July and October 2009 were followed by a final 2010 Consultation. 392 Major airline, aerospace, and car manufacturers lobbied strongly against their inclusion in EMIR, given the costs it would impose on their hedging activities: Grant, J, ‘The Route to Regulation Diverges for Europe and America’, Financial Times, 12 August 2010. 393 The European Parliament introduced, eg, the pension fund exemption and the intra-​group exemption. 394 It, eg, strengthened the guarantees in relation to CCP access and in relation to CCP access to trading venues trade flow.

VI.5 EMIR  597 of CCP colleges of supervisors as regards CCP authorization), and the UK’s agreement to drop its call for EMIR to also cover regulated-​market-​traded derivatives (not just OTC derivatives),395 the Council agreed on a compromise text in October 2011. Following difficult trilogue negotiations over October 2011–​February 2012,396 which focused on third country CCP access requirements, the extent of the TR reporting obligation, and the role of the CCP supervisory college and of ESMA in CCP authorization, the European Parliament and Council adopted the text in March and April 2012, respectively.

VI.5.2.2 From the Financial Crisis to the 2022 Review: A Decade of Calibration The EMIR regulatory design process generated the most complex of technical challenges for the EU’s legislators, across structural (the shape of the new CCP and TR markets and the impact of related competition and also monopoly dynamics); substantive (including with respect to the classes of derivatives which should be subject to CCP clearing, the nature of CCP regulation and risk management, and the standardization of the risk mitigation techniques to be employed in bilateral clearing); and international (in terms of the interaction between the EU regime and other jurisdictions internationally) dimensions. Exacerbating the challenges, the regulation of derivatives market clearing and risk management was something of a terra incognita for the EU, as it was for regulators internationally;397 in particular, CCP regulation in the EU had previously been developed at national level and varied significantly, while there was almost no experience with TR regulation.398 Compounding the difficulties, the EMIR reform agenda (and its international counterparts) generated a well-​documented series of risks to financial stability. Chief among them was that mandating CCP clearing has the effect of concentrating risk to a systemic extent within CCPs;399 relatedly, bilateral OTC dealers in derivatives can be better equipped than CCPs to engage in valuation and in risk assessment in certain circumstances and their incentives to engage in strong risk management can be sharper.400 The reform agenda was also associated with increased costs, in particular as regards the margin and collateral requirements for CCP-​cleared and also bilaterally cleared transactions, and as regards the related demand which ensued for high quality collateral.401 The adoption of EMIR was accordingly followed by the construction of the extensive administrative rulebook which sought to amplify and refine EMIR’s operation in practice, as outlined in section 5.3. The impact of EMIR has taken some time to emerge given the protracted period over which it was implemented. The application of many of EMIR’s provisions depended on the entering into force of the related administrative rules. While many of these came into force in 2013, it would be 2016 before the pivotal risk management/​margin rules governing bilaterally cleared derivatives transactions were adopted under RTS 2016/​2251;402 the RTS was then subject to lengthy phase-​in arrangements and to subsequent adjustments and 395 Barber, A, ‘Britain Wins Late Concessions on Derivatives Rules’, Financial Times, 5 October 2011. 396 Commissioner Barnier noted that the negotiations in the Parliament and Council had ‘not always been easy’: Statement on the EMIR Agreement. 9 February 2009 (MEMO/​12/​90). 397 Braithwaite, n 384. 398 By the time of EMIR’s development, only two TRs were operational: 2010 EMIR Proposal IA, n 354, 81. 399 See, eg, Singh, M, Making OTC Derivatives Safe—​A Fresh Look, IMF WP No 11/​66 (2011). 400 EMIR accordingly sought to avoid replacing well-​tried market/​private ordering practices with untested rules. See, eg, Braithwaite, n 384 and Awrey, D, ‘The Dynamics of OTC Derivative Regulation: Bridging the Public-​ Private Divide’ (2010) 11 EBOLR 155. 401 ESMA, TRV (No 1) (2013) 30–​3 and, on the global impact, Singh, n 381. 402 RTS 2016/​2251 [2016] OJ L340/​9.

598 Trading extensions.403 The keystone CCP clearing obligation did not start coming into effect until over 2015/​2016, when the first three sets of asset classes subject to the CCP clearing obligation were identified, subsequent to the related CCPs having been authorized under EMIR;404 the US market, by contrast, moved to mandatory clearing in 2012. Given EMIR’s scale and its staggered implementation, it is perilous to come to conclusions as to its effectiveness so far. The EU’s first major assessment of the regime, the 2015–​ 2016 EMIR Review, was undertaken at a relatively early stage of the regime’s application. It was broadly supportive,405 although it identified a series of costs associated with EMIR’s implementation, in particular for NFCs, which led, as noted below, to the 2019 EMIR 2.1 Refit Regulation reforms. Brexit brought an unforeseen set of challenges linked to the EU’s systemic dependence on ‘off-​shore’ UK CCP clearing, in particular in certain euro-​ denominated asset classes,406 and can be associated with, as also noted below, the 2019 EMIR 2.2 Regulation reforms to CCP supervision, which have extended the EU’s supervisory reach over UK CCPs by means of ESMA’s new supervisory powers over third country CCPs (Chapter X). It also prompted the 2022 Commission review of central clearing, which may lead to further reform.407 It is certainly clear that EMIR has shown some capacity to be refined and adjusted in light of experience, with legislative reform frequent. Some of the legislative reforms have taken the form of calibrating adjustments tied to cognate developments in the single rulebook: the 2017 Securitization Regulation, for example, allowed for a liberalization of the 403 In 2020, the Basel Committee/​IOSCO revised the implementation timeline for their 2015 standards for bilaterally cleared margin/​collateral (on which RTS 2016/​2251 is based), extending the final two phases of the implementation process (during which counterparties with the two lowest aggregate exposure levels to derivatives were finally to become subject to the requirements) by one year (to May 2021 for counterparties with an aggregate average notional amount of €50 billion or more; and to May 2022 for counterparties with an aggregate average notional amount of €8 billion or more), in light of the operational strains caused by the Covid-​19 pandemic. Related changes were made to RTS 2016/​2551. See section 5.7. 404 The first CCP authorization decision was made on 18 March 2014 (Nasdaq OMX Clearing AB). On 19 March 2014, ESMA was formally notified of the CCP’s authorization and of the derivative contracts cleared by the CCP. This notification triggered the EMIR clearing obligation assessment procedure for the first time. See section 5.6. 405 The Commission reported that there was no need for major change: Commission, Report on EMIR (COM(2016) 857). In 2017, the ESRB similarly reported that EMIR was a milestone in making Europe’s derivatives markets and the provision of central clearing services safer and was not in need of fundamental change (ESRB, Revision of the European Market Infrastructure Regulation (2017)). 406 See n 519. 407 Commission, Consultation on Review of the Central Clearing Framework in the EU (2022). Earlier, the Commission had signalled concern as to the dependence of the EU financial system on UK clearing and the need for EU clearing members to reduce their exposure to UK CCPs: Commission, The European Economic and Financial System: Fostering Openness, Strength and Resilience (COM(2021) 32). In response, ESMA recommended a series of reforms, including a fine-​tuning of the complex institutional system that supports EMIR supervision and the adoption of a more agile and speedy approach to revising the RTSs which determine which derivative classes are subject to the CCP clearing obligation: ESMA, Letter to the Commission, 1 April 2022. As this book went to press, the Commission adopted, in December 2022, proposals to reform the clearing regime, primarily set out in COM(2022) 697. The Commission reported that EMIR had provided a ‘robust framework’ for clearing and proposed a targeted set of reforms. Of a liberalization orientation in some respects, being designed to encourage clearing, the reforms also sought to enhance the resilience of the clearing process and to strengthen the supervisory regime. The most eye-​catching reform related, not unexpectedly, to the third country regime: the Commission proposed that firms subject to the clearing obligation be required to clear at least a portion of specified systemically-​significant derivatives through ‘active accounts’ at EU CCPs (see Ch X sections 9 and 11 on third country CCPs). The reforms also addressed, inter alia: simplification of the procedures applicable to CCPs as regards the launch of new clearing products and changes to risk models, in order to facilitate innovation, choice, and agile risk management; refinements to the margin and collateral regime, in particular in light of the disruption in energy derivatives markets in 2022, and including in relation to greater transparency of CCPs’ margin models, to support greater predictability as regards margin and liquidity needs; review of the clearing thresholds; and enhancements to supervisory coordination.

VI.5 EMIR  599 CCP clearing obligation to exempt OTC derivatives contracts concluded by a securitization special purpose entity.408 More swingeing reforms followed the 2019 EMIR Refit and 2019 EMIR 2.2 reforms, which had their genesis in the 2015–​2016 EMIR Review.409 The 2019 EMIR Refit Regulation was designed to refine EMIR by rendering it more proportionate, particularly for NFCs and for small financial counterparties as regards the CCP clearing obligation. Allied ameliorations for NFCs included a new obligation for CCPs to provide clearing services on fair, reasonable, non-​discriminatory, and transparent terms; a requirement for financial counterparties to be solely responsible for TR reporting where they contract with NFCs, thereby lifting the reporting obligation from NFCs; and an exemption for intra-​group transactions, where at least one counterparty is an NFC, from the reporting obligations. The reform also brought institutional innovation, in the form of a new system for suspending administrative rules, designed to empower the Commission to suspend the CCP clearing obligation for specified derivatives contracts in exceptional circumstances and on ESMA’s advice. The 2019 EMIR 2.2 Regulation was focused on supervision, reorganizing the supervisory framework for EU and non-​EU CCPs. As outlined in section 5.9, while the reform retained the college of supervisors structure originally adopted by EMIR for supporting NCA coordination as regards CCP supervision, it enhanced ESMA’s role and tightened the coordination process, situating NCA coordination within the new ESMA CCP Supervisory Committee. Also, and as outlined in Chapter X, the Regulation dramatically reformed the supervision of third county CCPs operating in the EU, by means of a new system of tiering: the least systemically significant Tier 1 CCPs are subject to home/​ third country supervision; Tier 2 CCPs are subject to direct ESMA supervision; while Tier 3 CCPs, the most systemically significant CCPs, can be required to relocate to the EU. In addition, the EMIR administrative rulebook has also been the subject of repeated reforms, often to calibrate EMIR’s application, including through changes to implementation timelines410 and alleviations for particular derivatives or counterparties.411 Overall, EMIR has reordered how risk is managed in the OTC derivatives markets without significant adverse disruption. Reporting on derivatives has changed out of all recognition, although data quality remains a concern.412 CCPs, although still the subject of contestation as to how their risks can be managed,413 are becoming increasingly central to the stability of EU derivatives markets, with the volume of contracts cleared through 408 The Securitization Regulation (Regulation (EU) 2017/​2402 [2017] OJ L347/​35) revised the Art 4 CCP clearing obligation to exempt such entities, subject to the conditions set out in RTS 2020/​447 [2020] OJ L94/​5. 409 For a summary of the review process see COM(2016) 857. 410 The timelines which apply to the application of RTS 2016/​2251 as regards risk management procedures governing collateral exchange for bilaterally cleared transactions, eg, are, reflecting the related 2015 Basel/​IOSCO standards, calibrated according to the scale of the counterparties’ derivatives exposures, with the most immediate deadlines applying where both counterparties have, or belong to groups each of which has, an aggregate notional amount of non-​centrally cleared derivatives above €3,000 billion, and the farthest out applying where both counterparties (or their groups) have an aggregate notional amount of above €8 billion. These timelines were adjusted in 2021 to reflect changes to the international timelines, but also EU-​specific market experience: n 403 and section 5.7. 411 An alleviation from the RTS 2016/​2251 risk management procedures governing collateral exchange for bilaterally cleared derivatives was provided for in 2021 in relation to physically settled forex forwards and swaps (which are widely used by counterparties to manage currency exposures) by means of a permanent exemption where one of the counterparties is not a credit institution or an investment firm: RTS 2021/​236 [2021] OJ L56/​1 (section 5.7). 412 For an initial assessment of the scale of the data transformation see 2016 ESRB Paper, n 366. 413 For sceptical perspectives see, eg, Nabilou and Asimakopoulos, n 369, Persaud, A, ‘Central Clearing and Risk Transformation’ (2017) 21 Financial Stability Review (Banque de France) 141, and, for a US-​oriented perspective, Saguato, P, ‘The Unfinished Business of Regulatory Clearing Houses’ (2020) Co BLRev 449.

600 Trading CCPs continuing to grow.414 The CCP regime has, however, proved resilient, including through the periods of acute volatility associated with the Covid-​19 pandemic (2020) and the Russian invasion of Ukraine (2022),415 has been repeatedly strengthened, most recently by the 2021 recovery and resolution reforms, and has been refined at the administrative level, including in relation to the collateral requirements governing margin and in response to the elevated volatility in energy derivatives markets that followed the Russian invasion of Ukraine. Nonetheless, EMIR recognizes that bilateral clearing of bespoke derivatives remains a centrally important feature of the financial system’s risk-​management architecture, and its risk management rules governing bilaterally cleared derivatives have been subsequently calibrated, including as regards their implementation timelines, to reflect the particular risks posed by different counterparties and derivatives.

VI.5.3  The EMIR Rulebook: Legislation, Administrative Rules, and Soft Law The technical complexity and scale of much of the legislation that grounds the single rulebook challenges the assumption that EU legislative measures are designed to address core regulatory principles and to reflect fundamental political decisions on the nature of financial markets regulation. With EMIR, the tendency, marked over the financial-​crisis era but persisting since, to encrust legislative measures with technical detail perhaps reached its apotheosis. That said, EMIR’s detailed and complex legislative requirements reflect the scale of the EMIR reforms, the challenges which appropriate calibration posed, and the technical nature of the risk-​management obligations which EMIR introduced. EMIR has also proved to be relatively agile, being repeatedly revised. Nonetheless, while it is the most unstable of the legislative measures that form the single rulebook, albeit that this instability is primarily a function of efforts to refine the regime, the core elements of EMIR as regards CCP clearing and supervision, the risk management of bilaterally cleared contracts, and TR reporting are, in their essentials, unchanged. EMIR is supported by an extensive administrative rulebook which brings further granularity as well as calibration. In its essentials, the administrative rulebook has been broadly unchanged since 2016, when the final material element of the administrative rulebook, RTS 2016/​2251 on bilaterally cleared contracts, was adopted, albeit that multiple revisions and refinements have been made since. The administrative rulebook includes some seven delegated regulations and thirty RTSs, as well as a series of implementing acts and ITSs. The core of the administrative regime is formed by a small number of RTSs: RTS 149/​2013 on, inter alia, the CCP clearing obligation and the risk management of bilaterally cleared contracts, and the related specific RTSs that identify the derivatives classes subject to the CCP clearing obligation; RTS 153/​2013 on the regulation of CCPs and RTS 152/​2013 on CCP capital; RTS 148/​2013 on the data to be reported to TRs and RTS 151/​2013 on the data to be provided by TRs; and RTS 2016/​2251 on risk mitigation for bilaterally cleared contracts.416 414 ESMA, EU Derivatives Markets (2021) 15-​16 (see section 5.6 on the CCP clearing obligation). 415 Peer reviews of supervision and annual stress tests, eg, have not exposed material weaknesses (nn 522 and 523). 416 Respectively: [2013] OJ L52/​11; [2013] OJ L52/​41; [2013] OJ L52/​37; [2013] OJ L52/​1; [2013] OJ L52/​33; and [2016] OJ L340/​9. A series of delegated regulations govern the supervision by ESMA of TRs as well as ESMA’s supervision of third country CCPs.

VI.5 EMIR  601 This rulebook provides, in effect, the operating manual for the structure and operation of the OTC derivatives markets. ESMA has been the determinative influence on the administrative rulebook. Most of ESMA’s proposals for these RTSs were accepted by the Commission without major change,417 albeit that the European Parliament flexed its oversight powers.418 Its influence has continued to be significant: for example, subsequent revisions and refinements to the administrative rules have frequently been on foot of an ESMA initiative,419 while ESMA has used ‘supervisory forbearance’ action to manage the complexities and implementation costs of RTS 2016/2251.420 ESMA has also adopted a dense soft law ‘rulebook’. ESMA was quick to deploy the (then-​ novel) Q&A device under EMIR421 and has adopted a wide-​ranging set of Guidelines,422 which typically have a strongly quasi-​regulatory quality. The 2017 Guidelines on CCP conflict-​of-​interest management, for example, are similar in design and substantive impact to the EMIR administrative rules which apply to CCPs.423 ESMA’s influence on the EMIR rulebook extends beyond shaping administrative rules and adopting soft law. It, inter alia, provides the Commission with technical advice on which classes of derivative should be subject to the CCP clearing obligation; is empowered to advise the Commission where it regards a suspension of the CCP clearing obligation to be required; coordinates NCA-​based CCP supervision, including CCP stress tests, through its CCP Supervisory Committee; directly supervises third country CCPs, again through its CCP Supervisory Committee; and directly supervises TRs and monitors the quality of the reports provided to and reported by TRs. ESMA also sits at the centre of a dense web of EMIR-​related OTC derivatives market data through, inter alia, its hosting of the ‘single EU access point’ for NCAs querying and retrieving derivatives transaction data from TRs (the Access to Trade Repositories Data (TRACE) system); its construction of a proprietary data-​ set on the OTC derivatives markets; its holding of the data which flows to ESMA directly 417 For an examination of the adoption process see the third edition of this book at 586–​92 and Moloney, n 367, 116–​45. 418 The Parliament deployed its RTS oversight powers for the first time over the EMIR process, when its ECON committee threatened to veto the first swathe of EMIR RTSs on substantive grounds (including lack of proportionality) as well as on procedural grounds (related to the Commission’s failure to communicate effectively with the Parliament). A veto was averted by an ECON/​Commission compromise under which the Commission acknowledged the Parliament’s concerns, committed to enhancing communication, and agreed to phase-​in certain of EMIR’s obligations: Statement to the European Parliament by Commission Member Hedegaard, 7 February 2013. 419 eg, ESMA successfully proposed that the three EMIR RTSs which impose CCP clearing obligations on identified classes of derivatives be revised so that the ‘phase-​in’ of these clearing obligations be extended for the smallest financial counterparties who were experiencing difficulties in ensuring the relevant derivatives were cleared through CCPs (ESMA/​2016/​1565). 420 In February 2017, the three ESAs called for NCA supervisory forbearance in response to industry concern that smaller counterparties would not be able to meet a then-​imminent March 2017 deadline for the application of certain margin requirements under the RTS: ESMA, EBA, EIOPA, Variation Margin Exchange under the EMIR RTS on OTC Derivatives, February 2017. Later in 2017, the ESAs announced that, given the challenges the industry was facing in meeting the margin requirements for certain foreign exchange derivatives, they would propose amendments to the RTS and, in advance of such changes coming into force, called on NCAs to exercise supervisory forbearance: ESA Joint Committee, EBA, EIOPA, ESMA, Variation Margin Exchange for Physically-​Settled FX Forwards under EMIR, 24 November 2017. In both cases, RTS reform followed. On supervisory forbearance see Ch I section 6. 421 The EMIR Q&A, which is among the most extensive and granular of the Q&As maintained by ESMA, was initially adopted in March 2013 and is regularly updated. 422 ESMA has to date adopted nine sets of Guidelines, primarily in relation to CCP supervision and TR reporting. A 10th is in development as regards the supervision of CCPs. 423 ESMA, Guidelines on CCP Conflict of Interest Management (2019).

602 Trading from certain reporting obligations imposed on derivatives market participants;424 and its hosting of several EMIR registers.425 Its pivotal role in the application of EMIR, which strengthens its capacity to develop related soft law, refine administrative rules, and recommend legislative reforms, has been well captured as it supporting an ‘OTC Derivatives Union’, within which there is a high level of regulatory and supervisory consistency.426

VI.5.4  Setting the Perimeter: Scope and Exemptions EMIR lays down CCP clearing and bilateral risk-​management requirements for OTC derivative contracts, reporting requirements for all derivative contracts, and uniform requirements for the performance of the activities of CCPs and TRs (Article 1). Perimeter control under EMIR is in part a function of the contracting parties subject to its requirements. EMIR’s CCP clearing, risk management, and reporting requirements apply to ‘financial counterparties’, widely defined to cover a range of regulated financial institutions, including collective investment funds.427 Small financial counterparties benefit from an alleviation from the CCP clearing obligation, following the 2019 Refit Regulation reforms (section 5.5). Non-​financial counterparties (NFCs)428 are also subject to EMIR, but only when specified thresholds are passed (section 5.5). CCPs429 and TRs430 also come within EMIR, being subject to discrete authorization and regulatory/​supervisory regimes. CCP clearing members431 and those members’ clients432 are subject to specific obligations as regards CCP clearing. Trading venues more generally come within EMIR, mainly with respect to the competition-​and access-​related provisions. EMIR perimeter control is also a function of the derivatives within its scope, as regards which EMIR takes a broad approach, defining these derivatives by reference to MiFID II/​ MiFIR.433 In practice, aside from the reporting obligation which applies to all derivatives, 424 eg, CCPs and counterparties must provide the EMIR-​required reports to ESMA where a TR is not available. 425 ESMA’s EMIR registers cover: the CCPs authorized to offer services in the EU; the third country CCPs registered to offer services in the EU; the NCAs responsible for the authorization and supervision of CCPs; and the instruments required to be cleared through CCPs. 426 ESMA Chair Maijoor, Statement to the European Parliament ECON Committee, 14 September 2015. 427 A financial counterparty is widely defined as including an authorized financial institution, including investment firms, credit institutions, insurance, assurance, and reinsurance undertakings, UCITSs and their management companies, and institutions for occupational retirement provision under Directive 2016/​2341: Art 2(8). The 2019 Refit Regulation extended the coverage of financial counterparties to cover authorized CSDs and also alternative investment funds either managed by an EU-​authorized fund manager (as originally provided by EMIR) or, in an extension to EMIR, established in the EU. 428 Undertakings other than financial counterparties or CCPs: Art 2(9). 429 A CCP is defined as a legal person that interposes itself between the counterparties to the contracts traded on one or more financial markets, becoming the buyer to every seller and the seller to every buyer: Art 2(1). 430 Defined as a legal person that centrally collects and maintains the records of derivatives: Art 2(2). 431 Defined as an undertaking which participates in a CCP and which is responsible for discharging the financial obligations arising from that participation: Art 2(14). 432 A client is defined as an undertaking with a contractual relationship with a CCP clearing member which enables that undertaking to clear its transactions with that CCP: Art 2(15). 433 Article 2(5) (which refers to MiFID I). On the derivatives within the scope of MiFID II/​MiFIR see Ch IV section 5.3. The interaction between EMIR and MiFID II/​MiFIR can be intricate. The extension of the scope of the derivatives covered by MiFID I by MiFID II/​MiFIR to cover certain physically settled energy derivatives, eg, brought these instruments within the scope of the EMIR obligations, once MiFID II/​MiFIR came into force. Given the potential costs and disruption, MiFID II provided a transitional period of six years before such contracts became subject to EMIR. Other difficulties have arisen, including as regards alignment difficulties between the MiFIR Derivatives Trading Obligation and the EMIR clearing requirement (section 5.11).

VI.5 EMIR  603 EMIR applies to ‘OTC derivatives’: OTC derivatives are those derivatives the execution of which takes place outside a MiFID II/​MiFIR regulated market (accordingly, OTC derivatives include those traded on MTFs and OTFs).434 EMIR accordingly applies widely to equity, credit, commodity, interest rate, and foreign exchange derivatives, despite significant industry pressure at the time of its negotiation to reduce its scope.435 EMIR’s extraterritorial reach is wide. As outlined in Chapter X, third country CCPs and TRs operating in the EU are subject to ESMA recognition requirements. The CCP clearing, risk management, and reporting obligations imposed on counterparties also have an extensive reach. The CCP clearing obligation applies to contracts between EU financial/​ non-​financial counterparties (that are subject to the CCP clearing obligation) and an entity established in a third country that would be subject to the CCP clearing obligation if it were established in the EU; it also applies to contracts between two entities established in third countries that would be subject to the CCP clearing obligation if established in the EU, provided that the contract has a ‘direct, substantial, and foreseeable effect within the EU’ or where such obligation is necessary or appropriate to prevent the evasion of any EMIR provision (Article 4(1)(a)).436 Similarly, the risk management/​margin regime for non-​CCP-​cleared OTC derivatives has an extensive reach, applying to OTC derivative contracts entered into between third country entities that would be subject to those obligations if they were established in the EU, provided that the contracts have a ‘direct, substantial, and foreseeable effect within the EU’ or where such obligation is necessary or appropriate to prevent the evasion of any EMIR provision (Article 11(12)). While these requirements are, in practice, anti-​avoidance mechanisms designed to prevent EU entities from structuring contracts to avoid EMIR, they underline EMIR’s potential reach.437 EMIR is calibrated, particularly as regards how it applies to NFCs, but there are also three sets of exemptions from its scope: for central banks/​public debt management entities; intra-​ group transactions; and pension scheme arrangements. While these exemptions reflect different concerns, all three are broadly related to market efficiency. EU entities engaged in the management of public debt—​in particular the members of the ESCB, other Member State bodies performing similar functions, and EU public bodies charged with or intervening in the management of public debt—​are, with the Bank for International Settlements, excluded from EMIR’s scope in order to ensure that EMIR does not prejudice the smooth operation of monetary functions (Article 1(4)). Specified third country central banks/​public bodies engaged in the management of public debt of specified jurisdictions are also exempted (Article 1(4)).438 In addition, multilateral development banks, public sector entities, and the European Stability Mechanism are exempted, with the exception of the Article 9 reporting requirements (Article 1(5)).

434 Article 2(7). The EMIR Q&A (OTC section Q1) confirms that MTF-​and OTF-​traded derivatives are OTC derivatives for the purposes of EMIR. 435 Industry stakeholders argued against the inclusion of commodity and foreign exchange derivatives in particular, as they were not implicated in the financial crisis. The Commission, however, underlined the importance of taking a forward-​looking and expansive approach: 2010 EMIR Proposal IA, n 354, 60. 436 This evasion-​oriented requirement is amplified by RTS 285/​2014 [2014] OJ L85/​1. 437 See further Ch X section 9 on EMIR and third countries. 438 In accordance with the relevant delegation for administrative rules (Art 1(6)), the jurisdictions were added by delegated regulations over 2013, 2017, and 2019 (the last to include the UK), following clarification of the extent to which major third country jurisdictions exempted such entities from the scope of their OTC derivative market rules.

604 Trading The second exemption relates to intra-​group derivatives transactions. As such transactions may be used to aggregate and manage risk within a group, submitting them to additional and likely costly risk management requirements may limit their efficiency and reduce incentives to manage risk. The intra-​group exemption is therefore available where specified conditions designed to mitigate risks are met (Article 3). The exemption is available for NFCs, in relation to an OTC derivative contract entered into with another counterparty which is part of the same group, as long as both counterparties are included in the same consolidation on a full basis and are subject to an appropriate, centralized risk evaluation, measurement, and control procedure, and the counterparty is established in the EU (Article 3(1)).439 The exemption is also available to financial counterparties within a group, but subject to an extensive series of conditions designed to mitigate systemic risks (Article 3(2)). The intra-​group exemption, when available, applies in relation to the CCP clearing obligation (Article 4); TR reporting where at least one counterparty is an NFC (Article 9, following a 2019 Refit Regulation reform); and to elements of the risk mitigation regime for bilaterally cleared transactions (given the heightened systemic risk thereby engaged, the collateralization requirements are lifted only where specific requirements are met), subject to notification of, and agreement by, the relevant NCA (Article 11). A final exemption, originally designed to be transitional but in place until mid-​2023, and exemplifying EMIR’s complexities, exempted pension scheme arrangements from the CCP clearing obligation.440 Over the EMIR negotiations, pension schemes successfully argued that their derivatives activities were related to the management of inflation and volatility risks, and were not speculative, and that EMIR’s requirements, and in particular the cash variation margin requirements associated with CCP clearing which would require pension schemes to hold significant cash funds, would damage returns to pension holders.441 A transitional, three-​year exemption was originally made available, but this was extended by the 2019 Refit Regulation to allow additional time for an industry-​led solution to be developed.442 In an indication of the extent to which it is embedded in EMIR, ESMA was closely engaged with the review of the exemption.443 439 Where the counterparty is established in a third country, the exemption remains available as long as the third country has been deemed by the Commission to be ‘equivalent’. 440 Defined under Art 2(10) and broadly covering institutions for occupational retirement provision. 441 Pension funds typically minimize their cash holdings to maximize returns for policy holders. EMIR recital 26 noted that the application of EMIR would require pension funds to divest a significant proportion of their assets into cash to meet variation margin requirements, and that this could have a negative impact on the future income of pensioners. 442 The 2019 Refit Regulation extended the exemption until June 2021, but allowed for two subsequent extensions, each of one year, where deemed necessary by the Commission, and in the absence of solutions to the difficulties. The Regulation also provided for the establishment of an expert group to monitor progress. The Commission reviewed the exemption in 2020 (following extensive advice from ESMA), emphasizing that the policy commitment to requiring CCP clearing by pension schemes remained; acknowledging the progress made in developing solutions, that some voluntary CCP clearing by pension schemes was being undertaken, but that further work was needed; and underlining that it would continue to monitor progress: COM(2020) 574. Delegated Regulation 2021/​ 962 [2021] OJ L213/​1 subsequently extended the exemption to June 2022. ESMA subsequently recommended a final one-​year extension (n 443) which was also adopted: Delegated Regulation 2022/​1671 [2022] OJ L252/​4. 443 In its 2020 report, ESMA noted that ‘it seems very unlikely that after so many efforts from all stakeholders and regulators since the start of the exemption, a new and never thought of ‘silver bullet’ solution’ would emerge. It suggested that the most likely solution would involve the optimization of existing solutions by the different actors engaged, including CCPs, clearing members, and NCAs. While ESMA underlined its support for a broad application of the CCP clearing obligation, it accordingly supported an extension to support the adoption of a solution: ESMA, Report on the Central Clearing Solutions for Pension Scheme Arrangements (No 2) (2020). Subsequently, ESMA reported in January 2022 that the industry was operationally ready, but recommended that the exemption be extended for one final year until June 2023 to allow for final preparations: ESMA, Letter to the Commission (Clearing Obligation for Pension Scheme Arrangements), 25 January 2022. ESMA noted that while

VI.5 EMIR  605

VI.5.5  Calibration for Small Financial Counterparties and NFCs: The Clearing Thresholds The wide scope of EMIR, in particular as regards the CCP clearing obligation, generated significant industry concern during EMIR’s initial development, with financial counterparties whose business models typically relied on OTC derivatives for hedging purposes rather than for speculative purposes, raising concerns as to the potential costs and prejudice to efficient risk management, in particular given the costly collateral/​margin requirements associated with CCP clearing. But among financial counterparties, only pension schemes were successful in negotiating an exemption from the CCP clearing obligation. The 2019 Refit Regulation, however, and in response to the challenges and costs experienced by small financial counterparties in accessing CCP clearing arrangements, introduced an exemption from the CCP clearing obligation for small financial counterparties (Articles 4(1) and 4a).444 The availability of the exemption is determined by reference to the ‘clearing thresholds’ (related to aggregate month-​end average derivative positions held over the previous twelve months) that govern the NFC exemption from the CCP clearing obligation (as noted below). The effect of the exemption, which is designed to provide an alleviation for financial counterparties where the volume of OTC derivatives trading engaged in by such counterparties is too low to pose systemic risk and too costly for CCP clearing to be economically viable,445 is to provide that a financial counterparty only becomes subject to the CCP clearing obligation where it exceeds the relevant clearing threshold in any asset class.446 By contrast with the treatment of NFCs, but in a recognition of the systemic risks potentially posed by financial counterparties, where a financial counterparty exceeds the clearing threshold in one asset class, it becomes subject to the CCP clearing obligation for all relevant asset classes.447 This exemption is based on the original EMIR exemption for NFCs from the CCP clearing obligation, which is based on clearing thresholds. NFCs were not granted a full efforts should continue to improve pension schemes’ ability to source cash to meet variation margin calls, particularly in stressed conditions, a mix of solutions had been made available to ensure schemes had sufficient cash (including through securities financing transactions) and that there was less reason to treat pensions schemes differently to other collective investment funds. 444 The new exemption was designed in particular to respond to the impact of the EU’s leverage ratio requirements (see Ch IV section 9.2 and 9.3) on CCP clearing members, as these requirements had the effect of raising the costs of the clearing services offered by clearing members, on which services small financial counterparties, not able to act as clearing members, depended. The exemption was also designed to respond to the significant costs incurred by small financial counterparties that undertook only limited activity in OTC derivatives: 2016 Commission Refit Report, n 405, 9–​10. 445 2019 Refit Regulation recital 9. 446 Article 4(1) applies the CCP clearing obligation to financial counterparties where they meet the conditions set by Art 4a (or, in effect, where they pass the relevant clearing thresholds, set in accordance with Art 10(4) which provides the mandate for the administrative rules, since adopted, that govern the clearing thresholds for NFCs). Art 4a governs, inter alia, how financial counterparties are to calculate derivative positions for the purposes of the threshold assessment (specifying that the calculation, done annually, must include all OTC derivative contracts entered into by the financial counterparty or other entities in the group to which it belongs); the ESMA/​NCA notification obligations that trigger when a threshold is passed; and the point at which the CCP clearing obligation applies, when the thresholds are passed, and when it lifts, when positions drop below the thresholds. It also requires that the financial counterparty be able to demonstrate to the relevant NCA that its calculation of the aggregate month-​end average positions does not lead to a systematic underestimation of those positions. If a financial counterparty does not calculate its position, or does not do so on time, the CCP clearing obligation applies by default (Art 4a(1)–​(3)). 447 Art 4a(1)(c).

606 Trading exemption from EMIR, given their importance in the OTC derivatives markets and the potential for systemic risk from some NFCs—​as well as the regulatory arbitrage risks which could be generated by such an exemption, given the incentives that would be created for financial counterparties to operate through NFCs.448 But EMIR could potentially have imposed significant costs on hedging activities related to commercial activities and to treasury/​funding activities which do not pose systemic risks. The calibration of EMIR’s application to NFCs is achieved by means of the ‘clearing threshold’ mechanism (Article 10).449 The clearing threshold mechanism, which is based on the NFC’s annual calculation of its aggregate month-​end average positions over a twelve-​month period,450 acts as a proxy for identifying sporadic and/​or non-​systemically significant derivatives activity. Following the 2019 Refit Regulation reforms, an NFC (and by contrast with small financial counterparties) is only subject to the CCP clearing obligation as regards those asset classes in relation to which it, on the basis of the annual calculation, exceeds the relevant clearing threshold; previously, exceeding the threshold in one asset class subjected the NFC to the CCP clearing obligation for all asset classes (Articles 4(1) and 10(1)).451 The clearing thresholds also govern the extent to which an NFC is subject to the Article 11 risk management rules that apply to bilaterally cleared contracts, in particular the collateral requirements.452 The clearing thresholds were originally designed to ensure that NFCs only become fully subject to EMIR where their activities were systemically significant and to protect hedging activities related to commercial and/​or treasury financing activities. The concern to protect hedging activities is implicit in the Article 10 positions calculation procedure: it provides for a hedging carve-​out, in that the positions calculation, for the purposes of establishing whether positions exceed the relevant clearing threshold, must include all OTC derivative contracts entered into by the NFC (or other NFCs within the group) which are not objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activities of the NFC (or the group) (Article 10(3)).453 The relevant clearing thresholds for NFCs (and small financial counterparties) are set out in RTS 2013/​149. The breadth of the criteria governing the hedging carve-​out led to the

448 2010 EMIR Proposal, n 354, 7. 449 Calibration is also achieved by the longer phase-​in period for NFCs where they are subject to the CCP clearing obligation (see n 480). 450 If the NFC does not calculate its positions or do so on a timely basis, the CCP clearing obligation applies by default (Art 10(1)). 451 Art 10, like Art 4a, specifies the calculation method (NFCs are required only to include OTC derivatives contracts entered into by other NFCs in their groups and not, by contrast with financial counterparties, contracts entered into by other group entities); ESMA/​NCA notification obligations; and how the CCP clearing obligation activates/​falls away where an NFC exceeds (or falls below) a threshold. 452 As outlined in section 5.7, only NFCs above the clearing threshold are required to provide variation margin. 453 RTS 2013/​149 Art 10 governs when a derivative meets the hedging carve-​out conditions and so can be excluded from the calculation. The criteria are broadly based and reflect ESMA’s concern that the carve-​out reflect the range of risks which commercial and treasury funding operations generate, the flexibility needed by NFCs, and the need to reduce the costs faced by NFCs in monitoring their positions for the purpose of the clearing threshold: ESMA, Final Report. Draft Technical Standards under EMIR (2012) 17. The clearing threshold calculation is also supported by the EMIR Q&A which provides extensive coverage of the thresholds and the related calculations, including the hedging carve-​out.

VI.5 EMIR  607 clearing thresholds, for the specified asset classes, being set at a relatively low level:454 credit derivatives (€1 billion in gross notional value); equity derivatives (€1 billion); interest rate derivatives (€3 billion); foreign exchange derivatives (€3 billion); commodity derivatives (€3 billion); and other OTC derivative contracts (€3 billion).455 The clearing thresholds were, given their pivotal importance, the subject of some initial contestation,456 but they proved resilient, at least prior to the 2019 Refit Regulation reforms when their use was extended to the new exemption for small financial counterparties. Brexit placed some pressure on the thresholds, with derivatives admitted to trading on UK regulated markets being regarded as OTC derivatives, and thereby bringing small financial counterparties and NFCs closer to the thresholds.457 ESMA’s first major review of the thresholds in 2021 (following the introduction of a review competence in the 2019 Refit Regulation) suggested, however, that they were overall working well.458 In a reflection of the market sensitivity of these thresholds, and of the need for an agile technocratic capacity in response, ESMA recommended an increase in the commodity derivatives threshold, given ongoing pressure on pricing in the energy market in particular; this reform was adopted later in 2022 as part of the Commission’s response to the elevated volatility in energy derivatives markets that followed the Russian invasion of Ukraine.459

454 2013 Commission Delegated Regulation 149/​2013 recital 20. 455 RTS 149/​2013 Art 11. 456 ESMA’s tying of the thresholds to a gross notional value assessment led to significant industry and European Parliament opposition, and to calls for the calculation to be based on a net, mark-​to-​market value on the grounds that this would allow the systemic risk represented by OTC derivative positions to be more accurately captured (and would have given NFCs more leeway to stay under the threshold). ESMA argued that a gross notional value was easier to implement and assess than a mark-​to-​market value, and provided greater stability and certainty in the assessment of positions, particularly for small and medium-​sized NFCs. ESMA also underlined that the absence of reliable data on net positions led it to conclude that gross value was a reasonable and practical proxy for systemic relevance: 2012 ESMA EMIR Draft BTS Report, n 453, 19. 457 In practice, the effect is not to increase CCP clearing costs, as most derivatives impacted are either already cleared in practice by counterparties, or are not subject to the clearing obligation, but, as regards any bilaterally cleared contracts, to bring NFCs (primarily energy companies) into the more extensive Art 11 risk management, and in particular, collateral requirements, that apply once the clearing thresholds are breached: 2021 ESMA Clearing Thresholds Report, n 359, 23. 458 In an extensive review (based on EEA data and including the UK), ESMA reported that the thresholds were ensuring wide coverage (in terms of total notional trading) by the CCP clearing obligation of those contracts subject to the obligation (eg, some 98 per cent of notional financial counterparty trading volume in interest rate derivatives subject to the obligation was captured (31 per cent of counterparties); and some 35 per cent of NFC trading (1 per cent of counterparties)). The lower proportions of counterparties covered was, ESMA concluded, indicative that the thresholds were having an appropriately proportionate effect, capturing counterparties engaged in the highest volumes and most systemically significant trading (in the financial counterparty segment, UCITSs and AIFs accounted for some 76 per cent of contracts subject to the CCP clearing obligation): 2021 ESMA Clearing Thresholds Report, n 359. 459 Following the 2021 review, ESMA proposed the threshold be increased by €1 billion, in response to constraints faced by NFCs in the energy market given rising prices: ESMA, EMIR RTS on the Commodity Derivative Threshold (2022). The reform was adopted later in 2022 as part of the EU’s response to the acute volatility in energy derivatives markets, and related increases in prices, which were pushing some NFCs closer to and over the clearing threshold and so leading to higher margin (and collateral) requirements: C(2022) 7414. Further reform may follow from the Commission’s 2022 clearing review, given ESMA’s recommendation that the clearing threshold calculation only cover non-​CCP-​cleared derivatives, in order to create incentives for CCP clearing: 2022 ESMA Clearing Consultation Letter, n 407. The subsequent 2022 EMIR Proposal (n 407) adopted ESMA’s recommendation and also provided for a review of the clearing thresholds and hedging carve-​out by ESMA, underlining ESMA’s increasingly pivotal role in the operation of EMIR.

608 Trading

VI.5.6  The CCP Clearing Obligation VI.5.6.1  Scope At the heart of EMIR is the Article 4 obligation on counterparties to clear460 all OTC derivatives contracts,461 pertaining to a class of OTC derivatives462 that has been declared subject to the CCP clearing obligation in accordance with the Article 5(2) procedure, through a CCP (Article 4(1)). These contracts must be cleared through an EU-​established CCP authorized under EMIR (Article 14) or a third country CCP recognized by ESMA (Article 25), in each case authorized to clear the relevant class of OTC derivatives and listed in the Article 6 ESMA-​maintained public register (Article 4(3)). In order to support the CCP clearing obligation, the counterparty must become a clearing member, a client of a clearing member, or establish indirect clearing arrangements with a clearing member (Article 4(3));463 the clearing obligation cannot thus be avoided by a counterparty not engaging with a CCP. This support by Article 4(3) of a range of CCP clearing access models is designed to respond to the heavy costs associated with becoming a CCP clearing member, given the capital, margin, and default fund requirements which apply, and to facilitate the development of new, indirect clearing access routes.464 In an effort to support access to clearing (particularly by NFCs above the clearing threshold), a 2019 Refit Regulation reform requires that clearing members and clients of clearing members which provide clearing services, whether directly or indirectly, provide those services on fair, reasonable, non-​discriminatory, and transparent commercial terms (Article 4(3a)). This reform also, however, confirms that such entities are not subject to an obligation to contract and that they are permitted to control the risks relating to the clearing services offered.465 The CCP clearing obligation has a wide reach (Article 4(1)). It applies in relation to contracts concluded between the following: two financial counterparties, where neither is a small financial counterparty; a financial counterparty that is not a small financial counterparty and an NFC over the clearing threshold; and two NFCs over the clearing threshold. The extraterritorial reach of the CCP clearing obligation is supported by its application to contracts between the following: a financial counterparty (that is not a small financial counterparty) or NFC over the clearing threshold and an entity established in a third country that would be subject to the CCP clearing obligation if it were established in the EU; and two entities established in one or more third countries that would be subject to the CCP clearing obligation if they were established in the EU, as long as the contract has a ‘direct,

460 Clearing is defined by EMIR as the process of establishing positions, including the calculation of net obligations, and ensuring that financial instruments, cash, or both are available to secure the exposures arising from these positions: Art 2(3). 461 In parallel, a CCP clearing obligation applies in relation to transactions in derivatives concluded on a regulated market (via MiFIR Art 29(1)). This is designed to close the CCP clearing ‘loop’, ensuring that the CCP clearing obligation applies as regards regulated-​market-​traded derivatives. 462 A class of derivatives is a subset of derivatives sharing common and essential characteristics including, at least, the relationship with the underlying asset, the type of underlying asset, and currency of notional amount (although maturities may differ): Art 2(6). 463 Indirect clearing arrangements must not increase counterparty risks and must ensure that the assets and positions of the counterparty benefit from protection equivalent to EMIR Arts 39 and 48 (which relate to CCPs; see section 5.9): Art 4(3). 464 On indirect clearing access and the related risks, including ownership risks, see Braithwaite, n 363 and, for a policy perspective, CPMI/​IOSCO, A Discussion Paper on Client Clearing: access and portability (2021). 465 RTS 2021/​1456 [2021] OJ L317/​1 specifies the conditions governing these requirements.

VI.5 EMIR  609 substantial and foreseeable’ effect within the EU, or where such an obligation is necessary or appropriate to prevent the evasion of EMIR.466 The CCP clearing obligation does not apply to small financial counterparties (Article 4a); NFCs below the clearing threshold (Article 10); pension funds (albeit on a transitional basis) (Article 89);467 intra-​ group transactions (Article 4(2));468 or, and reflecting the distinct regulation that applies to these structures, to derivative contracts concluded by covered bond entities in connection with a covered bond, or by securitization special purpose entities in connection with a securitization (Article 4(5)).469

VI.5.6.2 Identifying Classes of Derivatives The process for the identification of the classes of derivatives subject to the CCP clearing obligation is finely prescribed, reflecting the related and significant structural and cost implications for the OTC derivatives markets in the EU, as well as the implications for CCPs’ resilience: the more complex the class of derivative cleared, the greater the pressure on a CCP’s risk-​management systems—​particularly its processes for valuing margin—​and, accordingly, on the EMIR rulebook. The identification process has two elements: the ‘bottom-​ up’ (or industry-​driven) procedure; and the ‘top-​down’ (or ESMA-​driven) procedure. The ‘bottom-​up’ procedure (Article 5(1) and (2)) is driven by the CCP authorization process: the identification process only activates, under this procedure, where a CCP has been authorized to clear the relevant class reviewed, and, accordingly, its risk management and other procedures have been assessed, and the CCP’s business model is, relatedly, based on clearing the relevant class. Once an NCA has authorized a CCP to clear a class of OTC derivatives, it must inform ESMA of the authorization; public disclosure is made of elements of the related and extensive notification which the NCA must make to ESMA, in order to signal to the market that a potential CCP clearing obligation may arise.470 ESMA is then required to decide whether that class of derivatives should be subject to the CCP clearing obligation for all relevant counterparties. Procedurally, the determination is made by means of ESMA—​following a public consultation, and after consulting the ESRB and, where relevant, competent authorities of third countries—​submitting RTSs for Commission endorsement which specify the class of OTC derivatives to be subject to the CCP clearing obligation and the application date (Article 5(2)). In deciding whether to subject a class of OTC derivatives to the CCP clearing obligation, and with the over-​arching aim of reducing systemic risk, ESMA’s assessment must, in accordance with Article 5(4), extend beyond the NCA’s original assessment of whether the particular CCP can clear the class in question, and address the market-​wide implications of subjecting the asset class to a general CCP clearing

466 RTS 285/​2014 governs when the CCP clearing obligation applies to contracts between two third country counterparties in this regard. 467 See n 442 on the removal of this exemption. 468 The intra-​group exemption is dependent on the counterparties in question having notified their NCAs of their intention to use the exemption; where the relevant NCAs do not agree that the relevant conditions governing the use of the exemption (set out in Art 3) are met, ESMA is empowered to mediate. A similar process applies in relation to intra-​group transactions involving EU-​established and third country-​established counterparties. 469 This exemption is governed by conditions which require, inter alia, that arrangements are adopted that adequately mitigate counterparty credit risk in accordance with RTS 2020/​447 [2020] OJ L94/​5. 470 The extensive information which must be reported to ESMA by the NCA is set out in RTS 149/​2013 Art 6, while ESMA’s public register must contain the information on the class(es) of OTC derivatives notified under the CCP authorization procedure specified by Art 8.

610 Trading obligation.471 Accordingly, under Article 5(4), ESMA must take into consideration the degree of standardization of the contractual terms and operational processes of the relevant class—​the more standardized an instrument, the better suited it is to CCP clearing;472 the volume and liquidity of the relevant class;473 and, of particular importance to the ability of the CCP to make optimum risk-​management decisions, the availability of fair, reliable, and generally accepted pricing information on the relevant class.474 ESMA may also take into consideration the interconnectedness of the counterparties using the relevant class, the anticipated impact on levels of counterparty credit risk,475 and the impact on competition across the EU (Article 5(4)). The criteria which ESMA must take into account in deciding the date from which the CCP clearing obligation should apply are also specified (Article 5(5)). The ‘top-​down’ procedure is designed to ensure that the CCP clearing obligation applies to particular classes of OTC derivatives which are not, in practice, cleared through CCPs (and so not picked up through the bottom-​up process) but are deemed as systemically relevant—​although central to the design of the top-​down procedure is the assumption that no CCP will be required to clear derivatives unless it can safely do so. The top-​down process can also be associated with regulatory encouragement of the market to provide appropriate clearing facilities. Under this procedure, ESMA can independently, and after public consultation and consulting the ESRB (and third country competent authorities, as relevant), identify and notify to the Commission the classes of derivatives that should be subject to the Article 4 clearing obligation, but in respect of which no CCP has received authorization (Article 5(3)). But, given the risks of requiring CCPs to clear derivatives which have yet to be cleared in practice by a CCP, the ‘top-​down’ procedure was likely to be more peripheral to the clearing obligation process. This has been borne out over EMIR’s first decade or so, as it has yet to be deployed. When a CCP clearing obligation is imposed, and where counterparties are subject to the obligation, it applies to relevant contracts entered into (or novated on) after the date on which the clearing obligation takes effect (Article 4(1)(b)). The 2019 Refit Regulation removed the previous ‘frontloading’ obligation which applied the CCP clearing obligation, in addition, to contracts entered into between the notification that a CCP had been authorized

471 RTS 149/​2013 recital 9. 472 ESMA’s approach to standardization, articulated in RTS 149/​2013 Art 7(1), was broadly accepted by the market and is based on ESMA taking into consideration: (a) whether the contractual terms of the relevant class of OTC derivatives incorporate common legal documentation, including master netting agreements, definitions, standard terms and confirmations which set out contract specifications commonly used by counterparties; and (b) whether the operational processes of the class are subject to automated post-​trade processing and lifecycle events that are managed in a common manner to a timetable which is widely agreed among counterparties. 473 ESMA takes into consideration: whether the CCP’s margin or financial requirements would be proportionate to the risk that the CCP clearing obligation intends to mitigate; the stability of the market size and depth in respect of the class over time; the likelihood that market dispersion would remain sufficient in the event of the default of a clearing member; and the number and value of transactions: RTS 149/​2013 Art 7(2). 474 ESMA is to take into account whether the information needed to accurately price the contracts within the relevant class of OTC derivatives contract is easily accessible to market participants on a reasonable commercial basis, and whether it would continue to be easily accessible if the relevant class of OTC derivatives became subject to the clearing obligation: RTS 149/​2013 Art 7(3). 475 Defined as the risk that a counterparty to a transaction defaults before the final settlement of the transaction’s cash flows: Art 2(11). While the CCP clearing obligation is primarily designed to address counterparty credit risk, for certain classes of OTC derivative the key risk may be settlement risk, in which case CCP clearing may not be the optimal risk management response (EMIR recital 19).

VI.5 EMIR  611 to clear a class of derivatives and before the subsequent clearing obligation took effect, depending on the maturity of the derivative class in question.476

VI.5.6.3 Initial Application: Interest Rate Derivatives and Credit Derivatives The ‘bottom-​up’ procedure has proved to be the main procedure for determining the coverage of the CCP clearing obligation. The obligation has, accordingly, followed market practice and CCP experience. As EMIR came into force, the changed regulatory environment given the G20 reform agenda, and related regulatory pressure on the industry to pre-​empt the adoption of binding CCP clearing requirements, led to a wider range of classes and greater volumes of OTC derivatives globally being cleared through CCPs, particularly interest rate derivatives and credit derivatives (CDSs).477 Relatedly, and reflecting the CCP landscape in the EU at the time, the inaugural suite of CCP clearing obligation decisions all relate to interest rate derivatives and CDSs. Following the initial series of CCP authorizations after EMIR’s coming into force, and in accordance with the ‘bottom-​up’ procedure, ESMA undertook a set of omnibus consultations on the different derivatives classes engaged.478 It subsequently proposed that the CCP clearing obligation apply to specified interest rate derivatives in euro, pounds sterling, US dollars, and Japanese yen (2014); specified CDSs based on corporate bond indices (2015); and specified interest rate derivatives in three (non-​euro-​area) Member States’ currencies (Norway, Poland, and Sweden) (2015). Three RTSs were subsequently adopted over 2015–​ 2016 specifying that the identified classes of interest rate derivatives and CDSs be subject to the CCP clearing obligation.479 In each case, and reflecting the material cost and risk management implications for counterparties, the application of the obligation was phased in.480

476 The ‘frontloading’ obligation quickly emerged as problematic. ESMA advised the Commission, as the assessment process for identifying classes of derivatives for the CCP clearing obligation got underway, that uncertainties as to the exact scope of the derivatives subject to the frontloading requirement could generate incentives to avoid entering into potentially impacted contracts, given related uncertainties as to the contracts’ pricing (collateral costs being different for CCP-​cleared and bilaterally cleared contracts), thereby reducing hedging, and ultimately potentially impacting on financial stability: ESMA, Letter to Commission, 8 May 2014. The first set of interest rate derivative clearing obligations (RTS 2015/​2205) accordingly sought to limit the potentially adverse effects of the frontloading obligation. 477 Initially, the change was most marked in relation to CDSs and interest rate derivatives. By 2013, shortly after EMIR came into force, 60 per cent of interest rate derivatives were CCP-​cleared, as compared to 31 per cent in 2010: ESMA, TRV No 1 (2013) 7. 478 Although the ‘bottom-​up’ process triggers separately each time a CCP is approved by its NCA to clear a class of derivatives, to avoid the complication of multiple consultations, ESMA grouped its assessment by reference to the classes CCPs had initially been authorized to clear and so undertook consultations in relation to interest rate derivatives (euro, GBP, US$, and Japanese ¥); CDSs; certain foreign exchange classes; and interest rate derivatives in additional Member State currencies. For an account of the initial process and the generally supportive market response see ESMA, Draft Technical Standards on the Clearing Obligation—​Interest Rate Derivatives in Additional Currencies (2015). 479 RTS 2015/​2205 [2015] OJ L314/​13, specified interest rate swaps (euro, GBP, US$, and Japanese ¥); RTS 2016/​ 592 [2016] OJ L103/​5, specified CDSs; and RTS 2016/​1178 [2016] OJ L195/​3, specified interest rate swaps in three Member State currencies (NOK (Norway); PLN (Poland); and SEK (Sweden)). 480 Based on the classes to which counterparties were assigned which ranged from, and reflecting the systemic importance of the included counterparties, class 1 (clearing members) to class 4 (NFCs). The earliest implementation date applied to class 1 counterparties (who had a one-​year transition, reflecting the experience of clearing members with voluntarily clearing the relevant class but also to allow clearing members to adjust to the greater volume of clearing, in particular by supporting client clearing and indirect clearing) and the latest implementation date to class 4 NFCs (circa three-​year transition). Where counterparties were in different classes, the later date applied. See, eg, RTS 2015/​2205 recitals 5–​11.

612 Trading By way of example, the first RTS (RTS 2015/​2205) was adopted in August 2015 and, reflecting ESMA’s 2014 proposal, applied to a suite of interest rate swaps denominated in euro, pounds sterling, Japanese yen, and US dollars, and covered fixed-​to-​float interest rate swaps (‘plain vanilla’ interest rate derivatives), float-​to-​float swaps (‘basis swaps’), forward rate agreements, and overnight index swaps. The obligation was phased in over a period of one (CCP members) to three years (NFCs). Procedurally, this first process, despite its novelty, proved relatively deft, being characterized by extensive stakeholder engagement and relatively smooth inter-​institutional relations.481 The need for agile oversight of this CCP clearing obligation emerged relatively quickly, given the ongoing global transition from certain interest rate benchmarks (chief among them LIBOR), initiated in 2014 under the FSB’s leadership and in the wake of a series of interest rate benchmark scandals (see further Chapter VIII). The final withdrawal of most LIBOR rates (at the end of 2021) meant that those interest rate derivatives within the scope of the CCP obligation and referenced to LIBOR would rapidly lose liquidity, cease to be cleared by CCPs, and so fall outside the criteria for the CCP clearing obligation. ESMA consequently proposed in September 2021 that the CCP clearing obligation be removed from a series of interest rate derivatives referenced to LIBOR.482 The relevant RTS had not been adopted by end 2021, however, prompting ESMA to call for NCA supervisory forbearance in the supervision of the CCP clearing obligation in this regard.483 While a pragmatic solution, it underlines, as noted in the following section, how the formalities of administrative rule-​making can lead to the adoption of expedient, legally insecure solutions to address market disruption. A decade or so from the adoption of EMIR, CCP clearing volumes in the EU have increased,484 particularly for those contracts subject to the CCP clearing obligation, but also reflecting the incentives that the costs of the margin requirements for bilaterally cleared transactions create to clear transactions through CCPs.485 Volumes of CCP clearing in those derivative classes that are not subject to any form of CCP obligation (equity, currency, and commodity derivatives), however, remain low.486 Further, the systemic importance of UK CCPs in the interest rate and credit derivatives segment has meant that, in practice, the operation of much of the CCP clearing obligation has been off-​shored to the

481 There was extensive engagement between the Commission and ESMA, eg, as regards the technicalities of the obligation, including as regards its application to counterparties in third country groups. See ESMA, Opinion on Draft RTS on the Clearing Obligation on Interest Rate Swaps (January and March 2015). 482 ESMA, Final Report, 18 November 2021. ESMA proposed that the CCP clearing obligation be lifted from interest rate derivatives referencing GBP LIBOR, Japanese ¥ LIBOR, US$ LIBOR (albeit this last in the face of some stakeholder resistance given its higher liquidity levels, as this US$ LIBOR tenor was to be applied for a transition period), and the EU EONIA rate (which was also withdrawn). 483 ESMA, Public Statement, 16 December 2021. In a familiar formula, NCAs were urged not to prioritize supervisory action as regards the related CCP clearing obligation. The RTS was adopted by the Commission in February 2022: C(2022) 619. 484 As they have internationally and following the G20 reform programme. As at end June 2021, some 64 per cent of CDSs were centrally cleared (from 56 per cent or so over 2017–​2019), while 75 per cent of interest rate derivatives were centrally cleared (broadly stable since 2015): BIS, OTC Derivatives Statistics. End June 2021. A 2018 FSB-​coordinated report by the major international standard-​setters similarly reported on an increase in volumes of CCP clearing: FSB, Incentives to Centrally Clear OTC Derivatives (2018). 485 As at end 2020, 71 per cent of interest rate derivatives (up from 68 per cent in 2019) and 41 per cent of credit derivatives (up from 38 per cent) were CCP-​cleared: ESMA, EU Derivatives Markets (2021) 4. 486 ESMA has reported on low levels of CCP clearing in equity (1 per cent), currency (2 per cent), and commodity (10 per cent) derivatives: 2021 ESMA Clearing Thresholds Report, n 359, 25.

VI.5 EMIR  613 UK, with consequent political tensions, market uncertainties, and supervisory risks and complexities.487

VI.5.6.4 Suspending the CCP Clearing Obligation EMIR did not, originally, provide for the speedy suspension or withdrawal of the CCP clearing obligation, albeit that the support of financial stability requires that the obligation be lifted where a class of derivatives no longer qualifies for CCP clearing (where, for example, drastic changes occur in volumes cleared or liquidity), or where a CCP is no longer available to clear. The continuation of the obligation in such circumstances could bring widescale disruption to derivatives market and to hedging and risk management. The usual and cumbersome RTS adoption procedure would have applied to any change to the RTS originally imposing the obligation. A novel suspension mechanism was, however, introduced by the 2019 Refit Regulation (a parallel provision applies in the resolution context under the 2021 CCP Recovery and Resolution Regulation), illustrating the institutional innovations which EMIR’s complexities and exigencies have prompted. The reform was some time in the making. It was mooted under the 2015–​2016 EMIR Review, initially developed for the CCP recovery and resolution regime in the related 2016 proposal, subsequently adopted by the 2019 Refit Regulation for non-​resolution situations, and finally adopted in a tailored form as regards the CCP resolution context by the 2021 CCP Recovery and Resolution Regulation. Throughout, ESMA was a driving influence, highlighting the need for an expedited RTS review/​suspension process during the 2015–​2016 EMIR Review process,488 and calling for a new process which would allow it to make a decision to withdraw an RTS imposing a CCP clearing obligation, subject to procedural conditions. The suspension procedure which has followed locates the suspension power in the Commission, albeit that ESMA is the initiator of the process. The suspension procedure (Article 6a) is based on ESMA making a confidential request to the Commission to suspend the CCP clearing obligation for specific classes of OTC derivative, or for a specific type of counterparty, where one of three conditions are met: the classes of derivative are no longer suitable for CCP clearing in accordance with the Article 5 criteria; a CCP is likely to cease clearing the classes and no other CCP is able to clear the classes without interruption; or the suspension of the obligation is necessary to avoid or address a serious threat to financial stability or to the orderly functioning of financial markets in the EU, and the suspension is proportionate to those aims.489 ESMA may, at the same time, make a request to the Commission for a suspension to the Derivatives Trading Obligation for the asset classes, where necessary.490 The Commission is required, ‘without undue delay’ (which is not further specified), and on the basis of the reasons and evidence

487 See in outline Ch X sections 9 and 11. December 2022 saw the Commission propose in response that counterparties subject to the clearing obligation be required to clear a certain portion of specified interest rate derivatives and CDSs through EU CCPs (n 407). 488 ESMA, EMIR Review Report No 4 (2015) 8–​10. 489 Where the suspension is linked to financial stability, ESMA must consult with the ESRB and relevant NCAs. 490 See section 5.11 on the Derivatives Trading Obligation (DTO). Given that the CCP clearing obligation applies to OTC derivatives, defined as derivatives not traded on a regulated market, and that trading venues that qualify for the trading obligation include MTFs and OTFs, suspension of the CCP clearing obligation could impact derivatives traded on such trading venues under the DTO (as trading venues may require CCP clearing). ESMA may request the suspension where there is a material change in the criteria governing the imposition of the DTO.

614 Trading given, to suspend the obligation for the relevant classes or counterparties or to reject the request (in which case, and in an indication of the institutional sensitivities a refusal would engage, ESMA must be provided with a reasoned response and the Council and European Parliament informed). Any suspension is for an initial period not exceeding three months, but can be extended, assuming the grounds for the suspension continue to apply (as regards which ESMA is to provide an opinion), for additional three-​month periods, but no more than one year.491 While the procedure is initiated by ESMA, relevant NCAs engaged in the supervision of a CCP may request ESMA to act; ESMA is not required to request a suspension on foot of an NCA request, but must respond to the NCA within forty-​eight hours with its reasoned decision as to whether it will so request, or not. A more complex version of this process, which reflects the wider range of supervisory authorities engaged, applies in the case of CCP resolution, by means of Article 6b (introduced by the 2021 CCP Recovery and Resolution Regulation).492 In a reflection of the extent to which EU financial markets regulation now intervenes directly in market structure and practices and so requires such suspensive procedures, and also of the precedential effect of governance reform, a similar suspensive power was proposed in 2022 as regards the 2014 Central Securities Depositaries Regulation.493 The suspension power rests with the Commission. An independent ESMA power to suspend an RTS speedily in crisis conditions has functional appeal, but it would imply the exclusion of the Commission, European Parliament, and Council, all of which would have been formally engaged in the original RTS adoption process.494 The Meroni difficulties are also significant given the degree of discretion an independent suspensive power would confer on ESMA. ESMA’s pre-​eminence institutionally, however, as regards its capacity to gather and interrogate data on the derivatives markets, suggests that it would be unlikely that the Commission would not act speedily in support of an ESMA request. The process for adjusting a class of derivatives subject to the CCP clearing obligation does not benefit from this expedited process; the relevant RTS must be revised in accordance with the usual procedures. The formalities associated with the RTS process can lead to difficulties where nimble action is required: pending the adoption of the RTS to withdraw the CCP clearing obligation from certain LIBOR-​referenced interest rate derivatives and CDSs, in response to the withdrawal of LIBOR and the consequent failure of these derivatives to meet the conditions for the CCP clearing obligation, ESMA took soft law supervisory forbearance action to mitigate the risks of disruption.495 But while such soft law can provide an expedient, informal remedy, it sits uneasily with the market salience of CCP clearing obligation decisions. While a solution, on the lines of the suspension process, may

491 Any DTO suspension is subject to the same time limits and process. 492 The procedure is initiated by a request from the resolution authority (or other NCAs engaged in CCP supervision), or by a request from the NCA of a CCP clearing member, to the Commission to suspend the obligation on financial stability grounds; an ESMA opinion (within twenty-​four hours) on the request is required; and the Commission is then empowered to either suspend the obligation (for particular classes or counterparties) or reject it: Art 6b. 493 In relation to its mandatory ‘buy-​in’ rules: Ch V section 14. 494 The Parliament was quick to signal its concerns as regards any conferral of RTS suspension powers, even on the Commission: ECON Draft Report on the EMIR Review, 26 January 2018 (2017(0090)COD), amendment 16. The suspension power as adopted is designed to ensure communication with the Parliament in contested situations where ESMA and the Commission disagree. 495 n 483.

VI.5 EMIR  615 be found,496 the difficulties illustrate the strains that highly technical and market-​sensitive regulation, operating in dynamic market conditions, and the related increasing reliance by EU financial markets governance on ESMA’s technocratic capacity, can place on the rule-​ making process.

VI.5.6.5 Allied Supports A series of allied obligations support the CCP clearing obligation as regards CCP access and operation, and are designed to promote competition between CCPs and the liberalization of access to CCP clearing services, and to protect against discrimination by vertically integrated trading venue/​CCP silos. The core obligation requires that where a CCP has been authorized to clear particular OTC derivatives, it must accept the clearing of such contracts on a non-​discriminatory and transparent basis, including as regards collateral requirements and fees relating to access, regardless of the trading venue (in practice an MTF or OTF) on which the derivative contracts trade, subject to a series of risk management conditions (Article 7). Similarly, EMIR supports the provision of trading venues’ trade data feeds to CCPs, to ensure CCP/​trading venue vertical silos do not discriminate against other CCPs. Under Article 8, a trading venue must provide trade feeds on a non-​discriminatory and transparent basis to any CCP that has been authorized to clear OTC derivative contracts traded on that trading venue (in practice, an MTF or OTF) upon request by the CCP. Access by the CCP to the trading venue can only be granted, however, where it would not require interoperability or threaten the smooth and orderly functioning of markets.

VI.5.7  The Risk Mitigation Obligation for non-​CCP-​cleared Derivatives: Margin and Collateral VI.5.7.1  Scope Where OTC derivatives are bilaterally cleared, a series of risk mitigation obligations apply, including collateral exchange requirements in the form of bilateral initial and variation margin obligations, under Article 11 and its amplifying RTSs.497 These obligations are designed to mitigate counterparty credit risk and operational risk in bilateral clearing. They accordingly perform a similar function to CCP clearing but reflect the risk-​management techniques which the OTC markets have developed for bilaterally cleared derivative contracts.498 Article 11 applies to all financial counterparties; small financial counterparties are not exempted. As regards NFCs, however, only NFCs above the clearing threshold are subject to Article 11,499 with the exception of the over-​arching obligation to have in place risk management procedures which applies to all NFCs (Article 11(1)). A host of alleviating thresholds 496 In relation to the LIBOR adjustments, ESMA noted that other jurisdictions had ‘leaner and more reactive processes’ and called for reform: 2022 ESMA Clearing Consultation Letter, n 407, 9. 497 The risk mitigation regime has been significantly amplified, primarily by two pivotal RTSs: RTS 149/​2013 (risk mitigation generally) and RTS 2016/​2251 (collateral exchange/​bilateral margin). 498 Chief among these market-​developed techniques are portfolio compression (the process whereby mutually offsetting trades are terminated), exchange of collateral, and portfolio reconciliation (or the management of collateral requirements across a wide range of counterparties). 499 Where an NFC passes the clearing threshold for one derivative class, the bilateral margin rules apply to all bilateral contracts entered into.

616 Trading and phase-​in arrangements apply to the bilateral margin requirements, however, designed to mitigate the significant costs and operational change associated with their adoption, and reflecting related ameliorations in the international standards on which these requirements are based. Like the CCP clearing obligation, the risk mitigation regime has an extensive reach, applying to OTC derivative contracts entered into between third country entities that would be subject to those obligations if they were established in the EU, provided that the contracts have a direct, substantial, and foreseeable effect within the EU, or where such obligation is necessary or appropriate to prevent the evasion of any EMIR provision (Article 11(12)).

VI.5.7.2 Risk Management All financial counterparties and NFCs are required to ensure, exercising due diligence, that appropriate procedures and arrangements are in place to measure, monitor, and mitigate operational risk and counterparty credit risk (Article 11(1)). These procedures and arrangements must include timely confirmation (where available, by electronic means) of the terms of the contract, and also formalized processes, which are robust, resilient, and auditable, to reconcile portfolios, to manage the associated risk, to identify and resolve disputes between parties early, and to monitor the value of outstanding contracts.500 More stringent risk management requirements apply to financial counterparties and NFCs above the clearing threshold who must, in addition, mark-​to-​market on a daily basis the value of outstanding contracts; where market conditions prevent marking-​to-​market, a reliable and prudent marking-​to-​model must be used (Article 11(2)).501 VI.5.7.3 Bilateral Margin and Collateral Exchange CCP clearing is limited as a risk management device in that it is only appropriate for standardized derivatives. For bilaterally cleared derivative contracts, collateral exchange requirements, based on the principle that the defaulter pays, have long been used as risk management devices. Two types of collateral arrangements apply (and are also used for CCP clearing): ‘initial margin’ (in the form of specified, typically liquid, collateral), which is a dynamic form of collateral, being posted when the trade is initially executed and then adjusted as required over the life of the trade and so can represent a material commitment for a large portfolio of derivatives; and ‘variation margin’ (in the form of specified, typically liquid, collateral), which is paid daily between the trading parties, reflecting the current market value of the trade.502 In the case of CCP clearing, margin is posted to the CCP, but in bilaterally cleared trades it is exchanged between counterparties.

500 These requirements are amplified by RTS 149/​2013 Arts 12–​15, which address timely confirmation, portfolio reconciliation, portfolio compression, and dispute resolution. The application of these rules to NFCs, given their costs, generated some controversy over the RTS development process and in the European Parliament. In response, ESMA lightened its original proposals, including with respect to the portfolio reconciliation requirement which, in an alleviation designed for NFCs, is required only on a quarterly basis for a portfolio of less than fifty OTC derivative contacts (RTS 149/​2013 Art 13). 501 The criteria for mark-​to-​market models, and the market conditions which can prevent marking-​to market, are specified by RTS 149/​2013 Arts 16 and 17. 502 Initial margin is designed to cover any losses that could arise, where a counterparty defaults, over the period between the last variation margin payment and when the non-​defaulting party can replace or hedge the trade. See also n 558 on CCP initial and variation margin.

VI.5 EMIR  617 The Article 11 margin and related collateral requirements are designed to reduce systemic risk in the vast bilaterally cleared OTC derivatives markets by ensuring sufficient collateral is available to offset losses on a default and, given that margin requirements operate on a ‘defaulter pays’ principle, to internalize the cost of risk-​taking.503 These requirements are governed by RTS 2016/​2251, which, given its impact on a wide range of financial counterparties, was developed by all three ESAs in coordination. It amplifies the foundational EMIR Article 11(3) requirement that financial counterparties must have in place risk-​management procedures that require the timely, accurate, and appropriately segregated exchange of collateral with respect to OTC derivative contracts; and that NFCs above the clearing threshold must similarly have collateral exchange procedures in place.504 RTS 2016/​2251 follows the 2015 Basel Committee/​IOSCO principles on bilateral margin, which were adopted as part of the G20 crisis-​era reform agenda on OTC derivatives markets.505 A detailed and comprehensive measure, RTS 2016/​2251, which is concerned with the exchange, and with the related management and measurement, of initial margin and of variation margin,506 addresses general risk management; the collateral exchange agreement; collateral eligibility and related conditions;507 how margin is to be calculated (including the internal models which can be used for initial margin);508 collateral management and segregation; the valuation of collateral; exemptions from the bilateral margin requirements; and the highly segmented phase-​in/​transitional periods which have calibrated the application of the regime to different counterparties. The bilateral margin requirements have brought significant costs and operational adjustments for counterparties, in particular for NFCs above the clearing threshold. The rules have, accordingly, been extensively calibrated by means of exemptions, qualifying thresholds, and phase-​in transitional periods, notably for the initial margin requirements as these carry the heaviest costs. One of the most significant alleviations relates to the Article 11(6)–​ (11) intra-​group exemption from Article 11(3) generally, which is available where broadly functional substitutes are in place, and which is amplified by RTS 2016/​2251. In addition, the initial margin requirement is subject to a series of specific exemptions, including the instrument-​based exemption for specified foreign exchange contracts;509 and the notional-​ amount-​ based exemption for counterparties with an aggregate month-​ end average

503 Basel Committee/​IOSCO, Margin Requirements for Non-​centrally Cleared Derivatives (2015) (also noted in n 364 with the package of related international standards) 3. 504 Financial counterparties are additionally required to hold an appropriate and proportionate amount of capital to manage the risk not covered by appropriate exchange of collateral (Art 11(4)). 505 N 503. 506 Defined (initial margin) as the collateral collected by a counterparty to cover its current potential future exposure in the interval between the last collection of margin and the liquidation of positions or hedging of market risk following default by the other counterparty; and (variation margin) the collateral collected by a counterparty to reflect the daily marking-​to-​market or marking-​to-​model of outstanding contracts as required by EMIR Art 11(2): Art 1. 507 RTS 2016/​2551 specifies which asset classes qualify as collateral (in essence, liquid assets, including cash, gold, sovereign/​public debt, corporate bonds, equities included in specified indices, and shares in units in UCITSs, subject to the applicable conditions). It also imposes credit quality assessment requirements and concentration limits on the extent to which initial margin can be exposed to a single issuer: Arts 4–​8. 508 In effect, variation margin is calculated to cover the contract’s mark-​to-​market exposure. Initial margin can be calculated using the standardized approach set out in the RTS or using internal models which comply with the RTS. 509 RTS 2016/​2251 Art 27. This exemption maps the approach adopted by the 2015 Basel/​IOSCO Principles.

618 Trading notional amount of bilaterally cleared OTC derivatives of below €8 billion monthly.510 Variation margin requirements were not initially exempted, but have since benefited from a 2019 Refit Regulation reform which exempted specified foreign exchange contracts, where one of the counterparties was neither a credit institution nor investment firm, and the contract was accordingly less systemically significant.511 Finally, an intricate series of phase-​ins, calibrated to the systemic significance of different classes of counterparties, governed the coming into force of the bilateral margin regime. These have since been adjusted in light of market experience and the disruption wrought by the Covid-​19 pandemic.512 The Article 11(3)/​RTS 2016/​2251 bilateral margin regime is one of EMIR’s pillar measures for supporting stability in the OTC derivatives markets. While margin requirements can amplify procyclicality risks by transforming counterparty credit risk into liquidity risk (margin requirements reduce default risk but increase the risk of counterparties being subject to unexpected initial margin calls when asset prices are volatile),513 the reforms have been associated with a strengthening of financial stability.514

VI.5.8  Reporting EMIR’s reporting regime for derivative transactions (applicable to OTC and also regulated-​ market-​traded derivatives) has proved transformative, given the wealth of data now available from TRs on the previously opaque derivatives markets, as is well exemplified by ESMA’s annual reports on the EU derivatives market. The foundational EMIR obligation (Article 9) requires counterparties and CCPs to ensure that the details of any derivative contract they have concluded (whether or not OTC and whether or not CCP-​cleared), and of any modification or termination of the contract over its lifecycle, are reported to an ESMA-​registered or -​recognized TR (or to ESMA, where a TR is not available) no later than the working day following the contract conclusion, modification, or termination. Counterparties must also keep a record of any 510 RTS 2016/​2251 Art 28 provides that counterparties may provide in their risk management procedures that initial margins are not collected for all new OTC derivative contracts entered into within a year, where one of the two counterparties has an aggregate month-​end average notional amount of non-​centrally cleared derivatives, calculated in accordance with Art 28, of below €8 billion. 511 The reform was supported by the 2019 Refit Regulation (recital 21) and achieved by means of RTS 2016/​2551 Art 31a. Originally, reflecting the 2015 Basel Committee/​IOSCO Principles which provide that variation margin should apply to physically settled foreign exchange forwards and swaps, RTS 2016/​2551 required that these contracts be subject to variation margin, albeit with a phase-​in period. Following market concern and evidence that other jurisdictions had adopted a more limited approach to such contracts, the reform was adopted to limit the application of the variation margin requirements to contracts involving the most systemic counterparties. 512 The phase-​ins were governed by the aggregate average notional amount of OTC derivatives of the counterparties (or their groups), ranging from above €3,000 billion (regime applying one month after the Regulation’s adoption in 2016) to above €8 billion (regime applying from September 2022). These deadlines were adjusted in 2021 to reflect changes to the Basel/​IOSCO timetable and the impact of the Covid-​19 pandemic, including by the insertion of a new threshold (above €50 billion, regime applying from September 2021): RTS 2021/​236 [2021] OJ L56/​1. 513 As has been repeatedly emphasized by the ESRB, which has called for regulation and supervision to reflect these amplifying effects. eg, ESRB, Mitigating the Procyclicality of Margins and Haircuts in Derivatives Markets and Securities Financing Transactions (2020). 514 The margin rules were credited with ensuring that the March 2020 Covid-​19-​related market stress did not lead to a crystallization of counterparty credit risk, albeit that spikes in margin requirements followed the extreme market volatility: ESRB, Liquidity Risks Arising from Margin Calls (2020) and, from an international perspective, 2022 Basel Committee, CPMI, IOSCO Margin Report, n 368.

VI.5 EMIR  619 derivative contract they have concluded, and any modification thereto, for at least five years following contract termination. The 2019 Refit Regulation alleviated the Article 9 reporting burden for NFCs by providing that financial counterparties are solely responsible, and legally liable, for reporting on behalf of both counterparties where a contract is concluded with an NFC below the clearing thresholds. In a further alleviation, the 2019 Refit Regulation exempted from Article 9 contracts concluded within the same group, where at least one of the counterparties is an NFC, and also lifted the reporting obligation where an NFC below the clearing thresholds concludes a contract with an entity in a third country. This legislative underpinning has led to the construction of a vast and intricate reporting system based on dense administrative rules governing the reports to be made by counterparties and the reports to be produced by TRs;515 ESMA soft law on reporting protocols and TR operation;516 ESMA-​based data infrastructures (chiefly the TRACE system through which more than forty NCAs and central banks assess TR data); and the multifaceted supervisory tool-​box ESMA deploys in supervising TRs and monitoring data quality (section 5.10). It has also led to the production of a vast data-​set which, and while data quality remains a challenge and Brexit has disrupted data flows, has transformed market and supervisory visibility on the derivatives markets.517

VI.5.9  Infrastructure Regulation and Supervision: CCPs VI.5.9.1 CCP Authorization and Supervision: the institutional framework Under EMIR, and as is repeatedly emphasized in the literature, CCPs have become infrastructures of acute systemic significance for the EU financial market:518 a small number of EU CCPs now contain the risks, and in particular the counterparty credit risks, associated with derivatives subject to mandatory CCP clearing, but also with derivatives voluntarily

515 RTS 148/​2013 governs the reports to be provided to TRs in granular detail, setting out the circa 129 or so data fields which comprise these reports. RTS 151/​2013 addresses the reports to be provided by TRs, as well as the operational standards governing data aggregation, comparison, and access. Accompanying ITSs specify formats and templates. These administrative rules have been revised to reflect operational experience and to reduce costs and inconsistencies. 516 Including ESMA’s ‘validation tables’ for data points, its Guidelines on the supervisory reports to be provided by TRs (2021), and the EMIR Q&A which addresses the technical intricacies of the reporting requirements in detail. 517 ESMA reported in 2020 that some 95 billion reports (containing up to 129 fields) had been filed since EMIR came into force, with 300 million being filed weekly. These reports were used for a range of supervisory purposes, including micro-​and macro-​prudential supervision, risk analysis, the monitoring of counterparty connectedness, assessments of financial stability, and the monitoring of market abuse risks: ESMA, Supervision Annual Report 2019 and 2020 Work Plan (2020) 21–​3. Brexit had a significant impact on volumes, given that reporting by UK counterparties represented some 50 per cent of reporting volumes on open contracts: 2021 ESMA Data Quality Report, n 350, 11. 518 See, eg, Weber, M, ‘Central Counterparties in the OTC Derivatives Market from the Perspective of the Legal Theory of Finance, Financial Market Stability and the Public Good’ (2016) 17 EBOLR 71. The risks have been captured by the EMIR 2.2 Regulation: ‘the concentration of risk makes the failure of a CCP a low-​probability but a potentially extremely high-​impact event’ (recital 3). By way of illustration, in its quarterly assessment of EU systemic risk, which includes CCP risk, the ESRB tracks CCPs’ prefunded default resources, margining policies, collateral policies, liquidity policies, concentration levels, interoperability, share of client clearing, and cash reinvestment policies: eg, ESRB, Risk Dashboard November 2021, 39–​43.

620 Trading cleared through CCPs.519 The risks posed by CCPs are amplified by the multiple interconnections between CCPs and clearing members across the EU.520 The scale of the systemic risk CCPs pose to the EU is reflected not only in the dense rulebook applicable (section 5.9.2), but also in the bespoke and hybrid institutional framework developed to support their authorization and supervision. This framework locates the supervision of CCPs with NCAs, and so with the relevant national fiscal system, given the acute fiscal risks engaged by CCP supervision. But it also accommodates the pan-​EU interest in CCP stability by placing NCA supervision within a college-​based setting, and so subject to coordination, review, and, in the case of authorization decisions, veto; and, since the 2019 EMIR 2.2 Regulation reforms, within the ESMA CCP Supervisory Committee: this Committee does not have binding powers over NCAs, but enhances coordination, supports best practice, and acts as a central hub for the different supervisory authorities engaged in managing CCP risk. Operating in a context freighted with strong political interests, acute fiscal risks, and significant supervisory complexity, this three-​tiered, hybrid institutional framework is intricately engineered, multi-​layered, and inevitably cumbersome, but represents an attempt to provide a functional solution to the multiple challenges of CCP supervision.521 From the outset, there was hybridity in the EMIR institutional framework for CCP authorization and supervision. EMIR, as originally adopted, embedded college-​based cooperation and review in its NCA-​based supervisory arrangements and was the first legislative measure of the single rulebook to do so. EMIR also conferred ESMA with CCP-​specific supervisory convergence powers and obligations, alongside its usual powers of supervisory convergence. Chief among these were its powers and obligations to coordinate and oversee CCP colleges of supervisors, to carry out annual stress tests of CCPs,522 and to engage in peer reviews of

519 As at November 2021, 14 CCPs were authorized to offer services in the EU. These CCPs tend to specialize in specific derivative classes, furthering embedding them as ‘risk nodes’ in particular segments. Only one EU CCP (LCH SA (France)) clears credit derivatives, eg, while four CCPs clear interest rate derivatives: ESMA, List of Central Counterparties authorized to offer services and activities in the Union, 18 November 2021. This picture is distorted given the scale of CCP clearing, particularly of interest rate derivatives, that takes place in the UK through UK CCPs that operate in the EU under temporary equivalence arrangements. LCH Clearing, a UK CCP, cleared 91 per cent of all euro-​denominated interest rate derivatives globally in the first half of 2021, with only 9 per cent cleared in the EU: 2021 CEPS Report, n 365. 520 CCPs operate in a minority of twelve Member States, with markets in other Member States drawing clearing services on a cross-​border basis: 2021 ESMA CCP List, n 519. The interconnections are further amplified by the extent to which large clearing members (banks and investment firms) are members in multiple CCPs: 2018 ESRB Occasional Paper, n 358, 6. 521 It can only be considered in outline in this section. For further discussion of the resilience of the supervisory framework see Canini, R, ‘Central Counterparties are too big for the European Securities and Markets Authority Alone: Constructive Critique of the 2019 CCP Supervision Regulation’ (2021) 22 EBOLR 673. 522 ESMA’s stress tests have, so far, found CCPs to be resilient, in an indication of the robustness of the regulatory but also supervisory framework. ESMA’s first pan-​EU CCP stress test focused on counterparty credit risk and reported that CCPs were resilient, making only two recommendations (ESMA, EU-​Wide CCP Stress Test (2016)). By 2020, while the stress test process had evolved to cover also liquidity risk and concentration risk, and notwithstanding the severe market volatility which followed the Covid-​19 shock, CCPs were similarly found to be resilient: ESMA, Third EU-​Wide CCP Stress Test (2020). The stress test process continues to evolve, expanding in 2021 to cover operational risk: ESMA, Framework for the 2021 ESMA Stress Test for Central Counterparties (2021). The outcome of the 2022 stress test was similar to that of the earlier stress tests, with CCPs reported as being resilient overall, including as regards operational risk, albeit that ESMA raised concerns relating to outsourcing risk. ESMA also reported that CCPs remained resilient over the disruption in energy derivatives markets following the Russian invasion of Ukraine (although reforms to margin requirements have followed: n 368): ESMA, Fourth ESMA Stress Test Exercise for Central Counterparties (2022).

VI.5 EMIR  621 NCA supervision.523 These powers remain with ESMA, albeit now exercised through the CCP Supervisory Committee. ESMA also deployed (and continues to deploy) its standard suite of soft powers to shape NCA supervision and college operation.524 The 2019 EMIR 2.2 reform, which is designed to address the weaknesses which had emerged in practice in the operation of CCP colleges and in NCA coordination,525 has deepened this hybridity. Reforms to NCA coordination had already been broached under the negotiations on the CCP recovery and resolution regime,526 but the complex and volatile political and institutional setting in which EMIR 2.2 was negotiated, which was shaped by the different political and market forces swirling around CCP supervision following the 2016 decision by the UK to withdraw from the EU (outlined in Chapter X), led to the construction of an intricate coordination framework. The institutional framework accordingly now has three components: NCA-​based supervision; college-​of-​supervisors-​based coordination and review; and ESMA convergence/​coordination through the ESMA CCP Supervisory Committee. NCAs remain at the core of the EMIR institutional structure for CCP supervision. A Member State must designate the NCA responsible for the authorization and supervision of CCPs established in its territory (Article 22). This NCA (the home NCA) is charged with the CCP authorization process (Article 14) and with ongoing supervision of the CCP, which must include an, at least annual, review of a CCP’s arrangements for complying with EMIR and an evaluation of the risks to which it is or might be exposed (Article 21) (this is the annual ‘supervisory review and evaluation process’ (SREP) for CCPs).527 NCAs are also required to approve certain CCP governance arrangements and actions, including as regards CCP shareholders (Article 32), the outsourcing of major risk management functions

523 While ESMA had earlier been conferred with discretionary peer review powers under its founding Regulation, EMIR institutionalized peer review, mandating annual peer reviews of NCA supervision. A bespoke CCP peer review process followed. ESMA peer reviews of CCP supervision are typically granular, and have a frequently robust orientation, but typically find generally good outcomes. See, eg, the 2016 peer review (ESMA, Peer Review under EMIR Art 21 (2016)), reporting on some divergences in supervisory approaches, a potential case of non-​compliance, and good practice recommendations; and the 2021 peer review (ESMA, Annual Peer Review of EU CCP Supervision (2021)), finding that supervision had been effective over the intense volatility provoked by the Covid-​19 pandemic, but making specific recommendations as regard supervision of CCP liquidity requirements, the specific focus of that year’s review. The peer review process has experienced contestation, with Board of Supervisor meetings noting some NCA concern that ESMA should better reflect the national context of CCP supervision and NCAs’ powers (eg, Board of Supervisor Minutes, 14 December 2016). 524 It has adopted, eg, a raft of Guidelines which draw on its experience of coordinating colleges, including Guidelines on CCP interoperability (2013), margin (2019), and conflict-​of-​interest management (2019), as well as operational Guidelines on the conduct of the annual CCP supervisory review and evaluation process (SREP) (2022). 525 2017 EMIR 2.2 Proposal (COM(2017) 331) (IA SWD(2017) 246). The Commission highlighted ESMA’s concern that CCP colleges risked becoming vehicles for information exchange, rather than effective supervisory coordination mechanisms. The governance framework supporting colleges also proved rickety. ESMA, eg, proposed an RTS to address CCP college deadlock but was rebuffed by the Commission which rejected the RTS as going beyond the mandate EMIR provided for administrative rules on colleges (ESMA, Opinion on RTSs for Colleges for CCPs (2013); and Commission, Communication 7 November 2013). ESMA subsequently adopted related Guidelines, but college decision making remained somewhat insecure. 526 The 2016 CCP Recovery and Resolution Proposal (COM(2016) 865) proposed a strengthening of ESMA’s coordination role. While these negotiations started before the EMIR 2.2 negotiations, the complexities of CCP resolution delayed the adoption of the new regime until 2021. 527 The CCP SREP is not harmonized in the way the investment firm prudential regime SREP is (see Ch IV), but is nonetheless supported by operationally oriented ESMA Guidelines, adopted in 2022, which address the SREP methodology. They include, eg, that the review be composed of ‘core’ elements (aspects of EMIR compliance that are always examined) and ‘extended’ elements (the Guidelines identify factors and situations which may call for ‘extended’, deeper review).

622 Trading (Article 35), and the validation of changes to risk models (Article 49). NCA supervision of CCPs is carried out in accordance with the dense EMIR legislative rulebook for CCPs and its related administrative rules and soft law, including as regards the CCP SREP; and is situated within a college-​of-​supervisors setting and the ESMA CCP Supervisory Committee. NCA CCP supervision under EMIR is, accordingly, the most Europeanized and proceduralized segment of EU financial markets supervision, outside of those market segments subject to direct ESMA or ECB (the prudential supervision of certain investment firms) supervision. NCA supervision sits within the college-​of-​supervisor structures that were required from the outset under EMIR, but that were significantly strengthened by EMIR 2.2. The notification of an NCA by a CCP of that CCP’s intention to seek authorization triggers the obligation on that NCA to establish and chair a college of supervisors (Article 18). The composition and mandate of the college is governed in detail by Article 18. It specifies a wide membership, reflecting the range of NCAs and authorities with interests in the stability of a CCP, including NCAs of CCP clearing members; central banks of issue of relevant currencies (in which instruments cleared by the CCP are denominated); and the Chair (or other independent member of) of the ESMA CCP Supervisory Committee.528 The college, which operates under the required ‘written agreement’ and the detailed administrative rules governing college procedures,529 is charged with a series of coordination-​related functions, including to exchange information, coordinate supervision, and determine procedures and contingency plans in an emergency. But it also has more intrusive review and, as regards CCP authorization, veto powers (Article 18(4)). Its most significant review powers relate to the gateway CCP authorization process. The multi-​step college opinion procedure requires that the college give an opinion on the CCP home NCA’s proposed authorization decision (this opinion may include specific college recommendations to address shortcomings in the CCP’s risk management). In a significant incursion into the model of home NCA primacy which otherwise characterizes EU financial markets supervisory governance, the college may veto an authorization decision, albeit that any veto is subject to binding mediation by ESMA (Articles 17 and 19).530 The college also has a series of specific and less 528 The membership, as extended by EMIR 2.2, covers: the CCP’s NCA (college Chair and voting member); the Chair of the ESMA CCP Supervisory Committee, or other of the independent members of the Committee (non-​voting) (an EMIR 2.2 reform); the NCAs responsible for the supervision of the clearing members of the CCP which are established in the three Member States with the largest contributions to the CCP’s default fund and including, where relevant, the ECB, where these members include institutions subject to SSM supervision (voting) (an EMIR 2.2 reform); subject to the CCP NCA’s consent, the NCAs responsible for the supervision of other clearing members, where these NCAs request membership, given the financial stability risks the CCP could pose in their Member States (non-​voting) (an EMIR 2.2 reform); the NCAs of the trading venues served by the CCP (voting); the NCAs of CCPs with interoperability arrangements with the CCP (voting); the NCAs of CSDs linked to the CCP (voting); relevant members of the European System of Central Banks responsible for the CCP’s oversight/​oversight of CCPs with interoperability arrangements with the CCP (voting); central banks of issue of the ‘most relevant’ EU currencies of the financial instruments cleared by the CCP (voting); and other central banks of issue, on request and with the CCP NCA’s consent, given the impact the CCP’s financial distress could have on their currencies (non-​voting) (an EMIR 2.2 reform): Art 18(2) and 19(3). 529 To further formalize and empower colleges, EMIR 2.2 specified in more detail the coverage of the required college written agreement. It must cover governance modalities, including voting procedures; agenda-​setting (to allow greater input by the college); meeting frequency; timeframes for the assessment of documentation; communication protocols; and information exchange: Art 18(5). EMIR 2.2 also led to related reforms to the RTS governing college operation (RTS 876/​2013 [2013] OJ L244/​19), including to strengthen and clarify college powers and modes of operation as regards information exchange and the exercise of review powers. 530 The highly articulated authorization procedure covers the processes to be followed by the home NCA, including as regards informing the college and providing reasons for any disagreement with the college; reasoned decision-​making by the college; default ESMA decision-​making where the college does not adopt an opinion but a majority disagrees with the authorization; voting procedures; and ESMA mediation.

VI.5 EMIR  623 interventionist review competences, including to issue an opinion on proposed NCA approval decisions regarding the assessment of shareholders (Article 32), outsourcing of risk management functions (Article 35), and validation of changes to CCP risk models (Article 49);531 and it may also request the NCA to examine whether a CCP is still in compliance with authorization conditions (Article 20). The college must also be notified and consulted in relation to any withdrawals of authorizations (Article 20) and must be informed of the results of the required annual supervisory review (SREP) of the CCP (Article 21). This framework is further Europeanized through ESMA’s role. ESMA is, as is usual, charged with driving supervisory convergence (Article 23a(1)). But, and building on the NCA review powers ESMA had previously been conferred with elsewhere in the single rulebook (including as regards NCA decisions relating to position limits and short selling, as outlined in this chapter), the 2019 EMIR 2.2 Regulation placed EMIR’s original NCA/​ college model within a bespoke ESMA coordination/​convergence framework, in the form of the new CCP Supervisory Committee, a permanent internal committee within ESMA.532 Albeit located in ESMA and with independent ESMA members, the Committee is a hybrid structure, combining ESMA and NCA components: the CCP Supervisory Committee Chair (an independent, full-​time function), two independent, full-​time members, and the NCAs of EU CCPs.533 The Committee does not have independent decision-​making power, but prepares draft decisions, on issues within its competence, for adoption by the ESMA Board of Supervisors. The Committee is primarily designed to provide ESMA with the necessary supervisory capacity to supervise third country CCPs (discussed in Chapter X). But it has also been conferred with review powers over NCAs’ supervision of EU CCPs. The effect of these review powers is to require NCAs to submit ex-​ante their draft decisions as regards a specified series of material EMIR provisions (these decisions relate to areas which do not, reflecting the political sensitivities, carry significant fiscal risk)534 to ESMA (in effect, to the CCP Supervisory Committee) prior to adoption;535 NCAs may additionally and voluntarily submit draft decisions on any other CCP supervisory matters (Article 23a). The subsequent ESMA review process is not automatic, albeit that the related conditionality does not present a high bar to review: where necessary to promote a consistent and coherent application of the relevant EMIR provision, ESMA is to provide an opinion on the draft decision and, where the NCA draft decision shows a lack of convergence or consistency, may issue remediating soft law.536 ESMA may not, accordingly, veto the NCA decision, but

531 The validation of changes to risk models requires the approval of the CCP’s NCA and also of ESMA, both of which must take note of the related opinion issued by the college: Art 49 (see in brief section 5.9.2). 532 The Committee is supported by a dedicated staff and is structurally separate from other ESMA functions. The procedural modalities governing the Committee’s composition, the appointment of the independent Chair and the two required independent members (who are appointed for five years), and its operation within ESMA and relationship with the Board of Supervisors are set out in Art 24a. 533 The Committee also includes the relevant central banks of issue of the currencies of the financial instruments cleared by relevant CCPs (where these central banks request membership), and as regards discussions on stress testing and market developments, but they do not exercise voting rights: Art 24a(2)(d). 534 In its EMIR 2.2 Proposal, the Commission underlined that EMIR’s location of CCP supervision with NCAs reflected a ‘delicate political balance’ and also recognized that Member States had fiscal responsibility: n 525, 41–​2. 535 As specified by Art 23a(2): CCP/​trading venue access (Arts 7 and 8); authorization and extensions to the scope of authorization (Arts 14 and 15); record-​keeping, suitability of qualifying shareholders, changes to management, changes of ownership, and conflicts of interest (Arts 29–​33); outsourcing of risk management (Art 35); fair treatment principles (Art 36); and interoperability arrangements (Art 54). 536 In effect, the CCP Supervisory Committee prepares the related opinion and recommends to the Board of Supervisors whether soft law is required.

624 Trading the NCA is required to give the ESMA opinion ‘due consideration’ and, where it does not agree with the ESMA opinion, to provide ESMA with comments on any action which significantly deviates from the opinion. This review process is significantly less intrusive than that originally proposed under the EMIR 2.2 Proposal (outlined below) and some care has been taken to reinforce the primacy of NCAs as regards CCP supervision.537 It nonetheless places NCA decision-​making within an ESMA frame, albeit that the large constituency of CCP NCAs on the CCP Supervisory Committee renders the Committee, as regards supervision of EU CCPs, more of a coordination body than an executive one. In addition, the CCP Supervisory Committee is charged with conducting, at least annually, a peer review of CCP supervision and a stress test of CCP resilience (functions already conferred on ESMA but now placed within the Committee);538 promoting exchange and discussion among NCAs in relation to supervisory decisions, draft NCA decisions submitted to ESMA under Article 23a, and market developments; discussing all opinions adopted by CCP colleges of supervisors as required under EMIR; proposing soft law for adoption by the Board of Supervisors; and opining on Board of Supervisor decisions where they relate to CCP supervision (such as proposals for administrative rules). The complexity of this institutional model reflects the distinct political and institutional interests, and also operational supervisory risks, engaged by CCP supervision. The fiscal (and thereby political) risks of CCP supervision are real and extensive, as is reflected in CCP supervision being located with the relevant home NCA: the scale of the home Member State’s fiscal risk exposure to CCP failure, the deep interdependencies between the operation of CCPs and sovereign debt markets, and the competitive territory at stake given the value of CCP business, mean that the location and organization of CCP supervision is rarely a technical apolitical affair, with national interests and preferences strong and few incentives to cede supervisory control.539 The location of supervision within NCAs also reflects the demands of CCP supervision: CCPs are highly complex actors which require specialist, intense, and nimble supervision, which could be difficult to operationalize at EU-​level without significant institutional capacity. The EU interests, however, are also significant, particularly as regards financial stability. The ECB, which is, as a central bank of issue but also as the Banking Union/​SSM supervisor of CCP clearing members, embedded in CCP colleges, has long had strong interests in CCP supervision, given the risks CCPs pose to financial stability.540 These interests were reflected in its since-​invalidated 2011 ‘location policy’ for euro-​denominated derivatives CCP clearing. It required that such clearing take

537 The 2019 EMIR 2.2 Regulation recital 15 describes the review process as a ‘mandatory ex ante exchange and discussion’; notes that ESMA should not provide an opinion where, following discussion in the CCP Supervisory Committee, no diverging views have been identified; and characterizes any opinion delivered as ‘an additional reaction’ from specialized and experienced NCAs. The intent is unambiguous: the opinions ‘should not have any implication for the responsibility of the CCP’s competent authority to take the final decision’, which remains at the ‘full discretion’ of the NCA. 538 See nn 522 and 523 on stress testing and peer review. 539 Political sensitivities extend beyond direct fiscal risks. In 2011, at the height of the euro area sovereign debt crisis, the major Italian CCP, as required under the interoperability/​connection arrangement it had with the French CCP, significantly raised its margin requirement for Italian sovereign debt, making it very costly to clear such debt. In consequence, trading in Italian sovereign debt experienced further severe dislocation which hampered Italy’s ability to raise funding and weakened its banks: Bank of Italy, Financial Stability Report No 3 (2012) 38. 540 On the ECB’s interests and its role in the overall CCP supervisory framework (which role is primarily oriented towards risk assessment) see ECB, Eurosystem Oversight Policy Framework (2016), underlining the systemic importance of CCPs as focal points for credit and liquidity risk.

VI.5 EMIR  625 place in the euro area and be subject to ECB liquidity support.541 The location policy was found to be invalid by the General Court of the EU, which ruled that the ECB did not have the competence to adopt such a policy,542 but the litigation underlined the ECB’s interests in protecting euro area stability from any spill-​over disruption from CCP instability. Since then, the ECB has repeatedly reiterated its concerns as to the potential stability risks posed by the ‘off-​shoring’ of euro-​denominated CCP clearing in the UK post-​Brexit,543 and has sought greater engagement with CCP supervision, including over EU CCPs given the sharp increase in their scale and systemic importance. Reflecting the political and institutional interests and sensitivities at stake, this ambition has been only in part realized.544 The institutional framework for CCP authorization and supervision post the EMIR 2.2 reforms certainly pulls CCP supervision towards a more centralized model. But, and reflecting the political sensitivities and the fiscal risks associated with NCA supervision, its approach to coordination and review is significantly attenuated from that proposed in the Commission’s 2017 EMIR 2.2 Proposal.545 The Proposal, in effect, sought to secure the ‘single supervision’ of CCPs,546 and to constitute ESMA as a hierarchically superior, but fiscally neutral, ‘network supervisor’. The Proposal granted ESMA, acting through a ‘CCP Executive Session’ format,547 veto rights over NCAs as regards a similar range of specified provisions now subject to the CCP Supervisory Committee opinion power. Under the Proposal, ESMA consent to the relevant draft NCA decisions would have been deemed to be given, unless ESMA proposed amendments, or objected, within the specified timelines: where ESMA proposed amendments, the NCA could only have adopted the decision as amended by ESMA; and where ESMA objected, the decision could not

541 ECB, Eurosystem Oversight Policy Framework (2011). 542 Case T-​496/​11, ECB v UK (ECLI:EU:T:2015:133). The Court found that Art 127(2) TFEU on the ECB’s competences empowered the ECB only in relation to the smooth operation of payment systems, while Art 22 of the Statute of the ESCB and the ECB (on which the ECB had relied) did not contain an explicit competence in relation to the clearing of securities, referring only to ECB review and rule-​making competences regarding ‘clearing’ and ‘payment’ systems, which did not imply a competence as regards ‘securities clearing’ systems. 543 eg, Statement by ECB President Draghi to the European Parliament’s ECON Committee, 26 February 2018. 544 The ECB participates in CCP colleges as central bank of issue, and as supervisor of clearing members where those clearing members are supervised by it through the SSM, and can exercise two votes accordingly (Art 19(3)). The extent of its participation has generated contestation. Prior to the EMIR 2.2 reforms, ESMA refused the ECB’s request to have two seats on CCP colleges (ESMA/​2015/​838), leading the ECB to request that EMIR be revised to formalize its participation (two votes have since been provided for by EMIR 2.2). Similarly, while the EMIR 2.2 Proposal provided for a permanent ECB (non-​voting) seat on what was then constituted as the ESMA ‘CCP Executive Session’, this did not survive the negotiating process which saw the ECB’s role scaled back to potential non-​voting participation as a central bank of issue. The ECB has also sought binding powers (outside EMIR) to adopt rules and require remedial action of EU CCPs, as regards risks relating to the eurosystem’s objectives and tasks (as well as over third country CCPs), via ECB Recommendation 2017/​18 [2017] OJ C212/​14 which proposed a revision to the Statute of the ESCB and the ECB to clarify the ECB’s competences over clearing systems for securities. Following changes made to its proposed Statute revision over the inter-​institutional negotiation process, and which removed any powers over EU CCPs, the ECB withdrew the proposed revision, expressing concern as to the lack of clarity regarding its competences over CCPs: Letter from ECB President to European Parliament President, 20 March 2019. 545 COM(2017) 331. On the Proposal see Moloney, n 367, 296–​304. 546 EMIR 2.2 Proposal IA, n 525, 58. 547 The Proposal provided for a ‘Board of Supervisors in Executive Session’ (CCP Executive Session), composed of five permanent members (a voting Head and two Directors, a non-​voting ECB representative, and a non-​voting Commission representative); and a shifting cohort of non-​permanent members in the form of a voting representative of the NCA of each CCP and a non-​voting representative of the relevant central bank of issue for each CCP, each sitting where necessary and appropriate for the CCPs under their supervision. The Executive Session would have taken all decisions relating to CCPs reserved to ESMA, but would have been required to inform the Board of Supervisors of its decisions.

626 Trading have been adopted by the NCA. This reform would have, in effect, changed NCAs of CCPs from being autonomous local supervisors, welded together through college/​ESMA convergence mechanisms, to being operational outposts centrally steered by ESMA, at least as regards matters of limited fiscal sensitivity. Over the difficult negotiations on the Proposal, and reflecting material Member State as well as industry concern, the Proposal’s model for supervision was reconstructed, and tilted sharply back to the coordination-​oriented and NCA-​based model now in place.548 The Commission’s experiment ultimately found expression in ESMA’ direct supervision of third country CCPs (Chapter X), but the extent to which the negotiations scaled back the Proposal as regards EU CCPs underlines the scale of the interests at stake.549 The more incremental approach adopted by the 2019 EMIR 2.2 Regulation may yet prove sustainable and flexible over the medium and longer term, albeit that the current institutional structure is unwieldy,550 and its capacity to cope with a large-​scale crisis has yet to be tested.551 Based on pre-​existing college of supervisors and ESMA coordination/​ convergence tools, it refines these tools, affording ESMA more opportunities to shape convergence, but does not generate the legitimacy and functionality risks associated with the original EMIR 2.2 Proposal. Much will depend on the extent to which this new form of operating will support effective data-​sharing and, the litmus test of any stability-​oriented cooperation mechanism, cope in conditions of acute crisis.552

VI.5.9.2 The CCP Rulebook NCAs, operating within this institutional framework, are charged with supervising the extensive organizational, conduct, and prudential EMIR regime for CCPs, as amplified by detailed administrative rules,553 which is designed to contain CCP risk. This granular regime, noted here in brief outline only, has been more or less stable since the adoption of EMIR,

548 The sensitivities can be implied from the reference in the 2019 EMIR 2.2 Regulation to the CCP Supervisory Committee being ‘a unique solution to bring together expertise in the field of CCP supervision and should not constitute a precedent for the ESAs’: recital 7. 549 While there was some industry support, the European Association of Clearing Houses (EACH) was concerned as to potential supervisory inefficiencies. The Council significantly revised the Proposal to downgrade the ‘Executive Session’ into the more convergence-​oriented Committee now in place, while the European Parliament was concerned as to the adequacy of the oversight of ESMA’s proposed powers. On the complex negotiations see European Parliament Briefing, Review of EMIR, February 2019. 550 ESMA noted that it generated ‘sometimes duplicating and unnecessarily burdensome supervisory processes’ and called for fine-​tuning, as regards timelines and processes: 2022 ESMA Clearing Consultation Letter, n 407. 551 It did not, however, experience strain over the early 2020 Covid-​19-​related market volatility (as noted in the relevant stress test: n 522). The Russian invasion of Ukraine, and the related volatility in commodity and energy derivatives markets, led to an intensification of ESMA monitoring of the impacts on CCP margin requirements and also of ESMA/​NCA coordination regarding clearing members (ESMA, Public Statement (War in Ukraine), 14 March 2022) and to subsequent reviews and reform (n 368). 552 The 2022 EMIR Proposal (n 407) proposed a series of ‘targeted amendments’, including as regards enhancing supervisory coordination (including through Joint Supervisory Teams); extending the scope of ESMA’s competence to opine on NCA decisions (including as regards the annual review of CCPs); expanding the review powers of supervisory colleges; and establishing a new Joint Monitoring Mechanism, composed of all relevant public authorities engaged in/​with interests in CCP supervision, to review the market. While the direction of travel is therefore towards greater coordination and closer ESMA involvement, the regime looks likely, at present, to remain based on its current institutional framework, with the Commission underlining the importance of Member States’ fiscal responsibility as regards CCPs. 553 The key administrative rules are RTS 153/​2013 (on the CCP rulebook generally) and RTS 152/​2013 (on CCP capital).

VI.5 EMIR  627 experiencing only minor reforms. The DORA regime will also apply as regards CCPs’ digital operational resilience.554 The EMIR organizational requirements for CCPs include a range of requirements designed to enhance CCP risk management and to support the generation of strong CCP incentives to manage risk appropriately, given potentially perverse commercial incentives. These include requirements relating to organizational structure and internal control mechanisms; compliance procedures; continuity; effective resources, systems, and procedures; separation of risk management and other reporting lines; remuneration policy; IT requirements; and frequent and independent audit (Article 26). The organizational regime also includes record-​keeping (Article 29), conflicts-​of-​interest management (Article 33), business continuity (Article 34), and outsourcing (Article 35) requirements. Board governance is, as is usual across the single rulebook, addressed, including through composition (at least one-​third of and not less than two board members must be independent), independence, reputation, and expertise requirements (Article 27); in a reflection of their distinct risk profiles, CCPs must also establish an independent risk committee (composed of clearing member and client representatives and independent board members) to advise the board on a range of risk-​management issues (Article 28). The CCP’s senior management cohort is also addressed and subject to a requirement to be of sufficiently good repute and to have sufficient experience to ensure the sound and prudent management of the CCP (Article 27). Qualifying shareholders, any close links between the CCP and other natural or legal persons, and the acquisition or disposal of qualifying shareholdings are subject to a review regime similar to that which applies under MiFID II (Articles 30–​2). The conduct-​of-​business regime addresses the particular conduct risks associated with CCPs, and the related appropriate protection of CCP clearing members and clients, and covers fair treatment (Article 36); CCP participation/​access conditions (Article 37); transparency, including with respect to fees and prices and the risks associated with the services provided (Article 38); and segregation and portability of CCP records and accounts (Article 39), a requirement which also forms a central element of EMIR’s support of CCP stability by requiring that the assets of clearing members are clearly distinguishable, so that in a default the affected assets can be identified and losses contained. The extensive prudential regime governing CCPs is primarily concerned with the management of default by a CCP member and, relatedly, with the securing of the CCP’s ability to replace trades and to sustain associated losses.555 The CCP’s ability to absorb losses arising from the default of a clearing member is supported through an array of funding-​related measures, which together provide a graduated scale of resources that can be called on by the CCP where it is required to replace trades. At the base of the loss absorption regime are the margin and related collateral requirements imposed on clearing members (Articles 41 and 46); these requirements constitute a critical support to CCP stability as they allow a CCP to manage the initial and changing risks associated with the exposures cleared. They are designed to ensure that the CCP has access to margin in the form of high-​quality, liquid 554 The Digital Operational Resilience Act (DORA) addresses the security of financial firms’ network and information systems and the ability of financial firms to withstand threats and disruptions and covers CCPs. Provisional agreement on DORA was reached in May 2022 (the Commission Proposal is at COM(2020) 595). See in outline Ch I section 7.3. 555 An extensive literature examines how CCP stability can be secured against default by a clearing member. See, eg, Braithwaite and Murphy n 363.

628 Trading collateral and, relatedly, to provide strong risk-​management incentives for CCP members, given the costs of margin. Margin and collateral requirements must, however, tread a fine line between ensuring a CCP is adequately resourced against default, and imposing overly stringent and costly requirements on CCP members which shrink the pool of available collateral, create dis-​incentives to hedge exposures through derivatives, and increase costs and risks.556 EMIR manages this balance through administrative rules which establish criteria for how CCPs establish margin requirements; and which are designed to determine the minimum percentages that margins should cover for different classes of financial instruments, to establish principles which CCPs should follow in tailoring margin levels to the characteristics of each financial instrument or portfolio cleared, and to ensure that CCPs do not reduce margin to a level that compromises safety.557 These rules amplify the core EMIR requirements that: margins are imposed, called, and collected to limit the CCP’s credit exposures from its clearing members (and where, relevant, CCPs with which it has interoperability arrangements);558 margins are sufficient to cover the potential exposures that the CCP estimates will occur until the liquidation of the relevant positions; margins are sufficient to cover losses from at least 99 per cent of the exposures’ movements over an appropriate time horizon; and margins ensure that the CCP fully collateralizes its exposures with clearing members (and CCPs with which it has interoperability arrangements), at least on a daily basis (Article 41). CCPs must also regularly monitor, and revise where necessary, margin levels to reflect market conditions, but taking into account procyclical effects (Article 41).559 At the heart of the related and extensive regime on the type and quality of collateral which a CCP can accept as margin is the requirement that the CCP must require ‘highly liquid’ collateral, with minimal credit and market risk, to cover its initial and ongoing exposure to its clearing members (Article 46).560 The margin and collateral regime is supported by the requirement for a ‘default fund’ (Articles 42 and 45). To limit its credit exposure, a CCP must maintain a pre-​funded default fund (funded by clearing members) to cover losses that exceed the losses covered by margin requirements; the default fund requirements cover, inter alia, contributions to, size of, coverage of, and resilience of the fund.561 A third line of defence against default is the

556 And, relatedly, avoid exacerbating the amplifying effect margin calls can have on procyclicality, a risk frequently raised by the ESRB (eg n 358). 557 RTS 153/​2013 recitals 22–​23. 558 Initial and variation margin must be collected by the CCP. Initial margin, in this context, is defined as the margin collected by the CCP to cover potential future exposure to clearing members providing the margin and, where relevant, interoperable CCPs, in the interval between the last margin collection and the liquidation of positions following a default by a clearing member or default by an interoperable CCP. Variable margin is the margin collected or paid out to reflect current exposures resulting from actual changes in market price: RTS 153/​2013 Art 1. On the parallel margin regime for bilaterally cleared transactions see section 5.7. 559 The margin rules address, inter alia, the margin calculation; related time horizons; margining on a portfolio basis; and the incorporation of procyclicality risk management: RTS 153/​2013 Arts 24–​8. The margin rules have remained broadly stable (at the legislative and administrative level), albeit that the 2019 Refit Regulation additionally requires CCPs to have in place simulation arrangements to facilitate clearing members in assessing initial margin requirements (which fluctuate). 560 The collateral requirements are specified by RTS 153/​2013 Arts 37–​42 which address, inter alia, when different assets qualify as ‘highly liquid’ and impose concentration limits. These requirements were subject to a temporary alleviation in late 2022 to ease the liquidity pressure that elevated margin requirements, imposed by CCPs in response to acute volatility in energy and energy derivatives markets, were placing on some NFC CCP members: n 368. 561 The default fund must at least enable the CCP to withstand, under ‘extreme but plausible’ market conditions, the default of the clearing member to which it has the largest exposures (or of the second and third largest clearing

VI.5 EMIR  629 requirement that the CCP maintain ‘sufficient pre-​funded available financial resources’ to cover potential losses that exceed the losses to be covered by the margin requirements and the default fund (Article 43).562 The default fund and the ‘other financial resources’ must at all times enable the CCP to withstand the default of at least the two clearing members to which it has the largest exposures under ‘extreme but plausible’ market conditions (Article 43(2)). Finally, the CCP’s capital (Article 16) provides a last-​resort resource available to absorb losses from a clearing member’s default: the CCP’s capital is required to be at all times sufficient to ensure an orderly winding down or restructuring of activities over an appropriate time span, and an adequate protection of the CCP against credit, counterparty, market, operational, legal, and business risks which are not covered by the specific financial resources related to margin, the default fund, and ‘other financial resources’ (Article 16(2)). The priority in which the CCP can call on margin, the default fund, and ‘other financial resources’ is specified by the ‘default waterfall’ (Article 45), which determines the order in which contributions by defaulting and non-​defaulting members, and the CCP’s dedicated own resources, are to be used.563 Article 48 governs the procedures applicable on a default. Extensive related risk assessment and management requirements apply. The exposure management rule (Article 40), for example, requires a CCP to measure and assess its liquidity and credit exposures to each clearing member (or to another CCP, where the CCP has concluded an interoperability arrangement) on a near-​to-​real-​time basis. The liquidity risk control regime is designed to ensure that the CCP has access at all times to adequate liquidity to perform its services and activities, including with respect to credit lines (Article 44).564 Supporting risk-​management rules apply in relation to the CCP’s investment policy565 and to settlement.566 CCPs are, more generally, required to regularly review and stress test (including by means of back testing and in relation to ‘extreme but plausible’ market conditions) their risk-​management models and the parameters used for, inter alia, margin calculations, default contributions, collateral requirements, and other risk control mechanisms (Article 49).567 Reflecting the centrality of risk models to the CCP’s stability, any changes to risk models are subject to extensive validation requirements (amplified in RTS 153/​2013), and require NCA and also ESMA approval, prior to which a CCP college opinion must be issued (Article 49).568 Given the obligations on CCPs to continually review members, if the sum of their exposures is larger): Art 42(3). The rules have been amplified by RTS 153/​2013 Arts 29–​31, which address fund governance, the identification of ‘extreme but plausible’ market conditions, and the review of ‘extreme but plausible’ scenarios. Capital requirements apply to clearing members as regards their exposure to the default fund (under CRD IV/​CRR). 562 These funds must include dedicated resources of the CCP, be freely available, and not be used to meet EMIR’s capital requirements for CCPs: Art 43(1). 563 Amplified by RTS 153/​2013 Arts 35–​6 with respect to the amount of the CCP’s own resources which are to be used in the default waterfall. 564 Amplified by RTS 153/​2013 Arts 32–​4. 565 Article 47 and RTS 153/​2013 Arts 44–​6. 566 Article 50. A CCP must, where practical and available, use central bank money to settle its transactions; where such money is not used, steps must be taken to strictly limit cash settlement risks. It must also clearly state its obligations with respect to deliveries of financial instruments and, where it has such obligations, eliminate principal risk through the use of delivery-​versus-​payment mechanisms, to the extent possible. 567 The model review and stress testing requirements have been amplified in detail by RTS 153/​2013 Arts 47–​61, including as regards model review and validation, model testing, stress testing, testing of default procedures, frequency of validation and (stress) testing, and required public disclosures. 568 While this process is now formalized under Art 49, it was previously contentious, with a minority of NCAs on the ESMA Board of Supervisors not supportive of an ESMA validation competence: Board of Supervisors,

630 Trading and update risk-​management processes and models, EMIR seeks to ensure they have timely access to pricing information. ESMA’s assessment as to whether to subject a class of derivatives to the CCP clearing obligation, for example, includes an assessment as to the availability of fair, reliable, and generally accepted pricing information in the relevant class.569 A specific prudential regime applies to CCP interoperability arrangements, designed to support interconnectivity between CCPs and thus also the EU’s wider financial market integration agenda. Interoperability arrangements, which must be approved in advance by the NCAs of the CCPs concerned (following the procedures which govern the authorization of EU CCPs), are also, given the stability risks they generate, subject to distinct risk management arrangements (Article 52) and margin requirements (Article 53).570 In parallel, EMIR has recently been buttressed by a discrete recovery and resolution regime for CCPs, contained in the 2021 CCP Recovery and Resolution Regulation.571

VI.5.10  Infrastructure Regulation and Supervision: TRs TRs are charged under EMIR with receiving, processing, and providing access (by supervisory authorities) to the vast mass of derivatives trade reports which must be made, by relevant counterparties, to TRs under EMIR Article 9. The mandate of TRs has expanded since EMIR’s adoption, with TRs now also acting as repositories for the reports required under the 2017 Securitization Regulation and the 2015 Securities Financing Transactions Regulation; alongside, MiFIR allows counterparties to fulfil the MiFIR Article 26 transaction reporting requirements by reporting to TRs. TRs have, accordingly, become vast data nodes for the EU financial market, transforming regulators’ sightlines but thereby rendering TR data quality of systemic importance. Once registered by ESMA (as required under Article 55), TRs must fulfil their EMIR obligations, chief among them data collection, management, quality, transparency, and access obligations. TRs must, in particular, collect and maintain the Article 9 data; calculate positions, by class of derivative and by reporting entity; publish specified aggregated position information; and ensure that identified regulatory authorities and public authorities have direct and immediate access to their data (Articles 80–​1). TRs are, relatedly, subject to

Minutes, 29 January 2015. The 2019 EMIR 2.2 Regulation has since formalized ESMA’s role. These requirements may be liberalized on foot of the 2022 EMIR Proposal (n 407). 569 RTS 149/​2013 Art 7(3). 570 ESMA has adopted Guidelines (2013) relating to the assessment of interoperability arrangements by NCAs. 571 Regulation (EU) 2021/​23 [2021] OJ L22/​1. The Regulation, which came into force in August 2022, is designed to support financial stability and to avoid recourse to public funds, by putting in place procedures governing the orderly recovery and, where necessary, resolution of CCPs. It is based on the model developed for banks and systemically significant investment firms under the BRRD, albeit tailored to the specificities of CCP risk. It requires CCPs to adopt recovery plans which, where a CCP experiences distress, allow the CCP’s NCA to request action under the plan or other specified actions. Where this recovery/​early intervention stage does not restore the CCP to viability, the external resolution phase, imposed on the CCP, follows. This phase is based on activation of the options contained in the CCP’s resolution plan, which must be adopted ex-​ante by the CCP’s national resolution authority in coordination with the CCP and its NCA. The Regulation also sets out the hierarchy of losses to be followed in a resolution. Specified cooperation and coordination procedures apply, including as regards the ESMA CCP Supervisory Committee. For a review of its legal design and implications, and its wider international setting, see Binder, J-​H, Central Counterparties’ Insolvency and Resolution—​the New EU Regulation on CCP Recovery and Resolution, EBI WP 82 (2021), available via .

VI.5 EMIR  631 an array of operational requirements directed to the management of data, including with respect to their governance arrangements; organizational structure; internal control mechanisms; conflict-​of-​interest management; compliance procedures; business continuity; the separation of functions where conflicts may arise; ‘fit and proper’ qualifications for senior management and board members; access arrangements as regards counterparty reporting; price and fee transparency; data reconciliation, validation, and transfer; operational reliability; and data safeguarding and recording (Articles 78–​81).572 EMIR confers on ESMA, the exclusive supervisor of TRs, a suite of initial registration and also ongoing supervisory and enforcement powers. The latter follow the rating agency template and empower ESMA to, variously, request information, carry out investigations and on-​site inspections, take a range of administrative enforcement actions, and impose financial penalties.573 As under the rating agency regime, these powers are further specified, including as regards the procedural arrangements governing ESMA information requests, investigations, and on-​site inspections; enforcement procedures, including investigation by an ESMA Independent Investigation Officer prior to Board of Supervisor decision-​making; the identification of the EMIR breaches which are subject to ESMA administrative enforcement measures and financial penalties; the identification of the criteria governing how financial penalties are applied and the related use of aggravating and mitigating factors; and the setting of upper and lower ranges for financial penalties.574 As also under the rating agency regime, additional amplification of ESMA’s supervisory powers is contained in administrative rules,575 with ESMA supervision accordingly situated within a highly specified and proceduralized operating environment. The population of ESMA-​supervised TRs is small (given economy of scale effects) and was reduced further by Brexit.576 But ESMA’s supervision of this specialist corner of the EU financial market (ESMA undertook supervision in late 2013) is pivotal to the effectiveness of the massive derivatives data-​set produced under EMIR.577 ESMA’s supervisory activities have, accordingly, been primarily directed to ensuring and improving TR data quality, given the scale of the challenges posed by the volume, intricacy, and speed of EMIR derivatives reporting under Article 9, and the novel operational complexities associated with embedding TRs into the Article 9 data-​stream and with ensuring, inter alia, data validation and reconciliation and supervisory access. ESMA’s initial supervisory efforts were focused on ensuring that the newly registered TRs were ready to manage the massive new data flows, and to carry out their regulatory responsibilities in a continuous and effective manner, once the EMIR reporting obligations activated in February 2014. Since then, the need to enhance data quality and, relatedly, the operational resilience of TRs has been a recurring theme of

572 In addition, TRs will be subject to the DORA regime as regards their digital operational resilience: n 554. 573 EMIR Arts 55–​74. 574 The financial penalties applicable were originally significantly lower than those which apply to rating agencies, with the upper limits for specified infringements set at low caps of €20,000 and €10,000. These were raised to €200,000 and €100,000 by the 2019 EMIR Refit Regulation (Art 65). 575 Including as regards the TR registration process, the supervisory fees ESMA can impose, the financial penalties it can apply, and supervisory reporting by TRs to ESMA. 576 Brexit led to a significant restructuring of the EU TR business, including through the establishment of new EU legal entities for previously UK-​based business, with the EU industry moving from having nine TRs registered at end 2019 to four registered in 2021: 2021 ESMA Data Quality Report, n 350, 4. 577 For a more extended discussion of ESMA’s effectiveness as a supervisor of TRs see Moloney, n 367, 272–​7.

632 Trading ESMA’s supervisory agenda for TRs.578 System incidents, sharp spikes in reporting volumes in response to market volatility (reporting volumes increased significantly in March 2020, for example, as the Covid-​19 pandemic spread), burgeoning volumes of reporting more generally, expanding TR mandates, Brexit-​related market restructuring, and the technical complexity of TRs’ operating models579 all generate data quality and related supervisory challenges.580 In response, ESMA’s supervision, which is framed by its Data Quality Action Plan,581 draws on a wide range of supervisory tools, from on-​site inspections and thematic reviews, to Guidelines and the TR Q&A, to detailed and highly operational data validation metrics and templates, to peer review.582 While progress is being made and Brexit did not generate material disruption,583 data quality remains a challenge.584 Enforcement action has been limited,585 as can be expected given ESMA’s focus on stabilizing the derivatives market reporting system, and on embedding compliance and behavioural change through supervisory action. While difficulties remain, ESMA’s multi-​faceted supervisory approach, and the multi-​actor (counterparties, TRs, NCAs, and ESMA) engagement with the Data Quality Action Plan, suggests, at the least, a purposeful and data-​informed approach which augurs well for improvements in the long run. The scale of the data quality exercise underlines, nonetheless, the extent to which EMIR transformed reporting on the derivatives markets, and the scale of the market and supervisory response and adjustment that it wrought and continues to require.

578 Some ten years or so on, EMIR/​TR data quality remains a priority. See, eg, ESMA, Annual Work Plan (2021) 40–​1. ESMA now reports annually on EMIR (and SFTR) data quality in an annual data quality report (see its inaugural 2021 ESMA Data Quality Report, n 350). 579 ESMA has, eg, developed a ‘book of work’ in which TRs report to ESMA, in a standardized manner, on the scope, time, and progress of ongoing and planned IT projects; this allows ESMA to track how TRs are developing and applying the many system ‘fixes’ necessary, on an ongoing basis, to ensure data quality: ESMA, Supervision of Credit Rating Agencies, Trade Repositories, and Monitoring of Third Country Central Counterparties. 2017 Annual Report and 2018 Work Programme (2018) 24–​5. 580 For a recent review see ESMA, ESMA Supervision Annual Report 2019 and Work Programme 2020 (2020) 21–​8. 581 The Data Quality Action Plan (which considers, inter alia, TR data completeness, timeliness, availability, adherence to format, and integrity/​reconciliation) was adopted in 2014; supports ESMA and NCA coordination on supervisory priorities regarding EMIR reporting; and is operationalized by specific annual work plans on data quality and usability. It is accompanied by a Data Quality Review, under which NCAs review the quality of reporting by counterparties, and by a Data Quality Assessment Framework, which supports operational supervision: 2021 ESMA Data Quality Report, n 350, 7–​10. 582 A 2019 peer review assessed ESMA’s (as regards TRs) and selected NCAs’ (as regards counterparties) supervisory actions in relation to EMIR data quality; reported on a ‘mixed picture’ of progress but also continuing challenges; recognized the complexities and difficulties faced by the industry and by supervisors; and identified mitigating actions: ESMA, Peer Review into Supervisory Action Aiming at Enhancing the Quality of Data Reported under EMIR (2019). 583 The major exercise in data ‘porting’ or transfer between TRs in advance of the UK withdrawal was smooth and no market disruption was observed: 2021 ESMA Data Quality Report, n 350, 12. 584 ESMA’s inaugural 2021 data quality review reported on progress, as well as on significant efforts by counterparties, TRs, NCAs, and ESMA, but identified ongoing difficulties, including as regards completeness, accuracy, and reconciliation: n 350, 14–​20. 585 Five enforcement actions had been taken by mid-​2022 (2016; 2019; two in 2021; and 2022). ESMA’s largest fine, imposed in 2021, related to a series of failures as regards allowing a counterparty access to data to which it was not entitled, systems failures resulting in data being altered, and failures to provide regulators with information.

VI.5 EMIR  633

VI.5.11  The Derivatives Trading Obligation and MiFIR The EU’s derivatives markets ‘rulebook’ also includes the MiFIR Derivatives Trading Obligation, which requires that certain derivatives be traded on MiFID II/​MiFIR trading venues. Regulators have long outsourced elements of financial markets regulation to major trading venues, but over the financial-​crisis era trading venues were pressed into action as devices for managing the gaps which arise when financial innovation moves ahead of the market infrastructures which support orderly and stable trading. The G20 reform agenda for OTC derivatives markets included, in addition to the CCP clearing infrastructure reform, a commitment that the trading of standardized OTC derivatives move to ‘exchanges’ or ‘electronic trading platforms’.586 This reform was designed to move OTC trading in standardized derivatives, which were sufficiently liquid to support organized-​venue-​based trading, to regulated trading venues in the interests of ease of supervisory monitoring, greater transparency, operational and risk-​management efficiencies, and deeper liquidity. OTC derivatives trading continues to dominate, however, given the customized nature of many derivatives and the relatively thin liquidity in derivatives markets, albeit supported by CCP clearing and the enhanced risk management requirements for bilateral clearing.587 In the EU, the related Derivatives Trading Obligation (DTO) proved relatively uncontroversial over its adoption (achieved under MiFIR Articles 28–​34)588 and also since. Some difficulties arose with the 2019 EMIR Refit Regulation, which disrupted the alignment between the EMIR CCP clearing obligation and the MiFIR DTO (the DTO, reflecting the need for the obligation to apply to standardized derivatives, applies only to derivatives previously subject to the CCP clearing obligation) by narrowing the scope of the financial counterparties and NFCs subject to the CCP clearing obligation but not, in parallel, revising the scope of the DTO.589 An interim ESMA soft law fix followed,590 pending legislative reform (noted below). Otherwise, the DTO has been among the quieter corners of EU derivatives markets regulation: the 2017 adoption of the classes of derivatives subject to the DTO (a narrower subset of those subject to the CCP clearing obligation) was not significantly contested,591 albeit that

586 Pittsburgh G20 Summit, September 2009, Leaders’ Statement and, on the reform process, IOSCO, Report on Trading of OTC Derivatives (2011). 587 In December 2009, some 89 per cent of derivatives were traded OTC (in that trades took place between two contracting parties without an intermediary trading platform): IOSCO, n 586, 6. Given the applicable conditionality governing the movement of OTC derivatives to trading venues, the situation has not changed significantly in the EU (n 594). 588 Danish Presidency (Danish Presidency Progress Report on MiFID II/​MiFIR, 20 June 2012 (Council Document 11536/​12)), albeit that market participants were concerned as to a potential reduction in liquidity, increased costs, and restrictions on their ability to trade customized contracts: 2011 MiFID II/​MiFIR Proposals IA, n 45, 36. 589 The misalignment generated a series of distortions, including that the CCP clearing obligation, lifted by the 2019 Refit Regulation for certain counterparties, could, in effect, be reintroduced by the DTO, given that trading venues can, under their admission rules, require that derivatives be CCP-​cleared. For a review see ESMA, Alignment of MiFIR with the Changes Introduced by the EMIR Refit (2020). 590 Using its ‘supervisory forbearance’ formula, ESMA recommended to NCAs that they not prioritize supervision of DTO compliance by counterparties which fell outside the CCP clearing obligation following the 2019 Refit Regulation reforms: ESMA, Public Statement, 12 July 2019. 591 RTS 2017/​2417 [2017] OJ L343/​48 specified the classes of derivatives subject to the DTO, namely specified maturities of only the euro, GBP, and US$ interest rate derivatives previously subject to the CCP clearing obligation, and specified series of the CDSs subject to the CCP clearing obligation, in each case reflecting the applicable liquidity criteria governing the DTO, as noted below.

634 Trading the related data collection exercise proved challenging.592 The liquidity of EU trading venues for derivatives trading post-​Brexit remains, however, an industry concern.593 Overall, the impact of the DTO is of a lesser order than that of the CCP clearing obligation, with only a small portion of derivatives markets’ trading volumes on trading venues.594 The DTO is governed by MiFIR Articles 28–​34. It is based on the regulatory technology developed for the EMIR CCP clearing obligation, with the DTO designed to work in tandem with the CCP clearing obligation. The DTO is also linked to the MiFID II/​MiFIR trading venue reforms, being supported by the introduction of the OTF venue classification, which is designed to accommodate derivatives trading, and also by the tailored transparency regime that applies to derivatives traded on a trading venue (Chapter V). The MiFID II/​MiFIR trading regime is also calibrated to reflect the portfolio compression risk management technique used in derivatives trading (Article 31):595 where investment firms provide portfolio compression, they are not subject to best execution or to the MiFIR transparency requirements; the termination or replacement of component derivatives in the compression is not subject to the DTO; and the MiFID II position management regime does not apply. The DTO applies to EMIR financial counterparties and to NFCs above the clearing threshold (Article 28(1)); the 2021 MiFIR 2 Proposal revises Article 28(1) to align it with the 2019 Refit Regulation reforms that narrowed the application of the CCP clearing obligation as regards small financial counterparties and NFCs.596 These parties must conclude transactions (which do not qualify for the EMIR intra-​group transactions exemption or for transitional exemptions from EMIR) with other financial counterparties or with eligible NFCs, in relation to a class of derivatives that has been declared to be subject to the DTO (and listed in the required ESMA register), only on regulated markets, MTFs, and OTFs (together, MiFIR/​MiFID II trading venues) or on third country trading venues.597 As is the case with the CCP clearing obligation, ESMA is charged with assessing which classes of derivatives are subject to the DTO and with identifying the applicable timeline and any phase-​ins, through a draft RTS for Commission adoption. The procedure (Article 32) is tied to the CCP clearing obligation in that ESMA’s assessment is triggered when a class of derivatives is subject to the CCP clearing obligation.598 The related conditionality is

592 Given the difficulties associated with TR data at that point, ESMA drew directly on trading venue data but will, going forward, consider drawing data from the since developed FITRS database which holds transparency-​ related data: ESMA, MiFID II/​MiFIR Review Report on the Transparency Regime for Non-​equity Instruments and the Trading Obligation for Derivatives (2020). 593 While ESMA’s MiFID II/​MiFIR Review assessment of the DTO did not expose material difficulties, industry concerns as to the risk of a Brexit-​related contraction in liquidity for derivatives trading were raised, and ESMA committed to monitor developments: 2020 ESMA MiFID II/​MiFIR DTO Report, n 592, 53–​63. 594 At end 2020, OTC contracts accounted for 92 per cent of the outstanding notional amount: ESMA, Annual Report on EU Derivatives Markets (2021) 4. 595 Portfolio compression involves two or more counterparties wholly or partially terminating some or all of the derivatives submitted by the counterparties for inclusion in the portfolio compression and replacing the terminated derivatives with another derivative, whose combined notional value is less than the combined notional value of the terminated derivatives (Art 2(1)(47)). 596 MiFIR Art 28(1) applies the DTO to EMIR financial counterparties and to NFCs above the clearing threshold, and so does not reflect the exemptions now available for small financial counterparties as well as the restriction of the clearing obligation, for NFCs above the clearing threshold, to only the derivative class for which an NFC is above the threshold. The lack of alignment accordingly means that the DTO applies to a wider range of financial counterparties and NFCs than are subject to the CCP clearing obligation (see n 589). 597 As long as the related equivalence requirements are met. See further Ch X section 8. 598 As with the CCP clearing obligation, a ‘top-​down’ procedure is also provided for in that ESMA (on its own initiative) can identify and notify the Commission of classes of derivatives or individual derivative contracts that

VI.5 EMIR  635 less articulated than that for the CCP clearing obligation, given that the prior CCP clearing obligation assessment addresses criteria relevant for trading, including as regards standardization and information availability. The DTO criteria are concerned with liquidity. Two liquidity-​related conditions, designed to ensure the derivative can be efficiently traded, apply: the class of derivatives (or a relevant subset thereof) must be admitted to trading or traded on at least one trading venue (the venue condition);599 and there must be sufficient third party buying-​and-​selling interest in the class of derivatives (or subset) so that the class of derivatives is considered ‘sufficiently liquid’ to trade on these venues (the liquidity condition). The liquidity condition is specified by RTS 2016/​2020 which amplifies the MiFIR requirement that a class is to be determined as ‘sufficiently liquid’ by reference to the average frequency and size of trades over a range of market conditions, having regard to the nature and life cycle of products within the class, the number and type of active market participants (including the ratio of market participants to products/​contracts traded in a given product market), and the average size of spreads (as specified by MiFID Article 32(2)).600 The initial classes of derivatives subject to the DTO were identified in 2017 and subject to the same phase-​in arrangements as apply as regards their equivalent CCP clearing obligations.601 As with the suspension of the CCP clearing obligation, a bespoke process, based on ESMA advising the Commission, applies to the suspension of the DTO.602 The DTO is supported by the requirement that derivatives subject to the DTO must be eligible to be admitted to trading or to trade on any trading venue on a non-​exclusive and non-​discriminatory basis (Article 28(3)). In a related obligation, trading venues, CCPs, and investment firms which act as clearing members under EMIR must have in place effective systems, procedures, and arrangements to ensure that transactions in ‘cleared derivatives’603 are submitted and accepted for clearing as quickly as is technologically practical using automated systems (Article 29(2)).604

should be subject to the DTO but for which no CCP has been authorized, or which have not been admitted to trading or traded on a trading venue (Art 32(4)). ESMA has not used this route, an approach welcomed by the industry: 2020 ESMA DTO Report, n 592. 599 In practice, ESMA considers this criterion met where the derivative trades on one venue (despite some industry support for a two or three venue threshold): ESMA, Final Report on Draft RTS on the Trading Obligation for Derivatives under MiFIR (2017) 7. 600 RTS 2016/​2020 [2016] OJ L313/​2. 601 See n 591. The DTO applies to a narrower subset of the interest rate and credit derivatives already subject to the CCP clearing obligation, being applicable only to the specified maturities and series which met the liquidity assessment. ESMA’s approach to the DTO assessment (and the outcome) was broadly welcomed by the market: 2017 ESMA DTO Report, n 592. In 2021, ESMA proposed that the scope of the DTO be narrowed to manage the withdrawal of the LIBOR benchmark and be removed from GBP and US$ interest rate derivatives referenced to LIBOR. 602 The EMIR procedure governing the suspension of the CCP clearing obligation provides for the parallel suspension of the DTO (section 5.6). Following ESMA’s recommendation to this effect under the MiFID II/​MiFIR Review, a discrete suspension system, separate from, but based on the CCP clearing obligation procedure, and designed to provide for situations where a suspension of the DTO might be required where suspension of the CCP clearing obligation is not, has been proposed by the 2021 MiFIR 2 Proposal (Art 32a). 603 Derivatives subject to the CCP clearing obligation or derivatives otherwise agreed by the relevant parties to be cleared: Art 29(2). 604 This obligation has been amplified by RTS 2017/​582 [2017] OJ L87/​224 as regards the modalities governing expeditious transfer of related information between trading venues, CCPs, and counterparties.

VII

RATING AGENCIES VII.1  Introduction: Rating Agencies and Regulation VII.1.1  The Gatekeeper Function This chapter considers the regulation and supervision of credit rating agencies (CRAs). CRAs form part of the investment intermediation process as a type of market ‘gatekeeper’ in that they assess credit risk (through the ‘credit rating’ process). While long associated with self-​governance and market discipline, CRAs were, over the global financial crisis, brought within the EU regulatory perimeter as systemically significant components of the institutional structure supporting financial markets. This significant change to regulatory design was accompanied by precedent-​setting institutional change: the European Securities and Markets Authority (ESMA) was conferred with direct and exclusive supervisory powers over CRAs, the first time it had been conferred with executive supervisory powers over a market segment. The ‘gatekeeper’ function is associated with independent market actors who provide verification or certification services to investors and to the market generally.1 Gatekeepers traditionally include investment analysts,2 trading venues (with respect to their admission standards and monitoring functions),3 auditors,4 investment banks (particularly with respect to their underwriting function),5 and lawyers (particularly with respect to their legal opinions on offerings).6 The gatekeeper class is not closed but evolves in response to market demands for verification services, as is reflected in the recent growth of providers of review and rating services as regards sustainable finance (section 16). CRAs, the concern of this chapter, have long played a pivotal role as credit market gatekeepers by assessing credit risk and thereby supporting the credit risk pricing mechanism.7

1 For an early examination of gatekeepers see Kraakmann, R, ‘The Anatomy of a Third Party Enforcement Strategy’ (1986) 2 JLEO 53. 2 See further Ch II section 9. 3 See further Ch II section 8. 4 Auditors provide an important gatekeeping function by auditing the financial disclosures made by market participants, in particular issuers. As the audit function is primarily directed towards shareholders and is strongly associated with company law and corporate governance, it is not addressed by this book (it is noted briefly in Ch II n 547). 5 See further Ch IV. 6 For a review of the gatekeeping function and its regulation see Payne, J, ‘The Role of Gatekeepers’ in Moloney, N, Ferran, E, and Payne, J (ed), The Oxford Handbook on Financial Regulation (2015) 254. 7 They developed as a market response to the credit monitoring challenges raised by the massive funding demands generated by the development of the railways in the US in the nineteenth century. For a pre-​financial-​ crisis analysis see Levich, R, Majnoni, G, and Reinhard, C (eds), Ratings, Rating Agencies, and the Global Financial System (2002).

638  Rating Agencies In particular, they mitigate the information asymmetries in debt markets which would otherwise obstruct efficient risk assessment by investors and, relatedly, increase the cost of capital for debt issuers. CRAs do so by issuing ratings or opinions on the creditworthiness of a particular issuer or financial instrument and so on the likelihood of default on financial obligations.8 Ratings, which are based on proprietary methodologies, categorize issuers and debt instruments according to different grades which describe the relative risk of default, from ‘investment grade’ to ‘non-​investment grade’/​‘speculative’. They accordingly allow the market to assess relative credit risk through standardized risk indicators.9 Ratings typically also support investment management mandates and risk management policies, including as a means for specifying the proportion of a portfolio that can be held in lower-​risk/​return (investment grade) instruments and higher-​risk/​return (speculative grade) instruments. The movement of a rated instrument across a rating grade can, accordingly, generate ‘cliff-​edge’ risks, particularly where an instrument is downgraded from the lowest investment grade ranking (BBB) to a speculative grade ranking as this will likely trigger a sale obligation. CRAs long operated outside the regulatory perimeter internationally given the weight regulatory governance placed on the disciplining quality of their ‘reputational capital’. In effect, a gatekeeper’s reputational capital is regarded as an asset of the gatekeeper that is derived from the gatekeeper’s establishment of a reputation for competence and independence over time, and on which its business model is based: a gatekeeper notionally ‘pledges’ this reputational asset when it vouches for, or reviews, an issuer or financial instruments. The risks to gatekeepers from any erosion of their reputational capital (through, for example, competence or conflict-​of-​interest failures) serves, in theory, as a disciplining mechanism. Any benefits from collusion with an issuer, for example, should be insignificant by comparison with the erosion of the value of reputational capital should this collusion be detected by the market. The effect of this reputational dynamic on regulatory governance in the years prior to the global financial crisis was that CRAs, in particular, became strongly associated with the ‘new governance’ technique for supporting market discipline, then in the ascendant, which privileged self-​regulation and market/​private monitoring. The monitoring function provided by CRAs sat comfortably within a wider regulatory environment which was becoming increasingly ‘decentred’ and drawing on market/​private disciplining tools.10 CRAs were, in effect, ‘enrolled’ in the wider regulatory process as self-​regulating risk monitors.11 The over-​reliance by regulatory governance internationally on reputational capital as a disciplining mechanism for CRAs was exposed to searing effect by the global financial crisis. The failure of the CRA industry to correctly rate securitized debt, in particular, was an aggravating factor in the mispricing of risk, inadequacy of capital, and catastrophic 8 A rating has been described as ‘an assessment of the likelihood of timely payment on securities’: Schwarcz, S, ‘The Role of Credit Rating Agencies in Global Market Regulation’ in Ferran, E and Goodhart, C (eds), Regulating Financial Services and Markets in the 21st Century (2001) 289, 299. 9 eg Hill, C, ‘Regulating the Rating Agencies’ (2004) 82 Washington University LQ 43. 10 On this shift in regulatory governance see, eg, Black, J, ‘The Rise (and Fall?) of Principles Based Regulation’, in Alexander, K and Moloney, N (eds), Law Reform and Financial Markets (2011) 3, Ford, C, ‘New Governance, Compliance, and Principles-​Based Securities Regulation’ (2008) 45 American Business LJ 1, and Black, J, ‘Mapping the Contours of Contemporary Financial Services Regulation’ (2002) 2 JCLS 253. 11 Black, J, ‘Enrolling Actors in Regulatory Processes: Examples from UK Financial Services Regulation’ [2003] Public Law 63.

VII.1  Introduction: Rating Agencies and Regulation  639 drying-​up of liquidity in global credit markets over the crisis (see further section 1.2). The regulatory response, including in the EU, was to bring CRAs within the regulatory perimeter.12 Since then, the regulation of CRAs has been broadly stable globally, although the Covid-​19 pandemic brought renewed focus on the risks posed by over-​reliance on CRAs.

VII.1.2  The Global Financial Crisis and Reform The global financial crisis saw a destructive crystallization of the risks posed by CRAs to credit markets, but concerns had earlier been expressed about the scale of CRA influence on the pricing of credit risk given the structural weaknesses and related risks in the CRA business model.13 These persist, but are now addressed through regulation. The ‘issuer payment’ revenue model under which CRAs typically operate (ratings are a prerequisite for issuer debt financing and so are sought by issuers)14 injects a structural conflict-​of-​interest risk into the CRA business model as CRAs are paid by the issuers they rate. The strong incentives for CRAs to protect their reputational capital in theory operates as an effective mitigant to this risk.15 The dependence of the CRA business model on issuer payment nonetheless generates risks to the independence and objectivity of CRAs and so to the integrity and quality of the rating process. The integrity and quality of the rating process can also be compromised by competence failures; these can be exacerbated by conflict-​ of-​interest risks as they can dull incentives to carry out appropriate due diligence.16 These risks are deepened by the structure of the CRA market. There is limited competition in this market (and thus, potentially, limited investor monitoring), which is dominated by three main players (S&P Global (Standard & Poor’s), Moody’s, and Fitch). The tendency towards oligopoly can be considerable as rated instruments typically must have two ratings, whether to meet market expectations or admission to trading requirements. High barriers to entry, 12 On the international CRA reform context see Brummer, C and Loko, R, ‘The New Politics of Transatlantic Credit Rating Agency Regulation’ in Porter, T (ed), Transnational Financial Regulation after the Crisis (2014). 13 eg Partnoy, F, ‘The Siskel and Ebert of Financial Markets? Two Thumbs Down for the Credit Rating Agencies’ (1999) 77 Washington University LQ 619, quoting Thomas Friedman: ‘There are two super-​powers in the world today, in my opinion. There’s the United States and there’s Moody’s Bond Rating Services. The US can destroy you by dropping bombs and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful’ (at 260). 14 Some ratings can be unsolicited and issued by a CRA as a strategy to seek market share. While the conflict-​ of-​interest risk is lower with these ratings, reliability risks can arise as the challenges the CRA can face as regards ensuring it has sufficient issuer information to ground the rating can be significant. 15 Pre-​financial-​crisis, CRAs defended the issuer-​payment model in part by reference to the reputational argument that ‘ratings from a particular firm are only valuable insofar as the firm maintains a reputation for independence, accuracy, and thoroughness. CRAs would be unwilling to risk damaging their reputations just to retain a single client’: IOSCO, Report on the Activities of Credit Rating Agencies (2003) 11. 16 The implications of these risks began to emerge over the turn of the twentieth century Enron-​era scandals when auditors and analysts, but also CRAs, failed to identify the risks posed by off-​balance-​sheet transactions in particular. On the role of CRAs in the massive Enron bankruptcy scandal (which was associated with fraud relating to Enron’s off-​balance-​sheet transactions) see Rating the Raters. Enron and the Credit Rating Agencies. Hearings Before the Senate Committee on Governmental Affairs, 107th Congress (2002). A similar failure by auditors and CRAs to assess off-​balance-​sheet transactions was implicated in the EU Parmalat scandal, another massive bankruptcy which occurred shortly after the Enron collapse and was similarly associated with gatekeeper failure. See Ferrarini, G and Giudici, P, ‘Financial Scandals and the Role of Private Enforcement: The Parmalat Case’ in Armour, J and McCahery, J (eds), After Enron. Improving Corporate Law and Modernising Securities Regulation in Europe and the US (2006) 159. In its Communication on the Parmalat scandal, the Commission noted that significant audit failures associated with the Parmalat scandal may have been assisted ‘in some way’ by CRA failures: Commission, Preventing and Combating Financial Malpractice (COM(2004) 611) 3.

640  Rating Agencies particularly given the cost of acquiring reputational capital, render market structure weaknesses difficult to address. Liability risk tends not to be a powerful deterrent against conflicted or poor quality rating action; a rating is typically regarded as an opinion, with the CRA thereby largely insulated (depending on the jurisdiction) from liability claims.17 Prior to the global financial crisis, these risks were largely unregulated, with reputational capital carrying the weight as regards CRA governance.18 The nature of the rating process, which produces an opinion rather than a recommendation, and the traditional association between CRAs and market discipline, were also among the factors shaping a regulatory treatment based on ‘enrolling’ CRAs in the regulatory apparatus as self-​regulating actors.19 High barriers to entry, which could be increased by regulatory costs—​as well as the potential for moral hazard were ratings to be subject to some form of regulatory imprimatur—​lent further support to the prevailing self-​regulatory model. This dynamic was reflected in the adoption by the International Organization of Securities Commissions (IOSCO), in 2004, of a Code of Conduct for Rating Agencies, based on a self-​regulatory ‘comply-​or-​explain’ model.20 The risks of this self-​regulatory model were magnified by the ‘hardwiring’ of ratings into the global financial system, prior to the financial crisis, by means of market practice and regulation. Ratings shaped market practice, being used, for example, as diversification tools to shape investment management mandates and to confer rights on creditor counterparties. They were also embedded into regulation. The extensive reliance on ratings to determine capital requirements for bank assets under the Basel II capital assessment process21 led to CRAs being empowered, in effect, to confer a ‘regulatory licence’ on banks, which licence determined the level of capital required to be held against loan assets in particular.22 This ‘licensing model’ also, however, reduced banks’ incentives to monitor credit risk internally and at the same time raised the risk of herding effects where a rating change triggered similar behaviour across the market (for example, asset sales where a rating downgrade triggered higher capital requirements). Overall, the pre-​eminence of ratings as risk pricing tools embedded ratings in the global credit market and allowed ratings to become a primary influence on risk pricing and so on risk management and transmission. These longstanding risks crystallized to devastating effect over the global financial crisis which saw a destructive interaction between financial innovation (in the form of asset-​backed securities), CRA market structure, and the ratings process.23 As was 17 The financial crisis, however, led to change in the EU in this regard (section 15). 18 In the US, the home of the three global CRA groups, regulation initially took the form of designating CRAs as ‘Nationally Recognized Statistical Ratings Organizations’, eligible to provide the credit assessments and ratings used to determine capital requirements for broker-​dealers, but this designation was based on the extent to which agencies were of national repute, rather than on assessment by the US SEC. Regulatory requirements were not imposed until the US 2006 Credit Rating Agency Reform Act which responded to concerns as to why CRAs had failed to spot the Enron bankruptcy: US Senate Committee on Governmental Affairs, Oversight of Enron: The SEC and Private-​Sector Watchdogs (2002). 19 See eg Partnoy, n 13, 628–​36. 20 IOSCO, Code of Conduct Fundamentals for Credit Rating Agencies (2004). The Code addressed the quality and integrity of the rating process, the independence of agencies and the avoidance of conflicts of interest, and the responsibilities of CRAs to the investing public and issuers through a range of detailed operational and disclosure-​ based recommendations. 21 See, eg, Hertig, G, ‘Basel II and Fostering the Disclosure of Banks’ Internal Credit Ratings’ (2006) 7 EBOLR 625 and Schwarcz, S, ‘Private Ordering’ (2002) 97 Northwestern University LR 301. 22 CRAs were characterized, pre-​crisis, as selling ‘regulatory licences’ which allowed market participants to purchase favourable regulatory treatment (ie as regards lower capital requirement for debt assets): Partnoy, n 13. 23 eg Coffee, J, ‘What Went Wrong? An Initial Inquiry into the Causes of the 2008 Financial Crisis’ (2009) 9 JCLS 1 and Hunt, J, ‘Credit Rating Agencies and the “Worldwide Credit Crisis”. The Limits of Reputation, the

VII.1  Introduction: Rating Agencies and Regulation  641 well-​documented, under the ‘originate to distribute’ credit supply model prevailing prior to the financial crisis, debt such as mortgage loans, personal debt, and corporate bonds was ‘repackaged’ (or securitized) and issued in the form of asset-​backed securities (based on the original debt asset and its income flows) through a structured-​finance vehicle.24 This technique allowed financial institutions to sell or distribute their debt holdings and generate a related return. This model of credit origination and distribution, although of longstanding, burgeoned prior to the financial crisis given the alignment of financial institutions’ capacity to provide cheap credit (given prevailing low interest rates), financial innovation (which drove ever more complex repackagings and redistributions of these debt assets), and pressure for yield (to which the returns on the asset-​backed securities through which the original debt was distributed, provided a response). Growth in the asset-​backed securities market was explosive, including in the EU,25 but this increased the pressure on CRA self-​regulation. The success of the asset-​backed securities depended heavily on the rating assigned to them by CRAs, as this determined the classification of the securities (whether investment grade or speculative, for example) and their return, and so their marketability. The structure of the asset-​backed securities market, however, placed CRA reputational capital under strain. The CRA was often not an entirely disinterested reviewer of asset-​backed securities’ credit risk, but typically provided advice to the securities’ sponsor (typically the arranging investment bank) on the hypothetical rating the securities might receive, and the related degree of credit support required for a particular rating. In addition, the steep rise in the volume of asset-​backed securities being issued led to sharply increased revenues for CRAs but also to increasing dependence on this revenue stream and, relatedly, on the small number of financial institutions arranging these transactions.26 Further, the increasing complexity of asset-​backed securities generated competence risks, including as regards heavy reliance on models rather than judgement, insufficiently sensitive default risk tools, and limited CRA capacity to address systemic and correlation risks across different classes of asset-​backed securities.27 Also, investor monitoring of CRA reputational capital was weak given the global search for yield in a market characterized by exuberance.28 Investor monitoring was further weakened as the classic ‘AAA’ rating

Insufficiency of Reform, and a Proposal for Improvement’ (2009) Col Business LR 109. From a policy perspective, see the Commission’s Impact Assessment (IA) for what would become the CRA I Regulation (SEC(2008) 2746) 12–​21) and CESR, The Role of Credit Rating Agencies in Structured Finance (2008). 24 Structured finance involves the pooling of loan assets and the subsequent sale to investors of tranched claims on the cash flows backed by the asset pool (for a pre-​financial-​crisis, ratings-​oriented review see Bank for International Settlements (BIS), The Role of Ratings in Structured Finance: Issues and Implications (2005) 1. On the related securitization process and its regulation see Ch II section 12. 25 The volume of related securitizations more than doubled between 2001 and 2005: Commission, European Financial Integration Report (2007) (SEC(2007) 1696) 38. By Q1 2008, there were some €1,200 billion of securitized products outstanding in the EU Market: 2008 CRA I Proposal IA, n 23, 7. The EU did not, however, see steep growth in the highly complex securitizations which emerged in the US market. 26 In 2008, the Commission reported than some 50 per cent of CRA revenues came from structured-​finance business: 2008 CRA I Proposal IA, n 23, 10. 27 eg ECB, Financial Stability Review (2007) 13, Karsenti, R, ‘Recent Market Turbulence: Causes and Consequences’ ICMA Regulatory Policy Newsletter, Issue No 7 (2007) 3 and Buiter, W, Lessons from the 2007 Financial Crisis, Centre for Economic Policy Research, Policy Insight No 18 (2007). 28 The UK Financial Services Authority (FSA) noted the ‘self-​reinforcing cycle of irrational exuberance’ in pricing credit risk: FSA, Financial Risk Outlook 2009 (2008). Similarly, IOSCO, The Role of Credit Rating Agencies in Structured Finance Markets (2008).

642  Rating Agencies associated with the highest quality investment-​grade corporate debt was used for the rating of asset-​backed securities. In summer 2007, liquidity began to evaporate in global credit markets following the exposure of the systemic mispricing of the risks of asset-​backed securities as their underlying loan assets defaulted.29 While CRAs were initially slow to react, the quickening pace of rating downgrades soon turned into a catastrophic spiral.30 This drove a procyclical collapse in global credit markets as financial institutions reacted to the loss of value in these instruments, and to the related erosion of their capital, by large-​scale sales.31 CRAs became accordingly associated with accelerating, destructive procyclical effects: rating downgrades forced sell-​offs of securities into highly volatile and increasingly illiquid markets which, in turn, placed financial institutions under greater stress. It would become apparent that multiple factors had combined to toxic effect to drive the financial crisis. CRAs, however, were among the first targets of the international reform programme.32 A new version of the IOSCO Code was adopted in May 2008 and focused on the risks posed by the asset-​backed securities market. CRA regulation became a recurring theme of the financial-​crisis-​era G20 summits, with the April 2009 London G20 meeting committing to regulatory registration and oversight of CRAs.33 Subsequent G20 summits called for an end to mechanistic reliance on ratings and for market structure reforms, including as regards greater transparency and competition.34 In addition, IOSCO in 2015 adopted a new version of its Code which, in a reflection of the changed regulatory landscape, was designed to work alongside the regulatory oversight regimes being put in place internationally and to incorporate supervisory experience.35 By 2018, the Financial Stability Board (FSB), which monitored the related international reform programme,36 was reporting to the G20 that all FSB jurisdictions had put in place requirements for the registration and oversight of CRAs, although weaknesses remained as regards mechanistic reliance on ratings.37 That significant progress had been made internationally in addressing the procyclical risks to financial stability posed by CRAs became clear over the Covid-​19 pandemic. The pandemic fuelled a global expansion of bond issuance,38 but it also saw large-​scale downgrades of outstanding bonds,39 and it thereby placed 29 The underlying defaults were related to a host of factors but in particular to a collapse in the US subprime mortgage market. See, eg, ESME (European Securities and Markets Expert Group), Role of Credit Rating Agencies (2008). 30 Between 1 July 2007 and 24 June 2008, some 145,899 downgrades of structured-​finance instruments occurred, as compared to 1,455 corporate downgrades: 2008 CRA I Proposal IA, n 23, 7–​8. 31 FSB, Principles for Reducing Reliance on CRA Ratings (2010) 1. 32 eg FSA, Financial Risk Outlook 2008 (2007) and Financial Stability Forum, Report on Enhancing Market and Institutional Resilience (2008). See section 3 on the drivers of the EU reform process. 33 London G20 Summit, April 2009, Declaration on Strengthening the Financial System. 34 eg Cannes G20 Summit, November 2011, Final Declaration and Los Cabos G20 Summit, June 2012, Leaders’ Declaration. 35 IOSCO, Code of Conduct Fundamentals for Credit Rating Agencies (2015). 36 The FSB adopted Principles for Reducing Reliance on CRA Ratings (2010) and a roadmap for reducing reliance (2012) which was the subject of a thematic review of progress in 2014. 37 FSB, Implementation and Effects of the G20 Financial Regulatory Reforms: Fourth Annual Report (2018). 38 Goel, T and Serena, JM, ‘Bonds and Syndicated Loans during the Covid-​19 Crisis: De-​coupled Again?’ BIS Bulletin No 29 (2020). 39 One study reported on 20,000 downgrades being issued by the three major CRAs across different asset categories and jurisdictions: IOSCO, Observed Impact of Covid-​19 Government Support Measures on Credit Ratings (2021). The CRA response generated some criticism that the industry had over-​reacted: Raveh-​Burstein, N, ‘Pulling the Trigger: Activating Rating Triggers under Covid-​19’ (2022) 19 Berkeley Business LJ and, for a market perspective, Saharan, S, ‘Credit Rating Upgrades Hit Record Pace as US Economy Rebounds’, Financial Times, 16 July 2021.

VII.2  The EU CRA Rulebook  643 a spotlight on the quality of ratings and their capacity to drive procyclicality. The FSB reported in 2021, however, that while some concerns remained as to excessive procyclicality, there had been a decline in over-​reliance on ratings since 2008.40 The international financial markets regulatory reform agenda has now pivoted away from CRAs, albeit that they continue to attract attention, increasingly as regards sustainable finance and the role of related environmental, social, and governance (ESG) or ‘green’ ratings.41

VII.2  The EU CRA Rulebook The EU CRA regime42 is, as outlined in section 4, composed of the three CRA regulations (CRA Regulation I (2009),43 II (2011),44 and III (2013):45 together, the Consolidated Credit Rating Agency Regulation, CCRAR)46 and the 2013 CRA Directive.47 These legislative measures are supported by related administrative rules and ESMA soft law. The different legislative components of the CRA ‘rulebook’, all of which were pathbreaking in different ways, reflect the international financial-​crisis-​era reform programme, but also track the progress of the financial crisis in the EU.48 The first of these components was put in place in 2009 in the form of the 2009 Rating Agency Regulation (CRA Regulation I). A ‘first generation’ measure, it established the foundations of the legislative regime that now governs CRAs and relied on national competent authority (NCA)-​based supervision. The ‘second generation’ 2011 CRA II Regulation conferred on ESMA, established in 2011 as part of the European System of Financial Supervision, exclusive power to supervise CRAs. CRA Regulations I and II were, accordingly, epochal reforms in that they marked the opening of the financial-​crisis-​era reform agenda and the move to a single rulebook (CRA I) and established the constitutional, legal, and procedural template for ESMA to act as a direct supervisor (CRA II). The ‘third generation’ 2013 CRA III Regulation, which soon followed, was of similar importance as one of the first EU financial markets regulation measures to grapple with market structure, addressing CRA market structure risks, including by means of liability-​related and rotation-​related reforms. It also reflected specific EU 40 FSB, Lessons Learnt from the Covid-​19 Pandemic from a Financial Stability Perspective (2021). The FSB reported, however, that pockets of over-​reliance persisted. 41 See, eg, IOSCO, Environmental, Social and Governance (ESG) Ratings and Data Products Providers (2021). See section 16. 42 CRAs also come within the prudential regime governing banks and investment firms (Ch IV) as ‘external credit assessment institutions’ (ECAIs) whose ratings support the risk weightings of assets and thereby the determination of capital requirements. They are also subject to EU financial markets regulation generally, where applicable, notably the market abuse regime. 43 Regulation (EU) No 1060/​2009 [2009] OJ L302/​1. 44 Regulation (EU) No 513/​2011 [2011] OJ L145/​30. 45 Regulation (EU) No 462/​2013 [2013] OJ L146/​1. 46 The EU’s informal consolidation of the texts is at ELI . 47 Directive 2013/​14/​EU [2013] OJ L145/​1. 48 On the CRA regime see Nästegård, E, The Regulation of Conflicts of Interest in the Credit Rating Industry, Nordic & European Company Law WP No 16-​18 (2017), available via ;Wit​ tenb​erg, T, ‘The Regulatory Evolution of the EU Credit Rating Agency Framework’ (2015) 16 EBOLR 669; Johnston, A, ‘Corporate Governance is the Problem, not the Solution: A Critical Appraisal of the European Regulation on Credit Rating Agencies’ (2011) 11 JCLS 395; Möllers, T, ‘Regulating Credit Rating Agencies: The New US and EU Law—​Important Steps or Much Ado About Nothing?’ (2009) 4 CMLJ 477; and Amtenbrink, F and de Haan, J, ‘Regulating Credit Ratings in the European Union: A Critical First Assessment of Regulation 1060/​2009 on Credit Rating Agencies’ (2009) 46 CMLR 1915.

644  Rating Agencies preoccupations at the time, including in relation to sovereign debt, given the euro-​area sovereign debt crisis which followed the financial crisis. Together, these three measures form the CCRAR and are accompanied by the 2013 CRA Directive which extends to financial market participants beyond CRAs and addresses over-​reliance on ratings more generally.

VII.3  The Evolution of the EU Regime VII.3.1  Initial Efforts: The IOSCO Code and the EU While the CRA regime was forged over the global financial crisis,49 the first tentative steps towards regulating CRAs in the EU were taken in 2006, with the Commission’s Communication on CRAs.50 Reflecting the prevailing pre-​financial-​crisis sentiment, it relied on self-​regulation and called on CRAs to follow the 2004 IOSCO Code.51 Monitoring of CRA compliance with the IOSCO Code became subject to a voluntary agreement between the Committee of European Securities Regulators (CESR) and the CRAs operating in the EU, with CESR reporting to the Commission on Code compliance.52 CESR’s first monitoring report (2006) reported on widespread compliance,53 leading the Commission to conclude that self-​regulation was working reasonably well.54 Earlier, the European Parliament had also reviewed the CRA sector, being broadly supportive of CRAs but calling on the Commission to assess whether legislative reform was necessary.55 That the Commission eschewed a legislative response is not surprising. Parallel but separate discussions on the treatment of CRAs under the Basel II/​2006 Capital Requirements Directive regime may have provided a safety valve for the release of some of the political pressure to intervene as regards CRAs;56 while the IOSCO Code provided a convenient template for action, CESR provided an institutional vehicle for monitoring compliance, and market opinion was strongly in favour of a self-​regulatory response.57 Certainly, at a 49 See for the historical context Wymeersch, E and Kruithof, M, ‘Regulation and Liability of Credit Rating Agencies under Belgian Law’ in Dirix, E and Leleu, Y-​H (eds), Belgian Reports at the Congress of Utrecht of the International Academy of Comparative Law (2006) 355, noting that CRAs began to take root in continental Europe only when capital flows began to move away from the banking sector. 50 Commission, Communication on Credit Rating Agencies (2006). The Commission had earlier committed to this review in the wake of the Enron bankruptcy which had implicated gatekeepers: Commission, Note for the Informal ECOFIN Council, Oviedo, 12 and 13 April 2002, A First Response to Enron-​related Policy (2002). 51 Reflecting CESR’s advice: CESR. Technical Advice to the European Commission on Possible Measures Concerning Credit Rating Agencies (2005). A ‘distinct minority’ of CESR members supported a slightly more intrusive ‘recognition’ model, operating at EU level, under which CRAs would voluntarily register and commit to following the Code. 52 For an account of the procedure see CESR, Annual Report (2006) 31–​3. 53 CESR/​06-​545. 54 Letter from the Commission to CESR, 7 May 2007 (attached to CESR, Progress Report on CESR’s Dialogue with CRAs to Review how the IOSCO Code of Conduct is being Implemented (2007)). CESR’s view was that ‘the voluntary framework of cooperation between CESR and credit rating agencies has proved a successful way to move forward in an environment where there is an absence of regulation’: CESR, Annual Report (2006) 31. 55 Katiforis Report (Economic and Monetary Affairs (ECON) Committee) on the Role and Methods of Rating Agencies, 29 January 2004 (A5-​0040/​2004); European Parliament Resolution on The Role and Methods of Rating Agencies, 10 February 2004 (P5-​TA(2004) 0080); and European Parliament Resolution on Corporate Governance and Supervision of Financial Services—​the Parmalat Case, 12 February 2004 (P5-​TA(2004) 0096) para 3. 56 Guidelines for CRAs followed the reform: CEBS, Guidelines on the Recognition of External Credit Assessment Institutions (ECAIs) (2006). 57 CESR reported that ‘the enormous mass of comments stress that they support the IOSCO Code all the way’: CESR, Technical Advice to the European Commission on Possible Measures Concerning Credit Rating Agencies: Feedback Statement (2005) 24.

VII.3  The Evolution of the EU Regime  645 time when the international regulatory zeitgeist was in favour of self-​regulation, it would have been quixotic for the Commission to seek to capture the world’s leading and US-​based rating agencies in an EU regulatory net.

VII.3.2  The Global Financial Crisis The global financial crisis reset the EU institutional and political environment and brought profound change to how CRAs were regulated. It took some time, however, for the policy shift to emerge. By contrast, enhanced oversight was quickly brought to bear on CRA action over 2020–​2021 as the Covid-​19 pandemic led to a series of ratings downgrades, underlining the significantly greater technocratic and institutional capacity the EU now has to monitor market developments.58 Over 2007–​2008, as the crisis took root, CESR remained sanguine.59 Similarly, the Commission’s (then) major advisory group on financial markets, the European Securities and Markets Expert Group (ESME), was wary of intervention.60 But, and reflecting support from France and Germany in particular,61 political appetite for regulatory intervention increased as the crisis deepened. The Council’s October 2007 roadmap for financial stability included an examination of the role of CRAs,62 and political support for action followed in the European Council, although the European Council saw regulatory intervention as a fallback, in the absence of industry action.63 The European Parliament, from an early stage of the financial crisis, supported intervention.64 Reflecting the prevailing political dynamics, the Commission’s position shifted significantly over 2007–​ 2008. While Commissioner McCreevy was initially supportive of the IOSCO Code and of self-​ regulation, by autumn 2007 the Commissioner was underlining the difficulties in the CRA sector65 and by September 2008 was ‘deeply sceptical’, notwithstanding the 2008 reforms to the IOSCO Code, that the IOSCO Code was effective.66 The Commission’s proposal for CRA Regulation I was presented, with some fanfare, in November 2008 and was adopted, as

58 See the ESMA/​ESRB correspondence noted at nn 91 and 93. 59 Its reaction to the developing financial crisis can be tracked in its two reports on CRA compliance with the IOSCO Code (February 2008, CESR/​08-​036; and May 2008, CESR/​08-​277). The February 2008 review was broadly supportive of the IOSCO Code, while the May 2008 review concluded that ‘CESR and market participants believe that there is no evidence that regulation of the credit rating industry would have had an effect on the issues which emerged with ratings of US subprime backed securities and hence continues to support market driven improvement’ (at 4). 60 n 29. 61 eg the 6 September 2007 statements by French and German premiers Sarkozy and Merkel which called for greater clarity concerning the role of CRAs: Greater Transparency on the Financial Markets, Press and Information Office of the Federal Government, 6 September 2007. 62 2822nd Council Meeting, 7 October 2007, ECOFIN Press Release No 13571/​07. 63 Presidency Conclusions, Brussels European Council, 13–​14 March 2008, para 32. 64 It called, eg, for greater transparency on fees and for the separation of rating and ancillary business: European Parliament Van den Burg II Resolution on Financial Services Policy 2005–​2010, 11 July 2007 (P6-​TA-​(2007) 0338) para 9. 65 Commissioner McCreevy noted that CRAs had been very slow in downgrading ratings, that their methodologies had been weak and not well explained, and that that conflicts of interest arose from CRAs providing advice on the structuring of asset-​backed securities: Speech to the European Parliament ECON Committee, 11 September 2007. 66 Speech, 16 June 2008.

646  Rating Agencies noted below, speedily, with the EU relatedly displaying a strong concern to respond to, but also shape, the then emerging international financial crisis reform agenda.67

VII.3.3  The CRA Regime Negotiations VII.3.3.1 CRA I: A New Regulatory Regime Negotiated in the teeth of the financial crisis, the 2009 CRA I Regulation was adopted speedily.68 The Commission’s path-​finding July 2008 Consultation, which was open for only four weeks,69 was followed by its November 2008 Proposal which squarely linked CRAs with the financial crisis, rejected further reliance on the IOSCO Code, and, while relying on the Code as the template for a binding EU rulebook, sought to amplify its requirements. The essential design of the proposed Regulation did not change significantly over the negotiations, although its scope of application tightened significantly. The operational design for the cumbersome supervisory arrangements, based on coordination between CESR, NCAs, and CRA colleges of supervisors, proved difficult to resolve,70 but is now of only historical interest, being replaced by direct supervision by ESMA under CRA II. The Regulation was adopted in April 2009. VII.3.3.2 CRA II: ESMA Supervision The adoption of the CRA I Regulation represented, at the time, a major volte-​face in EU policy and an important indicator of the EU’s intention to shape the international financial crisis reform agenda, but its major significance as regards CRA regulation in practice lay in its form, rather than its substance. The CRA I Regulation, in effect, placed the IOSCO Code within a binding regulatory framework, but while it expanded on the Code’s coverage, it did not radically alter the essentials of the Code which were already being applied by CRAs. A much bolder step was taken with the CRA II Regulation: by conferring ESMA with direct supervisory powers over CRAs, CRA II transformed the governance of the CRA market in the EU (section 14).71 The case for conferring ESMA, albeit then a very new actor in EU financial markets governance, with supervisory power was a pragmatic one. CRAs have wide cross-​border reach and, unless supervision is centralized, require large colleges of supervisors to coordinate their supervisors.72 Further, the supervision of CRAs was, for all Member States, a relatively 67 Adopted in April 2009, and imposing binding rules on CRAs, the Regulation just pre-​empted the commitment at the April 2009 G20 London Summit to subject CRAs whose ratings were used for regulatory purposes to a registration regime. The EU saw the Regulation as shaping the global reform movement, with Commission President Barosso suggesting that ‘our G20 partners agreed in London to move in the same direction as the EU has taken today’, and Commissioner McCreevy suggesting that the ‘EU is setting an example to be followed and matched’: Commission Press Release 23 April 2009 (IP/​09/​629). 68 The main elements of the legislative history are: Commission Proposal COM(2008) 704 (2008 CRA I Proposal), 2008 CRA I Proposal IA, n 23; and ECON Committee Report A6-​0101/​2009 (the Gauzès Report) (on which the European Parliament’s Negotiating Position was based). The ECB Opinion is at [2009] OJ C115/​1. 69 Generating concern from CESR (CESR/​08-​671). 70 The Commission noted that the temporary system was ‘an admittedly complex and heavy structure’: 2010 CRA II Proposal IA (SEC(2010) 678) 7. 71 The main elements of the legislative history are: Commission Proposal COM(2010) 289 (2010 CRA II Proposal), IA, n 70; and ECON Committee Report A7-​0081/​2011 (the Klinz Report), on which the European Parliament’s Negotiating Position was based. The ECB Opinion is at [2010] OJ C337/​1. 72 The Commission’s CRA II Regulation IA predicted, eg, that fourteen regulators would participate in Moody’s college of supervisors under the CRA I Regulation: n 70, 9.

VII.3  The Evolution of the EU Regime  647 new venture, so the conferral of power on ESMA did not imply a removal of executive power from the Member States, for the most part, or raise related political risks. Similarly, the centralization of supervision within ESMA posed only limited direct fiscal risks to the Member States, given that a failure of a CRA would not represent a material threat to financial stability, and thus any supervisory failure by ESMA was unlikely to lead to fiscal consequences in the Member States. The political risks of centralizing CRA supervision were accordingly limited.73 Nonetheless, and although the principle that CRAs should be supervised centrally had been proposed in the widely supported de Larosière Report’s review of the financial crisis,74 and accepted by the 2009 June European Council,75 its articulation under the 2011 CRA Regulation II proved a sensitive and complex exercise. Some degree of difficulty could have been predicted, given the constitutional novelty and operational complexities engaged in conferring supervisory and enforcement responsibilities over a segment of the financial markets, for the first time, on an EU agency. In particular, ensuring that ESMA’s responsibilities were compliant with the Meroni doctrine76 dominated the development of CRA II,77 with certain powers over CRAs moving to and from the Commission over the negotiations, and ultimately led to much greater specification of how ESMA was to exercise its new suite of powers (section 14).78

VII.3.3.3 CRA III: Market Structure Risks With the 2013 CRA III Regulation, the EU sought to finesse the CRA I rulebook and to address risks which were proving to be intractable, in particular as regards over-​reliance on ratings and as regards CRA market structure. The Commission’s wide-​ranging 2010 Consultation on further CRA reform79 chimed with a similarly ambitious 2011 European Parliament Resolution on CRAs.80 Political concern over the ongoing convulsions in the sovereign debt market, and in particular over the impact of sovereign debt ratings downgrades on euro-​area stability, particularly over 2010, ensured that the CRA reform momentum was sustained. The ambitious and interventionist CRA III Proposal followed in November 2011. The reach and potential costs of the proposed reforms, the intractability of the risks addressed, and the highly politicized context, given the turmoil in the sovereign debt market over the negotiations, meant a troubled legislative 73 There was little sign of institutional or Member State dissent on the principle of ESMA supervision: eg European Council, 18/​19 June 2009, Presidency Conclusions, para 20. 74 The High Level Group on Financial Supervision in the EU, Final Report (2009) 19–​20 and 53. 75 European Council Conclusions, n 73. 76 Case 9-​56 Meroni v High Authority (ECLI:EU:C:1958:7). The ruling provides that discretionary powers involving a wide margin of discretion which may make possible the execution of economic policy cannot be delegated by an EU institution. See in brief Ch I section 6.3 77 Unusually, the Commission Impact Assessment Board called for a new IA of the 2010 CRA II proposal, given fundamental problems with the assessment, including with respect to the Meroni-​compliance argument. Notably, the Board observed that political support alone was not sufficient: Ref. Ares(2010) 108790. A second report, which reiterated many of the earlier concerns, followed the new IA (Ref. Ares(2010) 205437). 78 For an extended discussion of ESMA as a CRA supervisor see Moloney, N, The Age of ESMA. Governing EU Financial Markets (2018) 260–​72. 79 Commission, Public Consultation on Credit Rating Agencies (2010). The breadth and ambition of the options canvassed, from establishing a European Rating Agency to requiring institutional investors to purchase ratings independently, attest to the complexity of mitigating over-​reliance/​market structure risks. 80 European Parliament Resolution on Credit Rating Agencies: Future Perspectives, 8 June 2011 (P7_​TA-​ PROV(2011) 0258). The Commission and Parliament followed a broadly similar CRA III policy agenda from an early stage (particularly with respect to the treatment of sovereign debt and a new civil liability regime), although differences emerged with respect to execution over the negotiations.

648  Rating Agencies passage.81 The Proposal changed significantly over the negotiations, with the main flashpoints including: the Commission’s proposal that CRAs be required to rotate from issuers every four years, which was changed, given concerns as to impact on the bond markets, to a rotation regime for structured-​finance ratings; the Commission’s proposal that ESMA be required to approve CRA methodologies, which was removed, reflecting concern as to the risk of interference by ESMA in ratings; the proposed civil liability regime, given concerns as to its reach into national civil procedure regimes, its potentially prejudicial chilling effects on CRAs, and its utility, given the ESMA enforcement regime; and the proposed treatment of sovereign debt ratings.82 Agreement was finally reached in December 2012,83 with the measure including a new civil liability regime, market structure measures (including a rotation requirement for structured-​finance ratings), specific requirements for sovereign debt ratings, and an enhancement of CRA disclosures. The CRA III Regulation was accompanied by the CRA III Directive, which addresses over-​reliance on ratings in the collective investment context (section 12).

VII.3.4  From the Global Financial Crisis to Capital Markets Union Since the adoption of CRA III, the CCRAR legislative regime has been broadly stable. The 2016 Commission review, which was supported by a series of reports,84 found that the CCRAR was overall working well.85 The review found only limited progress as regards CRA market structure, however, with the CRA market remaining highly concentrated, and noted ongoing challenges in limiting mechanistic reliance on ratings, although improvements had been made. Nonetheless, overall it found that the CCRAR had made an important contribution to securing the independence of CRAs and was likely to have long-​term positive impact on the EU CRA market. Since then, there have been few legislative developments. The Capital Markets Union (CMU) reform agenda has had little traction on the CCRAR, leading to incidental reforms only. Minor revisions were made to the CCRAR by the 2017 Securitization Regulation, given the disclosure requirements the Regulation imposed on securitizations.86 These reforms, and a series of other financial crisis and post-​financial-​crisis reforms to disclosure (including the disclosures now required on secured financing transactions and derivatives),87

81 Which was foreshadowed by the difficulties experienced in the Parliament’s earlier passing of the 2011 Resolution (n 80), in respect of which the Socialist Party abstained from a number of provisions (calling in particular for tighter controls on sovereign debt ratings): ECON Press Release, 16 March 2011. 82 For an example of the range of concerns raised see, eg, ESMA Chief Executive Ross, Statement, European Parliament ECON Committee Hearings, 24 January 2012 83 The main elements of the legislative history are: Commission Proposal COM(2011) 747 (2011 CRA III Proposal); IA SEC(2011) 1354; and ECON Committee Report A7-​0221/​2012, on which the European Parliament’s Negotiating Position was based. The ECB Opinion is at [2013] OJ C167/​2. 84 Including: ESMA, Technical Advice on Reducing Sole and Mechanistic Reliance on External Credit Ratings (2015); ESMA, Technical Advice on Competition, Choice, and Conflicts of Interest in the Credit Rating Agency Industry (2015); Report by ICF for the Commission on the Feasibility of Alternatives to Credit Ratings (2015); and Report by Europe Economics for the Commission on the State of the Credit Rating Agency Market (2016). 85 COM(2016) 664. 86 Regulation (EU) 2017/​2402 [2017] OJ L347/​35. Previously, the CCRAR (Art 8b) required reporting on structured-​finance instruments to ESMA. The 2017 Securitization Regulation introduced a new reporting system for securitized instruments, through securitization repositories, and so repealed Art 8b. 87 Regulation (EU) 2015/​2365 [2015] OJ L337/​1. See Ch VI section 4.

VII.3  The Evolution of the EU Regime  649 have materially expanded the data-​set available to CRAs. They have, accordingly, strengthened CRAs’ capacity to produce robust ratings and so form part of the wider regulatory framework supporting the rating process. Also, ESMA has transformed the supervisory environment for CRAs (section 14). Accordingly, while the rulebook has not experienced major change, it has been thickened and operationalized by ESMA’s supervisory measures, including its supervisory remediation plans, thematic reviews, and extensive soft law which drills deeply into CRA processes. Regarded in terms of its longevity and stability, the CCRAR regime can be regarded as a success. It has not required significant reform and there has been little clamour for change. But whether or not the CRA rulebook has been a success in terms of market outcomes requires a more nuanced response. The CCRAR is not, unlike the prospectus or funds regimes for example, designed as a passporting/​transformative measure. It provides institutional support to the market finance/​market integration (and so CMU) project, but its primary concern is with the management of CRA risks: it is a precautionary measure. Its success is accordingly difficult to assess but certainly CRAs have not been associated with major market instability since the financial-​crisis era. The facilitative credit conditions prevailing since the financial crisis (at least until previously accommodating monetary policy changed direction in 2022), however, placed some pressure on the regulatory scheme. In particular, a related and significant increase in lending to highly leveraged firms, and the consequent growth in the collateralized loan obligations which package such loans (CLOs) and the related generation of financial stability risks, led to regulatory attention focusing on the quality of the CLO rating process.88 In addition, the outbreak of the Covid-​19 pandemic, and the related increase in downgrades of issuers and debt securities, drew attention to the persistence of over-​reliance on ratings, including in investment management mandates.89 The increased volume of BBB ratings also drew concern,90 given the consequent risks to financial stability were asset managers and insurers, the major holders of BBB debt in the EU, to face mass downgrades of their holdings.91 Nonetheless, thus far at least, and although monetary policy and credit market conditions are evolving at the time of writing, the CCRAR rulebook, as supervised by ESMA, appears to be containing CRA risk.92 In particular, the EU CRA sector emerged from the 88 ESMA, Thematic Report on EU CLO Ratings (2020). ESMA identified a series of risks but maintained a watchful rather than interventionist stance. 89 See, eg, Rodríguez de Codes, E, et al, ‘The Challenges Associated with the Use of Agencies’ Credit Ratings in the Context of the Covid-​19 Crisis’ (2020) 39 Banco de Espaňa Financial Stability Rev 45, warning of the potentially adverse impact on the transmission of monetary policy. 90 The significant growth in BBB-​rated bonds (the lowest level of investment grade debt, estimated to represent over 50 per cent of investment grade bond issuance globally over 2017–​2020) drew close attention as generating specific risks to financial stability as well as to issuer solvency. See, eg, OECD, The Functioning of Corporate Governance in Capital Markets Following the Covid-​19 Crisis (2021). The OECD reported that while the low interest rate environment and the operation of rating models had allowed issuers to issue investment grade bonds at BBB, these bonds sat on a cliff-​edge as any subsequent downgrade would tip them into speculative grade (although it reported that CRAs appeared cautious as regards downgrading: at para 5.4.3). 91 The ESRB warned as to the financial stability implications of mass downgrades of BBB-​rated bonds (and the related loss of investment grade status), given that most of these bonds (a market valued at some €737 billion) were held by insurers and investment funds, and that large-​scale sales (on downgrades) could generate consequent liquidity and solvency risks in these sectors. It called for more systematic monitoring of over-​reliance on ratings and of the transparency of rating methodologies. ESRB, Letter to ESMA (Procyclical Impact of Downgrades of Corporate Bonds), October 2020. 92 ESMA eg earlier reported that it was monitoring the BBB rated segment to ensure that creditworthiness was being appropriately assessed given the risk of disruption associated with the speculative grade cliff-​edge: ESMA Supervision, Annual Report 2019 and Work Programme 2020 (2020) 15.

650  Rating Agencies Covid-​19 pandemic without major difficulties,93 reflecting the international experience.94 The persistence of over-​reliance and related procyclicality risks,95 concerns as to perceived excessive volatility in ratings,96 and the limited traction the rulebook has had in addressing market structure risks, underline, however, the challenges yet to be overcome from the deep embedding of ratings in the EU financial system.

VII.4  The CRA Rulebook: Legislation, Administrative Rules, and Soft Law The CCRAR, a product of the financial crisis and an early example of the EU’s financial-​crisis-​ era shift to more intrusive and more intensely harmonized regulation, is strongly regulatory in orientation: regulation, not the support of passporting, is its concern. Annex I to the CCRAR, which sets out detailed organizational, operational, and conduct requirements for CRAs, amplifies the Regulation in a manner similar to the administrative rules typically used to amplify legislative requirements elsewhere in the single rulebook. The CCRAR deploys a range of different regulatory tools, chief among them process-​based conflict-​of-​interest management requirements, although it also draws heavily on disclosure, with its ‘European Rating Platform’ (which hosts the ratings of EU CRAs for public access) an innovative infrastructure-​related reform (albeit that, in practice, it has not proved to be a success; section 10). The administrative regime amplifying the CCRAR is accordingly primarily operational in nature, rather than substantive, and in particular is designed to specify ESMA’s CCRAR powers. It has as a result been largely uncontroversial. The first sequence of administrative rules was adopted in 2012 and covers ESMA’s fining powers,97 ESMA’s powers to apply supervisory fees,98 how ESMA is to assess CRA compliance with the rules governing methodologies,99 and the information required from CRAs for the purposes of the ESMA registration/​authorization process.100 The subsequent 2015 sequence of administration rules covers the periodic disclosures required to be made by CRAs to ESMA for supervisory purposes and also for public dissemination through the European Rating Platform,101 and also the periodic reporting required to be made by CRAs to ESMA on the fees they charge.102 93 In its response to the ESRB letter (n 91), ESMA reported that CRAs had considered the impact of the pandemic on credit quality and that there was sufficient transparency relating to methodologies: ESMA, Letter to ESRB, 29 March 2021. 94 US SEC, Covid-​19 Monitoring Group, Statement on Credit Ratings, Procyclicality and related Financial Stability Issues, July 2020. Similarly, a review by IOSCO did not suggest systemic difficulties with the rating process: 2021 IOSCO Report, n 39. Sovereign debt ratings, eg, were observed to have, broadly, conveyed price relevant information: Tran Y, et al, ‘Sovereign Credit Ratings during the Covid-​19 Pandemic’ (2021) 78 Int Review of Financial Analysis 101879. 95 ESRB, Issues Note, May 2020, 8–​12. 96 In response to the ESRB’s concerns as to potential volatility in the BBB debt market (and the cliff-​edge effects were BBB securities to be downgraded and so to lose investment grade status), ESMA noted that the CCRAR did not require ‘through the cycle’ rating (or limited volatility in ratings) and that ratings could, accordingly, be based on a point in time and, thereby, be volatile but indicated a willingness to work with the Commission and the ESRB on ‘through the cycle’ ratings: 2021 ESMA Letter, n 93. 97 Delegated Regulation (EU) No 946/​2012 [2012] OJ L282/​23. 98 Delegated Regulation (EU) No 272/​2012 [2012] OJ L90/​6. 99 RTS 447/​2012 [2012] OJ L140/​14. 100 RTS 449/​2012 [2012] OJ L140/​32. 101 RTS 2015/​2 [2015] OJ L2/​24. This measure replaced RTS 446/​2012 [2012] OJ L140/​2 on periodic reporting to ESMA and RTS 448/​2012 [2012] OJ L140/​17 on public disclosures. 102 RTS 2015/​1 [2015] OJ L2/​1.

VII.5  Setting and Securing the Regulatory Perimeter  651 This legislative and administrative regime has been significantly thickened by the extensive soft law which ESMA has adopted as the EU supervisor of CRAs and which has a more substantive orientation than the CCRAR’s administrative rules. Alongside a wide-​ranging Q&A,103 ESMA has adopted several sets of Guidelines which form something of a soft ‘rulebook’ for CRAs, covering, in particular: the scope of the CCRAR (including as regards the CRA registration obligation, the issuance of ‘private ratings’ which fall outside the CCRAR, and enforcement);104 the submission of periodic information to ESMA;105 the validation and review of methodologies;106 the disclosure which must accompany ratings (including as regards ESG factors);107 and internal controls.108 CRAs are charged with making every effort to comply with these Guidelines,109 with compliance assessed through ESMA’s ongoing supervision and monitoring, which includes regular industry thematic review of Guideline compliance. While typically detailed, the Guidelines follow the design of the CCRAR in that they are designed to apply proportionately in light of the nature, scale, and complexity of the relevant CRA. The Guideline ‘rulebook’ is dynamic, being used by ESMA to address CRA deficiencies and to communicate its expectations, and so can be expected to expand as ESMA identifies weaknesses in compliance with the CCRAR or emerging areas of risk.110

VII.5  Setting and Securing the Regulatory Perimeter The CCRAR is an overtly regulatory measure: it ‘introduces a common regulatory approach’ in order to enhance the integrity, transparency, responsibility, good governance, and independence of ‘credit rating activities’,111 thereby contributing to the quality of credit ratings issued in the EU and to the smooth functioning of the internal market, while achieving a high level of consumer and investor protection (Article 1).112 It relatedly ‘lays down conditions for the issuing of credit ratings’ and rules on the organization and conduct of CRAs (including their shareholders and members), to promote their independence and the avoidance of conflicts of interest, and the enhancement of consumer and investor protection (Article 1). Article 1 also specifies, underlining the centrality of structured-​finance ratings to the CRA reform process originally, that it lays down obligations for issuers and

103 Initially adopted in 2013, the regularly updated Q&A now covers a wide range of issues from methodologies, to unsolicited ratings, to disclosure requirements, to rotation periods. 104 ESMA, Guidelines and Recommendations on the Scope of the CRA Regulation (2013). The Guidelines were revised in 2022 to clarify further the scope of the CCRAR as regards private ratings. 105 Originally adopted in 2015, a revised edition was adopted in 2019: ESMA, Guidelines on the Submission of Periodic Information (2019). 106 ESMA, Guidelines on the Validation and Review of Credit Rating Agencies Methodologies (2016). 107 ESMA, Guidelines on Disclosure Requirements Applicable to Credit Ratings (2020). 108 ESMA, Guidelines on Internal Controls for CRAs (2021). 109 Guidelines typically apply to NCAs, although in practice they impose obligations on regulated actors. The compliance obligation on regulated actors ultimately derives from Art 16(3) of the ESMA Regulation (Regulation (EU) No 1095/​2010 [2010] OJ L331/​84) which requires market participants to ‘make every effort’ to comply. 110 In 2021, eg, ESMA began to develop Guidelines covering initial or preliminary rating exercises, following its identification of weaknesses and inconsistencies in CRAs’ application of the relevant CCRAR requirements, and designed to address risks as to related ‘ratings shopping’: ESMA, Consultation on Disclosure Requirements for Initial Reviews and Preliminary Ratings (2021). 111 Defined as data and information analysis, and the evaluation, approval, issuing, and review of ratings: Art 3(1)(o). 112 The reference to independence was added by the CRA III reforms, which also removed a 2009 reference to reliability.

652  Rating Agencies related third parties established in the EU regarding ‘securitization instruments’.113 ESMA’s approach to enforcement indicates that a high standard of care is expected of CRAs in complying with the CCRAR’s requirements.114 The scope of the CCRAR is a function of Article 2(1) and Article 14(1) which together set a wide regulatory perimeter. Under Article 14(1), a ‘CRA’, broadly defined as a legal person whose occupation includes the issuing of ‘credit ratings’ on a professional basis (Article 3(1) (b)), must apply for registration under the CCRAR. Article 2(1) works alongside Article 14(1), providing that the CCRAR applies to credit ratings issued by115 CRAs registered in the EU,116 and which are disclosed publicly or distributed by subscription (Article 2(1)).117 The application of the CCRAR, and its registration requirement, to an entity potentially in scope as a CRA is accordingly dependent on the entity’s issuance of a ‘credit rating’. This pivotal definition is cast broadly, with a rating defined as an ‘opinion’ regarding the creditworthiness of an entity, a debt or financial obligation, a debt security, a preferred share, or another financial instrument,118 or of an issuer of such obligations or other instruments, using an established and defined ranking system or rating categories119 (Article 3(1)(a)).120 A series of fairly limited exclusions apply. Under Article 2(2), the Regulation does not apply to ‘private’ ratings, provided exclusively to the person requiring the rating and not intended for public disclosure or distribution by subscription.121 Neither does it apply to credit scores,122 credit scoring systems, or similar assessments relating to obligations arising from consumer, commercial, or industrial relationships. Ratings produced by export credit

113 This reference was originally cast in terms of ‘structured finance instruments’ but was since been aligned by the 2017 Securitization Regulation to refer to ‘securitization instruments’. A securitization instrument for the purposes of the CCRAR refers to a financial instrument or other asset resulting from a securitization transaction or scheme within the scope of the Securitization Regulation (see further Ch II section 12): Art 3(1)(l). 114 As has been referenced by the ESA Board of Appeal in its 2021 Decision Scope Ratings GmbH v ESMA, 28 December 2020 (Decision 2020-​D-​03) para 158, noting the ‘high standard of care’ expected. 115 A rating is ‘issued’ when it has been published on the CRA’s website or by other means or distributed by subscription and presented and disclosed in accordance with the Regulation’s Art 10 presentation regime: Art 4(2). Following the 2013 CRA III reforms, the regime which applies to ratings also generally applies to ‘ratings outlooks’ (defined as an opinion regarding the likely direction of a rating over the short and medium term). 116 On the third country regime see Ch X. 117 The Regulation also uses the concept of a ‘rated entity’ and, further, significantly extends the reach of the regime by bringing ‘related third parties’ (to rated entities) within the scope of the rules, where specified. A rated entity is the legal person whose creditworthiness is explicitly or implicitly rated in the rating, whether or not it has solicited the rating and whether or not it has provided related information (Art 3(1)(f)). Third parties related to the rated entity are defined as the originator, arranger, sponsor, servicer, or any other party that interacts with a CRA on behalf of a rated entity, including any person directly or indirectly linked to that rated entity by control: Art 3(1)(i). 118 The perimeter for financial instruments is set by reference to the 2014 MiFID II/​MiFIR definition (Art 3(1)(k)). See further Ch IV section 5.3. 119 A rating category is a rating symbol used in a rating to provide a relative measure of risk to distinguish the different risk characteristics of the types of rated entities, issuers, and financial instruments or other assets: Art 3(1)(h). 120 ESMA has suggested additionally that a rating must include sufficient qualitative analysis. A measure of creditworthiness derived from summarizing and expressing data based only on a pre-​set statistical system or model, without additional and substantial, qualitative, rating-​specific analytical input from a rating analyst, should not be considered a credit rating (it would likely be a credit score—​see n 122): 2013 ESMA Scope Guidelines, n 104, 5. 121 In ESMA’s interpretation, recipients of private ratings are allowed to share such ratings with a limited number of third parties and on a confidential basis (eg, a rated client might provide its rating to a bank when seeking debt finance): 2013 ESMA Scope Guidelines, n 104, 6. 122 Defined as a measure of creditworthiness derived from summarizing and expressing data, based only on a pre-​established statistical system or model, without substantial rating-​specific input from a rating analyst (Art 3(1)(y)).

VII.5  Setting and Securing the Regulatory Perimeter  653 agencies or (subject to conditions) central banks are also excluded.123 The Regulation also specifies that ‘recommendations’ and ‘investment research’ within the scope of relevant EU regulation are excluded, along with other forms of general ‘buy’, ‘sell’, ‘hold’ recommendations relating to financial instruments or obligations (Article 3(2)), but this does not preclude a rating which also takes the form of investment research or an investment recommendation coming within scope.124 The wide perimeter established by Article 2(1) and Article 14(1) is secured in a number of ways, including by means of the establishment device. The provision of ratings in the EU by a CRA requires registration (Article 2(1)/​Article 14(1)), which in turn requires physical presence in the EU, as registration is conditional on establishment (Article 14(1)). Physical presence in the EU protects the CCRAR’s regulatory perimeter by supporting ESMA’s supervisory activities. Reliance by EU CRAs on non-​EU branches125 for significant operational functions has, for example, been identified by ESMA as a potential threat to its supervisory effectiveness and as potentially triggering enforcement action.126 The security of the CCRAR perimeter is also supported by the ‘double-​lock’ which applies under Article 4(1). It requires that the single rulebook’s credit institutions, investment firms, insurance undertakings, assurance undertakings, reinsurance undertakings, UCITSs, institutions for occupational retirement provision, alternative investment funds, and central counterparties (CCPs) may use ratings for ‘regulatory purposes’127 only if they are issued by CRAs which are, first, established within the EU, and second, registered in accordance with the Regulation (Article 4(1)).128 These financial institutions are accordingly brought within the CCRAR regulatory perimeter as quasi-​enforcers of the regime. Similarly, prospectuses approved under the EU prospectus regime must include ‘clear and prominent’ information as to whether ratings referenced in the prospectus are issued by an EU-​registered CRA (Article 4(1)). The regulatory perimeter is further secured by the outsourcing regime, which requires that any outsourcing of ‘important operational functions’ must not be undertaken in such a way as to impair materially the quality of the CRA’s internal controls and the ability of ESMA to supervise the CRA (Article 9).129 ESMA has similarly suggested that important operational functions should not be carried out through non-​EU branches.130 ESMA’s approach to policing the CCRAR perimeter through supervisory action has developed in a manner that suggests an expansive and robust approach, as well as an ESMA 123 The central bank rating must not be paid for by the rated entity, not be disclosed to the public, be issued in accordance with the principles which govern the integrity and independence of CRAs under the Regulation, and not relate to financial instruments issued by the central bank’s Member State(s) (Art 2(2)). The Commission is empowered to adopt decisions specifying that a particular central bank’s ratings fall outside the scope of the Regulation (Art 2(4)) and has, to date, specified, following an application by France, that ratings issued by the Banque de France fall within the exemption: Commission Decision, 18 June 2010 ([2010] OJ L 154/​29). 124 See Ch II section 9 on investment research and investment recommendations. Where an investment recommendation or investment research can also be defined as a credit rating it has been interpreted by ESMA as coming within the scope of the CCRAR, as noted below as regards the Nordic Banks enforcement action. 125 Any rating issued by a non-​EU branch would be regarded as an EU rating for the purposes of the Regulation. 126 2013 ESMA Scope Guidelines, n 104, 6. 127 Meaning the use of ratings for the specific purpose of complying with EU law, as implemented by the Member States: Art 3(1)(g). 128 The CRA I Proposal had a broader reach, requiring investment firms and credit institutions not to execute orders for clients in relation to rated financial instruments, unless the rating was issued by a CRA registered in accordance with the Regulation: 2008 CRA I Proposal, n 68, Art 4. 129 Outsourcing is also addressed in ESMA’s 2021 Internal Control Guidelines which address ESMA’s expectations as to CRA oversight and due diligence: n 108, para 21. 130 2013 ESMA Scope Guidelines, n 104, 7.

654  Rating Agencies appetite for testing the limits of the CCRAR.131 Most controversially, in 2018 ESMA took enforcement action against five Nordic banks for their failure to register as CRAs under the CCRAR although they were issuing ratings within the scope of the CCRAR.132 ESMA (through its Board of Supervisors) found that the longstanding practice among certain Nordic banks of issuing ‘shadow ratings’ in their investment research reports, on small and medium-​sized enterprise (SME) issuers in particular, breached the CCRAR as the banks in question were not registered as CRAs.133 In reaching this finding (which over-​turned a practice common in the Nordic market and in SME investment research for some twenty years and which was contested by the banks in question),134 ESMA found that these ‘shadow ratings’ fell within the Article 3(1)(a) definition of a credit rating as they were opinions on the creditworthiness of issuers and instruments and, as also required by Article 3(1)(a), used an established and defined system of rating categories.135 ESMA’s consequent imposition of fines on four of the five banks implicated136 was over-​turned on the appeal by four of the five banks to the European Supervisory Authorities (ESA) Board of Appeal, which found that the breaches had not been committed negligently, as required for the imposition of a fine, but reflected longstanding practice and (albeit flawed) industry understanding of the operation of the CCRAR.137 The Board of Appeal upheld, however, ESMA’s findings that the ‘shadow ratings’ came within the scope of the CCRAR.138 The Nordic Banks case underlines the extent to which ESMA now shapes and polices the CCRAR perimeter and its appetite for related robust enforcement action, but it also illustrates the complexities associated with the EU’s current concern, under the CMU agenda, to promote SME market finance. The practice of issuing shadow ratings was in part designed to facilitate investment in SMEs which would otherwise have struggled, given the costs, to obtain credit ratings. The distinct challenges that SMEs face in attracting gatekeeper

131 ESMA’s annual reviews of CRA supervision underline the importance it attaches to policing the perimeter. Its 2018 report, eg, noted that to ensure a level playing field, ESMA regularly ‘performs perimeter assessments’ to identify market participants who may be in breach of the CCRAR, drawing on information from, inter alia, market participants, NCAs, and its internal assessments (including periodic internet ‘sweeps’): ESMA, ESMA’s Supervision—​2018 Annual Report and 2019 Work Programme (2019) 34. 132 For an example from the five enforcement Decisions, see Decision of the Board of Supervisors (BoS), 11 July 2018 (Nordea Bank AB). 133 The ‘shadow ratings’ (which were not paid for by the issuers) were included in what were variously termed credit/​creditworthiness research/​investment research reports; relied on symbols to quantify credit risk; and derived from methods similar to those used by CRAs. The Nordea shadow ratings, eg, were in use from 1999, were derived from an S&P scale, and were designed to respond to investors’ needs for investment research reports to include a view on credit risk: 2018 ESMA Nordea Decision, n 132, para 14. 134 The banks claimed, in essence, that the shadow ratings were not ratings, but took the form of investment research/​investment recommendations (regulated under MiFID II/​MiFIR and the market abuse regime), and so could not come within the scope of the CCRAR. The BoS found, however, that it was possible for such reports to come under the CCRAR and also the investment research/​recommendations regimes. 135 The BoS noted that the ratings did not need to be produced using the same methodologies deployed by registered CRAs, or produced in a particular way, and that issuer payment was not a condition precedent for a rating opinion to fall within the CCRAR: 2018 ESMA Nordea Decision, n 132, paras 21–​2. 136 All five banks were fined €495,000 and subject to a public notice of sanction. 137 Svenska Handelsbanken AB, Skandinaviska Enskilda Banken AB, Swedbank AB, and Nordea Bank AB v ESMA 27 February 2019 (BoA Decision 2019 01-​04) (the Nordic Banks Decision). The original 2018 Decisions were remitted to ESMA which subsequently disapplied the relevant fines but retained the public notice element of the sanction. A fine of €495,000 was imposed, however, on Danske Bank, which alone of the five banks involved had not joined the appeal to the Board of Appeal. 138 The Decision also affirmed the finding by the BoS that a credit opinion could take the form of an investment recommendation and also come within the scope of the CCRAR, as long as it fell within the Art 3 definition of a credit rating.

VII.7  The Registration Process  655 support have also been brought into sharp relief by the EU’s recent experience with SME investment research (Chapter II section 9).

VII.6  Differentiation and Calibration Threaded across the CCRAR is a concern to tailor the regime to smaller CRAs and thereby to support competition in the CRA market. A proportionality calibration is available for smaller CRAs (Article 6; see section 8) and a specific exemption is available for smaller CRAs as regards the validation of methodologies (section 9). The administrative rulebook is also calibrated to manage the costs of registration for smaller CRAs,139 as are ESMA’s Guidelines.140

VII.7  The Registration Process The mandatory registration process for in-​scope CRAs (set out in Articles 14–​20) is operated by ESMA. ESMA must register the CRA if it concludes that the CRA’s application meets the requirements imposed under the Regulation (Article 14(4)). Once a CRA has been registered by ESMA, that registration is effective for the EU, and the CRA must comply at all times with its registration conditions (Article 14(2) and (3)). The CCRAR registration procedure is, very broadly, similar to the authorization procedures which apply to financial market actors across EU financial markets regulation, but it is subject to a much higher degree of legislative articulation, given the need to provide ESMA with a procedural framework for carrying out registration processes. The intensity of the CCRAR’s procedural specification also reflects the constraints imposed by the Meroni ruling,141 which are also implicit in the general direction to ESMA that it not impose registration requirements additional to those of the CCRAR on CRAs (Article 14(5)). The CCRAR accordingly addresses the time frames within which ESMA must operate, the treatment of group applications, the language to be used, the nature of the examination of the application to be carried out by ESMA (ESMA must assess whether the application complies with the Regulation), the communication of registration decisions—​whether to register, to reject the application, or to withdraw a registration142 (ESMA must also 139 eg, under the 2012 Supervisory Fees Delegated Regulation (n 98) supervisory fees are calibrated to the size and complexity of the CRA and small CRAs (total revenues of less than €10 million annually) are currently fully exempt from supervisory fees (Art 5). ESMA has recommended that this exemption be reduced to annual turnover of under €4 million, given that in practice only a small number of the CRAs it supervises generate revenues in excess of €10 million. To achieve proportionality, ESMA has proposed an alleviated fee regime for firms of turnover between €4 and €15 million: ESMA, Technical Advice on the Fees Charged by ESMA (2021). 140 eg, the 2015 Periodic Reporting Guidelines (and reflecting the 2015 Periodic Reporting RTS (n 101)), require a higher frequency of supervisory reporting for ‘Category 2’ CRAs, or those who are assessed by ESMA as requiring higher levels of supervisory engagement given, inter alia, their size, complexity, and level of market penetration. The reporting frequency was originally tied to turnover but was finessed in 2019 to refer to the level of supervisory engagement in order to ensure the supervisory reporting regime was more responsive to CRAs’ business models and to ESMA’s supervisory needs. CRAs are individually advised as to which reporting category applies. Similarly, the 2021 Internal Control Guidelines are designed to apply proportionately and to reflect the nature, scale, and complexity of different CRAs. 141 See n 76. 142 Including to EBA, EIOPA, the NCAs, and the Commission.

656  Rating Agencies maintain a related list of registered CRAs)—​and the conditions governing the withdrawal of registration143 (Articles 15–​20). Similarly, the registration (and supervisory) fees which ESMA must charge (Article 19(1)), and which are designed to cover ESMA’s necessary expenditures relating to CRA registration and supervision, are governed by 2012 Delegated Regulation on Supervisory Fees.144 The information which CRAs must provide to ESMA in the registration application are likewise prescribed in some detail in the Regulation’s Annex II and in the 2012 Delegated Regulation on CRA Registration.145

VII.8  Conflict-​of-​interest Management and Organizational Requirements The CCRAR can reasonably be characterized as an operationally intrusive measure146 which has at its core conflict-​of-​interest management. Article 6(1) imposes a far-​reaching, catch-​all obligation on CRAs to take all necessary steps to ensure that the issuing of a rating (or rating outlook) is not affected by any existing or potential conflicts of interest or business relationship involving the CRA, but also its shareholders, managers, rating analysts,147 employees, or any other natural person whose services are placed at the disposal or under the control of the CRA, or any person directly or indirectly linked to it by control.148 A related business structure rule was added by CRA III which provides that a 5 per cent shareholder in a CRA is prohibited from holding 5 per cent or more of the capital of another CRA (Article 6a);149 the restriction does not apply to group-​wide holdings.150 Supporting Articles 6(1) and 6a, CRAs are also to maintain an effective internal control structure governing the implementation of conflict-​of-​interest risk management policies and to ensure independence (Article 6(4)).151 The operative detail of these core obligations is largely contained in the detailed Annex I to the Regulation (sections A and B) which addresses organizational (section A) and operational (section B) requirements. Following a fairly standard template for addressing conflicts of interest through senior management and organizational controls, section A requires that senior management152 must ensure the sound and prudent management of the 143 ESMA must withdraw registration where a CRA expressly renounces its registration or has provided no ratings in the previous six months; has obtained the registration through false statements or other irregular means; or no longer meets the condition under which it was registered. 144 The Regulation is currently under review: see n 139. 145 Including with respect to ownership, organization, governance, financial resources, staffing, outsourcing, conflicts of interest, and methodologies. 146 In its first report on CRA supervision, ESMA reported that EU CRAs had to carry out significant change to their organizational structures and procedures to meet the new regulatory requirements: ESMA, Annual Report on the Application of the CRA Regulation (2012) 4. 147 A person who performs analytical functions that are necessary for the issuing of a rating: Art 3(1)(d). 148 As is usual across EU financial markets regulation, control is defined in terms of the relationship between a parent and subsidiary undertaking or as a close link between any natural or legal person and an undertaking: Art 3(1)(j). 149 The 5 per cent threshold reflects the 5 per cent threshold for ownership reporting under the EU’s major holdings notification regime (Ch II section 5.8). 150 The ownership restriction (which does not apply to holdings through diversified collective investment schemes) extends to related control relationships, including having the right to appoint or remove members of the administrative, management, or supervisory board of another CRA. 151 CRAs are also to establish ‘standard operating procedures’ concerning corporate governance, organization, and conflict of interest management. 152 Defined as the person(s) who effectively direct the business of the CRA as well as the members of its administrative or supervisory board (Art 3(1)(n)).

VII. 8  Conflict-of-Interest Management  657 CRA, that rating activities are independent, that conflicts of interest are properly identified, managed, and disclosed, and that the CRA complies with the Regulation. CRAs are also subject under section A to the high-​level organizational requirement that they be organized in such a way that ensures their business interests do not impair the independence or accuracy of rating activities. Board oversight is also addressed: the CRA must establish an administrative or supervisory board, with sufficient expertise.153 The independent members154 of the board are tasked in particular with monitoring rating policies and methodologies, internal quality control and conflict-​of-​interest management systems, and compliance and governance processes. A number of internal control requirements also apply under section A which, while addressing internal controls generally,155 are also directed to securing CRA independence and the avoidance of conflicts of interest. These include obligations to establish: adequate policies and procedures to ensure compliance with the Regulation; sound administrative and accounting procedures, internal control mechanisms, and risk management procedures; conflict-​of-​interest risk management procedures;156 continuity arrangements; and an independent review function, responsible for periodically reviewing methodologies, models, and key assumptions. CRAs must also establish an independent compliance function157 to assess the adequacy and effectiveness of procedures and processes, and to advise rating analysts and other relevant persons. Section B, which was heavily revised by CRA III to address conflicts of interest arising from ownership structures, focuses on operational conflict-​of-​interest management. It requires a CRA to identify, eliminate, or manage and disclose (clearly and prominently) any actual or potential conflicts of interest that may influence the analyses and judgements of its managers, rating analysts, employees, or other natural persons whose services are placed at the disposal or under the control of the CRA, and who are directly involved in the issuing of ratings or ratings outlooks. Related operational requirements include: disclosure by the CRA of all ‘rated entities’ or ‘related third parties’158 from which it receives more than 5 per cent of its annual revenue; a prohibition on rating entities in specified (typically control or ownership-​related) circumstances (or a requirement for disclosure of the related conflict); fee requirements designed to alleviate conflict-​of-​interest risk;159 a prohibition 153 The majority of members (including the independent members) must have sufficient expertise in financial services and, where the CRA issues ratings related to securitization instruments, at least one independent and one other member of the board must have in-​depth knowledge and experience at a senior level of the markets in these instruments. 154 At least one third, but not less than two, of the members of the board must be ‘independent members who are not involved in credit rating activities’. The remuneration of independent members is subject to requirements designed to enhance board member independence, while independent board members are also supported by controls on when dismissal can occur, as well as by fixed-​term arrangements. 155 CRAs will also, as regards their internal controls, be subject to the DORA regime. The Digital Operational Resilience Act (DORA) addresses the security of financial firms’ network and information systems and the ability of financial firms to withstand threats and disruptions and covers CRAs alongside a host of regulated financial institutions. Provisional agreement on DORA was reached in May 2022 (the Commission Proposal is at COM(2020) 595). See in outline Ch I section 7. 3. 156 Designed to prevent, identify, eliminate, manage, and disclose conflicts of interest. 157 A series of requirements apply to reinforce the compliance function, including with respect to resources and authority, a dedicated compliance officer being in place, remuneration arrangements (which must be independent of the CRA’s business performance), and the independence of compliance persons from the CRA activities which they monitor. 158 See n 117. 159 Under Annex I section B, fees must be non-​discriminatory, based on actual costs, and not depend on the level of the rating. Delegated Regulation 2015/​1 governs the fee-​related disclosures which must be reported by CRAs to ESMA.

658  Rating Agencies on providing consultancy or advisory services to rated entities or related third parties;160 a prohibition on rating analysts making proposals or recommendations regarding the design of securitization instruments on which the CRA is expected to issue a rating; and the establishment of adequate related record-​keeping and audit procedures. Section B also addresses the ‘ancillary services’ the fee income from which can drive conflicts of interests in the rating process, characterizing them as services which do not form part of credit rating activities and which comprise market forecasts, economic trend forecasts, pricing and general data analysis, and related distribution services. The provision of such ancillary services is not prohibited under the CCRAR or specifically regulated, save for the section B requirement that they must not present a conflict of interest with rating activities, and that their provision must be disclosed in the rating report on the rated entity. While ancillary services were originally associated with the financial-​crisis era (in the form of services relating to securitized instruments), they have recently drawn renewed regulatory attention following the burgeoning of the market for ‘green ratings’ or similar services relating to sustainable finance, and doubts as to whether the current regulatory system, including the CCRAR, is capturing its risks adequately (section 16). Procedural requirements of such operational granularity, while designed to provide an internal bulwark against conflict-​of-​interest risk, can be costly for smaller CRAs. They pose a conundrum accordingly given the CCRAR’s concern to promote competition in the CRA market. This conundrum is in part addressed by the proportionality mechanism which allows ESMA to exempt a CRA from certain of these requirements if the CRA can demonstrate that they are not proportionate in view of the nature, scale, and complexity of its business and the nature and range of its issue of credit ratings (Article 6(3)).161 The relatively limited exemption is further confined in that it can only apply where the CRA has less than 50 employees, the CRA has implemented measures and procedures which ensure effective compliance with the Regulation’s objectives, and an anti-​avoidance requirement is met in that the size of the CRA is not determined in such a way as to avoid compliance by the CRA (or a group162 of CRAs).163 The Article 6 regime is cascaded to the employee/​analyst level by Article 7, which imposes a range of requirements on analysts, employees, and similar persons, including conflict-​of-​interest requirements. The CRA must ensure that rating analysts, employees, and any other relevant natural persons164 have appropriate knowledge and expertise for the duties assigned (Article 7(1)). These persons are prevented from engaging in fee negotiations with rated entities;165 are subject to ‘an appropriate gradual rotation mechanism’; and compensation and performance evaluation must not be contingent on the revenues received by the CRA from rated entities or related third parties (Article 7(1), (4), and (5)). These persons are also subject to the detailed operational requirements set out in section C 160 The prohibition applies to consultancy or advisory services regarding the rated entity’s (or related third party’s) corporate or legal structure, assets, liabilities, or activities. 161 The exemption regime applies to Annex I, section A (senior management and board requirements; and the independent compliance function) and the Art 7(4) requirement relating to rotation (noted below). 162 ‘Group’ is defined by reference to the EU’s accounting regime (2013 Accounting Directive 2013/​34/​EU [2013] OJ L182/​19) and relates to parent/​subsidiary structures as well as related control structures. 163 Where the CRA forms part of a group of CRAs, ESMA must ensure that at least one of the CRAs within the group is not exempted under Art 6(3). 164 Whose, in the formula used across the Regulation, ‘services are placed at its disposal or under its control and who are directly involved in credit rating activities’. 165 And with related third parties or persons directly or indirectly linked to the rated entity through control.

VII.9 Methodologies  659 of Annex I. These include: a multi-​layered and wide-​ranging prohibition on activities which may generate conflict-​of-​interest risks, particularly, but not exclusively, with respect to any investments held by such persons; requirements relating to appropriate record-​keeping and professional secrecy obligations; a prohibition on accepting gifts; a whistle-​blowing obligation; and rotation requirements in support of the Article 7(4) rotation requirement.166 The granularity of the Articles 6/​6a/​7 and Annex I requirements, which were amplified by ESMA’s detailed 2021 Internal Control Guidelines, underlines the centrality of conflict-​ of-​interest avoidance and management to the CCRAR, a priority also reflected in ESMA’s supervisory and related enforcement activities.167

VII.9 Methodologies A core objective of the CCRAR is to secure the quality of ratings by addressing CRAs’ methodologies.168 Regulatory tools are not, however, straightforward to design or apply in this area. Methodologies are proprietary to CRAs and hard-​wired into their business models. Regulatory incursions into the design of these methodologies would therefore not only generate significant moral hazard risk and risk de-​stabilizing the independence on which the gatekeeper model is predicated, but would also risk disrupting longstanding business models. Reflecting the sensitivities, ESMA, the Commission, and any relevant Member State authorities are all prohibited from interfering in the content of methodologies (and of ratings) (Article 23). Nonetheless, the rules governing methodologies are among the most intrusive and granular in the CCRAR, taking the form of disclosure-​based but also substantive/​procedural requirements which are supported by ESMA soft law and supervisory engagement. The least intrusive requirements relate to disclosure. A general disclosure obligation applies under Article 8(1) which requires CRAs to disclose to the public the methodologies, models, and key ratings assumptions used in rating activities.169As outlined in section 10, disclosures on specific ratings, including related historical performance data (which evidences the operation in practice of methodologies), are also required. Beyond disclosure, a series of operational requirements, of varying intrusiveness, apply. An over-​arching due diligence obligation requires that where the lack of reliable data, the complexity of an instrument’s structure, or the quality of the relevant information is not satisfactory, or raises serious questions as to whether the CRA can provide a reliable rating, 166 eg, ‘lead rating analysts’ (the persons with primary responsibility for elaborating a rating, or for communicating with the relevant issuer generally, and for preparing rating committee recommendations, as relevant (Art 3(1)(e)), must not be involved in rating activities related to the same rated entity (or related third party) for a period exceeding four years. 167 2019 saw ESMA impose its largest fine to date, and as regards the conflict-​of-​interest rules. ESMA imposed a fine of €5.13 million (in total) on three Fitch entities for breaches of the shareholder-​related conflict-​of-​interest rules. Similar enforcement action followed in 2021 against Moody’s, also for breach of the shareholder-​related conflict-​of-​interest rules and involving the imposition of a fine of €3.7 million (in total) on five Moody’s entities. 168 ESMA has repeatedly emphasized the importance of CRA methodologies to the rating process. eg: ‘Methodologies are at the heart of the rating process and need to ensure the consistency and quality of credit ratings issued by CRAs. ESMA expects that methodologies guide the analytical judgment to ensure that the analysts’ assessment is consistent and complete’ (ESMA’s Supervision of Credit Rating Agencies, Trade Repositories, and Monitoring of Third Country Central Counterparties. 2017 Annual Report and 2018 Work Programme (2018) 33). 169 These disclosures are specified in Annex I, section E, part I.

660  Rating Agencies the CRA should refrain from rating or withdraw an existing rating.170 More procedurally, Article 8(2) requires CRAs to adopt, implement, and enforce adequate measures to ensure that ratings and ratings outlooks are based on a thorough analysis of all the information that is available to the CRA and that is relevant to the analysis.171 At the core of the methodology regime, however, is the more intrusive requirement that ratings methodologies must be rigorous, systematic, continuous, and subject to validation based on historical experience, including back-​testing172 (Article 8(3)).173 Article 8(3) operates in tandem with the internal ratings review function required of CRAs under Article 6, which supports the internal validation and oversight of methodologies (specified in Annex I section A). It also operates in tandem with Article 8(5) which provides that CRAs must monitor ratings and review ratings and methodologies on an ongoing basis and at least annually, particularly where material changes occur which could impact a rating.174 That ESMA is to supervise compliance with Article 8(3) is, unusually, expressly mandated by Article 22a.175 As ESMA is charged generally with oversight of the CCRAR, this privileging of Article 8(3) underlines the importance of this aspect of ESMA’s supervisory mandate over CRAs, notwithstanding the sensitivities associated with the supervision of methodologies. The delicate balance the methodologies regime must achieve between ensuring adequate oversight is secured, but inappropriate intrusion into commercial decisions avoided, is clear from the amplifying 2012 Methodologies RTS.176 It specifies how ESMA is to exercise its Article 8(3) supervisory powers; this specification is in part to ensure transparency and industry understanding of the methodologies regime, but in part also to delineate and limit ESMA’s sphere of operation. The RTS requires ESMA to apply an appropriate level of assessment—​determined, inter alia, by whether the CRA has a demonstrable history of consistency and accuracy177—​and establishes a series of benchmarks against which ESMA is to assess whether methodologies are rigorous, systematic, continuous, and subject to validation.178 It also addresses CRAs, requiring them to provide quantitative evidence of the discriminatory power of any methodology used and to, inter alia, assess the historical robustness and predictive power of the related ratings (over appropriate horizons and different asset classes) and the degree to which the assumptions used deviate from actual default and loss rates.179 In response to the empirical challenges that methodology review can generate, the Methodologies RTS includes an exemption from the back-​testing assessment where 170 Annex II, section D, para 4. 171 The CRA must adopt all necessary measures such that the information used is of sufficient quality and from reliable sources: Art 8(2). 172 ESMA is expressly injuncted to verify the execution of back-​testing, analyze the results of such testing, and verify that CRAs have processes to take into account the results in their methodologies: Art 22a(2). 173 At the time of its adoption, the view was expressed by an industry stakeholder that Art 8(3) ‘is one of the most important requirements [in the CRA Regulation] . . . as the methodologies and criteria that underline each . . . rating are among the most essential aspects of a rating decision’: ESMA Feedback Statement/​2011/​464 (on ESMA’s draft RTS for what would become the 2012 Methodologies RTS) 6. 174 Related internal arrangements must be in place to monitor the impact of macroeconomic change or financial market conditions on ratings. 175 ESMA is to ‘examine regularly’ compliance with Art 8(3) and is subject to specific obligations as regards back-​testing (n 172). 176 n 99. 177 2012 Methodologies RTS Art 3(3). 178 The ‘rigour’ assessment, eg, is based on the methodology being, inter alia, based on clear and robust controls which allow for suitable challenge, incorporating all driving factors relevant to the rating, and incorporating reliable, relevant, and quality-​related analytical models: 2012 Methodologies RTS Art 4. 179 2012 Methodologies RTS Art 7.

VII.9 Methodologies  661 only limited quantitative evidence is available to support the predictive power of a methodology, as long as the CRA can demonstrate that the methodology in question is robust.180 The RTS is supported by ESMA’s 2016 Guidelines on the validation of methodologies which are designed to clarify how CRAs should validate and review their methodologies, and to ensure the consistent application of validation and review measures.181 Reflecting the priority ESMA has attached to methodology validation and review, and underlining its appetite for granular supervision in what is a sensitive area, the Guidelines were designed to establish minimum standards in what ESMA has described as a ‘significant area’ of the Regulation where there were significant divergences in market practices.182 One of ESMA’s most significant interventions in the CRA area,183 the Guidelines address the quantitative measures used by CRAs to demonstrate and assess the discriminatory and predictive power of methodologies and their historical robustness, on initial validation and on subsequent review. While intrusive, the Guidelines are also designed to be proportionate184 and to reflect the empirical challenges that methodology validation can generate for CRAs, particularly where quantitative evidence is limited, and for new methodologies in particular.185 Firm-​specific and thematic review of CRA application of the Guidelines has followed, as has related enforcement action,186 although ESMA has reported significant progress in compliance with the Guidelines.187 Specific procedures govern changes to existing methodologies or the adoption of new methodologies.188 Where the CRA intends to make a material change to, or use, new methodologies, models, or assumptions that could have an impact on a rating, it must publish the proposed change for comment (Article 8(5a)) and notify ESMA of the proposed changes or any changes made after the consultation (Article 14(3)). The results of the consultation, and the new methodologies (and a related detailed explanation), must be published on the CRA’s website and notified to ESMA (Article 8(6)).189 ESMA was initially charged with reviewing

180 2012 Methodologies RTS Art 8. 181 2016 Methodologies Guidelines, n 106. 182 2018 ESMA Work Programme, n 168, 32. 183 The Guidelines are operationally oriented, highly detailed, and identify the measures that ESMA ‘typically expects’ a CRA to use. Their adoption accordingly generated some industry anxiety that the Guidelines would lead to the imposition of de facto standard measures, a concern ESMA sought to address by basing the Guidelines on industry best practice and allowing CRAs flexibility in choosing the measures that best suited their situation: Final Report on the 2016 Methodologies Validation and Review Guidelines (2016) 9–​10. 184 They clarify what ESMA ‘typically expects’ as to how the relevant CCRAR requirements for CRAs’ methodologies are to be met, but allow CRAs to document their rationale for not using the measures which ESMA typically expects. The Guidelines also emphasize ESMA’s support of expert judgement within firms, the basis of the Guidelines in industry good practice, and ESMA’s concern not to interfere with the content of ratings or firms’ ratings philosophies. 185 The Guidelines set out the specific measures to be adopted in validating methodologies with limited quantitative evidence, including as regards the use of data enhancement techniques: at para 5.2. 186 In 2020, ESMA imposed a fine on Scope Ratings for its failure to apply the methodology it had adopted for covered bond ratings in a systematic way (it had failed to analyze the relevant ‘cover pool’ (the securities backing the issuance) for a series of covered bond ratings, although its methodology for rating covered bonds had required the relevant pool to be analyzed for each covered bond security rated): Decision of the BoS 2020/​1, 28 May 2020. Scope Ratings contested ESMA’s interpretation of ‘systematic’, arguing that only the initial design of a methodology was required to be systematic not the subsequent application (and particularly as the analysis of the cover pool in each case would not have changed the rating). The Decision and ESMA’s interpretation of ‘systematic’ was upheld by the Board of Appeal (n 114). 187 n 131, 40. 188 Notification procedures (including ESMA notification) also apply where CRAs become aware of methodological errors: Art 8(7). 189 The affected ratings must also be reviewed as soon as possible.

662  Rating Agencies and approving changes to methodologies under the CRA III Proposal, but a notification requirement was imposed instead, reflecting concern as to the risk of ESMA interfering with the content of methodologies, in contravention of Article 23.

VII.10  Disclosure and Supervisory Reporting The CCRAR is strongly characterized by its imposition on CRAs of operational and process-​ based requirements which, particularly with respect to methodologies, allow ESMA to drill deeply into CRA operations. Nonetheless, disclosure-​related requirements, and thereby market discipline, are central features of the CCRAR. A series of requirements apply to the publication and presentation by CRAs of their ratings and ratings outlooks. CRAs must disclose ratings and ratings outlooks, as well as decisions to discontinue ratings, on a non-​selective basis and in a timely manner (Article 10(1)),190 and also comply with the detailed presentation requirements which apply to the publication of ratings (through Article 10(2)) under section D of Annex I.191 It requires, inter alia, the disclosure of: all substantially material sources; the principal methodology used; the meaning of each rating; the date of the rating’s release (and updating); whether the rating represents the first time the CRA has rated the instrument in question; guidance relating to the assumptions and methodologies used; and any attributes or limitations of the rating or outlook, whether it considers the quality of the information on the rated entity satisfactory, and the extent to which it has verified information provided to it by the rated entity (or related third party). Annex I section D also requires that the press release accompanying the rating explain the key elements underlying the rating. ESMA has amplified the disclosures required, notably as regards the content of the accompanying press releases.192 Unsolicited ratings, which raise distinct risks given the difficulties the CRA may have in ensuring it has sufficient data to ground the rating, as well as potential conflict-​of-​interest risks where such ratings may be used to develop and solicit business, are subject to specific presentation requirements.193 CRA ratings are also the subject of three forms of supervisory reporting obligation. CRAs must, when issuing a rating, submit specified disclosures on the rating (including related press releases) to ESMA for publication in the publicly accessible European Rating Platform (ERP) which, launched in 2015 and required under the CRA III reforms, acts a free-​access repository of the individual ratings issued by CRAs (Article 11a). The ERP hosts the ratings issued as well as the accompanying press releases. One of the more innovative features of the CCRAR, and designed to facilitate wider access to ratings, it has proved troublesome in practice. ESMA has reported that a lack of machine-​readability has limited its utility, as have doubts relating to the extent to which third parties can rely on ratings disclosed in the ERP for regulatory purposes without a license to use such ratings from the CRA in

190 This requirement also applies to ratings distributed by subscription. 191 The section D regime is subject to a proportionality filter in that where the relevant disclosures would be disproportionate in relation to the rating report, the report can ‘signpost’ the reader to where the relevant disclosures are directly and easily accessible, including on the CRA’s website. 192 2020 Guidelines on Ratings Disclosure (n 107). 193 Including that the CRA’s policy in relation to these ratings be disclosed and that where a rating is unsolicited, this (and the extent of the rated entity’s involvement) is stated prominently in the rating (Art 10(4) and (5)).

VII.11 Discrete Regulation and the Financial Crisis  663 question; and called for its obligation to maintain the ERP to be removed.194 Supervisory reports are also required from CRAs on the historical performance of ratings which are made available through the ‘CEREP’ database (Articles 11(2)). Finally, CRAs provide a series of confidential supervisory reports on ratings to ESMA.195 Ratings aside, CRAs are subject to a range of public and supervisory reporting requirements relating to governance, organizational, and operational matters. Under Article 11(1), a CRA must fully disclose to the public the information specified in Part I of section E of Annex I which covers, inter alia, any actual or potential conflicts of interests; the ancillary services it provides; its policy on the publication of ratings; its compensation arrangements; the methodologies used and any material changes to them; and any material modification to its systems, resources, or procedures. A related Transparency Report must be published annually by CRAs, covering, inter alia, the CRA’s legal and ownership structure, internal control mechanisms, staffing information, record-​keeping, the annual review by the compliance function, rotation policy, revenue information, the split between rating and non-​ rating activities, and governance disclosures (Article 12).196 In addition, CRAs are required to provide extensive periodic supervisory reports to ESMA, designed to support ESMA’s supervision, the content and reporting schedule for which are amplified in the 2015 Periodic Reporting Guidelines.197 While much of the periodic supervisory reporting regime accordingly takes the form of ESMA soft law, the CCRAR also addresses periodic supervisory reporting, requiring that CRAs report annually to ESMA on revenues, growth in revenues, and pricing policy (as specified by the 2015 CRA Fees RTS) (Article 11(3)).198 This reporting obligation forms part of the CCRAR’s conflict-​ of-​interest-​management framework, supporting ESMA’s supervision of the conflict-​of-​ interest management requirement that fees must not be discriminatory and must be based on actual costs.199

VII.11  Discrete Regulation and the Financial Crisis: Sovereign Debt Ratings and Securitization Instruments VII.11.1  Sovereign Debt Ratings The turbulence in the euro-​area sovereign debt market over the financial-​crisis era left a mark on the CCRAR.200 While doubts as to the effectiveness of CRAs’ sovereign debt 194 ESMA, Opinion on Improving Access to and Use of Credit Ratings in the EU (2021). 195 Under the 2015 Periodic Reporting RTS (n 101), a detailed but integrated regime governs the data which must be provided on ratings for public disclosure purposes (through the ERP) and to ESMA for supervisory purposes and how this data is classified and reported. 196 The disclosures are set out in Annex I, section E, part I. 197 Revised in 2019, the Guidelines set out the content of the reports required (including in relation to, eg, financial resources, staffing, complaints, corporate governance documents, and compliance, internal audit, and risk management work plans) and the related reporting schedule (whether quarterly, semi-​annually, bi-​annually or an on ad hoc basis). 198 The Art 11(3) requirements are set out in Annex I, section E, part II and cover fees charged to each client, pricing policy, clients who make a material contribution to the growth of the CRA in a given year, and a list of all ratings issued that year. 199 As required by Annex I, section B. 200 The prevailing political environment was reflected in the 2011 CRA III Proposal IA which suggested that unexpected downgrades had led issuers, investors, and regulators to question the consistency, rationale, and

664  Rating Agencies rating processes were raised internationally,201 these processes drew close policy and political attention in the euro area, reflecting concerns as to, inter alia, perceived CRA failures to reflect the array of euro-​area support measures adopted over the financial crisis202 and the high-​profile downgrading by CRAs of the European Financial Stability Mechanism in early 2012.203 A distinct but limited regime for sovereign ratings,204 designed to improve the transparency and quality of these ratings, followed under the CRA III reforms (Articles 8(5) and 8a). The rules require that the release of sovereign debt ratings must follow a pre-​set calendar, set a year in advance (Article 8a(3) and (4)), and that ratings must be reviewed every six months (Article 8(5)). Sovereign ratings must also be accompanied by a research report which explains the related assumptions and methodologies.205 General group ratings of sovereigns are prohibited, unless accompanied by specific sovereign research reports (Article 8a(1)). These requirements are significantly less radical, and more attuned to the conflict-​of-​ interest risks inherent in the Member States’ imposing a specific regime on the rating of sovereign debt risk, than the range of options canvassed earlier during CRA III’s development. The Commission’s CRA III Proposal Impact Assessment, for example, assessed options ranging from conferring on ESMA the ability to restrict or ban temporarily sovereign debt ratings, to conferring the rating of sovereign debt on the ECB, the Commission, or the European Stability Mechanism, to prohibiting the issuance of sovereign debt ratings.206 But the airing of these options at the time was in practice more an illustration of the depth of political anger as to the impact of rating downgrades on euro-​area stability than an insight into the Commission’s ambitions for the structure of the EU sovereign debt rating market. In practice, the requirements for sovereign debt ratings have proved largely uncontroversial. Certainly, ESMA has shown little signs of wariness in taking enforcement action for CCRAR breaches relating to sovereign debt ratings.207

transparency of sovereign ratings, and which noted concern as to arbitrariness and subjective bias in sovereign ratings as well as the risk of CRAs using sovereign rating downgrades as a means of rebuilding their reputational capital (n 83, 7 and 15). 201 eg IMF, Global Financial Stability Report, October 2010. 202 eg de Santis, R, the Euro Area Sovereign Debt Crisis. Safe Havens, Credit Rating Agencies, and the Spread of the Fever from Greece, Ireland and Portugal, ECB Working Paper No 1419 (2012). The downgrades by Standard & Poor’s of Greece on 29 March 2011 and of Italy on 21 May 2011, in particular, generated vocal political complaints about the accuracy and timeliness of the downgrades (2011 CRA III Proposal IA, n 83, 16) and prompted a press release from EU Commissioners Barnier (single market) and Rehn (economic policy), expressing confidence in the fiscal adjustments being achieved by Greece and signalling that CRA regulation would be extended. 203 Chaffin, J and Peel, Q, ‘Eurozone Bail-​out Fund Hit by Downgrade’, Financial Times, 17 January 2012. 204 Defined as ratings where the entity rated is a State (or its local or regional authorities), the issuer of the debt security is a State or regional/​local authority or special purpose vehicle for these entities, or the issuer is an international financial institution established by one or more States and designed to provide financial assistance to members: Art 3(1)(v). 205 The details of the report are out in Annex I, section D, part III. 206 2011 CRA III Proposal IA, n 83, 34–​9. 207 ESMA’s first enforcement action under the CCRAR concerned organizational failures which led to Standard & Poor’s erroneously issuing a false downgrade alert regarding France: Decision of the BoS, 20 May 2014. While the enforcement action related to general CCRAR organizational requirements and not the sovereign-​debt​specific rules, it suggested that ESMA would not be slow in addressing breaches of the sovereign-​debt-​related rules.

VII.12 Over-reliance  665

VII.11.2  Securitization Instruments The influence of the financial crisis on the CCRAR is also clear from its distinct treatment of ‘securitization instruments’.208 While these instruments were initially addressed by CRA I, the requirements were strengthened by CRA III. Given the potential complexity of these instruments, specific expertise requirements apply to CRAs’ senior management.209 Also, and to mitigate against competence and also conflict-​of-​interest risk, two ratings, each from different CRAs, are required for such instruments (Article 8c; introduced by CRA III).210 Specific ratings disclosure requirements, focusing on the nature of the review carried out by the CRA, also apply.211 In addition, the CRA must not, where it is using an existing rating from another CRA with respect to underlying assets or securitization instruments, refuse to issue a rating of an entity or a financial instrument because a portion of the entity or instruments had been rated previously by another CRA (Article 8(4)). The CRA must also record whenever it departs from existing ratings provided by another CRA with respect to underlying assets or securitization instruments, providing a justification (Article 8(4)). Specific presentation requirements also apply. Given the difficulties caused by use of the ‘AAA’ rating (usually associated with the highest-​grade corporate debt) for asset-​backed instruments over the financial crisis, securitization-​related ratings must be clearly differentiated, using an additional symbol that differentiates the securitization rating category from those rating categories used for other entities, instruments, or obligations (Article 10(3)).

VII.12  Over-​reliance The CCRAR also includes requirements designed to reduce over-​reliance on ratings, introduced by CRA III.212 The first set of requirements (Article 5a) target internal credit risk assessments by regulated financial institutions. The regulated undertakings referred to in Article 4(1) (including credit institutions, investment firms, collective investment managers, and CCPs) are required to make their own credit risk assessment and must not ‘solely or mechanistically’ rely on ratings for assessing the creditworthiness of entities or financial instruments. This obligation is policed by the sectoral NCAs who supervise these entities. NCAs must also assess these institutions’ use of contractual references to ratings and encourage them to mitigate the impact of such references (Article 5a). A proportionality filter applies in that NCAs must take into account the nature, scale, and complexity of the institution’s activities in this regard, given the cost and risk management efficiencies ratings can bring in appropriate circumstances. Disclosure is also called in aid as regards mitigating over-​reliance risks: ratings and rating outlooks must specify that they represent the CRA’s opinion and are to be relied 208 Under Art 3(1)(l), ‘securitization instruments’ are defined in accordance with the 2017 Securitization Regulation (previously, the CCRAR used the term ‘structured finance instrument’). 209 Annex I, section A requires that at least one independent member and one other member of the CRA board must have in-​depth knowledge and experience of the securitization market. 210 A series of restrictions apply to ensure that both CRAs are independent of each other (Art 8c(2)). 211 These are set out in Annex I, section D, part II. 212 These requirements also reflected the related FSB principles: FSB, Principles for Reducing Reliance on CRA Ratings (2010).

666  Rating Agencies on to a limited degree (Article 8(2)). The related 2013 CRA Directive revises the UCITS and alternative investment fund management regimes to require that these fund managers must not solely or mechanistically rely on ratings, and that NCAs must monitor the adequacy of the credit assessment processes of the relevant fund managers, assess their use of ratings, and, where appropriate, encourage mitigation of the impact of such use.213 The second set of requirements relates to the embedding of ratings within the single rulebook. The ESAs are required not to refer to ratings in their guidelines, recommendations, and draft BTSs, where such references have the potential to trigger mechanistic reliance on ratings by NCAs and by financial market participants; the ESAs were to have removed all existing references, where appropriate, by the end of 2013 (Article 5b).214 The Commission was also injuncted to review references to ratings in EU legislation, with a view to eliminating all references which could trigger mechanistic reliance by 2020, as long as appropriate credit risk assessment alternatives were identified and implemented (Article 5c). The scale of the risks associated with over-​reliance on ratings has receded considerably since the financial crisis, with over-​reliance not emerging as a major source of risk as the Covid-​19 pandemic saw mass downgrades of bonds, albeit that it remains of concern.215 In the absence of appropriate substitutes,216 ratings remain important, however, for many market participants, particularly smaller and less sophisticated actors.217 Nonetheless, the enhancement of regulated financial institutions’ obligations to undertake internal risk assessments,218 combined with efforts to minimize references to ratings in EU legislation,219 has been associated with a significant reduction in systemic over-​reliance.220

VII.13  Regulation, Market Discipline, and Market Structure The CCRAR is a regulatory and supervisory measure, designed to drill into the internal wiring of CRAs, in service of ratings quality. But it also seeks to support market monitoring

213 eg, UCITS Directive Art 51, as revised by the 2013 CRA Directive and which addresses the risk management process, requires the UCITS manager not to solely or mechanistically rely on ratings. 214 The major revision required of ESMA related to its use of ratings in its Guidelines on money-​market funds (MMFs): EBA, EIOPA, ESMA, Final Report on Mechanistic References to Credit Ratings in the ESAs’ Guidelines and Recommendations (2014). The regulation of MMFs is now framed by the 2017 MMF Regulation (see Ch III section 7). 215 The FSB, which monitors over-​reliance risk has, since the ebbing of the financial crisis, reported on a reduction in over-​reliance internationally, but continues to identify it as a residual risk eg, in the context of the Covid-​19 pandemic, 2021 FSB Covid-​19 Lessons Learned Review, n 40. 216 The 2015 ICF report on alternatives to ratings noted, however, that there was a range of complementary and substitute mechanisms, including in-​house risk assessment and market indicators (such as credit default swaps), and encouraged wider use of these mechanisms: 2015 ICF Ratings Alternatives Report, n 84. 217 2015 ESMA Over-​Reliance Review, n 84. 218 Such as the extensive risk assessment rules that now apply to investment firms under the prudential regime (see Ch IV). 219 ESMA’s 2015 review reported that while efforts were being made to reduce references to ratings, their embedding in the bank capital and insurance solvency regimes meant that reliance on ratings remained, at that time, significant: 2015 ESMA Over-​reliance Review, n 84. Since then, further progress has been made, including under the investment firm and credit institution prudential regimes. 220 eg 2021 ESRB Letter to ESMA (n 91) (albeit noting concerns as to the interaction between residual over-​ reliance and cliff-​edge effects where BBB bonds are downgraded into speculative grade); and EBA, Report on Reliance on External Credit Ratings (2021), noting the revision of the bank prudential regime to require enhanced risk assessment in assessing capital requirements.

VII.13  Regulation, Market Discipline, and Market Structure  667 and discipline by promoting competition in the CRA market, in particular by encouraging the development of smaller CRAs. To this end, the proportionality mechanism is used across the CCRAR to moderate the costs of regulation for smaller CRAs and to ease their market access. More direct tools, including an attenuated CRA rotation requirement, are also deployed. Rotation is a difficult tool to deploy in what is a highly concentrated CRA market with high barriers to entry, as was made clear by the scale of the concern generated by the Commission’s original CRA III rotation proposal that CRAs be required to rotate from an issuer every three years.221 This proposal lingers in the CCRAR in the form of a limited rotation obligation which applies only to the rating of resecuritized assets (Article 6b).222 While the Commission was charged with considering an expansion of this rotation requirement (Article 39), reforms have not followed. In addition, issuers (or related third parties)223 are directed, in a CRA III reform, to ‘consider the possibility’ of mandating at least one CRA (where issuers intend to mandate at least two) which does not have more than 10 per cent of the total CRA market share (Article 8d).224 This is supported by ESMA’s annual reporting on CRA market share in the EU.225 CRAs are also enjoined to ensure that their fees are not discriminatory and are based on ‘actual cost’ (Annex I section B),226 an obligation designed to avoid preferential treatment of issuer clients and related market distortions. Since the adoption of the CRA III reforms, there have been only marginal changes to CRA market structure in the EU, bearing out the 2016 prediction that, by 2020, there would be only a small decline in the market share of the three major CRAs.227 As at 2021,228 Standard & Poor’s (S&P Global Ratings), Moody’s, and Fitch represented, respectively, 51.77 per cent, 30.12 per cent, and 10.30 per cent of the EU CRA market; these market shares were down, aside from Standard & Poor’s’, from 2018 (respectively, 46.26 per cent, 32.04 per cent, and 15.0 per cent) and from 2016 (respectively, 45 per cent, 31.29 per cent, and 16.56 per cent).229 The nearest competitor in 2021 to the three major CRA groups was CERVED (1.18 per cent market share) (previously it was DRBS, with 2.99 per cent market share in 2020 (2.46 per cent in 2018 and 1.89 per cent in 2016)). Similarly, the number of CRAs registered in the EU has not changed significantly, amounting to twenty-​six in 2016 and twenty-​four in 2021.230 Although smaller CRAs are being registered, barriers to entry remain high, such 221 ESMA Chief Executive Ross, eg, noted the risk that new entrants could compete by offering higher ratings and that mandatory rotation could lead to undue reliance on poorly equipped CRAs: n 82. 222 A series of conditions apply under Art 6b but, in essence, a four-​year rotation requirement applies. This market segment was highlighted as it was regarded as posing the most risks in terms of conflicts of interest, and because, as the credit risk of a securitized transaction is specific to each transaction, the risk of a loss of expertise is lessened: 2013 CRA III Regulation recital 14. 223 On this definition see n 117. 224 The direction applies where a CRA is available, based on ESMA’s list of CRAs. The CRA must be evaluated by the issuer (or related third party) as being capable of rating the relevant issuance or entity. Where such a choice is not made, this must be documented. 225 ESMA must annually publish a list on which the issuer can rely and which identifies relative market shares: Art 8d(2). 226 Related reporting obligations apply under the 2015 Fees Disclosure RTS. 227 2016 Europe Economics CRA Market Study, n 84. The review suggested that the highly concentrated state of the CRA market, combined with investor conservatism, meant that subsequent, more significant changes were unlikely. 228 The following data is based on ESMA’s annual reports on CRA market share. 229 The changes to the market share of the three major CRAs reflected Brexit-​related restructuring and related revenue impacts: ESMA, Report on CRA Market Share Calculation (2021) 5. 230 ESMA, Annex to the Statement by the ESMA Interim Chair to the ECON Hearing, 14 October 2021; and 2021 ESMA CRA Market Share Report, n 229.

668  Rating Agencies CRAs remain confined to small, local markets,231 and there are few indications of any serious challenge to the dominance of the three major CRA groups.232 This is not to say that the CCRAR has failed to deal with market structure. The complex resecuritization rotation requirement has had limited traction, not least given the contraction in the securitization market in the wake of the financial crisis.233 On the other hand, the CRA registration requirement and the enhanced CRA and ratings disclosures required under the CCRAR have given greater visibility to CRAs, while the civil liability and ESMA enforcement regimes serve to reduce the risks associated with a highly concentrated market.234 Similarly, ESMA’s approach to supervision and enforcement has led to a concentration of its resources on the three major CRAs (section 14). The current policy posture, as reflected in ESMA’s supervisory and enforcement approach and in the Commission’s 2016 CCRAR review, appears to be to focus on securing the effectiveness of the oversight of the major CRAs, rather than on engineering structural change in the market.235 Given the risks associated with priming the CRA market, particularly as regards ratings becoming an instrument of competition, this approach may prove sustainable.

VII.14  ESMA and Supervision VII.14.1  The CCRAR Framework The 2011 conferral by the CCRAR (via CRA II) of exclusive supervisory power on ESMA over EU CRAs represented a watershed as the first time supervisory competence over an aspect of financial markets governance was located at EU level.236 Relatedly, the detailed proceduralization by the CCRAR of ESMA’s supervisory powers, which has since served as the template for subsequent conferrals of supervisory powers on ESMA, reflects the distinct political and institutional tensions and interests associated with decisions over the location of supervisory power in the EU, as well as the constraints imposed by the Meroni ruling which shaped the CRA II negotiations.237 Under Article 21, ESMA is charged with ensuring that the CCRAR is applied. To that end, a suite of direct supervisory powers is conferred on ESMA and specified in detail, including as regards the interaction with national courts and procedures as relevant (Articles 23b–​23d). As regards its power to request information, for example (Article 23b), ESMA 231 A 2021 analysis by ESMA of its CRA market data reported that smaller CRAs are excluded from the main ratings market and, almost exclusively, operate in local market segments where one rating for particular issuances is the convention. Only large CRAs provide ratings where an issuer (as is standard market practice) requires two ratings: Amzallag, A, ‘The Market for Small CRAs in the EU’, in ESMA TRV No 2 (2021) 82. 232 ESMA suggested, however, that the 2019 acquisition by US giant Morningstar of DRBS was an important market development and could have an impact on the competitive landscape: ESMA Supervision, Annual Report 2019 and Work Programme 2020 (2020) 12. 233 Leading ESMA to suggest that the resecuritization market was not the best sample market on which to test the rotation mechanism: 2015 ESMA CRA Market Report, n 84, 8. 234 2015 ESMA CRA Market Report, n 84. 235 In its 2016 Review, the Commission underlined the importance of a robust regulatory framework and a credible sanctioning regime as the CRA market was likely to take the form of a ‘highly concentrated oligopoly for the foreseeable future’: 2016 Commission CRA Review, n 85, 21. 236 At the time termed a ‘milestone achievement’: ESMA Executive Directive Ross, Speech, 12 June 2012. 237 See Ch I section 6.3

VII.14  ESMA and Supervision  669 may either by ‘simple request’ or by ‘decision’ require all information necessary to carry out its duties from a range of actors.238 The ‘simple request’ procedure is designed for non-​ binding requests, while the ‘decision’ procedure is designed for binding requests, failure to comply with which can lead to a penalty.239 General investigation powers are conferred under Article 23c, which empowers ESMA to conduct all necessary investigations of relevant persons and which also confers on its officials and authorized persons a range of related powers to act in Member States’ jurisdictions.240 The related Article 23c procedural framework covers the procedure governing such investigations; the requirement for relevant persons to submit to ESMA investigations; the assistance of ESMA by relevant NCAs; and the role of the national courts in reviewing related permissions to compel telephone or data traffic records. An ESMA power to conduct on-​site inspections is also provided for and proceduralized (Article 23d):241 ESMA may conduct all necessary on-​site inspections at the business premises of relevant persons and a suite of related powers are conferred on ESMA’s officials and authorized persons.242 Specific supervisory powers are conferred for the supervision of a CRA’s proprietary methodologies,243 underlining the extent to which ESMA can drill into CRA operation. This legislative framework is amplified by a series of administrative rules which govern the information ESMA can require of CRAs in supervisory reports; how the methodologies regime is to be supervised; and the supervisory fees ESMA can charge.244 Over time, ESMA has built on this legislative and administrative framework, including by means of its supervisory operating model (outlined below); its data repositories (the publicly available CEREP and ERP data-​bases and ESMA’s ‘RADAR’ supervisory data-​base); and an extensive suite of soft law which includes the Guidelines and Q&As through which ESMA communicates its supervisory expectations. The reach of ESMA’s supervisory powers is underlined by the discrete accountability and reporting requirements which apply.245 The CCRAR also governs the relationship between NCAs and ESMA. Article 30 empowers ESMA to delegate specific tasks to an NCA (including information requests, investigations, and on-​site inspections), but any such delegation does not affect ESMA’s responsibility to ensure the CCRAR is applied and must not limit ESMA’s ability to conduct and oversee the task delegated to the NCA. Article 30 also provides that specified supervisory responsibilities, including with respect to registration decisions, must not be delegated by ESMA. In practice, since ESMA took over CRA supervision in 2011, delegation 238 Including from CRAs, rated entities, related third parties, third parties to whom rating agencies have outsourced operational functions, and persons ‘otherwise closely and substantially related or connected to [CRAs]’: Art 23b. 239 Article 23b(2) and (3), respectively. The relevant procedural and disclosure requirements which apply in each case are specified. 240 Including to examine records and data, to take or obtain certified copies of materials, to summon persons for explanations, to interview persons, and to request telephone and data traffic records: Art 23c. 241 The procedural framework governs inter alia the need for written authorizations, the requirement for relevant persons to submit to ESMA’s inspection (and the related ESMA decision needed before an inspection can be launched), and relations with officials from the Member State in question. 242 Including the power to enter any business premises and exercise investigation powers, and to seal any business premises and books and records for the period of the inspection: Art 23d. 243 Article 22a. The powers relate to ESMA’s obligation to examine CRA compliance with the obligation to back-​ test methodologies under Art 8(3). 244 See section 4. 245 ESMA must publish an annual report on the application of the Regulation (Art 21(5)) and present a report on the supervisory measures taken and penalties imposed under the Regulation annually to the European Parliament, Council, and Commission: Art 21(5) and (6)).

670  Rating Agencies has not been widely used. Member States’ sectoral NCAs retain responsibility for the supervision of the use of ratings by regulated entities for Article 4(1) regulatory purposes, and, under Article 25a, for any related supervision of regulated entities under relevant sectoral legislation, in particular as regards the application of the over-​reliance rules (Article 5a) and the rules governing the issuance of securitization instruments (Article 8c). NCAs are, alongside, required to support ESMA’s supervision of CRAs through a series of cooperation and information exchange obligations.

VII.14.2  Experience Since 2011 From the outset, ESMA was purposeful in its approach, committing to being an ‘intrusive and proactive regulator’ and prioritizing the embedding of a new regulatory and supervisory discipline on a sector which had not previously been regulated to any material degree.246 ESMA supervision is delivered through a data-​driven and risk-​based approach designed to ensure ESMA’s supervisory activities are targeted to the risks most likely to materialize.247 In supervising CRAs under this risk-​based model, ESMA deploys an extensive supervisory tool-​kit which includes firm-​level tools (such as structured interaction with and letters to management, information requests, risk-​mapping undertaken in collaboration with CRAs to highlight ESMA’s priorities, on-​site inspections and interviews, and remedial action plans the completion of which is monitored by ESMA) as well as industry-​level tools (such as thematic reviews, peer comparisons, Guidelines, and Q&As).248 Supervision is supported by ESMA’s extensive and expanding capacity to collect and interrogate the data on which effective supervision depends, including through its bespoke ‘RADAR’ data system, launched in 2016, which manages the collection of CRA supervisory reports, and which has led to the development of new supervisory tools.249 ESMA’s supervisory style can generally, and reflecting the design of the CCRAR, be associated with a proportionate approach, particularly as regards smaller CRAs.250 ESMA’s approach to supervision has evolved since 2011. Its risk-​based model, for example, has been repeatedly finessed,251 while ESMA has also engaged in organizational reform, bringing together its CRA and trade repository supervisory functions in 2015 to allow for operational synergies and mutual learning.252 Its use of supervisory tools has also 246 ESMA, 2013 Annual Report on Credit Rating Agencies (2014) 4 and 5. ESMA subsequently declared its aim to be a credible and effective direct supervisor, aiming at lasting impact and known for its ability to be proactive and responsive: ESMA, 2014 Annual Report on Supervision of Credit Rating Agencies and Trade Repositories and 2015 Work Plan (2015) 26. 247 eg, ESMA Annual Work Plan (2022) 20. 248 See, eg, 2022 ESMA Annual Work Plan, n 247, 20–​2. 249 By 2018 ESMA was reporting on the new supervisory tools it had developed to interrogate RADAR and better inform supervision: ESMA, 2017 Annual Report on Supervision of Credit Rating Agencies and Trade Repositories and 2018 Work Plan (2018) 43 and 51. 250 ESMA’s 2021 Annual Report, eg, noted the implementation of a ‘more calibrated engagement’ with small and medium-​sized CRAs (at 34). Similarly ESMA has acknowledged that smaller CRAs can face challenges in embedding and implementing the required policies and procedures and seeks to support them through targeted supervisory engagement: ESMA, 2019 Annual Report on Supervision of Credit Rating Agencies and Trade Repositories and 2020 Work Plan (2020) 19. 251 ESMA’s annual reports on CRA supervision repeatedly reference ongoing enhancements to its risk-​based supervision model. 252 eg common approaches were since adopted for fee policies and cloud computing: ESMA, 2016 Annual Report on Supervision of Credit Rating Agencies and Trade Repositories and 2017 Work Plan (2017) 7.

VII.14  ESMA and Supervision  671 evolved. Industry-​wide thematic investigations, which have the advantage of facilitating pan-​industry benchmarking and the identification of systemic risks, are being used more frequently, as are CRA-​specific on-​site inspections;253 its data capacity has strengthened;254 and it is developing new analytical tools.255 As ESMA’s data capacity has grown, it has come to focus on the more complex aspects of its supervisory mandate, including oversight of the non-​discriminatory pricing obligations to which CRAs are subject.256 ESMA’s supervisory priorities have also evolved with market conditions, with its more recent supervisory agendas focusing on green/​ESG rating products and on the treatment of ESG risk in ratings, and on CRAs’ approaches to the rating of BBB-​rated instruments and CLO instruments, given the growth in these markets.257 ESMA is still a youthful supervisor and its approach continues to evolve.258 Support for its approach has, however, come from the ESA Board of Appeal. In 2013 and 2017, the Board ruled on appeals against ESMA decisions not to register a firm as a CRA.259 The Board’s rulings in these appeals established a standard of review for ESMA decision-​ making260 and subjected ESMA’s decision-​making to close examination.261 In both cases, however, the Board dismissed the appeals, supporting ESMA’s supervisory approach and allowing ESMA a margin of appreciation,262 and, thereby, reinforcing ESMA’s authority as a supervisor. ESMA’s supervisory judgment was also upheld in the 2021 Scope Ratings appeal. Here, the Board supported ESMA’s approach to the interpretation of Article 8(3) on methodologies, and upheld ESMA’s related imposition of a fine for breach of the Article 8(3) requirement that methodologies be ‘systematic’.263 The Board found against ESMA in the 2019 Nordic Banks appeal, but only as regards ESMA’s imposition of a fine (for failure to register as a CRA while providing ratings);264 the Board upheld ESMA’s finding that the contested ‘shadow ratings’ fell within the scope of the CCRAR. 253 In its 2016 CRA Supervision Report ESMA noted that it would engage in more targeted investigations, increase the number of investigations and inspections, and improve its IT tools: 2016 Annual Report and 2017 Work Plan, n 252, 17–​18. Its 2019 Report subsequently reported on thematic investigations into cybersecurity and the rating of CLO instruments, as well as a targeted investigation into rating practices: n 250, 16–​17. 254 In 2021, ESMA reported to the European Parliament that it had significantly expanded its market monitoring capabilities by improving its data-​related processes, and that its data-​driven approach (which relies, inter alia, on daily ratings data from CRAs) had allowed it to take preventative action as well as to detect emerging trends: Annex to the Statement by ESMA Interim Chair, ECON Hearing, 14 September 2021, 6. 255 Over the Covid-​19 pandemic, eg, it developed a new analytical framework for monitoring CRAs’ activities: ESMA, Annual Report 2021 (2022) 34. 256 eg ESMA, Thematic Report on Fees Charged by Credit Rating Agencies and Trade Repositories (2018). 257 2022 ESMA Annual Work Plan, n 247, 20–​1. 258 ESMA’s 2016 Methodologies Guidelines, eg, were adopted following a finding by the European Court of Auditors of shortcomings in ESMA’s supervision of methodologies: European Court of Auditors, EU Supervision of Credit Rating Agencies. Well Established but not yet Fully Effective (2015) 7. 259 FinancialCraft Analytics Sp. zo.o v ESMA, 3 July 2017 (Decision BoA 2017 01) and Global Private Rating Company v ESMA, 10 January 2014 (Decision BoA 2013-​14). Both cases concerned the same firm (renamed) and related to appeals against ESMA refusals to register (the appeals were based on a range of grounds relating to ESMA’s failure to give reasons and procedural irregularities). 260 Expressed in the 2017 FinancialCraft ruling as whether ESMA had correctly applied the law; was entitled to reach a refusal decision; and whether procedural irregularities or unfairness vitiated the decision: n 259, para 45. 261 In the 2014 Global Private Rating ruling, eg, the Board examined ESMA’s grounds for refusing registration in some detail. Although it found against the appellant overall (finding that the ESMA refusal was, on the whole, fully reasoned), in relation to one registration requirement it found that ESMA was not justified in refusing registration because of the failure in question, and in relation to two other requirements it was not able to come to a decision given limited information. 262 In the 2017 FinancialCraft ruling the Board noted that in technical matters the decision of ESMA, as a specialist regulator, was entitled to some margin of appreciation: n 259, para 45. 263 Scope Ratings ruling, n 114. 264 See section 5 on the ruling.

672  Rating Agencies ESMA acquired responsibility for CRA supervision in July 2011 and drew early support for its approach from stakeholders.265 Since then, the evidence suggests that it has matured as a supervisor and has come to deploy a now extensive supervisory tool-​kit and a generally robust but data-​informed and responsive approach which is proving resilient to periods of market stress, as the absence of major challenges in the CRA market over the Covid-​19 period of debt market stress might reasonably suggest.

VII.14.3  Enforcement of the CCRAR and ESMA The CCRAR also confers enforcement powers on ESMA which must be exercised within the CCRAR procedural framework. These powers (and in particular ESMA’s fining powers) generated considerable contestation over the CRA II Regulation negotiations, in particular as regards their compliance with the Meroni doctrine and the related prohibition on the delegation of wide-​ranging discretionary executive powers:266 the Commission’s CRA II Proposal relatedly conferred fining powers on the Commission and not ESMA, reflecting the Commission’s view of the Meroni constraints.267 But while the Regulation as adopted confers extensive enforcement powers on ESMA, it also, reflecting Meroni, confines ESMA’s discretion. The enforcement system is based on the investigation of CCRAR breaches by an ESMA ‘Independent Investigation Officer’ and on the adoption of a final decision on enforcement action by the Board of Supervisors (Article 23e).268 The reserving of enforcement decisions to the Board of Supervisors is designed to support legitimation, as NCAs can challenge and request revisions to ESMA decisions.269 Any enforcement decision must be taken in accordance with the CCRAR which sets out (Annex III) the specific CCRAR infringements that can be subject to ESMA enforcement action (no other breaches can ground ESMA enforcement action). Although the CCRAR does not provide for criminal sanctions, matters for criminal prosecution are to be referred to the relevant national authorities where there are serious indications of the possible existence of facts liable to constitute criminal offences

265 Mazars, Review of the New European System of Financial Supervision. Part 1: The Work of the European Supervisory Agencies. Study for the ECON Committee (2013) 97, reporting on the view that ‘ESMA has efficiently established the process and organization to professionally execute’ its responsibilities. 266 The UK in particular raised concerns: House of Commons European Scrutiny Committee, 7th Report, Session 2010–​2011, 70–​2, citing the Financial Services Secretary to HM Treasury as noting that ‘the legality of delegating discretionary powers to [ESMA] is of vital importance and has been a priority for the Government throughout the negotiations’. 267 The Commission noted the complexities engaged in splitting enforcement between the Commission and ESMA, but suggested that conferring fining powers on ESMA, while bringing efficiencies, ‘could raise some concerns of consistency with the Community acquis and notably . . . the Meroni case’: 2010 CRA II Proposal IA, n 70, 31. 268 Article 23e covers the standard to be met before an Independent Investigation Officer can be appointed (serious indications of possible existence of facts liable to constitute an infringement); the independence of the Officer; and the investigating powers of the Officer. During the investigation process, the relevant person has the right to be heard and rights to access files: Art 23e(3)–​(4).The Board of Supervisors must decide on any enforcement action based on the Officer’s findings and (when so requested) having heard the investigated person in question. The Officer is prohibited from taking part in Board of Supervisor deliberations. The Board acts through a simple majority vote (ESMA Regulation Art 44). 269 As was accepted by the Board of Appeal in rejecting an appellant’s argument that registration decisions were de facto taken by ESMA officers in breach of the legislative scheme which reserved the registration decision to the Board of Supervisors: Global Private Rating ruling, n 259, paras 86–​90.

VII.14  ESMA and Supervision  673 (Article 23e(8)). Any ESMA enforcement decision must be notified to the relevant person and is subject to the right of the person concerned to be heard (Article 25). The range of administrative non-​monetary sanctions which can be adopted by ESMA is specified under Article 24 as covering: the withdrawal of registration; the temporary prohibition of the CRA from issuing ratings throughout the EU, and/​or the suspension of the use of the CRA’s ratings for regulatory purposes, until the infringement has been brought to an end; requiring the CRA to bring the infringement to an end; and public notices. The application by ESMA of the relevant administrative sanction is subject to procedural requirements, including that ESMA must take into account the nature and seriousness of the infringement, having regard to a series of factors.270 A concern to avoid market instability and to address any related fiscal implications for Member States emerges from these procedures: where ESMA decides to suspend the use of a rating for regulatory purposes or to withdraw a CRA’s registration, the rating can be used for ten days after the ESMA decision; where another rating is not available, a three-​month period applies, and this period may be extended by three months in exceptional circumstances related to the potential for market disruption or financial instability (Article 24(4)). The administrative monetary penalties regime (for fines and periodic penalties) is specified with greater granularity (Article 36a), reflecting the significant concern as to Meroni risks over the CRA II negotiations. ESMA’s power to impose fines arises only where the Board of Supervisors finds that a CRA has negligently or intentionally271 committed a specific infringement identified in Annex III (Article 36a(1)). A minimum and maximum fine range applies to each of the Annex III infringements, but in no case does the range go higher than €750,000 (multiple incidences of a single infringement can, however, ratchet up the size of the fine imposed in one enforcement action) (Article 36a(2)). Article 36a also sets out how ESMA should decide whether fines ‘should be at the lower, the middle, or the higher’ end of these ranges and specifies when fines should be adjusted by means of mitigating or aggravating factors;272 and it also places a cap of 20 per cent of the CRA’s annual turnover in the preceding year on fines.273 Procedural requirements govern the imposition of fines, including with respect to the right to be heard by an ESMA Independent Investigation Officer and the Board of Supervisors, access to documents, limitation periods, and the collection of fines.274 In the case of continuing infringements or a lack of cooperation, ESMA may impose periodic penalties designed to compel action.275 ESMA is empowered in these cases

270 These are: the duration and frequency of the infringement, whether the infringement revealed serious or systemic weaknesses in the undertaking’s management systems or internal controls, whether financial crime was facilitated, and whether the infringement was intentional or negligent: Art 24(2). 271 An intentional infringement is considered to arise where ESMA finds objective factors which demonstrate that the CRA or its senior management acted deliberately to commit the infringement: Art 36a(1). 272 Article 36a(2) provides that CRA turnover (in the preceding business year) determines the basic amount of any fine: the basic amount should be at the lower limit where the annual turnover is below €10 million, at the middle of the limit where the turnover is between €10 million and €50 million, and at the higher end where the turnover is more than €50 million. Art 36a(3) and Annex IV provide coefficients to be used to adjust basic amounts to reflect the identified aggravating or mitigating factors. 273 But where the CRA has benefited financially, directly or indirectly, from the infringement, the fine must be at least equal to the financial benefit: Art 36a(4). 274 2012 Enforcement RTS (n 97). 275 Penalties can be imposed to compel a CRA to put an end to an infringement, and to compel a person to supply complete information, to submit to an investigation and produce related information, or to submit to an on-​site inspection: Art 36b(1).

674  Rating Agencies to impose periodic penalties which are effective and proportionate, and imposed on a daily basis until compliance is achieved, but for no longer than six months.276 Significant contestation attended the 2011 conferral on ESMA of enforcement powers. In practice, the enforcement tool has not been frequently deployed. At the time of writing, eight sets of enforcement action had been taken by ESMA, for a range of different breaches of the CCRAR, and usually (but not always) involving the imposition of fines and concerning the three major CRAs. These enforcement actions involved: a fine of €3.7 million (and public notice) imposed on Moody’s for conflict-​of-​interest breaches relating to the ownership rules (2021);277 a fine of €640,000 (and public notice) imposed on Scope Ratings for breach of the methodologies rules (2020); a fine of €5.3 million (and public notice) imposed on Fitch for conflict-​of-​interest breaches relating to the ownership rules (2019); fines of €495,000 (and public notices) imposed on five Nordic banks for failure to register as CRAs while providing ratings (the fine was later remitted from four of the banks who had successfully appealed to the Board of Appeal which found that ESMA had not established that the breach was negligent) (2018); a fine of €1.24 million (and public notice) imposed on Moody’s for breach of the ratings presentation and methodologies rules (2017); a fine of €1.38 million (and public notice) imposed on Fitch for breach of the procedures relating to sovereign debt ratings (2016); a fine of €30,000 (and public notice) imposed on DRBS for breach of internal control requirements (2015); and a public notice imposed on Standard & Poor’s for breach of the procedures relating to sovereign debt ratings (2014). In practice, the calculation of fines by ESMA follows a building block approach, based on the CCRAR processes. By way of example, in May 2017 ESMA imposed one of its larger fines (€1.24 million) on Moody’s for publicly disclosing ratings of different supranational entities without having made the required public disclosures on the related methodologies. As ESMA found evidence of negligence and so could impose a fine, it levied a turnover-​based fine and in accordance with the relevant limits, the quantum of which took into account an aggravating factor (in the form of the number of infringements as well as the period of time over which they took place) as well as a mitigating factor (as measures had been voluntarily taken to ensure no similar future infringements).278 With eight sets of enforcement action since 2011, the charge of unduly limited enforcement action is easy to make. ESMA is not, however, an enforcement-​led supervisor and deploys enforcement sparingly. This is not an unusual posture for a supervisor. Enforcement is a resource-​intensive tool and is typically deployed judiciously as a signalling device and to create deterrent effects. Frequent enforcement action might also, given the still novel quality of ESMA’s powers, generate political and institutional contestation which could ultimately weaken ESMA’s position. There is, however, evidence from ESMA’s enforcement history of an appetite for testing the boundaries of the CCRAR (the Nordic Banks example) and for

276 The amount of such a periodic penalty is set at 3 per cent of the CRA’s average daily turnover in the preceding business year (in the case of natural persons, 2 per cent of average daily income in the preceding calendar year): Art 36b(3). 277 In the case of the enforcement actions against Moody’s, Fitch, and Standard & Poor’s the enforcement actions cover component enforcement actions against relevant subsidiaries, each of which do not always involve the imposition of a fine, depending on whether negligence is made out in each case. For ease of reference, only the overall outcome is noted. 278 Decision of the BoS, 23 May 2017. The failures related to ratings of inter alia the European Investment Bank, European Stability Mechanism, and European Investment Fund.

VII.15  The CCRAR and Civil Liability  675 pursuing smaller CRAs where the breach so warrants (the Scope Ratings and DRBS examples), as well as of a concern to signal a lack of tolerance for conflict-​of-​interest breaches in particular (the largest fines of over €5 million and €3 million, respectively, were imposed on Fitch and Moody’s and in relation to conflict of interest breaches). With a sample of eight it is perilous to draw wider conclusions, but there is also evidence of the quantum of fines increasing since 2011. This may simply be a function of the types of breaches at issue, but it may also be a feature of growing ESMA confidence in this area. ESMA’s approach to enforcement has been supported by the Board of Appeal in the two appeals taken so far against its enforcement decisions. ESMA’s imposition of a fine on Scope Ratings was upheld and, while the Board of Appeal upheld the appeal by four of the five Nordic Banks, this was because it found that negligence was not fully evidenced (so a fine could not be used) and not because an enforceable breach was not made out; the sanction, and not the enforcement action, was at issue. Of more significance to the effectiveness of the CCRAR enforcement regime are the low upper limits the CCRAR imposes on fines, certainly relative to the financial power of the three major CRAs.279 In 2015, ESMA called for a strengthening of its fining powers, including by an increase (by a factor of five) to the penalty bands which currently apply.280 ESMA also called for a closing of current enforcement loopholes by the attaching of specific enforceable infringements to all breaches of the CCRAR, including breaches of the novel ‘fair pricing’ requirements which are not currently included among the infringements which can ground ESMA enforcement action.281 While the Commission was broadly supportive of change in its 2016 review,282 there are few indicators of reform following.

VII.15  The CCRAR and Civil Liability The introduction by the CRA III reforms of a harmonized civil liability regime (which operates independently of any contractual rights of action which may otherwise be available to issuers who contract with CRAs) represented at the time a new departure for EU financial markets regulation.283 Hitherto, civil liability mechanisms had been regarded as a Member State preserve, given the embedding of liability actions within national procedural regimes. Designed to work alongside ESMA supervision and enforcement to create strong compliance incentives, Article 35a is something of a double-​edged sword, supporting private causes of action, but also carrying the risk of increased costs, of ‘chilling’ CRAs, and

279 ESMA has argued that the current penalty limits are inadequate given that the global turnover of the largest CRAs has been as high as $2.4 billion: ESMA, Letter to the Commission, 27 January 2017. 280 2015 ESMA CRA Market Report, 84, 77–​9. ESMA suggested that the current upper limit of 20 per cent of turnover should remain, noting the need for proportionality. 281 2015 ESMA CRA Market Report, n 84, 77–​8. 282 2016 Commission CRA Review, n 85. The Commission noted the enhanced need for a credible sanctioning regime with proportionate fines and that the sanctioning regime might need revision. 283 For extensive and comparative review see Miglionico, A, The Governance of Credit Rating Agencies. Regulatory Regimes and Liability Issues (2019). Since then, a framework civil liability regime has also been put in place for the summary Key Information Document required under the PRIIPs Regulation (Ch IX section 5.3).

676  Rating Agencies of prompting vexatious litigation284—​although in practice the action has not had major impact. Article 35a provides that that where a CRA commits ‘intentionally’ or ‘with gross negligence’ any of the infringements specified in Annex III having an impact on a rating, an investor or issuer may claim damages from the CRA in respect of ‘damage’ caused ‘due to that infringement’. An investor may claim damages where it has established that it ‘reasonably relied’, in accordance with the Article 5a(1) reliance rules,285 or otherwise with due care, on a rating for a decision to invest in, hold, or divest financial instruments covered by the rating. A lower threshold of proof applies to the rated issuer, who can claim damages where it establishes that it or its financial instruments are covered by the relevant rating and the relevant infringement was not caused by misleading and inaccurate information provided by the issuer, directly or through information publicly available. It is the responsibility of the issuer or investor to present accurate and detailed information (the nature of which is to be determined by the relevant national court) indicating that an infringement has occurred and the infringement has had an impact on the rating. Civil liability may be limited in advance by the CRA, but only where the limitation is reasonable and proportionate and the limitation is allowed under applicable national law. Article 35a is crafted in loose terms. Operationally, it depends on national civil liability regimes, with the key determinants for the action—​including ‘damage’, ‘intention’, ‘gross negligence’, ‘reasonably relied’, ‘due care’, ‘impact’, ‘reasonable’, and ‘proportionate’—​all to be interpreted in accordance with applicable national law, and all relevant matters not covered by the Regulation to be determined by applicable national law. It is accordingly a framework regime which depends almost entirely on national interpretation and generates significant legal certainty and forum shopping risks as a result.286 Experience since 2011, however, suggests that ESMA supervision and enforcement carries out most of the heavy lifting as regards constructing incentives for complying with the CCRAR.

VII.16  CRAs and Sustainable Finance The reach of the sustainable finance agenda in the EU287 is well-​illustrated by its extension to the different gatekeeping mechanisms that support sustainable finance, including CRAs.

284 On the risks associated with CRA liability, and calling for civil liability only in relation to factual and methodological errors and for egregious failures, given the risks of chilling CRAs, see Lehmann, M, ‘Civil Liability of Rating Agencies: An Insipid Sprout from Brussels’ (2016) 11 CMLJ 60. 285 Article 5a(1) requires specified regulated actors to make their own credit risk assessment and not to solely or mechanistically rely on ratings for assessing creditworthiness (section 12). 286 The CCRAR liability regime, as a departure for EU financial markets regulation, has attracted significant and primarily negative analysis, including as regards the elements of the cause of action (including the absence of a liability cap which could calibrate the regime in terms of over-​and under-​deterrence) and the thin harmonization. See, eg, Miglionico, n 283, 227–​40; Picciau, C, ‘The Evolution of the Liability of Credit Rating Agencies in the US and in the EU: Regulation after the Crisis’ (2018) 15 ECFR 339; Lehmann, n 284; Risso, G, ‘Investor Protection in Credit Rating Agencies Non-​Contractual Liability: the need for a fully harmonized regime’ (2015) 40 ELRev 706; Haar, B, ‘Civil Liability of Credit Rating Agencies after CRA 3—​Regulatory All-​or-​Nothing Approaches between Immunity and Over-​Deterrence’ (2014) 25 EBLR 15; and Möllers, T and Niedorf, C, ‘Regulation and Liability of Rating Agencies—​A More Efficient European Law?’ (2014) 11 ECFR 333. 287 See further Ch I section 7.2.

VII.16  CRAs and Sustainable Finance  677 The Commission’s 2018 Sustainable Finance Action Plan highlighted the role of CRAs in supporting sustainable finance, and called for better integration of sustainability factors in ratings.288 The CCRAR is currently silent on how sustainability-​related risks are to be addressed by CRAs, albeit that consideration of sustainability-​related factors, where relevant to the assessment of the issuer’s or instrument’s default profile, would be covered by the foundational requirement that CRAs consider all relevant information when rating an issuer or instrument. CRAs are also subject to the 2021 ESMA CRA Disclosure Guidelines which require that a CRA make the disclosures specified by the Guidelines (in the press release accompanying a rating change) where ESG factors have been a ‘key driver’ of a rating change.289 In practice CRAs are becoming more transparent as regards the extent to which ESG factors shape a rating,290 while ESMA has similarly noted increased levels of ESG disclosures by CRAs in their ratings disclosures.291 The extent to which the CCRAR should expressly require CRAs to consider ESG factors in the rating process is not, however, clear. A rating is an expression of credit default risk addressed to debtholders; it is not an opinion on sustainability risks generally for the wider stakeholder base associated with sustainability-​related disclosures.292 CRAs are regulated as regards the rating process generally and so as regards how they use sustainability/​ESG-​related data when providing ratings. The related and burgeoning market of providers and vendors of ESG ratings, screening services, and similar products is, however, currently largely unregulated in the EU.293 A series of risks have been associated with this fast-​developing market, in the EU and globally, including in relation to transparency, standardization, reliability, accuracy, and financial materiality (as regards ESG ratings and similar products); and, as regards providers and vendors, conflicts of interests and competence risks, as well as the increasing risk that the concentration of such services within a small group of large providers will lead to an oligopolistic market structure, akin to that of the CRA industry.294 ESMA has deployed its significant technocratic capacity as the EU’s supervisor of CRAs to warn of the related risks as to capital mis-​allocation, mis-​selling, and greenwashing, in the absence of appropriate regulatory and supervisory tools.295 The CRA regime provides a template of sorts, assuming that the

288 Commission, Action Plan on Financing Sustainable Growth (COM(2018) 97) 7–​8. 289 2020 ESMA Disclosure Guidelines, n 107,which require, inter alia, disclosure of whether ESG factors (as determined by the CRA) were key drivers of the change and of the relevant factors and why they were material to the change. 290 Amariei, C, Sustainability in Practice: Ratings, Research and Proprietary Models. ECMI Policy Brief No 26 (2019). 291 Which it has related to compliance with the 2021 Guidelines: Amzallag, A et al, ‘Text Mining ESG Disclosures in Rating Agency Press Releases’, ESMA TRV Risk Analysis (2022). 292 ESMA reported to the Commission (on foot of the 2018 Sustainable Finance Action Plan) that, although ESG factors were considered by CRAs, the extent to which they were, and how CRA methodologies engaged with ESG factors, varied. It also cautioned that a rating was not a sustainability assessment and that it would be inadvisable to amend the CCRAR to mandate consideration of sustainability: ESMA, Technical Advice on Sustainability Considerations in the Credit Rating Market (2019). Its approach instead was to adopt the 2020 Guidelines governing the disclosures to be made when a rating is driven by ESG factors (n 107). 293 The benchmark regime, however, addresses sustainability-​oriented benchmarks. See Ch VIII section 10.3. 294 See ESMA, Response to the Commission Consultation on a Renewed Sustainable Finance Strategy (2020) 16 and Study by ERM for the Commission on Sustainability-​Related Ratings, Data and Research (2020). 295 2020 ESMA Sustainable Finance Consultation Response, n 294, 15–​18.

678  Rating Agencies universe of relevant ESG products can be captured appropriately, albeit that it is likely overly prescriptive for this developing market.296 While IOSCO has adopted principles for this market,297 the availability of ESMA as a potential supervisor, and the template that the CCRAR provides, cautions against predictions of a light touch or self-​regulatory approach, as does the history of the CRA regime.298

296 ESMA recommended that the EU regulate the ESG rating market and draw on the CCRAR template to do so, albeit in a proportionate manner which would require registration and supervision of providers of ESG ratings but which would only impose full-​scale organizational and conflict-​of-​interest requirements on more systemic entities. It also suggested that it be conferred with supervisory powers over ESG rating providers where they formed part of larger financial groups, including of CRAs: ESMA, Letter to Commissioner McGuiness (ESG Ratings) 28 January 2021. 297 IOSCO, Environmental, Social and Governance (ESG) Ratings and Data Products Providers (2021). 298 The Commission’s targeted 2022 consultation (Commission, Consultation on the Functioning of the ESG Market in the EU and on the Consideration of ESG Factors in Credit Ratings) suggested a majority view that the market for ESG ratings was not functioning well and that legislative intervention was necessary, as well as majority support for some form of authorization/​registration requirement for ESG rating providers: Commission, Summary Report on the ESG Ratings Market Consultation (2022).

VIII

MARKET ABUSE VIII.1 Introduction This chapter covers the EU regime which governs the prohibition of market abuse (or the prohibition of insider dealing and market manipulation). At the core of this regime is the 2014 Market Abuse Regulation (MAR).1 MAR is accompanied by the 2014 Market Abuse Directive (the 2014 MAD), which requires Member States to impose criminal sanctions for specified acts of market abuse.2 In common with regulatory regimes internationally, the EU regime has expanded over time beyond an original prohibition on insider dealing (the 1989 Insider Dealing Directive)3 to include prohibitions on market manipulation (originally introduced by the 2003 Market Abuse Directive).4 The EU’s regime governing the prevention of market abuse is, however, multi-​layered. Detection of market abuse is supported by the extensive Markets in Financial Instruments Regulation (MiFIR) Articles 25 and 26 record-​keeping and transaction reporting regime,5 discussed in Chapter V. Market abuse is also addressed, more tangentially, under the EU’s takeover regime,6 while discrete rules apply to the prohibition of market abuse in the wholesale energy market.7 The 2012 Short Selling Regulation8 can be associated with the prevention of market abuse, where short selling has abusive qualities, but it is primarily directed towards the management of financial stability risks (Chapter VI section 3). The EU’s market abuse ‘rulebook’ also covers benchmarks, by means of the discrete MAR rules governing benchmark manipulation as well as by means of the distinct regulatory scheme for benchmarks and their administrators established by the 2016 Benchmark Regulation.9

1 Regulation (EU) No 596/​2014 [2014] OJ L173/​1 (MAR). See Herlin-​Karnell E and Ryder, N, Market Manipulation and Insider Trading: Regulatory Challenges in the United States of America, the European Union and the United Kingdom (2019) and, for article-​by-​article commentary, Ventoruzzo, M and Mock, S (eds), Market Abuse Regulation: Commentary and Annotated Guide (2nd edn, 2022). 2 Directive 2014/​57/​EU [2014] OJ L173/​179 (2014 MAD). 3 Directive 89/​592/​EEC [1989] OJ L334/​30 (1989 IDD). 4 Directive 2003/​6/​EC [2003] OJ L96/​16 (2003 MAD). On the Directive, which was, until its replacement, a pillar measure of EU financial markets regulation, see Ferrarini, G, ‘The European Market Abuse Directive’ (2004) 41 CMLR 711; Hansen Lau, J, ‘MAD in a Hurry: The Swift and Promising Adoption of the EU Market Abuse Directive’ (2004) EBLR 183; and Coffey, J and Overett-​Somnier, J, ‘The Market Abuse Directive: The First Use of the Lamfalussy Process’ (2003) JIBLR 370. 5 Regulation (EU) No 600/​2014 OJ [2014] L173/​84 (MiFIR) which accompanies Directive 2014/​65/​EU [2014] OJ L173/​349 (MiFID II). 6 Directive 2004/​25/​EC [2004] OJ L142/​12. Art 3(1)(d) requires Member States to ensure that false markets are not created in the securities of the offeror, offeree, or any other company concerned with a takeover bid, while Art 8 requires that a bid must be made public in such a way as to ensure market transparency and integrity for the securities of the offeror, offeree, or any other company affected by the bid. As the Takeover Directive is more a creature of company law and corporate governance than of financial market regulation, it is not considered in this book. 7 Regulation (EU) No 1227/​2011 [2011] OJ L326/​1 (2011 REMIT Regulation). 8 Regulation (EU) No 236/​2012 [2012] OJ L86/​1. 9 Regulation (EU) No 2016/​1011 [2016] OJ L171/​1.

680  Market Abuse These measures work in tandem with the EU’s regulation of investment firms and trading venues, as the root causes of market abuse can be associated with a host of risks addressed by financial markets regulation more generally. These risks range from firm governance and culture weaknesses to structural market features, as the series of misconduct scandals that beset the ‘FICC’ (fixed interest, currency, and commodity) over-​the-​counter (OTC) markets over the financial-​crisis era exposed.10 A multi-​faceted regulatory tool-​kit is accordingly required in response. In the EU this tool-​kit includes the Market in Financial Instruments Directive II (MiFID II)/​MiFIR conduct regime for investment firms and also its regulation of venues and of trading,11 as well the European Market Infrastructure Regulation (EMIR) and its regulation of the OTC derivatives markets.12

VIII.2  The Rationale for Prohibiting Insider Dealing and Market Manipulation and the EU VIII.2.1  The Rationale for Prohibiting Insider Dealing and Market Manipulation VIII.2.1.1 Insider Dealing The EU’s treatment of insider dealing has been broadly stable for some time and was largely immune from the reform pyrotechnics of the financial-​crisis era. The relative stability of the EU rules, and also the prevalence of insider-​dealing prohibitions internationally,13 belies, however, the scholarly contestation that attends prohibitions on insider dealing. Attempts to identify a robust rationale for prohibiting insider dealing have generated a vast literature.14 This brief outline does not attempt to canvass all the legal and economic arguments raised by prohibitions on insider dealing but is limited to identifying the main features of the debate in order to contextualize the EU’s approach. Although the related arguments are often framed by reference to market integrity generally,15 and although they can also embrace justifications relating to constraining amorality 10 For a review see HM Treasury, Bank of England, Financial Conduct Authority, Fair and Effective Markets Review (2015). The series of FICC scandals led to a Financial Stability Board (FSB) workplan which included specific measures on benchmarks (section 10), but which also called for closer supervision of governance and conduct in the wholesale markets generally, as well as for more stringent enforcement of conduct breaches. See, eg, FSB, Strengthening Governance Frameworks to Mitigate Misconduct Risk (2018) and FSB, Measures to Reduce Misconduct Risk. Progress Report (2015). 11 See further Chs IV, V, and VI. 12 Regulation (EU) No 648/​2012 [2012] OJ L201/​1. See further Ch VI section 5. 13 One oft-​cited study reported that of the 103 countries studied, eighty-​seven had adopted insider-​dealing prohibitions: Bhattacharya, U and Daouk, H, ‘The World Price of Insider Trading’ (2002) 57 J Fin 75. See also International Organization of Securities Commissions (IOSCO), Insider Trading. How Jurisdictions Regulate It (2003), which noted that ‘nearly every jurisdiction’ had enacted a prohibition on insider dealing: at 1. 14 For a review of the major controversies see McVea, H, ‘Supporting Market Integrity’ in Moloney, N, Ferran, E, and Payne, J (eds), The Oxford Handbook of Financial Regulation (2015) 631; Beny, L, ‘Do Insider Trading Laws Matter? Some Preliminary Comparative Evidence’ (2005) 7 ALER; Bainbridge, S, ‘Insider Trading’ in The Encyclopedia of Law and Economics (2000) 772; and, for an early EU perspective, Hopt, K, ‘The European Insider Dealing Directive’ in Hopt, K and Wymeersch, E (eds), European Insider Dealing (1991) 129. 15 On the ambiguity (and ubiquity) of ‘market integrity’ as an objective of regulation, and calling for it to be more clearly delineated so as to be capable of interpretation and predictability see Austin, J, ‘What Exactly is Market Integrity? An Analysis of One of the Core Objectives of Securities Regulation’ (2017) 8 Wm & Mary Bus LR 215 (relating market integrity to the absence of abusive conduct, but also to non-​discriminatory market access, transparent and accurate pricing information, and accurate information on issuers being available to all market participants at the same time).

VIII.2  Rationale for Prohibiting Insider Dealing & Market Manipulation 681 and unfairness,16 the underlying rationale for prohibiting insider dealing17 can be described, very broadly, as being based on two competing and contrasting rationales.18 The first, relationship-​based rationale for insider-​dealing prohibitions has a micro focus. It characterizes insider dealing as a breach of a fiduciary relationship of trust and confidence, where one can be established, between, typically, the insider and the company concerned (a related strand characterizes insider dealing in terms of the allocation of property rights).19 The macro, market-​based focus of the second rationale (which has shaped the EU regime)20 is on market efficiency, and on the support of efficient price formation and deep liquidity. Insider dealing, under this rationale, is prohibited in order to support the efficiency with which the market allocates resources through the price-​formation mechanism. This argument is typically made by regulators, albeit often with little by way of empirical support, although there is evidence that the enforcement of insider dealing prohibitions can have quantifiable market effects.21 If investor confidence in the price-​formation process is compromised because of insider dealing, goes the argument, liquidity can be damaged, price formation weakened, and the cost of capital increased as investors price in the risk of trading against inside information or leave the market.22 While investor confidence is notoriously difficult to assess, in the insider-​dealing context it is often linked to confidence in market egalitarianism, or the confidence of investors in the equality of access to information.23 The elusive notion of market egalitarianism, and its associated notion of fairness,

16 Schepple, K, ‘It’s Just Not Right: The Ethics of Insider Trading’ (1993) 56 Law & Contemporary Problems 123. 17 Although in reviewing the rationale for prohibiting insider dealing, ‘[t]‌o cross between the doctrinal and policy discussion is to risk disorientation; in the policy debate even the settled legal rule against open trading by corporate insiders dissolves into a decidedly unsettled account of price behaviour and compensation contracts’: Kraakmann, R, ‘The Legal Theory of Insider Trading Regulation in the United States’ in Hopt and Wymeersch, n 14, 39, 47. 18 For analysis of the relationship (associated with the US) and market (associated with the EU) approaches see, eg: Venturozzo, M, ‘Company Insider Trading in the United States and in the European Union: History and Recent Developments’ (2015) 11 ECFR 554; Loke, A, ‘From the Fiduciary Theory to Information Abuse: the Changing Fabric of Insider Trading Law in the UK, Australia, and Singapore’ (2006) 54 Am J Comp L 123; Black, J, ‘Audacious But Not Successful: A Comparative Analysis of the Implementation of Insider Dealing Regulation in EU Member States’ (1998) 2 CFILR 1; and Davies, P, ‘The European Community’s Directive on Insider Dealing: From Company Law to Securities Market Regulation’ (1991) 11 OJLS 92. The two approaches have been described in terms of the contrasting interests at stake—​the ownership rights of the information holder, and the interest of investors in the integrity of the marketplace as a whole: Davies, P, ‘The Take-​over Bidder Exemption and the Policy of Disclosure’ in Hopt and Wymeersch, n 14, 243. 19 See, eg, Macey, J, ‘From Fairness to Contract: The New Direction of the Rules Against Insider Trading’ (1984) Hofstra LR 9 and Bainbridge, S, ‘Insider Trading Regulation: The Pathdependent Choice Between Property Rights and Securities Fraud’ (1999) 52 Southern Methodist University LR 1589. 20 Although MAR is increasingly being examined from a property rights perspective, in particular as regards its exemptions and alleviations. See Taleska, A, ‘European Insider Trading Theory Revisited: The Limits of the Parity-​ of-​Information Theory and the Application of the Property Rights in Information Theory to Activist Investment Strategies’ (2020) 17 ECFR 558, characterizing certain MAR exemptions for persons who have produced new information (such as the ‘market soundings’ safe harbour: section 6.3.4) as protecting property rights in information; and, characterizing the MAR delay mechanism, which allows issuers to delay publication of inside information (section 7.1), as reflecting the issuer’s property rights in the information, Hössl-​Neumann, M and Baumgartner, A, ‘Dealing with Corporate Scandal under European Market Abuse Law: The Case of VW’ (2019) 16 ECFR 484. 21 See the references at n 31. 22 ‘[I]‌n a stock market in which insiders trade with impunity . . . [t]he liquidity providers in such a market would protect themselves by increasing their sell price and decreasing their buy price. This increases the transaction costs, which in turn induces a stock trader to require an even higher return on equity’: Bhattacharya and Daouk, n 13, 76. 23 See Scott, K, ‘Insider Trading, Rule 10-​b(5), Disclosure and Corporate Privacy’ (1980) 9 J Legal Studies 801 and Brudney, V, ‘Insiders, Outsiders and Informational Advantages Under the Federal Securities Laws’ (1979) 93 Harv LR 322.

682  Market Abuse which have been influential on the EU regime,24 and on how the Court of Justice has interpreted MAR and its precursor MAD,25 imply that in the context of impersonal markets and trading venues, investors should deal on a relatively equal basis with equal opportunities to access information, and should not be unfairly disadvantaged by those with special access to non-​public information.26 Market-​efficiency-​based arguments have been subject to voluminous critique, in particular since Manne’s seminal 1966 work. In a controversial and agenda-​setting analysis, Manne argued against the prohibition of insider dealing, given its beneficial effects on price formation, and given its associated benefits in providing entrepreneurs with performance incentives (to produce positive information on which they can trade) and in thereby overcoming agency costs.27 Manne argued that insider dealing ultimately moved prices steadily in the right direction,28 benefited long-​term investors (including uninformed investors), harmed only speculators, and increased confidence in the price-​formation mechanism. The stage was then set for a long-​running and largely inconclusive debate on the impact of insider dealing on market efficiency and price formation,29 albeit that more recently that debate has tilted towards empirical assessment of the impact of insider dealing (and market abuse) prohibitions generally.30 Ultimately, while it is difficult to establish conclusively whether insider-​dealing prohibitions have an impact on the efficiency of price formation, on the depth of market liquidity, 24 The EU’s first attempt at prohibiting insider dealing linked investor confidence to the assurance afforded to investors that they would be on an equal footing and protected against the improper use of inside information (IDD recitals 4 and 5). Similarly, MAR relates the insider dealing prohibition to an ‘unfair advantage’ being obtained, to the detriment of third parties, and to the undermining of market integrity and investor confidence (MAR recital 23). On market egalitarianism and the EU approach to insider dealing, see further Venturozzo, n 18 and Moalem, D and Hansen Lau, J, ‘Insider Dealing and Parity of Information—​Is Georgakis Still Valid?’ (2008) 19 EBLR 949. 25 As regards the MAR prohibition on unlawful disclosure of inside information, Advocate General Kokott characterized the primary aim of European legislation on market abuse as ‘to ensure a capital market with integrity and equal rights for investors. This is intended to create investor confidence, which in turn plays a key role in the economic functioning of the market. Insider dealing law . . . helps to achieve this goal by ensuring that all market participants are on an equal footing’: Case C-​302/​20 A v AMF (ECLI:EU:C:2021:747) para 1. Earlier, the Court found that the precursor MAD had the aim of protecting the integrity of financial markets and enhancing investor confidence, and that confidence depended, inter alia, on investors being placed on an equal footing and protected against the improper use of information: Case C-​45/​08 Spector Photo Group NV and Chris Van Raemdonck v Commissie voor het Bank-​, Financie-​en Assurantiewezen (CBFA) (ECLI:EU:C:2009:806) paras 47 and 48. Egalitarianism was also influential on the Court of Justice’s interpretation of key IDD concepts in Case C-​391/​04 Oikonomikon and Amfissas v Georgakis (ECLI:EU:C:2007:272) and Case C-​384/​02 Grøngaard and Bang (ECLI:EU:C:2005:708). 26 Complete equality is impossible to achieve, given the superior ability of certain (typically professional) investors legitimately to access and decode publicly available information: Gilson, R and Kraakmann, R, ‘The Mechanisms of Market Efficiency’ (1984) 70 Va LR 549. 27 Manne, H, Insider Trading and the Stock Market (1966). For a summary see Manne, H, ‘In Defense of Insider Trading’ (1966) Harv B Rev November–​December 113. 28 The thesis is based on the notion that buying activity by insiders with price-​sensitive positive information about the firm will drive the price up, reflecting more accurately the status of the firm and allowing non-​insiders to trade at a more accurate price. Relatedly, managers are incentivized to produce, through superior performance, positive information on which they can then trade. 29 For the supporting argument that insider-​dealing prohibitions slow down the rate at which securities prices adjust to new information see Carlton, D and Fischer, D, ‘The Regulation of Insider Trading’ (1983) 35 Stanford LR 857. For a challenge to this view, based, inter alia, on the argument that the inside information driving the insider’s trading decision cannot be decoded by the marketplace (through ‘derivatively informed’ trading which supports market efficiency), see Gilson and Kraakmann, n 26 and, in the EU context, arguing that ‘essential information relevant to price is not supposed to reach the Stock Exchange slowly, indirectly and with a prior profit for insiders but immediately, directly and with due regard to equality of opportunity, thus through timely disclosure’, see Hopt, K, ‘Insider Regulation and Timely Disclosure’, Forum Internationale, No 21 (1996) 4. 30 For a review of this shift and of the major studies see McVea, n 14, albeit cautioning against the extent to which data can resolve a debate which is ultimately grounded in non-​market values.

VIII.2  Rationale for Prohibiting Insider Dealing & Market Manipulation 683 and on market development,31 insider-​dealing prohibitions are now well-​tried components of the regulatory tool-​kit internationally.32 The debate is now increasingly focusing on whether insider-​dealing prohibitions can carry the weight of market innovation, including as regards the development of autonomous, artificial reasoning tools in financial markets,33 and also as regards the evolving dynamics of information production within firms, for example as regards environmental, social, and governance (ESG) and relatedly sustainability-​ oriented disclosures.34

VIII.2.1.2 Market Manipulation Market manipulation prohibitions typically address information-​related abuses, such as the misuse of material information (and so can supplement or include insider-​dealing rules) and the dissemination of false or misleading information. They also address trading practices which distort the trading price or trading volume of a financial instrument.35 Trading-​ related abuses encompass a wide range of abusive conduct, but are typically regarded as covering two overlapping activities: conduct which creates an artificial and misleading impression about the ‘real’ market in, or price or value of, a financial instrument; and conduct which, by interfering with the ‘usual ‘forces of supply and demand, distorts the market. The former trading practices typically involve engaging in trades, or a series of trades, to create a false impression of a liquid market in particular financial instruments, or to maintain or position prices at an artificial level. The latter trading practices include ‘abusive squeezes’, through which a person who exercises significant influence over the supply of a financial instrument enters into transactions under which that person has the right to require others to deliver that instrument or to take delivery of it, and uses those transactions to distort the market by setting abnormal prices for the discharge of the obligations owed. Market manipulation accordingly engages a vastly wider range of abuses than insider-​ dealing related abuses. The regulatory design challenges in designing prohibitions that capture such abusive behaviour and do not disrupt legitimate behaviour are, relatedly, 31 Enforcement appears critical for a market effect to be observed: Bhattacharya and Daouk, n 13 and Fernandes, N and Ferreira, M, ‘Insider Trading Laws and Stock Price Information’ (2009) 22 Rev of Financial Studies 1845. For an EU analysis, based on the implementation of the 2003 MAD, see Christensen, H, Hail, L, and Leiz, C, ‘Capital-​ Market Effects of Securities Regulation: Prior Conditions, Implementation and Enforcement’ (2016) 29 Rev of Fin Studies 2885, finding that market liquidity increased (and firms’ cost of capital decreased) as the Directive came into force and that the liquidity effects were stronger in Member States with traditionally stronger regulators. Looked at over a longer horizon, the case is less clear, albeit that allowance must be made for different and less complex market structures. Prior to the enforcement of insider-​dealing rules in the 1960s, eg, the US had developed strong securities markets: Black, B, ‘The Legal and Institutional Preconditions for Strong Securities Markets’ (2001) 48 University of California LR 781. For a similar argument in the UK context, see Cheffins, B, ‘Does Law Matter: the Separation of Ownership and Control in the United Kingdom’ (2001) 30 J Legal Studies 459. For an early critique of the impact of the 1989 IDD, casting doubts on its impact on the development of the EU equity market, see Ferran, E, Building an EU Securities Market (2004) 30–​4. 32 The international momentum driving the adoption of insider-​dealing regimes internationally in the mid-​ 1980s was generated in part by pressure from the markets, and in part by pressure from the US SEC: Enriques, L, ‘EC Company Law Directives and Regulations: How Trivial Are They?’ (2006) 27 U Pa JIEL 1 and Pitt, H and Hardison, D, ‘Games Without Frontiers: Trends in the International Responses to Insider Trading’ (1992) 55 Law & Contemporary Problems 199. 33 Which raise challenges as regards the detection of abuse, but also where prohibitions have intention-​based elements. See, eg, Azzutti, A, Ringe, WG, and Stiehl, HS, ‘Machine Learning, Market Manipulation and Collusion on Capital Markets: Why the ‘Black Box’ Matters’ (2021–​2022) 43 U Pa J Int’l L 79. 34 Mülbert, P and Sajnovitz, A, ‘The Inside Information Regime of the MAR and the Rise of the ESG Era’ (2021) 18 ECFR 256, exploring whether ESG-​related disclosures should be regarded as having price impact. 35 See generally Avgouleas, E, The Mechanics and Regulation of Market Abuse. A Legal and Economic Analysis (2005). For an early policy review see IOSCO, Investigating and Prosecuting Market Manipulation (2000).

684  Market Abuse significant.36 For example, the establishment of robust indicators for when the price of a financial instrument is artificial, as evidence of manipulative conduct, can be difficult.37 Legitimate market practices might, to take another example, risk being characterized as manipulative:38 stabilization, market-​making, arbitrage activities, and hedging practices are all legitimate activities which support market efficiency but which could be associated with manipulative conduct. Regulatory prohibitions also require a degree of future-​proofing, as manipulative practices can be highly dynamic, evolving as trading techniques develop, new products are designed, new participants enter the marketplace, and, as markets become ever more interconnected, the opportunities for cross-​border manipulation increase.39 The difficulties imply that any such prohibitions should have a robust rationale. Although the rationale for prohibiting market manipulation is, as with the insider-​dealing prohibition, contested,40 prohibitions on market manipulation are typically designed to support market efficiency and to lower the cost of capital.41 Manipulative practices are, relatedly, typically characterized as a form of market failure which ultimately leads to an inefficient allocation of resources. Like insider-​dealing prohibitions, market manipulation prohibitions are also typically tied to notions of investor confidence and fairness, often being associated with enhancing investor confidence in the fairness, honesty, and integrity of markets.

VIII.2.2  The EU and the Prohibition of Market Abuse The EU market abuse regime was, from the outset, concerned with managing the risks to market efficiency associated with insider dealing and market manipulation. Market integration was and remains, nonetheless, a driving imperative. MAR reflects the 2003 MAD and the 1989 IDD in justifying intervention by identifying market integrity as essential for an integrated and efficient financial market, linking the smooth functioning of securities markets and public confidence in markets to economic growth and wealth, and finding that market abuse harms the integrity of financial markets and public confidence in securities and derivatives (recital 2). Similarly, MAR is designed 36 For a recent US reconsideration see Fox, M, Glosten, L, and Rauterberg, G, ‘Stock Market Manipulation and Its Regulation (2018) 35 Yale J Reg 67, finding ‘market manipulation’ to be a confused standard with a poorly articulated normative base (given the breadth but thinness of relevant rules). 37 For a challenge to prohibitions based on price-​distorting effects, given the difficulties in establishing the correct level at which a financial instrument should trade, see Fischel, D and Ross, D, ‘Should the Law Prohibit “Manipulation” in Financial Markets?’ (1991) 105 Harv LR 503. IOSCO’s suggestion that ‘the key question is whether there appears to be any logical trading pattern to the security’s price and volume, or whether it seems erratic. If it is erratic, the question is whether the pattern coincides with the activities of the promoter, broker, or other participant in the potential manipulation’: n 35, 13, is reflected in ESMA’s advice to market participants that trading practices without an economic rationale may be abusive: n 229. 38 eg, the extent to which the early 2021 meme stock volatility, exemplified by the Gamestop trading spike, could be regarded as manipulative (given the degree of social media coordination engaged) could be argued to depend on perceptions as to the legitimacy of retail investors’ concern to disrupt the positions held by professional investors: Chiu, I, ‘Social Disruption in Securities Markets—​What Regulatory Response Do We Need? (2021) 28 Richmond J of L and Tech 46. 39 The financial-​crisis era, eg, saw concerns as regards abusive short selling, algorithmic trading, mis-​use of information by hedge funds, and benchmark manipulation (McVea, n 14), while abusive conduct in the FICC market preoccupied regulators internationally in the post-​financial-​crisis era, with the 2021 adoption of the self-​ regulatory Global FX Code marking a major staging post in this regard. 40 See, eg, Fischel and Ross, n 37. 41 Enriques, L and Gatti, M, ‘Is There a Uniform EU Securities Law after the Financial Services Action Plan?’ (2008) 14 Stanford J of Law, Business and Finance 43.

VIII.2  Rationale for Prohibiting Insider Dealing & Market Manipulation 685 to establish a ‘common regulatory framework’ to ensure the integrity of financial markets in the EU and to enhance investor protection and confidence in those markets (Article 1). The support of market integrity, and thereby of investor confidence and market efficiency, is, accordingly, the main objective of the EU regime, and reflects the market-​oriented rationales associated with insider dealing and market manipulation prohibitions. The extent to which MAR is achieving its objectives as regards market integrity and the support of investor confidence and thereby of market efficiency, is difficult to quantify. The many reviews of the different iterations of the EU’s market abuse rules since 1989 typically focus on specific aspects of regulatory design. The 2020 review by the European Securities and Markets Authority (ESMA) of MAR is indicative in that it was concerned with the operation in practice of specified MAR rules, and not with MAR’s quantifiable impact on market integrity and relatedly on market efficiency.42 Similarly, the development of MAR did not see the gathering or consideration of empirical evidence on the impact of the earlier 2003 MAD regime on market integrity and market efficiency.43 And although the market abuse regime is associated with the achievement of Capital Markets Union (CMU),44 market integrity indicators (and their relationship with market efficiency, for example with liquidity) do not form part of the Commission’s tool-​kit of indicators on progress towards CMU.45 Certainly, appropriate market integrity indicators are difficult to establish,46 albeit that they would support the regulatory design process.47 ESMA does collect data on sanctioning levels, but this data is a poor proxy for market integrity, given the range of factors that shape Member States’ approach to enforcement (section 9.3). Nonetheless, the EU’s prohibition on market abuse now has a normative quality. Contestation is limited48 and is primarily associated with the costs and frictions of the different reporting and disclosure obligations that support the market abuse regime, and with the effectiveness of enforcement.49 42 ESMA, MAR Review Report (2020). 43 The Impact Assessment (IA) for the 2011 MAR Proposal referenced the significant difficulties in building an evidence base, albeit that it noted the generally reducing levels of criminal prosecutions (from a very limited data set) and presented tentative evidence of the cost to the market of abusive conduct, in the form of an estimation of a cost of €13.3 billion to EU equity markets in 2010: 2011 MAR Proposal IA (SEC(2011) 1217) 14–​17. 44 eg the Commission’s High Level Forum on CMU called for a series of alleviations to MAR’s reporting requirements in order to support fund-​raising, particularly by SMEs: A New Vision for Europe’s Capital Markets. Final Report of the High Level Forum on the Capital Markets Union (2020) 67–​72. 45 Commission, Monitoring Progress Towards a Capital Markets Union: A Tool-​ kit of Indicators (SWD(2021) 544). 46 The UK Financial Conduct Authority annually collects ‘market cleanliness’ data which assesses abnormal equity price movements around takeover announcements. While it can indicate potential insider dealing, the FCA has cautioned that it represents only one indicator of broader market cleanliness, not least given the episodes of volatility (such as the March 2020 spike in volatility relating to the Covid-​19 pandemic) that can distort price movements and data collection. See FCA, Market Cleanliness Statistics 2020/​2021. The ‘MC’ metric, which measures abnormal trading volumes, has, broadly, reduced over 2006–​2020 albeit that it has fluctuated across years. 47 It has been argued that the development of metrics for assessing market integrity would avoid the privileging of market-​efficiency-​oriented innovations which may disrupt market integrity: Austin, n 15. Elements of this dynamic can be observed in the EU where procedural aspects of MAR have been liberalized to support SME fund-​ raising, albeit that ESMA has warned against further SME-​oriented changes, noting that ‘rules to preserve market integrity should not be modulated to the typology of issuers’: ESMA, Response to the Commission Consultation on the Listing Act (2022). 48 MAR has, however, produced a significantly larger literature than other elements of EU financial markets regulation, reflecting, in part, its distinctiveness from the closely-​studied US market abuse regime, the private law and criminal law settings in which it operates, the evolution of abusive practices, the relatively high volume of European Court of Justice rulings, and its interaction with human rights protections. 49 Reporting requirements were the main concern of the 2020 reviews by ESMA (n 42) and the CMU High Level Forum (n 44).

686  Market Abuse

VIII.3  The Evolution of the Regime VIII.3.1  From the Insider Dealing Directive to the Market Abuse Directive The prohibition of insider dealing was, from a very early stage, associated with the EU’s regulation of financial markets, being highlighted by the foundational 1966 Segré Report.50 But in the context of widespread Member State resistance to a statutory prohibition on insider dealing,51 and given the slower development of market finance in the EU as compared to the US—​where insider-​dealing prohibitions were, by then, long established—​progress towards an EU regime was slow. The 1977 Code of Conduct52 promoted equality of access to information and the support of efficient pricing by fair and adequate disclosure, reflecting the market-​oriented approach adopted by a 1976 Commission report on harmonizing insider-​dealing rules,53 but did not have significant impact. Although continued resistance from certain Member States slowed progress on an EU regime,54 a series of insider-​dealing scandals in the late 1980s, together with a Member State movement to address insider dealing55—​particularly as market finance began slowly to gain traction56—​created conducive conditions for the Commission’s adoption of its first proposal for an insider-​dealing regime in 1987,57 which was replaced by a lightly revised proposal in October 1988.58 The Insider Dealing Directive was finally adopted in November 1989 (the 1989 IDD).59 The IDD did not, however, drive significant regulatory change, given the extent to which the Member States had already introduced insider-​dealing regimes while it was under negotiation.60 It proved relatively resilient, however, providing the design template for initially the 2003 MAD’s and subsequently the MAR’s insider-​dealing prohibitions. Nonetheless, the IDD suffered from several weaknesses relating to its scope, its limited coordination of supervision and enforcement, and its failure to address abuse in the form of market manipulation. In particular, the risks associated with the absence of a harmonized regime prohibiting market manipulation became acute as the EU trading environment evolved over the 1980s and 1990s; as trading began to fragment across different trading venues, the potential for prejudicial cross-​border effects from market manipulation was magnified, as was highlighted by Member State regulators.61 The limitations of the IDD 50 Report of a Group of Experts Appointed by the EEC Commission, The Development of a European Capital Market (1966) 248–​9. 51 Particularly in Germany: Standen, D, ‘Insider Trading Reforms Sweep Across Germany: Bracing for the Cold Winds of Change’ (1995) 36 Harv Int LJ 177. 52 Commission Recommendation 77/​534/​EEC concerning a European Code of Conduct relating to transactions in transferable securities [1977] OJ L212/​37. 53 Working Paper No 1, ‘Co-​ ordination of the Rules and Regulations Governing Insider Trading’, EC Commission XV/​206/​76-​E. 54 The Commission accordingly took some time to decide whether insider dealing should be addressed through a directive or a recommendation: Tridimas, T, ‘Insider Trading: European Harmonisation and National Law Reform’ (1991) 40 ICLQ 919. 55 See generally Ferran, n 31. 56 Fornasier, R, ‘The Directive on Insider Trading’ (1989–​1990) 13 Fordham Int LJ 149 57 [1987] OJ C153/​8 (the Original Proposal); Explanatory Memorandum at COM(87) 11. 58 [1988] OJ C277/​13 (the Revised Proposal); Explanatory Memorandum at COM(88) 549. 59 n 3. 60 On its implementation see Wymeersch, E, ‘The Insider Trading Prohibition in the EC Member States: A Comparative Overview’ in Hopt and Wymeersch, n 14, 65. 61 Federation of European Securities Commissions (FESCO), The Regulation of Alternative Trading Systems in Europe. A Paper for the EU Commission (2000).

VIII.3  The Evolution of the Regime  687 in addressing market manipulation were exposed by the 2007 Court of Justice Georgakis ruling,62 which concerned whether a decision by a group of shareholders to support trading in the shares of a publicly quoted company, at a time when the share price was coming under downward pressure, breached the Directive. Although a classic example of potential market manipulation, the conduct could, in the circumstances of the case, only be dealt with under the IDD, which the Court refused to apply, noting that while the practices were liable to provoke a loss in investor confidence ‘the fact remains that the scope of [the IDD]—​the sole Community measure applicable to the facts in the case . . . is limited to taking advantage of inside information . . . it is not applicable to transactions designed to determine artificially, by concerted means, the price of certain transferable securities’.63 In response, the 1999 Financial Services Action Plan (FSAP) committed to the adoption of a directive which would address market manipulation and thereby enhance market integrity.64 Support followed from the seminal 2000 Lamfalussy Report, which highlighted the absence of regulation in this area as one of the factors hindering the development of an integrated capital market.65 The Commission’s subsequent 2001 Proposal restructured and consolidated the insider dealing regime but also proposed a new set of prohibitions on market manipulation.66 The relatively smooth and speedy passage of the reforms,67 the first to be negotiated under the then-​novel Lamfalussy process,68 reflected wider political commitment to the FSAP, the transfer of technical issues to the then-​new administrative rule-​ making process,69 and, more generally, the ramifications of the 11 September 2001 attacks which revealed market abuse as a tool of international terrorism.70 Adoption of the MAD followed in 2003.71

VIII.3.2  The Global Financial Crisis Era and the Market Abuse Regulation The 2003 MAD, initially at least, was broadly regarded as a success,72 although weaknesses in implementation and in supervisory consistency emerged from the 62 n 25. 63 n 25, Ruling of the Court, para 41. 64 Communication from the Commission, Implementing the Framework for Financial Markets: Action Plan (COM(1999) 232) 18. 65 Final Report of the Committee of Wise Men on the Regulation of European Securities Market (2001) 10 and 12. 66 COM(2001) 281. 67 The main elements of the legislative history are: European Parliament first reading (T5–​0113/​2002 ([2003] OJ C47/​417) (the first reading ECON (Economic and Monetary Affairs Committee) Report is at A5–​0069/​2002)) and Parliament second reading (T5–​0513/​2002 ([2003] OJ C300/​442) (the Second Reading ECON Report is at A5–​0343/​2002)); and Council Common Position [2002] OJ C228/​19. Of now historic interest only given how consultation processes have changed, the Commission’s unusual failure to consult publicly on the Proposal generated significant market concern and was acknowledged to be a serious mistake by the Commission: Commission, FSAP Evaluation. Part I: Process and Implementation (2005). 68 See Ch I section 5.1 in outline. 69 Inter-​Institutional Monitoring Group, Second Interim Report on the Lamfalussy Process (December 2003) 8 and Third Interim Report on the Lamfalussy Process (November 2004) 13. 70 Coffey and Overett-​Somnier, n 4, 371. 71 The MAD was accompanied by four sets of administrative rules amplifying different aspects of the regime, including the (then novel) ‘accepted market practices’ system and the exemption for stabilizations and buy backs. 72 European Securities Markets Expert Group (ESME), The Market Abuse EU Legal Framework and its Implementation by Member States: A First Evaluation (2007), reporting that ‘the market abuse legislation . . . has

688  Market Abuse outset.73 Unlike other FSAP measures, the MAD was not subject to a review obligation, although the Commission committed to reviewing the Directive by the end of 2008. Review of the MAD became subsumed within the wider financial-​crisis-​era reform programme, with a Proposal for a recast market abuse regime following in 2011.74 Major weaknesses identified, and addressed by the Proposal, included gaps in the MAD’s regulation of trading venues and of instruments (notably as regards the treatment of abusive behaviour in commodity derivatives and related spot or physical markets); limited national competent authority (NCA) enforcement powers; legal certainty risks arising from implementation divergences; and administrative burdens, particularly for the small and medium-​sized enterprise (SME) sector, arising from the MAD’s reporting and monitoring obligations. The Commission’s proposed reforms also reflected the wider themes of the financial-​crisis-​era reform movement. Although market abuse was not strongly associated with the financial crisis in the EU, the crisis brought a sharp focus to bear on the efficiency and integrity of information dynamics in certain market segments, including the credit default swap (CDS) segment, which was reflected in the Proposal.75 By proposing a new suite of rules for derivatives markets, the Proposal also reflected the G20’s commitment to strengthening oversight of OTC derivatives markets. The negotiations were relatively smooth,76 certainly compared with the negotiations on other financial-​crisis-​era measures. But while the main elements of the Commission’s Proposal persisted in the text as adopted, the negotiations saw the text change in some key respects. The Council negotiations saw, for example, the Member States reject the Commission’s proposal that a distinct definition be employed for the ‘inside information’ that is subject to issuer-​disclosure obligations, and also reject the Commission’s proposal that the ‘accepted market practice’ defence to market manipulation be removed; they also saw a liberalization of the Proposal, on market efficiency grounds, in the form of the Council’s introduction of the ‘market soundings’ regime.77 The European Parliament’s position was close to the Council’s, but it was also concerned to address abuses arising from algorithmic trading and to impose more stringent sanctions.78 Overall, MAR, which was adopted in 2014 and came into force in July 2016, broadly reflects the Council position. led to an increased level of harmonization across Member States and is contributing to creating a common level playing field for all the involved stakeholders’ (at 3). 73 The Committee of European Securities Regulators (CESR) repeatedly highlighted weaknesses in supervisory convergence in a series of reports, including CESR, An Evaluation of Equivalence of Supervisory Powers in the EU under the Market Abuse Directive and the Prospectus Directive. A Report to the Financial Services Committee (2007). 74 COM(2011) 651. It followed an earlier Call for Evidence in 2009 and a 2010 Consultation (Commission, Public Consultation on a Revision of the MAD (2010)). 75 Over the MAD review, the Commission referenced the acute sensitivity of the sovereign debt market to information flows through CDS trading and the need to include these instruments within the market abuse regime: eg 2010 Commission MAD Consultation, n 74, 2. CESR similarly highlighted the importance of applying the market abuse regime to CDSs: CESR, Response to the Commission MAD Call for Evidence (2009). 76 The main elements of the legislative history are: 2011 Commission MAR Proposal, n 74 and IA, n 43; ECON Report, 22 October 2012 (A7-​0347/​2012) (on which the European Parliament’s Negotiating Position was based); and Council General Approach, 26 June 2013 (Council Document 11383/​13). 77 Danish Presidency Progress Report on MAR, 21 June 2012 (Council Document 11535/​12). 78 The main differences between the Council, European Parliament, and Commission texts can be traced in the tabular analyses produced over the negotiations, including Differences Table, 20 March 2013. The Parliament sought, eg, the introduction of a specific prohibition on ‘abusive order entry’ (which was not adopted) and higher sanctions than the Council (it proposed an unlimited pecuniary sanction for natural persons and pecuniary sanctions of up to 20 per cent of turnover for legal persons; lower thresholds were finally adopted).

VIII.3  The Evolution of the Regime  689

VIII.3.3  From the Global Financial Crisis to the Covid-​19 Pandemic: A Decade of Stability On its 2014 adoption, MAR heralded what would become a decisive shift towards greater reliance on directly applicable regulations across the single rulebook by repealing the 2003 MAD and replacing it with a regulation. The reforms were also substantively significant, in particular as they expanded the perimeter of the market abuse regime. The MAR reforms saw the market abuse regime extend to commodity derivatives, emission allowances, and, in certain circumstances, spot (physical) markets, as well as to a multiplicity of trading venues and to off-​venue trading. The MAR reforms also sought to strengthen oversight and enforcement, including by prohibiting ‘attempts’ to engage in market manipulation, refining the MAD’s ‘suspicious transactions and orders’ reporting requirements and its managers’ transactions reporting requirements, strengthening NCAs’ investigatory powers, and introducing a new administrative sanctions regime. MAR also, however, calibrated and in some respects liberalized the market abuse regime, including by introducing the ‘market soundings’ regime, which protects specified disclosures, designed to test investor appetite, from falling within the market abuse regime; by recasting the ‘legitimate behaviour’ alleviations that protect the legitimate conduct of business while in possession of inside information; and by retaining but finessing the ‘accepted market practices’ regime which provides an NCA-​approved safe harbour for identified practices from market manipulation. MAR accordingly brought significant reform. Since its coming into force in 2016 and the adoption of its administrative rules, it has, however, been one of the quieter concerns of the single rulebook. This is not to suggest that the regime is not a pivotal single rulebook measure. Its importance has been highlighted in recent periods of acute market volatility and disruption, including in relation to the March 2020 deepening of the Covid-​19 pandemic, the early 2021 Gamestop/​meme stock episode, and the early 2022 Russian invasion of Ukraine.79 But in a sign of MAR’s maturity, the executive application of the regime, in the form of NCAs’ supervisory practices and approaches to enforcement, rather than MAR’s regulatory design, has attracted most attention.80 Similarly, MAR’s regulatory architecture has been stable. MAR has not been subject to material or frequent legislative revisions. Two sets of subsequent reforms liberalized MAR, primarily as regards the reporting obligations placed on managers (achieved through the 2016 Benchmark Regulation),81 and as regards procedural alleviations for SMEs (achieved

79 In all these periods of intense market volatility, ESMA warned market participants and issuers of the need to ensure full disclosure of ‘inside information’ (where the periods impacted on issuers) and of the prohibitions on market manipulation. See, eg, ESMA, Public Statement (War in Ukraine), 14 March 2022 (noting that issuers should disclose as soon as possible any inside information concerning the impact of the crisis); ESMA, Public Statement (Episodes of Very High Volatility in Trading of Certain Stocks), 17 February 2022 (warning retail investors that, in posting information on social media platforms, special care should be taken to avoid disseminating false or misleading information and breaching the market manipulation rules, and that organizing or executing coordinated strategies to trade and to move a share price could constitute market manipulation); and ESMA, Recommendation to Financial Market Participants, 11 March 2020 (recommending that issuers disclose as soon as possible any inside information relating to Covid-​19 impacts in accordance with MAR). 80 As is illustrated by the series of Court of Justice rulings over 2018–​2021 relating to the Italian NCA’s (Consob) use of administrative sanctions of a ‘criminal nature’, and the primarily operational bent of the 2020 ESMA MAR Review (both noted below). 81 The reforms liberalize the application of the manager reporting rules as regards assets held indirectly through investment funds and portfolios (section 7.3).

690  Market Abuse through the 2019 SME Regulation),82 but these reforms, noted below in this chapter, did not bring material change. The MAR administrative rulebook has also been stable, in sharp contrast with the revisions and refinements that have been made to its MiFID II/​MiFIR and EMIR counterparts. Relatedly, ESMA’s 2020 MAR Review, prompted by MAR’s review clause (Article 38) and the Commission’s related request for advice, found widespread market familiarity with, and understanding of, the core elements of MAR and did not propose major reforms.83 ESMA found that the foundational elements of the regime, including the pivotal prohibitions on insider dealing and market manipulation, did not require reform, and proposed largely operationally-​oriented reforms. The CMU agenda has not prompted specific reforms to core MAR requirements, albeit that it saw concerns raised as to the costs of MAR’s reporting and disclosure requirements, particularly for SMEs, which were also raised over the 2022 ‘Listing Act’ review and reflected in the related Listing Act reform agenda.84 This relative stability is in part a function of MAR’s regulatory orientation. MAR is not a passporting or market construction measure, does not seek structural market change, and did not, on its coming into force, impose significant costs on firms (certainly by comparison with the structural change and costs brought by EMIR and MiFID II/​MiFIR). It does not, accordingly, attract the sharp political and market interests associated with other aspects of the single rulebook. MAR’s stability is also a function of how the market abuse regime has evolved over time. MAR’s gateway legislative definition of ‘inside information’, for example, remains largely based on the foundational formula originally introduced by the 1989 IDD,85 and subsequently refined by technocratic guidance (originally through CESR guidance), technocratic administrative amplification (the MAD’s administrative rules), Court of Justice interpretation, and political negotiation (over the MAR negotiations). This incremental process of refinement can be associated with MAR’s conceptual foundations becoming more or less normative.86 Relatedly, MAR’s core elements have not been extensively amplified by detailed administrative rules (the administrative rules are primarily concerned 82 Regulation (EU) 2019/​2115 [2019] OJ L320/​1. The reforms liberalize MAR in some respects as regards its application to issuers admitted to trading on an SME Growth Market. They extend, accordingly, beyond SMEs, as up to 50 per cent of issuers on SME Growth Markets can be non-​SMEs, but the SME Growth Market perimeter was adopted for the reform in order to provide consistency for issuers and clarity for investors (rec 4). See further Ch II section 8 on the SME Growth Market. 83 n 42. 84 eg 2020 CMU High Level Forum Report n 44, 67–​72, including as regards the ‘inside information’ disclosure obligation for issuers, the insider lists requirement, and the manager reporting obligation. As this book went to press, the Commission adopted three ‘Listing Act’ Proposals: the Listing Act Directive Proposal I (COM(2022) 760) (proposing the removal of the ‘official listing’ regime; and a liberalization of the investment research ‘unbundling rule’); the Listing Act Directive Proposal II (COM(2022) 761) (proposing a minimum harmonization regime for the treatment of multiple vote structures on SME Growth Markets); and the Listing Act Regulation Proposal (COM(2022) 762) (proposing greater flexibility regarding the disclosures required under the prospectus and market abuse regimes). The proposals, adopted in December 2022, were designed to reduce the costs associated with raising capital on the public markets and to support thereby CMU, in particular by addressing prospectus formats and exemptions (see Ch II). The Listing Act Regulation Proposal also, however, included largely technical revisions to MAR as regards its reporting requirements, albeit that it also proposed a refinement of the definition of ‘inside information’ as regards MAR’s issuer-​disclosure obligations. 85 IDD Art 1(1) defined inside information as ‘information which has not been made public of a precise nature relating to one or several issuers of transferable securities or to one or several transferable securities, which, if it were made public, would be likely to have a significant effect on the price of the transferable security or securities in question’—​a formula on which the MAR definition is based (section 6). 86 Although the extent of the issuer-​disclosure obligation relating to ‘inside information’, and particularly as regards when information has become sufficiently ‘precise’ to require disclosure, remains troublesome and may be reformed: section 7.

VIII.3  The Evolution of the Regime  691 with procedural and operational matters and with the operation of the MAR exemptions),87 only three sets of ESMA Guidelines have been adopted, primarily oriented towards technical and operational matters,88 and the MAR Q&A is primarily concerned with disclosure and reporting-​related obligations, and not with the foundational prohibitions on insider dealing and market manipulation.89 Similarly, while (unusually for EU financial markets regulation) the Court of Justice has ruled on aspects of MAR and of the precursor MAD90 (notably as regards what constitutes ‘inside information’ and on the interaction between the administrative sanctions regime and the Charter of Fundamental Rights of the EU (as noted below in this chapter), its jurisprudence, save, arguably, for the 2012 Getl ruling (section 7.1) has not disrupted how the regime’s governing concepts are understood, even if uncertainties remain.91 MAR may, however, struggle in containing new forms of potentially abusive practices, in particular those deriving from artificial intelligence (AI), given its dependence, in parts, on concepts relating to intent.92 More broadly, MAR’s field of operation is tied to financial instruments and specified commodity derivatives (and related spot markets), and so does not capture the full range of abusive behaviour that can be associated with financial markets. Two of the most high-​profile instances of abusive conduct since its 2014 adoption have operated outside MAR’s scope. The series of foreign exchange scandals that emerged in the FICC markets globally over 2013–​2014 fell outside of MAR’s reach as they engaged spot foreign exchange contracts which are not MiFID II ‘financial instruments’ and so fall outside MAR.93 Global reform has followed in the form of the 2021 FX Global Code, a self-​regulatory set of standards developed by central banks and major market participants.94 While MAR could, conceivably, be extended to cover spot foreign exchange contracts, ESMA has advised against any such reform given the adjustment costs and pending greater experience with the Global Code.95 Similarly, the 2018 Cum/​Ex Cum/​Cum scandal, concerning the use of trading strategies designed to minimize liabilities to dividend withholding tax, was primarily concerned with tax avoidance, not market abuse.96 While neither 87 The trading-​related aspects of the market manipulation prohibition, however, have been extensively illustrated by means of ‘indicators’ and ‘practices’: section 8. 88 The operation of the market soundings regime; the disclosure delay mechanism; and the technical operation of the inside information definition in commodity derivatives markets. 89 The relative stability of the MAR regime might also be associated with the tendency of NCAs to wait for harmonized ESMA guidance and soft law on MAR’s operation rather than to produce local interpretations: Hansen, J, ‘Market Abuse Case Law—​Where Do We Stand with MAR? (2017) 14 ECFR 367. 90 For a review of the Court’s jurisprudence see Hansen n 89. 91 Particularly as regards the application of the obligation MAR imposes on issuers to disclose ‘inside information’ and the related delay mechanism (section 7). 92 For a seminal analysis of the challenges that AI poses to legal concepts deriving from intention see Hildebrandt, M, Smart Technologies and the End(s) of Law (2016). 93 Spot foreign exchange contracts do not qualify as financial instruments: MiFID II Annex I, C(4) and Delegated Regulation 2017/​565 [2017] OJ L87/​1 Art 10(1)(a) and (2). 94 FX Global Code. A Set of Good Principles of Good Practice in the Foreign Exchange Market (2021). 95 ESMA acknowledged that there was a regulatory gap in MAR as regards spot foreign exchange contracts. But it referenced a lack of support from NCAs and from the market for any extension of MAR to cover such contracts, and also the multiple challenges which such an extension would generate, including the scale of the adjustments that would be required to key MAR concepts to accommodate the modalities of foreign exchange trading and the massive scale of the markets which would thereby come under NCA/​MAR oversight. ESMA concluded that a cost-​benefit analysis, greater experience with the Global Code, and consideration of the international supervisory setting were required before any determination as to the extension of MAR’s scope was made: 2020 ESMA MAR Review, n 42, 27–​9. 96 ESMA’s 2020 report on the scandal, which responded to a 2018 European Parliament Resolution requesting an ESMA review, and which drew on NCAs’ reporting of their related competences and experience, found that the scandal related to tax evasion rather than market abuse. Where the relevant strategies, which could engage trading

692  Market Abuse of these scandals can be associated with a specific failure of the MAR regime, they underline its limits as well the challenges in designing an omnibus measure to address market abuse. This is not to suggest that MAR’s scope is sub-​optimal. Where its perimeter is fixed is inevitably a compromise, and its current scope is aligned, more or less, with the coverage of EU financial markets regulation generally. The scandals do, however, highlight that expectation risks can arise, and the danger that MAR becomes subject to related legislative ‘tinkering’ which could destabilize its regulatory design, albeit that ESMA’s technocratic capacity may have a moderating effect. MAR has proved to be more troublesome as regards its executive application. To a greater extent than other components of the single rulebook, MAR is oriented towards prevention, detection, and enforcement. But related operational costs and frictions have been a persistent feature of MAR’s application since 2016, in particular as regards the different reporting and procedural obligations placed on issuers and regulated actors.97 Accordingly, while MAR’s foundational concepts as regards inside information, insider dealing, and market manipulation are relatively well-​settled, the encrustation of detailed reporting and procedural requirements, even where designed to protect legitimate market practices from the reach of MAR’s prohibitions, has generated frictions, costs, and ambiguities.98 Supervisory convergence can also struggle, with the MAR regime providing one of the few examples, across the single rulebook, of overt friction between ESMA and an NCA.99 And while indicators of optimal enforcement remain a challenge, given the different variables that drive the extent to which local enforcement matters to the achievement of MAR outcomes, it is certainly the case that enforcement and sanctioning disparities persist across the Member States.

VIII.4  The MAR Rulebook: Legislation, Administrative Rules, and Soft Law As outlined in section 3.3, MAR has proved to be a stable legislative measure. It is amplified by an extensive administrative rulebook, which includes a series of ITSs that specify the modalities of the regime’s different reporting and notification requirements. At its core are an omnibus Delegated Regulation that covers different aspects of MAR and five RTSs. Together, these measures form a procedural manual on how the regime’s prohibitions,

strategies such as short selling and securities lending, fell within the market abuse regime, NCAs could act, but the scandal was primarily one of tax evasion. ESMA also warned against expanding MAR to address tax evasion, arguing that this competence lay properly with tax authorities, and recommended instead enhanced information-​ exchange between NCAs and tax authorities: ESMA, Final Report on Cum/​Ex, Cum/​Cum and Withholding Tax Reclaim Schemes (2020). 97 ESMA’s 2020 MAR Review proposed a series of mitigating reforms, including to the persistently troublesome insider lists regime, which had previously been revised by the 2019 SME Regulation and which, on its adoption in 2014, was designed to streamline the precursor MAD regime. Reforms may follow from the 2022 Listing Act Regulation Proposal (n 84). 98 As was highlighted by the CMU discussions (n 44). 99 As regards the French NCA and ESMA and in relation to ESMA’s disagreement, articulated through its related MAR opinion powers, with the French NCA’s adoption of an ‘accepted market practice’ that conflicted with ESMA’s view of the practice’s compliance with MAR (section 8.2).

VIII.5  Setting the Perimeter: Scope  693 safe harbours, and reporting requirements operate in practice, covering: the indicators of market manipulation and also the trading prohibitions/​notifications that apply to managers (Delegated Regulation 2016/​522); the safe harbours for buy-​back and stabilization arrangements (RTS 2016/​1052); the procedures governing disclosures in the form of ‘market soundings’ which are exempt from the insider dealing prohibitions (RTS 2016/​ 960); the procedures governing the exemption for ‘accepted market practices’ from the market manipulation prohibition (RTS 2016/​908); and, in each case directed to supporting NCA monitoring, the financial instrument reference data that trading venues must provide (RTS 2016/​909) and the suspicious transactions reporting (STR) regime (RTS 2016/​ 957).100 This administrative rulebook has a strongly operational quality, being primarily concerned with the procedural modalities of different exemptions, with reporting requirements, and with the practical amplification of the ‘practices’ which can indicate manipulative conduct. These rules are supported by ESMA Guidelines101 and the MAR Q&A. In addition, ESMA has adopted supervisory convergence measures, chief among them its novel ‘Points for Convergence’ Opinion, which is designed to secure convergence in NCAs’ approaches towards accepted market practice safe harbours for liquidity contracts (section 8.2). ESMA’s soft law ‘rulebook’ is somewhat less dense here, as compared to other elements of the single rulebook, but its operational support of supervision and enforcement is significant (section 9.2).

VIII.5  Setting the Perimeter: Scope MAR establishes a common regulatory framework on insider dealing, unlawful disclosure of inside information, and market manipulation, as well as on measures to prevent market abuse to ensure the integrity of financial markets in the EU and to enhance investor protection and confidence in those markets (Article 1). Its reach extends therefore beyond the regulated actors typically the concern of the single rulebook to encompass all persons engaged in behaviours prohibited by MAR. Its scope is governed, for the most part, by two widely cast concepts: financial instruments; and the venues on which they trade. These two concepts are designed to capture the market abuse risks which arise where trading is fractured across multiple trading venues and where abuse can be hidden by the manipulation of trading across financial, derivative, and spot (physical) markets.

100 Respectively, Delegated Regulation (EU) 2016/​522 [2016] OJ L88/​1; RTS 2016/​1052 [2016] OJ L173/​34; RTS 2016/​960 [2016] OJ L160/​29; RTS 2016/​908 [2016] OJ L153/​3; RTS 2016/​909 [2016] OJ L153/​13; and RTS 2016/​ 957 [2016] OJ L160/​1. The development of the regime did not prompt significant contestation, in part given the significant volume of CESR soft law and the precursor MAD administrative rules which informed the development of the rules. On the development process and the stakeholder consultations see ESMA, Draft Technical Standards on the Market Abuse Regulation (2015) and ESMA, Technical Advice on Possible Delegated Acts Concerning the Market Abuse Regulation (2015). 101 The Guidelines cover market soundings (2016), delay in the disclosure of inside information (2016), and commodity derivatives (2016).

694  Market Abuse

VIII.5.1  Financial Instruments and Commodities Under Article 2(1), MAR applies to a wide range of ‘financial instruments’,102 defined by reference to MiFID II.103 Transactions in these instruments only come within MAR, however, when the venue-​related scope requirements are also met, although the venue requirements are widely drawn (section 5.2). MiFID II financial instruments include, alongside a wide range of derivatives including specified commodity derivatives, emission allowances. MAR accordingly contains a series of calibrations to reflect the specific features of emission allowances and of the markets on which they are auctioned and trade.104 MAR does not contain a definitive list of in-​scope financial instruments, although the MAR negotiations saw some discussion of whether ESMA should be empowered to propose administrative rules establishing such a list. MAR provides instead that market operators of regulated markets, and investment firms and market operators operating a multilateral trading facility (MTF) or organized trading facility (OTF), notify their NCAs of the instrument reference data of any instrument for which a request for admission to trading on their venue is made, which is admitted to trading, or which is traded for the first time (and when the instrument ceases to be traded or admitted) (Article 4). This notification requirement, designed to support NCA oversight and enforcement, overlaps with the instrument reference data reporting required under MiFIR Article 27 and has been streamlined to align with MiFIR.105 MAR extends beyond MiFID II/​MiFIR financial instruments as regards its prohibitions on market manipulation. These prohibitions also apply to spot (or physical) commodity contracts,106 which are not wholesale energy products (these are covered under the 2011 102 MAR does not apply to transactions, orders, or behaviours relating to in-​scope financial instruments carried out in pursuit of monetary, exchange rate, or public debt-​management policy, by a range of public institutions including Member States, the Commission, the European System of Central Banks, and relevant national agencies, or to actions by the EU, Member State special purpose vehicles, the European Stability Mechanism, the European Investment Bank, or other international financial institution established by two or more Member States which has the purpose of mobilizing funding and providing funding to members experiencing or threatened by severe financing problems (Art 6). The exemption also extends to actions by the Commission and Member States in pursuit of climate policy (given the inclusion of emission allowances within MAR) or actions in pursuit of the EU’s Common Agricultural Policy or Common Fisheries Policy (given the potential for commodity trading to come within the MAR): Art 6. Equivalent exemptions have been adopted for specified third country public bodies and central banks by Delegated Regulation 2016/​522 (UK institutions were added in 2019). 103 Article 3(1)(1). On the wide range of ‘financial instruments’, including derivatives, covered by MiFID II see Ch IV section 5.3. As noted in section 3.3, spot foreign exchange contracts do not come within MiFID II and fall outside MAR accordingly. 104 The trading of emission allowances engages the EU’s climate policy and the operation of the related carbon market under Commission Regulation 1031/​2010 [2010] OJ L302/​1 (the Auctioning Regulation). In order to avoid disruption to EU climate policy, and to reflect the particular structural features of the emission allowances trading market, the application of MAR is calibrated to the distinct features of this market. eg, MAR obligations typically imposed on issuers of financial instruments apply to ‘emission allowance market participants’ (persons who enter into transactions, including the placing of orders to trade, in emission allowances—​in effect, companies with large installations which fall within the Auctioning Regulation regime): Art 3(1)(20). Exemptions also apply (in relation to the MAR’s disclosure obligations) where emission allowance market participants fall below particular emission thresholds (Art 3(1)(20) and Art 17(2)). ESMA’s 2022 review of the emission allowances market did not find material difficulties with the operation of MAR in this market, although it suggested a series of related reforms to enhance market transparency and functioning and highlighted the volatility driven by the war in Ukraine: ESMA, Emission Allowances and Associated Derivatives (2022). 105 By RTS 2016/​909 and ITS 2016/​378 [2016] OJ L72/​1. See Ch V section 13.2 on the financial instrument reference data reporting system. 106 A spot commodity contract is any contract for the supply of a commodity traded on a spot market which is promptly delivered when the transaction is settled, as well other contracts for the supply of a commodity (such as physically settled forward contracts) that are not financial instruments. A spot market is any commodity market in

VIII.5  Setting the Perimeter: Scope  695 REMIT Regulation), where the relevant ‘transaction, order, bid, or behaviour’ has or is likely or intended to have an effect on the price or value of an in-​scope financial instrument (see further section 8) (Article 2(2)(a)). The market manipulation prohibitions also apply, conversely, to types of financial instruments, including derivative contracts or derivative instruments for the transfer of credit risk, where the transaction, order, bid, or behaviour has or is likely to have an effect on the price or value of a spot commodity contract where that price or value depends on the price or value of those financial instruments (Article 2(2)(b)). As discussed in section 10, the prohibitions on market manipulation also apply to conduct relating to benchmarks (Article 2(2)(c)).

VIII.5.2  Venues MAR’s perimeter design eschews the regulated-​market-​based107 approach which the precursor MAD followed.108 Reflecting the expansion of the MiFID II/​MiFIR perimeter to encompass trading venues more broadly, MAR covers financial instruments admitted to trading on a regulated market (or for which a request for admission has been made), but also financial instruments traded on an MTF, admitted to trading on an MTF or for which an admission request has been made, and financial instruments traded on an OTF (each as defined under MiFID II) (Article 2(1)(a)–​(c)). It also, in what was at the time a very significant extension of the perimeter, applies to instruments traded OTC (not covered by Art 2(1)(a)–​(c)), where those instruments can have an effect on trading on an in-​scope venue (Article 2(1)(d)).109 The application of MAR does not depend on the abusive conduct taking place on a trading venue. It applies to any transaction, order, or behaviour concerning in-​scope financial instruments, irrespective of whether the transaction, order, or behaviour takes place on a trading venue (Article 2(3)).

VIII.5.3  Jurisdictional Scope MAR confers wide-​ranging jurisdiction on NCAs, reflecting the cross-​border reach of abusive activities. A Member State must designate a single NCA responsible for ensuring that the Regulation is applied on its territory, and regarding all actions carried out on its territory, as well as those actions carried out ‘abroad’ relating to instruments admitted to which commodities are sold for cash and promptly delivered when the transaction is settled, as well as other non-​ financial markets, such as forward markets for commodities (Art 3(15) and (16)). 107 See Ch V section 6 on the ‘regulated market’ trading venue. 108 The Commission reported that of the forty-​one or so MTFs trading shares in the EU in 2010, twenty-​five admitted shares not admitted to trading on a regulated market and so fell outside the MAD. As only three Member States opted to apply the MAD to these venues, a large segment of trading fell outside the MAD: 2011 MAR Proposal IA, n 43, 19. 109 Art 2(1)(d) catches financial instruments not covered by Art 2(1)(a)–​(c), the price or value of which depends or has an effect on the price or value of a financial instrument covered by those provisions, including, but not limited to CDSs or CfDs. This provision is designed to capture abuse through derivatives and reflects the financial-​ crisis-​era concern as to the potential for market abuse to be conducted through OTC trading in CDSs: 2011 MAR Proposal, n 74, 7.

696  Market Abuse trading on a regulated market or trading on an MTF or OTF operating within its territory (Article 22). Under Article 2(4), MAR has significant extraterritorial reach, applying to actions and omissions, in the EU or outside the EU, as long as the relevant instruments are in scope; whether or not the conduct in question affects the EU market or takes place on an EU venue is irrelevant. MAR’s supporting supervisory framework accommodates related international coordination by requiring NCAs, where necessary, and facilitated by ESMA, to conclude cooperation arrangements with third country authorities to ensure the enforcement of obligations which arise in third countries, as well as information exchange (Article 26).110

VIII.6  The Prohibition on Insider Dealing VIII.6.1  Inside Information VIII.6.1.1 The Core Definition: Inside Information and Financial Instruments MAR’s definition of ‘inside information’ is at the core of the prohibition on insider dealing and pivotal to its operation. The MAR definition is based on the precursor MAD definition, although MAR reorganized and expanded some of its elements. The precursor MAD definition, as amplified by administrative rules which are now subsumed within the MAR definition, was generally regarded as working reasonably effectively.111 It had also been subject to a series of clarifying Court of Justice rulings. The Court, reflecting its framing of the prohibition on insider dealing as being a means for ensuring investor confidence by placing investors on an equal footing, typically adopted a maximalist approach to inside information in these rulings.112 MAR retained the well-​tested MAD approach, but expanded the MAD definition to address pricing and trading dynamics in particular market segments. MAR also retained the MAD’s ‘dual function’ approach to inside information (the definition of inside information supported the insider dealing prohibition and also the issuer obligation to disclose inside information), although MAR calibrates how the definition applies in the issuer disclosure context, in order to address some of the difficulties the dual function approach

110 A high degree of coordination applies to NCAs’ international engagement, with RTS 2021/​1783 [2021] OJ L359/​1 setting out the template for international agreements. The delay in the adoption of the RTS (originally required to be delivered by ESMA to the Commission by July 2015) arose from the need to consider the impact of the General Data Protection Regulation (GDPR) (Regulation (EU) 2016/​679 [2016] OJ L119/​1), which came into force in 2018. The RTS is designed to be flexible and to recognize that international cooperation and information exchange as regards market abuse prevention is of longstanding and operates under well-​established agreements. It accordingly follows a modular form that allows NCAs to use relevant parts of the template; and seeks to avoid disrupting any pre-​existing arrangements NCAs may have in place under, eg, multilateral agreements, such as the IOSCO Multilateral MoU, a foundational instrument of international cooperation which is designed to support enforcement in securities markets internationally: ESMA, Draft RTSs on Co-​operation Arrangements under the Market Abuse Regulation (2019). 111 Eg 2007 ESME Report, n 725. 112 Primarily: Case C-​628/​13 Lafonta v AMF (ECLI:EU:C:2015:162); Case C-​445/​09 IMC Securities (ECLI:EU:C:2011:459); Case C-​19/​11 Getl v Daimler (ECLI:EU:C:2012:397); and Spector, n 25. In all these cases (discussed below), the Court’s rulings were framed by the market confidence rationale for the insider dealing prohibition, with the Court characterizing the objective of the insider dealing prohibition as placing investors on an equal footing and protecting them against the improper use of information.

VIII.6  The Prohibition on Insider Dealing  697 had generated for issuers (section 7.1). Experience with the MAR inside information definition has, notwithstanding some practical challenges,113 been broadly positive. ESMA’s 2020 review reported that market participants were of the view that it was ‘working properly’, was sufficiently broad to capture abusive conduct, and that any amendment would generate legal certainty risks; and concluded that the definition had proved effective.114 The definition of inside information has a number of forms, all similar in design. The first form of the definition applies to financial instruments; specific forms apply to commodity derivatives and to execution information. Under Article 7(1)(a), and as regards financial instruments, inside information is information of a precise nature, which has not been made public, relating, directly or indirectly, to one or more issuers of financial instruments or to one or more financial instruments and which, if it were made public, would be likely to have a significant effect on the prices of those financial instruments or on the price of related derivative financial instruments. Each of these elements, which are mutually independent and constitute minimum conditions which must be met if the information is to be regarded as inside information,115 are discussed later in this section.116

VIII.6.1.2 Inside Information: Commodities and Emission Allowances MAR makes special provision for transactions in commodity derivatives in order to reflect the distinct dynamics of information production and price formation in the commodity derivatives markets.117 For example, commodity producers hold proprietary information relating to their commercial activities which might be regarded as inside information under the ‘standard’ financial instruments definition, but which is used by commodity producers when they enter into commodity derivative contracts to hedge their risks; application of the standard definition could, accordingly, limit hedging activities by commodity producers and lead to higher costs.118 Relatedly, the interaction between the underlying physical commodity (spot) markets and commodity derivatives markets is complex. The commodity/​spot markets, which vary considerably in their structure and in whether they 113 Particularly for issuers and as regards the extent to which sensitive information has met the ‘precise’ element of the definition of inside information and so must be disclosed (section 7.1). The UK FCA (MAR has been ‘on-​shored’ into UK law following Brexit) has acknowledged that ‘inside information is not always easy to identify’: FCA, Best Practice Note—​Identifying, Controlling and Disclosing Inside Information, June 2020. 114 2020 ESMA MAR Review, n 42, 45–​60. ESMA acknowledged, however, market participants’ calls for additional guidance on the application of the definition. It also noted that while a minority of respondents had called for clarifying revisions, which would have specified the definition in more detail, such revisions would have limited the reach of the prohibition and reduced investor protection and market confidence (at 56). 115 As has been repeatedly confirmed by the Court of Justice. eg, Getl, n 112, Ruling of the Court, paras 52 and 55 and Lafonta, n 112, Ruling of the Court, para 28. 116 In the MAR Proposal, the Commission proposed an additional, catch-​all definition of inside information, not otherwise covered by the foundational Art 7(1)(a) definition and the sector-​specific definitions, and designed to catch information related to one or more issuers of financial instruments, or to one or more financial instruments, not generally available to the public but which, if it were available to a ‘reasonable investor’ who regularly deals on the market and in the financial instrument (or related spot commodity contract) concerned, would be regarded by that investor as relevant when deciding the terms on which transactions in the financial instrument (or related spot commodity contract) should be effected (2011 MAR Proposal Art 6(1)I). This was removed during the negotiations. The definition was designed in part to limit issuers’ disclosure obligations with respect to inside information. 117 The distinct regulatory challenges generated by then opaque commodity derivatives markets, and by the risks of speculation thereon, formed part of the international financial-​crisis-​era reform agenda, as noted in Ch VI section 2.5 as regards the position management regime. For a review of the risks, which include abusive practices across spot and derivatives markets, see IOSCO, Principles for the Regulation and Supervision of Commodity Derivatives Markets. Consultation Paper (2021). 118 2020 ESMA MAR Review, n 42, 50.

698  Market Abuse are centralized or based on bilateral trading, can be regulated (or not) to different degrees, including with respect to the prohibition of market abuse; display different levels of transparency; and impose different reporting obligations on participants. Trading on these underlying commodity/​spot markets is not governed by MAR, given the distinct structures of these markets and their different underlying regulatory and self-​regulatory frameworks. The EU is extending its reach over these markets through specific instruments such as the 2011 REMIT Regulation on energy market transparency and integrity. But in the absence of market abuse regulation of these markets, the capacity for a leakage of abuse from commodity/​spot to derivative/​financial markets, and back again, is significant. To address such specificities, MAD had used a distinct definition of inside information for commodity derivatives. But it was troublesome, generating legal certainty difficulties as well as difficulties relating to the linkage between trading on the commodity/​spot markets and on the related derivative/​financial markets.119 The refined MAR definition of inside information as regards commodity derivatives is accordingly designed to ensure that abusive behaviour does not fall within regulatory gaps between the commodity/​spot markets and the derivative/​financial markets, as well as to reflect the distinct features of information production and use in the commodity/​spot and commodity derivatives markets. The definition has two elements: the first element is similar to the ‘standard’ definition of inside information; the second relates to disclosure practices on commodity/​commodity derivatives markets. Inside information in relation to commodity derivatives is, first, specified as information of a precise nature, which has not been made public, relating directly or indirectly to one or more such derivatives or relating directly to the related spot commodity contract,120 and which, if it were made public, would be likely to have a significant effect on the prices of such derivatives or related spot commodity contracts; and, in the second element, where this is information which is reasonably expected to be disclosed, or required to be disclosed, in accordance with legal or regulatory provisions at EU or national level, market rules, contracts, practices, or custom, on the relevant commodity derivatives or spot markets (Article 7(1)(b)).121 ESMA’s 2020 review found this definition to be working well; market participants supported the bespoke definition given the structural features of commodities/​commodity derivatives markets.122

119 Leading NCAs to regard the MAD legal framework as not suited to addressing manipulative strategies that extended across physical and financial markets: 2011 MAR Proposal IA, n 43, 116. 120 Defined as any contract for the supply of a commodity traded on a ‘spot market’ (a commodity market in which commodities are sold for cash and promptly delivered when the transaction is settled and also other non-​ financial markets, such as forward markets for commodities: Art 3(16)) which is promptly delivered when the transaction is settled (and including derivative contracts which must be settled physically, such as physically-​ settled forward contracts): Art 3(1)(15). 121 MAR recital 20 notes that such information (such as that required to be disclosed under the REMIT Regulation or under the Joint Organizations Database Initiative (JODI) for oil) may serve as the basis of market participants’ decisions to enter into commodity derivatives contracts/​related spot contracts and so should constitute inside information. Following a MAR mandate, ESMA adopted Guidelines giving indicative examples of the type of information reasonably expected to be disclosed: ESMA, MAR Guidelines (information relating to commodity derivatives markets or related spot markets) (2017). The examples include, inter alia, legally-​required information such as that required under the REMIT Regulation; publicly available statistics such as the oil statistics produced by JODI and statistics reasonably expected to be produced by public entities in the EU or otherwise, and information reasonably expected to be produced by inter-​agency platforms aimed at enhancing food market transparency; and information reasonably expected to be disclosed by private entities, including regarding changes in storage conditions. 122 ESMA also supported the definition, noting that application of the ‘standard’ inside information definition would lead to higher costs for commodity producers: 2020 ESMA MAR Review, n 42, 50 and 57.

VIII.6  The Prohibition on Insider Dealing  699 A distinct regime applies to emission allowances (and related auctioned products), in respect of which inside information is defined as information of a precise nature, which has not been made public, relating directly or indirectly to one or more such instruments and which, if it were made public, would be likely to have a significant effect on the prices of such instruments or related derivative financial instruments (Article 7(1)(c)).123

VIII.6.1.3 Inside Information: Execution Information Investment firms generate distinct risks as regards insider dealing as persons such as dealers, brokers, portfolio managers, investment analysts, and corporate finance advisers can all have access to material information regarding the direction of trading. Related prohibitions on insider dealing can, however, catch legitimate behaviour and can also have complex interactions with firms’ conflict-​of-​interest management practices, including with respect to whether such practices, for example internal information barriers prevent the attribution of inside information to relevant persons and, thereby, prevent the application of insider dealing prohibitions and so accommodate legitimate activities.124 The MAR inside information definition makes specific provision for the information produced by the trading process on the direction of trading and order flow. Article 7(1) (d) provides that, ‘for persons charged with the execution of orders concerning financial instruments’, inside information also means information conveyed by a client and related to the client’s pending orders, which is of a precise nature, relates directly or indirectly to one or more issuers or to one or more financial instruments, and which, if it were made public, would be likely to have a significant effect on the prices of those financial instruments, the price of related spot commodity contracts, or the price of related derivative financial instruments. Proprietary trading on the basis of information provided by advance knowledge of client transactions is therefore prohibited. A series of provisions, however, protect ‘legitimate behaviour’ (section 6.3.5). While this form of the inside information definition has not proved problematic, the 2020 MAR Review led to ESMA recommending that it be expanded beyond the firm/​client relationship to cover all those in possession of information regarding future orders, such as issuers and their management, as well as those in possession of order information by virtue of their employment, such as managers of proprietary funds or accounts.125 VIII.6.1.4 Inside Information: Of a Precise Nature MAR’s characterization of inside information as being ‘precise’ is designed to ensure that speculation, opinion, and rumours are not inappropriately treated as inside information.126 123 This definition is designed to capture the nature of inside information in this area, which typically arises in relation to those companies, with large installations, that come within the EU emissions trading system: Commission, European Parliament’s Endorsement of the Political Agreement on the Market Abuse Regulation, 10 September 2013 (MEMO/​13/​774). Similarly, these companies, rather than the issuers of emission allowances, are the subjects of the issuer-​disclosure obligation in relation to emission-​allowance-​related inside information. 124 Specific requirements apply to investment firms as regards the management of conflict-​of-​interest risks relating to execution-​related disclosures (Ch IV section 8.3). See further on the interaction between insider dealing rules and conflict-​of-​interest rules Tuch, A, ‘Financial Conglomerates and Information Barriers’ (2014) 39 J Corp L 563. 125 2020 ESMA MAR Review, n 42, 58. 126 AG Kokott in the A case underlined, however, that rumours were not entirely excluded from the market abuse regime (the case concerned the MAD) and played a ‘significant practical role’ in market practice, and that, while difficulties inevitably arose as regards rumours, in relation to how specific the relevant information needed to be, there were no grounds for a generalized exclusion of rumours based on their inherent uncertainties: n 25,

700  Market Abuse The ‘precise’ qualification is also pivotal to the determination of when sensitive information becomes inside information and so must be promptly disclosed by issuers under Article 17(1). The meaning of precise is governed by Article 7(2), which is based on the precursor MAD administrative rules127 and which provides a somewhat unwieldy but reasonably pragmatic definition, which incorporates a price impact assessment. Information is of a precise nature if (i) it indicates a set of circumstances which exists (or may reasonably be expected to come into existence) or an event which has occurred (or may reasonably be expected to occur); and (ii) the information is specific enough to enable a conclusion to be drawn as to the ‘possible’ effect of that set of circumstances or event on the prices of the financial instruments (or the related derivative financial instrument, the related spot commodity contracts, or the auctioned products based on the emission allowances). In an attempt to clarify the scope of the related Article 17(1) obligation on issuers to disclose ‘inside information’—​particularly where, for example, sensitive negotiations are ongoing—​MAR further specifies that, in the case of a protracted process that is intended to bring about, or that results in, particular circumstances or a particular event, those future circumstances or that future event, but also the intermediate steps of that process which are connected with bringing about or resulting in those future circumstances or that future event, may be deemed to be precise information; an intermediate step in a process can be deemed to be inside information if, by itself, it satisfies the criteria for inside information (Article 7(2) and (3)). This finessing as to intermediate steps in larger processes reflects the Court of Justice’s 2012 Getl ruling, which, in relation to the 2003 MAD, took a wide approach to when the (precursor) Article 17(1) issuer-​disclosure obligation activated as regards ‘inside information’ arising from a process.128 The Court’s 2015 Lafonta ruling (also in the context of issuer disclosure of inside information and in relation to the 2003 MAD) further specified the nature of ‘precise’, in similarly maximalist terms. The Court found that it was enough, as regards the ‘precise’ qualification, for the information to be ‘sufficiently exact or specific’ to constitute a basis from which to assess whether the circumstances or event in question was likely to have a significant effect on the price of instruments to which it related. The Court found that the only information excluded from the scope of ‘inside information’, by virtue of the operation of ‘precise’, is information that is ‘vague or general’, from which it is impossible to draw a conclusion as to its possible effect on the prices concerned. The Court rejected the contention that ‘precise’ was a function of the information making it possible to determine the direction of change to the price of the relevant financial instrument.129 A similarly expansive approach to the notion Advocate General Opinion, paras 45–​7. The Court took a similar approach in its ruling: Ruling of the Court at ECLI:EU:C:2022:190. 127 Commission Directive 2004/​124/​EC [2003] OJ L339/​70. 128 See section 7. The recitals to MAR additionally suggest that such inside information can relate to, eg, the state of contract negotiations, provisional agreed terms, the possibility of a placement of financial instruments, the conditions under which a financial instrument will be marketed, and consideration of the inclusion of a financial instrument in a major index (or its deletion): recital 17. The specification of ‘precise’ is not, however, intended to prohibit discussions of a general nature regarding the business and market developments between shareholders and management, which MAR recognizes as being essential for the efficient functioning of markets: recital 19. 129 The Court noted that, given the increased complexity of financial markets and the difficulty of evaluating likely price directions, any such qualification of ‘precise’ could give the holder of the information a pretext for not disclosing it and profiting as a result: Lafonta, n 112, Ruling of the Court, paras 29–​36.

VIII.6  The Prohibition on Insider Dealing  701 of ‘precise’, this time in the context of the disclosure by a journalist of the upcoming publication of articles disclosing potential takeover bid activity, in alleged breach of the prohibition on disclosing inside information, was adopted by the Court in the 2022 A case (which also addressed the 2003 MAD).130 The optimal definition of ‘precise’ is inevitably elusive, as the definition needs to be sufficiently broad to capture and deter abusive behaviour, but sufficiently specific to provide reasonable guidance to the market, particularly where the information relates to an ongoing process which has yet to complete. While some degree of constructive ambiguity has advantages when it comes to preventing abusive behaviour, the difficulties are more significant in the issuer disclosure context, as issuers can be required to make what can be fine and difficult judgments as to when potentially ‘inside information’ has become sufficiently precise to require disclosure (section 7.1).131

VIII.6.1.5 Inside Information: Information which Has Not Been Made Public MAR does not specify how far the relevant information must be disseminated before it shakes off the taint of ‘inside information’ and has become ‘public’. ‘Not been made public’ could imply wide availability of the relevant information, and thereby respond to the market egalitarianism rationale for prohibiting insider dealing, which rationale has been repeatedly underlined by the Court of Justice.132 Market egalitarianism could also suggest, however, that investors trade on an equal basis in that the price-​formation process on which they are relying efficiently reflects the available information. Sectoral disclosure to an influential group of institutional investors with power to move the market price might therefore suffice for the information to be ‘public’.133

130 n 126. The case related to the alleged illegal disclosure by a journalist, to two sources, of two forthcoming press articles reporting market rumours concerning takeover bids. The inside information in question therefore related not to the substance of the articles (the takeover rumours) but to the fact that the articles were forthcoming. The Court underlined that, as regards the meaning of ‘precise’, a case-​by-​case assessment was necessary: information could not be ruled out as not precise, simply because it fell within a category of information (such as information relating to the forthcoming publication of press articles regarding takeover rumours). Information that an article was forthcoming could give the person to whom it was disclosed an advantage over other investors and so could not be treated, in principle, as not sufficiently precise to form inside information. Whether or not the publication-​related information was, in fact, precise, required consideration of relevant factors, including as regards the content of the press article in question and the specificity of the rumour it reported, and also the reputation of the journalist and the relevant media organization and their reliability. The Court accordingly found that information as to forthcoming publication was capable of being ‘precise;’ and that the fact that the press articles in question mentioned the price at which the securities would be purchased in the takeover, the identity of the journalist, and the identity of the media organization that published the article, were all relevant factors to assessing ‘precise’, in so far as they were disclosed prior to the publication. The actual effect of the articles on the prices of the securities in question could constitute ex-​post evidence as to the ‘precise’ nature of the disclosure relating to the forthcoming publication, but was not sufficient, in itself, in the absence of an examination of other factors known or disclosed prior to the publication, to establish that the original disclosure was ‘precise’. 131 Further explanatory soft law is likely. Over the 2020 MAR Review, ESMA reported on market calls for guidance on the nature of ‘precise’, including where the relevant information was, eg, subject to board or public approval. In response, ESMA was supportive, given the benefits to market participants and issuers but also as regards pan-​EU convergence: n 42, 48 and 57. 132 See recently AG Kokott in A: ‘The primary aim of European legislation on market abuse is to ensure a capital market with integrity and equal rights for investors’: n 25, Opinion of the Advocate General, para 1. 133 The dynamics of information disclosure and its impact on price are the subject of a rich scholarship which considers the implications of the efficient-​market hypothesis and the findings of behavioural finance. For an extensive review see the 2003 special issue of the Journal of Corporation Law (29 J Corp L, issue 4 Summer 2003) marking the 21st anniversary of Gilson and Kraakmann’s seminal analysis (n 26) and, for a financial-​crisis-​era perspective, see Gilson, R and Kraakman, R, ‘Market Efficiency after the Financial Crisis: It’s Still a Matter of Information Costs’ (2014) 100 Va LR 313.

702  Market Abuse This longstanding element of the inside information definition has not, however, prompted an ESMA soft law response or Court of Justice amplification, suggesting that in practice it is does not generate material difficulties.

VIII.6.1.6 Inside Information: Likely to have a Significant Effect on Prices Inside information is information which, if made public, would be likely to have a ‘significant effect’ on prices. Where potential price impact, a slippery concept, is deployed in financial markets regulation, means must be found to capture it.134 MAR uses a ‘reasonable investor’ proxy, following the approach adopted by many jurisdictions internationally:135 information which, if it were made public, would be likely to have a significant effect on prices is information a reasonable investor would be likely to use as part of the basis of his or her investment decisions (Article 7(4)).136 This ‘reasonable investor’ approach is of longstanding, being based on the 2003 MAD’s administrative rules, although it has attracted controversy, particularly in light of the behavioural challenges that can attend investment and that are in particular associated with retail investors.137 As the ‘reasonable investor’ is not defined, this approach also demands considerable convergence in NCAs’ supervisory practices, as well as in enforcement decisions and related judicial rulings, for a consistent approach to be adopted pan-​EU. Some guidance is provided by MAR (recital 14) which emphasizes that any assessment of whether a reasonable investor would take particular information into account must be made on the basis of the information available to the investor ex-​ante.138 Recital 14 also asserts that the assessment as to the investor’s decision must take into account the anticipated impact of the information, in light of the totality of the related issuer’s activities, the reliability of the source of the information, and ‘any other market variables likely to affect’ the instrument in question. The recital reflects the Court of Justice’s interpretation of ‘significant effect’ on prices in the 2009 Spector ruling (on the 2003 MAD). The Court ruled that the capacity of ‘inside information’ to have a significant effect on price must be assessed in light of the content of the information at issue and the context in which it occurred, and that it was not necessary, accordingly, to assess whether the information actually had a significant effect on the price of the instrument in question.139

134 For an analysis of the empirical challenge posed where enforcement of financial markets regulation is tied to price impacts, and for a US perspective, see Fisch, J, Gelbach, J, and Klick, J, ‘The Logic and Limits of Event Studies in Securities Fraud Litigation’ (2018) 96 Texas LR 533. 135 IOSCO, n 13, 4. 136 The ‘significant effect’ assessment is calibrated for emission allowances in order to reflect the particular dynamics of this market: Art 7(4) para 2. 137 See Coffey and Overett-​Somnier, n 4. The 2020 High Level Forum on CMU, eg, favoured a ‘rational investor’ model: n 44, 72. For a recent reconsideration see Mülbert and Sajnovits, n 34, reviewing the merits of an approach based on the ‘average investor’ or, alternatively, on regarding the reasonable investor as a proxy for a hypothetical market reaction. On the challenges of linking materiality in financial markets regulation to reasonable investor proxies, and from a comparative perspective, see Schulzke, K and Berger-​Walliser, G, ‘Toward a Unified Theory of Materiality in Securities Law’ (2017) 56 Co J Transnat’l Law 6. 138 Ex-​post information may be used to check the presumption that the ex-​ante information was price sensitive but should not be used to take action against persons who drew reasonable conclusions from the ex-​ante information available to them: recital 15. 139 n 25, Ruling of the Court, paras 67–​9.

VIII.6  The Prohibition on Insider Dealing  703

VIII.6.2  Persons Subject to the Prohibition MAR imposes dealing, recommending/​inducing, and disclosure prohibitions on persons in possession of ‘inside information’ (Articles 8, 10, and 14, respectively). While a market-​ based approach to insider dealing implies that further differentiation is not required once the person in question is in possession of inside information,140 MAR, following the approach of the 2003 MAD, nonetheless imposes the prohibitions on five separate, if widely-​ drawn, categories of persons. Under 8(4), the prohibitions apply to any legal or natural person who possesses ‘inside information’ as a result of: being a member of the administrative, management, or supervisory bodies of the issuer (or emission allowance market participant); having a holding in the capital of the issuer (or emission allowance market participant); having access to such information through the exercise of an employment, profession, or duties; or being involved in criminal activities. The prohibitions also apply to any person who possesses inside information under other circumstances and where that person knows or ought to know that it is inside information. While this scheme is well settled, some opacities persist. Article 8(4) does not, for example, specify how large the relevant holding in the issuer’s capital must be before the prohibitions attach. The holding must be such, however, that ‘as a result’ of that holding the person in question possesses inside information. It is most likely to attach to large shareholders who, either due to a relationship of influence over the issuer arising from their voting power (which may in certain cases entitle them to board positions bringing them within the first category of insiders) or, for example, in the course of company briefings to institutional shareholders, acquire inside information. Ambiguities also persist with respect to the category of persons who have access to the inside information ‘through the exercise of an employment, profession or duties’. It appears clear (given MAR’s market orientation and the wide definition of ‘inside information’ as including information directly but also indirectly related to the issuer or in-​scope instruments) that those persons unconnected with the issuer, but in possession of inside information, and who acquire such information due to a direct link between the inside information and the nature of their occupation, are covered. These persons could include, for example, an investment analyst in possession of price-​sensitive information from the issuer, an employee of a rating agency aware of a forthcoming change in an issuer’s bond rating, and a central bank official aware of price-​sensitive interest rate changes. The picture becomes blurred where the inside information held is not related to the employment, profession, or duties in question and is acquired by chance, albeit in the course of the relevant occupation.141 A maximalist approach, which does not require a connection of any kind between the employment/​profession/​duties and the nature of the information, had its supporters with respect to the original 1989 IDD regime.142 The Court of Justice remains the final

140 Taken to its logical conclusion, the market-​based approach to defining the insider would mean that ‘there would be no need to distinguish different categories of insider; anyone possessing inside information would be the target of the regulation’: Black, n 18, 11. 141 Classic examples include the taxi driver or hospitality employee who overhears, or the employee of a financial printer who reads, inside information which they would not have had access to if they did not perform those particular roles. 142 See the discussion in Tridimas, n 54, 926 and Davies (1991), n 18, 102.

704  Market Abuse arbiter on this question. A wide approach might be predicted given the expansive approach the Court has taken as regards the insider dealing provisions generally.

VIII.6.3  The Prohibition: Dealing, Recommending, and Disclosing VIII.6.3.1  Dealing Save for those persons outside the four categories of persons identified in Article 8(4) as being subject to the prohibition (those persons outside the four categories must, as also specified in Article 8(4), know, or ought to know, that the information which they have obtained is inside information before they can become liable), a strict liability regime applies to dealing by persons in possession of inside information. Under Article 14(a)/​Article 8 a person (as specified in Article 8(4)) must not engage or attempt to engage in ‘insider dealing’. ‘Insider dealing’, under Article 8(1), is dealing where a person possesses inside information and ‘uses’143 that information by acquiring or disposing of, for its own account or for the account of a third party, either directly or indirectly, financial instruments to which the information relates.144 VIII.6.3.2 Recommending and Inducing The dealing prohibition is supplemented by Article 14(b)/​Article 8, which extends the dealing prohibition to recommending that another person engages in insider dealing or inducing another person to engage in insider dealing.145 Where a person acts on the recommendation or inducement, this amounts to insider dealing where the person ‘using the recommendation or inducement’ knows or ought to know that it is based on inside information (Article 8(3)). VIII.6.3.3 Unlawful Disclosure The final element of the prohibition relates to disclosure. Under Article 14(c)/​Article 8, persons specified as within the scope of Article 8(4) must not ‘unlawfully disclose’ inside information. Unlawful disclosure arises where a person who possesses inside information discloses that information to any other person, except where the disclosure is made in the ‘normal exercise of an employment, a profession, or duties’ (Article 10(1)).146 The onward 143 On ‘uses’ see section 6.3.5. 144 Article 8(1) also specifies that the use of inside information to cancel or amend an order concerning a financial instrument to which the information relates, where the order was placed before the person concerned possessed the information, is also inside information. A calibration addresses emission allowances auctions in that the use of inside information also comprises submitting, modifying, or withdrawing a bid by a person for its own account, or for the account of a third party. 145 ‘Recommending or inducing’ is clarified by Art 8(2) which provides that such prohibited recommending/​ inducing arises where the person possesses inside information and recommends, on the basis of that information, that another person acquire or dispose of (or cancel or amend an order concerning) financial instruments to which that information relates, or induces that person to make such an acquisition of disposal (or cancellation or amendment). 146 The Court of Justice took a strict approach to the scope of the 1989 IDD’s parallel exemption in Grøngaard. The ruling concerned alleged unlawful disclosure by a company board member (who was appointed to represent employee interests) of inside information to the general secretary of a trade union (which had appointed the board member to the company’s ‘liaison committee’; the board member was also secretary to one of the union’s local sections) and onward disclosure by the general secretary. The Court found that the exemption was to be interpreted strictly as an exception to the general prohibition on disclosure and that, as a result, a ‘close link’ was required between any disclosure and the exercise of the employment, profession or duties; that any disclosures must be strictly necessary for such exercise; and that, in interpreting relevant national rules, national courts were

VIII.6  The Prohibition on Insider Dealing  705 disclosure of a recommendation or inducement also amounts to unlawful disclosure when the person disclosing knows or ought to have known that it was based on inside information (Article 10(2)). Special consideration is given to the role of the media (Article 21). For the purpose of applying MAR’s rules on unlawful disclosure of inside information, where information is disclosed or disseminated and where recommendations are produced for the purpose of journalism or other form of expression in the media, such disclosure or dissemination is to be assessed taking into account rules governing press freedom and freedom of expression in other media, and the rules or codes governing the journalist profession—​unless the persons concerned, or persons closely associated with them, derive (directly or indirectly) an advantage or profits from the disclosure or dissemination or where the disclosure or dissemination is made with the intention of misleading the market (Article 21).147 A distinct regime applies under Article 20 to investment recommendations and is considered in Chapter II with reference to investment analyst regulation.

VIII.6.3.4 The Market Soundings Safe Harbour The strictness of the unlawful disclosure prohibition is mitigated by the ‘market soundings’ regime (Article 11). It is designed to facilitate the well-​established practice of issuers and their advisory investment firms communicating certain information, prior to the announcement of a transaction,148 in order to gauge market appetite.149 In effect, where a disclosure of inside information is ‘made in the course of a market sounding’, and as long as the relevant conditions are complied with, a safe harbour is available in that the disclosure is deemed to have been made in the normal course of the exercise of a person’s employment, profession, or duty (Article 11(4)). Procedural constraints apply, given the risk of inside information being transmitted.150 The market soundings regime acts as a safe harbour as regards inside information, but its procedural requirements apply broadly. It addresses the communication of information, required to consider that the exception was to be interpreted strictly, to consider that each additional disclosure was liable to increase the risk of breach of the Directive, and to consider the sensitivity of the inside information: n 25. 147 The interaction between Art 10 and Art 21, as regards the exercise of journalism, was considered by the Court in the A case (n 126). The Court found that Art 21 did not operate independently of Art 10, and that whether or not a disclosure was lawful had to be considered in light of Art 10, taking into account the further specification provided by Art 21. As regards the balance between the prohibition on disclosing inside information, and the freedom of the press and of expression, Arts 10 and 21 were to be interpreted as meaning that disclosure of inside information was to be regarded as lawful where it was necessary for the exercise of the profession of journalism and complied with the principle of proportionality. On the relevant facts, disclosure by a journalist, to his usual sources, of a forthcoming article could be regarded as for the purposes of journalism where the disclosure was necessary for the purpose of carrying out a journalistic activity, including investigative work in preparation for the publication. For analysis of the ruling see Oudin, P, Insider Trading, Market Efficiency and Journalism: A Discussion of the CJEU’s Daily Mail Case, Oxford Business Law Blog, 23 March 2022. 148 Market soundings can include situations where an investment firm has been in discussions with an issuer about a potential transaction and seeks to gauge market interest in order to determine the terms; where an issuer intends to announce a debt issuance or additional equity offering and key investors are contacted by the investment firm as regards a potential commitment; or where an investment firm is planning to sell a large block of securities on behalf of an issuer and seeks to gauge potential interest: MAR recital 33. 149 MAR characterizes market soundings as a ‘highly valuable tool’ to gauge investor interest, enhance shareholder dialogue, ensure transactions run smoothly, and align the views of issuers, investors, and shareholders, and as being of particular importance in volatile conditions: recital 32. 150 Situations where market soundings are used are likely to generate inside information, as acknowledged by MAR recital 34.

706  Market Abuse prior to the announcement of a transaction, to one or more potential investors, by an issuer, a secondary offeror of a financial instrument,151 an emission allowances market participant, or a third party acting on behalf of these persons (such as an underwriting investment bank), in order to gauge the interest of potential investors in a possible transaction and its related conditions (such as size and pricing) (Article 11(1)). ‘Market soundings’ also cover the disclosure of inside information by a person intending to make a takeover bid for the securities of a company (or engage in a merger) to parties entitled to the securities, as long as the information is necessary to enable the parties entitled to the securities to form an opinion on their willingness to offer their securities, and the willingness of the parties entitled to the securities is reasonably required for the decision to make the takeover bid or merger (Article 11(2)). In each case, the ‘disclosing market participant’152 must consider, prior to conducting the sounding (and for each disclosure made in the course of a sounding), whether the sounding will involve the disclosure of inside information, and make a written record of the conclusion drawn and its reasons; these records must be made available to the NCA on request (Article 11(3)). A number of other conditions apply to soundings, including that the consent of the person receiving the sounding to receiving inside information is obtained, and that this person is informed of the prohibitions and requirements which follow under MAR for those in possession of inside information (Article 11(5)).153 The persons receiving the sounding remain responsible for determining whether they are in possession of inside information as a result or when they cease to be in possession of inside information (Article 11(7)).154 Receipt of a market sounding accordingly imposes obligations on the receiver as regards the management and control of any related information which may take the form of inside information.155 Detailed procedural modalities apply under RTS 2016/​960. The market soundings regime has, given its breadth of application and the operational costs it imposes on ‘disclosers’ and ‘receivers’, proved one of the more contested elements of MAR, although it is designed to facilitate issuers and market participants. The 2019 SME Regulation liberalized its operation as regards debt-​financing through private placements, in an effort to facilitate SME access to fund-​raising and given concerns that the market soundings rules were obstructing issuers and investors in this market.156 Accordingly, where an offer of securities is addressed solely to ‘qualified investors’ under the 2017 Prospectus Regulation,157 communication of information to those investors, for the purpose of negotiating the contractual terms and conditions of their participation in an issuance of bonds by an issuer that has financial instruments traded on a traded venue (or by any person acting on its behalf or account), does not constitute a market sounding (Article 151 The offer must be of such quantity or value that it is distinct from ordinary trading and involves a selling method based on the prior assessment of potential interest from potential investors. 152 The natural or legal person who discloses information in the course of a market sounding and is covered by Art 11(1) or (2): Art 3(1)(32). 153 The ‘disclosing market participant’ must also make a record of all information given to the person receiving the market sounding and the identity of the potential investors to whom the information has been disclosed. 154 Where the ‘disclosing market participant’ has assessed the relevant information as no longer constituting inside information, the ‘receiving person’ must be informed: Art 11(6). 155 The procedures to be followed by ‘receiving persons’, including as regards their independent assessment of whether the information is ‘inside information’, are further specified through Guidelines (ESMA, MAR Guidelines, Persons Receiving Market Soundings (2016)). 156 SME Regulation recital 6. 157 See Ch II section 4.3.

VIII.6  The Prohibition on Insider Dealing  707 11(1a)).158 Further, any such communication is regarded as being made in the normal exercise of a person’s ‘employment, profession or duties’ and so falls outside the prohibition on disclosure of inside information. This amelioration, which came into effect in January 2021, applies to the contracting stage only, and so is designed to facilitate the structuring and finalization of a bond financing, and not to the earlier gauging of interest. While designed to support SMEs, it applies widely in the bond private placement markets.159 The market soundings regime remains troublesome, however, with the 2020 MAR Review highlighting a series of weaknesses,160 and thereby underlining the challenges the market abuse rulebook encounters as it becomes more proceduralized.

VIII.6.3.5 Legitimate Behaviour A further form of safe harbour is available where the conduct can be characterized as ‘legitimate behaviour’ (Article 9). This alleviation is tied to the notion of the ‘use’ of inside information when engaging in insider dealing. The Article 8(1) insider dealing prohibition requires that the insider must ‘use’ the information when dealing, but it does not address knowledge or intention as regards the inside information. Prior to the Court of Justice’s 2009 Spector ruling, and under the equivalent 2003 MAD provision, Member States adopted either a restrictive approach, under which simple possession of inside information amounted to ‘use’ and triggered the insider dealing prohibition; or a more intention-​based approach, which regarded ‘use’ as a function of the decision to trade being influenced by the inside information.161 In the Spector ruling (which addressed the 2003 MAD), the Court adopted a restrictive approach to ‘use’, finding that simple possession of inside information served to meet the ‘use’ requirement and triggered the insider dealing prohibition.162 The Court also found, however, that, in order not to 158 An appropriate ‘wall-​crossing’ agreement must also in place in which the qualified investors acknowledge the legal and regulatory implications arising from access to inside information. 159 In its 2018 Proposal (COM(2018) 331), the Commission applied the exemption to issuances of debt and equity by issuers admitted to an SME Growth Market. Over the negotiations, the exemption was limited to bonds but expanded to include issuers generally. 160 ESMA’s 2020 MAR Review revealed a widely-​held market view that the market soundings regime was optional, allowing those market participants that followed the relevant procedures to benefit from a safe harbour. ESMA’s view was that the regime was mandatory, in that where a communication met the definition of a market sounding, the relevant procedures were required, in particular given the importance of these procedures for establishing audit trails, and for supporting supervision, in a context where there was a high risk of inside information being passed. ESMA accordingly recommended that the Commission clarify the mandatory nature of the regime; and that it also identify any breach of the market soundings rules as a breach of MAR that must be subject to administrative sanctions (breach is not currently subject to mandatory sanctions under the MAR). ESMA also rejected calls for the scope of application of the market soundings regime to be narrowed, although it acknowledged market concern that the procedures could dissuade some potential investors from being ‘sounded’ and recommended a series of related procedural alleviations. 2020 ESMA MAR Review, n 42, 73–​83. The 2022 Listing Act Regulation Proposal (n 84), however, saw the Commission take a different approach to ESMA. The Proposal clarified the regime to provide that it is not mandatory, although the Proposal’s fate remains to be seen. 161 For analysis of the use/​possession distinction as regards the 2003 MAD see Langenbucher, K, ‘The “Use or Possession” Debate Revisited—​Spector Photo Group and Insider Trading in Europe’ (2010) 5 CMLJ 452. 162 The Court found the 2003 MAD prohibition did not require that dealing took place with full knowledge of the facts, set out subjective conditions in relation to intention, or require that the inside information be decisive in relation to the dealing decision, noting the legislative history of the provision: n 25, Ruling of the Court, paras 31–​ 2. The 2003 MAD prohibition on insider dealing was more restrictive than the precursor IDD prohibition which included a ‘with full knowledge of the facts’ qualifier. Similarly, the 2003 MAD prohibition replaced ‘taking advantage’ of inside information, with ‘using’ information, in order to remove the notion of intention from the dealing prohibition. This led the Court to rule that the prohibition treated insider dealing objectively, without reference to intention: at para 34. By contrast, the Advocate General suggested a general exception where the information did not influence the action of the person. See Hansen Lau, J, ‘What Constitutes Insider Dealing? The Advocate General’s Opinion in Case C-​45/​08 Spector Photo Group’ (2010) 7 ICCLJ 1.

708  Market Abuse extend the insider dealing prohibition beyond what was appropriate and necessary to attain the MAD’s goals, the insider dealing prohibition was not to be interpreted as applying automatically to persons in possession of inside information, and that the presumption of breach of the dealing prohibition could be rebutted,163 generating some debate as to how the rebuttal would operate. MAR, however, clarifies the meaning of ‘use’, in different contexts, by means of the Article 9 ‘legitimate behaviour’ safe harbour. Article 9 did not bring major reform at the time as many of the situations protected by Article 9 had previously been acknowledged through specific legislative provisions or through recital references, but it did enhance legal certainty. The risks that a possession-​based approach to ‘use’ poses to multi-​service investment firms are addressed by Article 9(1). It provides that it shall not be deemed from the mere fact that a legal person is in, or has been, in possession of inside information that that person has ‘used’ that information and thus engaged in insider dealing on the basis of an acquisition or disposal, where the legal person has established, implemented, and maintained adequate and effective internal arrangements and procedures that effectively ensure that neither the natural person who dealt in the instruments to which the inside information relates, nor any other natural person who may have had any influence on that decision, was in possession of the inside information; and the legal person did not encourage, recommend to, induce, or otherwise influence the natural person. In effect, Article 9(1) protects dealing where an effective internal information barrier prevents the flow of inside information. Article 9(2) addresses order execution and dealing specifically. It provides that it shall not be deemed from the mere fact that a market-​maker, in a financial instrument to which inside information relates, is in possession of inside information, that the market-​maker has ‘used’ that information, and has thus engaged in insider dealing, where the dealing to which the information relates is made legitimately in the normal course of exercise of its function as a market-​maker or a counterparty for the financial instrument. A person authorized to execute orders on behalf of third parties is similarly protected, where the acquisition or disposal is made to carry out such an order legitimately in the normal course of the exercise of the person’s employment, profession, or duties. More generally, Article 9(3) provides that it shall not be deemed from the mere fact that a person is in possession of inside information that that person has ‘used’ that information, and thus engaged in insider dealing on the basis of an acquisition or disposal, where the person engages in an acquisition or disposal of financial instruments where the transaction is carried out in discharge of an obligation that has become due in good faith, and not to circumvent the prohibition on insider dealing, and the obligation results from an order placed or agreement concluded before, or to satisfy a legal or regulatory obligation that arose before, the person concerned possessed inside information. Takeovers are specifically addressed: insider dealing is deemed not to arise from the mere fact that a person possessing inside information obtained in the conduct of a public takeover or merger uses that information solely for the purpose of proceeding with that takeover or merger, provided that, at the point of approval of the merger or acceptance

163 Paragraphs 44 and 55. The Court acknowledged that ‘certain situations’ could require a ‘thorough examination of the factual circumstances, enabling it to be ensured that the use of the inside information is actually unfair’ (para 55). The extent of the potential for rebuttal generated some debate, eg, Klöhn, L, ‘The European Insider Trading Regulation after the ECJ’s Spector Photo Group Decision’ (2010) 7 ECFLR 347.

VIII.7  Disclosure Obligations  709 of the offer by the relevant shareholders, any inside information has been made public or ceased to be inside information (Article 9(4)). ‘Stakebuilding’164 using inside information is, however, expressly excluded from this protection and is not deemed to constitute legitimate behaviour in accordance with Article 9. Finally, the mere fact that a person uses their own knowledge that they have decided to acquire or dispose of financial instruments does not constitute in itself the ‘use’ of inside information (Article 9(5)). Notwithstanding these different safe-​harbours, a breach of the insider dealing prohibition can still be deemed to have occurred if the NCA establishes that there was an illegitimate reason behind the orders to trade, transactions, or behaviours concerned (Article 9(6)).

VIII.7  Disclosure Obligations VIII.7.1  Issuer Disclosure VIII.7.1.1 Article 17(1) and Ongoing Issuer Disclosure The pivotal definition of ‘inside information’ serves a dual function under MAR. As well as governing how MAR addresses abusive behaviour relating to inside information, it also governs the Article 17(1) obligation on issuers to make public disclosure of material developments outside the periodic reporting cycle.165 A concern to protect market efficiency is common to the two functions fulfilled by the ‘inside information’ definition. Nonetheless, the disclosure function, and the prevention of abusive conduct function, are distinct,166 and the use of a broadly-​designed, abuse-​prevention-​oriented definition to ground the issuer disclosure obligation has created operational challenges for issuers, as noted below. The Article 17(1) issuer disclosure obligation is closely based on the precursor 2003 MAD obligation. It requires that an issuer must inform the public as soon as possible of ‘inside information’ (as defined under MAR) which directly concerns the issuer. The issuer must also ensure that the inside information is made public in a manner which enables fast access and complete, correct, and timely assessment of the information by the public167 and, where applicable, in the relevant Officially Appointed Mechanism.168 The disclosure 164 Defined as the acquisition of securities in a company which does not trigger a legal or regulatory obligation to make an announcement of a takeover bid (Art 3(1)(31)). 165 In this regard, MAR forms part of the issuer-​disclosure system examined in Ch II. The obligation was originally introduced by the 2003 MAD and described then as the missing part of the issuer-​disclosure puzzle: Ferran, n 31, 197. The earlier 1989 IDD had imposed an ongoing disclosure obligation with respect to material, ad hoc disclosure, but Member States’ approaches varied considerably: Lannoo, K, ‘The Emerging Framework for Disclosure in the EU’ (2003) JCLS 329. 166 See Hansen, J, The Hammer and the Saw: A Short Critique of the Recent Compromise Proposal for a Market Abuse Regulation (2012), available via , noting that while insider-​dealing prohibitions and issuer-​disclosure obligations both serve market efficiency, they do so in different ways, and highlighting the potential damage to market efficiency where an overly-​wide issuer-​disclosure obligation leads to an issuer not being able to protect sensitive disclosures and to torrents of potentially unreliable disclosures feeding market volatility. 167 The technical modalities relating to publication are set out in ITS 2016/​1055 [2016] OJ L173/​47 which specifies, inter alia, that the information must be disseminated to as wide a public as possible, on a non-​discriminatory basis, free of charge, and simultaneously throughout the EU (Art 2). 168 Officially Appointed Mechanisms (OAMs) are the official repositories for mandated issuer disclosures (see Ch II section 7.2). The issuer must also post and maintain on its official website all inside information which it is required to publish (for a period of five years). In addition, Art 17(1) specifies that the issuer must not combine the disclosure of inside information to the public with the marketing of activities. The European Single Access Point reform will see these disclosures posted through a new centralized repository (Ch II section 7.3).

710  Market Abuse obligation applies only to issuers who have requested or approved the admission of their financial instruments to trading on a regulated market in a Member State or, in the case of financial instruments only traded on an MTF or OTF, issuers who have approved the MTF/​OTF trading or who request the admission to trading of their financial instruments on an MTF in a Member State. A calibrated disclosure obligation of similar design applies to emission allowance market participants, who are required to publicly, effectively, and in a timely manner disclose inside information concerning emission allowances which they hold in respect of their businesses (Article 17(2)). The expansive nature of the definition of ‘inside information’, and particularly the broad approach to whether information is ‘precise’ (section 6.1.4), can generate difficulties for issuers in identifying the point at which, for example, an ongoing transaction, negotiation, management change, or approval process has crystallized sufficiently to become disclosable, particularly as while disclosure by issuers of early-​stage developments can generate commercial risks for the issuer, premature and potentially frequently-​changing issuer disclosures can also mislead the market. Identifying the point at which disclosure should be made can therefore be a difficult needle to thread. These difficulties are of longstanding, being associated initially with the 2003 MAD’s choice of ‘inside information’ to govern the issuer disclosure obligation, and subsequently framing the MAR negotiations on what would become Article 17.169 As regards the 2003 MAD, the broad definition of inside information (including the ‘precise’ element) was argued to place issuers at risk of being required to disclose, and continually correct, fast-​changing information, which could drive market volatility.170 The financial crisis intensified the debate, exposing the distinct financial stability risks associated with public disclosure by financial institutions of their receipt of financial support.171 The MAD delay regime allowed an issuer to delay disclosure of inside information, but only where delay would not be likely to mislead the public. Given that the MAD definition of inside information was cast in terms of whether a reasonable investor would take the information into account, the circumstances in which delay was legitimate were accordingly very limited. The difficulties led to calls for reform and, in particular, for a distinction to be made between ‘inside information’ as defined for the purposes of ongoing issuer disclosure and as defined for the purposes of the insider-​dealing prohibition.172 The 2012 Court of Justice Getl ruling,173 issued over the 2003 MAD review process,174 underscored the challenges. At issue was whether, in the case of a protracted issuer process intended (over a series of steps) to bring about a particular event or circumstance, intermediate steps in the process could constitute ‘precise’ information, for the purposes of the ‘inside information’ definition (and so be disclosable). The Court did not address the dual function of the inside information definition, confining its ruling to the issuer-​disclosure 169 eg Hansen, J, ‘Say When: When Must an Issuer Disclose Inside Information?’ Nordic & European Company Law LSN Research Paper Series (2016), available via , di Noia, C and Gargantini, M, ‘Issuers at Midstream: Disclosure of Multistage Events in the Current and in the Proposed EU Market Abuse Regime’ (2012) ECFR 484, and Hansen Lau, J and Moalem, D, ‘The MAD Disclosure Regime and the Twofold Notion of Inside Information: the Available Solution’ (2009) 4 CMLJ 323 170 Hansen and Moalem, n 169, noting the potential for a flood of disclosures and for disruption to markets. 171 2007 ESME Report, n 72, 5–​6. 172 Eg 2007 ESME Report, n 72, 7. 173 n 112. 174 Council discussions were postponed pending the ruling: Danish Presidency MAR Progress Report, n 77, 2.

VIII.7  Disclosure Obligations  711 obligation as designed under the 2003 MAD, and ruled that an intermediate step could be ‘precise’ for the purposes of the definition of inside information and so require disclosure.175 While the Court acknowledged that information would not be precise where it concerned events and circumstances the occurrence of which was implausible, the ruling confirmed the wide scope of the issuer disclosure obligation and the need for careful issuer assessments as to when information had crystallized to the point of becoming disclosable inside information. The subsequent MAR negotiations on the reach of the issuer-​disclosure obligation sought to address the longstanding concerns but ultimately led to a continuation of the 2003 MAD dual function approach. The Commission had supported a twin-​track definition approach: its 2011 Proposal made a distinction between ‘inside information’ for the purposes of the insider-​dealing prohibition and other ‘inside information’ also subject to the prohibition but which was not sufficiently precise to be subject to the issuer-​disclosure obligation.176 But while there was some support in the Council for this approach, it did not prevail, with many Member States opposed to changing the definition of inside information and supporting instead a clarification of the definition.177 The Article 17 obligation accordingly follows the contested 2003 MAD model in that it is governed by the same definition of ‘inside information’ as applies to the prohibition on insider dealing. The disclosure delay regime, however, was finessed, mitigating the costs and risks to issuers (section 7.1.2). Since MAR’s adoption, the issuer-​disclosure obligation has become quieter.178 ESMA’s 2020 MAR review did not indicate significant market disquiet, reporting also that issuers had systems and controls to identify inside information and to ensure its disclosure. The review saw some relitigation of the dual function debate and calls for additional guidance,179 but ESMA’s guarded response as regards additional guidance (warning of unintended consequences) underlines the perennial challenge posed by defining ‘inside information’: the greater the level of regulatory prescription, the greater the risk of evasion and of unintended consequences. The 2022 Listing Act reform agenda, however, proposed adjustments, although the outcome remains to be seen.180

VIII.7.1.2 Delaying Article 17(1) Disclosure The Article 17(1) issuer-​disclosure obligation is accompanied by a delay mechanism, based on the 2003 MAD version, but finessed, including by amplifying administrative rules and 175 The Court argued that to find otherwise would undermine the purpose of the 2003 MAD with respect to placing investors on an equal footing, as parties could be placed in an advantageous position with respect to other investors: n 112, Ruling of the Court, paras 33–​6. 176 The Commission proposed an additional and broader definition of inside information, which would have incorporated information which was not precise or price sensitive, but which would be regarded by a reasonable investor as relevant, but excluded this category of inside information from the issuer-​disclosure obligation: 2011 MAR Proposal, n 74, Art 12(3). 177 Danish Presidency MAR Progress Report, n 77, 2–​3. 178 The CMU agenda saw some airing of the dual function debate. The High Level Forum on CMU called for a safe harbour for non-​disclosure by issuers of ‘preliminary information’ in order to facilitate capital-​raising: n 44, 67 and 71. 179 N 42, 47–​8 and 65. Some respondents called for a distinction between inside information for the purposes of market abuse prevention and a more ‘advanced’ definition of inside information which would link the issuer-​ disclosure obligation to information which had a higher degree of certainty. 180 The 2022 Listing Act Regulation Proposal, adopted by the Commission as this book went to press (n 84), removed from the scope of ‘inside information’ for the purposes of Art 17 information relating to intermediate steps in a protracted process. Such information would continue to be inside information for the purposes of the dealing prohibitions.

712  Market Abuse soft law designed to minimize operational frictions and interpretive ambiguities in its operation. Under Article 17(4), an issuer of a financial instrument (or emission allowance market participant) who does not otherwise benefit from an NCA-​permitted delay may, under its own responsibility, delay the public disclosure of inside information, provided a series of conditions are met: the immediate disclosure would likely prejudice the issuer’s ‘legitimate interests’; the delay would not be likely to mislead the public; and the issuer (or emission allowance market participant) is able to ensure the confidentiality of the information.181 In a nuance to the precursor 2003 MAD delay regime, designed to acknowledge the risks to the issuer generated by the 2012 Getl ruling, Article 17(4) confirms that, subject to the delay conditions being met, in the case of a protracted process that occurs in stages and that is intended to bring about, or that results in, a particular circumstance or particular event, an issuer (or emission allowance market participant) may on its own responsibility delay the public disclosure of inside information relating to this process. Immediately after the delayed information is disclosed, the issuer (or emission allowance market participant) is required to inform the relevant NCA of the delay182 and provide a ‘written explanation’ of how the delay conditions were met.183 NCA notification was optional under the 2003 MAD but was made mandatory by MAR to facilitate ex-​post NCA review of issuers’ delay decisions.184 The 2019 SME Regulation introduced an alleviation for issuers with financial instruments admitted to trading only on an SME Growth Market: they are only required to provide the written explanation to NCAs on request by the NCA (Article 17(4)). The original 2003 MAD delay mechanism came under close scrutiny over the global financial crisis given the market instability which had followed the disclosure by certain banks of their receipt of central bank liquidity support, and related concerns as to the inability of financial institutions to delay such disclosures despite the financial stability risks.185 MAR relatedly clarifies that, in order to preserve the stability of the financial system, an issuer that is a credit institution or investment firm may, under its own responsibility, delay the public 181 The nature of the relevant ‘legitimate interests’ is addressed by ESMA Guidelines (mandated by MAR): ESMA, MAR Guidelines, Delay in the Disclosure of Inside Information (2016, updated 2022). The Guidelines set out a non-​exhaustive and indicative list of the legitimate interests likely to be prejudiced by immediate disclosure, including jeopardizing negotiations (including on mergers and acquisitions); prejudice to financial viability by jeopardizing negotiations on measures to ensure financial recovery; and protection of inventions. They also address situations when delay is likely to mislead the public, including where the delayed information is materially different from previous public announcements on the issue or in contrast with market expectations, where those expectations were conditioned by signals sent by issuer. The 2022 update relates to the treatment of disclosures relating to the capital requirements imposed by, or capital guidance issued by, an NCA under the EU’s prudential regime (see in brief Ch IV sections 11.3.1 and 11.3.2 on capital ‘add ons’), the extent to which such disclosures (which could relate to requirements or guidance relating to additional capital) may constitute inside information, and the circumstances under which related disclosures could be delayed. 182 To mitigate the jurisdiction allocation risks, the NCA to which the notifications must be made is governed by Delegated Regulation 2016/​522 Art 6 which is, very broadly, based on the notified NCA being that of the Member State of the issuer’s registration. 183 National law may provide that the information be submitted only at the request of the NCA. Ten Member States have exercised this option, and their NCAs typically request explanations in the context of reviews or investigations: 2020 ESMA MAR Review, n 42, 63. 184 The technical modalities of the delay mechanism, including the content of the NCA written explanation, are governed by ITS 2016/​1055. 185 The delay regime generated some controversy with respect to the collapse in the share price of UK bank Northern Rock and the run on its deposits in autumn 2007, following disclosure of the liquidity support provided by the Bank of England. Criticisms that disclosure of this support had led to a run on the bank were met by arguments that disclosure was required under by MAD.

VIII.7  Disclosure Obligations  713 disclosure of inside information (including information related to a temporary liquidity problem and related to temporary central bank/​lender of last resort liquidity assistance); the disclosure must entail a risk of undermining the issuer’s financial stability or that of the financial system, its delay must in the public interest, confidentiality must be ensured, and the relevant NCA must have consented to its delay on the basis that these conditions are met (Article 17(5)).186 Where the NCA does not consent, the issuer must disclose this inside information. Whether the inside information is delayed under Article 17(4) or (5), where the confidentiality of the information is no longer ensured, the issuer must inform the public as soon as possible (Article 17(7)).187 The delay regime, like the issuer-​disclosure obligation, has not, in practice, experienced material difficulty or contestation,188 with ESMA’s 2020 review of MAR not identifying significant concern.189 The extent to which ex-​post notifications of delays are made by issuers to their NCAs varies significantly across the EU, albeit that this may be less a function of diverging issuer interpretations of how the issuer disclosure/​delay regime operates, and more a consequence of NCAs taking different approaches to how they engage with issuers regarding the Article 17(1) obligation.190

VIII.7.1.3 Selective Disclosure: Article 17(8) The market egalitarianism tenor of Article 17 is most clear in Article 17(8). It addresses selective issuer disclosure and reflects the controversial US SEC Regulation Fair Disclosure (FD) (2000), which was designed to eliminate selective issuer disclosure to market professionals, particularly selective disclosure of quarterly earnings forecasts to analysts, albeit that analyst assessment of issuer disclosure is now well established as a key factor in efficient price formation and as an engine of market efficiency (Chapter II).191 The similar Article 186 The NCA must ensure that the delay is only for such period as is necessary in the public interest, and evaluate the conditions on a weekly basis. 187 Art 17(7) further specifies that public disclosure is required where a rumour is explicitly related to undisclosed inside information and the rumour is sufficiently accurate to indicate that the confidentiality of the inside information is no longer ensured. 188 It has, however, been litigated at national level, including in the context of a shareholder action against Volkswagen (VW) regarding its delay in publishing the inside information that its vehicles had not been meeting emission requirements, and VW’s argument that the relevant disclosures did not (at the relevant time) constitute inside information (as it was prior to the subsequent regulatory finding of failures relating to emissions) and, if they did constitute inside information, the delay was permissible as it protected VW’s legitimate interests. For an examination of this litigation and other national rulings see Hössl-​Neumann and Baumgartner, n 20. 189 Most NCAs reported that the delay conditions were clear, although they acknowledged that the delay assessment could be difficult for issuers. Market participants had more mixed views, some finding the regime to be working well but others requesting more clarification regarding the scope of ‘legitimate interests’ and in particular regarding the interaction between protecting egitimatee interests and not misleading the public, notably as regards mergers and acquisitions. While ESMA acknowledged that the issuer-​disclosure obligation and the delay mechanisms required complex assessments of issuers, it concluded that the system was overall working well but undertook to revise its Guidelines on the delay mechanism to provide greater clarity: 2020 ESMA MAR Review, n 42, 60–​73. 190 Between June 2016 and June 2019, some 14,000 uses of the delay mechanisms were recorded by NCAs, but numbers of notifications varied widely across Member States. Lower levels of notifications were explained in part by the relevant NCAs instead holding meetings with issuers regarding delays: 2020 ESMA MAR Review, n 42, 63. The stability-​related delay mechanism is used only rarely, reflecting prevailing market conditions, with only fifteen instances being noted (to only three NCAs) over the review period. 191 The Regulation (Final Adopting Release No 33–​7881) was criticized for being justified on the grounds of investor confidence without empirical evidence of how it would shape confidence: Choi, S and Pritchard, A, ‘Behavioural Economics and the SEC’ (2003) 56 Stanford LR 1. For a recent review, suggesting that the Regulation has chilled disclosure, and calling for a market in information that would allow issuers to sell tiered access to enhanced disclosure products see Haeberle, K and Henderson, T, ‘Making a Market for Corporate Disclosure’ (2018) 35 Yale J Reg 383.

714  Market Abuse 17(8) disclosure obligation, originally introduced by the 2003 MAD, accordingly serves as a striking, if relatively unusual, example of the influence exerted by US regulatory policy on EU regulatory design pre-​financial-​crisis, an influence which has since waned. Under Article 17(8), where an issuer or emission allowance market participant (or a person acting on either actor’s behalf) discloses any inside information to any third party in the normal course of the exercise of an employment, profession, or duty192 (as referred to in Article 10(1)), that person must make complete and effective public disclosure of the information, simultaneously in the case of an intentional disclosure and promptly in the case of a non-​intentional disclosure. This obligation does not apply where the person receiving the information owes a duty of confidentiality.

VIII.7.1.4 The SME Segment As is the case with the prospectus and periodic issuer-​disclosure regimes (Chapter II), the MAR issuer-​disclosure regime seeks to manage the costs of disclosure for SME issuers. At the time of its application, MAR increased disclosure obligations for smaller issuers as it applied beyond regulated markets to other trading venues, including as regards the issuer disclosure obligation. MAR made a limited concession to these issuers by allowing SME Growth Markets to disclose Article 17(1) disclosures for issuers admitted to their Markets’ on the Markets’ websites (rather than on the issuer’s website) (Article 17(9)). In practice this concession is of limited value and MAR’s application of the issuer-​disclosure obligation beyond regulated markets sits uneasily with the regulated-​markets-​orientation of the bulk of the issuer-​disclosure regime (Chapter II). The 2019 SME Regulation subsequently adopted a series of procedural alleviations as regards issuer disclosure obligations for smaller issuers, including the bond-​market-​related alleviation for market soundings (section 6.3.4), as well as the insider lists alleviation noted in the next section below. The dangers of carving out specific classes of issuer from the reach of the market abuse prohibitions are reflected in this largely procedural orientation of the SME-​oriented reforms.193

VIII.7.2  Insider Lists The insider-​lists regime (Article 18) requires issuers to maintain lists of those with access to inside information. A procedural provision, supported by administrative rules,194 it is nonetheless one of MAR’s anchor provisions as regards the monitoring of insider dealing and illustrates the extent to which MAR’s substantive rules are supported by procedurally-​ oriented reporting requirements. Article 18 is designed to support NCA monitoring of abusive conduct but also to facilitate issuers in managing inside information, including as regards managers’ transactions in ‘closed periods’ (section 7.3). First adopted under the 2003 MAD, the insider-​lists regime 192 The MAR regime (and the earlier MAD) is more widely drawn than Regulation FD, which, in an effort to reduce ‘chilling effects’, only prohibits selective disclosure to identified persons, including analysts. 193 ESMA has repeatedly underlined its view that the market abuse rules should apply horizontally to all issuers and should not be liberalized for smaller or SME issuers: 2022 ESMA Listing Act Consultation Response, n 47. The 2022 Listing Act Regulation Proposal (n 84) did not revise MAR materially as regards SMEs but it did propose a refinement of the administrative sanctions regime (as regards monetary penalties) to ensure that it was proportionate. 194 Set out in ITS 2022/​1210 [2022] OJ L187/​23 which includes insider list templates.

VIII.7  Disclosure Obligations  715 proved to be one of the most costly and controversial of MAD’s reforms, particularly for SMEs.195 MAR streamlined and clarified the regime and it was subsequently further refined by the 2019 SME Regulation. Nonetheless, while ESMA’s 2020 MAR review reported on widespread NCA and market agreement that insider lists perform a useful function for NCAs and for issuers, difficulties persist and ESMA has recommended a series of procedural alleviations.196 Under Article 18(1), issuers197 (and persons acting on their behalf or on their account: following a 2019 SME Regulation clarification these persons are also subject to the list obligation alongside the issuer) must draw up a list of all persons who have access to inside information, where such persons work for them under a contract of employment or otherwise perform tasks for the issuer through which they have access to inside information, such as advisers, accountants, or credit rating agencies.198 The insider list obligation is a dynamic and potentially onerous one in that it is designed to capture those who, at any given time, have access to inside information, a cohort that can change frequently.199 Relatedly, the ‘insider list’200 must be regularly updated: the issuer and any person acting on its behalf or account must update the list promptly where there is a change in the reason for including a person on the list, where there is a new person who has access to inside information and needs to be added, and where a person ceases to have access to inside information (Article 18(4)). The list must be transmitted to the NCA whenever requested (Article 18(1)).201 Lists must be retained for at least five years by issuers and by any person acting on their account or behalf (Article 18(5)). Issuers whose securities are admitted to an SME Growth Market benefit from an alleviation in that they can limit their lists to only those persons who, due to their function or position within the issuer, have regular access to inside information (in effect, ‘permanent insiders’; these issuers accordingly have less onerous monitoring and updating obligations), although Member States can opt to require of these issuers that all relevant persons be included where justified by specific national market integrity concerns (Article 18(6)).202 195 Discontent with the insider lists system was a recurring theme of the MAD Review: 2011 MAR Proposal IA, n 43, 29–​30. 196 2020 ESMA MAR Review, n 42, 83–​101. See n 202 on the 2022 Listing Act Regulation Proposal. 197 Issuers who have not requested or approved the admission of their financial instruments to trading on an in-​ scope venue are exempt: Art 18(7). The obligation also applies to emission allowance market participants and auction platforms, auctioneers, and auction monitors relating to the auction of emission allowances under Regulation 1031/​2010: Art 18(8). 198 Issuers, and any person acting under their behalf or account, must also take all reasonable steps to ensure that any person on the list acknowledges in writing the legal and regulatory duties entailed in possessing inside information and that they are aware of the sanctions applicable to the misuse or improper disclosure of such information. 199 ITS 2022/​1210 Art 1 and Annex I specify that the list can identify ‘permanent insiders’, but it must also, at any time, include those who have access to ‘new’ inside information as it arises, and specify the time at which a person obtained access. Lists must also be divided into different sections relating to different inside information and so cannot simply take the form of a list of function holders who would typically have access to inside information. 200 Art 18(3) specifies that the list include at least the identity of the person having access to inside information, the reason for including the person on the list, the date and time at which the person obtained access to the information, and the date at which the list was created. These requirements are amplified by ITS 2016/​347. 201 NCAs’ practices vary on the extent to which requests are made, although most NCAs do, to some extent, request them, whether systemically or as part of specific investigations: 2020 ESMA MAR Review, n 42, 86–​7. 202 MAR originally provided that such issuers were exempt from the insider list requirement, as long as the relevant issuer took all reasonable steps to ensure that any person with access to inside information acknowledged the legal and regulatory duties which followed, and was aware of the sanctions applicable. But as the issuer was required to provide the NCA, on request, with the insider list, the alleviation was, in practice, something of a dead letter. The 2019 reform accordingly followed. The 2022 Listing Act Regulation Proposal (n 84) proposed that this alleviation apply to all issuers.

716  Market Abuse

VIII.7.3  Disclosure of Insider Transactions: Managers’ Transactions Transactions by persons holding managerial responsibility in an issuer, in the relevant issuer’s securities, are regarded as informative for price formation and also as being vulnerable to insider-​dealing risk.203 They are, accordingly, typically subject to discrete reporting requirements and to dealing restrictions.204 Rules of this type were first introduced at EU-​ level by the 2003 MAD which imposed reporting requirements on manager transactions. This reporting regime was subsequently clarified by MAR,205 given concerns as to its costs and as to its effectiveness.206 The MAR regime was then subsequently refined (by means of the 2016 Benchmark Regulation) as regards its application to managers’ indirect holdings of issuer securities, through funds and asset portfolios. MAR also introduced a dealing restriction on manager transactions in ‘closed periods’, reflecting common practice in major financial markets internationally. Efforts to mitigate the costs and complexities associated with these widely-​cast requirements, including by means of administrative amplification of the rules and the provision of exemptions, have led to a highly articulated and granular regime.207 Article 19(1) addresses manager transactions.208 The widely-​cast reporting obligation requires that persons discharging managerial responsibilities within an issuer (PDMRs),209 and also those ‘closely associated’ with PDMRs,210 must notify that issuer and the relevant NCA (of the issuer’s registration) of every transaction that is conducted on their own account and that relates to the issuer’s shares or debt instruments (or to derivatives or other financial instruments linked to such instruments).211 The rules also apply to emission allowance market participants and are calibrated accordingly.212 Alleviations apply as regards instruments held indirectly through collective investment schemes and asset portfolios (Article 19(1a) and (7)). The relevant notification must be made promptly and no later than three business days after the transaction (Article 19(1)). The issuer must then, given the associated price informativeness of these transactions, make public the information 203 An extensive financial economics literature assesses the extent to which such insider trades are informative, and whether ‘outsiders’ can profit from following publicly-​disclosed insider transactions. See, eg, Lakonishok, L and Lee, L, ‘Are Insider Trades Informative?’ (2001) 14 Rev Fin Studies 79. 204 Rules of this type are long-​established in the US and have been examined by an extensive literature. See, eg, Fried, J, ‘Reducing the Profitability of Insider Trading through Pre-​Trading Disclosure’ (1998) 71 Southern California LR 303. 205 Primarily on the foot of Council revisions to the 2011 MAR Proposal. The Council’s revisions inter alia extended the reporting obligation beyond shares and specified the issuer’s obligations and the content of the required notification. 206 2011 MAR Proposal IA, n 43, 29–​30. 207 Only its main features are noted here. 208 As with the insider list rules, Art 19 does not apply to issuers who have not requested or approved the admission of their financial instruments to trading on a MAR-​scope venue: Art 19(4). 209 Defined under Art 3(1)(25) as a person within an issuer who is a member of the administrative, management, or supervisory body of that entity; or who is a senior executive, who is not a member of such a body, but has regular access to inside information relating directly or indirectly to that entity, and has the power to make managerial decisions affecting the future developments and business prospects of that entity. 210 Defined in Art 3(1)(26) and covering identified family members; and specified legal persons (in essence, those linked through control and influence ties to the PDMR and its associated persons). 211 The ‘transactions’ covered by Art 19(1) are addressed by Art 19(7) which is widely-​drawn and includes the pledging or lending of financial instruments, transactions undertaken by any person professionally arranging or executing transactions on behalf of the PDMR (including where discretion is exercised), and specified transactions made under a life insurance policy. Delegated Regulation 2016/​522 Art 10 further specifies the transactions that are notifiable. 212 This section addresses only the issuer requirements.

VIII.8  The Prohibition on Market Manipulation  717 contained in the notification within two business days of receipt of the notification (Article 19(3)).213 While widely-​drawn, the PDMR (and associated persons) reporting obligation applies only where the relevant reporting threshold is met. The threshold is, however, set at a low level: the obligation applies to any subsequent transaction once a transaction total of €5,000 (calculated without netting the transactions) has been reached in a calendar year (Article 19(8)). An NCA may decide to increase the threshold to €20,000, and thereby limit the reach of the reporting obligation (Article 19(9)).214 Alongside, MAR imposes a dealing rule in the form of a ‘closed period’ restriction. Under the restriction, PDMRs are prohibited from conducting any trading that is related to shares or debt instruments of the issuer, or to derivatives or financial instruments linked to these instruments, on their own account or for the account of a third party, directly or indirectly, during the specified ‘closed periods’ (Article 19(11)). These closed periods cover the period of 30 calendar days before the announcement by the issuer of an interim financial report, or year-​end report, which the issuer is required to make public. An issuer may permit PDMR trading during a closed period either on a case-​by-​case basis and due to the existence of exceptional circumstances which require the immediate sale of shares (such as severe financial difficulty); or due to the characteristics of the trading involved (such as trading in relation to an employee share scheme, savings schemes, or where the beneficial interest in the security does not change) (Article 19(12)).215 Both sets of PDMR obligations reflect requirements in common application internationally. They have, however, introduced significant proceduralization into the market abuse regime which has required both amplification and legislative revision to manage the costs placed as a result on market participants.

VIII.8  The Prohibition on Market Manipulation VIII.8.1  The Prohibition on Market Manipulation and Identification of Market Manipulation Capturing the notion of market manipulation for the purposes of a regulatory prohibition presents challenges, not least as detailed definitions can struggle to capture the full range of manipulative activity, are prone to obsolescence, and can generate perverse incentives to engage in avoidance strategies, but an overly broad definition can capture legitimate

213 Art 19 specifies the content of the notification, which must, inter alia, include the price, volume, and nature of the transaction (Art 19(6)), and which is amplified by ITS 2016/​523 [2016] OJ L88/​19 which provides the related template. To support reporting persons, the issuer must draw up a list of PDMRs and their associated persons and advise them of their Art 19 obligations (Art 19(5)). 214 Five NCAs (of larger financial markets: the NCAs of Denmark, France, Germany, Italy, and Spain) have applied the higher threshold, in order to achieve a balance between transparency and imposing undue costs: 2020 ESMA MAR Review, n 42, 103. ESMA’s review reported on significant market concern regarding the volume of reporting required where the lower €5,000 threshold applied. ESMA did not recommend that the lower threshold be increased, arguing that, for some Member States, an increase in the threshold would prejudicially limit reporting: at 110. The High Level Forum on CMU, however, called for an increase in the threshold to €50,000 to reduce reporting burdens: n 44, 68. The 2022 Listing Act Regulation Proposal (n 84) favoured liberalization, increasing the threshold to €20,000. 215 The closed period prohibitions have been amplified by Delegated Regulation 2016/​522, including as regards the exceptional circumstances in which trading may be permitted.

718  Market Abuse conduct. The 2003 MAD, at the legislative level, adopted a high-​level approach, defining market manipulation in broad terms. In addition, the MAD’s administrative rules and CESR’s soft law supervisory convergence measures specified indications, signals, and examples of potential market manipulation in order to build market understanding of which practices breached the 2003 MAD and to provide NCAs with flexible tools for investigating manipulative practices.216 MAR has a more atomized design. It brought much of the 2003 MAD administrative rulebook regarding market manipulation within the Regulation, by means of Article 12, which specifies what constitutes market manipulation, and by means of Annex I, which sets out ‘indicators’ for different types of market manipulation; Delegated Regulation 2016/​ 522 amplifies the meaning of these ‘indicators’ in detail. The MAR prohibition also applies more widely than its 2003 MAD counterpart. The perimeter of MAR is widely cast and, in particular, captures cross-​market manipulation between the relevant commodity derivative market and the related (and often unregulated) spot or physical market.217 The foundational provision, MAR Article 15, prohibits any person from engaging in market manipulation and from attempting to engage in market manipulation.218 The meaning of market manipulation is specified by Article 12(1), which provides that market manipulation encompasses three classes of behaviour: (i) manipulative trading practices (Article 12(1)(a) and (b)); (ii) the dissemination of false or misleading information (Article 12(1)(c)); and (iii) benchmark manipulation (Article 12(1)(d)) (considered in section 10.2). A wide-​angled, effects-​based approach is used to define these classes of prohibited behaviour. The reach of the application of Article 12 is scaled back somewhat, however, by the ‘accepted market practice’ safe harbour, which is designed to protect legitimate market behaviour from the prohibitions (section 8.2); and by the intention requirement, which governs when manipulation through the dissemination of false or misleading information arises (the other prohibitions do not have an intention element). Under Article 12(1)(a), market manipulation comprises entering into a transaction, placing an order to trade, or any other behaviour which: gives, or is likely to give, false 216 The 2003 MAD prohibition was designed to ‘encourage and guide the responsible behaviour’ of market participants rather than to set out detailed rules on what behaviour was not permitted: 2001 MAD Proposal, n 66, para 2. 217 Section 5.1. In particular, MAR’s prohibitions on market manipulation apply beyond financial instruments to spot commodity contracts, where the relevant ‘transaction, order or behaviour’ in those spot commodity contracts (excluding wholesale energy products covered by the 2011 REMIT Regulation), has, or is likely or intended to have, an effect on an in-​scope financial instrument. Related, the prohibitions apply to types of financial instruments (including derivatives for the transfer of credit risk) where the relevant ‘transaction, order, bid, or behaviour’ has, or is likely to have, an effect on the price or value of a spot commodity contract, where that contract’s price or value depends on the price or value of those financial instruments: Art 2(2)(a) and (b). Wholesale energy products (contracts and derivatives relating to electricity and natural gas supply) fall outside the market manipulation prohibitions, being subject to the 2011 REMIT Regulation which applies discrete prohibitions regarding inside information and market manipulation in these markets. Relatedly, Art 25 requires cooperation between ESMA, NCAs, and ACER—​the EU Agency for the Co-​operation of Energy Regulators. National regulatory authorities for energy, NCAs, ESMA, and ACER have long cooperated (including through their Energy Trading Enforcement Forum), but the increased volatility in energy markets following the outbreak of the war in Ukraine led to enhanced monitoring and surveillance by the relevant authorities and to more intense coordination between ESMA, ACER, and the relevant authorities, including through a joint ESMA/​ACER task force set up in October 2022. 218 Attempts to engage in market manipulation were not covered by the 2003 MAD. They were included by MAR to align the market manipulation prohibition with the insider-​dealing prohibition and thereby also to ease the burden on NCAs (who, in the absence of a prohibition on attempted action, are otherwise required to produce evidence of the relevant transactions or orders): 2011 MAR Proposal, n 74, 8. ‘Attempting’ covers, inter alia, efforts to engage in manipulative conduct that fail due to technology failures or because an instruction to trade is not acted on (MAR recital 41).

VIII.8  The Prohibition on Market Manipulation  719 or misleading signals as to the supply of, demand for, or price of a financial instrument, a related spot commodity contract or an auctioned product based on emission allowances; or secures, or is likely to secure, the price of one or several financial instruments or a related spot commodity contract or auctioned product based on emission allowances at an abnormal or artificial level (thereby covering behaviour typically termed ‘price positioning’).219 This conduct is not manipulative where the person who entered into the transaction (or who placed the order to trade or engaged in the relevant behaviour) establishes that the reasons for so doing were legitimate and that the transaction, order, or behaviour conforms with an ‘accepted market practice’ established under Article 13 (section 8.2). Under Article 12(1)(b), market manipulation also comprises entering into a transaction, placing an order to trade, or any other activity or behaviour which affects or is likely to affect the price of one or several financial instruments or a related spot commodity contract or an auctioned product based on emission allowances, which employs a fictitious device or any other form of deception or contrivance. Article 12(1)(c) addresses manipulative activities related to information, and covers the dissemination of information through the media, including the internet, or by any other means, which gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of a financial instrument, a related spot commodity contract, or an auctioned product based on emission allowances, or which secures, or is likely to secure, the price of one or several financial instruments, a related spot commodity contract, or an auctioned product based on emission allowances at an abnormal or artificial level, including through the dissemination of rumours. Unlike Article 12(1)(a) and (b), an intention requirement applies: the person who made the dissemination must know, or ought to have known, that the information was false or misleading. The Article 12(1) legislative scaffolding for the market manipulation prohibition uses, accordingly, a host of broadly-​drawn terms, but it is built out, albeit in a principles-​based manner, by Article 12(2). Non-​exhaustive in design, Article 12(2) sets out high-​level examples of the types of behaviour which will ‘be considered as market manipulation’. It covers ‘abusive squeezes’,220 market open/​close abuses,221 abuses relating to algorithmic and high frequency trading,222 and information-​related abuses (involving taking advantage of

219 The Court of Justice has ruled (in the context of the precursor 2003 MAD provision) that the prohibition of behaviour which secures prices at an abnormal or artificial price level is not qualified by a duration requirement and so can capture a single abusive transaction; otherwise, ruled the Court, the objectives of the market abuse regime to protect the integrity of markets and to enhance investor confidence would be undermined (in the case in question, the impact of the manipulative behaviour on prices did not last for more than one second): IMC Securities, n 112. 220 Conduct by a person (or persons acting in collaboration) to secure a dominant position over the supply of or demand for a financial instrument (or related spot commodity contract or auctioned product based on emission allowances) which has, or is likely to have, the effect of fixing, directly or indirectly, purchase or sale prices, or which creates, or is likely to create, other unfair trading conditions: Art 12(2)(a). 221 The buying or selling of financial instruments at the opening or closing of the market, which has or is likely to have the effect of misleading investors acting on the basis of the prices displayed, including the opening or closing prices: Art 12(2)(b). 222 The imprints of the financial crisis on MAR can be seen in this specification of practices related to algorithmic trading. As discussed in Ch VI section 2, algorithmic and in particular high frequency algorithmic trading (HFT) emerged as a crisis ‘poster child’ for ‘excessive’ financial market innovation and intensity. Relatedly, and somewhat unnecessarily (the 2011 MAR Proposal noted that the market manipulation definition was broad and capable of applying to such abusive behaviour: n 74, 8) Art 12(2)(c) specifies the behaviours concerning algorithmic and HFT strategies considered to amount to market manipulation. These are further specified by the ‘indicators’ and ‘practices’ that amplify the market manipulation prohibition (noted below).

720  Market Abuse occasional or regular access to the traditional or electronic media).223 Specific behaviours in the emission allowance markets are also covered (Article 12(2)(e)). The Article 15 prohibition, as specified by Article 12, is designed to operate as a foundational, catch-​all legislative prohibition. It serves as the EU’s bulwark against the emergence of manipulative practices, being less vulnerable to atrophying in the face of market change and innovation than highly detailed technical rules would be. The prohibition is, however, amplified in detail by the non-​exhaustive ‘indicators’ of manipulative conduct and by the related illustrative ‘practices’ that are set out in MAR (Annex I: indicators) and Delegated Regulation 2016/​522 (Annex II: practices); these amplify the Article 12(1)(a) and (b) trading-​related prohibitions.224 These indicators/​practices are not dependent on intention, as the Article 12(1) specification of prohibited manipulative trading practices is effects-​based, but are designed to be objective and to address market effects. MAR Annex I recognizes, however, that the existence of any indicator should not necessarily be deemed, in itself, to indicate an instance of market manipulation; the indicators are to be taken into account by market participants and NCAs.225 The Annex I indicators are amplified in detail by Delegated Regulation 2016/​522 (Annex II) as regards the specific ‘practices’ which could generate the ‘indicators’.226 The combined effect of MAR Annex I and Delegated Regulation 2016/​522 Annex II is to construct an illustrative ‘catalogue’ of some granularity of the types of trading-​related evidence which could indicate manipulative conduct,227 albeit that the indicative and non-​limiting nature of this catalogue is frequently underlined.228 Further, the different indicators and practices seek to provide a ‘practical tool’ that is designed to contribute to, but not replace, market participants’ judgment as to whether particular trading practices might breach the Article 15/​12 prohibition.229 ESMA soft law has not followed (the MAR Q&A does not further amplify the nature of manipulative conduct), reflecting the diminishing returns from ever more granular specification and illustration of the framework legislative prohibitions. The MAR Annex I/​Delegated Regulation 2016/​522 Annex II ‘catalogue’ covers manipulative trading practices. The nature of market manipulation through information 223 This provision captures the taking advantage of such access by voicing an opinion about a financial instrument or related spot commodity contract or auctioned product based on emission allowances (or indirectly about its issuer), while having previously taken positions on those instruments or contracts, and profiting subsequently from the impact of those opinions without having simultaneously disclosed the conflict of interest to the public in a proper and effective way: Art 12(2)(d). 224 They are drawn from precursor 2003 MAD administrative rules. 225 Similarly, Delegated Regulation 2016/​522 notes that the ‘practices’ should not be considered to constitute market manipulation per se but are to be taken into account by NCAs and market participants (recital 6). 226 The ‘practices’ are designed to clarify the indicators and also to take into account technical developments on financial markets: Delegated Regulation 2016/​522 recital 5. The Annex also includes additional indicators developed by ESMA to amplify MAR Annex I. 227 By way of example, MAR Annex I(A)(a) identifies as an indicator of ‘false or misleading signals’, or price securing, the extent to which orders to trade or transactions represent a significant proportion of the daily volume of transactions in the relevant instrument or conduct, in particular where those activities lead to a significant change in price. Delegated Regulation 2016/​522 Annex II amplifies this indicator in detail as regards four illustrative practices, including executing orders to trade to uncover orders of other participants and then entering an order to take advantage of the information obtained (‘phishing’) (Annex II section 1(1)). 228 Delegated Regulation 2016/​522 recitals 5, 6, and 7, eg, call for a proportionate approach to applying the indicators and practices, taking into account the nature and specific characteristics of the instruments and market concerned; and also note their non-​exhaustive nature and that other practices may illustrate the indicators of manipulative behaviour. 229 2015 ESMA MAR Technical Advice, n 100, 9. ESMA warned that market participants should pay particular attention to where trading practices deviate from usual practices and lack an economic rationale.

VIII.8  The Prohibition on Market Manipulation  721 dissemination (Article 12(1)(c)), and in particular through social media dissemination, has not been amplified,230 arguably given the longstanding familiarity with abusive conduct as regards information through the insider dealing prohibition. Article 12(1)(c) remains, nonetheless, a core element of the market manipulation prohibition, as was underlined by ESMA over the 2021 ‘meme-​stock’/​Gamestop period of market volatility,231 albeit that this period also underlines the fine judgments that making a determination as to the existence of potentially manipulative conduct can require of regulators.232

VIII.8.2  Accepted Market Practices and Liquidity Contracts Under Article 13, a safe harbour against a finding of market manipulation with respect to Article 12(1)(a) trading practices is available where the person who entered into the transaction (or who placed the orders to trade or engaged in any other behaviour) establishes that (i) the action was carried out for ‘legitimate reasons’ (an intention-​based element); and (ii) the actions conform with an ‘accepted market practice’ (AMP), established under the Article 13 AMP regime. The AMP safe harbour is not available for Article 12(1)(b) as there can never be a legitimate reason for entering into ‘fictitious devices’ or any other form of ‘deception or contrivance’. The AMP system is proceduralized by MAR, and overseen by ESMA, in an attempt to strike what can be a delicate balance between domestic and EU interests and, relatedly, between conflicting perspectives as to the nature of manipulative conduct. The AMP system was originally adopted by the 2003 MAD as a means for accommodating the different trading practices that can evolve on different national markets, typically to support liquidity, and that become accepted as legitimate and so form part of the institutional structure of the relevant markets.233 Where such accepted practices diverge, however, they can generate arbitrage risks, raise costs, and damage intra-​NCA trust. The 2003 MAD safe harbour for AMPs accordingly required NCAs to establish formally such AMPs, in accordance with a series of non-​exhaustive criteria set out in administrative rules.234 The extent of the consequent NCA divergence as to which practices could constitute AMPs,235 however, led to 230 MAR recital 48, however, noted the applicability of the prohibition to social media sites and unattributed blogs. 231 ESMA warned investors that information dissemination through social media could constitute market manipulation: n 79. Similarly, ESMA Chair Maijoor underlined that posting false or misleading information about an issuer or financial instruments could constitute market manipulation (as could coordinated strategies to buy and sell at certain conditions and a certain point in time, with the objective of inflating a share price): Statement (ECON Exchange of Views in Relation to Gamestop Share Trading and Related Phenomenon), 23 February 2021. Social media coordination also formed part of ESMA’s 2022 work programme, including as regards any guidance necessary for ‘new generations of retail investors’: ESMA, 2022 Work Programme (2021) 28. On the meme stock/​ Gamestop episode see Ch VI section 2.2 and Ch IX section 4.9.2. 232 Chiu, n 38, warning that while aspects of the related coordination, through social media, of retail investor trading might have constituted manipulative conduct, any related enforcement action could have damaged retail investor trust in market investment. 233 The Commission described the precursor 2003 MAD AMP regime as reflecting the existence of behaviours that could reasonably be regarded as acceptable behaviours in a given national market (due to, eg, local, long-​ established customs) but as potentially constituting market manipulation in other Member State markets: 2011 MAR Proposal IA, n 43, 28. 234 CESR additionally established a template for assessing AMPs, a reporting system, and a publication mechanism, as well as a market-​facing FAQ document. 235 Some eleven AMPs, specific to different Member State markets, were in place when MAR was adopted in 2014.

722  Market Abuse the Commission proposing the abolition of the AMP system in its 2011 MAR Proposal.236 Following significant resistance within the Council (which supported national discretion and flexibility),237 the AMP regime was retained, but was significantly recast and tightened, including by the conferral of oversight powers on ESMA. The continued tolerance of local AMPs might be regarded as undermining the MAR rulebook, but they provide a means for responding to different local market features and practices, particularly as regards the support of liquidity. In practice, AMPs have become more limited and more harmonized, although ESMA/​NCA friction can arise.238 The criteria which govern when an NCA can establish an AMP are set out in detail in Article 13(2). An NCA can establish an AMP taking into account whether the specific market practice has a substantial level of transparency to the market; the practice ensures a high degree of safeguards to the operation of market forces and the proper interplay of the forces of supply and demand; the practice has a positive impact on market liquidity and efficiency; the practice takes into account the trading mechanism of the relevant market and enables market participants to react properly and in a timely manner to the new market situation created by that practice; and the practice does not create risks for the integrity of (directly or indirectly) related markets, whether regulated or not, in the relevant financial instrument within the EU. In addition, the NCA must take account of the outcome of any investigation of the practice by any NCA or other authority, in particular whether the practice breached rules or regulations designed to prevent market abuse, or codes of conduct, be it on the market in question or on directly or indirectly related markets within the EU; and the structural characteristics of the relevant market for the AMP, including whether it is regulated or not, the types of financial instrument traded, and the types of market participants, including the extent of retail investor participation in the relevant market. Reflecting their sensitivity, AMPs are specific to the relevant local markets: a practice that is accepted as an AMP by the NCA in one market is not considered applicable to other markets, unless the relevant NCAs have accepted that practice. These criteria map those which applied under the precursor 2003 MAD regime (albeit that the MAD criteria applied through administrative rules, now subsumed within MAR). MAR also, however, charges ESMA with an oversight function, akin to that which ESMA exercises in relation to NCAs’ decisions regards position limits and short selling (Chapter VI). An NCA must, not less than three months before the AMP is intended to take effect, notify ESMA (and other NCAs) of its intention to establish an AMP and provide details of its assessment of the applicable criteria (Article 13(3)). ESMA must issue (and publish) an opinion on the compatibility of the proposed AMP with the Article 13(2) criteria; the opinion must also consider whether the AMP would threaten market confidence in the EU’s financial market (Article 13(4)). ESMA does not have the power of veto but, where an NCA establishes an AMP contrary to an ESMA opinion, that NCA must publish (within 24 hours) its reasons for doing so, including why the AMP does not threaten market confidence

236 2011 MAR Proposal IA, n 43, 28 and 57. 237 Danish Presidency MAR Progress Report, n 77, 3. Nonetheless, most Member States were of the view that an AMP should be limited and only apply within the particular Member State that permitted the AMP and could not be transposed to other Member States. 238 As noted below in this section, ESMA and the French NCA (the AMF) disagreed in 2018 on the validity of an AMP and again in 2021 as regards the AMF’s subsequent recasting of the original AMP in light of ESMA’s objections: ESMA, Opinion 28 May 2021 (on the AMF AMP on Liquidity Contracts).

VIII.8  The Prohibition on Market Manipulation  723 (Article 13(5)). Alongside this ESMA-​based ‘comply or explain’ disciplining mechanism, peer NCA oversight is called in aid: where another NCA considers that an NCA has not met the Article 13(2) criteria, ESMA is to assist in the reaching of an agreement, using its ESMA Regulation Article 19 mediation powers (Article 13(6)). NCAs must also review their AMPs regularly and at least every two years (Article 13(8)). The AMP system is further proceduralized in some detail, reflecting the sensitivities associated with the establishment of AMPs, by RTS 2016/​908.239 ESMA, which publishes a list of current AMPs, is also required to report annually to the Commission on AMPs (Article 13(9) and (10)). Use of AMPs is now limited across the EU. Five NCAs (of Austria, France, Italy, Portugal, and Spain) notified ESMA in 2016 of pre-​existing MAD AMPs (the notification of pre-​ existing AMPs was required by Article 13(11)). By 2020, these AMPs had all been either terminated or replaced with new MAR AMPs (established by four NCAs: France, Italy, Portugal, and Spain). All of the new AMPs relate (at present) to ‘liquidity contracts’240 of varying design.241 In its 2021 report on AMPs, ESMA reported that the importance of AMPs had become limited, including as regards the volumes traded under AMPs.242 The AMP process is of some significance, however, as it illustrates an ESMA appetite for NCA review and also ESMA’s capacity to place a procedural frame around what is a discretionary and sensitive NCA power. For example, ESMA’s first (2016) AMP opinion related to an AMP for liquidity contracts proposed by the Spanish NCA.243 In its review, ESMA underlined that it regarded its AMP opinion/​review power as being of the ‘utmost importance’, given the market integrity risks associated with liquidity-​contract-​related AMPs.244 While ESMA ultimately adopted a positive review, this followed a preliminary ‘comment and review’ procedure through which ESMA indicated the changes which it would require to the AMP before it would be supported as being in compliance with the relevant Article 13(2) criteria. Subsequently, ESMA adopted in 2017 a ‘Points for Convergence’ Opinion on AMPs relating to liquidity contracts (the PfC) which provides guidance to NCAs on how they should approach such AMPs, and which is notable for the precise and granular conditions it applies in order to ‘ensure increased uniform application’ of MAR.245 The AMP process has also, however, indicated the limits of the ESMA review process. In 2018, ESMA found that an AMP relating to liquidity contracts, proposed by the French NCA (the most 239 [2016] OJ L153/​3. The RTS specifies the processes NCAs are to follow in establishing and in maintaining and reviewing an AMP and amplifies in detail the criteria which NCAs are to consider when assessing a potential AMP. 240 A liquidity contract performs similar functions to market-​making activities, but with a liquidity contract the liquidity function is provided for by means of a contract between the issuer and the relevant third party (rather than between the market operator and the third party). These contracts are associated with facilitating daily quotations and SME liquidity in particular. 241 ESMA, Report to the European Commission on the Application of Accepted Market Practices (2020). 242 ESMA, Report to the European Commission on the Application of Accepted Market Practices (2021). Liquidity contracts are most heavily used in France (in relation to some 70 per cent of listed issuers), but trading volumes under such liquidity contracts account for less than 1 per cent of trading volumes in the relevant shares (at 15). 243 ESMA/​2016/​1663. The AMP was designed to replace the earlier AMP adopted by the Spanish NCA under the 2003 MAD AMP regime. 244 ESMA noted its concern that while five NCAs had different forms of liquidity-​contract-​related AMP, these contracts were regarded as manipulative practices by other NCAs. 245 ESMA, Opinion (Points for Convergence in relation to MAR Accepted Market Practices on Liquidity Contracts), 25 April 2017. The PfC is a soft supervisory convergence measure adopted under ESMA Regulation Art 29 (see further Ch I section 6.5). The PfC is specified in some substantive detail, including as regards the price, volume, and resource limits to be applied to AMPs. eg, the PfC applies a volume cap on any such AMP of 15 per cent of average daily volume on the market in the previous twenty to thirty trading sessions for liquid shares and of 25 per cent for illiquid shares.

724  Market Abuse significant user of AMPs in the EU),246 did not meet the Article 13 requirements, as amplified by the 2017 PfC.247 The French NCA proceeded with the AMP nonetheless. Following a subsequent revision by the French NCA of the AMP, in light of market experience and ESMA’s 2018 review, and a further finding of non-​compliance by ESMA in 2021,248 the AMP remained in place, underlining the sensitivity of the AMP process and the limits of ESMA oversight where NCA and local interests are strong.249 Without prejudice to the AMP process, and in a refinement introduced by the 2019 SME Regulation, issuers admitted to trading on an SME Growth Market can enter into liquidity contracts for their shares where the related MAR conditions are met and without a specific AMP being in place (Article 13(12)).250 The alleviation is designed to facilitate SME Growth Market liquidity and to reduce volatility by allowing such issuers to benefit from liquidity contract support without the need for a related AMP to be in place.251 In an indication of the difficulties that SME-​related segmentation can generate, the coexistence of this specialist regime for liquidity contracts alongside, and without prejudice to, the AMP system has, however, generated some ambiguities as to how the two regimes interact.252 The alleviation also underscores the challenges in designing a prohibition on market manipulation that accommodates practices that support market efficiency and liquidity. In effect, the reform puts in place a harmonized regime for certain liquidity contracts which, in other circumstances, can be regarded as manipulative practices and as regards which only four NCAs have put in place specific AMPs.

VIII.8.3  Stabilization and Buy-​Backs MAR also accommodates the longstanding market practices of stabilization and buy-​back. Stabilization involves trading in securities by the lead managers of a primary distribution of securities for a limited period of time after the offering in order to support the price against excessive volatility which may arise under the initial pressure of early sell orders. It is designed to ensure that the price reflects the security’s real, as opposed to speculative, value.253 246 See n 242. 247 ESMA, Opinion, 11 April 2018. ESMA’s concern derived primarily from the AMP’s waivers for issuers and intermediaries from the conditions set out in ESMA’s PfC (these waivers applied over a two-​year transitional period). 248 ESMA, Opinion, 28 May 2021. The new AMP took into account the data the AMF had subsequently gathered on the operation of the AMP. In this Opinion, ESMA was concerned in particular by the absence of price and volume limits under the AMP. 249 AMF, Notice Published pursuant to Art 13(5), 23 June 2021. The AMF was robust in response, referencing the specific context of the French market and related data and noting its ‘bafflement’ with the ESMA analysis. 250 The terms and conditions of the liquidity contract must comply with the Art 13(2) criteria for assessing AMPs and the related new RTS for liquidity contracts; the liquidity provider must be authorized under MiFID II and be a member of the relevant Growth Market; and the market operator must be notified and agree with the contract. The RTS amplifying the criteria was adopted by the Commission in July 2022, based on ESMA’s proposal which set out the terms and conditions for such contracts, akin to those applicable under the 2017 PfC. 251 The 2019 SME Regulation identified the absence of liquidity contracts as an impediment to the development of SME Growth Markets and as requiring an EU framework for such contracts (which would operate in parallel with the bespoke regimes which certain (four) NCAs have in place for certain liquidity contracts): recital 7. 252 The parallel operation of the Art 13 regime governing the adoption of AMPs for liquidity contracts generally, and of the specific regime for SME Growth Markets, led to some confusion as to how the two regimes interact, leading ESMA to call for Commission interpretive guidance: ESMA, Final Report (Amendments to MAR regarding SME Growth Markets), 27 October 2020. 253 See Lombardo, S, ‘The Stabilization of the Share Price of IPOs in the United States and in the European Union’ (2007) 8 EBOLR 521.

VIII.9  Supervision and Enforcement  725 Buy-​backs involve the purchase by an issuer of its own shares from the market, and the reduction thereby of the number of shares outstanding, a process which can be used, inter alia, for distributing cash to shareholders.254 Both forms of trading are well-​established means for supporting issuer fund-​raising and balance sheet management, but can be regarded as artificially manipulating the market price. They are therefore typically subject to controls designed to minimize the risks of price distortion and of insider dealing, often in the form of time and price constraints and disclosure obligations. The 2003 MAD established, in the form of administrative rules, a harmonized regime governing stabilization and buy-​backs.255 Difficulties emerged, however, with the regime’s application to non-​equity asset classes as the rules were based on an equity market template. A refined regime, calibrated to equity and non-​equity asset classes followed under MAR (Article 5). It provides that the insider dealing and market manipulation prohibitions do not apply to trading in own shares in buy-​back programmes,256 or to the stabilization of securities more generally,257 subject to compliance with Article 5 and the specific conditions that apply under RTS 2016/​1052.258

VIII.9  Supervision and Enforcement VIII.9.1  Context MAR is not a passporting measure and so is not directly concerned with market construction and liberalization. Relatedly, it is not an authorization-​based measure. Its supervisory arrangements are not, accordingly, designed to ensure the effectiveness of an anchor home NCA as ongoing supervisor of pan-​EU activity and as steward of the passporting process, the usual concern of supervisory arrangements under the single rulebook. NCAs under MAR are, however, pivotal to ensuring the integrity of the EU financial market through ex-​ ante prevention of and ex-​post enforcement in relation to abusive conduct and, thereby, to supporting the integration process. Links have frequently made between the success of the EU’s financial market integration project/​CMU and the effectiveness of the prohibitions on market abuse and of their enforcement.259 And while the nature and extent of MAR’s impact 254 On the EU experience see Siems, M and de Cesari, A, ‘The Law and Finance of Share Repurchases in Europe’ (2012) 12 JCLS 33. 255 Commission Regulation (EC) No 2273/​2003 [2003] OJ L336/​33. 256 A buy-​back programme involves trading in own shares in accordance with the Company Law Directive 2017/​1132 [2017] OJ L169/​46: Art 3(1)(17). 257 Defined as a purchase or offer to purchase relevant ‘securities’, or any transaction in ‘associated instruments’ equivalent thereto, by investment firms or credit institutions, undertaken in the context of a ‘significant distribution’ of such relevant securities, exclusively for supporting the market price of the securities for a predetermined period of time, due to selling pressure in those securities. A ‘significant distribution’ is an initial or secondary offer of securities distinct from ordinary trading, in terms of the amount in value offered and the selling method to be employed: Art 3(2)(c) and (d). For the purposes of the stabilization regime, ‘securities’ covers shares and securities equivalent to shares, bonds, and other forms of securitized debt, or securitized debt convertible or exchangeable into shares or into other securities equivalent to shares (Art 3(2)(a)). ‘Associated instruments’ are contracts or rights to subscribe for, acquire, or dispose of the securities, financial derivatives on the securities, and, where the securities are convertible or exchangeable debt instruments, the securities into which the relevant securities can be converted or exchanged: Art 3(2)(b). 258 The RTS addresses disclosure and reporting, and trading conditions. 259 See recently, eg, Allen, F et al, ‘Market Efficiency and Limits to Arbitrage: Evidence from the Volkswagen Short Squeeze’ (2021) 142 J of Financial Intermediation 166.

726  Market Abuse on the efficiency and liquidity of the EU financial market, and on the integration process, remain difficult to quantify,260 a now considerable body of international evidence suggests that the enforcement of market abuse prohibitions can have quantifiable, positive effects on markets.261 The challenges for NCAs are, however, significant. These include the wide reach of the insider dealing and market manipulation prohibitions, which extend beyond regulated actors and which apply across different financial, derivative, and spot markets, as well as the investigatory difficulties in corralling evidence from complex trading data, particularly in an automated trading context.262 NCA cooperation and coordination needs are, relatedly, distinct, including as regards the efficient flow of information between NCAs and other regulatory authorities, and between NCAs and the wide range of different financial, derivative, and spot markets subject to MAR. MAR’s supervisory and enforcement arrangements reflect this distinct context and have a decidedly operational orientation, being tilted towards prevention, detection, and coordination.

VIII.9.2  Supervision and Prevention VIII.9.2.1  NCAs ESMA is becoming increasingly embedded in MAR’s supervisory arrangements, with coordination on market abuse prevention, detection, and related enforcement becoming increasingly institutionalized through ESMA.263 Nonetheless, the supervision of MAR is, as across the single rulebook, conducted through NCAs, connected through cooperation and coordination links and supported by ESMA. Each Member State must designate a single administrative competent authority for the purposes of MAR (Article 22).264 NCAs’ jurisdictional reach under MAR is wide: an NCA is responsible for ensuring MAR is applied on its territory regarding all actions carried out on its territory, as well as those actions carried out ‘abroad’ relating to instruments admitted to or trading on in-​scope venues within its territory (Article 22). So too is their substantive reach: as outlined in section 5, MAR’s scope extends beyond regulated firms to all persons potentially engaged in the prohibited behaviours and to a wide range of instruments and venues.

260 As previously noted, metrics relating to market integrity are not included in the Commission’s ‘tool-​kit’ of indicators for monitoring progress towards CMU: n 45. 261 Bhattacharya and Daouk, n 13 and Bhattacharya, U and Daouk, H, ‘When No Law is Better than a Good Law’ (2009) 13 Rev of Finance 577, pointing to an increase in the cost of capital where such rules are adopted but not enforced. Similarly, Fernandes and Ferreira n 31 and Beny, n 14. For an EU-​oriented assessment see Christensen et al, n 31. 262 On the detection challenges and the main monitoring techniques deployed by regulators see Austin, J, ‘Unusual Trade or Market Manipulation? How Market Abuse is Detected by Securities Regulators, Trading Venues, and Self-​Regulatory Organizations’ (2015) 2 J of Fin Reg 263. 263 The 2019 ESA Reform Regulation (Regulation (EU) 2019/​2175 [2019] OJ L334/​1) introduced, eg, a competence for the ESMA Management Board to set up Coordination Groups where needed to respond to specific market developments (Art 45b). 264 These authorities are to exercise their functions directly, but can also act in collaboration with other authorities or with market undertakings, by delegation to such authorities or undertakings, or by application to the competent judicial authorities (Art 23(1)).

VIII.9  Supervision and Enforcement  727 The extent to which NCAs can engage in effective domestic and cross-​border prevention and detection of abusive conduct depends in large part on the suite of powers conferred on NCAs, and on how these powers are applied. MAR, in common with most financial-​crisis-​ era legislative measures, strengthened the minimum suite of powers already required of NCAs (under the 2003 MAD), but particularly, given the market abuse context, as regards access to data. Under Article 23, Member States must ensure that appropriate measures are in place so that NCAs have all the supervisory and investigatory powers necessary to fulfil their duties, and the minimum suite of NCA powers required is specified. These specified powers, which have an investigatory orientation, include the power to have access to documents and other data in any form; to require or demand information from any person;265 to carry out inspections or investigations at non-​private premises; and to enter into private premises in order to seize documents and other data in any form, as long as prior authorization is received from the relevant judicial authority and reasonable suspicion exists that the documents or other data may be relevant to prove market abuse.266 NCAs must also be empowered to require telephone and data traffic from telecommunications operators (as well as from investment firms and credit institutions), where reasonable suspicion exists that such records may be relevant to prove market abuse.267 Reflecting MAR’s concern to capture cross-​market abuse, NCAs must be empowered to request information from related spot market participants directly, obtain transaction reports, and have direct access to traders’ systems.268 NCAs’ access to data, and particularly trading venue data, is supported by MiFIR’s record-​keeping regime (Article 25). It requires that investment firms and trading venues maintain for five years records of all orders and transactions in financial instruments either carried out on own account or on behalf of a client (investment firms); or of all orders advertised through their systems (trading venues). NCAs can accordingly interrogate this MiFIR data to monitor trading venues for abusive activity, as the Article 25 obligation in effect allows NCAs sight of trading venues’ entire order books. NCAs typically either request Article 25 data on an ad hoc basis for particular investigations or, deploying their MAR Article 23 information powers, impose ongoing reporting obligations on trading venues. The MAR Article 25 cooperation powers (noted below) can also be used to allow NCAs access to order book records of trading venues in other Member States and thereby to facilitate NCAs in building a picture of on-​venue trading, pan-​EU in a particular financial instrument.269 In its 2020 review of MAR, ESMA did not propose enhancements to the MiFIR order book reporting system, finding that it was working well with NCAs able to access data as required, albeit that ESMA committed to facilitating NCA cooperation in this regard.270

265 Including from those successively involved in the transmission of orders or conduct of the operations concerned, and their principals. 266 Due process conditions apply which reflect rights under the Charter of Fundamental Rights of the European Union. 267 EU data protection law may, however, restrict such access. For an analysis of recent case law see Cameron, I, ‘Court of Justice Metadata Retention and National Security: Privacy International and Law Quadrature du Net (2021) 58 CMLRev 1433. 268 This power is designed to afford NCAs access to continuous spot market data, and to allow them to monitor real-​time data flows, by requiring such data to be submitted directly to them and also by giving NCAs access to spot market traders’ systems: 2011 MAR Proposal, n 74, 11. 269 2020 ESMA MAR Review, n 42, 128–​30. 270 2020 ESMA MAR Review, n 42, 132–​3.

728  Market Abuse In addition, NCAs can draw on MiFIR Article 26 transaction reporting data (Chapter V section 13.2) as well as on the ‘suspicious transactions and orders reports’ (STORs) that MAR requires of trading venues and investment firms (section 9.2.4). The suite of powers required under MAR Article 23 also extends to preventive measures, including powers to request the freezing and/​or sequestration of assets; to suspend trading in the financial instrument concerned; to require the temporary cessation of any practice the NCA considers contrary to MAR; and to impose a temporary prohibition on the exercise of professional activity. It also includes the remedial power for NCAs to take all necessary measures to ensure that the public is correctly informed (including the correction of false or misleading information). The distinct nature of MAR’s prohibitions is also evident from the requirement that NCAs be empowered to refer matters for criminal investigation.

VIII.9.2.2 Supervisory Cooperation and Coordination Given that an instance of market abuse can engage multiple persons (within regulated firms and not), markets, trading venues, instruments, regulatory authorities, and jurisdictions, the NCA cooperation obligation, in particular as regards information exchange, is articulated by MAR in some detail.271 The NCA cooperation system also provides the scaffolding on which ESMA’s coordination activities are based. A series of ITSs govern the procedural modalities of cooperation and information exchange under MAR,272 but the foundational obligation requires NCAs to cooperate with each other and ESMA, where necessary for the purpose of the Regulation, unless a relevant exception applies (Article 25(1)).273 More specifically, NCAs are to render assistance to each other and to ESMA, exchange information without undue delay,274 and cooperate in investigation, supervision, and enforcement activities (Article 25(1)).275 A specific cooperation obligation applies as regards facilitating the recovery of monetary administrative sanctions (Article 25(6)). Where a Member State chooses to apply criminal sanctions to breaches of MAR, NCAs must have all necessary powers to liaise with relevant judicial authorities to receive specific information related to criminal investigations under MAR, and provide the same to other NCAs and ESMA, in fulfilment of the cooperation obligations (Article 25(1)). As is the case across the single rulebook, NCAs may require the assistance of other NCAs regarding on-​site inspections or investigations; ESMA must be informed and can, where requested, coordinate the investigation or inspection (Article 25(6)).276 271 Also, professional secrecy and data protection requirements apply to NCAs generally and in the cross-​border cooperation context. 272 ITS 2018/​292 [2018] OJ L55/​34, eg, specifies the procedures and forms for exchange of information and assistance, including as regards on-​site inspections and the taking of statements. 273 Specific cooperation obligations address NCAs’ relationships with spot market authorities (Art 25(8)). 274 NCAs must, on request, immediately supply information required under Art 25(1): Art 25(4). As noted in section 9.2.1, Art 25 can be used to request access to the order book records of trading venues operating in the Member State of the ‘requested’ NCA. 275 The cooperation obligations extend to the relevant supervisory authorities at national and EU level under the 2011 REMIT Regulation for the energy markets (including ACER, which is responsible for monitoring wholesale energy markets for market abuse under the REMIT Regulation: as noted in n 217 the increased volatility in energy markets following the outbreak of war in Ukraine led to enhanced coordination) and to the Commission, as appropriate, with respect to spot markets for agricultural commodities: Art 25(1) and (3). 276 The NCA in receipt of the request may provide assistance in various forms, including by carrying out the investigation or inspection itself, allowing the requesting NCA to participate in the investigation or inspection, allowing the NCA to carry the investigation or inspection out independently, appointing auditors or inspectors to carry out the investigation or inspection, or sharing tasks relating to the investigation or inspection with other NCAs (Art 25(6)).

VIII.9  Supervision and Enforcement  729 The limited and exceptional conditions under which an NCA may refuse to act on an information or cooperation request are specified as: where the communication might adversely affect the security of the Member State; compliance would be likely to adversely affect the NCA’s own investigation or enforcement activities or, as relevant, a criminal investigation; judicial proceedings have already been initiated in respect of the same persons and action; and a final judgement has already been delivered in relation to the same persons and action (Article 25(2)). Otherwise, an NCA whose request is not acted on within a reasonable time or rejected may refer this to ESMA, who may exercise its ESMA Regulation mediation and enforcement powers (Article 25(7)). In an attempt to prevent abusive behaviour slipping through jurisdictional loopholes, an NCA is required to inform the relevant NCAs (and ESMA)277 where it is convinced that acts contrary to MAR are being, or have been, carried out on the territory of another Member State, or that acts are affecting financial instruments traded on a trading venue situated within another Member State. The NCAs involved must consult each other (and ESMA)278 on the appropriate action to take, inform each other of significant interim developments, coordinate their actions in order to avoid duplication and overlap when applying sanctions in cross-​border cases, and assist in the enforcement of their decisions (Article 25(5)). The 2019 reforms to the ESMA Regulation have strengthened ESMA’s position in ‘live’ cases of cross-​border abuse by requiring an NCA, where it has evidence or clear indications to suspect that orders, transactions, or any other activity with significant cross-​border effects threaten the orderly functioning and integrity of financial markets (or financial stability), to promptly notify ESMA; and by expressly empowering ESMA to issue an opinion to NCAs of the Member States where the suspected activity has occurred on appropriate actions to take.279 Given its extraterritorial reach, MAR also addresses cooperation with third countries (Article 26), requiring NCAs, where necessary, to conclude cooperation arrangements (coordinated and facilitated, where possible, through ESMA—​who, with the other NCAs, must be informed where an NCA proposes such an arrangement—​and following an ESMA template) with third country competent authorities concerning information exchange and enforcement of MAR obligations in third countries.280 ESMA is, where possible, to facilitate and coordinate information exchange between NCAs and third country supervisory authorities. These arrangements are to include third country spot markets and their authorities (Article 25(8)).281

VIII.9.2.3 Supervisory Coordination, Convergence, and ESMA This legislative scheme is supported by ESMA’s coordination and convergence activities.

277 And ACER, in relation to wholesale energy products. 278 And ACER, in relation to wholesale energy products. 279 ESMA Regulation Art 31b. 280 Professional secrecy and data protection requirements apply. 281 Cross-​border cooperation as regards market abuse prevention is an established feature of financial markets regulation globally given the distinct investigatory challenges associated with market abuse prevention and the cross-​border reach of abusive conduct. IOSCO’s Multilateral Memorandum of Understanding (MMoU), established in the wake of September 11 2001 terrorist attacks, eg, is associated with cross-​border cooperation and information exchange generally, but particularly with information exchange regarding cross-​border fraud and misconduct. The number of information exchanges under the MMoU ballooned from 56 in 2003 to 4,319 in 2019: IOSCO, Annual Report (2020).

730  Market Abuse NCA cross-​border cooperation and coordination as regards market abuse prevention has long been on a reasonably secure footing, including prior to MAR’s strengthening of NCA cooperation obligations.282 The market abuse area has also long been something of a pathfinder for institutionalized cooperation and coordination. Prior to the financial crisis and the establishment of ESMA, CESR’s extensive efforts included the establishment of CESR-​Pol, a permanent operational group within CESR responsible for the surveillance of securities markets and the exchange of information; the Surveillance Intelligence Group, which fostered simultaneous and comprehensive intelligence sharing and sharing of practices; and the Urgent Issues Group system which allowed CESR-​Pol members to coordinate and jointly conduct investigations in specific cases. In the ESMA-​era, institutional coordination has continued through ESMA’s Standing Committee on Market Integrity but also through different institutional experiments, including ESMA’s Enforcement Network, which supports exchange between enforcement specialists, and the Senior Supervisors’ Forum, which supports exchange on issues of practical and strategic concern, such as cyber-​security.283 Coordination aside, MAR’s effectiveness in preventing market abuse also depends on the embedding of convergent and effective supervisory practices within NCAs, as weaknesses in an NCA’s approach could lead to a leakage of abusive conduct cross-​border. The CESR-​era saw a close focus by CESR on levels of supervisory convergence which, while they improved over the CESR-​era, remained patchy, particularly as regards investigatory powers.284 ESMA has maintained this focus on operational convergence. Market abuse prevention was, for example, the subject of one of ESMA’s first peer reviews in 2013. And while the review (of the 2003 MAD powers) was broadly positive, finding generally effective supervisory practices across NCAs and NCAs’ use of a wide range of investigative tools, it led to ESMA’s first follow-​up peer review.285 More recently, ESMA’s 2019 wide-​ranging peer review of NCAs’ use of the ‘suspicious transactions and orders reports’ (STORs) provided to NCAs by market participants under MAR was robust in tone and in outcomes.286

282 Strong levels of cooperation were reported by CESR under the 2003 MAD regime: CESR, An Evaluation of Equivalence of Supervisory Powers in the EU under the Market Abuse Directive and the Prospectus Directive. A Report to the Financial Services Committee (2007). 283 ESMA, Supervisory Convergence Work Programme 2018 (2018). 284 While NCAs had developed sophisticated IT tools for direct market surveillance and the detection of market abuse, and deployed a range of different investigatory tools, including on-​site inspections, in some cases they had only weak data-​compelling powers which were prejudicing supervision and enforcement: 2011 MAR Proposal IA, n 43, 24–​5. 285 ESMA, Peer Review on Supervisory Practices under the Market Abuse Directive (2013); and Follow Up Report (2015). 286 The review found that NCAs were generally performing well in analyzing STORs for suspected abusive conduct and in cooperating and sharing best practices. NCA supervision and enforcement as regards STOR compliance by reporting persons, however, was patchier, with 11 NCAs partially or fully non-​compliant in supervising STOR requirements and 23 NCAs partially or fully non-​compliant in responding to poor-​quality or suspected non-​reporting. ESMA called for, inter alia, robust, ongoing, proactive, and reactive supervision by NCAs of reporting persons; NCA challenge of non-​reporting; appropriate use by NCAs of IT tools to maximize the value of STORs; and use by NCAs of the full supervisory tool-​kit, including sanctions (ESMA noted that NCAs tended to rely on moral suasion and bilateral engagement). ESMA, Peer Review on the Collection and Use of STORs (2019).

VIII.9  Supervision and Enforcement  731 It suggests that convergence in how MAR’s powers and requirements are applied in practice by NCAs remains both a challenge and an ESMA priority.

VIII.9.2.4 Harnessing Market Actors: Suspicious Transactions and Orders Reports MAR also imposes market abuse prevention and monitoring obligations on market operators and investment firms which are designed to support NCAs’ detection and enforcement of market abuse.287 Under Article 16(1) market operators and investment firms that operate a trading venue must establish and maintain effective arrangements, systems, and procedures, aimed at preventing and detecting market abuse and attempts to engage in market abuse, in accordance with MiFID II/​MiFIR which requires that such systems be in place.288 Alongside, MAR imposes requirements regarding suspicious transactions and orders: market operators and investment firms operating a trading venue must report orders and transactions (including cancellations and modifications) that could constitute market abuse or attempted market abuse to the trading venue’s NCA without delay (Article 16(1)). More generally, persons professionally arranging or executing transactions in financial instruments are also required to report suspicious transactions, where they have a ‘reasonable suspicion’ of abuse (Article 16(2)). These persons must establish and maintain effective arrangements, systems, and procedures to detect and report suspicious orders and transactions; and where such persons have a reasonable suspicion that an order or transaction in any financial instruments (whether placed or executed on or outside a trading venue) could constitute market abuse or an attempted market abuse, notify the relevant NCA without delay. These persons are subject to the notification rules of the Member State in which they are registered, and the notification is made to that NCA.289 NCAs must transmit the notifications made to the NCAs of the trading venues concerned. The procedures and formats governing the required systems and these suspicious transactions and orders reports (STORs) are governed by RTS 2016/​957.290 The volume of STOR reporting increased significantly on MAR’s adoption, with STORs now established as a key information source for NCAs in detecting market abuse.291

287 These include ‘whistle-​blowing’ obligations. Art 32 requires, inter alia, that NCAs have procedures governing the receipt of reports of infringements and for protecting the personal data of reporting persons and persons alleged to have committed an infringement; and that employers who carry out activities regulated by financial services regulation have in place appropriate internal procedures for employees to report MAR infringements. It also addresses the provision by Member States of financial incentives for offering information regarding potential infringements. See, eg, Schmolke, K-​U, ‘Financial Incentives for Whistleblowers in European Capital Markets Law’ (2012) 9 European Co L 250. 288 Ch V section 6 as regards regulated markets, for example. 289 Or the rules of where the branch is located, in the case of a branch (and to the branch NCA). 290 RTS 2016/​957 covers a range of related procedural and operational matters, including the detection and reporting systems required, the need for human and not only system-​based analysis, and the timing and content of STORs. 291 The volume of STORs increased by 130 per cent in the twelve months after MAR coming into force, and by 4.5 per cent in the following year. Most STORs are provided by investment firms (84 per cent), with the majority (60 per cent) relating to suspected insider dealing and in relation to equities (75 per cent): 2019 STOR Peer Review, n 285, 6–​8. The Peer Review also found that STORs were a key element of the NCA tool-​kit, allowing NCAs to detect and analyze suspicious trading patterns.

732  Market Abuse

VIII.9.3  Enforcement VIII.9.3.1 Enforcement and the Market Abuse Regulation The success of MAR in preventing abusive conduct also depends on its effective administrative enforcement by NCAs: MAR is based on a public enforcement model, although it sits alongside the civil liability regimes (as regards market abuse) which are frequently a feature of national legal systems.292 NCAs’ enforcement practices are shaped by a complex range of factors, including internal institutional, procedural, and resource dynamics, as well as wider cultural, legal/​procedural, market structure, and political dynamics.293 The MAR legislative framework sets, however, minimum standards as regards how administrative sanctioning systems are designed and deployed by NCAs. On its adoption, MAR, like most of the financial-​crisis-​era measures, marked a step change in the EU’s approach to the enforcement of financial markets regulation in that it harmonized the use by NCAs of administrative sanctions to a materially greater extent than previously. The financial-​crisis era saw enforcement come to the fore in EU financial markets policy generally,294 but divergences across, and weaknesses within, Member States’ administrative sanctioning regimes as regards market abuse had earlier been identified as a threat to the effectiveness of the EU’s prohibitions on market abuse.295 These divergences proved sticky, with ESMA’s 2012 report on sanctioning under the 2003 MAD revealing persistent and strong divergences in NCAs’ powers of, and approaches to, administrative enforcement.296 Approaches to pecuniary (monetary) administrative sanctions, in particular, varied, with such sanctions not available for insider dealing in four Member States or for market manipulation in eight Member States.297 Reform followed with MAR.

292 On the MAR enforcement regime see Gargantini, M, Regulatory Harmonization and Fragmented Enforcement in the Capital Markets Union, JMN EULEN WP Series (2022). For analysis of the interaction between MAR and national private enforcement regimes see Tountopoulos, V, ‘Market Abuse and Private Enforcement’ (2014) 11 ECFR 297. 293 As has been examined in an extensive literature. See, eg, Jackson, H and Roe, M, ‘Public and Private Enforcement of Securities Laws: Resource-​Based Evidence’ (2009) 93 J Fin Econ 207 and Enriques and Gatti, n 41. See in outline Ch I section 5.2. 294 The new approach to sanctioning was set out in Commission, Communication on Reinforcing Sanctioning Regimes in the Financial Sector (COM(2010) 716). 295 CESR reported that there was little consistency in the application of administrative sanctions, with some NCAs deploying sophisticated approaches, including expedited settlement mechanisms, others applying administrative sanctions only to breaches of reporting obligations and otherwise relying heavily on criminal sanctions, other authorities inexperienced in dealing with market abuse issues, and considerable differences with respect to the size of the financial penalty which could be imposed: 2007 CESR Financial Services Committee Supervisory Powers Report, n 73 and CESR, Report on Administrative Measures and Sanctions as well as the Criminal Sanctions available in Member States under the Market Abuse Directive (2007). Procedural divergences were also considerable, including as regards access to enforcement decisions, obstructing the evolution of a body of practice and case law on the market abuse regime: Mayhew, D and Anderson, K, ‘Whither Market Abuse (In a More Principles-​Based Regulatory World)?’ (2007) 22 JIBLR 516 and Mayhew, D, ‘Market Abuse: Developing a Law for Europe’ (2006) 3 European Company Law 1. 296 ESMA, Actual Use of Sanctioning Powers under the MAD (2012). ESMA reported on a host of divergences, including as regards: procedural approaches to the pre-​investigation, investigation, and sanctioning stages; the factors determining whether enforcement action would be taken; resources and degree of NCA specialization and organization; the use of settlement procedures; levels of pecuniary sanction; and standards of proof. 297 2011 MAR Proposal IA, n 74, 25–​6. The Commission reported that the range of administrative pecuniary sanctions ranged from €200 or less (four Member States, with respect to insider dealing and nine Member States, with respect to market manipulation) to €1 million or more (ten Member States, with respect to insider dealing and fourteen Member States, with respect to market manipulation): at 26.

VIII.9  Supervision and Enforcement  733

VIII.9.3.2 The MAR Sanctions Regime The foundational obligation (Article 30(1)), requires that Member States, without prejudice to any criminal sanctions and to the supervisory powers of NCAs, must provide for NCAs to have the power to take ‘appropriate administrative sanctions’ and other ‘administrative measures’ in regards to the specified MAR infringements.298 Member States may choose not to apply administrative sanctions where criminal sanctions apply.299 MAR, in what was at the time a major innovation (and which established the template for other reforms), also specifies the types of administrative measures and sanctions which must be available (Article 30(2)).300 In another major reform at the time, Article 30(2) also specifies that pecuniary sanctions must be available and sets the minimum quantum.301 A maximum administrative pecuniary sanction, of at least three times the amount of the profits gained or losses avoided because of the breach, must be set. MAR also specifies that, for natural persons, maximum administrative pecuniary sanctions must be set at no lower than €5 million in respect of breaches of Articles 14 and 15 (the market abuse prohibitions), €1 million for breaches of Article 16 and 17 (STORs and detection systems; issuer disclosure), and €500,000 for breaches of Articles 18–​20 (insider lists, PDMR requirements, and investment recommendations); and, for legal persons, no lower than €15 million or 15 per cent of total annual turnover,302 €2.5 million or 2 per cent of total annual turnover, and €1 million, respectively. These are not maximum harmonization obligations; NCAs may have other sanctioning powers and impose higher levels of pecuniary sanction. MAR also specifies how administrative measures and sanctions are to be applied (Article 31). NCAs are to take into account all relevant circumstances, including, where appropriate, the gravity and duration of the breach, the degree of responsibility of the relevant person, the financial strength of the person,303 the importance of the profits gained or losses avoided, the level of cooperation by the relevant person and previous breaches by that person, and measures taken, after the breach, by the relevant person to prevent the repetition of the breach. Depending on the severity of the administrative measures and sanctions imposed, they can engage the protections afforded to defendants in criminal trials under the Charter of Fundamental Rights of the EU, including as regards the right to silence and the ne bis in idem principle.304 298 The list of specified infringements is extensive, covering the key elements of MAR and addressing breaches of the insider dealing and market manipulation prohibitions but also failures to comply with, eg, the issuer disclosure, insider lists, and PDMR requirements, as well as failures to cooperate, or comply with an investigation, inspection, or request. 299 Five Member States have exercised this option (Denmark, Finland, Germany, Ireland, and Poland), 300 Injunctions; orders for the disgorgement of profits gained or losses avoided through the breach; public warnings; withdrawal or suspension of investment firm authorization; temporary bans of persons discharging managerial responsibility in an investment firm or any other natural person, who is held responsible for the breach, from exercising management functions in investment firms, and, in the event of repeated breaches of the insider dealing and market manipulation prohibitions, a permanent ban on such persons; and a temporary ban on such persons from dealing on own account. 301 Negotiations on the quantum were difficult with some Member States concerned that the proposed levels were too high and disproportionate in relation to other national offences, and others arguing that they were too low and lacked deterrent effect. The compromise solution was to allow Member States to adopt higher levels than MAR’s minimum thresholds: Danish Presidency MAR Progress Report, n 77, 4. 302 Turnover is calculated by reference to the formula set out in Art 30. 303 As indicated in particular by total annual turnover or annual income. 304 In Case C-​481/​19 DB v Consob (ECLI:EU:C:2021:84), the Court of Justice found, in the context of the imposition by the Italian NCA (Consob) of an administrative pecuniary penalty on a person as regards failure to respond to questions in the context of a breach of the insider dealing rules, and in relation to MAR’s Art 30(1)(b)

734  Market Abuse A ‘name and shame’ mechanism, contested over the MAR negotiations but designed to harness market discipline dynamics, attaches to administrative measures and sanctions (Article 34).305 Each decision imposing an administrative measure or sanction must be published by the relevant NCA on its website immediately after the person sanctioned is informed (and ESMA must be notified; ESMA must accordingly update its register of investment firms (Article 33(4)).306 The reporting obligation does not apply to investigatory measures. Where publication of the identity of legal persons or personal data of natural persons is considered by the NCA to be disproportionate or as jeopardizing the stability of financial markets or an ongoing investigation, the NCA can either delay publication, publish on an anonymous basis, or not publish.307 In addition, an NCA/​ESMA reporting obligation (Article 33), designed to enhance monitoring of how MAR is enforced and to support convergence, requires that NCAs provide ESMA annually with aggregated information regarding all administrative measures and sanctions (and, where relevant, criminal sanctions) imposed under MAR, which must be published by ESMA in an annual report. There are limits to what harmonization can (or should) achieve here given the dependence of NCAs’ approaches to administrative enforcement and sanctioning on a host of local variables, the absence of benchmarks as regards the optimal level of enforcement, and MAR’s ex-​ante preventive dimension. ESMA’s annual reports on MAR enforcement since 2016 reveal, as could have been predicted, widely varying levels of enforcement across NCAs which fluctuate annually.308 ESMA has tentatively suggested that the number requirement that sanctions be available for failures to cooperate with an investigation, that the right to silence implicit in the Charter (Arts 47 and 48) applies in the context of proceedings which may lead to the imposition of administrative sanctions of a ‘criminal nature’ (in accordance with relevant jurisprudence which takes into account, inter alia, the severity of the penalty), or the evidence from which could be used in criminal proceedings to establish criminal liability. While the Court found that it was for the referring court to establish whether the sanctions in question were of a ‘criminal nature’, it noted (as it has in other cases) that some of the administrative sanctions imposed by Consob appeared to serve a punitive purpose and to present a high degree of severity such that they were liable to be regarded as criminal in nature. It ruled accordingly that Art 30(1)(b), read in light of the Charter (Arts 47 and 48), must be interpreted as allowing Member States not to penalize natural persons who, in an investigation carried out in respect of them by the competent authority, refuse to provide the authority with answers capable of establishing their liability for an offence punishable by sanctions of a criminal nature, or their criminal liability. The Court has also addressed the relationship between parallel criminal and administrative proceedings, and in light of other Charter protections, in particular the ne bis in idem protection (Charter Art 50) which provides that a person cannot be tried or punished again in criminal proceedings for an offence for which the person has been acquitted or convicted. The Court’s approach has been to confirm that the principle does not prevent parallel proceedings, given the need to promote the integrity of financial markets and public confidence in financial instruments, but to apply justificatory conditions, including as to proportionality. These conditions were not met, on the facts, in the relevant cases, where there had been, respectively, a previous acquittal and a previous conviction: Cases 596/​16 and 597/​16 di Puma v Consob and Zecca v Consob (ECLI: EU:C:2018:192); and Case C-​537/​16 Garlsson Real Estate v Consob (ECLI: EU:C:2018:193). On the Consob litigation and its implications see Perrone, A, ‘EU Market Abuse Regulation: the Puzzle of Enforcement’ (2020) 21 EBOLR 379 and Schiavo, GL, ‘The Principle of Ne Bis in Idem and the Application of Criminal Sanctions: Of Scope and Restrictions’ (2018) 14 European Constitutional LR 644. 305 The Council struggled to reach agreement, with some Member States opposing publications of sanctions and others regarding it as a necessary deterrent: Danish Presidency MAR Progress Report, n 77, 4. 306 The report must identify the person concerned and the type and nature of the breach. 307 The decision not to publish can be taken where the NCA decides that delayed or anonymous publication is insufficient to ensure that the stability of financial markets would not be jeopardized; or that publication would be disproportionate, where the measure in question is deemed to be minor. 308 The annual reports show that the aggregate number of administrative measures and sanctions imposed (in the EEA) rose from 472 in 2018 to 541 in 2020 (via a drop to 279 in 2019) but dropped to 366 in 2021; that the value of total pecuniary sanctions imposed increased from €10 million in 2018 to over €54 million in 2021 (the 2021 figure, however, reflected large monetary penalties imposed in France and Sweden; the 2020 figure

VIII.9  Supervision and Enforcement  735 of administrative measures and sanctions is relatively low but, in the absence of a reliable benchmark, and given the tentative nature of the data, it is difficult to draw conclusions as regards the effectiveness of the enforcement regime and as to its wider impact on market integrity.309 Gaps can, however, be identified in the harmonized regime. It does not, for example, include a harmonized competence for NCAs to engage in settlements. In practice, the extent to which NCAs can enter into settlements (and whether or not on a liability-​ based or ‘no-​fault’ basis) varies across NCAs and can shape the extent to which an NCA can impose sanctions. Nonetheless, MAR’s adoption of a more tightly harmonized approach to NCAs’ use of administrative measures and sanctions has, at the least, placed sanctioning practices more securely within an EU framework, brought greater transparency to sanctioning practices, and created the potential for peer NCA as well as ESMA monitoring and for the sharing of best practice.

VIII.9.3.3 Criminal Sanctions: the 2014 Market Abuse Directive MAR’s administrative sanctions are accompanied by a discrete regime governing criminal sanctions. In what was, at the time, an epochal reform, and in what remains the only example of the use of criminal sanctions in the single rulebook, Member States must provide for criminal offences relating to insider dealing and market manipulation, and provide for related criminal sanctions, in accordance with the minimum standards set out in the 2014 Market Abuse Directive (MAD).310 Adopted under Article 83(2) TFEU, which provides for the adoption of common minimum rules on criminal law (where this is essential to ensure the effective implementation of a harmonized EU policy), the 2014 MAD was, on its adoption, a landmark measure. Based on the 2011 MAD Proposal, it reflects the financial-​crisis-​era concern to strengthen enforcement generally and under the market abuse regime specifically. The Proposal was designed to strengthen the sanctions available for market abuse by requiring the availability of criminal sanctions which would ‘demonstrat[e]‌social disapproval of a qualitatively different nature compared to administrative sanctions’.311 Despite the pioneering nature of the reform, the financial crisis (and in particular the LIBOR scandal; section 10) created supportive political conditions for criminalizing market abuse.312 Nonetheless, the negotiations was €17.5 million); and that the number of EU NCAs not imposing any sanctions in a given year dropped from eleven in 2019 to nine in 2021 (seven in 2020). They also show significant variation in the number of sanctions and measures imposed by NCAs (in 2021, eg, the range was from highs of 94 (Sweden), 81 (Bulgaria), and 31 (Italy), to eleven EU NCAs between one and ten). The annual fluctuations in the data, the differing paces at which sanctioning procedures, given their relative complexity, conclude, different national approaches (in 2020, eg, the Bulgarian NCA imposed 187 sanctions, far and away the largest number that year, but this reflected the separate sanction the NCA imposes for every failure to provide a PDMR report to it as NCA but also, additionally, to the issuer), and the still limited data-​set available all caution against drawing any firm conclusions from the data, as ESMA has repeatedly underlined. On the impact of the sanctions regime see Gargantini, n 292, suggesting that while the quantum of sanctions specified by MAR may be dissuasive, divergences in NCA practice may run the risk of regulatory arbitrage. 309 ESMA’s 2020 MAR Review concluded that a ‘relatively low’ number of sanctions had been imposed but that it was difficult to discern an overall trend given great divergences across NCAs: n 42, 144. 310 See generally Herlin-​Karnell, E, ‘White-​collar Crime and the European Financial Crisis: Getting Tougher on EU Market Abuse’ (2012) ELJ 481. 311 COM(2011) 654 3. The Proposal was amended in 2012 to incorporate offences related to the manipulation of benchmarks. 312 The European Parliament strongly supported the Proposal and strengthened it (notably by introducing minimum terms of imprisonment), frequently adverting to the need for strong enforcement following the Libor

736  Market Abuse were not straightforward, given in particular the interaction with Member States’ criminal justice systems,313 and difficulties, in the Council in particular, as to the specific design of the criminal offences, including as regards the treatment of intention.314 The Proposal did not change significantly over the negotiations, however, although the regime became more extensive, with the final text including minimum harmonized standards governing length of imprisonment terms, and the criminal offences being extended to include unlawful disclosure of inside information. The 2014 MAD is a minimum harmonizing measure which requires Member States to provide criminal sanctions for insider dealing, unlawful disclosure of inside information, and market manipulation, to ensure the integrity of financial markets in the EU and to enhance investor protection and confidence in those markets (Article 1(1)).315 Its scope, set by Article 1(2), maps that of MAR: the Directive applies to financial instruments (as defined under MAR and by reference to MiFID II/​MiFIR) admitted to trading on a regulated market (or for which a request for admission to trading has been made); financial instruments traded or admitted to trading on an MTF (or for which a request for admission to trading on an MTF has been made); OTF-​traded financial instruments; and financial instruments not otherwise covered, but the price or value of which depends on, or has an effect on, the price or value of in-​scope financial instruments (including, but not limited to CDSs and contracts for difference (CfDs) (Article 1(2)). Like MAR, the Directive also applies to the auctioning on an auction platform of emission allowances or other auctioned products (Article 1(2)). Similarly, it applies to in-​scope instruments, irrespective of whether the activity in question takes place on a trading venue (Article 1(5)). Trading in buy-​back programmes and for the stabilization of securities, in each case in accordance with MAR, falls outside the Directive (Article 1(3)).316 The jurisdictional scope of the Directive is wide to support enforcement. Member States must take the necessary steps to establish their jurisdiction over the offences established by the Directive where the offence has been committed in whole or in part within their territory, or by one of their nationals, at least in cases where the act is an offence where it was committed (Article 10). The required criminal offences are closely based on MAR, although they incorporate an intention element and apply only to ‘serious’ infringements. The insider-​dealing offence (Article 3) (Member States must take the necessary measures to ensure the specified rate-​fixing scandal: eg, European Parliament Press Release, 4 February 2014. The Libor scandal is also referenced in the Directive: recital 7. 313 Council discussions were accordingly carried on in the Justice and Home Affairs (JHA) Council, in coordination with ECOFIN discussions on MAR. 314 Presidency Report, Proposal for a Directive on Criminal Sanctions—​Outstanding Issues, 3 July 2012 (Council Document 12089/​12). 315 Member States can adopt more stringent systems. Recital 21, eg, suggests that Member States may provide that the offence of market manipulation is committed where the conduct is reckless or seriously negligent. As noted in n 299, Member States can also apply criminal sanctions to breaches of MAR in place of administrative sanctions (five Member States do so: Denmark, Finland, Germany, Ireland, and Poland). Since MAR coming into force in 2016, ESMA has reported on a gradually increasing use of criminal sanctions by these Member States, although the incidence remains low (ranging from under ten in 2017 to thirty in 2021 (with a spike of sixty in 2019)). As it has done with its reporting on administrative sanctions, ESMA has underlined the need for care in interpreting this data given the specificities of criminal procedures as well as variances in the quantity and quality of STORs received by NCAs: ESMA, Report on Administrative and Criminal Sanctions imposed under MAR in 2020 (2021) 11-​13. 316 As do transactions, orders, and behaviours in support of monetary, exchange rate, or public debt management policy, the EU’s climate policy, or its common agriculture and fisheries policies.

VIII.9  Supervision and Enforcement  737 behaviour is a criminal offence (Article 3(1)) applies to ‘insider dealing’, as defined, and to recommending or inducing another person to engage in insider dealing, at least in ‘serious cases’,317 and ‘when committed intentionally’ (Article 3(1)). Article 3 defines insider dealing for the purposes of the criminal offence in accordance with the MAR approach, and so as arising where a person possesses inside information and uses that information by acquiring or disposing of, for own account or the account of a third party, either directly or indirectly, financial instruments to which that information relates; and with respect to persons who possess inside information as a result being a member of the issuer’s governance bodies, having a holding in the issuer’s capital, having access to the information through the exercise of an employment, profession or duties, or being involved in criminal activities (as well as persons who obtain inside information under other circumstances, but where the person knows it is inside information) (Article 3(1)–​(3)).318 The recommending or inducing offence arises where the person possesses inside information and recommends, on the basis of the information, that another person acquire or dispose of financial instruments to which the information relates (or induces that person to make such an acquisition or disposal), or recommends, on the basis of the information, that another person cancel or amend an order covering a financial instrument to which that information relates (or induces that person to make such a cancellation or amendment) (Article 3(6)).319 Unlawful disclosure of inside information must also be made the subject of a criminal offence. Under Article 4, Member States must take the necessary measures to ensure that the unlawful disclosure of inside information constitutes a criminal offence, at least in serious cases and when committed intentionally. The offence arises where a person (within the scope of Article 3) in possession of inside information discloses it to another person (except where disclosure is made in the normal course of an employment, profession, or duties, and including where the disclosure takes the form of a ‘market sounding’ under MAR). The onward disclosure of recommendations or inducements (under Article 3(6)) amounts to unlawful disclosure when the person disclosing knows that the recommendations or inducements were based on inside information. This offence must be applied, however, in accordance with the need to protect the freedom of the press and of expression (Article 4(5)). Market manipulation must also be treated as a criminal offence, at least in serious cases,320 and when committed intentionally (Article 5). Here again, the 2014 MAD follows the MAR approach, defining market manipulation as comprising: entering into a transaction, placing an order to trade, or any other behaviour which either gives false or misleading signals as to the supply of, demand for, or price of, a financial instrument or a 317 This key distinguishing factor for the criminal offence is not specified, allowing Member States significant discretion. Recital 11, however, suggests (in general terms) that insider dealing should be deemed to be ‘serious’ in cases such as where the impact on market integrity, the actual potential profit derived or loss avoided, the level of damage to the market, or the overall value of the instruments traded is high. Whether the offence has been committed within the framework of a criminal organization, or by a person who has previously committed an offence, are also identified as relevant factors. 318 The use of inside information by cancelling or amending an order, where the order was placed before the person possessed the inside information, is also considered as insider dealing (Art 3(4)). 319 The use of the recommendations or inducements amounts to insider dealing when the person so using knows that it is based on inside information (Art 3(7)). 320 Recital 12 identifies the same factors governing ‘serious’ as apply to insider dealing (n 317), with the addition of whether the level of alteration of the value of the instruments or the funds deployed is high, and whether the person in question is employed in the financial sector or in a supervisory or regulatory authority.

738  Market Abuse related spot commodity contract, or secures the price of one or several financial instruments or a related spot commodity contract at an abnormal or artificial level—​in each case unless the reasons for so doing of the person are legitimate, and the transactions or orders are in conformity with accepted market practices on the relevant trading venues; entering into a transaction, placing an order to trade, or any other activity or behaviour which affects the price of one or several financial instruments or a related spot commodity contract, which employs a fictitious device or any other form of deception or contrivance; dissemination of information through the media, including the internet, or by any other means, which gives false or misleading signals as to the supply of, demand for, or price of a financial instrument (or a related spot commodity contract), or secures the price of one or several financial instruments (or a related spot commodity contract) at an abnormal or artificial level, where the person in question derives for themselves or another person an advantage or profit from the dissemination of the information; or transmitting false or misleading information or providing false or misleading inputs or any another behaviour which manipulates the calculation of a benchmark (see section 10 on benchmarks).321 Inciting, aiding, or abetting these offences, and attempts to engage in insider dealing or market manipulation must also be punishable as criminal offences (Article 6). The relevant criminal offences for natural persons must be punishable by ‘effective, proportionate and dissuasive criminal penalties’ (Article 7). A minimum-​harmonization requirement applies in that the insider dealing and market manipulation offences must be punishable by a maximum term of imprisonment of at least four years, and the unlawful disclosure offence by a maximum term of imprisonment of at least two years. A distinct regime applies to legal persons. Under Article 8, Member States must take the necessary measures to ensure that legal persons can be held liable for offences committed for their benefit by a person, acting either individually or as part of an organ of the legal person, and having a ‘leading position’ within that legal person.322 Legal persons must also be held liable where a lack of supervision or control by a person in a leading position has made possible the commission of an offence for the benefit of the legal person by a person under its authority.323 Legal persons must be subject to effective, proportionate, and dissuasive sanctions, which must include criminal (or non-​criminal) fines and may include other sanctions such as exclusion from entitlement to public benefits or aid, temporary or permanent disqualification from the practice of commercial activities, being placed under judicial supervision, judicial winding-​up, or temporary or permanent closure of establishments used for committing the offence.

321 Like the MAR prohibition on market manipulation, Art 5 also covers behaviours relating to the auctioning of emission allowances (or other auctioned products based thereon) (Art 1(2)). It similarly also extends to spot commodity contracts (apart from wholesale energy products) where the transaction, order, or behaviour has an effect on the price or value of an in-​scope financial instrument; to types of financial instruments, including derivative contracts or instruments for the transfer of credit risk, where the transaction, order, bid, or behaviour has an effect on the price or value of a spot commodity contract where the price or value depends on the price or value of those financial instruments; and to behaviour in relation to benchmarks (Art 1(4)). 322 This position being based on a power of representation of the legal person; an authority to take decisions on behalf of the legal person; or an authority to exercise control within the legal person: Art 8(1). 323 Liability of legal persons does not exclude criminal proceedings against natural persons who are involved as perpetrators, inciters, or accessories in the offences.

VIII.10  Benchmark Abuse and Benchmark Regulation  739

VIII.10  Benchmark Abuse and Benchmark Regulation VIII.10.1  The Reform Context The prohibition of abuse relating to financial benchmarks is subject to a discrete regime in the EU, the roots of which are in the financial-​crisis era/​post-​financial-​crisis era spate of scandals relating to benchmark manipulation. The global scandal relating to the manipulation of major interest rate benchmarks (notably LIBOR and EURIBOR)324 which erupted over 2012325 was followed in quick succession by a series of other benchmark scandals.326 These exposed to searing effect the vulnerability of benchmarks to manipulation and the consequent prejudice to market integrity. Benchmarks327 are embedded into the pricing and structure of financial instruments internationally. They relatedly serve a host of functions in financial markets, including with respect to risk management and asset management, which have led to their ‘hard-​wiring’ into financial markets. But the process through which they are constructed can, as the series of benchmark scandals exposed, be vulnerable to acute procedure and conflict-​of-​interest failures.328 Reform poses challenges, however, not least among them the scale of the benchmark sector,329 the multiplicity of benchmarks and the range of public and private purposes they serve,330 the wide range of benchmark providers,331 and the significant stability risks generated when a benchmark is withdrawn from use or radically changed. Given these challenges, the more expansive any related regulation, the more intricate the regulatory design issues.332 324 The London interbank offered rate and the Euro interbank offered rate. 325 The LIBOR and EURIBOR rates were set by means of submissions from banks based on banks’ borrowing and lending in the interbank market. The abuse related to banks providing estimates of lending rates for the purpose of benchmark-​setting which were different from the rates they would have accepted in practice. Among the many impacts was the misleading of the market as to banks’ cost of funding. The scandal led to historically high sanctions being imposed on the implicated banks. In the UK, eg, the scandal led to a fine of £59.9 million being imposed on Barclays (reduced from £80 million because of early settlement) for making interest rate submissions which took into account requests made by its derivative traders, which requests sought to benefit Barclays’ trading positions: FSA, Final Notice, Barclays Bank, 27 June 2012. 326 Including the global foreign exchange rate-​setting scandal which led to international regulatory investigations into allegations that key exchange rates and benchmarks had been manipulated and, ultimately, to the adoption of the Global FX Code of Conduct in 2021. By 2015, in excess of $9 billion in fines had been imposed by EU, UK, and US regulators as regards the interest rate scandal, and in excess of $10 billion as regards foreign exchange benchmark failures: 2015 HMT et al Fair and Effective Markets Review, n 10, 41. 327 Where an index is used as a reference price for a financial instrument or a contract it operates as a benchmark (the Benchmark Regulation definition of benchmarks is tied to the related indices: section 10.3.3). 328 Benchmarks can have particular structural features that expose them to manipulation in different ways. In the case of LIBOR, its vulnerability flowed from its submission-​based design; in the foreign exchange markets, the technical modalities of setting foreign exchange benchmarks (in very short time windows) supported manipulation; while as regards commodity benchmarks, reliance on opaque auctions, based on conference calls of contributors, increased the risk of manipulation. 2015 HMT et al Fair and Effective Markets Review, n 10, 41. 329 The size of the markets impacted by benchmarks was estimated by the Commission, as the EU reform process got underway, at €1,000 trillion: Commission 2013 Benchmark Proposal IA (SWD (2013) 337/​2). 330 Which can extend from market-​wide price-​setting to tailored risk and performance management for individual firms and in relation to particular products. A significant segment of the benchmark production market relates to the production of bespoke products for clients. Such products, designed for proprietary use, typically in the OTC market, are often based on non-​public information and are not disclosed (and so fall outside the EU’s Benchmark Regulation). 331 Which range from public authorities to specialist index providers. 332 From the literature on the benchmark scandals see Foster, S, ‘Financial Benchmark Control as Monopoly Power’ (2021) 17 Hastings Business LJ 233, Fletcher, G-​G, ‘Benchmark Manipulation’ (2017) 102 Iowa LR 1929, Hockett, R and Omarova, S, ‘Systemically Significant Prices’ (2016) 2 J of Fin Reg 1, and Verstein, A, ‘Benchmark Manipulation’ (2015) 56 Boston College LR 215,

740  Market Abuse The global reform movement which followed the cascade of benchmark scandals was, relatedly, multi-​layered, encompassing legislative reform but also soft law, and with governance, conduct, and operational elements. It included, internationally, the 2013 International Organization of Securities Commissions (IOSCO) Principles for Financial Benchmarks, the 2021 Global FX Code of Conduct, and the Financial Stability Board (FSB)-​overseen technical project supporting the transition from interest rate benchmarks; and, domestically, the wholesale-​market-​oriented legislative reforms and soft law adopted in the UK, a market that was heavily impacted by the scandals.333 In the EU, reform has taken two forms: the 2014 MAR and 2014 MAD prohibitions on the manipulation of benchmarks (section 10.2); and the regulation of benchmark construction and management by the 2016 Benchmark Regulation (BMR) (section 10.3). The result has been a highly engineered and complex EU regulatory scheme which extends far beyond the prohibition of abuse relating to benchmarks to encompass the granular regulation of a wide universe of benchmarks and their administrators, data contributors, and users.334 The speed of the EU’s initial response to the benchmark scandals (proposals to adapt the market abuse regime were adopted in 2012 and for the BMR in 2013) signalled, at the time, the extent to which the EU had come to command the financial markets regulatory space. Since then, the EU’s approach to benchmark regulation has been similarly emblematic. The EU’s benchmark regime, which now includes the BMR’s conferral on ESMA of direct supervisory powers over certain benchmark administrators, and also addresses the technical and operational intricacies of the LIBOR transition, signals the sprawling reach of EU financial markets regulation and the technocratic capacity on which it can draw. An outline of the main features of the benchmark regime follows.335

VIII.10.2  Market Abuse and Benchmarks MAR imposes a specific prohibition on the manipulation of benchmarks (Article 2(2) (c)),336 in order to address any potential regulatory gaps, as regards benchmarks, under MAR and also to ensure the market manipulation prohibition is appropriately tailored to benchmark manipulation.337 The MAR definition of market manipulation is relatedly 333 The scandal led to the LIBOR-​focused Wheatley Review (2012) which was followed by the Fair and Effective Markets Review (2015 (n 10)), a wide-​ranging review which led to a host of reforms relating to conduct in the wholesale markets, including the FICC segment, and including benchmark-​specific reforms (alongside the parallel EU reforms). 334 Benchmarks are also addressed under the prospectus regime, which requires that where a prospectus refers to an index, specific disclosures should be made; the UCITS regime imposes asset-​allocation rules on index-​ related investments; and MiFID II/​MiFIR addresses access to benchmarks (with respect to clearing and trading). In the energy markets, the 2011 REMIT regulation provides that the manipulation of benchmarks used for wholesale energy products is illegal. 335 The scale and technical complexity of the BMR means that only its main design features can be addressed in this discussion. 336 A benchmark is defined by MAR as any rate, index, or figure, made available to the public or published, that is periodically or regularly determined by the application of a formula to, or on the basis of the value of one or more underlying assets or prices, including estimated prices, actual or estimated interest rates, or other values or surveys, and by reference to which the amount payable under a financial instrument or the value of a financial instrument is determined: Art 3(1)(29). 337 The original proposals for MAR and for the 2014 MAD were amended in 2012 to address market abuse relating to benchmarks in the wake of the LIBOR scandal (COM(2012) 421 and COM(2012) 420, respectively). The introduction of the specific prohibition arose from concerns that the original Proposals (then under negotiation) did not capture this form of manipulation, and to remove the necessity of NCAs making enquiries into the price

VIII.10  Benchmark Abuse and Benchmark Regulation  741 calibrated to benchmark abuse, covering transmitting false or misleading information or providing false or misleading inputs in relation to a benchmark where the person who made the transmission or provided the input knew or ought to have known that it was false or misleading, or any other behaviour which manipulates the calculation of a benchmark (Article 12(1)(d)).338 The 2014 MAD similarly applies the requirement for criminal sanctions to benchmark manipulation. While the MAR/​MAD prohibitions are designed as deterrents, they are connected to the BMR, which operates in parallel as an ongoing governance regime, by the BMR administrative rules that require benchmark administrators to have in place systems for the detection of any conduct that may involve manipulation of a benchmark.339

VIII.10.3  The Benchmark Regulation VIII.10.3.1  Evolution The EU’s regulation of benchmarks is primarily a function of the wide-​ranging and intricate Benchmark Regulation (BMR) which came into force in January 2018 and which is designed to strengthen the governance supporting the construction and management of benchmarks.340 It imposes an authorization requirement on benchmark administrators which leads to the application of extensive operating requirements, including as regards benchmark methodologies and the input of data, the management of conflicts of interests, and the exercise of discretion, which are designed to ensure the resilience and integrity of indices used as benchmarks. In addition, the BMR imposes requirements on contributors of data to benchmarks and on regulated financial actors that use benchmarks. The BMR might have been expected to experience a quiet negotiation process, particularly as it was not entirely novel: the 2013 BMR Proposal followed the earlier adoption by EBA and ESMA of principles governing benchmark production,341 as well the 2013 IOSCO Principles for Financial Benchmarks.342 Nonetheless, its adoption was contested343 and led to the intricate calibration and segmentation that characterizes the BMR.344 impact of this form of manipulation, given the very severe challenges this would pose: 2013 Benchmark Proposal (COM(2013) 641) 1. 338 ESMA’s 2020 review of MAR did not lead to any recommendations for reform. 339 RTS 2021/​1351 [2021] OJ L291/​13. 340 The main elements of the legislative history are: Commission Proposal n 337 and IA n 329; European Parliament Negotiating Position, 9 May 2015 (T8-​0195/​2015); and Council General Approach, 4 December 2015 (Council Document 14985/​15). The ECB opinion is at [2013] OJ C113/​1. 341 ESMA and EBA, in an early indication of their capacity for technocratic entrepreneurialism, adopted joint Principles for Benchmark-​Setting Processes in the EU (2013). While intended to provide an immediate response to benchmark risk pending legislative action by the EU, because benchmark administrators fell outside the ESAs’ remit at that point, the Principles were acknowledged not to have binding effect but as being designed to provide relevant market participants with a common and consistent framework. 342 IOSCO, Principles for Financial Benchmarks (2013). 343 The Proposal was, at the time, described as the ‘most heavily lobbied’ proposal in recent years: Marriage, M, ‘Political Infighting Delays Benchmark Regulation’, Financial Times, 23 February 2014. The index provider industry and commodity houses heavily resisted the proposals. 344 The Council was concerned in particular to achieve greater proportionality in the application of the Regulation (proposing the targeted regimes that apply to regulated data benchmarks, interest rate benchmarks, and commodity benchmarks); and to calibrate how ‘critical benchmarks’ (a feature of the Commission Proposal) were to be identified by adding qualitative criteria to the Commission’s quantitative approach. ESMA’s role under the Regulation also proved contentious, including as regards the extent of its oversight over benchmark college of supervisors (although since then ESMA has been conferred with direct and exclusive supervisory competence

742  Market Abuse The Regulation did not prove stable after its adoption, being shaped by two significant reform agendas: the 2017 European Supervisory Authority (ESA) Review; and the EU’s sustainable finance agenda. Major related reforms followed in 2019: ESMA was conferred with direct and exclusive supervisory competence over ‘EU critical benchmarks’ by the 2019 ESA Reform Regulation;345 and ESG (environmental, social, and governance) disclosure requirements were introduced for all benchmarks, alongside a bespoke regulatory scheme for two EU-​level low carbon benchmarks, by the 2019 Low Carbon Benchmarks Regulation.346 Further material reform followed in 2021, with the introduction of a process governing the Commission’s adoption of statutory replacement benchmarks in order to manage the risks associated with the withdrawal of major benchmarks, in particular LIBOR.347

VIII.10.3.2 Approach and Design The BMR addresses a specific and specialized segment of the financial markets (primarily, benchmark administrators) which is less prone to generating financial stability risks than other regulated segments.348 Nonetheless, not only is the Regulation amplified by an immensely detailed administrative rulebook and by related soft law,349 its legislative design is complex and technical. The Regulation is unusually intricate, applying widely to benchmark administrators, data contributors, and benchmark users, and including a self-​regulatory code of conduct element for data contributors. It is, similarly, highly segmented, being calibrated according to the type of benchmark engaged, including low carbon benchmarks. It grapples with the complex technicalities of benchmark construction and review.350 Its supervisory architecture is highly articulated, with ESMA-​based components (the supervision of administrators of ‘EU critical benchmarks’), NCA-​based components (supervision of benchmark administrators), and a college of supervisors element. Regarded as a whole, the BMR regime is heavily engineered. Whether or not its weight of regulation and the complexity of its supervisory arrangements is justified remains to be seen, although its adoption in 2016 generated some concern that it would create incentives to eschew the construction and use of benchmarks, notwithstanding their value in supporting risk management.351 over administrators of critical benchmarks): Progress Report, 18 December 2014 (Council Document 17059/​14). The Parliament was similarly concerned to achieve greater proportionality, but it also significantly expanded the Commission’s more principles-​based regulatory design, introducing, inter alia, the BMR rules relating to accountability, control, record-​keeping, and methodology. 345 Regulation (EU) 2019/​2175 [2019] OJ L334/​1. 346 Regulation (EU) 2019/​2089 [2019] OJ L317/​17. 347 Regulation (EU) 2021/​168 [2021] OJ L49/​6. See section 10.3.6. This reform was the major outcome of the Commission’s 2019 review of the BMR (which was carried out in parallel with the separate reform streams relating to ESMA’s supervisory powers and the sustainable finance/​low carbon benchmarks reform): Commission, Review of the EU Benchmark Regulation (2019). 348 While the FSB related the level of misconduct associated with the benchmark scandals with potential financial stability risks, inter alia as regards the scale of the related monetary penalties (eg the reports at n 10), the prohibitions on benchmark abuse (including criminal prohibitions) now in place under the 2014 MAR and the 2014 MAD, and the granular ex-​ante regulation of administrators under the BMR, militate against serious misconduct, and related stability risks, emerging in the future. 349 The Regulation is accompanied by in the region of 20 RTSs and four delegated acts which together form an administrative rulebook of formidable density (which cannot be addressed in this outline discussion). Also, two sets of Guidelines and an extensive Q&A have been adopted by ESMA. 350 Including as regards the operational intricacies of interest rate, commodity, and low carbon benchmark construction (BMR Annexes I-​III and related administrative rules). 351 See, eg, Clifford Chance, The New EU Benchmark Regulation, Briefing Note, September 2016.

VIII.10  Benchmark Abuse and Benchmark Regulation  743 Much of the intricacy and complexity of the BMR (and of its supporting administrative rules) is a function of the interaction between its wide scope and the granular approach it takes to regulatory design.352 The BMR addresses the technical modalities of how benchmark administrators construct, oversee, and, where necessary, withdraw benchmarks, and it accordingly required calibration to ensure it applied proportionately, given the wide range of benchmarks it captures and their different features and risk profiles.353 A more high-​level measure would have required less articulation. Its intricacy and complexity are also, and relatedly, a function of dynamic market conditions and of the EU’s increasingly sophisticated technocratic capacity to respond: for example, the withdrawal of LIBOR and other major interest rate benchmarks necessitated the 2021 reform which empowers the Commission to adopt replacement benchmarks; while the 2019 introduction of specific regimes for low carbon benchmarks is in part a response to market innovation.

VIII.10.3.3 The Benchmark Regulation In principle, the regulatory ‘technology’ used by the BMR is similar to that deployed across the single rulebook. At its core is the requirement for benchmark administrators to be authorized and to be subject to ongoing regulation. The related rulebook does not have the prudential/​conduct orientation associated with MiFID II/​MiFIR or EMIR, but it has strong resonances with the rating agency rulebook, being mainly concerned with governance and conflict-​of-​interest management requirements and with the processes (including verification and testing) governing the production of a benchmark. These rules are highly specified to the benchmark context, covering, for example, the exercise of discretion and of expert judgment in benchmark construction and management,354 and are amplified in some technical detail.355 The BMR applies widely to benchmark administrators, contributors to benchmarks, and regulated financial entities (‘supervised entities’)356 that use benchmarks. The pivotal definition of a ‘benchmark’ is the peg that fixes the BMR’s perimeter: the benchmark administrators subject to the BMR rulebook, for example, are natural or legal persons that have control over the provision of a ‘benchmark’ (Article 3(1)(6)). A benchmark is widely defined as a form of index: a benchmark is any index357 by reference to which the amount payable under a financial instrument or a financial contract, or the value of a financial instrument, 352 The Regulation is designed to have as broad a scope as necessary to create a preventive regulatory framework, and to apply to all benchmarks sharing the characteristic of discretion, given that the conflict-​of-​interest risks that flow from the exercise of discretion in benchmark provision are common to all benchmarks: BMR recitals 8 and 17. 353 Given the variety of benchmarks it captures, the Regulation is designed to take a proportionate approach to the risks that different benchmarks pose, and to avoid placing excessive administrative burdens on benchmarks the cessation of which would pose less of a threat to the financial system: BMR recitals 9 and 40. 354 The exercise of ‘expert judgment’ (defined by reference to the exercise of discretion: Art 3(1)(13)) is subject to discrete controls across the BMR given the heightened conflict-​of-​interest risk. 355 The related RTSs cover, eg, the standards applicable to input data and to methodologies; the disclosures to be made available by administrators; systems and controls; and the governance and control requirements for regulated financial actors where they submit data to a benchmark. 356 Supervised entities are specified regulated entities including investment firms, credit institutions, insurance and reinsurance undertakings, UCITSs, alternative investment funds, CCPs, trade repositories, and market operators: Art 3(1)(17). 357 An index is defined in general terms as any figure that is published or made available to the public; and that is regularly determined entirely or partially by the application of a formula or any other method of calculation, or by an assessment, and on the basis of the value of one of more underlying assets or prices, including estimated prices, actual or estimated interest rates, quotes and committed quotes, or other values or surveys (Art 3(1)(1)).

744  Market Abuse is determined; or an index that is used to measure the performance of an investment fund with the purpose of tracking the return of such index or of defining the asset allocation of a portfolio or of computing the performance fees (Article 3(1)(3)). Whether an index comes in scope (and so is treated as a benchmark under the BMR) is accordingly linked to the use made of the index and whether it determines value or an outcome in some way, with asset management, a major user of benchmarks, expressly referenced. The definition is also designed to catch a wide range of benchmarks, with ‘financial instruments’ defined by reference to MiFID II instruments for which a request for admission to trading on a MiFID II trading venue has been made or which are traded on a trading venue or on a systematic internalizer358 (Article 3(1)(16));359 and ‘financial contracts’ defined by reference to in-​scope consumer credit and mortgage agreements (Article 3(1)(18)). The BMR applies accordingly to a wide range of financial benchmarks, including interest rate, foreign exchange, securities, and commodities benchmarks, and so captures a potentially wide range of benchmark administrators but also data contributors and users.360 The reach of the Regulation is tempered, however, by its calibration with reference to whether a benchmark is critical, significant, or non-​significant. The authorization and regulation of benchmark administrators (administrators) is the main regulatory lever deployed by the BMR; this reflects the approach taken to rating agencies which is based on authorizing and regulating rating agencies in order to secure the integrity and reliability of ratings (Chapter VII). Under the widely cast gateway requirement, any natural or legal person located in the EU that intends to act as an administrator must apply for authorization to the NCA of the Member State in which that person is located if it provides or intends to provide indices which are used, or are intended to be used, as benchmarks; in the case of certain ‘critical benchmarks’, however, ESMA is the exclusive supervisor of the administrator and is charged with authorization (Article 34). The application of the regime does not depend on the intention of the administrator as regards the relevant indices: provision of an index that is used as a benchmark activates the authorization requirement, even if this use of the index is not intended by the person in question.361 The authorization system is segmented in that where the administrator is a ‘supervised entity’ (and so already subject to discrete regulation) and does not provide an index that would qualify as a critical benchmark,362 or where the administrator (not being a supervised entity) provides or intends to provide only indices that qualify as ‘non-​significant’ benchmarks, only registration with the NCA is required (Article 34).363 But while registration implies a lighter process than authorization,364 it does not lead to a lighter rulebook: the 358 A systematic internalizer is a form of MiFID II/​MiFIR venue. See Ch V section 9.1. 359 On MiFID II financial instruments see Ch IV section 5.3. 360 A series of exemptions apply to specified actors (including central banks, public authorities, and CCPs (as regards reference prices or settlement prices used for risk management and settlement) but also to the provision of a single reference price for a financial instrument or derivative (but not for commodities): Art 2. 361 In order to limit the risk of an index provider/​administrator inadvertently becoming an administrator subject to the authorization requirement, where a prospectus is issued for securities or for investment products/​funds that reference a benchmark, the prospectus must contain a clear statement as to whether the benchmark is provided by an administrator included in the ESMA register of authorized/​registered administrators: Art 29 and recital 49. 362 See n 356 on supervised entities. 363 ESMA maintains a register of authorized and registered administrators (Art 36). A series of transitional arrangements applied (and continue to apply) to avoid disruption in the use of benchmarks: Art 51. 364 Authorization and registration should be distinct processes, with authorization involving a more extensive assessment: recital 48.

VIII.10  Benchmark Abuse and Benchmark Regulation  745 authorized or registered administrator is subject to the extensive ‘rulebook’ which follows under the Regulation. This rulebook covers governance and operational requirements which, while not dissimilar to those applicable to other regulated actors in their essentials, are heavily tilted towards conflict-​of-​interest management. Specifically, it covers governance and organizational arrangements and conflict-​of-​interest management (Article 4);365 skills and experience (Article 4); the required permanent oversight function (Article 5);366 the control framework ensuring a benchmark complies with the BMR, including operational risk management and contingency arrangements (Article 6); accountability (including audit and review and the complaints process) (Article 7); record-​keeping (including as regards the construction and operation of the benchmark, input data, and any exercise of judgment or discretion) (Article 8); complaints handling procedures (Article 9); and outsourcing (Article 10).367 The rulebook also covers the construction and management of the benchmark, including as regards its input data, which must, inter alia, be sufficient to represent accurately and reliably the market or economic reality that the benchmark is intending to measure, and be in the form of transaction data (and so not exposed to discretion and related conflicts of interest), where available and appropriate368 (Article 11); and benchmark methodologies (Articles 12 and 13).369 A disclosure requirement is also imposed in the form of a requirement to publish a ‘benchmark statement’ for each benchmark (or family of benchmarks; in effect, benchmarks of similar purpose using similar data) which must be updated as necessary and at least every two years (Article 27).370 The BMR cascades from administrators to ‘contributors’ of data to benchmarks.371 A different regulatory tool is used here. Under Article 15, and in order not to dis-​incentivize

365 While conflict-​of-​interest management is threaded through the BMR, it is addressed specifically by Art 4 as regards identification, management, and disclosure. The foundational Art 4(1) principle requires administrators to take adequate steps to identify and to prevent or manage conflicts of interests between themselves, including their managers, employees, or any person directly or indirectly linked to them by control, and contributors or users; and to ensure that where any judgment or discretion in the benchmark determination process is required, it is independently and honestly exercised. NCAs can require an administrator to establish an independent oversight function which includes a balanced representation of stakeholders (including users and contributors) where ownership-​related conflicts cannot be adequately mitigated and, ultimately, can require that the activities/​relationships creating the conflict cease, or that provision of the benchmark be terminated (Art 4(4)). 366 This function must, inter alia, review the benchmark’s definition and methodology at least annually, oversee the administrator’s control framework, monitor contributors’ input data, and review the procedures governing cessation of a benchmark (Art 5). 367 The design of the outsourcing regime is similar to that in use across the single rulebook. An administrator is not prohibited from outsourcing functions, but must not outsource functions in such a way as to impair materially the administrator’s control over the provision of the benchmark or the NCA’s ability to supervise the benchmark, and a series of conditions govern any outsourcing. 368 Other input data, such as estimated prices, quotes, or other values, can be used where transaction data is not sufficient or not appropriate to represent accurately and reliably the market or economic reality intended to be measured by the benchmark. Art 11 establishes a series of principles governing input data, including that it be verifiable; that guidelines govern the exercise of independent judgment; where drawn from contributors that the data be taken from a reliable and representative panel or sample of contributors; and as regards the applicable controls. 369 A series of principles apply to the methodology for determining the benchmark, including that it be robust and reliable, have clear rules governing the use of discretion, and be resilient so that the benchmark can be calculated in the widest set of possible circumstances without compromising its integrity (Art 12). Administrators must also publish a transparency statement on the benchmark’s methodology (Art 13). 370 The content of the statement, which covers, inter alia, the methodology deployed and risk warnings, is specified in detail by Art 27 and amplified by administrative rules. 371 A contributor is a natural or legal person contributing ‘input data’ (or the data used by the administrator to construct the benchmark): Arts 3(1)(9) and (14).

746  Market Abuse contributors from providing data, subject to appropriate controls,372 contributors are governed through a self-​regulatory code of conduct requirement, in a throw-​back to the pre-​ financial-​crisis deployment of an IOSCO code of conduct to govern credit rating agencies in the EU, albeit that the code device here is hardened by being placed in a legislative framework. Where a benchmark is based on input data from contributors, the administrator is to develop a code of conduct (for each benchmark/​benchmark family) specifying contributors’ responsibilities, that complies with the governing principles set out in Article 15, and that is subject to NCA oversight in that where the administrator’s NCA finds that the code does not comply with the Regulation, the code must be adjusted by the administrator. Additional governance and control requirements apply where a contributor is a supervised entity, including as regards conflict-​of-​interest management, control frameworks, and the use of independent judgment in constructing input data (Article 16). The final, least intrusive component of the BMR regime addresses benchmark ‘users’. In an echo of the similar requirement that applies as regards the use of credit ratings by regulated actors, a ‘double-​lock’ applies in that supervised entities that ‘use’ benchmarks can only use a benchmark in the EU if the benchmark is provided by an administrator located in the EU and included in ESMA’s register of authorized/​registered EU administrators (or by a qualifying third country administrator).373,374 Users in the form of supervised entities are additionally required to have written procedures in place governing the actions to be taken where a benchmark materially changes or ceases to be provided (Article 28). The application of the Regulation’s requirements is segmented according to the class into which the benchmark falls, with either additional requirements applicable (critical benchmarks) or alleviations available (significant/​less significant benchmarks). Classification accordingly acts as a proportionality mechanism. Additional requirements apply to critical benchmarks, the failure of which could potentially disrupt market efficiency and integrity and, ultimately, stability.375 ‘Critical benchmarks’ are so designated by the Commission (by means of an implementing act), in accordance with the conditions and the process set out in the Regulation (Article 20). All benchmarks that are used directly (or indirectly with a combination of benchmarks) for measuring underlyings of total value of at least €500 billion are automatically designated as critical benchmarks (Article 20(1)(a)). A second class of critical benchmark is designed to capture benchmarks below this quantitative threshold but which, given the application of qualitative conditions, are of similar importance: this class applies to benchmarks that measure underlyings of at least €400 billion but for which there are no or very few appropriate market-​led substitutes and, if the benchmark ceased to be

372 Albeit that the BMR adopts an austere approach, noting that data contribution is a voluntary activity and that where the Regulation requires significant change to a contributor’s business model, it could cease to contribute: recital 12. 373 Third country administrators/​benchmarks can operate in the EU through three routes: an equivalence determination; ESMA recognition; or endorsement (of the benchmark) by an EU administrator/​supervised entity (Arts 30–​3). See Ch X section 10.2. 374 ‘Use’ is widely drawn to cover, eg, use of benchmarks in the issuance of financial instruments, the determination of amounts payable under financial contracts, measuring the performance of an investment fund, and providing a borrowing rate: Art 3(1)(7). 375 The rules governing critical benchmarks came into force when the Regulation was adopted in June 2016, and in advance of the Regulation coming into force in January 2018, to avoid critical benchmarks being undermined by a mass withdrawal of data contributors who faced additional regulation.

VIII.10  Benchmark Abuse and Benchmark Regulation  747 provided,376 there would be significant adverse impacts on market integrity, financial stability, consumers, the real economy, or the financing of households and businesses in one or more Member States (Article 20(1)(c)). Inclusion in this class is dependent on ESMA requesting the Commission that the benchmark be designated as ‘critical’.377 Both these classes are designed to capture ‘EU critical benchmarks’. A final class of critical benchmark, directed to domestically-​oriented benchmarks, is based on NCA review (albeit subject to ESMA submitting an opinion to the Commission on the NCA’s compliance with the relevant conditions for designation) and relates to benchmarks which are based on submissions by contributors the majority of which are located in one Member State and which are recognized as being critical in that Member State (Article 20(1)(b)).378 Where a benchmark is designated as ‘critical’, more intrusive regulation follows.379 In particular, NCAs are empowered to intervene to require the continued operation of a critical benchmark: they may compel the administrator to continue to publish the benchmark until the benchmark has been ‘transitioned’ to a new administrator, its provision can be ceased in an orderly fashion, or the benchmark is no longer critical (Article 21); and they may require that contributors and supervised entities continue to contribute to a benchmark, in the case of supervised entities for up to five years (Article 23).380 In addition, administrators of critical benchmarks are subject to a market power constraint (without prejudice to EU competition law) in that they must take adequate steps to ensure that licenses of, and information relating to, such benchmarks are provided to all users on a fair, reasonable, transparent, and non-​discriminatory basis (Article 22); and to additional audit requirements, in that an administrator’s compliance with the benchmark’s methodology and the Regulation must be subject to external review by an independent auditor annually (Article 7). The institutional arrangements are also distinct: supervision of administrators of critical benchmarks is coordinated through mandatory college of supervisors (Article 46); while ESMA is the designated supervisor for EU critical benchmarks (those designated under Article 20(1)(a) and (c)) (Article 34(1a)). At present, there is only one EU critical benchmark so designated and supervised by ESMA (EURIBOR), and, notwithstanding the wide discretion of NCAs in this regard, only three domestic/​Article 20(1) (b) critical benchmarks, supervised by NCAs.381 376 Or, in a formula that recurs across the Regulation as an alternative to the cessation of a benchmark, the benchmark is provided on the basis of input data that is no longer fully representative of the underlying market or economic reality or on the basis of unreliable data 377 Where the benchmark falls below the €400 billion threshold, a procedure applies whereby NCAs of the relevant Member States impacted by the benchmark, and the administrator’s NCA, may agree that the benchmark is critical and request the Commission that it be so designated (where there is disagreement between the NCAs, ESMA may issue an opinion). 378 The NCA’s review is to reflect the impact the cessation of the benchmark would have, taking into account the metrics specified in Art 20(3) as to the value of the measured underlyings and their relevance to GNP and any other measures which would objectively assess the impact of the benchmark’s cessation. 379 Administrators of critical benchmarks will also be subject to the DORA regime as regards their digital resilience. The Digital Operational Resilience Act (DORA) addresses the security of financial firms’ network and information systems and the ability of financial firms to withstand threats and disruptions. Provisional agreement on DORA was reached in May 2022 (the Commission Proposal is at COM(2020) 595). See in outline Ch I section 7.3. 380 By way of example, the UK FCA reported that it would not (under the ‘on-​shored’ UK Benchmark Regulation) require any ‘panel’ banks to continue to submit to LIBOR, following the announced departure of the majority of the panel banks contributing to LIBOR, or require the LIBOR administrator to continue to publish the different LIBOR benchmark settings using the pre-​existing methodology: FCA, Announcement on future cessation and loss of representativeness of the LIBOR benchmarks, 5 March 2021. It did, however, compel the use of a temporary ‘synthetic’ methodology for certain rates to ease the transition. 381 EURIBOR is currently the only critical benchmark designated in accordance with Article 20(1)(a) or (c) and so supervised by ESMA (LIBOR and EONIA were previously so designated but have been withdrawn). The

748  Market Abuse For ‘significant’ benchmarks (benchmarks which measure at least €50 billion of underlyings but which have no or very few appropriate substitutes and which would have an adverse market impact if they ceased to be provided (Article 24)) the rules governing administrators are somewhat liberalized, in that the administrator is exempted from certain rules, albeit subject to a ‘comply or explain’ requirement and the NCA may require that these rules are followed (Article 25). Finally, for ‘non-​significant’ benchmarks (all other benchmarks), a wider range of rules are subject to the exemption/​comply or explain mechanism; the NCA may not require compliance with the relevant rules, but it may request information and require changes (Article 26). The BMR is further segmented in that its requirements (in particular those relating to methodology and to oversight) are calibrated for two sets of benchmarks which have specific features: interest rate and commodity benchmarks (Articles 18 and 19).382 ‘Regulated-​ data benchmarks’, which are based on the regulated data produced by trading venues, cannot be designated as critical benchmarks and are subject to a series of alleviations which reflect MiFIR’s regulation of such data sources (Article 17).

VIII.10.3.4 Supervision and Enforcement The institutional structure that supports the supervision of the BMR has a multi-​layered and intricate design which draws on institutional innovations developed for rating agency supervision (under the Credit Rating Agency Regulation II (CRA II) (Chapter VII)) and for central clearing counterparty (CCP) supervision (under EMIR (Chapter VI section 5)).383 At its core are the NCAs that supervise benchmark administrators (and also data contributors/​users of benchmarks). But bolted on are: (i) ESMA, which (following the template developed for rating agency supervision) directly supervises administrators of EU critical benchmarks (those benchmarks designated as critical in accordance with Article 20(1)(a) or (c); currently there is only one such benchmark); and (ii) a college-​of-​supervisors mechanism, previously used only in EMIR and for CCP supervision, which coordinates ESMA and relevant NCAs as regards EU critical benchmarks. No other single rulebook measure combines, as regards the supervision of regulated actors, NCA supervision with direct ESMA supervision and college-​of-​supervisor-​based coordination.384 The BMR might accordingly be regarded as the culmination, so far, of the supervisory innovations which have developed since the establishment of ESMA in 2011. NCAs sit at the centre of this structure, being charged with the authorization or registration and the ongoing supervision of benchmark administrators. To this end, NCAs must be conferred with the required suite of supervisory and enforcement powers, and related

Stockholm, Warsaw, and Norwegian Interbank Offered Rates are also designated as critical, but are subject to NCA supervision: ITS 2021/​1122 [2021] OJ L243/​39. 382 Specified additional but also substitute requirements apply under Annex I (interest rate benchmarks) and Annex II (commodity benchmarks), and the regime governing alleviations for significant and non-​significant benchmarks does not apply. 383 Regulation (EU) No 513/​2011 [2011] OJ L145/​30 (CRA Regulation II, which conferred direct supervisory powers on ESMA)); and Regulation (EU) No 648/​2012 [2012] OJ L201/​1 (EMIR, as subsequently revised in 2019 by EMIR 2.2 to enhance supervision through ESMA-​coordinated colleges). 384 EMIR comes closest but direct ESMA supervision under EMIR is limited to third country CCPs. See further Ch VI section 5.9.1.

VIII.10  Benchmark Abuse and Benchmark Regulation  749 cooperation and coordination powers, the design of which is similar to that which is in operation across the single rulebook (Articles 37–​45 and 47–​8). Alongside, and following reforms made by the 2019 ESA Reform Regulation, ESMA is charged with the direct supervision of administrators of EU critical benchmarks (Article 40(1)) (in parallel with its supervisory convergence role as regards NCA supervision).385 So far, only EURIBOR has been designated as an EU critical benchmark and so subject to direct ESMA supervision.386 While ESMA’s direct supervisory competence is accordingly limited to one type of benchmark and, so far in practice, to one administrator, this conferral of competence nonetheless represents a significant hardening of the coordination-​based role ESMA previously played under the Regulation; ESMA’s supervisory competences under the BMR as originally adopted were directed to overseeing and supporting the college of supervisors required for NCAs of administrators of EU critical benchmarks. There is a strong logic, and a degree of inevitability, as regards ESMA’s supervision of administrators of EU critical benchmarks: EU critical benchmarks are of pan-​EU reach, do not expose Member States to significant fiscal risks on failure, the granularity of the administrative rulebook that applies to the relevant administrators limits ESMA’s discretion, and ESMA now has significant experience with supervising rating agencies, a population that generates similar risks as regards conflicts of interest, modelling, and data management.387 Nonetheless, the related negotiations were not straightforward, with the more expansive approach adopted by the Commission and supported by the European Parliament scaled back by the Council,388 in a reflection of the persistent tensions that conferring executive supervisory powers on ESMA can generate. ESMA’s highly articulated suite of powers (Articles 48a–​48n) follows the template established in 2011 for ESMA’s supervisory powers over rating agencies and designed to reflect the constraints imposed by the Meroni ruling as well as the political sensitivities associated with ESMA supervision.389 This template is by now well-​tested (and has been used also for ESMA’s powers over EU trade repositories, data reporting services providers, and third country CCPs)390 and has not experienced significant strain since its original adoption in 2011. EU critical benchmarks are also placed within a college of supervisors setting (Article 46). These colleges are, reflecting the materially lower risk profile of benchmarks as compared to CCPs, significantly less powerful than EMIR CCP colleges, not being conferred with veto or approval powers.391 Where an EU critical benchmark is so designated in accordance with Article 20(1)(a) or (c), the competent authority of the administrator must, 385 As it does across the single rulebook, ESMA supports supervisory convergence through a host of soft law tools, including Guidelines (on the application of the BMR to less significant benchmarks (2019) and (2022)), a Q&A, and other measures (such as its 2021 Supervisory Briefing on outsourcing by benchmark administrators). 386 ESMA took over supervision of the EURIBOR administrator (the European Money Market Institute) from the Belgian NCA and, relatedly, the chairing of the EURIBOR college of supervisors, on 1 January 2022. 387 See further Ch VII section 14 on rating agency supervision. 388 The Commission’s 2017 Proposal to revise the ESA Regulation conferred ESMA with powers over all critical benchmarks, including critical benchmarks of national importance, arguing that critical benchmarks were of major economic importance, constituted an inherently EU-​wide business, and that regulatory and supervisory problems could not be addressed by Member State action alone (as was implicit in the use of colleges of supervisors under the BMR as originally adopted): COM(2017) 536 7. While this reform was supported by the Parliament, it was rejected by the Council which limited ESMA supervision to EU critical benchmarks (benchmarks designated in accordance with Art 20(1)(a) and (c) only). 389 See further Ch VII section 14. 390 See Ch VI section 5.10, Ch V section 12.3, and Ch X section 9.2. 391 On the EMIR CCP colleges see Ch VI section 5.9.1.

750  Market Abuse within thirty days, establish and lead a college of supervisors, composed of the relevant competent authority/​ESMA and the NCAs of the ‘supervised contributors’ (a college is not required where the majority of data contributors are not supervised entities).392 Colleges are not conferred with binding powers and are primarily vehicles for coordination and information exchange, although the competent authority of the administrator (ESMA) is required to consult with the college before requiring supervised contributors to contribute data, authorizing or withdrawing authorization from the administrator, and imposing sanctions on the administrator.

VIII.10.3.5 Benchmarks and Sustainable Finance Benchmarks can support sustainable finance by facilitating investors in allocating resources to sustainable investments and in managing exposures to sustainability-​related risks, including those associated with the transition to a low carbon economy, but they can also generate risks, particularly as regards ‘greenwashing’.393 In the EU, the recent emergence of different forms of sustainability-​related benchmarks (broadly, ‘low carbon benchmarks’), with varying purposes, degrees of ambition, and levels of transparency, rendered comparability across benchmarks difficult but also increased the risk of greenwashing. Benchmarks were accordingly folded into the EU’s sustainable finance agenda by the Commission’s foundational 2018 Action Plan on Sustainable Finance,394 which, following the recommendation of the earlier Report of the High Level Expert Group on Sustainable Finance,395 committed the Commission to adopting standards for the methodologies of low carbon benchmarks, and to developing standards governing ESG disclosures by benchmarks generally. In its subsequent 2018 Proposal on Low Carbon Benchmarks,396 the Commission related the reforms to the potentially transformative impact of benchmarks on sustainable finance, given the role benchmarks play in investment decision-​making and their impact on portfolio allocation, but also highlighted the need for greater standardization, given in particular the risks of greenwashing in the absence of clear and comparable standards. The 2019 Low Carbon Benchmarks Regulation accordingly revised the BMR to support the construction of low carbon benchmarks and also to address the risk of investors being misled as to the extent to which a benchmark’s underlyings achieve sustainability objectives.397 It imposes ESG disclosure requirements on all benchmarks and it provides for two standardized forms of EU low carbon benchmark: the EU Climate Transition Benchmark (the CTB); and the EU Paris Aligned Benchmark (the PAB). The CTB is the less demanding of the two benchmarks constructed by the BMR in that it allows for wider diversification and thereby seeks to support the portfolio allocation needs of institutional investors.398 The CTB is designed to bring the resulting benchmark portfolio on a decarbonization trajectory: a CTB is one which is labelled as such, and where its 392 NCAs of other Member States have the right to be members where the cessation of the benchmark would have a significant adverse impact. 393 See in outline Ch I section 7.2. 394 COM(2018) 97. 395 High Level Expert Group on Sustainable Finance, Financing a Sustainable European Economy (2018). 396 COM(2018) 355. 397 Regulation (EU) 2019/​2089 [2019] OJ L317/​17. 398 EU Technical Expert Group on Sustainable Finance (TEG), Final Benchmark Report, September 2019, 8. The 2019 reforms and the related administrative rules are based on the highly granular technical specifications recommended by the Report.

VIII.10  Benchmark Abuse and Benchmark Regulation  751 underlying assets are selected, weighted, or excluded in such a manner that the resulting benchmark portfolio is on a ‘decarbonization strategy’399 and the Regulation’s specifications are followed: Art 3(1)(23a). The PAB, by contrast, is ‘highly ambitious’, being designed to bring the resulting benchmark portfolio’s carbon emissions in line with the Paris Climate Agreement target to limit the global temperature rise to 1.5 degrees centigrade, compared to pre-​industrial levels:400 it is one which is labelled as such, and where its underlying assets are selected, weighted, or excluded in such a manner that the resulting benchmark portfolio’s carbon emissions are aligned with the objectives of the Paris Agreement, the activities relating to its underlying assets do not significantly harm other ESG objectives, and the Regulation’s specifications are followed: Art 3(1)(23b)). The supporting regime for both benchmarks is finely specified, with a high level of technical granularity, as regards the applicable methodologies and the minimum standards governing the relevant assets.401 In an echo of the rating agency regime’s regulatory encouragement of issuers to use smaller rating agencies, administrators are also encouraged to provide one or more CTBs (Article 19d). The 2019 reforms also revised the BMR more generally to require administrators to provide disclosure on ESG factors. Administrators must explain in their methodology disclosures how a benchmark’s methodology (excluding interest rate and foreign exchange benchmarks) reflects ESG factors (Article 13). ESG disclosures are also required in the mandatory benchmark statement which must explain how ESG factors are reflected in each benchmark/​family of benchmarks402 and contain the specified disclosures relating to carbon emissions and the achievement of the Paris Agreement objectives (Article 27).403 The implementation of these requirements proved troublesome given the high degree of technical complexity engaged by the design of the amplifying administrative rules,404 a feature of sustainable finance regulatory design generally. Related delays in the adoption of the administrative rules led to ESMA issuing one of its first ‘no action’ opinions under its ‘no action’ power under ESMA Regulation Article 9a (introduced by the 2019 ESA Reform Regulation): ESMA advised NCAs not to prioritize supervisory or enforcement action as regards these requirements, given the legal ambiguities and technical difficulties created by the absence of amplifying administrative rules, and advised the Commission to secure their expeditious adoption.405

399 A ‘decarbonization strategy’ is a measurable, science-​based, and time-​bound strategy towards alignment with the Paris Agreement’s objectives and in accordance with the technical specifications of the Regulation: Art 3(1)(23c). 400 As described in the 2019 TEG Report: n 398. The PAB is therefore based on stricter minimum requirements and is directed towards institutional investors who wish ‘to be at the forefront’ of the climate transition. 401 Arts 19a–​19d and Annex III. These requirements, which reflect the 2019 TEG Report, are further amplified in detail as regards methodology and transparency requirements by Delegated Regulation 2020/​1818 [2020] OJ L406/​17. The rules are based on the advice of the TEG (n 398) which also issued a detailed accompanying Handbook. 402 Where the benchmark does not pursue an ESG strategy this can be stated instead. 403 The required benchmark statement disclosures, which are also based on the 2019 TEG Report (n 398), have been amplified by RTS 2020/​1816 [2020] OJ L406/​1 which provides a template specifying the disclosures. RTS 2020/​1817 [2020] OJ L406/​12 addresses the methodology disclosures. 404 The TEG warned that the current state of development of methodologies, and limited related issuer disclosures, meant that it was not possible to achieve an ‘evident and irrefutable’ conversion of climate scenarios into detailed rules, and that the rules should be reviewed within three years: n 398, 8. 405 ESMA, No Action Letter (NCAs) and No Action Opinion (Commission), 29 April 2020. While the BMR obligations relating to these disclosures came into force in April 2020, the related administrative rules were not in force until December 2020.

752  Market Abuse

VIII.10.3.6 Benchmark Replacement The replacement of key interest rate benchmarks, and in particular LIBOR, by alternative risk-​free rate benchmarks proved a knotty feature of the global benchmark reform agenda, generated complex regulatory and contracting conundrums, and led to BMR reform. Prior to the financial-​crisis-​era exposure of related benchmark manipulation, reference interest rates based on unsecured interbank term lending rates (chief among them the LIBOR rate) had become dominant as benchmark interest rates, being embedded in a wide range of lending and derivative contracts globally.406 Confidence in the reliability of these ‘IBOR’ rates (interbank offered rates), which were constructed from submissions made by panel banks, was undermined by the benchmark manipulation scandals. It was also undermined, however, by structural changes in the underlying unsecured interbank term lending market as banks, over and since the financial crisis, drew on a wider and more diverse set of funding sources beyond interbank loans, including deposits. Accordingly, as liquidity in the interbank lending market thinned and transactions became scarcer, it became more difficult to develop reliable reference rates. In consequence, in its 2014 review of interest rate benchmarks, the FSB called for the major IBOR benchmark rates to be strengthened, but ultimately for their replacement by alternative risk free benchmark rates which would be based on transactions and which would not be dependent on judgment.407 A large-​scale global exercise to secure contract continuity and avoid market disruption followed as markets transitioned from IBORs, and in particular LIBOR. The Covid-​19 pandemic saw the FSB call for an acceleration of the transition, warning in 2020 that the pandemic had underlined the thinness of liquidity in the unsecured interbank term lending market and of the related weaknesses in IBORs.408 Much of the international effort related to the withdrawal of LIBOR, given the extent to which it had become embedded in contracts globally. The cessation of most LIBOR rates by end 2021 was announced by the UK Financial Conduct Authority (FCA) in March 2021 (albeit signalled earlier), following notification by the FCA-​supervised LIBOR administrator that it would no longer provide the LIBOR benchmark.409 The FCA, in consequence, and to support the transition, replaced a small number of withdrawn LIBOR rates with substitute ‘synthetic’ LIBOR rates.410 This process has shaped the BMR. As well as supporting the LIBOR transition,411 the EU was also required to support the transition from EONIA, the interbank overnight lending rate for the euro, identified as an EU critical benchmark in 2019 but finally withdrawn in

406 For a review see FSB, Reforming Major Interest Rate Benchmarks (2014). 407 2014 FSB Report, n 406. 408 See, eg, FSB, Reforming Major Interest Rate Benchmarks. Progress Report (2020). 409 2021 FCA LIBOR Statement, n 380. 410 FCA, Art 21(3) Benchmark Regulation Notice of First Decision, 10 September 2021. The Decision related to replacement rates for six ‘tenors’ (or interest rate periods), three for sterling and three for the Japanese Yen, given the need for transition measures for these rates. As the related rates are ‘synthetic’ and not representative of the underlying market, they were designed to support the LIBOR transition only and so could not be used for new contracts. As noted below, the Commission is empowered to adopt such replacement benchmarks under the BMR (the FCA’s powers are based on an on-​shored, post-​Brexit version of the BMR). 411 The scale of the potential disruption from a disorderly withdrawal of LIBOR was emphasized in the joint warning from the ECB, ESMA, EBA, and the Commission in June 2021 that market participants should reduce their exposure to LIBOR’s different settings and not wait for the Commission’s exercise of the replacement powers it had been conferred with in 2021 (see below): Joint Public Statement, June 2021.

VIII.10  Benchmark Abuse and Benchmark Regulation  753 January 2022.412 The BMR was accordingly revised in 2021 to address the risks posed by the withdrawal of benchmarks.413 It now empowers the Commission to adopt temporary replacement benchmarks for pre-​existing contracts, where necessary to avoid market disruption, and thereby to support contractual continuity by providing, in effect, a form of safe harbour (through the replacement benchmarks) for contracts based on withdrawn benchmarks (Articles 23a–​23b).414 A parallel power empowers NCAs to designate a replacement benchmark for domestic critical benchmarks (those designated as critical under Article 20(1)(b)) (Article 23c). While targeted to the idiosyncratic risks generated by the withdrawal of LIBOR and EONIA,415 the BMR replacement power represents a marked increase in the level of operational EU intervention in the EU financial market.416 It accordingly serves as a signal reminder of the extent to which the EU’s technocratic capacity as regards financial markets regulation has expanded since the financial-​crisis era.

412 EONIA had become less resilient as liquidity in the underlying lending market had thinned and as panel banks withdrew from making submissions. EONIA’s administrator, the European Money Market Institute, announced in February 2018 that it would not be in a position to comply with the BMR and that EONIA would be wound down in an orderly manner (EONIA was discontinued on 3 January 2022). The private sector but ESMA-​ convened Working Group on Euro Risk Free Rates recommended later in 2018 the ECB’s euro short-​term rate (€STR) as the EONIA replacement (the €STR was, in consequence, first published in October 2019 and tracked by EONIA). The group also adopted a series of recommendations and analyses to support the transition. 413 By means of Regulation (EU) 2021/​168 [2021] OJ L49/​6. The Commission noted the ‘tens of thousands’ of contracts that referenced LIBOR, the limited use of contractual ‘fallback’ provisions to deal with the LIBOR transition, and the potential disruption to debt issuances, debt held by supervised entities, loan agreements, deposits, and derivative contracts which could generate stability risks: 2020 Proposal COM(2020) 337. 414 The Commission’s replacement power applies widely to EU critical benchmarks; any EU benchmark, based on the contribution of input data, where the cessation or wind-​down would significantly disrupt the functioning of financial markets in the EU; and third country benchmarks (such as LIBOR) if their cessation or wind-​down would significantly disrupt the functioning of financial markets in the EU or pose a systemic risk to the EU financial system (Art 23b). The related ‘safe harbour’ applies widely: the replacement benchmark covers any contract or MiFID II financial instrument that references the withdrawn benchmark and is subject to the law of a Member State; and also any contract, the parties to which are established in the EU, that references the withdrawn benchmark, and that is subject to the law of a third country, where that law does not provide for the orderly wind-​down of a benchmark: Art 23a. Any replacement rate only applies, however, where there is no fallback provision in the relevant contract or financial instrument, or no ‘suitable’ fallback provision, concepts amplified by Art 23b. Under Art 23b, the replacement process can be triggered by the Commission when the relevant conditions are met, which include the administrator’s competent authority (which could be ESMA) finding that the benchmark no longer reflects the underlying market or economic reality or the administrator announcing the benchmark will be wound down. The Commission’s determination of any replacement rate is to be based on available recommendations, relevant central bank rates, or advice from specialist working groups (such as the Working Group on Euro Risk Free Rates). 415 Indications so far suggest that EURIBOR (the only EU critical benchmark) will not be withdrawn. The FSB has reported on EURIBOR’s improved resilience since the BMR reforms, given in particular its greater reliance on transaction data and changes to how it uses contributor data, and its resilience over the pandemic-​related period of market volatility, when it was published daily. The FSB has nonetheless called for EURIBOR to be monitored: 2020 FSB Report, n 408, 13. 416 Thus far, two replacement benchmarks have been established: (i) to replace the Swiss Franc LIBOR (with a rate based on the Swiss Average Overnight Rate), achieved by Implementing Regulation 2021/​1847 [2021] OJ L374/​1; and (ii) to replace EONIA (with the €SRTR), achieved by Implementing Regulation 2021/​1848 [2021] OJ L374/​6. The reasoning for each replacement benchmark emphasizes the potential market disruption in the absence of a replacement, given the scale of reliance on the relevant benchmarks being withdrawn.

IX

RETAIL MARKETS IX.1 Introduction IX.1.1  Regulating the Retail Markets This chapter considers EU financial markets regulation from the perspective of retail investors and of the retail markets.1 Regulation in the retail markets can be associated with complementary, if sometimes competing, functions. It seeks to protect retail investors from abusive market conduct and also to address their behavioural vulnerabilities, and so has a protective dimension; but it also seeks to support and facilitate retail investors as long-​term savers and as capital suppliers to the economy, and so has an empowerment dimension.2 The relative degree of influence exerted by these two poles—​protection and empowerment—​and the extent to which regulation is tilted in either direction tends to shape the design of retail market regulation. While longstanding features of retail market regulation, these poles framed the debate on retail market regulation which ignited over 2021 in the wake of the early 2021 ‘meme-​stock’ trading spiral. Organized retail investor trading, facilitated by technological innovation (in particular zero-​commission trading apps), fuelled by pandemic-​related savings and a low interest rate environment, and coordinated through social media, generated massive volatility in targeted shares, including but not only Gamestop shares.3 The episode followed changes to retail investor trading patterns over the Covid-​19 pandemic which saw significant growth in direct online retail trading as well as an increase in retail market investment

1 Characterizing the ‘retail investor’ presents a definitional challenge for regulation given the range of traits and competences associated with such investors. The spectrum of characterization can range from vulnerable consumer of investment products required for welfare needs, to informed financial citizen taking on welfare provision responsibilities from the state, to empowered capital supplier, and, in the wake of the rise of ‘meme stock’ activism, social activist investor. See, eg, Chiu, I, ‘Social Disruption in Securities Markets—​What Regulatory Response Do We Need? (2021) 28 Richmond J of L and Tech 46, Kingsford Smith, D and Dixon, O, ‘The Consumer Interest and the Financial Markets’ in Moloney, N, Ferran, E, and Payne, J (eds), The Oxford Handbook of Financial Regulation (2015) 695, and Moloney, N, ‘The Investor Model Underlying the EU’s Investor Protection Regime: Consumers or Investors’ (2012) 13 EBOLR 169. For the purposes of this chapter, the ‘retail investor’ is used to denote a non-​ professional investor investing discretionary funds in market-​based instruments (whether direct investments or packaged investment products), whether for welfare or accumulation purposes. On the EU’s approach to classifying investors see section 4.4. 2 In the US context see Langevoort, D, Selling Hope, Selling Risk. Corporations, Wall Street and the Dilemmas of Investor Protection (2016). 3 In the US, the epicentre of the trading spike, the episode was linked to low trading commission rates, the liquidity being provided by the Federal Reserve, quarantined households, and pandemic-​related increases in savings: Darbyshire, M and Smith, C, ‘US Brokers’ Race to Attract Investors Stokes Concerns over Risks’, Financial Times, 11 February 2021. See further section 4.9.2. and Ch VI section 2.2.

756  Retail Markets levels generally (particularly in the US).4 Coming hard on the heels of this change in retail investment patterns, the meme-​stock episode prompted widespread debate on retail investor behaviour and the role of financial markets regulation.5 The issues canvassed ranged from the existential (for example, whether or not a new paradigm of market-​moving, activist, retail investor capitalism was emerging and the implications for financial markets regulation and corporate governance; and whether or not the market needed to be ‘protected’ from the disruption of mass retail engagement) to the technical (for example, how conflict-​of-​interest rules applied to zero-​commission brokers; and whether regulation was sufficiently calibrated to capture digital distribution of investment products and marketing through social media channels). The debate was broadly concerned, however, with the balance between investor protection and investor empowerment and, relatedly, the extent to which regulation should intervene in the retail markets.6 Whether or not the meme-​stock episode marks a decisive shift in retail investor behaviour remains to be seen.7 In the EU, while levels of retail investor trading increased over the pandemic, EU financial markets did not see spikes of coordinated meme stock trading on the scale of those recorded in the US in early 2021.8 The issues the meme-​stock episode raised as to the balance between ensuring an optimal level of protection and empowering investors are, however, of longstanding. Investor protection in the retail markets can be associated with the correction of market failures, in particular those flowing from the wide information asymmetry between retail investors and professional market actors.9 These are exacerbated by the agency relationship which strongly characterizes retail investor engagement with the markets,10 and by the 4 2021 saw sharp increases in retail investor investment in exchange-​traded funds, eg: Masters, B, ‘How to Balance Freedom and Investor Protection? Disclose the Downside’, Financial Times, 13 September 2021. 5 The implications of the meme -​stock episode for retail market regulation forms a distinct thread in the related and emerging scholarship. See, eg, Chiu, n 1; Gramitto Ricci, S and Sautter, C, ‘Corporate Governance Gaming: The Collective Power of Retail Investors’ (2021) 22 Nevada LJ 51; Macey, J, ‘Securities Regulation and Class Warfare’ (2021) Co Bus LR 796; and Angel, J, Gamestonk: What Happened and What to do About it, Georgetown McDonough School of Business Research Paper (2021), available via . 6 For an analysis supporting the ‘re-​emergence’ of the retail investor as a means for enabling citizen capitalism, but calling for a measured regulatory response oriented to improving the retail investor experience, and which does not obstruct the development of facilitative technologies, such as those based on gamification, see Fisch, J ‘Gamestop and the Reemergence of the Retail Investor’ (2022) 102 Boston U LR 1799. 7 As 2021 waned and by early 2022 signs had emerged of a fall-​off in US retail investor trading activity: Oliver, J and Darbyshire, M, ‘Is the Army of Lockdown Traders Here to Stay?’, Financial Times, 18 October 2021; Reuters, ‘Retail investors show signs of fatigue after last year’s trading frenzy’, 19 January 2022. This was sustained as economic conditions deteriorated and inflation risks rose. By mid-​2022, retail inflows had reduced considerably (Darbyshire, M and Megaw, N, ‘Retail Traders No Longer “Buyer of First Resort” as US Stocks Slide’, Financial Times, 12 May 2022, reporting on retail inflows of $2.4 billion in May 2022 as compared to $17 billion in March 2022). 8 ESMA Chair Maijoor, Introductory Statement, ECON Exchange of Views in Relation to GameStop Share Trading and Related Phenomena, 23 February 2021. The episode did see increased levels of trading, but not on the scale of the US experience. Similarly, and reflecting the impact of ‘lock-​downs’, the share of total EU retail trading was estimated to have jumped to 7 per cent of total trades by mid-​2020 (from 2 per cent in 2019), whereas in the US (albeit in a very different market context), retail trading can represent some 32 per cent of trading: Chatterjee, S, ‘Retail investor base doubles in Europe as US “meme” stock mania spreads—​Euronext’, Reuters, 11 June 2021. 9 Consumer financial markets have been described as providing ‘the textbook case of market failure due to information asymmetries’: Campbell, J, Jackson, E, Madrian, B, and Tufano, P, ‘Consumer Financial Protection’ (2011) 25 J Econ Perspectives 91. 10 Given in particular heavy reliance on investment advisers and similar distribution channels (eg Choi, S, ‘A Framework for the Regulation of Securities Market Intermediaries’ (2004) 1 Berkeley Business LJ 45) and on collective investment schemes (eg Mahoney, P, ‘Manager-​Investor Conflicts in Mutual Funds’ (2004) 18 J of Econ Perspectives 161). From the extensive financial economics literature on structural conflict-​of-​interest risks in retail market intermediation see, eg, Inderst, R and Ottaviani, M, ‘How (Not) to Pay for Advice: A Framework for Consumer Financial Protection’ (2012) 105 JFE 393

IX.1 Introduction  757 behavioural risks to which retail investors are exposed,11 including from their propensity to trust the intermediation process.12 The investment distribution process, for example, is vulnerable to related conflict-​of-​interest risks, such as those associated with payment-​for-​ order-​flow in the context of zero-​commission trading apps, but also those generated in the more traditional setting of commission-​based advice services. Investment product design, to take another example, can also generate risks; ‘packaged’ investment products (such as funds and structured investments) can be poorly designed and have onerous cost profiles. Retail investors can also struggle with marketing and disclosures; the risk of ‘greenwashing’, for example, is currently preoccupying the EU’s regulators, given the ongoing and large-​ scale expansion of ‘green’ products.13 The classical response to market failures deriving from information asymmetries is to correct the information failures by means of mandatory disclosure requirements which support investors in achieving efficient bargains. But in the retail markets, regulation has long had a more paternalistic dimension and so has been more interventionist and supportive of the investor decision, deploying disclosure but also product design and distribution rules, including conduct rules relating to fair treatment, the quality of advice, and conflict-​of-​interest management. Alongside, retail market regulation typically also has a more proactive dimension. This is associated with facilitating and empowering retail investors, and with regulation relatedly having a ‘marketing’ dimension14 and being concerned with constructing financially competent and responsible retail investors who can confidently access the financial markets to meet their savings needs and also to support the real economy.15 The period prior to the global financial crisis saw extensive discussion of the implications of the extent to which regulation was leading to households being ‘empowered’ and ‘financialized’,16 and to financial markets being ‘democratized’ through large-​scale public participation.17 The financial-​crisis period subsequently led to large-​scale regulatory repairs to financial markets, albeit primarily as regards financial stability and only secondarily as regards retail 11 For financial-​crisis-​era perspectives and from an extensive literature see, eg, Avgouleas, E, ‘The Global Financial Crisis, Behavioural Finance, and Financial Regulation: In Search of a New Orthodoxy’ (2009) 9 JCLS 23 and Kingsford Smith, D, ‘Regulating Investment Risk: Individuals and the Global Financial Crisis’ (2009) 32 U of New South Wales LJ 514. For an earlier assessment see Campbell, J, ‘Household Finance’ (2006) 61 J Fin 1553. 12 A significant literature addresses the notion of trust in retail financial markets. For an EU and legally oriented perspective see Mülbert, P and Sajnovits, A, ‘The Elements of Trust in Financial Markets Law (2017) 18 German LJ 1, from the perspective of public offers see Stout, L, ‘The Investor Confidence Game’ (2002–​03) 68 Brooklyn LR 407, and for a financial economics perspective, see Sapienza, P, Guiso, L, and Zingales, L, ‘Trusting the Stock Markets’ (2008) 63 J Fin 2557. Relatedly, the behavioural economics literature considers the ‘choice architecture’ (or setting, including how information is presented) that shapes investment decisions. See Lunn, P, McGowan F, and Howard, N, Do Some Financial Product Features Negatively Affect Consumer Decisions? ESRI Dublin, Research Series No 78 (2018). 13 2020 saw ninety new exchange-​traded funds (ETFs) with environmental, social, and governance (ESG) objectives launched, eg, outstripping new ‘non-​ESG’ ETFs (sixty-​two launched), while ESG fund assets increased by 20 per cent in the first half of 2021: ESMA, TRV No 1 (2021) 46. 14 As argued in particular in the work of Donald Langevoort in the context of the US Securities and Exchange Commission (SEC). See, eg, Langevoort, D, ‘Managing the Expectations Gap in Investor Protection: The SEC and the Post-​Enron Reform Agenda’ (2003) 48 Villanova LR 1139. 15 See, eg, Williams, T, ‘Empowerment of Whom and for What? Financial Literacy Education and the New Regulation of Consumer Financial Services’ (2007) 29 Law & Policy and Ramsay, I, ‘Consumer Law, Regulatory Capitalism and New Learning in Regulation’ (2006) 28 Sydney LR 9. 16 See, eg, the special edition of the International Journal of Political Economy (2013) 42; Ertürk, I, Froud, J, Johal, S, Leaver, A, and Williams, K, ‘The Democratization of Finance? Promises, Outcomes and Conditions’ (2007) 14 Rev of International Political Economy 553 and Ireland, P, ‘Shareholder Primacy and the Distribution of Wealth’ (2005) 68 MLR 4981. 17 eg Shiller, R, The Subprime Solution (2008).

758  Retail Markets market regulation.18 But it did not significantly disrupt the prevailing orthodoxy that sub-​ optimal market participation levels, and related impaired ability to save for the long-​term, can generate household but also societal welfare costs,19 given the capacity of long-​term market-​based savings to strengthen household financial security, for those households with sufficient means.20 Most recently, changed retail investor behaviour over the Covid-​19 pandemic and the meme-​stock episode saw renewed discussion of the role of regulation in empowering retail investors and releasing household capital,21 even as retail investors were exposed to historically high levels of market volatility and market risk.22 The protective and empowering dimensions of retail market regulation are typically blended in the design of retail market regulation. The protective dimension can be associated with a precautionary approach, directed to preventing malfeasance and to mitigating behavioural risks, which relies on interventionist strategies such as process-​related controls on distribution and advice, marketing restrictions, and product authorization/​governance requirements. The empowering dimension can be associated with more facilitative strategies that are typically associated with supporting choice and that privilege disclosure. Whatever the blend of regulatory devices relied on, retail market regulation poses myriad difficulties. These include those associated with pinning down the class of retail investor targeted;23 the regulatory perimeter can be difficult to fix and require fine decisions as to the optimal level of risk in the retail markets, the level of investor responsibility which can be expected, and the extent to which choice can be supported. Regulation must similarly be adapted to how retail investors behave, if poor regulatory design and consequent undue costs are to be avoided.24 Further, regulatory tools can be difficult to use: conflict-​of-​interest risk, for example, continues to crystallize in the retail markets, despite the range of regulatory tools used to mitigate it.25 And risks are evolving. The potentially transformative effect of digital distribution and social media communication channels on how disclosure is delivered and investments are distributed is prompting debate on the extent to which core regulatory principles should be adjusted to reflect technological innovation.26 The task is 18 The scholarly debate, however, called for greater focus on the retail market risks arising from financial instability. See, eg, Allen, H, ‘Financial Stability Regulation as Indirect Investor/​Consumer Protection Regulation: Implications for Regulatory Mandates and Structure’ (2016) 90 Tulane LR 1113. 19 From a household financial economics perspective see the work of John Campbell: eg, Campbell, J, ‘Restoring Rational Choice: The Challenge of Consumer Protection Regulation’ (2016) 106 AER 1 and Campbell, n 11. 20 Dynan, K, ‘Changing Household Financial Opportunities and Economic Security’ (2009) 23 J of Econ Perspectives 49. 21 eg, Fisch, n 6. 22 In the EU, the deepening of the pandemic over early 2020 saw a period of acute market volatility. Over end-​ February to mid-​March, eg, equity prices fell by 30 per cent while Q1 saw the value of household equity and collective investment scheme holdings drop by 6 per cent and 9 per cent, although asset prices had recovered to 2019 levels by end 2020: ESMA, Performance and Costs of Retail Investment Products (2022) 7. 23 See the references at n 1. 24 For an extensive survey from a financial economics perspective see Gomes F, Haliassos, M, and Ramadorai, T, ‘Household Finance’ (2021) 59 J of Econ Lit 919. 25 For a recent discussion see Laby, A (ed), The Cambridge Handbook of Investor Protection (2022). 26 The treatment of digital disclosure and distribution was a recurring theme over the development of the Commission’s Retail Investment Strategy agenda which was launched with Commission, Consultation on a Retail Investment Strategy for Europe (2021). ESMA’s related advice acknowledged the ongoing change to how disclosure and marketing communications were being delivered, including through social media influencers, but did not recommend changes to core legislative principles, advising that any related adjustments be in the form of soft law: ESMA, Final Report on the Commission Mandate on Certain Aspects Relating to Retail Investor Protection (2022) (which followed ESMA, Call for Evidence on the European Commission Mandate on Certain Aspects relating to Retail Investor Protection (2021)). See further sections 2.5 and 4.3.2 (distribution); and 4.7 and 5.1 (disclosure).

IX.1 Introduction  759 not made easier by the tendency of retail market regulation to impose transaction costs on capital formation: the ‘sweet spot’ between investor protection and not obstructing capital formation can be difficult to hit.27

IX.1.2  Regulating the Retail Markets and the EU: A Challenging Setting IX.1.2.1 Encouraging Retail Participation and Capital Markets Union The EU retail market regulatory regime grapples with the protective and empowerment functions of retail market regulation and with the related design difficulties. But it also engages with distinct challenges, deriving from the nature of the EU retail market. As outlined in section 3, EU retail market regulation has long had a transformative purpose. It is designed to protect retail investors but also to support wider household participation in financial markets by empowering retail investors. This purpose is persistent. The 2020 Capital Markets Union (CMU) Action Plan, for example, linked the CMU agenda to facilitating households’ access to financial products that would match their needs and preferences,28 and committed the Commission to adopting a Retail Investment Strategy which would seek to ensure that retail investors could take full advantage of capital markets.29 Similarly, the emphasis the 2020 CMU Action Plan placed on strengthening financial literacy30 suggests an empowerment orientation.31 The Commission’s 2020 Capital Markets Recovery Package, designed to support the ‘Covid-​19 Recovery’, had a similar hue, identifying household capital as being essential to the recovery.32 This drive to encourage wider retail participation is supported by the European Securities and Markets Authority (ESMA), which has repeatedly identified the importance of wider retail investor engagement to the efficient funding of the real economy and to welfare provision.33 An 27 Langevoort, n 2, 3 and 131. 28 Commission, A Capital Markets Union for People and Businesses. New Action Plan (COM(2020) 590). The Action Plan noted that while Europe had one of the highest levels of individual savings rates in the world, it had very low levels of retail participation in capital markets, depriving, thereby, EU firms and the EU economy of long-​term investment through household capital. It also suggested that households were being deprived of higher returns and did not benefit sufficiently from the investment opportunities offered by the capital markets: at 10. For an assessment of how the CMU agenda, as it evolved from 2015, engages with retail market risk see Moloney, N, ‘EU Financial Market Governance and the Retail Investor: Reflections at an Inflection Point’ (2018) 37 YEL 251. 29 The Strategy, which was launched with the 2021 Retail Investment Strategy Consultation (n 26) and supported by, inter alia, Kanter Public, milieu, and CEPS, Study for the European Commission on Disclosure, Inducements, and Suitability (2022), was under development at the time of writing and expected in quarter one 2023. The first question of the 2021 Consultation captured both poles of retail market regulation: ‘does the EU retail investor protection framework sufficiently empower and protect retail investors when they invest in capital markets?’ . 30 The 2020 Action Plan included a Commission commitment to explore the feasibility of a European financial competence framework: n 28, 10. Financial literacy has long featured on the EU’s retail market agenda, albeit that its prominence tends to come and go with reform cycles. It was frequently raised prior to the financial crisis and in relation to the empowerment of retail investors, eg, but was not a prominent part of the financial crisis reform agenda. 31 From the literature on the interaction between financial literacy and household participation see, eg, Bucher-​ Koenen, T et al, Fearless Woman: Financial Literacy and Stock Market Participation, NBER WP No w28723 (2021), available via < https://​ssrn.com/​abstr​act=​383​470>, Angrisani, M et al, The Stability and Predictive Power of Financial Literacy, Evidence from Longitudinal Data (2020), NBER WP No w28125, available via , and Lusardi, A and Mitchell, S, ‘The Economic Importance of Financial Literacy: Theory and Evidence’ (2014) 52 J of Econ Lit 5. 32 Retail investor access to bond investments was regarded as an ‘essential part’ of the Capital Markets Recovery Plan which included a related and limited liberalization of the EU’s product governance rules (SWD(2020) 120). See section 4.11.3. 33 ESMA has frequently linked wider retail market participation to the need for a large investor base to help finance the economy, and to the more effective long-​term financial planning that can be achieved through market

760  Retail Markets empowerment orientation can also be identified in the EU’s sustainable finance strategy. The Commission’s 2021 Proposal for a ‘green bonds’ standard is primarily designed for institutional investors, but it is also associated with strengthening retail engagement with sustainable investments.34 Similarly, the 2018 Sustainable Finance Action Plan related greater transparency on sustainable investments to retail investor engagement and included extending the EU ‘ecolabel’ to retail investment products.35 The scale of the regulatory challenge is, however, significant given current levels of retail market participation. EU household participation in the financial markets is limited.36 EU household financial assets have long been predominantly composed of insurance and private pension assets (currently circa 31.1 per cent of household financial portfolios) and currency and deposits (31.6 per cent), with equity and investment fund assets representing 32.9 per cent, and investment in debt securities limited.37 Similarly, 10.2 per cent of households in the euro area hold investment fund assets, 8.6 per cent hold listed shares, and 3.2 per cent hold debt securities, but 97.6 per cent hold deposits and 28.4 per cent hold private pension and life insurance assets.38 This asset allocation has been broadly stable over time, although holdings of equities and investment funds have decreased over time.39 Overall asset allocation patterns were not significantly disrupted by the pandemic-​related increase in household savings,40 with households tending to keep any additional savings in the form of cash and deposits.41 investments, as compared to saving through deposits. See, eg, ESMA, Performance and Costs of EU Retail Investment Products (2020) 8 and ESMA Chair Maijoor, Speech, 18 October 2020. 34 2021 Green Bond Proposal Impact Assessment (IA) (SWD (2021) 181) 29. 35 Commission, Action Plan: Financing Sustainable Growth (COM(2018) 97) 4–​5. It envisaged expanding the Ecolabel Regulation (Regulation (EC) No 66/​2010 [2010] OJ L27/​1), which governs the (voluntary) EU ‘Ecolabel’, to cover the ecolabelling of packaged retail investment products in accordance with the EU’s taxonomy rules relating to sustainable investments. See further Ch I section 7.2. 36 A weight of reports has examined the composition of household financial assets in the EU and the potential for greater retail participation in the capital markets. For recent examples see 2022 Disclosure, Inducements, and Suitability Study, n 29 and ECMI, Asset Allocation in Europe. Reality v Expectations (2020). 37 Eurostat, Households—​Statistics on Financial Assets and Liabilities, November 2022. Similarly, ESMA reported earlier in 2022 that savings, currency, and deposits represented 30 per cent of total household financial assets, investment funds 8 per cent, and shares 20 per cent: 2022 ESMA Retail Investment Products Report, n 22, 7. The 2022 Disclosure, Inducements, and Suitability Study (n 29) likewise reported on increasing holdings of currency and deposits and of pension and insurance products, and of declining holdings of equities and investment funds, over the twenty-​year period 2000 to 2020, although household financial assets generally more than doubled over the same period: at 57–​58. Italy is an outlier in that bonds represent an unusually high proportion of household financial assets, albeit that, as in the EU generally, bond holdings as a proportion of household portfolios declined over 2007–​ 2020: CONSOB, Report on the Financial Investments of Italian Households (2020) 16. The Commission has similarly reported that EU households tend to hold only a small portion of their financial wealth in market investments as a percentage of GDP: Commission, Monitoring Progress Towards CMU: a tool-​kit of indicators (SWD(2021) 544) 70. 38 ECB, The Household Finance and Consumption Survey: Results from the 2017 Wave (2020). The survey reported on relatively small changes in participation rates since the previous (2014) Wave. 39 As tracked in ESMA’s assessment of household financial portfolios since 2010. See most recently 2022 ESMA Retail Investment Products Report, n 227, Statistical Annex (Market Environment) 55. This pattern has been developing over time, with investment fund, equity, and debt holdings on a downward trend since 2000: 2022 Disclosure, Inducements and Suitability Study, n 29, 57–​58 and Commission, Distribution Systems of Retail Investment Products across the EU (2018) 11–​12. 40 Eurostat, Quarterly Sector Accounts (Households), 28 October 2020, reporting on an EU-​27 household saving rate (gross household savings over gross disposable income) of 15.8 per cent for quarter one 2020, as compared to 11.5 per cent in the same period in 2019; and of 23.9 per cent for quarter two 2020. This was the highest saving rate ever recorded for households by Eurostat, the EU’s statistics agency. Since then, the savings rate has dropped. Eurostat’s October 2022 review reported that the EU-​27 saving rate had dropped from 14.6 per cent in quarter one 2022 to 12.6 per cent in quarter two 2022. 41 2021 Commission CMU Indicators Report, n 37, 39 reporting that the increased levels of investment activity (in shares and funds but also in life insurance and pension investments) were not sufficient to counterbalance increasing levels of deposit-​based savings.

IX.1 Introduction  761 Alongside, risk aversion levels are high42 and levels of retail investor financial literacy are generally low, as has been repeatedly reported in a series of EU and Member State studies.43 The Covid-​19 pandemic did see a sharp increase, from a low base, in levels of direct retail trading activity (particularly online), in shares and investment funds in particular,44 and including in Member States with traditionally low levels of direct retail investor trading.45 ESMA related this development to the effect of the pandemic, the growth of digitalization and ‘platformization’, and the meme-​stock related emergence of coordinated retail investor activism.46 It is not yet clear whether a structural shift in EU household investment patterns is underway; overall asset allocation profiles, at least at present, suggest otherwise. Some of the drivers of the increase in retail investor trading activity, such as the impact of ‘lock-​ downs’ on investor behaviour and also increased savings levels, may be transitory, particularly given the 2022 change in monetary policy and, relatedly, higher returns being available from deposits. But others may prove structural, such as the impact of digitalization, in particular the emergence of low-​cost trading apps and the related ‘gamification’ of investment, and also increasing household interest in sustainable investments.47 The extent and nature of market participation varies across the EU. Household portfolios in some Member States can have significantly lower proportions of investment assets than the average EU portfolio, reflecting a range of structural features, including income levels, home ownership patterns, the incidence of taxation on different financial assets, and the availability and extent of state pensions.48 Similarly, wide variations persist in the relative popularity of different investment products across the Member States,49 reflecting, inter alia, investor preferences, industry structure, different product cost structures, and variability in investor risk aversion, trust, and financial literacy levels.50 There is little evidence

42 Bekhtiar, K, Fessler, P, and Lindner, P, Risky Assets in Europe and the US: Risk Vulnerability, Risk Aversion and Economic Environment, ECB WP No 2270 (2019). More than 70 per cent of surveyed households stated they were not willing to take any financial risks, as compared to below 40 per cent in the United States. 43 In 2018, a Commission study reported bleakly that ‘an average consumer is overwhelmed by the sheer complexity of, and uncertainty associated with, investment products even more so as the general familiarity with basic financial concepts and terminology is low across Europe. Consequently, most households do not invest at all or do so very infrequently across their lifetime: 2018 Commission Retail Distribution Report, n 39, 107. Similar findings were reported in the 2022 Disclosure, Inducements, and Suitability Study: n 29. 44 ESMA, TRV No 1 (2021) 32, reporting on an increased flow in equity and investment fund shares in the third quarter of 2020, but a drop in flows of debt securities. ESMA related the sharp drop in valuations and the surge in volatility in March 2020, as the pandemic deepened, in part to a large increase in share buying by retail investors. In France, purchases of blue-​chip shares by retail investors increased four-​fold in March 2020; Belgium saw retail investors in the 18–​35 year category making around ten times as many share purchases in the main Belgian index as compared to the same period prior to the pandemic; and Italy also reported on an upsurge in retail trading: at 34. 45 Arnold, M, ‘Europe’s Cautious Savers Catch on to Share-​dealing Craze’, Financial Times, 28 February 2021, reporting on a sharp increase in holdings of shares and investment funds in Germany, with the sharpest rise among those under thirty. 46 ESMA, TRV No 1 (2021) 33. 47 As reported in, eg, 2022 Disclosure, Inducements, and Suitability Study, n 29, 69 and Commission, European Financial Stability and Integration Review (SWD(2021) 113) 26–​7. 48 2021 Commission CMU Indicators Report, n 37, 39–​41. Similarly, reporting on higher levels of market investment in Nordic Member States as compared to France and Germany, Brière, M and Ramelli, S, Can Responsible Investing Encourage Retail Investors to Invest in Equities? ECMI Commentary March 2021. 49 ESMA, TRV No 1 (2021) 32. Currency and deposit holdings, eg, can range from 14 per cent of portfolios in Sweden to more than 60 per cent in Cyprus and Greece, while equity investments can range from around 40 per cent in the Baltic Member States to below 20 per cent in Croatia, Germany, and Ireland: ESMA, Performance and Costs of EU Retail Investment Products (2020) 8. 50 See 2022 Disclosure, Inducements, and Suitability Study, n 29, 69, Commission, CMU Mid Term Review Economic Analysis (SWD(2017) 22), and Rodriguez Palenzuela, D and Dees, S, Savings and Investment Behaviour in the Euro Area, ECB Occasional Paper Series No 167/​2016.

762  Retail Markets of cross-​border retail investor activity.51 A host of factors, including language, taxation, the home bias, savings and investment cultures and preferences, familiarity with local distribution structures (particularly the multi-​function banks (‘financial supermarkets’) which dominate in the EU), and industry costs have long militated against the development of a cross-​border retail market. The setting for EU retail market regulation is accordingly complex. The nascent nature of retail investment makes the delivery of investor protection challenging, while increasing the level of EU participation by using regulatory tools is not a straightforward task, given the range of factors that shape participation levels. The challenge is all the more significant given the market risk to which retail investors are exposed and the limited capacity of regulation to address this.52

IX.1.2.2 Distribution Patterns and Challenges Further regulatory design challenges flow from the structure of EU retail market distribution. Direct trading by retail investors is increasing, as noted above, albeit that it remains to be seen whether the upsurge associated with the Covid-​19 pandemic and the growth of trading apps will persist. For the most part, access to the financial markets by EU retail investors remains heavily intermediated through advice-​based distribution channels.53 These distribution channels vary across the EU, reflecting market structure and retail investor preferences, but are generally in the form of ‘closed architecture’ distribution structures, in the form of banking and insurance groups often distributing proprietary products, usually investment funds.54 Distribution in the form of ‘open architecture’ distribution of a wider range of products by ‘non-​independent’ advisers, typically paid by product commissions from product manufacturers, is less common.55 Distribution through independent advisers, distributing the market profile of products, is rarer again.56 Longstanding local dynamics, such as the familiarity of retail investors with local distribution arrangements and resistance to new arrangements, as well as cost structures, have driven these advice and distribution practices. So too have different savings patterns, with greater wealth associated with more complex investment needs and more sophisticated advice structures. This dominance of proprietary or commission-​based distribution structures brings with it particular regulatory challenges for EU retail market regulation and for the encouragement of wider retail investor participation. Principal-​agent risks can be acute in 51 2018 Commission Retail Distribution Report, n 39 and reflecting a consistent trend which can be dated back to one of the first major assessments (Commission, Financial Integration Monitor (SEC(2004) 559)). 52 On pandemic-​related losses see n 22. Retail market regulation does not typically address market risk (which is tied to returns) albeit that the precautionary turn the EU retail market rulebook has taken since the financial crisis can be associated with moderating market risk. See further Moloney, n 28. 53 2022 Disclosure, Inducements, and Suitability Study, n 29 and 2018 Commission Retail Distribution Report, n 39. The dependence on advice is a longstanding feature of the EU retail market: Decision Technology, Chater, N, Huck, S, Inderst, R, and Online Interactive Research, Consumer Decision-​Making in Retail Investment Services: A Behavioural Economics Perspective (2010). 54 2022 Disclosure, Inducements, and Suitability Study, n 29, 229–​35, 2020 ECMI Report, n 36, 17–​20, and 2018 Commission Retail Distribution Study (generally), n 39. 55 eg, 2022 Disclosure, Inducements, and Suitability Study, n 29. 56 The 2022 Disclosure, Inducements, and Suitability Study reported that investments (including equities sold through non-​advised, execution-​only channels) were typically distributed through banks and insurance companies; that, relatedly, non-​independent advice channels (including those funded by commission/​inducement payments and those operated by bank/​insurance group product manufacturers) were dominant in the distribution of retail investment products; and that independent investment advisers were the ‘exception,’ accounting for only a small and ‘not significant’ share of distribution: n 29, 70–​76 and 229–​36.

IX.1 Introduction  763 the distribution context generally, including as regards fraud, misuse of investor funds, and incompetence,57 while the behavioural weaknesses which bedevil retail investor decision-​ making may simply be replaced by adviser weaknesses, and not displaced.58 Overall, however, remuneration-​based conflict-​of-​interest risk poses the greatest threat to good investor outcomes and is the most significant driver of mis-​selling and poor-​quality advice.59 The well-​documented detriment which can follow includes biased advice, failure to provide debt reduction advice, poor product selection, inappropriate advice to switch products, and ultimately mis-​selling. Specifically, closed-​architecture distribution can be vulnerable to the deeply embedded conflict-​of-​interest risks associated with the distribution of proprietary products, whose sale may by driven by internal remuneration incentives or business model design, while open-​architecture, commission-​based product distribution can be vulnerable to advice being based on the value of commissions, not the investor’s best interests.60 The financial crisis highlighted the conflict-​of-​interest risks associated with distribution channels in the EU,61 particularly given the mis-​selling of complex, structured products it exposed.62 It also drew attention to the risks faced by retail investors where banks engaged in the ‘self-​placement’ of their capital instruments, to support their balance sheets, which risks were brought into sharp relief by the major mis-​selling scandal that erupted in Spain in relation to the mis-​selling by banks of complex, high-​risk preference shares (‘preferentes’) to retail investors.63 While a high-​profile example, it formed part of a wider pattern of mis-​ selling by banks, before and over the financial crisis, of high risk, subordinated capital instruments to retail investors through their proprietary networks.64 The 2014 Bank Recovery and Resolution Directive since imposed ‘know-​your-​client’ protections for retail investors as regards the distribution of ‘bail-​inable’ securities.65 But this reform, as well as the related 2018 warnings by EBA and ESMA that applicable investor protection requirements be followed in the distribution of such securities to retail investors,66 underlines the stickiness of 57 Odean, T, ‘Are Investors Reluctant to Realise Their Losses’ (1998) 53 J Fin 1775. 58 Langevoort D, ‘Selling Hope. Selling Risk. Some Lessons from Behavioural Economics about Stockbrokers and Sophisticated Investors’ (1996) 84 California LR 627. 59 eg, Inderst and Ottaviani, n 10. 60 While an extensive international policy and scholarly literature examines the risks associated with commission-​based distribution, the UK experience provides a leading example. Repeated cycles of mis-​selling in the UK led to the 2013 ‘Retail Distribution Review’ (RDR) reform, a massive exercise in regulatory reform which led to large-​scale structural industry change given the RDR’s prohibition on commission payments and the extensive ‘labelling’ it required as to the nature of the advice/​distribution service provided. On its rationale see FSA, A Review of Retail Distribution (2007) and for a recent review of its impact see FCA, Evaluation of the Impact of the Retail Distribution Review and the Financial Advice Market Review (2020). 61 Which had been examined in, eg, Synovate, Consumer Market Study on Advice within the Area of Retail Investment Services—​Final Report (2011). 62 Reviewed in CESR, The Lehman Brothers Default: An Assessment of the Market Impact (2009). A subsequent ESRB study found that retail structured products, of complex design, proved profitable to distributing banks, had a lower performance, and were more frequently sold by banks targeting low-​income households, suggesting that complexity was used strategically by banks: Célérier, C and Vallée, B, Catering to Investors through Product Complexity, ESRB WP No 16/​2016 (2016). Mis-​selling occurred on a global basis and led to the G20’s recommendation that conduct rules be reviewed to protect markets and customers: G20 Washington Summit, November 2008. In response, IOSCO adopted Suitability Requirements with Respect to the Distribution of Complex Financial Products (2013) and a Report on the Regulation of Retail Structured Products (2013). 63 For a review see Zunzunegui, F, Distribution of Preferred Shares Among Retail Clients (2019), available via . 64 See Ventoruzzo, M and Sandrelli G, ‘O Tell Me the Truth about Bail-​In: Theory and Practice’ (2020) 13 J Bus Entrepreneurship & L 187 and Tröger, T and Götz, M, Should the Marketing of Subordinated Debt be Restricted in One Way or the Other? Report for the European Parliament ECON Committee (2016). 65 Directive 2014/​59/​EU [2014] OJ L173/​190, as noted in section 4.8. 66 EBA and ESMA, Joint Statement (Treatment of Retail Holdings of Debt Financial Instruments subject to the BRRD), 30 May 2018.

764  Retail Markets mis-​selling risks. So too do the series of reports produced for the European Parliament over 2017–​2018 on instances of mis-​selling,67 and ESMA’s pathbreaking 2018 prohibition of the marketing of binary options to retail investors and restriction of contracts for difference (CfD) marketing to retail investors (section 4.12). Large-​scale reform to the management of conflict-​of-​interest risk in distribution followed under MiFID II,68 as outlined in section 4. The outcome of these reforms remains to be seen, although the CMU-​related Retail Investment Strategy process should bring some empirical heft to the longstanding debate on how best to address distribution in the EU. The challenges are considerable as regulatory reforms to distribution can lead to a contraction of distribution channels and so obstruct retail investor access to advice. The challenges are also evolving as technological innovation and digital distribution shape distribution processes, as discussed further in section 2.5.

IX.2  The Evolution of EU Retail Market Regulation IX.2.1  Initial Developments The EU’s embrace of retail market regulation is a relatively recent phenomenon. The seminal 1966 Segré Report did not address retail investor protection in any detail.69 The early phases of EU financial markets regulation (from the late 1970s) were concerned with market access by issuers. In the wake of the 1985 Commission White Paper on the Internal Market,70 and the arrival of minimum harmonization and mutual recognition, regulation came to embrace market intermediaries and collective investment schemes, and thus, if indirectly, the retail markets. The major measures of relevance to retail market protection were the now-​repealed 1985 Undertaking for Collective Investment in Transferable Securities (UCITS) Directive,71 the now-​ repealed 1993 Investment Services Directive (ISD),72 and the 1997 Investor Compensation Schemes Directive (ISCD).73 These measures were, however, primarily designed to support passporting. The ISD, for example, was designed to protect investors, but this assertion sat uneasily in a Directive which was primarily focused on the investment firm, the investment services passport, and achieving the minimum level of harmonization required to support home Member State control of cross-​border investment firm activity, and which did not establish robust minimum standards for conduct of business and marketing. The first significant moves towards a harmonized investor protection regime came in the late 1990s when supporting the confidence of retail investors in the single financial market acquired some traction as a means of promoting integration.74 Initial indications of 67 Over 2017–​2018 the European Parliament’s ECON Committee commissioned a series of reports on mis-​ selling in the retail markets (including Alexander, K, Marketing, Sale and Distribution. Mis-​selling of Financial Products (2018) and Conac, P-​H, Mis-​selling of Financial Products: Subordinated Debt and Self-​placement (2018)). 68 Directive 2014/​65/​EU [2014] OJ L173/​349. 69 Report by a Group of Experts Appointed by the EEC Commission, The Development of a European Capital Market (1966) (Segré Report). 70 Commission, Completing the Internal Market (COM(85) 310). 71 Directive 85/​611/​EC [1985] OJ L357/​3. 72 Directive 93/​22/​EEC [1993] OJ L141/​27. 73 Directive 97/​9/​EC [1997] OJ L84/​22. 74 Moloney, N, ‘Confidence and Competence: the Conundrum of EC Capital Markets Law’ (2004) 4 JCLS 1.

IX.2  The Evolution of EU Retail Market Regulation  765 a retail-​investor-​facing approach came in 1996 with the Green Paper on Financial Services Consumers75 which highlighted a number of retail market risks, including as regards aggressive marketing and poor disclosure. A separate development outside the financial market policy sphere, the adoption of the 2000 E Commerce Directive,76 sharpened the focus on the retail markets. The Directive anchored cross-​border online services (including online investment services) to the ‘Member State of origin’ (essentially the State of establishment), and removed the ability of host Member States to apply their protective rules to cross-​border online services (subject to an investor protection derogation), but did not engage in parallel rule harmonization. The subsequent 2001 Commission Communication on E Commerce and Financial Services called for further convergence of investor protection rules, including conduct-​of-​business rules, in order to address the risk that Member States would rely on the Directive’s derogations to the Member State of origin principle to protect investors and consumers and that online service delivery would be obstructed.77 An initial response came with the 2002 Distance Marketing of Financial Services Directive, which, still in force, addresses disclosure, marketing, contractual rights (including withdrawal rights), and redress in the distance marketing context, and which applies to a range of financial services, including investment services.78 Likely to be replaced and consolidated within the 2011 Consumer Rights Directive,79 it was the EU’s first sustained attempt to grapple with retail investor protection.

IX.2.2  The FSAP, the Pre Global Financial Crisis Period, and the Retail Markets Over the Financial Services Action Plan (FSAP)80 era (1999–​2004), and prior to the financial crisis, the EU regulatory agenda embraced retail market law and policy to a significantly greater extent, best exemplified by the 2004 MiFID I.81 This period also saw the development of summary disclosure techniques under the 2003 prospectus (summary prospectus) and 2009 UCITS (Key Investor Information Document (KIID)) regimes.82 Belated efforts were made to understand retail investor behaviour, with the publication of agenda-​setting reports on long-​term retail saving patterns and on retail market disclosures.83 This period 75 Commission, Green Paper on Financial Services. Meeting Consumers’ Expectations (COM(96) 209). 76 Directive 2000/​31/​EC [2000] OJ L178/​1. 77 Commission, Communication on E Commerce and Financial Services (COM(2001) 66). 78 Directive 2002/​65/​EC [2002] OJ L271/​16. 79 COM(2022) 204. Following the Directive’s review, and given the parallel protections now available in sectoral financial services measures and the horizontal protections available under measures such as GDPR (the General Data Protection Regulation (EU) 2016/​679 [2016] OJ L119/​1), the Commission has proposed that the Directive be repealed, and its financial services-​specific provisions (including in relation to pre-​contractual disclosures and withdrawal rights) be subsumed within the 2011 Consumer Rights Directive 2011/​83/​EU [2011] OJ L304/​64. The Commission has also proposed that these provisions be updated to reflect technological innovation, including by means of a requirement that firms do not use the structure, design, function, or manner of operation of their online interface in a way that could distort or impair consumers’ ability to make a free, autonomous, and informed decision or choice. 80 Commission, Communication on Implementing the Framework for Financial Markets Action Plan (COM (1999) 232) (FSAP). 81 Directive 2004/​39/​EC [2004] OJ L145/​1. 82 See Ch II section 4.9.8 and Ch III section 4.9.2. 83 Optem, Pre-​contractual Information for Financial Services. Qualitative Study in the 27 Member States (2008) and BME Consulting, The EU Market for Consumer Long-​Term Retail Savings Vehicles. Comparative Analysis of Products, Market Structure, Costs, Distribution Systems, and Consumer Savings Patterns (2007).

766  Retail Markets can also be strongly associated with a concern to promote stronger retail market participation,84 with the Commission placing MiFID I in the context of ‘investors turn[ing] to market-​based investments as a means of bolstering risk-​adjusted returns on savings and for provisioning for retirement’,85 and references to ‘investor confidence’ pervasive.86 This concern persisted into the financial-​crisis period. In its 2009 Communication on packaged products, for example, the Commission highlighted the need to rebuild investor confidence, arguing that ‘the foundations for future investor re-​engagement with packaged retail investment products will need to be laid; people will continue to need to save and invest’.87

IX.2.3  The Global Financial Crisis Over the financial crisis, household and individual savers across the EU sustained massive losses.88 Equities,89 bond investments,90 and collective investment schemes91 were all affected. The Commission estimated that assets invested in the most common retail packaged products fell in value from €10 trillion at the end of 2007 to around €8 trillion at the end of 2008.92 EU retail market regulation does not claim or seek to protect investors from market risk,93 but the financial crisis exposed weaknesses in the EU’s regulation of distribution and of disclosure, and the persistence of mis-​selling, despite the MiFID I reforms, as outlined in section 1.2.2. The first wave of financial-​crisis-​era reform was almost entirely concerned with financial stability and prudential regulation. The initial reform agenda contained only two retail market measures: the Commission’s 2009 Packaged Retail Investment Products Communication which reflected discussions that predated the crisis but which received impetus from the crisis (section 5.2); and a proposal for reform of the Investor Compensation

84 Evident also in repeated calls for stronger household financial literacy, savings levels, and ability to save for the long term. eg, 2798th Council Meeting, 8 May 2007, ECOFIN Press Release No 9171/​07, 10–​11 and European Parliament, Resolution on Improving Consumer Education and Awareness on Credit and Finance, 18 November 2008 (P6_​TA_​PROV(2008) 0539) paras A and B. 85 2002 MiFID I Proposal (COM (2002) 625) 3. 86 The wealth of policy and regulatory examples include the Commission’s Explanatory Memorandum to MiFID I which emphasized the need to support investor confidence in the wake of the dot-​com era scandals: 2002 MiFID I Proposal, n 85, 4. 87 Commission, Communication on Packaged Retail Investment Products (COM(2009) 204) 1 and 12. 88 The largest losses of value occurred in Greece (a drop of 76 per cent in the value of household financial assets) and Spain (a drop of 37 per cent): Commission, European Financial Stability and Integration Report 2011 (SWD (2012) 103) 100. 89 eg the market capitalization of European stock exchanges fell by €5.6 trillion in the twelve months prior to October 2008: Federation of European Securities Exchanges, Share Ownership Structure in Europe (2008) 5, noting ‘the loss of financial wealth has been massive’. 90 As the crisis heightened, reports emerged of issuers defaulting on or delaying meeting their redemption obligations: Davies, P and Wilson, J, ‘Deutsche Bank Faces Buyer Strike over Decision Not to Redeem Bond’, Financial Times, 19 December 2008. 91 Equity schemes, eg, shrank dramatically in 2008, reducing from €350 billion to €188 billion over 2008, and massive investor withdrawals took place in the first and third quarters of 2008: Johnson, S, ‘Hopes of Return to Calmer Times’, Financial Times Fund Management Supplement, 5 January 2009. The picture became significantly worse in the final quarter of 2008, with outflows reaching €142 billion, making that quarter the worst in the sector’s history: European Fund and Asset Management Association (EFAMA), Quarterly Statistical Release No 36 (2008) 2 and 5. 92 2009 Commission Packaged Retail Investment Products Communication, n 87, 1. 93 In the context of the financial-​crisis era see Moloney, N, ‘Regulating the Retail Markets: Law, Policy and the Financial Crisis’ in Cinnéide, C and Letsas, G (eds), Current Legal Problems 2009–​2010 (2010) 375.

IX.2  The Evolution of EU Retail Market Regulation  767 Schemes Directive which was driven by the stability-​oriented concern to reform the related Deposit Guarantee Directive (section 6.3). The position of retail stakeholders was shown to be insecure: most notably, the de Larosière Group, whose seminal 2009 Report constituted the major diagnostic assessment of why the EU rulebook failed to contain the financial crisis, consulted widely with the industry but failed to engage with any retail stakeholders.94 The financial-​crisis era would, however, lead to the adoption of a series of important retail market reforms.95 The regulation of distribution was tightened under the 2014 MiFID II, and also under the 2016 Insurance Distribution Directive which addressed insurance-​based investment products.96 Disclosure was enhanced under MiFID II, the 2010 Prospectus Directive (summary prospectus reforms),97 and the cross-​sector 2014 Packaged Retail and Insurance-​based Investment Products (PRIIPs) Regulation.98 Product governance (MiFID II) and intervention (MiFIR)99 became part of the retail market tool-​box. And the establishment of ESMA brought a new dynamic to retail market law and policy, with respect to rule-​ making but also with respect to supervisory convergence in the retail markets. The regime which emerged from this period and which, primarily in the form of MiFID II and the PRIIPs Regulation, constitutes the current retail rulebook, has a precautionary orientation. For example, the MiFID II restriction of execution-​only (non-​advised) sales to ‘non-​complex products’, and its requirement that product manufacturers ensure that products address the ‘needs, characteristics, and objectives’ of an identified ‘target market’, can be associated with a concern to limit complexity within the retail perimeter. Similarly, the standardized risk disclosures required of packaged investment products under the PRIIPs Regulation create regulatory incentives for firms to avoid constructing products with riskier profiles. Overall, the financial-​crisis-​era reforms, that continue to form the base architecture of the retail ‘rulebook’, imply a concern to use regulation to construct a more controlled investment space and to steer the retail investor towards optimal outcomes and not just to reduce the risks of market failure.100

IX.2.4  From the Global Financial Crisis to Capital Markets Union As the financial-​crisis period began to wane from 2014, there were few signs of any resiling from the then-​dominant precautionary and heavily harmonized approach to the retail market. Following the 2014 adoption of MiFID II and the PRIIPs Regulation, the regulatory focus turned to the development and adoption of the related administrative rulebooks (which were in place by 2018), a process which led to an intensification of the precautionary orientation of the legislative rulebook, with the administrative rules drilling into firms’ procedures and methodologies. 94 The High Level Group on Financial Supervision in the EU, Report (2009). The oversight generated a strong protest from the EU consumer stakeholder body, FIN-​USE: Letter to José Manuel Barosso Concerning User Representation in the de Larosière Group, 3 February 2010. 95 For discussion see the articles in the special edition of the EBOLR 13(2)(2012) on ‘Retail Financial Services After the Crisis—​Legal and Economic Perspectives.’ 96 Directive (EU) 2016/​97 [2016] OJ L26/​19. See further section 4.13. 97 Directive 2010/​73/​EU [2010] OJ L327/​1. See Ch II section 4.9.8. 98 Regulation (EU) No 1286/​2014 [2014] OJ L352/​1. 99 Regulation (EU) No 600/​2014 [2014] OJ L173/​84. 100 See further Moloney, n 28

768  Retail Markets There were, at the same time, moves to proactively facilitate, through regulation, access by retail investors to higher risk premia. Chief among the reforms here was the 2015 adoption of the European Long Term Investment Fund (ELTIF) Regulation, which was in part designed to facilitate retail investor access to an illiquidity premium for long-​term investments.101 But while the ELTIF Regulation leans to a facilitative, empowering form of retail market intervention, as it eases access by retail investors to riskier long-​term investment funds and allows them access to an illiquidity premium, it also has a strongly precautionary hue.102 The launch of the CMU agenda in 2015, however, saw the EU policy rhetoric become more assertive as regards retail market participation, albeit few specific reforms. The 2015 CMU Action Plan linked the CMU agenda to fostering retail investment, arguing that retail investors needed to save more to meet retirement needs.103 It placed considerable weight on the ability of market mechanisms to encourage retail investment, and on the competence of empowered investors, and suggested that restoring the trust of retail investors was primarily an industry responsibility, although regulation and supervisors could ‘help to establish the rules of the game’.104 But while the 2015 CMU Action Plan policy rhetoric had suggested something of a pivot away from the precautionary posture of the retail ‘rulebook’, in practice there were few indications of a destabilizing policy shift. In addition to committing the Commission to the adoption of a Green Paper on Retail Financial Services (this was adopted in 2015 and was followed by the March 2017 Consumer Financial Service Action Plan),105 and to examining the case for a European Personal Pension Product (the PEPP, adopted in 2019), the main retail market commitment under the 2015 CMU Action Plan was empirical. The Commission committed to a series of retail market reviews, which, inter alia, led to ESMA’s now annual survey of the performance and costs of retail investment products, which has shed sharp new light on the retail markets.106 Other CMU reforms, however, while oriented to the funding markets, have shaped how investor protection is delivered in the retail investment market, chief among them the 2020 Crowdfunding Regulation107 and the 2017 Prospectus Regulation,108 discussed in Chapter II. The Crowdfunding Regulation in particular can be associated with a precautionary approach. While it facilitates retail investor access to crowdfunding services and platforms, it extends beyond the disclosure requirements which typically dominate in the regulation of fund-​raising by issuers, deploying know-​your-​client requirements and related risk warnings as well as ‘cooling off ’ periods in service of retail investor protection.109 Subsequently, the 2020 CMU Action Plan returned to the theme of retail investor participation and had an empowerment orientation.110 But while finessing reforms to the pillar MiFID II/​MiFIR and PRIIPs Regulation measures may follow, there are few indications 101 Regulation (EU) 2015/​760 [2015] OJ L123/​98. 102 Extensive investor protection rules govern the ELTIF: see Ch III section 6.4 103 Commission, Action Plan on Building a Capital Markets Union (COM(2015) 468) 18. 104 n 103, 18. 105 Commission, Green Paper on Retail Financial Services. Better Products, More Choice and Greater Opportunities for Consumers and Businesses (COM(2015) 630) and Commission, Consumer Financial Services Action Plan: Better Products More Choice (COM(2017) 139). Both were primarily concerned with the consumer finance market, not with retail investment. 106 ESMA has produced, since 2019, an annual and extensive report on ‘Performance and Costs of EU Retail Investment Products’ which contains a wealth of data on retail investment funds and structured products. 107 Regulation (EU) 2020/​1503 [2020] OJ L347/​1. 108 Regulation (EU) 2017/​1129 [2017] OJ L168/​12. 109 See in outline Ch II section 11.2. 110 As noted in section 1.2.1.

IX.2  The Evolution of EU Retail Market Regulation  769 of large-​scale change. The CMU-​related Retail Investment Strategy review process should shed light, however, on the impact of the MiFID II/​PRIIPs ‘rulebook’ since its coming into force in 2018.111 It augurs well, accordingly, for future regulatory design, given the importance of data to effective retail market regulation.112 It remains to be seen whether the liberalization thread which can be identified in the wider, pandemic-​related 2020 Capital Markets Recovery Package reforms is an indicator of how the retail market rulebook will develop, or whether this thread reflects the funding pressures created by the pandemic and is not indicative of a wider shift in direction. The Package included, for example, a limited liberalization of the MIFID II product governance regime (section 11.3), in order to facilitate firms in accessing household capital.113 The direction of travel since the adoption of the 2020 CMU agenda, however, suggests a focus on finessing the retail rulebook in light of experience rather than on liberalization. ESMA’s increasingly pivotal role can also be expected to gear the regime towards technical fine-​tuning rather than liberalization.114 In this area, and as across the single rulebook, ESMA has come to wield material influence, not only through its support of the administrative rule-​making process and supervisory convergence, but also given the extent to which it is relied on by the Commission in the legislative reform process.115

IX.2.5  Retail Markets, Digital Finance, and Sustainable Finance The future shape of the retail rulebook is also likely to be influenced by parallel developments in the wider financial markets policy sphere, chief among them the digital finance and sustainable finance agendas. As regards digital finance and the ongoing digitalization of the investment process, so far there are few indications of major change. The MiFID II/​PRIIPs rulebook is designed to be technologically neutral and to be robust to innovation and, so far at least, there is little sign of appetite for adjusting these measures in response to technological innovation and the digitalization of distribution and disclosure. As outlined in section 4.3.2, robo-​advisers and trading apps, and the related use of artificial intelligence (AI) in firms’ operating systems, have drawn Commission and ESMA attention, but soft law and supervisory convergence appears to be the favoured response, rather than adjustment of the rulebook. Similarly, the use of digital techniques and social media platforms to communicate disclosures (including regulated disclosures), is drawing attention but, here again, the emphasis appears to be on 111 The Retail Investment Strategy process included the 2022 Disclosure, Inducements, and Suitability Study (n 29), as well as advice from ESMA (which undertook an extensive Call for Evidence in 2021 and reported to the Commission in 2022 (n 26)). Relatedly, the ESAs are increasingly drawing on and promoting the importance of behavioural evidence. The ESAs’ extensive 2022 advice to the Commission on reform of the PRIIPs Regulation, eg, called for behavioural testing of any proposed reforms: ESA Joint Committee, ESA Advice on the Review of the PRIIPs Regulation (2022). 112 Om the importance of metrics and data in the retail markets see Willis, L, ‘Performance-​Based Consumer Law’ (2018) 82 U Chi LR 1309. 113 The 2020 Capital Markets Recovery Package contained a series of reforms to pillar EU financial markets measures, including to the prospectus regime (Ch II section 4.9.5), to facilitate capital-​raising. For an overview of the combined proposals and their rationale see the Commission’s analysis of the reforms: n 32. 114 ESMA’s 2022 advice to the Commission on the Retail Investment Strategy, eg, called for greater standardization of the pre-​contractual disclosures provided under MiFID II: n 26, 8. 115 Evident in, eg, the Commission’s mandating of ESMA for advice on digital distribution and disclosure as part of the Retail Investment Strategy process (see ESMA’s 2022 advice at n 26).

770  Retail Markets using soft law to explain how core principles apply. The EU’s wider 2020 Digital Finance Strategy does not have immediate implications for the retail rulebook, although in the medium term it will likely lead to adjustments to how firms are regulated and how they engage with retail investors.116 Similarly, the earlier 2018 FinTech Action Plan117 which sought to enable innovation and to facilitate access to financial services without investor protection being compromised, did not lead to rulebook adjustments, being primarily focused on monitoring developments,118 including as regards the use of regulatory ‘sandboxes’ for fintech firms.119 Adjustments are likely to follow, but, overall, the retail rulebook as currently constituted can be expected to remain the spine of retail market protection in the EU.120 More substantial reform to the rulebook has come as regards sustainable finance. The 2018 Sustainable Finance Action Plan sought to channel household capital to the support of sustainable finance, and to respond to the growing retail market appetite for sustainable investments, but also to address the risks of ‘greenwashing’ or the misleading of investors as regards the sustainability profile of an investment. The Action Plan led to a nuancing of the MiFID II ‘know-​your-​client’ regime, to reflect the sustainability preferences of retail investors in the distribution/​advice context (section 4.8), and also to a finessing of the MiFID II product governance rules (section 4.11), to reflect sustainability considerations. Both these reforms are nested within the wider sustainable finance disclosure regime (which, inter alia, applies to investment firms providing investment advice and to providers of investment products) and the related taxonomy framework which frame the sustainable finance agenda.121

IX.3  The Retail Rulebook: Legislation, Administrative Rules, and Soft Law IX.3.1  The Retail Rulebook The legislative rulebook governing the EU retail market has as its core the 2014 MiFID II/​ MiFIR (distribution, disclosure, and product governance/​intervention; section 4), the 2014 116 COM(2020) 591. The Strategy is concerned with the wider digital setting for financial services, including as regards digital identities, potential adjustments to authorization and passporting for fintech firms, firms’ digital resilience, and crypto-​assets (see in outline Ch I section 7.3). In their joint response to the Strategy, the ESAs’ recommendations included review of disclosure to ensure its fitness for purpose (including when presented in an app or online form); complaints handling; and digital literacy: Joint ESA Response to Digital Finance Strategy Call for Evidence (2022). 117 Commission, FinTech Action Plan: For a more competitive and innovative European financial sector (COM(2018) 109). 118 The Action Plan called on the ESAs to map national authorization approaches for innovative fintech business models (and whether the opportunities for proportionate and flexible approaches provided for in EU financial legislation were being used), to adopt soft law as appropriate, and to advise the Commission where adaptations to EU financial law were needed. 119 The Action Plan acknowledged the unease in some quarters regarding regulatory sandboxes (which were pioneered by the UK FCA and allow qualifying fintech firms to provide services under a limited authorization), but committed the Commission to exploring their use further, including through best practice recommendations: at 9. 120 The Commission’s 2021 Consultation on the Retail Investment Strategy (n 26) raised a series of related issues, including as regards ‘open finance’ (the use by third parties of client disclosures to support distribution and product development (ie trading apps, robo-​advisers, and comparison websites) and advice relationships) and the dissemination of information on social media platforms. ESMA’s related technical advice was generally to monitor and use soft law, rather than to advise regulatory change: n 26. 121 Regulation (EU) 2019/​2088 [2019] OJ L317/​1 (Sustainable Finance Disclosure Regulation) and Regulation (EU) 2020/​852 [2020] OJ L198/​13 (Taxonomy Regulation). See in outline Ch I section 7.2.

IX.3  The Retail Rulebook   771 PRIIPs Regulation (summary disclosure; section 5), and the 1997 Investor Compensation Schemes Directive (1997) (ex-​post compensation; section 6). MiFID II/​MiFIR addresses the provision of investment services (including brokerage, investment advice, and discretionary asset management) in relation to ‘financial instruments’ by investment firms. It accordingly captures the distribution services typically associated with the retail markets and as regards a wide range of financial instruments, from shares and ‘plain vanilla’ bonds, to units in collective investment schemes, to a wide range of financial and commodity derivatives, including the contracts for difference (CfDs) associated with ESMA’s first use of its MiFIR product intervention powers in 2018.122 The MiFID II/​MiFIR regulatory scheme, which is based on a gateway authorization process and ongoing prudential and conduct rules (Chapter IV), is designed to protect retail investors in their engagement with investment firms. But within this scheme, the MiFID II/​MiFIR conduct rules that govern the distribution of financial instruments are of pivotal importance to the retail market. These cover the traditional territory of retail market protection, from rules governing fair treatment, to disclosure and marketing requirements, to rules governing the management of conflicts-​of-​interest and inducements, to ‘know-​your-​client’ obligations, as well as the more innovative requirements relating to product governance and intervention. MiFID II/​MiFIR has been amplified in immense detail, but three sets of administrative rules are pivotal to retail distribution: Delegated Regulation 2017/​565 (conduct generally), Delegated Directive 2017/​593 (inducements; product governance), and Delegated Regulation 2017/​567 (product intervention).123 Alongside, the 2014 PRIIPs Regulation, a disclosure measure, works in tandem with the MiFID II/​MiFIR distribution requirements by requiring standardized, short-​form disclosures for PRIIPs. PRIIPs form a class of investment products that is both narrower than that governed by MiFID II/​MiFIR (in that the PRIIPs class does not cover investments that are not wrapped or structured in some way, such as shares or ‘plain vanilla’ fixed interest bonds (which fall within MiFID II/​MiFIR)) but also wider (in that the PRIIPs class covers insurance-​based investment products (which fall outside MiFID II/​MiFIR)). The Regulation supports MiFID II/​MiFIR by imposing a cross-​asset summary disclosure requirement: its ‘key information document’ or KID requirement applies to all PRIIP investment products. The format and coverage of the KID has been amplified in granular detail, including as to relevant methodologies, by RTS 2017/​653.124 Finally, the ICSD requires that investor compensation schemes be available in every Member State to provide investors with minimum levels of redress in identified cases of failure. The weight of investor protection in the retail markets is carried by the MiFID II/​MiFIR and PRIIPs regimes, as the ICSD regime is a last resort measure, providing backstop support for retail investors. While they form the twin pillars of retail market distribution and disclosure regulation, the two measures do not operate in isolation. The EU’s prospectus

122 MiFID II ‘financial instruments’ are widely defined, covering, inter alia, transferable securities, money market instruments, units in collective investment undertakings and broadly based classes of financial and commodity derivatives, including contracts for differences (CfDs), while MiFID II ‘investment firms’ are natural or legal persons providing MiFID II services (which include reception and transmission of orders, order execution, portfolio management, and investment advice) in relation to MiFID II financial instruments. See Ch IV section 5. 123 Respectively, [2017] OJ L87/​1; [2017] OJ L87/​500; and OJ [2017] L87/​90. 124 [2017] OJ L100/​1.

772  Retail Markets regime (under the 2017 Prospectus Regulation)125 is not directly a retail market protection measure, being concerned with issuer disclosure in the primary markets, although it has been an incubator for retail market regulatory innovation in the form of the summary prospectus. It is, however, integrated into the PRIIPs disclosure and MiFID II distribution systems. Where an investment product falls within the PRIIPs Regulation and is also subject to the prospectus requirement, both regimes apply, albeit with calibrations.126 The MiFID II distribution regime similarly integrates the prospectus regime, with firms required to advise retail investors as to the availability of a prospectus, where relevant.127 Alongside, discrete regimes apply to collective investment management (which falls outside MiFID II/​MiFIR but within PRIIPs and which is subject to discrete regulation, as discussed in Chapter III), to insurance-​related investments (which fall outside MiFID II/​MiFIR but within PRIIPs (section 4.13)), and to consumer financial services contracts generally. MiFID II/​MiFIR and the PRIIPs Regulation remain, however, at the core of the retail market regime. They also act as template measures, shaping how related regimes are designed. In particular, the 2016 Insurance Distribution Directive draws on MiFID II’s design in addressing the distribution of insurance-​based investments. This effect extends beyond the retail investment markets. The innovative 2019 Pan European Pension Product (PEPP) Regulation,128 which is related to MiFID II/​MiFIR/​PRIIPs in that is designed to support household long-​term savings through the market, albeit through the vehicle of a pension product, draws on MiFID II devices for its distribution regime and on PRIIPs devices for its disclosure regime.129

IX.3.2  Silos and the Retail Markets The MiFID II/​MiFIR/​PRIIPs rulebook, while extensive, is not fully comprehensive or internally coherent. EU retail investors invest in, alongside ‘plain vanilla’ shares and (to a lesser extent) bonds, a wide range of substitutable packaged products, primarily investment funds but including structured products as well as insurance-​based investments, not all of which, and not all of the distributors of which, are covered by the MiFID II/​MiFIR/​ PRIIPs rulebook.130 The compartmentalized design of EU financial services law generally, a legacy feature that has deep historical, political, and market-​based roots131 and of

125 Regulation (EU) 2017/​1129 [2017] OJ L168/​12 (Ch II). 126 Ch II section 4.9.8. 127 Delegated Regulation 2017/​565 Art 48(3). 128 Regulation (EU) 2019/​1238 [2019] OJ L198/​1. 129 A specific distribution regime applies to PEPP distributors, including as regards advice, but it draws on MiFID II in some respects (including as regards fair treatment and product governance) and, where a distributor takes the form of a MiFID II investment firm, specified MiFID II requirements apply directly. In addition, a key investor document (KID) requirement applies, similar to that required under the PRIIPs regime: PEPP Regulation Arts 22–​40. 130 Funds are by far the largest asset class among retail investment products, as is regularly reported in ESMA’s annual reports on the performance and costs of retail investment products. ESMA’s 2022 report found that retail investor holdings in UCITS funds accounted for some €4 trillion of assets, far ahead of other funds (€400 billion) and structured retail products (€400 billion): 2022 ESMA Retail Investment Products Report, n 22. 131 It reflects, eg, the different tax treatment and distribution channels which have, over time, shaped how product markets have developed: Commission, Need for a Coherent Approach to Product Transparency and Distribution Requirements for ‘Substitute’ Retail Investment Products (2007).

IX.3  The Retail Rulebook   773 strong path-​dependent quality, has meant that for investment products which leak into the banking and insurance fields (notably structured deposits and insurance-​based investments), different regulatory treatment can apply, but other inconsistences, notably as regards collective investment schemes, can also arise. The removal of inconsistencies and gaps, and the related management of regulatory arbitrage, level playing field, and investor protection risks, has, however, and particularly since the financial-​crisis era, become a preoccupation of EU retail market regulation. The period immediately prior to the financial crisis, which saw an upsurge in the development of substitutable products, in particular structured investment products of varying insurance-​, deposit-​, and financial-​instrument-​based hues, saw EU policy attention turn to the investor protection and arbitrage risks posed by the segmentation of retail investor protection across different regulatory silos.132 The Commission’s related 2009 Packaged Products Communication was ambitious, suggesting that the ‘fragmented regulatory patchwork’ be replaced by a coherent, cross-​sector, horizontal ‘selling’ regime for packaged retail investment products generally, which would address conflict of interests, inducements, and conduct-​of-​business regulation.133 This omnibus approach was ultimately abandoned in favour of targeted reforms to MiFID I by MiFID II/​MiFIR, large-​scale reform of insurance distribution (then addressed by the since-​repealed Insurance Mediation Directive),134 and a new cross-​product short form disclosure regime for packaged investment products (the PRIIPs Regulation). Difficulties remains, however, particularly as regards collective investment schemes and insurance-​based investment products. As regards collective investment management, the challenges arise from the interaction between the EU’s collective investment management rulebook (which is based on the UCITS Directive and the Alternative Investment Fund Managers Directive (AIFMD) and the specialist regimes applicable to different funds, including the ELTIF regime);135 and the MiFID II/​PRIIPs distribution and disclosure system. UCITS and AIFMD collective investment managers do not come within MiFID II and so fall outside its distribution requirements; but the UCITS and AIFMD regimes do not impose MiFID II-​style requirements on the distribution by UCITS or AIFMD managers of fund units, although high-​ level marketing requirements apply in both cases, following reforms adopted in 2019.136 More articulated protections apply to the distribution of units by ELTIF collective investment managers, in the form of MiFID II-​style ‘know-​your-​client’ requirements, given the heightened risks associated with the ‘lock-​up’ of investments in the ELTIF structure, but they are an outlier in the collective investment management rulebook. Where fund units

132 See, eg, 2798th Council Meeting, 8 May 2007, ECOFIN Press Release No 9171/​07 (calling for a Commission review) and European Parliament, Resolution on Asset Management II, 13 December 2007 (P6_​TA-​PROV(2007) 0627 (2007)) (raising silo risks). Concern was also raised nationally. The Delmas Report (Delmas-​Marsalet, J, Report on the Marketing of Financial Products for the French Government (2005)), eg, highlighted the case of a French product provider who was able to avoid regulatory oversight of its complex and high-​risk investment product by repackaging a UCITS product as an identical structured product, within an insurance product issue, listed by a subsidiary in another Member State. 133 n 87. It followed a 2007 Call for Evidence and Feedback Document, a 2008 Industry Workshop, and a 2008 Open Hearing. 134 Directive 2002/​92/​EC [2003] OJ L9/​3. 135 Directive 2009/​65/​EC [2009] OJ L302/​32; Directive 2011/​61/​EU [2011] OJ L174/​1; and Regulation (EU) 2015/​760 [2015] OJ L123/​98. See Ch III. 136 Under the 2019 ‘Refit’ reforms. See Ch III.

774  Retail Markets are distributed by MiFID II firms, however, the full range of MiFID II conduct requirements apply. Different protections apply, accordingly, depending on whether fund units are distributed directly by the fund manager or indirectly through MiFID II firms. Similarly, the UCITS ‘eligible assets’ regime, a product-​oriented, portfolio shaping set of rules, applicable under the UCITS Directive and integral to the UCITS regulatory scheme, can be associated with retail market protection in that it is designed to manage UCITS risk levels, ensure redemption on demand, and protect the UCITS ‘brand’ (as a retail-​appropriate fund). It does not, however, require that the UCITS manager conduct a ‘target market’ analysis as to whether the fund meets the ‘needs, characteristics, and objectives’ of the relevant target market; but this requirement applies to MiFID II-​scope firms as regards the manufacture of financial instruments. Relatedly, while the MiFIR product intervention rules empower national competent authorities (NCAs) to prevent MiFID II firms from distributing the units of an investment fund, they do not apply to the collective investment manager of the relevant fund.137 Collective investment schemes do come within the PRIIPs regime, but the integration of UCITS funds within the PRIIPs regime proved difficult, given a lack of alignment between the earlier UCITS-​specific ‘key investor information document’ (KIID) and the subsequent cross-​sectoral PRIIPs KID. Insurance-​based investments have also posed silo risks. Although they are popular household investments in some Member States (particularly France), their distribution falls outside MiFID II because insurance-​based investments are not MiFID II financial instruments (they do fall within the PRIIPs regime, following difficult negotiations on its scope). After a series of reforms, the distribution rules applicable to insurance-​based investments have now become more closely but not entirely aligned with MiFID II. Prior to the adoption of MiFID II, the distribution of insurance-​based investments through intermediaries fell within the (since repealed) Insurance Mediation Directive (IMD) which did not expressly address the distinct risks posed by insurance-​based investment products. MiFID II made targeted revisions to the IMD in the form of additional MiFID II-​based disclosure and conflict-​of-​interest requirements being applied to the distribution of insurance-​related investments. This reform was subsequently overtaken by the adoption of the 2016 Insurance Distribution Directive (IDD),138 which applies more extensive, MiFID II-​like distribution requirements, including product governance requirements, to the distribution of insurance-​related investments.139 The Directive also applies additional requirements to the PRIIPs KID as regards insurance-​based investments. Alongside, the PRIIPs Regulation confers MiFIR-​like product intervention powers on insurance NCAs as well as on the European Insurance and Occupational Pensions Authority (EIOPA), and thereby closes the gap with MiFIR, as MiFIR’s product intervention regime does not apply to insurance-​based investment products. The MiFID II and IDD regimes are not seamless, however, particularly as regard the treatment of conflict-​of-​interest management/​inducements and disclosure

137 A gap that has been repeatedly highlighted by ESMA. See, eg, ESMA, Opinion, Impact of the Exclusion of Fund Management Companies from the Scope of the MiFIR Intervention Powers (2017). 138 Directive (EU) 2016/​97 [2016] OJ L26/​19. 139 The Directive acknowledges that insurance-​based investment products are often available as potential alternatives to or substitutes for MiFID II investment products, and seeks to impose ‘specific standards’ on such products to deliver consistent investor protection standards and avoid regulatory arbitrage risks: recital 65.

IX.3  The Retail Rulebook   775 requirements, although MiFID II financial instruments and IDD insurance-​based investments are broadly substitutable investment products.140 Structured deposits, which pay a return/​interest payment linked to the performance of the relevant underlying assets, were strongly associated with silo risks prior to the financial crisis as this product market expanded, but they have proved less problematic since following targeted reforms to their treatment by MiFID II. Structured deposits fall outside the scope of MiFID II as they are not MiFID II ‘financial instruments’, but investment firms and credit institutions when selling, or advising clients on, structured deposits,141 are, by means of the imposition of a distinct obligation, subject to the MiFID II conduct/​distribution regime (MiFID II Article 1(4)). Similarly, MiFIR confers product intervention powers on EBA (mapping the powers conferred on ESMA as regards MiFID II financial instruments). These different reforms have brought significantly greater coherence to what was, prior to the financial crisis, a partial, segmented, and silo-​based regime governing substitutable retail investment products. Further impetus for adjustments has come through ESMA142 and from cross-​European Supervisory Authority (ESA) cooperation.143 Nonetheless, inconsistencies remain, particularly as regards MiFID II/​IDD/​PRIIPs disclosure requirements,144 and as regards the treatment of commissions and inducements under MiFID II/​IDD.145 The regulatory setting is further complicated by the horizontal marketing and contracting protections that apply to consumer, and consumer financial services, contracts generally.146 The persistence and complexity of silo risks is clear from their inclusion in the 2020 CMU Action Plan, albeit primarily as regards disclosure reform.147 While further reform can be expected,148 differing and deep-​rooted market structure and related political economy

140 See in outline section 4.13 on the IDD regime. 141 A structured deposit is a deposit, fully repayable at maturity, on terms under which interest or a premium is paid (or will be at risk) according to a formula which may be based on, inter alia, benchmarks, financial instruments, commodities, or foreign exchange rates (or combinations thereof): MiFID II Art 4(1)(43). 142 For one of its earlier interventions in this regard, and as regards the treatment of collective investment managers, see ESMA, Response to the Commission Green Paper on Retail Financial Services (2016). 143 The three ESAs were jointly mandated to develop the administrative rules for the PRIIPs regime, eg, but have also coordinated more generally as regards the treatment of substitutable products. 144 Particularly as regards costs disclosure. These are in part linked to the product orientation of the PRIIPs regime and the wider scope of the IDD/​MiFID II regimes which also cover other costs, in particular as regards distribution services. 145 For extended analysis see Colaert, V, Busch, D, and Incalza, T (eds), European Financial Regulation. Levelling the Cross-​Sectoral Playing Field (2021), Colaert, V, ‘MiFID II in Relation to other Investor Protection Regulation: Picking up the Crumbs of a Piecemeal Approach’ in Busch, D and Ferrarini, G (eds), Regulation of the EU Financial Markets: MiFID II and MiFIR (2017), and Colaert, V, European Banking, Securities and Insurance Law: Cutting through Sectoral Silos’ (2015) 52 CMLRev 1579. 146 Respectively, Directive 2002/​65/​EC [2002] OJ L271/​16 (Distance Marketing of Financial Services Directive, currently subject to a proposal for repeal and consolidation within the 2011 Consumer Rights Directive, as noted in n 79); Directive 2005/​29/​EC [2005] OJ L149/​22 (Unfair Commercial Practices Directive); and Directive 93/​13/​ EC [1993] OJ L95/​29 (Unfair Contract Terms Directive). These measures were revised and enhanced, including as regards enforcement and also as regards protections relating to online contracts, by the 2019 Modernization Directive (Directive (EU) 2019/​2161[2019] OJ L328/​7). See further Duivenvoorde, B, ‘The Upcoming Changes to the Unfair Commercial Practices Directive’ (2019) 8 J of European Consumer and Market L 219. 147 2020 CMU Action Plan, n 28, 10–​11 relating limited retail participation in capital markets to inter alia limited comparability of investment products. 148 Ensuring greater consistency across the MiFID II/​IDD/​PRIIPs/​UCITS regimes, as well as in relation to the PEPP regime, was a concern of the Commission’s 2021 consultation on the Retail Investment Strategy. The related 2022 Disclosure, Inducements, and Suitability Study (n 29) was broadly positive as regards the degree of coherence achieved, although it identified inconsistencies as regards, eg, costs disclosures and the point at which disclosures were to be provided over the distribution process.

776  Retail Markets effects makes full coherence of regulatory treatment across the wide and expanding universe of retail investment products unlikely.

IX.3.3  ESMA and Supervisory Convergence The EU retail rulebook is supervised and enforced by NCAs, using the supervisory powers and enforcement tools specified under the relevant legislation.149 Of particular relevance to the retail markets are the related complaints management requirements imposed by MiFID II (ESMA monitors complaints data which can inform its supervisory convergence priorities)150 and by the PRIIPs Regulation.151 Private enforcement action is not common across the EU, in part given restrictions on class actions,152 but the PRIIPs Regulation has marked a significant way-​point in that it provides for a private cause of action for retail investors (section 5). The effectiveness of the rulebook accordingly depends heavily on NCA supervision and enforcement and, relatedly, on ESMA’s supervisory convergence activities. ESMA has materially thickened the retail rulebook through typically detailed and often heavily proceduralized soft law, including the Guidelines and Q&As that amplify MiFID II/​MiFIR and the PRIIPs Regulation. ESMA’s soft law ‘rulebook’ can be expected to expand in response to market conditions, in particular as regards digitalization in relation to which soft law is likely to carry the weight of the EU’s response. Soft law aside, ESMA has engaged in a raft of more operationally oriented supervisory convergence activities, including ‘Common Supervisory Actions’ which see NCAs undertake thematic reviews of aspects of the rulebook, ‘Supervisory Briefings’ to NCAs on key elements of the rulebook, and peer reviews, notably as regards the pivotal ‘suitability/​know-​your-​client’ MiFID II requirements (section 4). Alongside, ESMA has shown some appetite for acting as a quasi-​regulator, producing retail-​investor-​directed warnings.153 It has, further, engaged in extensive data-​gathering exercises which are materially extending the data-​set available on the retail markets.154 149 On the MiFID II supervisory and enforcement arrangements see Ch IV section 11. 150 ESMA reports on complaints data and trends in its bi-​annual TRVs. 151 eg, the administrative rules amplifying the MiFID II requirement that firms have in place procedures to ensure compliance (Art 16(3)) include requirements for the prompt handling of complaints (Delegated Regulation 2017/​565 Art 26). In addition, Member States must provide ‘efficient and effective’ extra-​judicial complaints and redress mechanisms for the settlement of consumer disputes (MiFID II Art 75), such as ombudsman-​type functions. 152 Della Negra, F, MiFID II and Private Law: Enforcing EU Conduct of Business Rules (2019). A harmonized class action system (representative actions for the protection of the collective interests of consumers) for EU consumers, which covers specified financial services regimes, including the EU’s distance marketing, UCITS/​AIFMD, PRIIPs and MiFID II regimes, was to be applied by Member States from June 2023: Directive (EU) 2020/​1828 [2020] OJ L409/​1. 153 It produced a series of warnings in relation to the meme-​stock episode, eg, including as regards the use of social media to make investment recommendations (October 2021), payment-​for-​order-​flow and zero-​commission brokers (July 2021), and trading in high volatility conditions (February 2021). While the impact of such warnings on investor behaviour is likely limited, they serve as a signal to the market more generally as to ESMA’s commitment to retail market protection. 154 These include its annual reports on the performance and costs of retail investment products; its half-​yearly Trends, Risks, and Vulnerabilities Reports (TRVs) which report on retail market sentiment and trading/​investment patterns; its annual reports on the alternative investment fund market which cover retail activity; its periodic reports (with the other ESAs) on automation in financial services; and its annual statistical reviews of the EU securities markets generally. In support of these reports, ESMA is developing specific ‘retail risk indicators’, reflecting its related mandate under ESMA Regulation (Regulation (EU) No 1095/​2010 [2010] OJ L331/​84, as amended by

IX.4  MiFID II/MiFIR and the Retail Markets  777 Perhaps most revealing as to its appetite for purposive engagement with the retail markets, ESMA has emerged as having an ambitious approach to direct intervention in the retail markets, using its MiFID II product intervention power in 2018, shortly after it came into force, despite the political and constitutional sensitivities (section 4.12). Given the scale of ESMA’s supervisory convergence and operational activities, the extent to which it has shaped the retail market administrative rulebook (as noted across this chapter), the Commission’s growing reliance on ESMA in developing legislative reforms,155 and the increasing expectation that it act as the EU’s ‘first responder’ in times of retail market turmoil,156 ESMA can reasonably be regarded as something of a steward of EU retail market policy.157 There are, however, risks here, including as regards any undue constraining of NCA discretion and experimentation in what are heterogeneous national retail markets; and also as regards legitimation, as retail market regulation is one of the most politically exposed aspects of the rulebook, given the costs it imposes, but also the political reaction which large-​scale episodes of retail detriment can generate.

IX.4  MiFID II/​MiFIR and the Retail Markets IX.4.1  Context and Coverage: Retail Distribution MiFID II/​MiFIR is the backbone of the EU’s retail investor protection system in that it sets out the conduct regulation framework which supports the protection of investors in the distribution of investment products by investment firms. This ‘distribution rulebook’, while in principle applicable to all firm/​investor (or client) relationships (albeit with carve-​outs for professional investors and not applicable to eligible counterparties),158 is primarily oriented to retail investors. Some of its rules are totemic and familiar to many systems of investor protection internationally—​such as the disclosure, know-​your-​client, and conflict-​of-​interest management rules. Others have a more distinctly EU colour—​such as the rules governing ‘independent investment advice’ and those applicable to product governance and product intervention. The rulebook covers the life-​cycle of product distribution: from upstream product development and governance (MiFID II Article 16(3) and Article 24(2), as amplified by Delegated Directive 2017/​ 593); to midstream marketing and disclosure (MiFID II Articles 24(3) and (4), as amplified by Delegated Regulation 2017/​565); to the downstream conduct of the firm/​client relationship, including know-​your-​client requirements and conflict-​of-​interest management (MiFID II Articles 24 and 25, as amplified by Delegated Regulation 2017/​565 and Delegated Directive 2017/​593); to, finally, the exceptional suspension or prohibition, by ESMA or

the 2019 ESA Reform Regulation (EU) 2019/​2175 [2019] OJ L334/​1)) Art 9: ESMA, TRV Analysis. Key Retail Risk Indicators for the Single Market (2022). 155 eg, its mandate to provide advice to the Commission on the Retail Investment Strategy which led to its 2022 advice on disclosure and digitalization matters: n 26. 156 eg, ESMA’s actions as regards the 2021 meme-​stock/​Gamestop episode, which included investor warnings as well as a European Parliament briefing. 157 See further Moloney, N, The Age of ESMA. Governing EU Financial Markets (2018) 233–​6. 158 Ch IV section 6.2.

778  Retail Markets NCAs, of product distribution (MiFIR Articles 40–​3, as amplified by Delegated Regulation 2017/​567). While the distribution rulebook is the focus of this discussion, it does not sit in isolation. Retail investor protection in the investment firm/​client relationship is also a function of the investment firm authorization process and of the organizational/​operational and prudential regulation of investment firms, discussed in Chapter IV, and of the specific rules governing the trading process, including order execution and best execution, discussed in Chapter VI. It is also supported by the wider universe of rules that apply to discrete investment products, chief among them the UCITS and AIFMD regimes for investment funds and the PRIIPs disclosure requirements for packaged products. Although a subset of the MiFID II/​MiFIR investment firm rulebook, the distribution rules, regarded as a whole, have distinct features which are a function of the retail market setting that has shaped their design. In particular, they have a strongly proceduralized, precautionary, and interventionist hue. The amplifying and highly granular administrative rules, in particular, form something of a compliance manual for firms, in the extent to which they proceduralize how the distribution rules apply in practice. Relatedly, the distribution rulebook constructs a retail investor protection design model of a distinctly precautionary hue, particularly as regards the distribution of complex products. These muscular qualities are also reflected in the rulebook’s interventionist quality, most obvious in its imposition of business-​model controls on independent investment advice (by means of a commission ban), but also seen in the product governance rules (which have a tilt towards encouraging the development of less complex products for retail distribution). These features have the effect of constructing a model of retail investor protection which is oriented more towards protection than to empowerment, albeit that empowerment remains a concern of the MiFID II regime. The distribution rulebook has also been the site of significant innovation, from the structural industry reform sought by the constraints on ‘independent investment advice’, to the novel product governance requirements, to ESMA’s exceptional and intrusive powers to suspend the distribution of products. The distribution rulebook represents, for now, the culmination of a long incubation period which can be traced back to the 1993 Investment Services Directive and which is outlined in the following section.

IX.4.2  Evolution IX.4.2.1 From the ISD to MiFID II The 1993 Investment Services Directive (ISD) was a landmark measure in the EU’s regulation of distribution in that it was the first EU measure to address conduct regulation. But it was a limited measure, containing only high-​level principles designed to inform how Member States regulated the conduct of investment firms, and disclosure, marketing, and incentive/​conflict-​of-​interest management were not addressed in any detail. Investment advice, for example, was not fully within the scope of the ISD, being treated as an ancillary service; stand-​alone advice firms were not covered. MiFID I brought major reforms. It included investment advice as a MiFID I service and imposed a new set of harmonized conduct requirements, including disclosure and conflict-​ of-​interest management rules, which were amplified by the MiFID I administrative rulebook. MiFID I also signalled a tilt towards more interventionist regulation. It embraced a

IX.4  MiFID II/MiFIR and the Retail Markets  779 ‘conduct-​shaping’ style of regulation, which emphasized the firm/​investor fiduciary relationship and which limited the extent to which disclosure and investor consent were used to deliver good outcomes. While disclosure was an important element of MiFID I (and remains so under MiFID II), MiFID I was designed to ‘reinforce the fiduciary duties of firms’ through the conduct-​of-​business regime.159 The subsequent MiFID II distribution/​conduct-​related reforms, which focused on the quality of advice and on conflict-​of-​interest risk, amounted to a further step-​change, heralding the more precautionary, proceduralized, and interventionist approach which would come to shape retail market regulation. The reforms formed part of the much wider MiFID reform exercise which was shaped by the financial crisis,160 but they also reflected growing concern, pre-​and over the financial crisis, at EU level and across the Member States, as to the persistence of mis-​selling and conflict-​of-​interest risk. The Commission’s 2011 MiFID II Proposal proposed three major reforms as regards distribution (aside from the product governance/​intervention reforms outlined in sections 4.11 and 4.12): bringing structured deposits in scope to address the arbitrage risks which the exclusion of these investment products had generated under MiFID I; confining further the execution-​only channel; and introducing a new category of ‘independent investment advice’, which would be subject to a prohibition on commission payments and to a requirement for such advice to relate to a cross-​market selection of financial instruments. This final and major reform, trailed by the Commission in the 2010 Commission MiFID I Review as being necessary given concerns as to the quality of advice,161 was based on the then-​emerging empirical evidence as to incentive and mis-​selling problems in the distribution market. A ban on all inducements and commission payments, across all open and closed distribution channels, was rejected on cost grounds.162 The Proposal’s treatment of independent investment advice generated contestation within and between the Council and the European Parliament, reflecting the very significant industry interests at stake. In the Council, although some Member States supported a more wide-​ranging commission/​incentive prohibition across all open and closed distribution channels (an approach also called for by leading consumer stakeholders163),164 most Member States did not (with France a leading member of this group), reflecting local distribution structures, and supported instead enhanced disclosure requirements as a means for addressing conflict-​of-​interest risk generally.165 The final Council agreement retained the Commission’s prohibition on commissions in independent investment advice, but additionally addressed remuneration structures more generally (in a version of what is now Article 24(10) on remuneration). Within the European Parliament, similar fault-​lines emerged. Some MEPs supported a general prohibition on all commission-​type/​incentive

159 Commission Working Document EC/​24/​2005, Explanatory Note to ESC/​23/​2005 (July 2005) 1. 160 See further Chs IV and V. 161 Commission, Consultation on the MiFID I Review (2010). 162 2011 MIFID II/​MiFIR Proposals IA (SEC(2011) 1226) 16. 163 Woolfe, J, ‘Widespread Belief MiFID II Set to Fail Retail Investors’, Financial Times Fund Management Supplement, 30 January 2012. 164 Notably the UK and the Netherlands: Sullivan, R, ‘European States at Odds over Commission’, Financial Times Fund Management Supplement, 18 July 2011. 165 Cyprus Presidency Progress Report on MiFID II/​MiFIR, 13 December 2012 (Council Document 16523/​12) 8 (but reporting that a smaller group of Member States ‘seems firmly committed to introducing a general ban on inducements’).

780  Retail Markets payments, but there was also support, as in the Council, for a disclosure-​based approach.166 After intense negotiations,167 the Parliament ultimately supported the proposed prohibition on commissions in independent investment advice and, like the Council, introduced rules governing remuneration structures, but also introduced rules on inducements generally—​ the latter reform has since (in the form of Article 24(9)) become pivotal to the treatment of inducements as well as of commission-​based ‘non-​independent’ advice. During the trilogue negotiations, the Council and Parliament enhancements relating to remuneration and inducements were retained, along with the new regime for independent investment advice, leading to the multi-​layered approach to commission and incentive risk across open and closed distribution networks now in place.

IX.4.2.2 From the Global Financial Crisis to Capital Markets Union The subsequent and extensive amplification of these requirements through administrative rules (which were adopted in 2017) proved less contentious.168 ESMA’s advice to the Commission on the proposed rules amplifying the MiFID II disclosure/​know-​your-​client obligations, for example, was largely uncontroversial with stakeholders, and accepted by the Commission, reflecting its basis in the earlier MiFID I administrative rules and previous CESR and ESMA soft law. Most stakeholder contestation related to the specification of the scope of the MiFID II Article 24(9) prohibition on inducements (inducements are prohibited by MiFID II unless they enhance the quality of the relevant service), given the potential of the prohibition to disrupt non-​independent (commission-​based) advice services.169 Institutionally, relations were generally smooth, with the Commission following ESMA’s advice in very large part.170 Since its coming into force in 2018, the distribution regime has been relatively stable, save as regards soft law. A thicket of soft law has developed, with the distribution rulebook proving something of a launchpad for different forms of ESMA soft law and supervisory convergence measure. A thick layer of further specification and proceduralization has been applied to the rulebook through detailed Guidelines (on the know-​ your-​ client appropriateness test and the execution-​ only rules (2022); the suitability test (2018); and product governance (2018));171 and by the MiFID II Investor Protection 166 Ferber Report on MiFID II (A7-​0306/​2012). 167 The final amendments as regards commissions/​inducements were reportedly added on the day of the plenary vote on the Parliament’s Negotiating Position: Malhère, M, ‘MiFID II-​MiFIR: EP Confirms Negotiating Mandate for Rapporteur’, EuroPolitics, 29 October 2012. 168 The main themes of the extensive consultations and of the ESMA/​Commission approaches can be tracked in ESMA’s omnibus advice to the Commission (Final Technical Advice, December 2014 (ESMA/​2014/​1569); the two sets of Commission IAs that grounded the subsequent delegated acts (SWD(2016) 157 and SWD(2016) 138); and the Commission’s explanatory memoranda to what would become Delegated Regulation 2017/​565 and Delegated Directive 2017/​593 (C(2016) 2398) and C(2016) 2031). 169 The ‘quality enhancement’ rules proved contentious, in particular as regards the extent to which the rules should have a negative orientation, imposing default prohibitions on inducements, or (the approach which prevailed) a positive orientation, specifying the conditions which, where met, would qualify an inducement as permissible. The Commission supported the latter approach, emphasizing that the rules were designed to facilitate non-​independent (commission-​based) advice services: SWD(2016) 157 25–​8. 170 By way of illustration, the Commission carried out a separate IA only as regards the rules governing the prohibition on inducements, given that ESMA’s approach to the other MiFID II administrative rules (including as regards know-​your-​client/​suitability, disclosure, and independent investment advice (as well as the product governance requirements)) was either based on earlier MiFID I rules, previous soft law, or international (IOSCO) standards, or largely uncontested. See, eg, SWD(2016) 138. 171 Less wide-​ranging and operational Guidelines apply to the determination of when complex debt instruments and structured deposits quality for execution-​only treatment as ‘non-​complex’ investments (2016). See further section 4.9.

IX.4  MiFID II/MiFIR and the Retail Markets  781 Q&A.172 Supervisory convergence has been further supported by ‘Supervisory Briefings’ for NCAs (on appropriateness (2019) and suitability (2018)).173 Alongside, the distribution rulebook has been a pathfinder for ESMA’s ‘Common Supervisory Action’, a practical, supervisory convergence tool that ESMA has developed and which involves an ESMA-​ coordinated review by NCAs of how the regulated sector has complied with particular EU rules. A series of CSAs have been carried out to date on the appropriateness rules (2019, the first CSA to be launched by ESMA), the suitability regime (2020), the product governance rules (launched 2021), and MiFID II costs and charges disclosures (launched 2022).174 These reviews typically produce granular evidence on how the rulebook operates in practice and on areas where further NCA convergence is needed, but they also drive adjustments to Guidelines and soft law, furthering thickening, if also refining, the soft rulebook.175 Regulatory reform of the distribution administrative rulebook has been limited, taking the form of the 2021 refinements to the know-​your-​client/​suitability rules (and product governance rules) to reflect sustainability factors and preferences.176 Legislative reform has likewise been limited, being confined to the 2021 ‘Quick Fix’ MiFID II reforms, part of the pandemic-​related 2020 Capital Markets Recovery Package.177 The Quick Fix reforms reinforced distribution protections in some respects,178 but they also brought some deregulation of the MiFID II product governance rules, to facilitate capital-​raising in support of the EU’s economic recovery: they lifted the product governance requirements, as regards their retail market application, from certain bonds (bonds with a ‘make-​whole’ clause and which do not have any other derivative components). While, as noted in section 4.11, this reform is limited, it nonetheless privileged capital formation. If the evolution of EU retail market protection can be seen as something of a tug between two poles—​the retail investor as empowered capital supplier and as vulnerable consumer—​the Quick Fix reform saw the regime shift towards the capital supplier pole. As regards future developments in relation to distribution regulation, the wider MiFID II/​MiFIR Review and the 2021 MiFID III/​MiFIR 2 Proposals which followed179 were primarily concerned with trading venues and order execution and did not address retail market risks, save as regards payment-​for-​order-​flow practices.180 Some indication of the future direction of travel can be drawn from the Commission’s 2020 Consultation on the MiFID II/​MiFIR Review process generally. It had a liberalization tilt in that it raised the prospect of a new tier of ‘semi-​professional’ investors which could opt-​out of certain protections, and of reform to the product governance regime; but it also had a more protective 172 ESMA, Q&A on MiFID II and MiFIR Investor Protection and Intermediaries Topics. The extensive Q&A includes the suitability and appropriateness rules, independent investment advice, inducements, product governance, product intervention, and disclosure (costs and charges). 173 Supervisory Briefings are designed as an ‘accessible’ introduction for NCAs and to provide a ‘useful starting point’ for areas of supervisory focus, as described in the 2019 Supervisory Briefing on appropriateness/​execution only. 174 For an example see ESMA, Public Statement (2020 CSA on MiFID II Suitability Requirements), 21 July 2021. 175 ESMA’s 2021 Guidelines on the appropriateness and execution-​only rules, eg, draw on the appropriateness CSA. 176 Respectively, Delegated Directive 2021/​1253 [2021] OJ L277/​1 and Delegated Directive 2021/​1269 [2021] OJ L277/​137. 177 Directive (EU) 2021/​338 [2021] OJ L68/​14 (Proposal at COM(2020) 280). 178 Providing that retail clients can choose to have MiFID II disclosures delivered in paper form, although the Quick Fix Reform otherwise makes electronic delivery the default. 179 MiFID III Proposal (COM(2021) 726) and MiFIR 2 Proposal (COM(2021) 727). 180 Section 4.9.2 and Ch VI section 2.2.

782  Retail Markets tilt in that it raised concern that the MiFID II inducements/​commissions regime had not proved sufficiently dissuasive and suggested that an outright ban on such payments in the distribution context might be warranted.181 ESMA’s related 2020 review of the MiFID II inducement regime did not call for any major reforms, but it echoed the 2020 Commission Consultation in suggesting that the impact of an outright ban on inducements as regards distribution be considered.182 At the time of writing, the CMU-​related Commission Retail Investment Strategy looked set to lead to some refinements.183 There is little evidence, however, of large-​scale reform following, and in particular of any material liberalization.

IX.4.3  Scope and the Impact of Technology IX.4.3.1  Scope The distribution rules are a subset of the MiFID II conduct regime and so their scope is that of MiFID II generally. As outlined in Chapter IV, MiFID II applies to specified ‘investment services’, provided with respect to a wide range of simple and complex ‘financial instruments’ the reach of which encompasses the shares, bonds, investment funds, and structured products which form the major asset classes in households’ investment assets portfolios.184 Structured deposits are outside the scope of MiFID II as they are not MiFID II financial instruments, but their distribution by investment firms and credit institutions is subject to specified MiFID II requirements, including its conduct requirements (Article 1(4)). MiFID II does not cover insurance-​based investment products; their distribution is governed by the 2016 IDD (section 4.13). MiFID II covers a wide range of ‘investment services’, including discretionary asset management services. Of most direct relevance to the retail markets, given the structure of distribution in the EU, is its coverage of brokerage (execution-​only) services, including, in a scope clarification added by MiFID II, execution services in the form of sales by credit institutions and investment firms of their own securities (or ‘self-​placement’ activities);185 and of investment advice. Investment advice is a gateway retail market service for MiFID II’s regulation of distribution as it triggers the application of the MiFID II distribution regime’s most onerous rules, particularly as regards the know-​your-​client/​suitability assessment. ‘Investment advice’ is defined as the provision of ‘personal recommendations’ to a client, either on its request or at the initiative of the investment firm, in respect of one or more transactions relating to financial instruments (Article 4(1)(4)).186 The personalization of 181 Commission, Public Consultation on the Review of the MiFID II/​MiFIR Regulatory Framework (2020). 182 ESMA, Final Report on the Impact of Inducements and Costs and Charges Disclosure Requirements under MiFID II (2020). 183 The related consultations and reviews were wide-​ranging, seeking, eg, evidence on the effectiveness of MiFID II’s disclosure, know-​your-​client, and conflict-​of-​interest/​inducements requirements, including as regards their resilience to digital delivery and disruption (see n 26). 184 MiFID II Art 4(1)(1) and (2) and Annex I sections A and C. On the scope of MiFID II see Ch IV section 5. 185 Under MiFID I, it was not clear whether sales by investment firms and credit institutions of securities issued by them came within the regulatory regime. Following a series of high-​profile mis-​selling scandals related to bank securities (notably in Spain), MiFID II clarified that the ‘execution of orders on behalf of clients’ includes the conclusion of agreements to sell financial instruments issued by a credit institution or an investment firm at the moment of issuance (Art 4(1)(5)). 186 The definition been amplified as regards ‘personal recommendation’ by Delegated Regulation 2017/​565 Art 9, which provides that such a recommendation is one made to a person in that person’s capacity as an investor or potential investor, presented as suitable for that person or based on a consideration of the circumstances of that person, and constituting a recommendation to: (a) to buy, sell, subscribe for, exchange, redeem, hold, or

IX.4  MiFID II/MiFIR and the Retail Markets  783 the advice to the client’s personal situation, and the specificity of the advice given, are central to its regulatory characterization as regulated ‘investment advice’.

IX.4.3.2 Technological Innovation A necessarily brief excursus is warranted into the resilience of the design of the scope of MiFID II in light of the burgeoning retail market technological innovation that is preoccupying regulators globally.187 Two of the totemic examples are ‘robo-​advisers’, automated systems which use algorithms to process individual investor profiles, to deliver personalized investment recommendations, and to support portfolio allocation; and trading apps, which support online trading. Robo-​advisers offer low-​cost access to investment advice and can facilitate investor access to a wider range of investment products. Their algorithms require careful design and oversight, however, in particular as regards how investor data is integrated and assessed and as regards how conflict-​of-​interest risks are managed.188 Trading apps can facilitate direct access to investments by low-​cost digital means, while their ‘gamification’ features have been associated with the democratization of financial markets.189 They have, however, been associated with increased conflict-​of-​interest risks, particularly where ‘zero-​commission’ trading apps are funded through payment-​for-​order-​flow arrangements; while gamification has been associated with a ratcheting of incentives to engage in levels of trading which are detrimental to returns.190 Relatedly, digitalization is driving innovation in how disclosures are designed and in social-​media-​based marketing practices, and can support better outcomes for investors by, for example, injecting competence and suitability checks and related ‘nudges’ into the decision-​making setting; it is also, however, generating disclosure-​ related risks, including as regards the sufficiency of retail investor comprehension of the risks of market investment, in particular as digitalization can reduce frictions which might otherwise slow and so enhance decision-​making. 191 At present, levels of automation and digitalization in investment services are relatively low in the EU, particularly as regards robo-​advisers,192 although the potential for digitalization to transform how disclosure is delivered is significant. underwrite a particular financial instrument; or (b) to exercise, or not to exercise, any right conferred by a particular financial instrument to buy, sell, subscribe for, exchange, or redeem a financial instrument. A recommendation is not a personal recommendation if it is issued exclusively to the public. 187 Well exemplified by IOSCO’s 2022 review: IOSCO, Report on Retail Distribution and Digitalisation (2022). 188 An empirical review by Better Finance, an EU retail market stakeholder body, found that while robo-​advice platforms offered retail investors lower fees, increased accessibility to products, speed, and commission-​free advice, they could display weaknesses in how know-​your-​client/​suitability assessments were carried out: Better Finance, Robo-​Advice, A Look under the Hood 2.0 (2019). See also Maude, P, Study on Robo-​Advisers for the European Parliament ECON Committee (2021) and Baker, T and Dellaert, B, ‘Regulating Robo Advice Across the Financial Services Industry (2018) 103 Iowa LR 713. 189 Such as congratulatory visuals when a trade is executed. On the rise of gamification, the risks it poses, and in favour of the application of traditional financial regulation tools see Tierney, J, ‘Investment Games’ (2022–​2023) 72 Duke LJ 353 and Langvardt, K and Tierney, J, ‘On “Confetti Regulation”: The Wrong Way to Regulate Gamified Investment’ (2021) 131 Yale LJ Forum 717. 190 See section 4.9 on the regulation of trading. 191 While digitalization promises much in terms of the accessibility and comprehensibility of disclosure, it generates risks, including as regards gamification and the related removal of productive frictions to investment; confusion and conflict-​of-​interest risks where social media influencers are used to market investments; data security; the retrievability of data; and a dulling of the impact of risk warnings: 2022 ESMA Retail Market Commission Advice, n 26, 23–​45. 192 In its 2022 advice to the Commission on digital distribution, ESMA reported on market evidence that robo-​ advisers had not taken off in the EU: 2022 ESMA Retail Market Commission Advice, n 26, 46–​9. Earlier, the ESAs

784  Retail Markets MiFID II (like the single rulebook generally) is designed to be technology-​neutral; its rules apply regardless of the investment service delivery mode and so of whether the investment service is provided in person, online, or through automated technology that incorporates AI.193 So far, it seems relatively robust to technological change,194 albeit that major pressure has yet to be exerted. As regards trading apps, for example, the matrix of MiFID II rules that apply to trading appeared reasonably resilient in the face of the 2021 meme-​stock episode, at least as regards core conduct protections. Reform here is likely to be primarily in the form of a prohibition on payment-​for-​order-​flow practices, a reform which is technology neutral.195 Robo-​advisers, where they come within the MiFID II definition of ‘investment advice’, which requires a personalized recommendation, are similarly subject to MiFID II, including as regards the design of their algorithms.196 It may not be clear, however, when MiFID II applies: the boundary at which an AI-​based system crosses over from guiding and informing an investor, to providing a personalized recommendation, is fuzzy, generating liability risks for firms and exposing retail investors to the risk that MiFID II advice protections are not applied.197 Similarly, disclosures, however delivered, are subject to the foundational MiFID II requirement that they be ‘fair, clear and not misleading’, albeit that digital delivery generates distinct risks. Current indications suggest that any finessing of the MiFID II rulebook in response to technological innovation is likely to draw on ESMA’s technocratic capacity, and to be in the form of explanatory soft law, for NCAs and for market participants, which has a practical orientation. The implications of technological innovation and digitalization, including as regards disclosure, social-​media-​based marketing, digital distribution, and online trading, featured strongly in the Commission’s 2021 Retail Investment Strategy consultation, but ESMA’s related advice to the Commission was to use soft law to clarify how the relevant MiFID II rules apply.198 This approach is not novel: ESMA’s supervisory convergence had similarly reported on low levels of robo-​advice: ESA Joint Committee, Report on the Results of the Monitoring Exercise on ‘Automation in Financial Advice’ (2018). The evolution of robo-​advice in the EU is monitored by the consumer stakeholder body, Better Finance, which has also found slow growth in the sector. Its fifth (2020) review found that while robo-​advisers represented some €615 billion of assets under management in the US, that fell to €95 billion in the EU. The market was most developed in Italy, followed by France and Germany: Better Finance, Robo-​Advice 5.0. Can Consumers Trust Robots (2020). 193 Although there are isolated examples of a targeted approach, including as regards the regulation of algorithmic trading (Ch VI section 2.3). 194 For a supportive industry view see, eg, European Banking Federation, Response to ESMA’s Call for Evidence on Retail Investor Protection, 16 December 2021, suggesting that a technology-​neutral approach to, eg, the MiFID II know-​your-​client rules was appropriate and that any frictions on the development of online services were more a function of demand-​side factors, such as taxation and investor familiarity. 195 Section 4.9.2 and Ch VI section 2.2. 196 As is underlined by Delegated Regulation 2017/​565 which provides, as regards the MiFID II know-​your-​ client suitability requirement, that where investment advice or portfolio management services are provided through automated systems, responsibility for the suitability assessment lies with the firm: Art 54. Better Finance has reported, based on its field data, that discrepancies can be observed between investor profiles and proposed portfolio allocations, which could be related to weaknesses in the design of the questionnaires used to elicit investor information and/​or the advice algorithms: 2020 Better Finance Robo-​Advice Review, n 192. 197 For an assessment of how MiFID II applies to robo-​advisers and calling for additional guidance for firms see Maume, P, ‘Reducing Legal Uncertainty and Regulatory Arbitrage for Robo-​Advice’ (2019) 16 ECFR 622. 198 As part of its Retail Investment Strategy process, the Commission mandated ESMA to provide advice on digital distribution, including robo-​advisers and social-​media-​based marketing, and on the digitalization of disclosures. ESMA concluded, after a call for evidence, that, given market conditions, there was no need for regulatory reform as regards robo-​advisers, but committed to monitoring the sector. As regards digital disclosures, and including social media marketing devices, ESMA adopted a similar approach, urging reliance on the core MiFID II requirement that disclosures be ‘fair, clear, and not misleading’ and on soft law to provide clarification on digital innovations as required: 2022 ESMA Retail Market Commission Advice, n 26. More generally, the 2020 Digital

IX.4  MiFID II/MiFIR and the Retail Markets  785 measures have already provided a means for explaining how core rules apply to particular innovative delivery modes and for alerting retail investors to the risks,199 while the ESAs together are already providing the EU with significant technocratic capacity to monitor technological developments and the emergence of any regulatory gaps.200 It augurs well, however, given that nuanced and tailored supervision and enforcement has been identified as key to the regulatory response to digitalization.201 If this approach prevails, the risk of the MiFID II rulebook becoming prejudicially atomized and unstable in response to technological change should be minimized, although much depends on the efficacy of NCA supervision and enforcement and on ESMA’s technocratic capacity—​as well as on secure legitimation of ESMA action, particularly if digitalization comes to fulfill its transformative capacity.

IX.4.4  Segmentation and Classification Segmentation strategies, usually based on classifying investors and also investment products, are frequently deployed in retail market regulation. They typically place restrictions on how and which investment products are marketed to retail investors and on the related distribution channels; more radical segmentation strategies might engage with, for example, investor testing.202 Segmentation allows regulators to target regulation, to mitigate the costs of regulation, and to construct regulatory spaces, limited to specified categories of investor, within which innovations can be developed.203 But segmentation can be a problematic regulatory device. For example, segmentation can be associated with troublesome regulatory determinations, based on incomplete proxies, that certain products or markets are ‘too risky’ for direct retail market access, or as to the design of ‘appropriate’ retail market products, and with complex trade-​offs between access/​choice and protection. The line between ‘safer’ and ‘too risky’ investment products is a difficult one to draw and, once drawn, the perimeter within which ‘safer’ retail market products are contained can be porous and allow ‘excessive’ risk to flow to the retail market. Conversely, segmentation may place undue restrictions and costs on the retail market and limit returns. Segmentation may also underestimate the monitoring discipline which can come through institutional investor monitoring of traditionally riskier investments and

Finance Strategy commits the Commission, in conjunction with the ESAs, to ensuring clarity on supervisory expectations as regards the use of AI by 2024: n 116, 11. 199 ESMA’s 2018 Guidelines on the MiFID II suitability requirements cover how the rules apply in the context of robo-​advice. ESMA also regularly issues warnings on the risks associated with technological innovation, including as regards the meme-​stock phenomenon (see n 279 below). 200 The ESA Joint Committee, eg, reviewed the development of robo-​advice systems in 2015, 2016, and 2018, with its 2018 report concluding that no specific regulatory responses were required: n 192. 201 IOSCO’s 2022 review, eg, was oriented towards oversight of firms’ processes and internal controls and effective supervision and enforcement, rather than to the recasting of regulation. 202 Of historical interest, an early draft of a Commission MiFID I administrative rule proposed an investor aptitude test designed to ‘explore a more effective and targeted solution’, and would have allowed relevant investors to choose to opt-​out of aspects of the disclosure regime: ESC/​23/​2005 Art 9 and July 2005 Explanatory Note (ESC/​24/​ 2005) 2. 203 eg Zingales, L, A Capitalism for the People. Recapturing the Lost Genius of American Prosperity (2012) 231–​2.

786  Retail Markets from which retail investors can benefit.204 Segmentation accordingly demands nuanced regulatory design. Segmentation is a marked feature of the EU’s approach to retail market regulatory design and particularly of MiFID II. Only specified classes of investment products (generally ‘non-​ complex’ products) can be distributed to retail investors through execution-​only channels (section 4.9), for example, while the MiFID II product governance and intervention regimes imply an investor protection model oriented towards less complex products being distributed in the retail markets (sections 4.11 and 4.12). Alongside, and framing MiFID II generally, a client classification system applies which is designed to target how MiFID II applies to different classes of investor. The MiFID II client classification system (MiFID II Annex II) is, broadly, based on distinguishing between retail investors (or clients) and professional investors (or clients). Its function is to calibrate the application of MiFID II’s conduct-​of-​business protections, based on whether or not the investor is a ‘retail client’:205 services provided to retail clients are subject to the full range of legislative and administrative requirements, but their application to ‘professional clients’ and ‘eligible counterparties’ is tailored.206 Persons, including ‘private individual investors’, can seek to ‘opt-​in’ to professional client status and thereby waive some of the conduct-​of-​business protections, being in effect treated as professional clients (‘opt-​in professional clients’) by the relevant investment firm. A procedural filter applies in that any such waiver is only valid where an adequate assessment by the firm of the expertise, experience, and knowledge of the client gives reasonable assurance, in light of the transactions or services envisaged, that the client is capable of making investment decisions and of understanding the risks involved; the assessment includes minimum experience and asset tests.207 Consent, notification, and risk warning requirements apply, and firms are required to have in place procedures governing client classification.208 While the classification regime allows retail clients to progress to professional client status, and thereby supports investor autonomy, the stringency of the conditions suggests that the liability risks faced by firms, where they assess a client as qualified to change status, are significant.209 The classification system has, accordingly, a strongly precautionary hue. The retail perimeter set by the MiFID II classification system has proved a challenge to fix in a reliable way. A feature of conduct regulation since MiFID I, it tends to expand and 204 Mahoney, P, ‘The Development of Securities Law in the United States’ (2009) 47 J of Accounting Research 325. 205 Defined by default as a client who is not a professional client: MiFID II Art 4(1)(11). Very broadly, professional clients are regulated financial institutions, various forms of public body, and larger firms (in excess of €40 million balance sheet, €40 million turnover, and €2 million own funds): Art 4(1)(10) and Annex II. 206 On the definitions of, and calibrations for, ‘professional clients’ and ‘eligible counterparties’ see Ch IV section 6.2. 207 The waiver assessment includes the requirement that two of three conditions be met: the client has carried out transactions, in a significant size, on the relevant market at an average frequency of ten per quarter over the previous four quarters; the client’s financial instrument portfolio (including cash deposits and financial instruments) exceeds €500,000; and the client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged: MiFID II, Annex II, section II.1. 208 The client must state in writing that professional status is sought (whether generally or in respect of a particular service or transaction), be given a clear warning by the firm of the protections and compensation rights that may be lost, and state in writing that it is aware of the consequences of the change in status: MiFID II, Annex II, section II.2. Firms must take ‘all reasonable steps’ to ensure the client meets the requirements: section II.1. 209 Albeit that, in response to the restrictions imposed by ESMA and NCAs on the marketing of CfDs to retail investors over 2018–​2019, evidence emerged of an increase in the volumes of retail investors transferring to professional client status, as well as of the inducement by firms marketing CfDs, in contravention of MiFID II, of retail investors to switch status to avoid the restrictions: section 4.12.

IX.4  MiFID II/MiFIR and the Retail Markets  787 contract with prevailing political and market conditions. The financial-​crisis era led to a more restrictive definition of a professional client/​investor, for example, following evidence that local authorities, previously in the professional classification but now removed, had been exposed to high levels of detriment from investments in more risky products. By contrast, the CMU agenda has created some momentum for a new hybrid classification, in the form of a ‘semi-​professional’ investor classification, which would facilitate retail investors seeking exposure to investments with a higher risk premium.210 In the absence of compelling evidence of material distortions by the classification system to retail investor choice, the design challenge associated with any such reform may be significant. In particular, the more finely the classification system is segmented, the greater the procedural costs for firms, the supervisory challenges for NCAs, and the risks of classification becoming a tool for facilitating mis-​selling.211

IX.4.5  Fair Treatment The MiFID II fair treatment obligation (Article 24(1)) applies to retail and to professional clients (and a version applies to transactions between eligible counterparties under Article 30), but it is of signal importance to the protection of retail investors. Based on the precursor MiFID I Article 19(1) (the adoption of which, at the time, marked a significant shift towards a more interventionist approach and away from disclosure), Article 24(1) imposes a foundational, fiduciary-​style obligation on investment firms to act fairly in the client’s best interests: a firm, when providing investment services to clients, must act honestly, fairly, and professionally in accordance with the best interests of its clients, and comply with the Article 24 and 25 conduct-​of-​business requirements. This provision is not (unusually) further amplified by administrative rules.212 It represents one of the few high-​level principles governing the firm/​client relationship in an otherwise heavily proceduralized and specified conduct-​of-​business/​distribution regime. Its inchoate nature carries risks, including with respect to diverging NCA supervisory approaches and ex-​post enforcement action.213 Nonetheless, as a default, flexible, catch-​all mechanism for deterring abusive behaviour and for grounding enforcement action, it can be regarded as a backstop to the entire conduct-​of-​ business/​distribution regime. It also protects the MiFID II regulatory scheme from obsolescence: the fair treatment principle was, for example, highlighted as forming part of the EU’s response to the payment-​for-​order-​flow risks associated with the meme-​stock episode.214

210 The later phases of the CMU agenda saw some political support for such a change: Council of the EU, Conclusions on the Deepening of the Capital Markets Union, 5 December 2019 (Council Document 14815/​19) 10 and German Ministry of Finance, Necessary Amendments and Revisions to Investor Protection Provisions in MiFID and PRIIP (2019). A change to the classification system was also mooted in the Commission’s 2020 MiFID Consultation (n 181) and in its 2021 Retail Investment Strategy Consultation (n 26). 211 ESMA proved cautious about any such reform, with ESMA Chair Maijoor calling for a ‘careful assessment’ and warning that any change could increase complexity and risk undermining appropriate levels of protection: ESMA Chair Maijoor, Speech, 15 October 2020. 212 And has not been addressed directly by the MiFID II Investor Protection Q&A or other soft measures. 213 Ex-​post fairness assessments may become an occasion for value judgments on the investment process: Park J, ‘The Competing Paradigms of Securities Regulation’ (2007) 57 Duke LJ 625. 214 ESMA warned that any firm in receipt of payment-​for-​order-​flow must ‘rigorously assess’ whether they were able to comply with Art 24(1): ESMA, Public Statement (Zero Commission Brokers), 13 July 2021.

788  Retail Markets The fair treatment obligation is supported by two additional obligations which, concerned with the appropriate targeting of services, exemplify the more precautionary posture MiFID II adopted to retail market regulation. Reflecting the injection of product governance requirements into the MiFID II investor protection scheme, investment firms which manufacture financial instruments for sale to clients must ensure those instruments are designed to meet the needs of an identified target market of end clients within the relevant category of clients, that the strategy for the distribution of those instruments is compatible with the identified target market, and that the firm takes reasonable steps to ensure the instruments are distributed to the identified target market (Article 24(2)) (see section 4.11). In addition, the investment firm must understand the financial instruments it offers or recommends, assess the compatibility of the financial instruments with the needs of the clients to which it provides investment services (taking into account the identified target market), and ensure that financial instruments are only offered or recommended when this is in the interests of the client (Article 24(2)). While a related and more detailed know-​ your-​client/​suitability/​appropriateness assessment applies in relation to particular types of investment service (section 4.8), this obligation has the effect of imposing an overarching obligation on firms to consider clients’ interests when distributing products through any distribution channel.

IX.4.6  Marketing Communications Marketing communications typically represent the first stage in the investment process, carry disproportionate impact, and are a key risk point for retail investors who are typically ill-​equipped to decode marketing strategies and are trusting of firm communications. While marketing risks have long attended retail market investment, the nature and intensity of these risks change. The recent ‘gamification’ of trading and of related marketing has been associated with heightened investor protection risks,215 as has the use of social media, including ‘influencers’, to market investments.216 Whatever the delivery mechanism, the evidence suggests that retail investors tend to over-​rely on ‘simpler’ marketing disclosures, where product disclosures are complex, and can also over-​react to how marketing frames the investment decision, particularly as marketing communications tend to accentuate opportunities rather than risks.217 Retail investor protection against marketing risks is largely a function of MiFID II, albeit that ancillary protections (including a cooling-​off period) apply under the 2002 Distance Marketing of Financial Services Directive.218 MiFID II addresses marketing risks through 215 Among the many assessments see, eg, Britainthinks, Study for the FCA. Understanding Self-​Directed Investors (2021). 216 As recently examined by ESMA: 2022 ESMA Retail Market Commission Advice, n 26, 33–​7. 217 For a behavioural analysis of the MiFID II requirements, calling for a behaviourally informed approach to their supervision, see Brenncke, M, ‘The Legal Framework for Financial Advertising: Curbing Behavioural Exploitation’ (2018) 19 EBOLR 853. 218 The Directive, which applies to consumer financial services (including investment services), imposes a 14-​ day withdrawal right (not applicable to financial services where the price depends on fluctuations in the financial market outside the supplier’s control, which may occur during the withdrawal period, including services relating to transferable securities and units in collective investment schemes): Art 6. The Directive is likely to be repealed and its provisions, including as regards withdrawal rights, subsumed within the 2011 Consumer Rights Directive and enhanced to reflect online delivery (n 79).

IX.4  MiFID II/MiFIR and the Retail Markets  789 an over-​arching, conduct-​shaping rule which requires that all information, including ‘marketing communications’ (which is not defined), addressed by a firm to (potential) clients must be, in the totemic formula, ‘fair, clear, and not misleading’. This principle governs all communications between the firm and the investor, but has particular significance for marketing communications. By contrast with the fair treatment principle, Article 24(3) has been amplified and specified in some detail, albeit that, as a high-​level principle, it also empowers NCAs to capture new forms of marketing risk, including those arising through digital channels.219 Delegated Regulation 2017/​565 (Article 44) applies a catalogue of specific rules, designed to address forms of marketing more prone to creating investor protection risks, and covers, inter alia, the use of past performance data, simulated past performance data, information on future performance, and comparisons. It also requires firms to be proactive in adopting an investor-​oriented approach, requiring that the information communicated be sufficient for, and presented in such a way that it is likely to be understood by, the ‘average member’ of the group addressed. The marketing regime may be calibrated to some degree to respond to digital marketing innovations, albeit that ESMA soft law is likely to carry weight of any such calibration.220 It has not otherwise experienced major strain, although the persistence of mis-​selling scandals (such as the contracts for difference (CfD) mis-​selling scandal that triggered ESMA’s first application of its product intervention powers; section 14.12) underlines that marketing controls will not deter determined mis-​selling. As currently designed, the regime avoids the risks of over-​prescription and related ‘tick-​the-​box’ compliance, but imposes minimum standards on more sensitive forms of marketing.221 It accordingly gives NCAs the flexibility to design related supervisory and enforcement strategies calibrated to local market needs, although much depends on agile and nimble supervision of how the core ‘fair, clear, and not misleading’ principle is embedded within firm processes, so that these processes are resilient to wider changes in market conditions and investor behaviour and to technological innovation.222

219 And has accordingly been identified by ESMA as a core principle for supervising digital marketing: 2022 ESMA Retail Market Commission Advice, n 26. 220 In furtherance of its 2021 Consultation on a Retail Investment Strategy, the Commission mandated ESMA to examine whether reforms to MiFID II were required to respond to the growth of digital delivery channels and related marketing techniques. In its related call for evidence, ESMA noted that the ‘fair, clear, and not misleading’ principle applied regardless of the channel but considered whether the opportunities and risks of digital disclosures (through, eg, mobile apps, social media, and email), and in particular the use of gamification techniques to convey complex information in simple ways, required adjustments to the MiFID II framework: n 26. Its subsequent advice to the Commission considered the risks of digital marketing, including through social media influencers, and concluded that the MiFID II requirements applied regardless of the delivery channel, that the dynamic nature of industry developments suggested that adjustments should not be made at the legislative level, and that the risks were best addressed by application of MiFID II’s requirements and the development of soft law where relevant. ESMA did, however, recommend that MiFID II be revised to include a definition of ‘marketing communications’ which would specify that all online communications, including social media communications, are covered: 2022 ESMA Retail Market Commission Advice, n 26, 20 and 45. 221 The past performance requirements, eg, require that a prominent warning be given as to past performance not being a reliable indicator of future events, and also specify that ‘appropriate performance information’ be provided over a five-​year period and that the past performance information is not the most prominent feature in any communication: Delegated Regulation 2017/​565 Art 44(4). 222 eg, the increase in retail trading activity over the pandemic led ESMA to warn investment firms of the need to comply with the ‘fair, clear, and not misleading’ principle in their communications with retail clients (ESMA, Public Statement (Covid-​19 and Increasing Retail Investor Activity), 6 May 2020), while increasing inflation rates in 2022 prompted a similar warning (ESMA, Public Statement (Impact of Inflation), 27 September 2022).

790  Retail Markets

IX.4.7  Disclosure As discussed in section 5.1, disclosure is a limited tool for delivering good investor outcomes in the retail markets, particularly where disclosure requirements do not address the ‘processability’ of disclosure. The MiFID II disclosure regime is, at the legislative level, traditional and focuses on the identification of the types of disclosures which must be provided to clients, rather than on processability. It contrasts sharply with the summary disclosure delivered under the PRIIPs KID regime, which focuses to a materially greater extent on how key disclosures are delivered and designed.223 The high-​level Article 24(3) requirement that communications (including marketing communications) be ‘fair, clear, and not misleading’ governs all communications between the firm and investor. More specifically, Article 24(4) requires that ‘appropriate information’ be provided to clients or potential clients ‘in good time’ (recital 83 to MiFID II notes that the time available should reflect the client’s need for sufficient time to read and understand disclosures and should reflect the complexity of the product/​service and the client’s experience) regarding: the nature of the services (and including the nature of the investment advice provided); the financial instruments and proposed investment strategies (including appropriate guidance on, and warnings of, the risks associated with these instruments or particular investment strategies and whether the financial instrument is intended for retail or professional clients, taking account of the intended target market); execution venues; and all costs and associated charges (which must include the cost of advice (where relevant) and the cost of the financial instrument recommended or marketed to the client and how the client may pay for it, and encompass any third party payments). Information about costs and charges must be aggregated to allow the client to understand the overall cost as well as the cumulative effect on the return of the investment, and, where the client so requests, an itemized breakdown must be provided. In a nod to processability, this information must be provided in a comprehensible form in such a manner that the client is reasonably able to understand the nature and risks of the investment service and the specific type of financial instrument being offered and, consequently, to take investment decisions on an informed basis (Article 24(5)). Following the 2021 MiFID II Quick Fix alleviations, disclosures are to be provided in an electronic format, although retail investors can request paper communications (Article 24(5a)).224 Information may be provided in a standardized form (Article 24(5)). This legislative foundation provides the basis for the litany of disclosure items specified by Delegated Regulation 2017/​565 and which amounts to an extensive catalogue of 223 Alongside, MiFID II imposes a series of record-​keeping and reporting requirements, including the base-​line requirement that an investment firm establish a record that includes the document(s) agreed between the firm and the client and that sets out the rights and obligations of the parties and the other terms on which the firm will provide services to the client (Art 25(5)). The firm must also provide clients with adequate ongoing reports, which are to include periodic communications with clients, taking into account the type and the complexity of the financial instruments involved and the nature of the service provided, and include, where applicable, the costs associated with the transactions and services undertaken (Art 25(6)). Delegated Regulation 2016/​575 amplifies these requirements. 224 In another Quick Fix alleviation, cost and charges disclosures may be provided after the conclusion of an agreement to buy or sell a security through means of distance communication which prevent the prior delivery of information on costs and charges: Art 24(4). The reform is designed to address the time lag risks and costs created where clients expect immediate execution of orders and the supply of ex-​ante cost information leads to delays in the execution of transactions where time is of the essence: 2021 Quick Fix Proposal, n 177, 6–​7.

IX.4  MiFID II/MiFIR and the Retail Markets  791 disclosures relating to the firm and the service, the financial instruments in question and the risks engaged, asset protection, costs and charges,225 and ongoing obligations regarding the communication of changes to disclosures.226 Overall, the disclosure requirements have a precautionary orientation, with extensive disclosures required on financial instrument risk, for example.227 While it has in key respects proved effective,228 the disclosure regime does not engage with formats, standardization, or processability generally,229 and has come to lag behind the summary disclosure reforms adopted under the PRIIPs regime, in particular, but also under the prospectus regime. Cross-​sector consistency has been a persistent and intensifying difficulty, with overlaps, redundancies, and variations, particularly but not only as regards costs and charges, in the disclosures required under MiFID II, the IDD, the AIFMD, the UCITS regime, and the PRIIPs regime.230 Alongside, investment firms must provide the extensive sustainability-​related disclosures required under the Sustainable Finance Disclosure Regulation.231 While the difficulties and intricacies associated with investment firm disclosure are of longstanding and predate MiFID II, reform now appears likely, with the comprehensibility of retail market disclosures, the implications of digital innovation, and the consistency of disclosures across comparable retail investment products major themes of the current policy agenda.232 In what would represent a material shift from the current reliance on regulatory tools, operational reform may also follow in the form of an online hub of investment product disclosures, designed to support comparability.233 225 The detailed requirements on costs and charges are further amplified by the MiFID II Investor Protection Q&A, section 9. Together the administrative rules and the Q&A address the required costs and charges disclosures as well as when they must be provided, which charges are to be aggregated, and the basis on which costs are calculated. 226 Delegated Regulation 2017/​565 Arts 45–​51. 227 Disclosure is required relating to, eg, leverage and its effects, volatility, illiquidity risks, contingent liability, and any margin requirements: Art 48. 228 ESMA’s 2020 review found that the costs and charges disclosures had ‘proved effective’ in informing retail investors, and recommended that other measures be more closely aligned to the MiFID II model, including the PRIIPs Regulation and the IDD: ESMA, Final Report On the Impact of Inducements and Costs and Charges Disclosure Requirements under MiFID II (2020) 43–​6. Similarly, the 2022 Disclosure, Inducements, and Suitability Study was broadly positive as regards the retail disclosure regime as a whole (including MiFID II), albeit that it also identified weaknesses, including as regards the regime’s capacity to support investor engagement with disclosures: n 29, 86–​221. 229 The costs and charges regime, however, does engage with processability, requiring eg an illustrative table showing the cumulative effect of costs on returns and showing the effects of any anticipated spikes or fluctuations in costs. 230 While ESMA’s 2020 review found that the costs and charges disclosures were generally working well and supporting investor decision-​making, it identified inconsistencies between the PRIIPs and MiFID II approaches which have led to reform proposals (section 5.4). 231 These disclosures must be made by investment firms providing portfolio management but also firms providing investment advice. See in outline Ch I section 7.2. 232 2021 Commission Retail Investment Strategy Consultation, n 26, 15–​25, as regards retail investment products and also consumer financial products generally. ESMA’s MiFID II-​related advice to the Commission called for a series of enhancements, including that disclosures be machine-​readable, greater standardization as regards the presentation of costs and charges, and, in the most significant proposal, that a short subset of ‘vital information’ requirements be identified (based on prior consumer testing), and required to be prominently disclosed, so that this ‘vital information’ informed retail investors of the essential characteristics of the product or service ‘at a glance’ and mitigated information overload risks: 2022 ESMA Retail Market Commission Advice, n 26, 14–​15 and 20–​1. The ‘vital information’ innovation draws on EIOPA’s proposals as regards insurance products: EIOPA, Consultation Paper. Advice to the Commission Regarding Certain Aspects Relating to Retail Investor Protection (2022). ESMA has not, however, recommended that specific reforms be made as regards digitalization, suggesting instead a soft law-​based approach. 233 The development of a disclosure hub for investment product disclosures has been a recurring theme of the CMU agenda and was examined in the Commission study on Options for the Development of Online Tools and Services Supporting Retail Investors in Investment Decisions (2020).

792  Retail Markets

IX.4.8  Know-​your-​Client: Suitability and Appropriateness Know-​your-​client rules, long-​established investor protection tools, sit further along the regulatory spectrum from information-​based disclosure and marketing requirements. They intervene more directly in the relationship between the client or investor and the investment firm by requiring the firm to make a determination, personalized to the investor, as to the suitability of an investment. Know-​your-​client rules are process-​based and do not prescribe a particular outcome. Instead, they require that the firm ‘knows the client’ and makes a personalized recommendation which reflects the client’s/​investor’s profile. They have been associated with a paternalistic approach to investor protection234 and, relatedly, with minimizing the behavioural weaknesses which can disable optimal investor decision-​ making.235 A mandatory know-​your-​client assessment can also have an empowerment dimension, however, in that it can support retail investor access to a wider range of investment products than might otherwise be available. For example, the EU imposes restrictions on the range of investment products that can be sold execution-​only, without advice; these restrictions do not apply where a suitability assessment is made. A suitability assessment can therefore support diversification and increase investors’ ability to hedge against market risks. The suitability assessment required under MiFID II takes two forms: (i) the (most stringent) assessment of ‘suitability’ (Article 25(2)); and (ii) the (lighter) assessment of ‘appropriateness’ (Article 25(3)). Whether the assessment is to suitability or appropriateness depends on the degree of client reliance on the firm: the suitability assessment applies to investment advice and portfolio management services; the appropriateness assessment applies to other services, in effect, execution-​only services for complex products. Execution-​only services in ‘non-​complex products’ are not subject to any know-​your-​client requirements (section 4.9).236 Under Article 25(2), where a firm provides investment advice or portfolio management services, a suitability assessment is required. The firm must obtain the ‘necessary information’ regarding the client’s knowledge and experience in the investment field, which must be relevant to the specific type of product or service, and regarding the client’s financial situation (including ability to bear losses) and investment objectives (including risk tolerance),237 so as to enable the firm to recommend the investment services and financial instruments ‘suitable’ for the client and, in particular, in accordance with the client’s risk tolerance and ability to bear losses.238 Where an investment firm provides investment advice 234 Markham, J, ‘Protecting the Institutional Investor—​Jungle Predator or Shorn Lamb’ (1995) 12 Yale J Reg 345. 235 Cunningham, L, ‘Behavioural Finance and Investor Governance’ (2002) 59 Washington & Lee LR 767. 236 The know-​your-​client regime is supported by the obligation on Member States to require investment firms to ensure (and demonstrate to NCAs on request) that natural persons giving investment advice or information about financial instruments or services possess the necessary knowledge and competence to fulfil their obligations under Art 25 and Art 24; Member States are to publish the criteria used to assess knowledge and competence (Art 25(1)). 237 The information to be collected concerning the investor’s financial situation includes, where relevant, information on the investor’s source and extent of regular income, assets, investments and real property, and regular financial commitments (Delegated Regulation 2017/​565 Art 54(4)), while the information with respect to investment objectives covers the investor’s time horizon, risk-​taking preferences, risk profile, and the purposes of the investment (Art 54(5)). Information related to knowledge and experience includes the level of education, profession, or former profession of the investor (Art 55). As noted below, information relating to sustainability preferences must also be collected, following a 2021 reform. 238 The firm is to obtain such information as is necessary for it to understand the ‘essential facts’ about the client, and for it to have a ‘reasonable basis for believing’, given due consideration of the nature and extent of the service provided, that the transaction satisfies three suitability criteria: it meets the client’s investment objectives; the client

IX.4  MiFID II/MiFIR and the Retail Markets  793 recommending a package of services or ‘bundled’ products, the assessment must consider whether the overall package or bundle is suitable.239 Also as regards investment advice in particular, a suitability statement, which sets out how the investment advice offered meets the preferences, objectives, and other characteristics of the client, and that is designed to strengthen firms’ compliance incentives and support investor monitoring, must be provided to the client before the relevant transaction (Article 25(6)). Where the necessary information is not provided by the client, a firm can only proceed with the transaction in question on a non-​advised basis, under the execution-​only regime,240 as long as the conditions of that regime and the Article 24(1) fair treatment principle are met; there is something of a grey zone, however, as regards the completeness of the client information required to fulfil the firm’s suitability obligation.241 The same strategy could be adopted where a firm determines that a transaction is unsuitable for the client but the client wishes to proceed.242 The suitability assessment is heavily proceduralized by Delegated Regulation 2017/​565. Firms must, for example, take reasonable steps to ensure that the information collected about clients is reliable, including by ensuring that all tools, such as risk assessment profiling tools, are fit-​for-​purpose and appropriately designed; ensuring that questions used in the suitability process are likely to be understood by clients; and taking steps to ensure the consistency of client information. Firms must also have, and be able to demonstrate, adequate policies and procedures to ensure they understand the nature, features, and risks of any services/​instruments selected for their clients and they can assess whether equivalent services/​instruments could meet a client’s needs.243 Automated process (robo-​advisers) are expressly highlighted and the need for firm judgment emphasized; the responsibility to undertake a suitability assessment is specified as resting with the firm and cannot be reduced by reliance on electronic systems.244 A lighter-​touch ‘appropriateness’ regime (Article 25(3)) applies where services ‘other than Article 25(2)’ (other than investment advice and discretionary asset management) services are provided. These ‘other services’ include in particular execution-​only transactions in complex products: the appropriateness standard is primarily associated with is able financially to bear the related investment risks consistent with the client’s investment objectives; and the client has the necessary experience and knowledge in order to understand the risks involved in the transaction or in the management of the portfolio (Delegated Regulation 2017/​565 Art 54(2)). 239 In a MiFID II Quick Fix reform, the suitability assessment is further specified by the requirement that, where the service (whether investment advice or discretionary portfolio management) involves the switching of financial instruments, the firm is to obtain the necessary information on the client’s investment and to analyze the costs and benefits of switching, and to inform the client of whether the benefits outweigh the costs. This requirement was originally contained in Delegated Regulation 2017/​565 but was moved to MiFID II to allow the lifting of this obligation for professional clients under the Quick Fix reform. 240 This is implicit in Art 25(2) but is confirmed by Delegated Regulation 2017/​565 Art 54(8). 241 ESMA has suggested that, given that the depth and detail of the information required can vary given the complexity, risks, and structure of the investment, there may be some flexibility, in limited circumstances, where the suitability of a product could be assessed without full disclosure on the investor’s financial situation: MiFID II Investor Protection Q&A, section 2, Q7. 242 ESMA’s MiFID II Investor Protection Q&A (section 2, Q6) addresses this situation and suggests that firms should avoid any behaviour that breaches the suitability obligation, which would include influencing the client to proceed at its own initiative or changing the client’s profile to fit the recommendation. Where the client wishes to proceed against a recommendation (what ESMA terms the ‘insistent client’), the client should proceed on an appropriateness basis (if the product is complex) or, at its own risk, on an execution-​only basis for non-​complex products. The client should also be informed that the course of action is not suitable and of the potential risks. 243 Delegated Regulation 2017/​565 Art 54(7) and (9). 244 Delegated Regulation 2017/​565 Art 54(1).

794  Retail Markets execution-​only sales of complex products, which must be accompanied by an appropriateness assessment.245 The Article 25(3) appropriateness assessment is much lighter than the Article 25(2) suitability assessment. It requires the firm to ask the client to provide information only regarding the client’s knowledge and experience in the investment field,246 relevant to the specific type of product or service offered or demanded, so as to enable the firm to assess whether the service or product is ‘appropriate’. To this end, the firm must simply assess whether the client has the necessary knowledge and experience in order to understand the risks involved in relation to the specific type of product or service offered or demanded.247 By contrast with the suitability regime, an assessment of the client’s financial situation or investment objectives is not required. Where the service relates to a bundle of services or products, the assessment must consider whether the overall bundle or package is appropriate. Where the firm concludes on the basis of the relevant information that the product or service is not appropriate, it may (by contrast with the suitability regime) still be provided, but a risk warning is required which may be in a standardized format. Similarly, where the required information is not provided or is insufficient, the firm must warn the client that it is not in a position to determine the appropriateness of the investment but it can proceed with the transaction. The MiFID II know-​your-​client regime is process-​based and does not prescribe specific outcomes. The related suitability/​appropriateness recommendations do, however, frame the investor decision and they also impose frictions where the investor wishes to transact against a suitability or an appropriateness recommendation. A more intrusive approach is taken in three discrete areas of the single rulebook, each associated with higher risks. Under the 2015 ELTIF Regulation, which addresses long-​term investment funds which lock-​up investment capital, the ELTIF manager or distributor must, as regards the retail distribution of an ELITF, undertake a suitability assessment as to whether the ELTIF investment is suitable for the retail investor. In addition, the retail investor must make a minimum investment of €10,000 (a proxy for suitability) and a highly precautionary cap applies: where the retail investor’s portfolio does not exceed €500,000, the firm must ensure (on the basis of information provided by the investor) that the investor does not invest an aggregate amount (across all ELTIFs) in excess of 10 per cent of its financial instrument portfolio in ELTIFs. The reforms proposed by the Commission to the ELTIF regime in 2020, and agreed in October 2022, will lead to the removal of the investment restrictions and to the application of the MiFID II, process-​based approach to suitability, but the original approach remains an example of a significantly greater incursion, by means of a know-​your-​client tool, into retail investor autonomy.248 The 2014 Bank Recovery and Resolution Directive (BRRD) is similar in design. Where subordinated debt is sold to retail clients (defined in accordance with MiFID II), the firm must undertake a MiFID II suitability assessment, but an ELTIF-​ style cap also applies: where the retail client’s portfolio does not exceed €500,000, the firm 245 Online brokers and fund platforms, which are execution-​only in design, can deliver the appropriateness assessment through ‘robo-​adviser’ processes. 246 Specified under Delegated Regulation 2017/​565 Art 55. 247 Delegated Regulation 2017/​565 Art 56. 248 Regulation (EU) 2015/​760 [2015] OJ L123/​98 Arts 28 and 30. See Ch III section 6.4 on the ELTIF regime and the reforms. In October 2022, the co-​legislators reached provisional agreement on the Commission’s 2020 Proposal, agreeing, inter alia, that the investment restrictions (the 10 per cent portfolio limit and the requirement for a minimum investment of €10,000) be removed (to facilitate retail investment and support CMU) and that the suitability requirement be aligned with MiFID II to support investor protection.

IX.4  MiFID II/MiFIR and the Retail Markets  795 must ensure (on the basis of information provided by the client) that the client does not invest an aggregate amount in excess of 10 per cent of its financial instrument portfolio in one or more such instruments.249 Finally, the 2017 Securitization Regulation adopts a similar approach, requiring sellers of securitization positions to retail clients to undertake a MiFID II suitability assessment, and prohibiting such a sale where the investment is not suitable for the client, but also requiring, where the retail client’s financial instrument portfolio does not exceed €500,000, that the retail client does not investment an aggregate amount (across all securitization positions) in excess of 10 per cent of its portfolio.250 Alongside, the 2020 Crowdfunding Regulation, which also deploys a suitability device, is more akin to, if less intrusive than, MiFID II, being more oriented to process. It requires providers of crowdfunding services to assess whether the relevant services (such as access to a crowdfunding platform) are ‘appropriate’ for ‘non-​sophisticated investors’, and imposes related and specified information-​gathering responsibilities, but it does not prohibit the services from being provided where they are deemed not to be appropriate, requiring instead that risk warnings be provided. Such services providers are also, however, under an obligation to require non-​ sophisticated investors to simulate their ability to bear losses (specified at 10 per cent of net worth) and must provide risk warnings and receive investor consent where an investor invests the higher of €1,000 or 5 per cent of net worth.251 Know-​your-​client rules have limitations. For example, in the context of investment advice, the range of investment products from which recommendations are drawn, following a suitability assessment, will reflect the form of distribution, with the widest range available from independent advisers, narrower ranges available from ‘open architecture’ non-​ independent (commission-​based) advisers, and proprietary products ranges only, typically, from financial institutions distributing their proprietary products (‘closed architecture’ distribution). As outlined in section 10, ‘independent’ (non-​commission-​based) investment advisers are required to carry a market profile of products, non-​independent advisers are required to meet ‘quality enhancement tests’ related in part to the product range they offer, but closed distribution can be limited to proprietary products only.252 Know-​your-​client assessments are also vulnerable to the myriad behavioural and other factors which shape the exercise of investment firm/​adviser judgement, including herding dynamics, which are difficult to displace through regulation. And while the increasing reliance by firms on automated systems and algorithms to identify ‘suitable’ investments in the context of investment advice can mitigate behavioural risks,253 these systems require careful design and oversight. 249 Directive 2014/​59/​EU [2014] OJ L173/​190 Art 44a. Member States may also set a minimum denomination of €50,000 for such subordinated debt. These marketing restrictions were added in 2019 to ensure that retail investors do not ‘invest excessively’ in such instruments: Directive (EU) 2019/​879 [2019] OJ L150/​296 recital 16. 250 Regulation (EU) 2017/​2402 [2017] OJ L347/​35 Art 3. In addition, it imposes a minimum investment requirement of €10,000 as a proxy to ensure the necessary investor competence. 251 Regulation (EU) 2020/​1503 [2020] OJ L347/​1 Art 21. 252 The Commission’s pre-​MiFID II study of retail distribution found that most retail investors in the EU received investment advice through closed distribution banking/​insurance groups and which was based on proprietary product ranges, typically investment funds, with third party products offered only rarely. It also found that the suitability recommendation typically flowed from a small portfolio of proprietary products determined suitable to cover the needs of retail investors. The Commission noted that while this limited the risk of an unsuitable recommendation, it also exposed the potential for internal incentive risks: 2018 Commission Distribution Report, n 39, 22–​4 and 31–​3. 253 ESMA’s 2020 Common Supervisory Action on suitability found that the majority of sampled firms used algorithms and automated systems to underpin suitability assessments: ESMA, Public Statement (2020 Suitability CSA), 21 July 2021.

796  Retail Markets Supervision of compliance can also pose challenges.254 Supervisory fact-​finds relating to compliance with know-​your-​client requirements are complex and may require troublesome, ex-​post benchmarking of advice and a considerable commitment of supervisory resources and expertise. The know-​your-​client regime has, however, emerged as a trailblazer for ESMA’s supervisory convergence powers, attracting almost the full gamut of these powers and providing a useful example of how they can empower ESMA to drill below the rulebook into the practical business of supervision. ESMA’s 2018 (revised 2022) (suitability) and 2022 (appropriateness) Guidelines are of a strongly operational bent and have also allowed ESMA to respond to market practice, notably the use of digital and automated know-​your-​client processes, including robo-​advisers.255 These Guidelines have been accompanied by Supervisory Briefings (on suitability and on appropriateness) for NCAs and by extensive coverage of the suitability and appropriateness requirements in the MiFID II Investor Protection Q&A.256 Coordinated NCA operational action, overseen by ESMA, has also been taken under the 2020 (suitability) and 2019 (appropriateness) Common Supervisory Actions through which NCAs review firms’ compliance with specified rules.257 Peer review has also been used. The MiFID I suitability regime was subject to an ESMA peer review in 2016 which was notable, at the time, for its robust approach. While the review found examples of good NCA practices, it also identified weaknesses and called for stronger NCA oversight of compliance and a related fuller allocation of supervisory resources.258 The tone of the review was assertive: it identified ‘a lack of a proactive and focused supervisory approach’ in some areas;259 an over focus on the distribution of complex products and insufficient attention to the supervision of advice on less complex products; and that NCAs had not sufficiently supervised the suitability regime over the review period. The review was also notable for the granular quality of the recommendations made, including that NCAs review telephone records, assess sales scripts, and simulate the client experience; consider using thematic reviews and mystery shopping techniques; communicate more frequently with firms, including through ‘Dear CEO’ letters; and make greater use of non-​pecuniary sanctions. This multi-​faceted approach appears to have yielded some results, with the subsequent 2020 Common Supervisory Action on suitability finding an ‘adequate’ level of firm compliance with the foundational elements of the MiFID II regime which were familiar from MiFID I, albeit shortcomings as regards the new MiFID II elements, including the suitability report requirement.260 254 For a pan-​EU, pre-​MiFID II assessment of compliance see 2011 Synovate Report, n 61. 255 The 2018/​revised 2022 Suitability Guidelines cover, eg, how the suitability assessment can be explained to clients to maximize efficient information gathering; the design of questionnaires and other tools; the information to be gathered; checks on the reliability of client information; the matching of clients with products; the use of profiling tools, automated tools, and algorithms (robo-​advisers); and the treatment of sustainability considerations. The 2021 Appropriateness Guidelines are of similar design but focus in particular on client understanding of the nature of ‘complexity’. 256 MiFID II Investor Protection Q&A sections 2 and 10, which include explanatory case studies. 257 n 253. The appropriateness CSA took place over 2019 but was not the subject of a Public Statement, although it shaped ESMA’s 2022 Appropriateness Guidelines. 258 ESMA, MiFID Suitability Requirements. Peer Review Report (2016). A follow-​up peer review report was issued in 2018 which reported on improvements to NCAs’ practices, albeit to different degrees. 259 ESMA, MiFID Suitability Requirements. Peer Review Report (2016) 18. 260 n 253. Similarly, the 2022 Study on Disclosure, Inducements, and Suitability was broadly positive regarding the suitability regime, finding inter alia that advice received was generally of good quality in that it aligned with investors’ profiles, albeit that it warned that the timing and quality of suitability assessments varied in practice, with some assessments coming too late in the distribution process to effectively support the investor decision: n 29, 302–​45.

IX.4  MiFID II/MiFIR and the Retail Markets  797 Despite the challenges, the know-​your-​client requirements are a keystone of the MiFID II investor protection scheme. They have also had some traction on the wider retail rulebook, being used, if to different degrees and in different risk contexts, in the ELTIF Regulation, the BRRD, the Securitization Regulation, and the Crowdfunding Regulation, as noted previously in this section. The importance of the MiFID II know-​your-​client requirements in supporting investor protection was highlighted by ESMA over the Covid-​19 pandemic as retail investor trading, and in particular execution-​only trading in complex products (which is subject to the appropriateness assessment), burgeoned.261 The know-​your-​client requirements have also been called in aid to support the EU’s sustainable finance agenda and, relatedly, to protect investors against mis-​selling risks and greenwashing. Sustainability factors have, following a 2021 reform, been embedded into the MiFID II suitability assessment, with firms required to include any client ‘sustainability preferences’ in the assessment of clients’ investment objectives and, relatedly, to gather information relating to such ‘sustainability preferences’.262 The reform ensures that, where such preferences are indicated, the systems and controls required under the suitability regime apply.263 It also limits the potential for investors being misled as to the sustainability of the investments recommended or being mis-​sold investments. Know-​ your-​ client requirements continue to attract attention as a means for protecting but also empowering retail investors. The development of the CMU-​related Retail Investment Strategy saw the Commission consult on the merits of a new ‘personalized asset allocation strategy’, which would be provided to retail investors, portable, not tied to a specific product recommendation or instance of investment advice, and designed to support the suitability and appropriateness tests by providing ‘concrete guidance on optimal investment allocations’.264 While its fate is uncertain at the time of writing,265 it indicates the

261 2020 ESMA Retail Trading Public Statement, n 222. 262 This reform (to Delegated Regulation 2017/​565) was achieved by Delegated Regulation 2021/​1253 [2021] OJ L277/​1. ‘Sustainability preferences’ means the client’s choice as to whether (and, if so, to what extent) one or more of the following financial instruments are to be integrated into the client’s investment: a financial instrument for which the client determines that a minimum proportion be invested in ‘environmentally sustainable investments’ (as defined under the 2020 Taxonomy Regulation); a financial instrument for which the client determines that a minimum proportion be invested in ‘sustainable investments’ (as defined under the 2019 Sustainable Finance Disclosure Regulation); or a financial instrument that considers principal adverse impacts on ‘sustainability factors’ (as addressed under the 2019 Sustainable Finance Disclosure Regulation), where qualitative or quantitative elements demonstrating that consideration are determined by the client. This classification is designed in part to ensure investors are advised of the different types of sustainability-​related investments under development. The reform also requires firms to provide disclosures on the ‘sustainability factors’ (as defined under the Sustainable Finance Disclosure Regulation) taken into consideration in selecting financial instruments. On the Taxonomy Regulation and the Sustainable Finance Disclosure Regulation which frame these obligations see Ch II section 7.2. The practical application of the reform is addressed by ESMA’s 2018/​2022 Suitability Guidelines which specify that the sustainability preferences assessment is a second step in the suitability process, taken after the initial suitability assessment, and following the identification of a range of ‘suitable’ investments. 263 Investments not eligible to meet individual sustainability preferences can still be recommended, but not as meeting sustainability preferences. The client can adapt the expressed preferences to accommodate the investment, but records must be maintained to avoid greenwashing: Art 54(10). 264 Commission, Targeted Consultation on Options to Enhance the Suitability and Appropriateness Assessments (2022). 265 ESMA was wary, underlining the importance of the MiFID II know-​your-​client regime as a keystone investor protection requirement, querying, inter alia, where the responsibility for preparing the strategy would lie, the assessment criteria, the investor disclosures required, and the risks of a ‘one size fits all’ approach, and warning that it could amount to a ‘radical change’ for firms and clients: ESMA, Letter to Commission (Suitability Consultation), 13 April 2022.

798  Retail Markets weight the know-​your-​client process is expected to carry in EU retail market regulation as regards protection and empowerment.

IX.4.9  Know-​your-​Client: The Execution-​only Context IX.4.9.1 Execution-​only Distribution The suitability and appropriateness tests are mandatory in the contexts in which they apply. They represent a precautionary approach to the retail markets and so lean more to the protective pole than to the empowerment pole, although they have an empowerment dimension. These tests do not apply where financial instruments are distributed through execution-​only (non-​advised) channels in accordance with the requirements of Article 25(4). Execution-​only distribution channels provide retail investors with a lower cost, speedy, and flexible means for transacting and so can be associated with investor empowerment. They can, however, expose retail investors to risks, particularly as regards the distribution of more complex financial instruments. The MiFID II execution-​only regime, while accommodating such channels and so investor empowerment, takes a precautionary approach, applying a series of restrictions to the range of instruments that can be sold execution-​only and without a suitability or appropriateness assessment. Alongside, the MiFID II product governance regime places guard-​rails around the types of financial instruments that are distributed through execution-​only channels, while the MiFIR product intervention regime provides NCAs and ESMA with exceptional intervention powers to prohibit the distribution of specified financial instruments, including through execution-​only channels (sections 11 and 12). The MiFID II execution-​only regime (Article 25(4)) is more prescriptive than the precursor MiFID I regime as regards the range of instruments which can be sold, without a know-​your-​client assessment, through execution-​only channels, reflecting institutional and political support at the time of its negotiation for a more restrictive approach.266 Six classes of instruments may be sold execution-​only. Shares admitted to trading on a regulated market, or on an equivalent third country market,267 or on a multilateral trading facility (MTF) may be sold execution-​only,268 but only where these are shares in companies; shares in non-​UCITS collective investment undertakings and shares that embed a derivative are excluded, given the higher risk they represent. Bonds or other forms of securitized 266 In its MiFID II IA the Commission acknowledged that the execution-​only channel was strongly supported by investors, but argued that ‘precautionary’ intervention was necessary given the evidence from the financial crisis that access to more complex instruments needed to be strictly conditional on a proven understanding of risk, and that the ability of investors to borrow funds solely for investment purposes needed to be tightly controlled (ie, the availability of margin services in execution-​only transactions), given the potential for risks to be magnified. The Commission also highlighted the need to review the classification of UCITSs for the purposes of execution-​only distribution, given that complex products could be sold under the UCITS label: 2011 MiFID II/​ MiFIR Proposals IA, n 162, 16. The political climate also favoured a more restrictive approach. The Commission originally proposed only the exclusion of structured UCITSs from execution-​only channels (alongside the MiFID I conditions which included the exclusion of derivatives). The Council MiFID II negotiations led to a significantly more restrictive regime, including the requirement that instruments sold execution-​only should not incorporate structures which make it difficult for clients to understand the risks involved. 267 See Ch X section 8.2 on the equivalence assessment. 268 A multilateral trading facility (MTF) is a form of organized trading venue which includes many of the EU’s leading ‘second tier’ markets on which shares in smaller companies are traded. See further Ch V.

IX.4  MiFID II/MiFIR and the Retail Markets  799 debt admitted to trading on a regulated market or on an equivalent third country market or on an MTF can be sold execution-​only, but not debt instruments that embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved. Money-​market instruments can be sold execution-​only, but not those money-​ market instruments that embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved. Shares or units in UCITSs may also be sold execution-​only, but not structured UCITSs.269 Structured deposits may be sold execution-​only, but not if they incorporate a structure which makes it difficult to understand the risk of return or the cost of exiting the product before term. Finally, other ‘non-​ complex’ financial instruments can be sold execution-​only, subject to their compliance with a lengthy series of conditions, set out in Delegated Regulation 2017/​565, related to liquidity, risk profile, and the information available.270 Complex debt instruments have been subject to additional, albeit soft, amplification in the form of ESMA Guidelines.271 In addition, Article 25(4) requires that the execution-​only service must be provided at the initiative of the client, who must be clearly informed that the firm is not required to assess the appropriateness of the instrument or service offered and that the client does not accordingly benefit from the corresponding protections of the relevant conduct-​of-​business rules. The firm must also comply with its background conflict-​of-​interest obligations under Article 23 (section 10). Where the requirements for an execution-​only sale are not met (for example, all transactions in derivatives fall outside the execution-​only regime), the Article 25(3) appropriateness assessment must be undertaken. The appropriateness assessment therefore carries much of the weight of investor protection where ‘complex’ products are sold execution-​only to retail investors. A further restriction applies as regards margin services: the provision of credits or loan services to clients (margin services) takes the execution of related orders outside the Article 25(4) execution-​only regime, given the increased risks of such transactions, and requires that an appropriateness assessment be undertaken. The Article 25(4) execution-​only regime is highly articulated and also prescriptive. Detailed conditions, amplified by administrative rules and Guidelines, govern the extent to 269 Structured UCITSs are defined under the UCITS regime as UCITSs which provide investors, at certain predetermined dates, with algorithmic-​based payoffs that are linked to the performance or to the realization of price changes or other conditions, of financial assets, indices, or reference portfolios, or UCITSs with similar features: Commission Regulation (EU) No 583/​2010 [2010] OJ L176/​1 Art 36. The ‘UCITS III’ expansion in the range of investments which could be undertaken through the UCITS structure drove the adoption of this restriction, although the related Council negotiations were difficult. While most Member States agreed that certain UCITSs were too complex for retail investors to trade in through execution-​only channels, there was disagreement on how to address the issue, particularly with respect to the criteria which would disqualify particular UCITSs from execution-​only sales (Danish Presidency Progress Report on MiFID II/​MiFIR, 20 June 2012 (Council Document 11536/​12) 8. 270 Delegated Regulation 2017/​565 amplifies the conditions governing ‘non-​complex’ instruments by specifying these instruments in relation to the following criteria: their not being MiFID II derivatives; in relation to which there are frequent opportunities to dispose of, redeem, or otherwise realize the instrument at prices publicly available to market participants and which are market prices or prices made available, or validated, by valuation systems independent of the issuers; that they do not involve any actual or potential liability for the client that exceeds the cost of acquiring the instrument; that they do not incorporate a clause or trigger that could fundamentally alter the nature or risk of the investment or its pay-​out profile; that they do not include any exit charges that have the effect of making the instrument more illiquid (even if there are technically frequent opportunities to realize the instrument); and in relation to which adequately comprehensive information on the characteristics of the instrument is publicly available and likely to be readily understood so as to enable the average retail client to make an informed judgement as to whether or not to enter into the transaction: Art 57. 271 ESMA, Guidelines on Complex Debt Instruments and Structured Deposits (2016). The Guidelines include a list of the types of debt instruments which should be regarded as complex for the purposes of the execution-​only regime.

800  Retail Markets which an instrument is complex or non-​complex and so whether it qualifies for execution-​ only distribution. All derivatives (however straightforward) are deemed complex and excluded from the execution-​only channel, while the exclusion of instruments that incorporate structures that make it difficult to understand the risks involved or that embed derivatives excludes a wide range of debt instruments and structured deposits.272 These products can be purchased by retail investors, but subject to the appropriateness test. This approach to execution-​only distribution can be regarded as seeking to control and limit the space within which retail investors can operate without any form of advice. Whatever the merits of this approach, it tells much about the evolution and orientation of the EU’s approach to retail market regulation. It also places some pressure on regulatory design. The highly segmented and specified articulation of the instruments that do not qualify for Article 25(4) execution-​only distribution needs to be resilient to market innovation as well as to prevailing investor sentiment as to the risk/​return calculation.

IX.4.9.2 Execution-​only and Direct Trading The execution-​only channel also supports direct trading by retail investors, as is exemplified by it being the main vector for the 2020 pandemic-​related surge in retail trading and for the early 2021 surge in meme-​stock trading. The order execution (trading) process, and so related execution-​only services, is exposed to principal/​agent risks arising from the investor (client)/​broker relationship. Alongside, direct retail investor trading through execution-​only channels has long been associated with elevated behavioural risks, given the evidence of poor investor outcomes from sub-​ optimal trading decisions and over-​trading;273 intermediated investment is often associated with better outcomes.274 Recently, technological innovation has shed new light on this familiar set of risks. The growth of trading apps which minimize the frictions associated with trading, including through low-​cost/​zero-​cost fee structures and gamification features, has facilitated wider and lower cost retail investor access to trading and become linked to the democratization of trading associated with the Gamestop/​meme-​stock episode.275 It has, at the same time, generated behavioural risks, as trading apps can lead to a detrimental ratcheting of incentives to trade. It has also been associated with elevated conflict-​of-​interest risk, in particular as regards ‘zero-​commission’ apps. While not charging a fee to traders (and thereby ratcheting up incentives to trade), these apps may expose retail traders to conflict-​ of-​interest risk where they are funded through opaque payment-​for-​order-​flow arrangements, under which the brokerage firm hosting the app is paid a fee for directing the order 272 ESMA’s 2016 Guidelines exclude, eg, debt instruments the return from which is subordinated to the reimbursement of debt held by others, debt instruments where the issuer can modify the instrument’s cash flow, debt instruments lacking a specified redemption or maturity date, debt instruments with an unusual or unfamiliar underlying, debt instruments with complex mechanisms to calculate the return, debt instruments structured in a way that may not provide for full repayment of the principal, debt instruments issued by a special purpose vehicle (SPV), and debt instruments with leverage features. 273 For a survey of the evidence see Gomes et al, n 24 and for an earlier review see Anderson, A, ‘All Guts, No Glory: Trading and Diversification Among Online Investors’ (2007) 13 European Financial Management 448 (based on a Swedish sample and pointing to failures to diversify, aggressive trading, and market underperformance linked to trading costs). 274 eg French, K, ‘Presidential Address: the Cost of Active Investing’ (2008) 63 J Fin 1537; Barber, B and Odean, T, ‘The Internet and the Investor’ (2001) 15 J of Econ Perspectives 41; and Barber, B and Odean, T, ‘Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors’ (2000) 55 J Fin 773. 275 See generally Macey, n 5.

IX.4  MiFID II/MiFIR and the Retail Markets  801 flow to a trading platform, most usually a specialized investment firm.276 Trading apps (and online platforms) also place pressure on the resilience of know-​your-​client/​appropriateness requirements where complex products are sold.277 Trading apps aside, the opportunities technological innovation and social media create for retail investor coordination and information-​sharing, exemplified by the Gamestop/​meme-​stock episode, are intensifying the risks posed by execution-​only trading, particularly as regards the information on which trading is based and the related vulnerability of retail investors to informal sources of information. More generally, ESMA has indicated some wariness as to increasing levels of engagement but also risk-​taking by retail investors in an environment of high volatility.278 The contours of the EU regulatory framework are, however, relatively clear. The MiFID II fair treatment principle, disclosure requirements, and conflict-​of-​interest management rules all apply to the order execution process. As discussed in Chapter VI (section 2.2) a series of discrete order execution requirements also apply, including the best execution requirement, which includes a price benchmark for retail trades. The 2021 meme-​stock episode did not suggest that undue pressure was being placed on these trading-​related rules, although it generated an ESMA soft law response, indicative of ESMA’s increasingly pivotal position in retail market governance.279 The Commission has, however, proposed, under the 2021 MiFIR 2 Proposal, a complete prohibition on payment-​for-​order-​flow, a reform, given the MiFID II conditions that restrict payment-​for-​order-​flow, that can be associated more with signalling than with a material investor protection gap.280 Otherwise, while finessing reforms may follow, in particular as regards digitalization and technological innovation, a soft-​law-​based response to changing retail investor behaviour appears likely. A soft-​law-​based approach has merits here as execution-​only trading by retail investors sits at a delicate law and policy interface where investor autonomy interacts with troublesome and elusive notions as to ‘excessive’ retail risk and trading, and where regulatory design poses complex challenges. The policy levers available to dull ‘excessive’ trading are limited and the risks of intervention are considerable.281

IX.4.10  Conflict-​of-​interest Management and Investment Advice IX.4.10.1 Conflict-​of-​interest Management, Inducements, and Commissions The retail investor is exposed to myriad conflict-​of-​interest risks in the investment firm/​investor relationship generally. For most retail investors, however, the main source of conflict-​ of-​interest risk is the investment advice channel and related remuneration arrangements, 276 See further Ch VI section 2.2 on payment-​for-​order-​flow. 277 Clear from the major mis-​selling episode that arose in relation to complex CfDs and binary options over 2017 and which triggered ESMA’s first exercise of its exceptional product intervention powers: section 4.12.5. 278 ESMA, TRV No 1 (2022) 5. 279 ESMA issued a series of warnings over the episode, including as regards the risks associated with trading over a period of high volatility (Public Statement (Episodes of High Volatility in Trading of Certain Stocks), 17 February 2021); the risks raised by payment-​for-​order-​flow and need for firms to comply with relevant MiFID II rules (Public Statement (payment-​for-​order-​flow), 13 July 2021); and the potential market manipulation risks relating to investment recommendations made on social media (Public Statement (Investment Recommendations on Social Media), 28 October 2021). 280 Ch VI section 2.2 281 For an early assessment see Mahoney, P, ‘Is There a Cure for Excessive Trading’ (1995) 81 Virginia LR 713, 715–​16 and, more recently, Gomes et al, n 24.

802  Retail Markets specifically commissions (classically paid by the investment product manufacturer/​provider to the investment adviser on the sale of investment products) and inducements. Commission/​inducement risk is one of the most acute risks faced by retail investors in the distribution of products given the powerful incentives commissions and inducements can create to act against the interests of the investor. Relatedly, the most intrusive regulation of distribution under MiFID II, at least as it impacts on business model design and on the structure of the investment advice and product distribution industry, relates to the management of commission and other inducement risks in the distribution of products. The MiFID II prohibition on commissions in the context of independent investment advice (section 4.10.2) is designed to materially reduce conflict-​of-​interest risk in this context. But given the current structure of the EU’s investment advice and investment product distribution industry, and limited reliance on independent investment advice, this prohibition is limited in scope. The management of commission and other inducement risk in other investment advice/​distribution channels, whether ‘open architecture’ commission-​based channels, or ‘closed architecture’ proprietary channels, depends on interlocking MiFID II requirements, including the know-​your-​client regime and the fair treatment principle. Alongside, the MiFID II investment firm governance regime requires the management body of an investment firm to define, oversee, and be accountable for the implementation of governance arrangements that ensure effective and prudent management of the investment firm, including the segregation of duties in the investment firm and the prevention of conflicts of interest, in a manner that promotes the integrity of the market and the interests of clients (Article 9(3)). Client interests and related conflict-​of-​interest management are accordingly placed at the core of the management body’s responsibilities. At the heart of the conflict-​of-​interest management regime, however, are the foundational conflict-​of-​interest management requirements that apply to all investment firms under Articles 23 and 16(3), and the specific requirements that apply to remuneration and inducements/​commissions under Article 24(10) and (9). The foundational conflict-​of-​interest management regime (Article 23 and 16(3)) is designed to contain damaging conflicts ex-​ante through identification and prevention/​management techniques.282 Firms must take ‘all appropriate steps’ to identify, to prevent, and to manage conflicts of interests, including those caused by the receipt of inducements from third parties or by the firm’s own remuneration and other incentive structures (Article 23(1)); and adopt organizational and administrative arrangements with a view to taking ‘all reasonable steps’ to prevent conflicts of interest from adversely affecting client interests (Article 16(3)). Where the organizational and administrative arrangements adopted are not sufficient to ensure ‘with reasonable confidence’ that risk of damage to client interests will be prevented, the firm must clearly disclose the general nature and/​or the sources of the conflicts of interest to the client, and the steps taken to mitigate those risks, before undertaking business on its behalf (Article 23(2)). Alongside, conflicts of interest arising from investment firm remuneration structures, such as firm incentive payments to employees which may generate conflict-​of-​interest risks in the sale of proprietary products, are specifically addressed by Article 24(10) (which is accordingly of particular importance to closed distribution). It provides that a firm must



282

See further Ch IV section 8.3 on the conflict-​of-​interests regime, which is noted here in outline.

IX.4  MiFID II/MiFIR and the Retail Markets  803 ensure it does not remunerate or assess the performance of staff in a way that conflicts with its duty to act in the best interests of clients. In particular, it must not make any arrangements by way of remuneration, sales targets, or otherwise that could incentivize its staff to recommend a particular financial instrument to a retail client when the firm could offer a different financial instrument which would better meet that client’s needs.283 This requirement is bolstered by the MiFID II investment firm governance regime, which requires that the management body define, approve, and oversee a remuneration policy aimed at encouraging fair treatment of clients as well as at avoiding conflicts of interest in relationships with clients.284 In addition, a wide-​ranging prohibition, which was at the time of MiFID II’s coming into force associated with significant market change,285 applies to inducements, including commissions (and is, accordingly, of particular importance to ‘open architecture’ distribution, in particular commission-​based distribution and advice channels). The provision is constructed in somewhat convoluted terms but, in essence, prohibits inducements unless they can be shown to enhance the quality of the relevant services to the client. Under Article 24(9) where a firm pays or is paid any fee or commission, or provides (or is provided with) any non-​monetary benefit in connection with the provision of an investment service or ancillary service, it will be regarded as not fulfilling the Article 23 conflict-​of-​interest management obligation or the Article 24(1) fair treatment obligation, unless the payment or benefit is designed to enhance the quality of the service and does not impair compliance with the firm’s duty to act honestly, fairly, and professionally in the best interests of the client. Disclosure requirements also apply. The existence, nature, and amount of the payment or benefit (or, where the amount cannot be ascertained, the method of calculating the amount) must be clearly disclosed to the client, in a manner that is comprehensive, accurate, and understandable, prior to the provision of the related investment service or ancillary service. In a final condition, and where applicable, the firm must inform the client of mechanisms available for transferring the payment or benefit in question to the client (these mechanisms are not mandatory). Payments or benefits necessary for the provision of services (such as those related to custody costs and settlement fees) and which, by their nature, cannot give rise to conflicts with the firm’s Article 24(1) duty to act honestly, fairly, and professionally in accordance with the best interests of clients are not subject to this regime. This wide-​ranging prohibition of inducements (including commissions), which hinges on the quality enhancement test, has been amplified by Delegated Directive 2017/​593. It provides that the quality enhancement test requires that three conditions are met: the inducement is justified by the provision of an additional or higher level service to the relevant client, proportional to the level of inducement received; does not directly benefit the recipient firm (or its shareholders or employees) without tangible benefit to the relevant client; and is justified by the provision of an ongoing benefit to the client, in relation to an

283 ESMA’s Guidelines on Remuneration amplify this requirement in some detail, including though practical examples of good and bad practices: ESMA, Guidelines on Certain Aspects of the MiFID II Remuneration Requirements (2022). 284 Art 9(3). On the investment firm governance regime, see Ch IV section 7.2. 285 Widespread media attention in the UK focused on its impact on, eg, client entertainment budgets and attendance at the annual Chelsea flower show.

804  Retail Markets ongoing inducement (Article 11).286 Where the inducement results in distorted or biased services it cannot be justified. The Article 24(9) inducement prohibition is not designed to prohibit commission-​based investment advice (where the advice is in effect paid for through commissions paid by the product provider to the adviser on the products sold), a major channel for investment product distribution in the EU. Reflecting regulatory support for commission-​based investment advice/​distribution which stretches back to MiFID I,287 the quality enhancement test is in part designed to capture the structural reality of the EU investment advice market: it has few independent (fee-​based) advice/​distribution channels, but includes commission-​ based, open architecture business models which allow retail investors access to a wider range of products than those available through closed architecture channels which distribute proprietary products only.288 Delegated Directive 2017/​593 Article 11 accordingly specifies three (non-​exhaustive) forms of commission-​based investment advice that are acceptable and applies conditions to minimize the conflict-​of-​interest risk to investors and to enhance the quality of advice received. The quality enhancement test is met where the inducement (the commission from the product provider) relates to: the provision of non-​ independent investment advice on, and access to, a wide range of suitable financial instruments (including an ‘appropriate number’ of instruments from third party providers having no close links with the investment firm); or to the provision of non-​independent investment advice, combined with either an offer to the client (at least on an annual basis) to assess the continuing suitability of the instruments in which the client has invested or, alternatively, with another ongoing service likely to be of value to the client (such as advice about optimal asset allocation); or to the provision of access, at a competitive price, to a wide range of financial instruments likely to meet the needs of the client (including an appropriate number from third party providers), together with either the provision of added-​value tools (designed to support investor decision-​making or monitoring) or periodic reporting on the performance and costs of the financial instruments. Where an inducement, typically a product commission payment, supports any of these forms of investment advice or investment product distribution, it will meet the quality enhancement test. This regulatory treatment is designed to support the development of commission-​based open architecture models, subject to constraints designed to ensure high quality advice services and to reduce conflict of interest risk, and also to facilitate NCA monitoring.

IX.4.10.2 Independent Investment Advice The most rigorous controls apply to ‘independent investment advice’. Structural reform of the EU investment advice/​distribution sector through support of fee-​based independent investment advice has been a recurring feature of EU retail market policy for some time.289 The Commission, an early supporter of independent investment advice (during the MiFID 286 Requirements also apply governing the evidencing of quality enhancement and the disclosures required to clients. These disclosures have struggled, as noted in section 4.10.3. 287 See, eg, CESR, Inducements under MiFID (2007). 288 During the development of Art 11, the Commission (and ESMA) made clear that the Art 24(9) inducement prohibition was not designed to restrict open architecture distribution and that the administrative rules were designed to encourage such channels where they displayed a robust focus on benefits to clients: SWD(2016) 157, 25–​8. 289 See, eg, FIN-​USE, Opinion on the European Commission Green Paper on the Enhancement of the EU Framework for Investment Funds (2005).

IX.4  MiFID II/MiFIR and the Retail Markets  805 I negotiations)290 warned in its 2007 Green Paper on Retail Financial Services, for example, that the sales and distribution infrastructure ‘[was] not always optimal’,291 while the European Parliament similarly highlighted in 2007 the importance of access to ‘unbiased investment advice’.292 MiFID II saw the EU impose specific requirements on independent investment advice. The foundational requirement is disclosure-​based: information must be provided to clients or potential clients, and in good time before the investment advice is provided, as to whether the advice is provided on an ‘independent’ basis or not; whether it is based on a broad or more restricted analysis of different types of financial instruments and, in particular, whether the range of financial instruments is limited to financial instruments issued or provided by entities having close links with the investment firm, or having any other legal or economic relationships with the firm, such as a contractual relationship, so close as to pose a risk of impairing the independent basis of the advice provided (in effect, whether the advice relates to proprietary or otherwise ‘tied’ products); and whether the firm will provide the client with a periodic assessment of the financial instruments recommended to clients (Article 24(4)). This requirement applies to all forms of investment advice and supports the disclosure and conflict-​of-​interest rules applicable to non-​independent advice. Where investment advice is provided on an ‘independent’ basis, two constraints apply (Article 24(7)). The first relates to the scope of the advice. The firm must assess a ‘sufficient range’ of financial instruments available on the market, which financial instruments should be ‘sufficiently diverse’ with regard to their type and issuers or product providers to ensure that the client’s investment objectives can be suitably met. In particular, the range should not be limited to instruments issued or provided by the investment firm itself, or by entities having close links to the investment firm, or by entities with which the investment firm has such close legal or economic relationships (such as a contractual relationship) so as to pose a risk of impairing the independent basis of the advice provided. This requirement, designed to ensure independent advice refers to a wide range of financial instruments (the market profile, in effect), has proved intricate in its application, being amplified in some operational detail (by Delegated Regulation 2017/​565), which detail exemplifies the proceduralized turn retail market protection has taken with MiFID II. Delegated Regulation 2017/​565 governs, for example, the ‘selection process’ for constructing the range of instruments offered where independent investment advice is provided,293 the conditions applicable where a firm offers independent investment advice on a targeted basis (such as in relation to sustainable or ethical investments) and/​or provides independent investment advice in parallel with 290 The Commission’s 2001 ‘Initial Orientations’ for what would become MiFID I suggested that ‘advice’ could be defined as ‘independent investment advice’ paid for by the client: Commission, Overview of Proposed Adjustments to the ISD (2001) 11. Following support during the related consultation process for the independence of advice to be supported instead through background conflict-​of-​interest and disclosure techniques (Commission, Revised Orientations on ISD Reform (2002) Annex 4, 16), the latter model was followed in MiFID I. 291 n 75, 17. 292 European Parliament, Resolution on Financial Services Policy (2005–​2010) White Paper, 11 July 2007 (P6_​ TA(2007) 0338) (2007) para 36. 293 Delegated Regulation 2017/​565 Art 53(1) requires that the number and variety of financial instruments is proportionate to the scope of the independent investment advice offered and adequately representative of financial instruments available on the market; that the quantity of financial instruments issued by the firm or entities closely linked to it is proportionate to the total amount of financial instruments considered; and that the criteria for selecting the instruments includes all relevant aspects, such as costs, risks, and complexity as well as the characteristics of the firm’s clients. Where this type of exercise is not possible given the firm’s business model or the services provided, the firm cannot present itself as ‘independent’.

806  Retail Markets (non-​independent) investment advice,294 and the disclosures required on the nature of the investment advice provided.295 Second, the firm cannot accept and retain fees, commissions, or any monetary and non-​ monetary benefits paid or provided by any third party (or person acting on behalf of a third party) in relation to the provision of the advice service to clients. A de minimis exception applies in that ‘minor non-​monetary benefits’ that are capable of enhancing the quality of the relevant service provided to the client, and which are of a scale and nature that they could not be judged to impair compliance with the investment firm’s duty to act in the best interest of the client, should be clearly disclosed, but are not subject to the prohibition.296 A prohibition on such payments or benefits (excluding also minor non-​monetary benefits) also applies in relation to discretionary asset management (Article 24(8)). Recital 74 to MiFID II suggests that where a payment is received (the recital highlights in particular payments from issuers and product providers) it must be returned in full to the client as soon as possible after receipt, and that the firm may not offset any such payments from fees owed by the client to the firm, and that a policy must be set up to ensure that any such payments are allocated and transferred to clients.

IX.4.10.3 The Investment Advice Market and Regulatory Intervention The management of conflict-​of-​interest risks in investment advice has long preoccupied EU retail market regulation, but a harmonized solution is not easily found. As outlined in section 1.2.2, investment products are typically distributed through proprietary (closed architecture) distribution systems, often in the form of banks and insurance companies selling and advising on their proprietary products, usually investment funds. Distribution in the form of advice by open architecture investment advisers distributing a wider range of products (typically funded through commission payments) is less common, while open architecture distribution through fee-​based, independent advisers is rare. All these channels generate different risks and frictions. Independent advice channels are the more costly, commission-​based channels are exposed to conflict-​of-​interest risk, and proprietary channels typically involve a narrower product range and may be exposed to internal incentive risks.297 But disrupting these channels by promoting one form over another is fraught with risk, not least as different forms of distribution reflect deeply embedded local path-​ dependencies, including as regards market structure and investor behaviour, and given what can be high levels of political contestation.298 294 Delegated Regulation 2017/​565 Art 53(2), which addresses related disclosures, marketing, and systems and controls. 295 Delegated Regulation 2017/​565 Art 52, which requires disclosures on, eg, the range and type of instruments offered and the selection process. 296 The conditions governing these permissible inducements are governed by Delegated Directive 2017/​593 Art 12, which applies a general principle (such benefits are to be reasonable, proportionate, and of a scale that they are unlikely to influence the firm’s behaviour in a way detrimental to the interests of the client) but also specifies the permitted benefits in some granular detail (including as regards ‘hospitality of a reasonable de minimis nature’). 297 ESMA’s 2020 review of inducements disclosure saw some concern that the conflict-​of-​interest risks in closed distribution channels were not being adequately captured by the inducements rules (which apply to third party payments), and ESMA consider whether a suitability-​related obligation, requiring such firms to consider the merits of third party products against proprietary products, be introduced: 2020 ESMA Inducements and Costs Disclosure Review n 228. 298 For analysis of the potential impact of the MiFID II inducements/​commissions rules on the structure of distribution see Restelli Rino, E, ‘Shaped by the Rules. How Inducement Regulation Will Change the Investment Services Industry’ (2021) 4 ECFR 640. So far, as noted below, MiFID II has had limited impact on distribution

IX.4  MiFID II/MiFIR and the Retail Markets  807 For example, fee-​based independent advice might be regarded as the gold standard as regards conflict-​of-​interest management. But its costs and the MiFID II regulatory constraints means that this form of advice business model is most likely to be directed to affluent retail investors.299 There has also been little sign of significant growth in independent advice business models and few indications of retail investor demand, which might be related to poor investor understanding of the potential impact of commissions (or of internal incentives in closed distribution),300 as well as to the well-​documented reluctance of retail investors to pay a fee.301 It may also reflect the absence of large-​scale mis-​selling arising from current distribution arrangements and so suggest that the MiFID II regulatory framework and its supervision is working reasonably well. Nonetheless, the extent to which the development of independent investment advice channels should be promoted through more muscular regulatory intervention, in particular through a prohibition on commission payments in all advice settings, has long shaped the EU debate on the regulation of distribution. The very limited incidence of independent advice channels implies that any such reform would amount to a major structural change which would need to be accompanied by extensive analysis of related market impacts and unintended effects: only the Netherlands currently imposes such a prohibition (since 2013). These impacts and effects include the potential emergence of an ‘advice gap’ were commission-​based advice firms to withdraw, in consequence, from the provision of investment advice.302 Relatedly, incentives could be created for firms to move from open structures, with little evidence of any decline in the use of inducements/​commissions or of growth in independent investment advice channels: 2022 Disclosure, Inducements, and Suitability Study, n 29, 222–​301. 299 At time of the development of MiFID II, some 16–​18 per cent of what the Commission described as the ‘mass affluent’ sector in the EU (some 40–​45 million persons) received ‘independent’ advice, and most of this population was based in the UK (60 per cent of all EU independent advisers were based in the UK: 2011 MiFID II/​MiFIR Proposals IA, n 162, 190. Subsequently, the Commission found that independent investment advice was typically directed to affluent retail investors: 2018 Commission Distribution Report n 39, 108. The UK experience has been that, on average, full-​scale independent advice is associated with average investment ‘pots’ of £150,000: 2020 FCA Advice Review, n 60. Similar findings were reported by the 2022 Study on Disclosure, Inducements, and Suitability, n 29. 300 ESMA’s 2020 review of commissions/​inducements disclosure reported that it had little impact on the development of the independent advice channel, given generally limited understanding of the potential impact of commissions/​inducements: 2020 ESMA Inducements and Costs Disclosure Review, n 228. The Commission’s 2018 review of distribution similarly found that the average retail investor did not understand the incentive schemes under which non-​independent advisers operated (such as commission payments) and perceived the advice to be free: n 39, 102 and 108. Most recently, the 2022 Disclosure, Inducements, and Suitability Study found no evidence of a decline in the use of commissions/​inducements, the use of which remained widespread (the Study also reported on weaknesses in the related disclosures), or of growth in the independent investment advice sector, following the application of MiFID II: n 29, 222–​301. 301 This resistance is of longstanding and is sticky. Reported on in ESMA’s 2020 review of inducements and costs disclosure (n 228) and in the Commission’s 2018 review of distribution (n 39), it has long been a feature of retail investor behaviour. The extent of retail investor reluctance to pay a fee for advice was a recurring theme of major policy reviews and studies across the EU prior to the financial crisis and the adoption of MiFID II, including at national level (eg France’s 2005 Delmas Report (n 132) and at EU level (2008 Optem Report, n 83). 302 The first major review of the swingeing UK Retail Distribution Review reforms (which prohibited commissions: see n 60) found that while transparency had improved and the conflicts of interests generated by the previous commission-​based advice model had been removed, concerns had emerged as to an advice gap, particularly for those with smaller amounts to invest; this gap was not, however, entirely driven by supply-​side constraints but reflected also low investor demand: HM Treasury and FCA, Financial Advice Market Review (2016). Since then, improvements have been observed, with increases in the number of adults receiving advice, but the FCA has also reported on many ‘mass-​market’ consumers holding money in cash that could be invested and not receiving support from financial services firms. It related this ‘gap’ to demand-​side factors, linked to a lack of interest in receiving advice, but also to supply-​side factors, linked to a lack of investment firm innovation in developing lower-​ cost services for less wealthy investors, and called for a wider range of services to support mass-​market investors, including simpler advice or guidance (short of advice) services: 2020 FCA Advice Report, n 60.

808  Retail Markets to closed distribution, offering only proprietary products, which would reduce the range of choice available to retail investors. Further, significant competitive and regulatory arbitrage risks would arise were a commission prohibition to be limited to MiFID II advice services, given in particular that insurance-​based investment products (the distribution of which is regulated under the lighter 2016 IDD) can act as functional substitutes for MiFID products. Conversely, however, prohibitions on commission-​based advice have been associated with the emergence of low-​cost distribution channels, such as online ‘fund supermarkets’303 and robo-​advisers, which offer retail investors wider and lower cost access to a broader range of investment products.304 Similarly, any consequent low-​cost commodification of portfolios and products offered, particularly where supported by non-​personalized guidance and information (not subject to the costs of know-​your-​client requirements), has attractions given the nascent quality of the EU retail market. The MiFID II approach (which followed difficult negotiations)305 does not disrupt longstanding distribution channels, but addresses conflict-​of-​interest risks by means of an interlocking series of regulatory tools designed to address the different settings in which conflicts can arise: fair treatment, know-​your-​client, and general conflict-​of-​interest management requirements apply across all distribution channels; the remuneration requirements are of particular relevance for closed distribution and the inducement rules for open distribution; and independent investment advice is subject to the most stringent controls. The regulation of investment advice and the treatment of commissions remains, however, unfinished business. ESMA’s 2020 review of the inducements/​commissions disclosure regime, as part of the MiFID II/​MiFIR Review, did not reveal major difficulties, but it saw some relitigation of the MiFID II debate on the merits of a full commission ban.306 Similarly, the 2022 Retail Investment Strategy review of disclosure, inducements, and suitability reported on the persistence of commissions and inducements and the failure of independent investment advice channels to develop, while earlier the Commission’s 2020 MiFID Review Consultation and its 2021 Retail Investment Strategy Consultation addressed inducement/​ commission risk. Battle may be joined again over this major line of contestation in EU retail market policy.307 303 Fund supermarkets are online platforms that allow investors to access a range of funds from different providers, using a single account. Their relatively low incidence and their business models were widely reviewed by the Commission in 2018: n 39, 120–​50. 304 The Netherlands experience has been that its ban on commissions was a ‘strong driver’ for the emergence of online ‘fund supermarkets’ and online brokers, which use automated mechanisms to assess appropriateness where complex products are offered, and which provide lower-​cost access to investments: 2018 Commission Distribution Report, n 39, Executive Summary, 13. The study also found that retail investors seeking advice from financial institutions were typically directed to firms’ online execution-​only services: at 23. Similar findings were reported by the 2022 Disclosure, Inducements, and Suitability Study, n 29. 305 Section 4.2. 306 ESMA was cautious in response, advising that the Commission examine the impact of any such ban as part of a wider review of the impact of the inducements/​commissions regime. ESMA also made a series of other recommendations, including that plain language be used to explain the meaning and potential impact of commissions and that more practical disclosures, which would show investors which products advised on carry the highest level of commission, be provided: 2022 ESMA Retail Market Commission Advice, n 26, 21. This approach may yield results. One study has shown that the efficacy of conflict-​of-​interest disclosure depends on the extent to which the consequences of conflicts are explained: Helleringer, G, Trust Me, I Have a Conflict of Interest! Testing the Efficacy of Disclosure in Retail Investment Advice, Oxford Legal Studies Research Paper No 14/​2016 (2016), available via . 307 On the findings of the 2022 Study see n 29, 222–​301. While, as the time of writing, the outcome of the Retail Investment Strategy process remained to be seen (it was also addressing less contested areas, including training requirements for advisers (SWD(2022) 184)), European Parliament ECON Committee members were, in October 2022, reported to have proposed revisions to the MiFID III Proposal to introduce a prohibition on commissions

IX.4  MiFID II/MiFIR and the Retail Markets  809

IX.4.11  Product Governance IX.4.11.1 The Product Governance Regime and its Evolution The financial-​crisis-​era tilt towards a more precautionary approach to retail market regulation is most apparent in the MiFID II product governance regime which represented, at the time of its adoption, a significant innovation. Product-​related regulation (which can extend across a spectrum from ex-​ante product authorization, to oversight of firms’ product development processes, to the prohibition of the marketing of products) can, by addressing upstream product design, lift the pressure from distribution-​related regulation.308 But it requires careful handling given the attendant risks.309 These include regulatory arbitrage, frictions to innovation and on investor choice, and moral hazard (given the strong implication of regulatory approval which product authorization, in particular, can generate and the related risk that the product provider (and investor) takes less care in monitoring the product). The association between product regulation and ‘over-​regulation’ is also considerable.310 Relatedly, making a determination as to whether a product is not appropriate for retail distribution, whether through product authorization requirements, product governance rules, or ex-​post prohibition powers, demands of the regulator that difficult choices are made as to the optimal levels of risk and choice in the retail market. The MiFID II approach to product regulation dilutes these risks as it is based on requiring firms to have product development and review procedures in place to ensure, in the MiFID II formula, that products meet the ‘needs, characteristics, and objectives’ of a ‘target market’ of investors; it is concerned with product governance and so with how retail investment products are designed, not with the hard-​wiring of specific products or classes of products. The MiFID II product governance regime nonetheless constitutes a muscular form of intervention in that it requires the embedding of investor needs, alongside business interests, in the product development process: the rules are designed to ensure that only those products that meet the ‘needs, characteristics, and objectives’ of the relevant ‘target market’ are distributed to those investors. Still a relatively new regime, its potential for enhancing retail investor outcomes, facilitating retail investor choice through better investment firm targeting of products, and short-​circuiting mis-​selling risk is considerable, if it succeeds in aligning business interests with investor interests in the product development process. Further, because it is integrated with distribution (the product governance regime requires that investment firms’ product development processes assess the proposed distribution channels), it supports the MiFID II regime governing execution-​only transactions, in that firms are required to consider whether or not a product should be distributed through execution-​only channels. (Better Finance, Press Release, 25 October 2022). The fate of any such radical reform remains to be seen, with the Council reportedly opposed (Better Finance, Press Release, 18 November 2022). Certainly, the MiFID II negotiations suggest that such a prohibition would face stiff political resistance. 308 For financial-​crisis-​era perspectives see Fisch, J, ‘Rethinking the Regulation of Securities Intermediaries’ (2009–​2010) 158 U Pa LR 1961 and Moloney, N, How to Protect Investors. Lessons from the EC and the UK (2012) 133–​91. 309 Karmel, R, ‘Mutual Funds, Pension Funds and Stock Market Volatility—​What Regulation by the Securities and Exchange Commission is Appropriate’ (2004–​2005) 80 Notre Dame LR 909. 310 eg Epstein, R, ‘The Neoclassical Economics of Consumer Contracts’ (2008) 92 Minnesota LR 808 and Bar Gill, O, ‘The Behavioural Economics of Consumer Contracts’ (2008) 92 Minnesota LR 749.

810  Retail Markets Notwithstanding its novelty, the MiFID II product governance regime emerged from a largely uncontroversial negotiation process. Prior to the financial crisis, harmonized EU retail market regulation (and Member State rules) tended to eschew product regulation in favour of disclosure and distribution rules.311 Product regulation was not entirely overlooked by EU retail market regulation, but it was primarily a function of the portfolio-​shaping and risk management rules which apply to the UCITS fund (Chapter III). The financial-​crisis era, however, led to product regulation coming to the fore in many Member States,312 as an additional tool for addressing retail market risk, and in response to the persistence of mis-​selling risks which were being exacerbated by product complexity.313 The MiFID II reform process followed this trend, with the Commission proposing product governance requirements directed to ensuring that investment firms adopted policies governing product development. The reform was not heavily contested and drew strong support from the European Parliament which introduced a series of refinements, including the pivotal ‘target market’ assessment, which, although the Council favoured the Commission’s more light-​ touch approach, prevailed. Prior to the MiFID II product governance regime coming into force in 2018, it was subject to detailed, process-​oriented amplification through administrative rules (Delegated Directive 2017/​593), the development of which was contested reflecting the rules’ novelty,314 and also through extensive ESMA Guidelines (2018).315 Since then, the product governance regime has become a pivotal component of MiFID II, attracting close supervisory attention, including by means of a 2021 ESMA-​coordinated Common Supervisory Action.316 It has also experienced some instability. As outlined in section 4.11.3, the product governance regime has, reflecting its novelty, reach of application, and costs, become a site for de-​regulation, with the 2021 MiFID II Quick Fix reform liberalizing its application, albeit that the 2021 sustainable-​finance-​related reform to its application underscores the extent to which the product governance regime has become embedded in the EU retail market tool-​kit. Nonetheless, while it has generated some contestation in practice, the MiFID II product governance regime has not experienced the constitutional challenges that attended its soft law counterpart under the banking regime. 311 On the emergence of product governance as a retail market tool in the EU see further Moloney, N, ‘The Legacy Effects of the Financial Crisis in the EU’ in Alexander, K, Coffee, J, Ferran, E, Hill, J, and Moloney, N, The Regulatory Aftermath of the Global Financial Crisis (2012) 111. 312 eg, in an October 2010 ‘position’ (AMF Position No 2010-​05), the French NCA in effect prohibited the marketing of complex structured products to investors: Jory, R, ‘New Regulations Leave Retail Structured Products on Shaky Ground in France’, Financial Risk Management News and Analysis, 21 April 2011. 313 For a summary of product-​related failures across the EU see ESMA, EBA, EIOPA, Joint Position of the ESAs on Manufacturers’ Product Oversight & Governance Processes (2013) Annex 1, reporting on failures with respect to complex and illiquid alternative investment products (UK), structured products (Denmark), equity instruments issued by banks (Spain), and complex products generally (Italy). 314 The product governance administrative rules generated significant market reaction, including some market concern that they not be applied to equity and bonds (calls which ESMA rejected given the investor protection objective of the rules). There was also some demand for greater specification of how the ‘target market’ test, at the core of the rules, be carried out (ESMA declined to propose more granular rules given the need for the rules to apply flexibly to a range of products, from simple to highly complex, albeit that it subsequently adopted extensive Guidelines): ESMA/​2014/​1569, 50–​5. 315 ESMA, Guidelines on Product Governance Requirements under MiFID II (2018). 316 The CSA was of a practical orientation, designed to allow ESMA and NCAs to assess progress in firms’ application of the new rules, including as regards how product manufacturers ensured that the costs and charges of products did not undermine products’ return expectations; the target market process; and information exchange between manufacturers and distributors: ESMA, Public Statement (Launch of Common Supervisory Action with NCAs on MiFID II Product Governance Rules), 1 February 2021.

IX.4  MiFID II/MiFIR and the Retail Markets  811 Product governance is not expressly covered under the banking rulebook but EBA nonetheless adopted Guidelines on product governance and oversight for retail banking and payment products317 and has regularly reported on industry compliance.318 Following a challenge to EBA’s competence to adopt these Guidelines (given that product governance was not expressly addressed under the banking legislative rulebook), the Court of Justice, in a ruling generally supportive of the ESAs’ role in supporting the single rulebook, found that the Guidelines were validly adopted in that they, inter alia, supported the consistent application and enforcement of the wider internal governance obligations imposed on in-​scope institutions under the CRD IV prudential regime, obligations which fell within EBA’s field of operation.319

IX.4.11.2 The Product Governance Regime The MiFID II product governance regime has two elements: management body oversight; and investment firm procedures. Article 9(3) injects product governance into the MiFID II investment firm governance regime by requiring the firm’s management body to take responsibility for product governance systems and procedures: the management body must define, approve, and oversee a policy as to the services, activities, products, and operations offered or provided, in accordance with the risk tolerance of the firm and with the characteristics and needs of the clients of the firm to whom they will be offered or provided (including with respect to stress-​ testing, where appropriate). This oversight requirement is accompanied by specification of how the investment firm’s product governance processes are to be designed, by means of a general principle (Article 24(2)) and by specific process requirements (Article 16(3)). Under Article 24(2), investment firms which ‘manufacture’320 financial instruments321 for sale to clients must ensure those instruments are designed to meet the needs of an identified ‘target market’322 of end clients within the relevant category of clients, that the distribution strategy is compatible with the identified target market, and that reasonable steps are taken to ensure the instrument is distributed to the identified target market. An investment firm must also, as regards distribution, understand the financial instruments offered or recommended, assess the compatibility of the financial instruments with the needs of the clients to whom investment services are provided, taking into account the identified target market of end clients, and ensure that financial instruments are only offered or recommended when this in the interests of clients (Article 24(2)). Product design and distribution are accordingly treated in an

317 The Guidelines were originally incorporated in EBA, Guidelines on Internal Governance (2011) and subsequently adopted as EBA, Guidelines on Product Oversight and Governance Arrangements for Retail Banking Products (2015, applied from 2017), covering the design, marketing, and life-​cycle maintenance of retail market products, such as mortgages, and deploying similar devices to those used under MiFID II, including the target market analysis. The EBA Guidelines derive from a pre-​MiFID II ‘joint position’ adopted by the three ESAs in 2013, in which they adopted a series of high-​level principles to ground subsequent work by the ESAs as regards product governance. ESMA’s agenda subsequently became framed by MiFID II. 318 See eg EBA, Report on the Application of the Guidelines on POG Arrangements (2020). 319 Case C-​911/​19 FBF v ACPR (ECLI:EU:C:2021:599) (relating to the validity of the 2011 Guidelines). See further Ch I section 6.4 (n 254). 320 Amplified by administrative rules, as noted below. 321 MiFID II financial instruments: a wide range of instruments from ‘plain vanilla’ debt instruments through to complex structured and packaged products that embed derivatives are accordingly engaged. 322 Amplified by administrative rules, as noted below.

812  Retail Markets integrated manner which also supports the conduct rules which apply to the investment advice and execution-​only processes. Article 16(3) addresses the product development process. An investment firm which manufactures financial instruments for sale to clients must maintain, operate, and review a process for the approval of each instrument (or significant adaptations of existing financial instruments) before it is marketed or distributed to clients. The approval process must specify an identified target market of end clients within the relevant category of clients for each financial instrument, and ensure that all relevant risks to such identified target market are assessed and the intended distribution strategy is consistent with the identified target market. The firm must also regularly review the financial instruments offered or marketed by the firm, taking into account any event that could materially affect the potential risk to the identified target market, to assess at least whether the financial instrument remains consistent with the needs of the target market and whether the intended distribution strategy remains appropriate. Further, firms which manufacture financial instruments must make available to any distributor all appropriate information on the financial instrument and the product approval process, including the identified target market. Relatedly, where a firm offers or recommends financial instruments which it does not manufacture, it must have in place adequate arrangements to obtain the information required to be made available by the manufacturer, and to understand the characteristics of the intended target market of each financial instrument. These requirements are accordingly designed to operate in tandem with the conduct rules governing distribution, to form an integrated whole.323 The product governance regime is amplified in some procedural detail by Delegated Directive 2017/​593 which specifies how firms’ product approval and review processes are to be designed.324 Its approach underlines the extent to which EU retail market regulation became, in the aftermath of the financial crisis, concerned with shaping the environment in which retail investment decisions are made and tilted towards a precautionary approach. The immensely detailed administrative rules, which apply to ‘manufacturers’ of MiFID II financial instruments,325 require, for example: that the target market for a financial instrument be identified at a ‘sufficiently granular level’ for each financial instrument and must specify the type(s) of client for whose ‘needs, characteristics, and objectives’326 the instrument is compatible (Article 9(9));327 that the financial instrument be assessed to determine whether it meets the needs, characteristics, and objectives of the identified target market, including in relation to its risk/​reward profile (Article 9(11)); and that a scenario analysis be undertaken which assesses the risk of poor outcomes for end clients and when they may occur, in relation to a series of identified and potentially detrimental events (Article 9(10)). The target market analysis required of manufacturers extends to distribution, with manufacturers required to review whether the instrument, once distributed, is being distributed 323 The Art 16(3) product governance regime applies without prejudice to the other requirements of MiFID II in relation to disclosure, quality of advice, and conflict-​of-​interest management. 324 Delegated Directive 2017/​593 [2017] OJ L87/​500 Arts 9 and 10. 325 The rules apply to investment firms which ‘manufacture’ financial instruments, encompassing the creation, development, issuance, and/​or design of financial instruments: Delegated Directive 2017/​593 Art 9. Somewhat lighter rules apply to distributors of financial instruments as regards the distribution requirements, as noted below. 326 As noted in section 4.11.3, sustainability-​related objectives must now be considered. 327 Where the manufacturer constructs instruments which are distributed through other firms (and thus has only a limited data-​base on the investors targeted), it must deploy its theoretical knowledge and past experience: Art 9(9).

IX.4  MiFID II/MiFIR and the Retail Markets  813 to its target market, or instead reaching clients for whose needs, objectives and characteristics it is not compatible (Article 9(14)). Further integrating distribution with product development, manufacturing firms must ensure that the information required to be provided to distributors (under MiFID II Article 16(3)) is adequate to allow distributors to understand and recommend/​sell the instrument appropriately, and addresses the product approval process, the target market assessment, and the appropriate distribution channels (Article 9(13)). These administrative rules are heavily proceduralized, particularly as regards the pivotal ‘target market’ analysis. As part of the target market assessment process, the ‘negative’ target market (those clients for whom the product is not compatible) must be identified; the risk/​reward profile of the instrument must be assessed as being consistent with the target market; whether or not the instrument’s design is driven by features that benefit the client, and not by a business model that depends on poor client outcomes, must be assessed; and, of particular relevance to the alignment of firm and investor interests, the charging structure must be compatible with the needs, characteristics, and objectives of the target market, and appropriately transparent to that target market.328 Ongoing review obligations are also imposed by Delegated Directive 2017/​593 (Article 9(14)-​(15)), including that the financial instrument must be reviewed on a regular basis to take into account any event that could materially affect the potential risk to the target market, and to ensure the instrument remains consistent with its target market and is being appropriately distributed to the target market; and that the review process must assess whether the instrument has functioned as intended. The detailed process requirements of Delegated Directive 2017/​593 extend to staffing and to how effective oversight is to be secured. Relevant staff involved in the manufacturing of financial instruments are required to possess the necessary expertise to understand the characteristics and risks of the financial instruments in question (Article 9(5)), while the firm’s internal compliance function must monitor the development and periodic review of the firm’s product governance arrangements to detect any risk of compliance failures (Article 9(7)). In support of the management body’s oversight responsibilities (MiFID II Article 9(3)), and in an indication of the granularity of the administrative rules, related compliance reports provided to the management body must systematically include information on financial instruments manufactured by the firm and their distribution strategy (Article 9(6)). Alongside, similar obligations are imposed by Delegated Directive 2017/​593 on distributors (Article 10), cascading from the core obligation to identify a target market for the financial instruments distributed (even where such a market was not identified by the manufacturer, which could be the case where the manufacturer is a collective investment manager and so not within MiFID II); and including as regards assessment of whether the intended distribution strategy is compatible with the identified target market, review of the financial instruments offered in light of any risks to the intended target market, compliance and governance, expertise, and an obligation on firms to ensure they obtain the necessary information from manufacturers to ensure that financial instruments are distributed in accordance with the needs, characteristics, and objectives of the target market. The silo-​based



328

Delegated Regulation 2017/​593 Art 9(9), (11), and (12).

814  Retail Markets design of EU retail market regulation, which limits the application of the product governance regime to MiFID II investment firms, means that managers of collective investment schemes (in effect, manufacturers of funds) are not required to make relevant information available to distributors under Delegated Directive 2017/​593. A form of workaround is provided by Article 10(2) which requires distributing investment firms to ‘take all reasonable steps’ to ensure they obtain adequate and reliable information from manufacturers not subject to MiFID II, to ensure that the products are distributed in accordance with the needs, characteristics, and objectives of the target market; the information can be drawn from public sources, but where not publicly available, ‘reasonable steps’ must be taken to obtain the information from manufacturers (or their agents). In practice, industry solutions have developed to respond to this gap in the regulatory scheme and to reduce the compliance risks faced by distributing investment firms.329 The distribution requirements are also integrated with the MiFID II conduct rules that apply alongside: under Article 10, distributing investment firms, when deciding on the range of financial instruments and services offered and the respective target markets, must have in place procedures to ensure compliance with disclosure, know-​your-​client, and inducements/​conflict-​of-​interest requirements. These already granular requirements have been further thickened and subject to proceduralization by ESMA’s Product Governance Guidelines, which drill deep into the ‘target market’ process.330 Operational supervisory convergence action has also followed, with a Common Supervisory Action launched in 2021. The product governance regime is further supported by specific supervisory powers: NCAs are empowered to, for example, suspend the marketing or sale of financial instruments or structured deposits where the firm has not developed or applied an effective product approval process or otherwise failed to comply with Article 16(3) (Article 69(2)).

IX.4.11.3 Experience with the Product Governance Regime and Reform The MiFID II product governance regime is among the most heavily amplified and proceduralized corners of the retail market rulebook. A dense product governance ‘manual’ has emerged, in the form of administrative rules and soft law, that can be related to the novelty of the regime and to the related need for clarity. The product governance regime relatedly brought significant change to how firms design investment products, and associated costs and systems changes, requiring that processes be oriented to evidenced investor needs alongside business development and revenue priorities.331 Its wide field of application generated some industry concern from the outset, in particular as regards the application of the target market assessment to products distributed solely in the wholesale markets, and also to less complex products, in particular ‘plain

329 In practice, fund managers typically provide target market disclosures on their funds, using a standard industry template, to allow investment firms to comply with the distribution requirements. Similarly, fund managers typically review the target market of their funds, so that they can advise investment firm distributors accordingly, allowing them to comply with the requirements to review the appropriateness of distribution strategies. The product governance regime has, to some extent, therefore leaked into the collective investment management regime. 330 n 315. 331 The regime has yet to be fully reviewed. ESMA’s 2021 Common Supervisory Action underlined the challenges, finding, eg, that while firms identified target markets, this was, in some cases, approached as a formalistic exercise, carried out in an insufficiently granular manner, and not translated into a compatible distribution strategy: ESMA, Public Statement (2021 Product Governance Common Supervisory Action), 8 July 2022.

IX.4  MiFID II/MiFIR and the Retail Markets  815 vanilla’ bonds.332 While of wide application, the regime is, however, designed to apply proportionately, with proportionality embedded in the administrative rules333 and the ESMA Guidelines similarly suggesting that more complicated products be subject to a more detailed target market analysis.334 An early reform nonetheless followed, with the 2021 MiFID II Quick Fix reform exempting bonds with a high degree of embedded investor protection (‘make-​whole’ bonds, or bonds with no other embedded derivative than a make-​whole clause)335 from the product governance regime (MiFID II Article 16a); despite some ambiguity in the drafting, the exemption applies only to make-​whole bonds and not to ‘plain vanilla’ bonds generally.336 The liberalization was based on the assumption that the imposition of product governance requirements on these bonds was not necessary, given their structure, placed undue costs on financing and could, accordingly, disrupt the capacity of the financial markets to support the recovery from the Covid-​19 pandemic, and could hinder retail investor access to the returns and diversification potential of bond investments.337 In addition, the Quick Fix reforms lifted the product governance requirements fully from all financial instruments marketed or distributed exclusively to eligible counterparties, in response to concerns as to the cost and relevance of the product governance rules in the wholesale markets. The reform, while limited as regards the retail markets, marks an early liberalization of the product governance regime and, as regards retail investor protection, suggests a privileging of capital formation over investor protection, particularly given the proportionality alleviations already in place.338 It may herald a more wide-​ranging liberalization of the product governance regime, with the MiFID II/​MiFIR Review identifying some support for reform.339 332 eg as regards the wholesale markets, International Capital Markets Association (ICMA), Response to ESMA Consultation on the Product Governance Guidelines, January 2017. 333 The administrative rules are to be complied with in a way that is ‘appropriate and proportionate’ (Art 9(1)), while recital 19 to Delegated Directive 2017/​593 notes that ‘for simpler, more common’ products the target market could be identified with less detail, with more detail required for more complex instruments, such as bail-​in-​able instruments. Similarly, recital 18 provides that the rules are to be applied in a proportionate manner, taking into account the nature of the instrument, the service, and the target market, and specifies that for certain ‘simple products’ distributed on an execution-​only basis, where the products are compatible with the needs and characteristics of the ‘mass retail market’, the ‘rules’ (presumably the process) could be relatively simple. 334 eg, 2018 Product Governance Guidelines, n 315, 8 (suggesting that structured products with more complicated return profiles be subject to a more extensive target market analysis). 335 A ‘make-​whole’ clause is one that aims to protect the investor by ensuring that, in the event of an early redemption of a bond, the issuer is required to pay to the holder of the bond an amount equal to the sum of the net present value of the remaining interest payments expected until maturity and the principal amount of the bond to be redeemed: Art 4(1)(44a). 336 Art 16a refers to ‘bonds with no other embedded derivative than a make-​whole clause’. ESMA has advised that the exemption applies only to such bonds, and not to plain vanilla bonds generally: MiFID II Investor Protection Q&A, section 16, Q5. 337 2020 Quick Fix Proposal, n 177, 8. The Commission noted that the exemption would allow issuers to tap a broader base of investors, but ensure that the protections of the product governance regime were retained for complex products. The Commission, in an indication of the influence of ESMA’s soft law, also referenced ESMA’s 2018 Guidelines on product governance, which accommodate a more flexible application of the rules for ‘plain vanilla’ bonds. 338 The reform was contested, with some disquiet in the Council, as was clear from Poland, Italy, and the Netherlands all entering reservations relating to investor protection concerns: Council Document 11861/​10, 21 October 2020. 339 The German Ministry of Finance, reporting on market doubts as to the value of the product governance regime, suggested that a thorough review was needed to assess whether the regime was achieving its investor protection objectives: n 210, 3. Similarly, the Commission’s 2020 MiFID II Consultation had a liberalization orientation asking, eg, whether the product governance regime prevented retail clients from accessing products that could be appropriate or suitable, whether the regime should be simplified, and whether a firm should be permitted to sell a product in the ‘negative target market’, if a client insisted: n 181, 46–​8.

816  Retail Markets For now, the product governance regime remains integral to the retail market regime,340 as was clear from its further revision in 2021 as regards sustainable finance. The product governance regime now requires that ‘sustainability factors’ be taken into account in product governance and oversight processes (including as regards distribution) requiring, inter alia, that the ‘needs, objectives, and characteristics’ of the target market include any sustainability-​related objectives.341 Alongside, manufacturers of products are subject to the sustainability-​related disclosures required under the 2019 Sustainable Finance Disclosure Regulation.342

IX.4.12  Product Intervention IX.4.12.1 The MiFIR Product Intervention Regime and its Evolution Alongside the MiFID II product governance regime, MiFIR introduced a suite of product intervention powers for NCAs and for ESMA.343 These powers allow NCAs and ESMA to restrict or prohibit the marketing, distribution, or sale of products (and to restrict or prohibit ‘types of financial activities or practices’) in exceptional circumstances. The conferral of these powers, which were new to most NCAs344 and which represented at the time a signal expansion of ESMA’s competence, exemplifies the move over the financial crisis towards a more precautionary and interventionist orientation in EU retail market regulatory design. The MiFIR product intervention regime is directed to exceptional intervention, but it sits on a continuum with the MiFID II restrictions on execution-​only distribution and with the MiFID II product governance rules. Together, these regulatory design choices all suggest a regulatory regime that seeks proactively to shape the investment environment in a precautionary manner. The negotiations on the MiFIR product intervention powers were, despite the novelty of these powers, relatively smooth,345 save as regards the scope of, and constraints on, ESMA’s powers. The conferral of direct supervisory/​intervention powers on ESMA has become, following the intervening decade or so since its 2011 establishment, somewhat less (if still) freighted with competing political and institutional interests. At the time of the MiFIR negotiations, however, any proposed empowerment of ESMA was quick to generate political and institutional contestation. The proposed product intervention powers accordingly saw 340 The Quick Fix negotiations saw some discussion of additional liberalization, in the form of the exclusion of non-​structured UCITSs from the regime, but this reform did not prevail: KPMG, Product Governance: evolving expectations (2021). 341 Delegated Directive 2021/​1269 [2021] OJ L277/​137. The reforms also require that the sustainability factors of a product must be consistent with its target market, and that sustainability factors be presented transparently so that distributors can consider the sustainability-​related objectives of clients. ‘Sustainability factors’ are defined by reference to the 2019 Sustainable Finance Disclosure Regulation and the 2020 Taxonomy Regulation. See in outline Ch I section 7.2. 342 See in outline Ch I section 7.2. 343 MiFIR confers parallel powers to ESMA’s powers on EBA, as regards structured deposits (Art 41), while the PRIIPs Regulation confers parallel powers on NCAs and EIOPA in relation to insurance-​based investment products (Arts 16–​18). 344 Although a number of Member States, including the UK, Belgium, and the Netherlands, introduced product intervention powers at an early stage of the financial crisis. 345 The Commission proposed the intervention powers in order to address the persistence of mis-​selling and the dangers of ‘socio-​economic impacts’ were consumers to lose confidence in investment products, but also to ensure greater coordination across NCAs and avoid unilateral action which could disrupt the single market: 2011 MiFID II/​MiFIR Proposals IA, n 162, 17–​19 and 44.

IX.4  MiFID II/MiFIR and the Retail Markets  817 a relitigation of the 2012 Short Selling Regulation debate on the extent to which ESMA could be conferred with direct intervention powers within the constraints of the Meroni doctrine which limits the discretionary executive powers of agencies.346 Most contestation arose in the Council where, although the majority of Member States supported ESMA’s product intervention powers, the negotiations saw divergences as to the degree of discretion which could be exercised by ESMA.347 The final position agreed by the Council, and which is reflected in MiFIR, tightened the constraints on ESMA’s powers, including that its powers only be exercised where the relevant conditions were fulfilled,348 and included more detailed specification of the mandate for administrative rules governing how the ESMA (and NCA) powers were to be exercised.349 Amplification of the conditions governing ESMA (and NCA) action followed in Delegated Regulation 2017/​567.

IX.4.12.2 The NCA Intervention Powers The MiFIR NCA product intervention power (Article 42) is designed as an exceptional measure. Its design reflects many of the features developed for exceptional NCA intervention under the 2012 Short Selling Regulation, with exercise of the power being framed by an ex-​ante monitoring obligation, subject to a series of threshold conditions, and governed by mandatory NCA consultation and ESMA review procedures. The NCA product intervention power is linked to a monitoring obligation: NCAs are required to monitor the market for financial instruments and structured deposits which are marketed, distributed, or sold in or from their Member States (Article 39(3)). Flowing from this monitoring obligation, NCAs are given the power to prohibit or restrict, in or from the Member State, the marketing, distribution, or sale of certain financial instruments or structured deposits, or financial instruments or structured deposits with certain specified features, or a type of financial activity or practice (Article 42(1)), where a series of threshold conditions, specified in Article 42(2), are met.350 The NCA must be satisfied (on reasonable grounds) either: that a financial instrument, structured deposit, or activity or practice gives rise to ‘significant’ investor protection concerns, or, beyond investor protection, poses a threat to the orderly functioning and integrity of financial markets or commodity markets or to the stability of the whole or part of the financial system within at least one Member State; or that a derivative has a detrimental effect on the price formation mechanism in the underlying market. Further constraints apply. The NCA must also be satisfied that existing regulatory requirements under EU law (which are applicable to the financial instrument, structured deposit, or activity or practice) do not sufficiently address the risks in question and that the issue would not be better addressed by improved supervision or enforcement of existing requirements. The action must also be proportionate, taking into account the nature of the risks identified, the level 346 Case 9-​56 Meroni v High Authority (ECLI:EU:C:1958:7). See further Ch I section 6.3 on ESMA and Meroni and Ch VI section 3 on the short selling regime. 347 2012 Danish Presidency Progress Report, n 269, 11. The UK in particular was concerned as to the legality of the proposed powers which it viewed as conferring ESMA with a degree of discretion incompatible with Meroni constraints. 348 The 2011 MiFIR Proposal had been more loosely constructed, proposing that ESMA be empowered to act where it was satisfied on reasonable grounds that the relevant conditions were met. 349 MiFIR Council General Approach 18 June 2013 (Council Document 11007/​13) Arts 31 and 32. 350 The prohibition or restriction may apply in particular circumstances, or be subject to exceptions, specified by the NCA.

818  Retail Markets of sophistication of the investors or market participants concerned, and the likely effect of the action on investors and market participants who may hold, use, or benefit from the financial instrument, structured deposit, activity, or practice. The cross-​border implications are addressed: the measure must not have a discriminatory effect on services or activities provided from another Member State. Similarly, the NCA is required to consult ‘properly’ with NCAs in other Member States that may be significantly affected by the action, and also with the public bodies competent for the oversight, administration, and regulation of physical agriculture markets (given that the intervention could relate to commodity derivatives), where a financial instrument, activity, or service poses a serious threat to the orderly functioning and integrity of these agriculture markets. The NCA may impose the prohibition or restriction on a precautionary basis, before a financial instrument or structured deposit has been marketed or sold to clients (Article 42(2)), and the prohibition or restriction must be removed when the conditions no longer apply (Article 42(6)). Immensely detailed administrative rules under Delegated Regulation 2017/​567 (Article 21) govern the ‘criteria and factors’ which the NCA must take into consideration before deciding ‘significant investor protection concerns’ (or market functioning, integrity, or stability risks) arise and proceeding to prohibit or restrict a product (or activity/​practice). The granular specification of these criteria and factors underscores the exceptional nature of the product intervention power. It also provides an indication of the type of product features which the EU regards as potentially troublesome and, by implication, and in combination with the criteria governing whether a product is ‘complex’ and so cannot be sold execution-​ only without an appropriateness assessment, of the type of investment space regarded as appropriate for retail market investment. The criteria and factors which can ground a restriction/​prohibition of a product include the complexity of the product; the size of the potential detriment; the type of client engaged, including their skill and ability, economic situation, financial objectives, and, integrating the product intervention regime with the product governance regime, whether the product has been sold outside its ‘target market’; the product’s degree of transparency; the product’s components (including leverage); disparity in the expected risk/​return profile; liquidity risks; the degree of innovation; and selling practices. The criteria and factors are specified in a highly granular manner and are further atomized into sub-​criteria and factors.351 NCAs are to assess the relevance of all the identified criteria and factors, and take them all into consideration, in determining whether the conditions relating to significant investor protection concerns and market functioning/​ stability/​integrity threats are met (Article 21(1)). The existence of significant investor protection concerns or a market functioning/​stability/​integrity threat as required under MiFIR can, however, be based on only one of the criteria/​factors (Article 21(1)). Alongside, procedural requirements also apply under MiFIR Article 42, similar to those applicable under the 2012 Short Selling Regulation, designed to facilitate NCA coordination and also to support ESMA review of any NCA action. In particular, the NCA must give not less than one month’s written notice (or notice through another agreed medium) to the other NCAs and ESMA (in exceptional cases where urgent action is necessary to

351 The Art 21 product ‘complexity’ criteria, eg, requires NCAs to consider the type of underlying or reference asset and its transparency; the degree of transparency of costs and changes; the complexity of the performance calculation, taking into account how the return is constructed; the nature and scale of any risks; the bundling of the instrument, where relevant; and the complexity of any terms or conditions: Art 21(2)(a).

IX.4  MiFID II/MiFIR and the Retail Markets  819 prevent detriment, an NCA can act on a provisional basis with no less than twenty-​four hours written notice, as long as a series of conditions are met) (Article 42(3) and (4)).352 On receipt of notification from an NCA of a proposed intervention, ESMA must adopt an opinion on whether the action is justified and proportionate and, where it considers that action by other NCAs is necessary to address the risk, state this in the opinion (Article 43(2)). Where an NCA proposes to take, or takes, action contrary to an ESMA opinion, or declines to take action (contrary to such an opinion), it must publish its reasons—​thereby potentially allowing ESMA to take direct action using its direct powers of intervention (Article 43(3)). Accordingly, while these intervention powers represented at the time a significant empowerment of many NCAs, they were confined by the extensive conditionality and proceduralization framing their exercise, and they were also placed within an ESMA review framework. The ESMA review process provides for a form of regulatory ‘second line of defence’ against the emergence of risks to the single market, as well as a means for facilitating regulatory learning and dialogue, and for supporting NCAs against potential local resistance. The injection of ESMA review into NCAs’ exercise of the product intervention powers also, however, marked, at the time, a significant deepening of ESMA’s influence over NCA operational action.

IX.4.12.3 The NCA Intervention Powers in Action In practice, NCAs’ exercise of their Article 42 powers has, at least so far,353 primarily been a function of prior ESMA action, with little evidence (albeit some) of ‘independent’ NCA action. All NCA Article 42 interventions to date, with two exceptions, have related to NCAs putting in place permanent restrictions to replace the temporary restrictions on CfDs and binary options that ESMA, exercising its parallel Article 40 powers, put in place over July 2018–​July 2019, as discussed in section 4.12.5. One of the two exceptions relates to the Netherlands NCA, which notified restrictions relating to the marketing, distribution, or sale of ‘turbo’ instruments to retail clients (in June 2021); the measure, which received a positive ESMA opinion, was, however, closely based on ESMA’s earlier temporary CfD measures and addressed similar risks. The second relates to the German NCA, which notified a prohibition relating to the marketing to retail clients of futures with additional payment obligations (in August 2022); this measure, which was distinct from the earlier ESMA CfD measures but related to them, also received a positive ESMA opinion.354 Accordingly, 352 The NCA must meet all the relevant Art 42 criteria and, in addition, it must be clearly established that the one-​month notification period would not adequately address the specific concern or threat. The NCA may not take action on a provisional basis for a period in excess of three months. 353 As at November 2022. Details of NCAs’ notification can be found at: . 354 The Netherlands NCA measure was reviewed in ESMA Opinion, 8 June 2021 (Netherlands NCA ‘Turbos’ Intervention). ESMA concluded that the proposed leverage limits, marketing restrictions, and risk warning requirements for ‘turbos’ (a highly leveraged form of bond, used to speculate on the movement of underlying assets, including shares, currencies, and indices) were justified and proportionate. The German NCA’s measure, which was also supported by ESMA, prevented the marketing, distribution, or sale of futures with additional payment obligations to retail clients on the grounds, inter alia, that these products exposed retail clients to potentially significant additional payments in volatile market conditions; were poorly understood by retail clients; that how they were marketed risked exploiting retail client vulnerabilities; and that the product market was growing strongly in the German retail market, with material risks to retail clients: ESMA Opinion, 20 October 2022 (German NCA Futures with Additional Payment Obligations Intervention).

820  Retail Markets while the design of ESMA’s Article 40 temporary direct intervention powers implied that their exercise would follow a failure by NCAs to act under Article 42 (see below), in practice NCA Article 42 action can, for the most part, be regarded as ‘quasi-​implementing’ a prior, temporary ESMA decision under Article 40. The 2021 and 2022 interventions by the Netherlands and German NCAs nonetheless indicate some appetite for independent NCA intervention, particularly in the context of execution-​only distribution, where MiFID II requirements may not provide sufficient protection if products are complex and leveraged, potential losses significant, and the marketing setting vulnerable to exploitation. As regards NCAs’ ‘quasi-​implementation’ of ESMA’s prior 2018-​2019 measures, and taking the CfD restrictions as an example, most NCAs, in replacing the ESMA Article 40 temporary measures with permanent Article 42 measures, followed the terms of the ESMA restrictions almost exactly (save as regards some nuancing by a small number of NCAs of the terms of the original ESMA CfD risk warning). Only a very small number of NCAs adopted more stringent or more specified restrictions; these were found by ESMA, in reviewing the NCAs’ actions, to be justified and proportionate as evidencing an investor protection need.355 In the case of three NCAs, a less stringent approach was adopted, and in all three cases ESMA adopted a negative opinion, finding that the measures were not, as a result, justified and proportionate. In the case of the Polish NCA’s measures, their reduced territorial scope and their relaxation of ESMA’s original margin limitations on CfD transactions, were found by ESMA to prejudicially limit investor protection; while in the case of the Cyprus NCA, a limitation on territorial scope was also found to limit investor protection.356 In the case of the Hungarian NCA’s measures, the lack of competence of the NCA, under its national law, to impose a generally applicable prohibition meant that the NCA could only make the temporary ESMA measures permanent by means of individual decrees, and also could not attach the restrictions to passporting firms, a territorial limitation which ESMA found rendered the measures not justified or proportionate. Following a subsequent legislative change to the NCA’s powers, a revised and expanded prohibition met with a positive ESMA opinion.357 A fourth example is now of only historical interest, but it underscores ESMA’s appetite for active review of NCA Article 42 action. The UK NCA, in replacing the ESMA temporary measures, significantly reduced the original leverage limits adopted by ESMA. ESMA’s review found that the proposed intervention measures did not, as a result, adequately meet evidenced investor protection needs and that they also generated regulatory arbitrage risks.358 355 See the ESMA Opinions on the permanent measures replacing the temporary ESMA restrictions on CfDs proposed by the French and Austrian NCAs (more detailed specification as regards virtual currencies) and Spanish NCA (additional disclosure requirements): ESMA Opinions 26 June and 3 May 2019, and 24 June 2019, respectively. 356 The Polish NCA had loosened the margin restrictions contained in the original ESMA temporary measures for more experienced retail clients, an alleviation ESMA found to be made without evidence; and did not apply its restrictions to home-​authorized firms in other Member States, unless there was no such restriction in place in the other Member State, a feature ESMA found to reduce investor protection: ESMA Opinion, 30 July 2019. The Cyprus NCA had similarly disapplied its restrictions to home-​authorized firms operating in other Member States (unless there were no such restrictions in place), also leading to a negative ESMA review: ESMA Opinion, 27 September 2019. 357 ESMA Opinions, 8 April 2020 and 30 July 2019. 358 ESMA Opinion, 24 June 2019. The UK NCA had reduced the relevant ESMA leverage limit on CfD transactions (5:1) to 30:1 (as regards instruments linked to certain government bonds and given evidence from the UK market). In a sharply worded Opinion, ESMA noted that its original leverage limit was based on a ‘balanced level of granularity’, took into account evidence from other NCAs, including the UK, and represented a ‘common basis’

IX.4  MiFID II/MiFIR and the Retail Markets  821 Experience so far with the Article 42 NCA intervention powers suggests two observations: first, NCAs seem, to some extent at least, to deploy these powers under the shadow of ESMA’s temporary powers of intervention;359 and second, ESMA has emerged as purposeful in using its review powers to signal that any prior action by it sets a minimum floor for subsequent NCA action. The NCA intervention power has accordingly, at least so far, developed as an ESMA-​framed power.

IX.4.12.4 ESMA’s Intervention Powers In a parallel obligation to that imposed on NCAs, ESMA is charged with monitoring the market for financial instruments (EBA is conferred with this power in relation to structured deposits) which are marketed, distributed, or sold in the EU (MiFIR Article 39(1)). This monitoring obligation is accompanied by direct powers of intervention, although any such ESMA measures apply on a temporary basis only (Article 40). ESMA’s Article 40 temporary intervention powers are similar to the NCAs’ Article 42 powers, albeit that tighter conditions apply, designed to limit ESMA’s discretion and thereby to ensure compliance with Meroni.360 ESMA, acting under the foundation enabling power conferred on it by ESMA Regulation Article 9(5),361 and where the relevant MiFIR conditions are fulfilled, may temporarily prohibit or restrict in the EU the marketing, distribution, or sale of certain financial instruments, or financial instruments with certain specified features, or a type of financial activity or practice (Article 40(1)).362 These powers (like the NCA Article 42 powers) apply only to MiFID II firms. Collective investment scheme managers accordingly fall outside Article 40, through a regulatory gap that illustrates the inconsistencies that flow from the EU’s silo-​based system.363 Albeit that any ESMA Article 40 action can only be temporary in nature, ESMA’s hierarchically superior position is clear: action by ESMA prevails over any previous action taken by an NCA (Article 40(7)). In practice, as noted in section 4.12.3, the taking of temporary action by ESMA has come to frame

for NCA action; and found that the alleviation would result in a prejudicial divergence and was not justified or proportionate. 359 Absence of intervention does not, however, imply a lack of NCA oversight (as also shown by the 2021 and 2022 Netherlands and German NCAs’ actions). eg, the German NCA undertook a review of the appropriateness of a prohibition on certain credit-​linked notes being marketed to retail investors, over 2016–​2017 (including notification of potential restrictions), but concluded that voluntary industry action had addressed the retail market risks: BaFIN, Statement (Credit-​linked Notes: BaFIN Decides Not to Prohibit Retail Distribution), 5 December 2017. 360 Constraints are similarly imposed as regards ESMA’s position limits and short selling powers (Chapter VI sections 2.5.3 and 3.7.2). 361 This provision empowers ESMA to temporarily prohibit or restrict the marketing, distribution, or sale of certain financial products, instruments or activities that have the potential to cause significant financial damage to customers or consumers, or to threaten the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system in the EU, in the cases specified, and under the conditions laid down, in relevant EU legislation (such as MiFIR); or, if so required, in the case of an emergency situation (as governed by Art 18 of the ESMA Regulation which addresses emergency conditions; see Ch I section 6.5 in outline). 362 The prohibition or restriction may apply in particular circumstances, or be subject to exceptions, specified by ESMA. 363 Accordingly, an ESMA Art 40 restriction of the marketing of a UCITS or alternative investment fund share or unit would apply to any MiFID II investment firms distributing such instruments, but not to the direct distribution of such instruments by the relevant UCITS or alternative investment fund manager where they were not authorized to provide MiFID II services. This gap has repeatedly been raised by ESMA as generating distortions and arbitrage risks, including in its 2020 review of the product intervention regime for the Commission (n 374), as noted below.

822  Retail Markets how NCAs exercise their Article 42 powers, with NCAs, in effect, using their parallel powers to translate ESMA’s temporary actions into permanent measures. Stringent conditions apply to any ESMA action. These are similar to those applicable to NCA action, albeit oriented to the cross-​border context and to pan-​EU risks. ESMA may only act if all three threshold conditions are met (Article 40(2)): the proposed ESMA action addresses a ‘significant’ investor protection concern or a threat to the orderly functioning and integrity of financial markets or commodity markets or to the stability of the whole or part of the financial system in the EU; regulatory requirements under EU law applicable to the financial instrument or activity do not address the threat; and an NCA or NCAs have not taken action to address the threat or the relevant action taken has not adequately addressed the threat. ESMA may act on a precautionary basis (before the financial instrument is marketed, sold, or distributed) once these conditions are met. ESMA must also ensure that the action does not have a detrimental effect on the efficiency of financial markets or on investors that is disproportionate to the benefits of the action; does not create a risk of regulatory arbitrage; and has been taken following consultation with relevant public authorities in the case of action relating to commodity derivatives (Article 40(3)). Article 40 also specifies a series of procedural requirements, including that ESMA must inform NCAs of any proposed action, publish notification on its website of the decision, and review the action at appropriate intervals and at least every six months.364 An immensely detailed set of administrative rules, almost identical to those governing NCA Article 42 action, govern ESMA’s powers by specifying the ‘criteria and factors’ to be taken into account before Article 40 action can be taken (Delegated Regulation 2017/​567 Article 19). As is also the case with the Article 42 NCA power, ESMA must assess the relevance of all the identified criteria and factors, and take them all into consideration, in determining whether the threshold conditions relating to significant investor protection concern and market functioning/​stability/​integrity threats are met, but it may determine the existence of a significant investor protection concern or a market functioning/​stability/​integrity threat based on only one of the criteria/​factors.365 While the threshold conditions governing ESMA Article 40 action are almost identical to those governing NCA Article 42 action, they are more prescriptive in practice (in an articulation of the Meroni principle that also reflects the political and institutional sensitivities) in that these conditions ‘must’ be fulfilled; as regards NCA Article 42 action, a ‘reasonable grounds’ qualification applies.366 A parallel suite of temporary intervention and coordination powers are conferred on EBA with respect to structured deposits. While this silo-​based approach reflects the allocation of banking and financial market competences to EBA and ESMA respectively, it underlines the risks of the EU’s sectoral approach to regulation and the need for close coordination between ESMA and EBA. 364 NCAs, by contrast, are not required to review their action at regular intervals, although they must revoke the action if the threshold conditions no longer apply: MiFIR Art 42(6). 365 Delegated Regulation 2017/​567 Art 19(1). Recital 19 reinforces this direction, explaining that the need to assess all the criteria or factors should not prevent the power being used by ESMA where only one of the criteria or factors leads to the concern or threat. 366 Under Art 40(2), ESMA ‘shall take a decision [to adopt measures] only if all the . . . conditions [as to investor protection/​market functioning, stability, integrity; and as to no regulatory requirements addressing the threat and NCAs not having acted] are fulfilled’. By contrast, NCAs are required to be satisfied on ‘reasonable grounds’ that the relevant conditions are met (Art 42(2)).

IX.4  MiFID II/MiFIR and the Retail Markets  823

IX.4.12.5 ESMA’s Intervention Powers in Action ESMA might have been expected to have been wary of exercising its Article 40 powers, given their novelty and the political sensitivities. These intervention powers are not, however, ‘paper tigers’, as became clear from ESMA’s first (and so far only) deployment of these powers in 2018, shortly after MiFIR came into force in January 2018. In June 2017 ESMA gave its first indication that it would exercise these powers, in relation to the pan-​EU outbreak of mis-​selling of complex CfDs367 and similar products over 2015–​17,368 once MiFIR came into force in January 2018.369 ESMA confirmed its appetite for intervention over December 2017 and January 2018, but took a cautious approach, engaging first in a call for evidence on its proposed intervention.370 Its decision to adopt product intervention measures was taken and communicated to the market in March 2018, in advance of the subsequent publication of the formal decisions in May 2018.371 The path-​ breaking measures imposed a series of temporary restrictions on the marketing in the EU of CfDs to retail investors; and also imposed a temporary prohibition on the marketing of binary options to retail investors. As regards CfDs, the marketing restrictions (applicable to retail investors only, and from 1 August 2018) included leverage limits on the opening of a CfD position (tailored to the volatility of the underlying asset and ranging from 2:1 for crypto-​currencies to 30:1 for major currencies); restrictions on the extent to which margin could be deployed; a negative balance protection to limit losses; and standardized risk warnings.372 As regards binary options, a complete prohibition was applied to the marketing, distribution, or sale of binary options to retail investors, from 2 July 2018.373 The measures were renewed on three occasions, before the restrictions lapsed at end of July 2019, by which time most NCAs had put in place parallel permanent measures under MiFIR Article 42. ESMA’s subsequent review, which was based on a public call for evidence, reported on a significant impact:374 the market for binary options (for retail investors) closed; and, as regards CfDs, there was a decrease in CfD retail accounts and trading volumes, the average costs incurred by retail clients were significantly lower, and there was a sustained decrease in the number of times retail accounts went into negative equity and in the size of negative equity balances.

367 A CfD (contract for difference) is a cash-​settled derivative instrument that allows investors to speculate on the price direction, long or short, of the underlying asset, without owning the asset. 368 Over 2015–​17, aggressive online marketing by certain Cyprus-​based investment firms of CfDs to retail investors led to investor losses, a swathe of complaints, and to concerns across affected NCAs and within ESMA. While ESMA’s subsequent intervention measures were associated with practices by Cyprus-​based firms, they were designed to capture the CfD market generally. In its initial May 2018 Decision imposing restrictions, ESMA noted that a rapid increase had occurred in the marketing, distribution, or sale of CfDs, which were ‘inherently risky and complex products’, with marketing often involving ‘aggressive marketing techniques’ and a lack of transparent information; and reported on widespread NCA concern and numerous retail investor complaints: ESMA Decision (EU) 2018/​796 [2018] OJ L136/​50, May 2018, section 1(1). 369 ESMA, Product Intervention, General Statement, 30 June 2017. 370 ESMA, Statement (Preparatory Work in relation to CfDs and Binary Options offered to Retail Clients), 15 December 2017 and ESMA, Call for Evidence on Potential Product Intervention Measures (2018). 371 ESMA, Statement (Additional Information on the Agreed Product Intervention Measures relating to Contracts for Differences and Binary Options), 27 March 2018. 372 ESMA Decision (EU) 2018/​796 [2018] OJ L136/​50, May 2018. The Decision was subsequently replaced by three subsequent Decisions, each extending the original measures for a period of three months. 373 ESMA Decision (EU) 2018/​795 [2018] OJ L136/​31, May 2018. The Decision was subsequently replaced by three subsequent Decisions, each extending the original measures for a period of three months. 374 ESMA, Technical Advice to the Commission on the Effects of Product Intervention Measures (2020).

824  Retail Markets This intervention by ESMA represented at the time, and continues to mark, a major staging post in the development of EU retail market governance. As the first, and so far only, exercise of the Article 40 power, care must be taken in drawing conclusions, but some preliminary observations can be hazarded.375 The apparently smooth and speedy adoption of the ESMA measures, notwithstanding their novelty, and the subsequent adoption by the vast majority of NCAs of very similar national measures to replace the temporary ESMA measures,376 suggests a strong degree of NCA/​ESMA cohesion, and also an NCA preference for ESMA action to precede NCA action. Far from representing an incursion into NCA autonomy, the ESMA temporary measures, preceding as they did permanent NCA action, can be regarded as amounting to something of a useful test-​bed for NCAs377 before they imposed similar measures.378 The exercise of the power also suggests that ESMA action will be reserved for serious cases of retail investor detriment379 of pan-​EU extent,380 and accompanied by extensive empirical assessment.381 A concern for proportionality (as required under Article 40(3)) can, however, be observed.382 Relatedly, the measures were of a last resort nature. ESMA had previously pursued a multi-​faceted supervisory convergence response, which included the establishment of an ESMA CfD Task Force and a Joint Group of NCAs to facilitate NCA coordination; ESMA’s support of the Cyprus NCA in intensifying its supervisory and enforcement activities; and investor warnings and directions to the industry.383 Finally, the experience suggests significant ESMA reach over the product intervention ‘regulatory space’. The vast majority of NCAs adopted permanent measures which were almost identical to ESMA’s temporary measures, and in those limited cases where NCAs adopted more liberal approaches, ESMA found that the measures were not justified or proportionate. In the case of the Hungarian NCA, ESMA’s negative review opinion led, as noted in section 4.12.3, to a change to Hungarian legislation to expand the NCA’s powers. 375 For extensive analysis see Iglesias-​Rodríguez, P, ‘ESMA as a Residual Lawmaker: the Political Economy and Constitutionality of ESMA’s Product Intervention Measures on Complex Financial Products’ (2021) 22 EBLOR 627. 376 Twenty-​three of twenty-​seven NCAs, eg, adopted parallel permanent measures restricting CfD marketing, to replace ESMA’s temporary CfD measures. 377 Not least as stakeholder concern was directed to ESMA. One of the Europe’s largest online trading platforms, eg, set up a web platform from which customers could protest against the reforms, which generated some 14,600 responses: Murphy, H, ‘Europe Market Watchdog Hits Retail Trading Platforms with Tough New Rules’, Financial Times, 27 March 2018. 378 The UK FCA, at the time one of the pioneers of product intervention in the EU, noted its support for ESMA’s 2017 consideration of potential intervention action, and signalled that any permanent action it would take in the future would take into account any related temporary measures adopted by ESMA: FCA, Statement on ESMA’s Ongoing Work on Possible Product Intervention Measures, 15 December 2017. 379 The May 2018 CfD Decision, eg, reported on retail loss levels in Member States ranging from 75 per cent in Ireland to 89 per cent in France: section 2.3(35). 380 The May 2018 CfD Decision reported on the extent to which CfD losses were being experienced at large scale across the Member States, the rapid growth in CfD sales in the retail market across the Member States, and widespread concern by NCAs. 381 Clear from the extensive discussion of the measures in the two May Decisions and in the earlier January 2018 Call for Evidence, which referenced internal ESMA modelling as well as ESMA analysis of investor returns and of data provided by NCAs. 382 ESMA did not, eg, include warrants and ‘turbo-​certificates’ in the CfD decision despite their similarities to CfD products, although it noted that it would closely monitor such products: May 2018 CfD Decision, section 2(10). 383 ESMA, Statement, European Parliament Committee on Petitions, 17 July 2017; and ESMA Executive Director Ross, Speech, 20 October 2016. On foot of recommendations from its newly constituted CfD Task Force, ESMA also reissued and updated its previously adopted Q&A on CfDs in 2017, and also issued two related warnings to investors.

IX.4  MiFID II/MiFIR and the Retail Markets  825 Alongside, ESMA showed some appetite for soft oversight of industry compliance with the measures, albeit that supervision and enforcement of product intervention measures is an NCA competence.384 ESMA also called for the reach of the product intervention powers to be extended, to address the regulatory gap that arises from the exclusion of collective investment managers (which fall outside MiFID II/​MiFIR) from their reach; and for its powers to be strengthened, by either extending the timespan of ESMA measures from six months to eighteen months or by an empowerment for ESMA to adopt permanent measures.385 ESMA’s 2018–​2019 intervention (and the related NCA actions) sits at the upper end of the spectrum in terms of retail market intervention and is a far-​cry from the disclosure techniques that initially characterized EU retail market regulation. It impacted firms’ business models386 and generated significant industry contestation.387 It implies a precautionary approach to the retail markets that privileges investor protection over investor autonomy (in particular as regards highly leveraged, speculative trades that can generate high returns as well as losses), and that substitutes regulatory determinations as to complexity and risk for investor determinations in this regard, albeit that retail investors retained the freedom to switch their status to professional client status, thereby avoiding the restrictions.388 The debate on the merits of the intervention is likely to continue, but it is certainly clear that it marked the first time there was an operationalized, coordinated, and decisive EU-​level response to a live episode of retail market risk.

IX.4.13  Distribution and the Insurance Distribution Directive The distribution of insurance-​based investment products sits outside MiFID II/​MiFIR, being governed by the 2016 Insurance Distribution Directive (IDD).389 The IDD addresses the distribution of insurance products390 by insurance intermediaries and also addresses distribution by insurance undertakings.391 Its sphere of application is accordingly different 384 ESMA warned the industry of the emergence of practices which were not in compliance with its and NCAs’ intervention measures, in particular firms seeking to avoid the restrictions by inducing retail investors to opt-​in to professional client status, in breach of the MiFID II procedures governing the client classification process (which prohibit any such inducements): Public Statement (Avoidance of Public Intervention Measures), 11 July 2019. 385 2020 ESMA Product Intervention Review, n 374. For an assessment of how the product intervention powers could be finessed see Colaert, V, The MiFIR and PRIIPs Product Intervention Regime: In Need of Intervention (2020) ECFR 99. 386 Plus500, a brokerage firm offering CfDs, eg, experienced a 30 per cent drop in market value linked to the measures: Rovnik, N, ‘Plus500 Plunges 30% on Warning over Tighter Regulation Hitting Profits’, Financial Times, 12 February 2019. 387 ESMA’s 2020 review reported on a series of industry concerns, ranging from the specifics of the two Decisions (in particular the leverage limits imposed on CfDs); the instruments included in the scope of the CfD Decision; the horizontal reach of the actions, instead of being targeted to specific cases of firm malfeasance; and the need for greater clarity in ESMA’s communications: n 374, 11–​13. 388 ESMA’s 2020 review reported on an increase in the number of retail clients classified as professional, and also on increased demand for such reclassification: 2020 ESMA Product Intervention Review, n 374, 10. This demand was, however, in part driven by inducements, in breach of the MiFID II classification requirements (n 384). 389 n138. As the roots of the IDD are in the distinct regulatory devices used to address insurance market risks, and in the particular political economy of the EU insurance market, it will be noted here in high-​level outline only. 390 Defined broadly as advising on, proposing, or carrying out other work preparatory to the conclusion of an insurance contract or in the context of the administration and performance of the contract (including claims), and including the provision of information/​ranking systems which allow a customer to conclude an insurance contract: Art 2(1)(1). 391 Insurance intermediaries must be registered under the IDD, but insurance undertakings are not so required as they are separately authorized under ‘Solvency II’, the EU’s pillar insurance market measure.

826  Retail Markets to that of MiFID II/​MiFIR, and so is its design: the IDD is a minimum harmonization, principled-​based directive that accommodates national discretion and regulation, and that necessarily addresses how any higher standards adopted by Member States apply to passporting actors. It, inter alia, imposes high-​level conduct obligations on the distribution of insurance products, including a fair treatment principle; that disclosures and marketing communications be ‘fair, clear, and not misleading;’ disclosure requirements; advice-​ related obligations (including as regards the requirement to assess the ‘demands and needs’ of the customer, an insurance-​market-​specific obligation; and the provision of the ‘insurance product information document’); and product governance requirements.392 All these are specific to the insurance context, albeit that they have some muted resonances with the MiFID II approach. The IDD also imposes an additional sub-​set of requirements (Articles 26–​30) on the distribution of ‘insurance-​based investment products.’393 These apply where insurance distribution is carried out in relation to the sale of insurance-​based investment products by an insurance intermediary or an insurance undertaking (Article 26). These requirements are modelled on, but not identical to, MiFID II. Specifically, additional organizational requirements, similar to MiFID II Articles 23 and 16(3), apply as regards conflicts-​of-​interest management. These require the intermediary/​ undertaking to have in place effective organizational and administrative arrangements with a view to taking all reasonable steps designed to prevent conflicts of interest from adversely affecting the interests of customers (and which are proportionate to the activities performed, the insurance product sold, and the type of distributor); and to take all appropriate steps to identify conflicts of interest arising in the course of insurance distribution activities and, where the relevant organizational and administrative arrangements are not sufficient to ensure, with reasonable confidence, that risks of damage to customer interests will not be prevented, to disclose such conflicts (Articles 27–​8). Additional disclosure requirements also apply and broadly follow the MiFID II Article 24(4) and (5) approach, if in a more high-​level manner (Article 29(1)). Firms must, in good time prior to contract conclusion, provide ‘appropriate information’ (in a comprehensible form and in such a manner that the customer can reasonably understand the nature and risks of the product and take an investment decision on an informed basis) regarding the distribution of the product and with regard to all costs and charges, including, where ‘advice’ is provided,394 on whether a periodic assessment of suitability will be provided; appropriate guidance on and warnings of the risks associated with the product or in respect of particular investment strategies proposed; and, as regards costs, the cost of advice and the cost of the product and how the customer might pay for it. As regards inducements and commissions, the regime is similar but not identical to MiFID II Article 24(9), being less prescriptive, including as regards quality enhancement. Intermediaries/​undertakings are regarded as fulfilling their fair treatment and conflict-​of-​ interest obligations where they pay/​are paid by a fee or commission, or where they provide/​are provided with a non-​monetary benefit in connection with the distribution of the 392 IDD Arts 17–​20 and 25. 393 An insurance-​based investment product is defined as an insurance product which offers a maturity or surrender value and where that maturity or value is exposed directly or indirectly to market fluctuations; this definition maps the approach taken by the PRIIPs Regulation (section 5): Art 2(1)(17). 394 Advice is defined in MiFID II-​like terms as a personal recommendation to a customer, on their request or at the initiative of an insurance distributor, in respect of one or more insurance contracts: Art 2(1)(15).

IX.4  MiFID II/MiFIR and the Retail Markets  827 product (and in each case by any party except the customer), only where the payment or benefit does not have a detrimental impact on the quality of the relevant service to the customer; and does not impair compliance with the fair treatment principle (Article 29(2)). Member States may impose stricter requirements, including additional prohibitions or restrictions on the acceptance of commissions or non-​monetary benefits, or requirements to return any commission or benefit to customers, but this is a matter for individual Member State discretion (Article 29(3)). The IDD does not impose mandatory requirements on advice where the intermediary describes the advice as ‘independent’, but Member States may require, where such services are provided, that the intermediary assess a sufficiently large number of insurance products available on the market (sufficiently diversified to ensure the client’s objectives can be met) and not limited to proprietary products (Article 29(3)). The IDD also imposes ‘know-​your-​client’ requirements, which are based on MiFID II. Where advice is provided on an insurance-​based investment product, the intermediary/​ undertaking is subject to a suitability obligation, based on MiFID II Article 25(2), to gather and assess the ‘necessary’ customer information as to knowledge and experience, financial situation and ability to bear losses, and investment objectives; and, where such a product is distributed but advice is not provided, is subject to an appropriateness obligation, based on MiFID II Article 25(3)), to gather and assess ‘necessary’ customer information as to knowledge and experience (Article 30(1) and (2)). The IDD also contains a form of MiFID II Article 25(4) ‘execution-​only’ requirement, albeit of distinct design and at the Member States’ discretion. Member States may, where no advice is given in relation to insurance-​ based investment products, allow the distribution to be carried out without an appropriateness assessment where (and in addition to the specified risk warnings) the distribution is at the initiative of the customer, the Article 27 and 28 conflict-​of-​interest requirements are met, and either the product only provides investment exposure to ‘non-​complex’ financial instruments, as defined by MiFID II, and does not incorporate a structure which makes it difficult for a customer to understand the risks, or the product is another form of non-​ complex insurance-​based investment product (Article 30(3)). The IDD regime for insurance-​based investment products has resonances with the MiFID II regime and draws on many of its devices. But it is materially less prescriptive with the result that the regulatory playing field between IDD insurance-​based investments and MiFID II substitutable products is not level, with related risks to investor protection and of regulatory arbitrage driving product design.395 It underscores the challenges the EU faces in ensuring consistent regulatory treatment of substitutable products in a retail market setting where varying political economy effects and market structure dynamics can lead to different regulatory outcomes.

395 Colaert (2015), n 145, calling for a cross-​sectoral omnibus measure addressing the distribution of investment products generally.

828  Retail Markets

IX.5  The PRIIPs Regulation, Disclosure, and the Retail Markets IX.5.1  Context and Coverage Ensuring effective disclosure in the retail markets represents one of the most intractable of regulatory challenges. Disclosure is an investor-​facing tool, but a wealth of evidence underlines the severe difficulties which retail investors face in decoding disclosure.396 To the extent disclosure is useful, its utility is a function of its ‘processability’, or of the extent to which it can be used by investors and achieves the outcomes sought;397 repeated extensions and refinements of the types of disclosure which must be provided are of limited value unless processability is addressed. The designing of effective retail market disclosure accordingly requires close engagement with the behavioural dynamics of information processing; increasingly, this engagement requires examination of the implications of digitalization and ‘gamification’.398 In the EU the challenges are acute, as harmonized rules may not only prove ineffective, but may obstruct productive national innovation. Arbitrage risks are also significant given the silo-​based nature of the EU regime and given in particular the dangers which arise where disclosures are product-​specific and product innovation outstrips the perimeter of regulation. Disclosure has long been a key element of EU retail market regulation, but the financial-​ crisis-​era reform period saw a transformation in the scale, and to the design, of mandatory retail market disclosures: retail investors now receive more disclosures, but disclosures are also more concerned with processability. This shift was long in the making, although retail market disclosures only received sustained attention after the FSAP period. The UCITS Review, which commenced as the FSAP closed, led to the ground-​breaking, retail-​oriented UCITS ‘key investor information document’ (KIID) reform: the KIID was a summary disclosure document that was highly standardized and deployed an array of mechanisms to support processability, including a standardized risk indicator and composite cost disclosures.399 Subsequently, the financial-​crisis-​era reform period led to an expansion of distribution-​related disclosures under MiFID II. As outlined in section 4.7, MiFID II requires that all disclosures be ‘fair, clear, and not misleading’ and imposes pre-​contractual and ongoing disclosure obligations as regards, inter alia, marketing communications, investment firm and product disclosures, conflicts of interests and inducements, costs, suitability, and the advice relationship. Delegated Regulation 2017/​565 amplifies these disclosure requirements in detail. MiFID II does not, however, address processability to any significant extent. The financial-​crisis era also, however, saw the adoption of the PRIIPs Regulation, which, focused to a much greater extent than MiFID II on processability, put in place an innovative, cross-​product, short-​form disclosure regime for investment products, and which is discussed in this section. The PRIIPs Regulation requires that a key information 396 From a vast literature as regards investment products and also public offer-​related securities issuance disclosures see, eg, Williams, n 15; Paredes, T, ‘Blinded by the Light: Information Overload and its Consequences for Securities Regulation’ (2003) 81 Washington University LQ 417; and Schwarcz, A and Wilde, L, ‘Intervening in the Market on the Basis of Imperfect Information: A Legal and Economic Analysis’ (1978–​1979) 127 U Pa LR 630. 397 eg Willis, n 112 and Kozup, J and Hogarth, J, ‘Financial Literacy, Public Policy and Consumers’ Self Protection—​More Questions, Fewer Answers’ (2008) 42 J of Consumer Affairs 127. 398 As examined in ESMA’s recent advice to the Commission on digitalization: 2022 ESMA Retail Market Commission Advice, n 26 399 See Ch III section 4.9.2.

IX.5  The PRIIPs Regulation, Disclosure, and the Retail Markets  829 document (KID) be prepared by manufacturers of ‘packaged retail and insurance-​based investment products’ (PRIIPs) and provided to retail clients when PRIIPs are distributed. MiFID II and PRIIPs, together, are the cornerstones of the retail market disclosure regime, although they sit within a wider disclosure regime that includes the distribution-​oriented disclosures for insurance-​based investments under the IDD, and the prospectus requirements which apply to the issuance of securities under the prospectus regime. While it has evolved significantly, the EU retail market disclosure regime remains a work-​ in-​progress. Its silo-​based nature remains a persistent weakness, particularly as regards the different ways in which distribution costs and product costs are disclosed across the MiFID II, IDD, and PRIIPs regimes. The PRIIPs regime, reflecting its novelty and its wide scope, has struggled in practice. And technological innovation and the development of digital distribution are changing how firms communicate with retail investors, including through ‘gamification’ techniques. Reform is likely, with the Commission’s 2021 consultation on its Retail Investment Strategy highlighting the disclosure regime;400 the 2022 Disclosure, Inducements, and Suitability Study addressing the effectiveness of disclosure;401 the PRIIPs regime under review;402 and ESMA proposing that soft law be used to provide guidance on how the regulatory framework applies to digital disclosures.403 While the outcome of this reform process remains to be seen, the focus on processability, rather than on additional disclosures, augurs well for any future refinements. The dominance of intermediated sales/​advice in the EU suggests, however, that any investment in disclosure design may generate only limited returns given the extent to which EU households rely on advisers of some form. The primary benefits of the EU disclosure regime may, therefore, be indirect. The PRIIPs KID construction process, for example, requires PRIIP designers to focus closely on a PRIIP’s objectives and risks, and so on its suitability for retail market distribution, and thereby supports the MiFID II product governance regime. The following discussion examines the PRIIPs Regulation, the cornerstone (with MiFID II) of the retail market disclosure regime.

IX.5.2  The Evolution of the PRIIPs Regime IX.5.2.1 The PRIIPs Regulation The roots of the PRIIPs Regulation are in the UCITS Key Investor Information Document (KIID). On its adoption in 2009, the KIID was the most advanced of the EU’s retail market disclosure regimes in terms of processability.404 But, while a major breakthrough, it did not address functionally similar products which substitute for UCITS funds, including non-​UCITS collective investment schemes, structured products, and insurance-​based 400 The 2021 Consultation had a wider reach than the investment markets, covering also insurance and pension disclosures, but was concerned, broadly, with whether the current regime was delivering reliable and understandable disclosures, was appropriately clear, supported comparability, contained overlaps and redundancies, and addressed costs effectively: n 26. 401 n 29. 402 See section 5.4. 403 2022 ESMA Retail Market Commission Advice, n 26, emphasizing the applicability of the foundational MiFID II ‘fair, clear, and not misleading’ requirement, and suggesting that soft law be used to address digital innovations. See also n 232. 404 See further Ch III section 4.9.2 on the KIID.

830  Retail Markets investment products, all of which are, to different degrees, substitutable retail investments. Comparability across substitutable products was, accordingly, difficult to achieve and regulatory arbitrage risks were considerable. Cross-​product summary disclosure emerged as a reform priority over the financial crisis, with the Commission proposing a cross-​sector regime in 2012.405 The 2012 Proposal, which, in what was then a novel design choice, took the form of a regulation,406 applied to investment products, defined, in a formula similar to that finally adopted, as products where, regardless of the legal form of the investment, the amount payable to the investor was exposed to fluctuations in reference values or in the performance of one or more assets not directly purchased by the investor. This definition was designed to capture investment funds of all types (UCITSs and non-​UCITSs), structured products (whether packaged as insurance policies, funds, securities, or deposits), insurance-​based investment products, and derivatives.407 Traditional, pure protection, non-​investment insurance products, ‘plain’ shares and bonds (as they are not packaged),408 deposits with a rate of return related to an interest rate (which are not exposed to market risk), and occupational pension schemes were all excluded. The Proposal took a ‘factory gate’ approach in that the manufacturer of an in-​scope investment product was to draw up a Key Information Document (KID) for each investment product produced. A KID was also to be provided in the distribution of in-​scope products. The KID was designed to be a highly standardized short-​form document which would support comprehensibility, but also comparability, across a wide range of investment products. The Proposal adopted a novel, processability-​oriented approach to disclosure, building the KID around a series of blocks organized as questions the retail investor might ask, including ‘what is this investment?’; ‘could I lose money?’; ‘what is it for?’; ‘what are the risks and what might I get back?’; what are the costs?’; and ‘how has it done in the past?’ Unusually, the Proposal also made provision for causes of action by retail investors: where a KID did not comply with the requirements, and the retail investor had relied on it when making an investment decision, the Proposal provided that the investor could claim from the manufacturer damages for any losses caused through the use of the KID. The negotiations on the Proposal proved to be fraught, reflecting the novelty, but also the wide reach, of the new regime. Industry opposition—​particularly from the insurance sector, which would become subject to a new disclosure regime409—​was fierce, and institutional negotiations were difficult. Negotiations in the European Parliament were concerned in particular with the scope of the Proposal, with strong support for the KID additionally to apply to shares and bonds,410 and also for the Proposal to extend beyond disclosure to 405 COM(2012) 169; IA SWD(2012) 187. The Proposal was preceded by extensive consultation and assessment, including a Commission Consultation in 2010, a 2009 Issues Workshop, and a 2010 report from CESR and its sister banking and insurance/​pensions committees. 406 The Proposal took the form of a regulation in order to ensure uniformity and to impose direct obligations on private parties (manufacturers) with respect to the preparation of the required disclosures: 2012 Proposal, n 405, 6. 407 The Proposal was designed to capture ‘manufactured’ products which address capital accumulation needs and which are indirectly exposed to fluctuations in the market value of assets. Key to the notion of an investment product for the purposes of the Proposal was the notion of ‘wrapping’ or ‘packaging’, as products of this type are economically similar and share similar risks in terms of complexity, costs, and opacity: 2012 Proposal, n 405, 7. 408 The extent to which bonds are captured by the PRIIPs Regulation has, however, caused difficulties in practice: section 5.4. 409 During the European Parliament negotiations, strong representations from the insurance industry led to a series of draft amendments to exclude insurance-​based investment products from the Proposal; these amendments were defeated in the November 2013 plenary vote on the Parliament amendments (n 411). 410 The initial draft ECON Committee Report on the Proposal extended its application to shares, interest rate savings products, sovereign debt, bank term accounts, and life insurance (A7-​0368/​2013).

IX.5  The PRIIPs Regulation, Disclosure, and the Retail Markets  831 include distribution and product governance reforms. A complex series of amendments was adopted by the Parliament in late 2013 which, inter alia, extended the Proposal to cover corporate bonds, prescribed new disclosures (including a requirement for the label ‘complex’ to be used in certain circumstances), and introduced product distribution and product governance requirements (thereby creating alignment difficulties with MiFID II).411 The Council reached a position earlier in June 2013 which was relatively close to the Commission’s 2012 Proposal and which restricted the KID to packaged products only.412 Ultimately, the Commission’s original model prevailed (for the most part), following intense trilogue negotiations over spring 2014.413 The PRIIPs Regulation was due to come into force at the end of 2016, but following difficulties with the subsequent administrative rule-​making process, this was delayed to 1 January 2018.

IX.5.2.2 RTS 2017/​653 The development of the administrative rules required to ‘operationalize’ the KID (what would become RTS 2017/​653) also proved contentious. Given the cross-​sector nature of the PRIIPs landscape, the ESAs were jointly charged with delivering the draft RTS. The process was informed by an extensive data-​set, which included consumer testing,414 technical input from a specially constituted Consultative Expert Group, several consultations,415 and an impact assessment.416 The final RTS adopted by the Commission in June 2016, and on the basis of the ESAs’ April 2016 advice,417 became, however, the location of material inter-​ institutional tensions. The European Parliament exercised its RTS veto powers for the first time, and by a significant majority, to reject the Commission RTS in September 2016. The veto was based on the Parliament’s disagreement with the Commission on several technical elements of the RTS’ KID requirements, including as regards the treatment of PRIIPs with multiple underlying investment options (multi-​option PRIIPs or MoPs), the design of the performance scenario models used for the required KID performance scenario disclosures, and when the required ‘comprehension alert’ should be used.418 Further delays followed, with the ESAs disagreeing with the Commission’s consequent revisions,419 but the rules 411 After difficult negotiations, the Parliament voted on a set of amendments in November 2013 (P7-​ TA(PROV(2013) 0489)). 412 PRIPs Regulation Council General Approach, 24 June 2013 (Council Document 11430/​13). 413 Agreement was reached by the Parliament and Council just as the Parliament’s 2009–​2014 term finished. The new regime was adopted by the Parliament at its last plenary session in April 2014 (‘Super Tuesday’ 15 April 2014). 414 Study by London Economics and Ipsos for the European Commission, Consumer Testing Study on Possible New Format and Content for Retail Disclosures of Packaged Retail and Insurance-​based Investment Products (2015). 415 See, eg, ESA Joint Committee Discussion Paper (17 November 2014) and Technical Discussion Paper on the Risk, Performance Scenarios and Cost Disclosures (25 June 2015). 416 See ESA Joint Committee, Final Draft Regulatory Technical Standards (2016). 417 Albeit in the face of significant fund industry opposition, including as regards the RTS’ prohibition on past performance information (which reflected the PRIIPs Regulation): Mooney, A, ‘Big Investors Hit Out at EU over Retail Fund Rules’, Financial Times Fund Management Supplement, 20 June 2016. 418 European Parliament, Objection to a Delegated Act: key information documents for packaged retail and insurance-​based investment products, 14 September 2016 (P8_​TA(2016) 0347). The Parliament raised concerns, eg, as to the treatment of UCITS KIID disclosures where a UCITS was incorporated in a multi-​option PRIIP; that the adverse performance scenario model for the KID did not sufficiently illustrate downside risks; and that a lack of detailed guidance on the comprehension alert could lead to implementation risks. The vote was decisive: 561 votes in favour of a veto, nine against, and seventy-​five abstentions. 419 The Commission, in responding to the Parliament’s concerns, clarified that the UCITS KIID could be used to provide additional disclosures for multi-​option PRIIPs; adjusted the adverse performance scenario to be more prudent and added an additional ‘stressed’ scenario; and provided more detail on when the comprehension alert was to be used (these revisions were ultimately adopted): Commission, Letter to the ESAs, 10 November 2016. The

832  Retail Markets were finally adopted, as RTS 2017/​653, in April 2017.420 The inter-​institutional imbroglio, which generated significant industry concern given the related delays,421 also led to a postponement of the implementation of the PRIIPs Regulation by one year to 2018.

IX.5.3  The PRIIPs Regulation IX.5.3.1  Scope The PRIIPs Regulation is concerned with the design, format, and processability of PRIIPs short form disclosure but also, and adopting an integrated approach, with the distribution of this disclosure. The Regulation lays down uniform rules on the format and content of the key information document (KID) to be drawn up by PRIIP manufacturers, and on the provision of the KID to retail investors, in order to enable retail investors to understand and compare the key features and risks of a PRIIP (Article 1). Distribution of a PRIIP without a KID is illegal.422 The Regulation has been amplified in intricate operational detail by RTS 2017/​653, which was heavily reformed, following a fraught revision process, by RTS 2021/​ 2268.423 RTS 2017/​653 is primarily concerned with the KID’s format and content, and with the related and detailed methodologies governing risk calculations, performance scenarios, and cost disclosures, but it also amplifies the Regulation’s obligations relating to KID review and the timely delivery of the KID to retail investors. Alongside, a detailed ESMA Q&A supports the regime, in particular as regards the practical application of the KID methodologies.424 The Regulation applies to manufacturers of PRIIPs and to persons advising on, or selling, PRIIPs (Article 2(1)).425 The gateway definition of a ‘PRIIP’ is cast in broad terms, capturing a wide universe of products from investment funds to structured deposits. A packaged retail and insurance-​based investment product (PRIIP) is a product that is either a ‘PRIP’ (a packaged retail investment product) or an insurance-​based investment product (Article 4(3)), both of which are defined terms. A PRIP is an investment where, regardless of the legal form, the amount repayable to the retail investor is subject to fluctuations because of exposure to reference values or to the performance of one of more assets which are not directly purchased by the retail investor (Article 4(1)).426 A PRIP is not accordingly defined Commission’s revisions were not, however, supported by the ESAs. While ESMA and EBA supported the revisions by a qualified majority vote, a majority could not be achieved at EIOPA given concerns as to the treatment of multi-​ option PRIIPs, the comprehension alert criteria, and the treatment of insurance-​based PRIIPs. Alongside, all three ESAs advised the Commission of their concern that the performance scenario changes, which were designed to dampen performance expectations in light of the Parliament’s concerns that the related models were overly optimistic, could lead to retail investors being misled, and undermine the credibility of the disclosures, if the results were overly pessimistic: ESA Joint Committee, Letter to the Commission, 22 December 2016. The performance scenarios remained problematic, albeit on the upside, as outlined in section 5.4. 420 RTS 2017/​653 [2017] OJ L100/​1. 421 Mooney, A, ‘Industry Frustrated by EU Retail Regulation Saga’, Financial Times Fund Management Supplement, 9 January 2017. 422 As confirmed by the Commission: Commission, PRIIP Guidelines (2017) [2017] C218/​11. 423 RTS 2021/​2268 [2021] OJ L455/​1. See section 5.4. 424 Joint ESA Committee, Q&A on the PRIIPs Key Information Document. 425 Specified products are exempted from the Regulation, primarily: non-​life insurance and insurance contracts and pension products (regulated under discrete regimes); sovereign and other public debt; and deposits other than structured deposits (Art 2(2)). 426 Including instruments issued by specified special purpose vehicles and securitization special purpose entities, in each case as defined and regulated under the relevant sectoral regime.

IX.5  The PRIIPs Regulation, Disclosure, and the Retail Markets  833 by reference to whether or not the assets are held directly or indirectly, through a wrap or structure of some kind, but in relation to the nature of the return; its application to bond instruments accordingly has caused difficulties.427 An insurance-​based investment product is one which offers a maturity or surrender value, and where that maturity or value is wholly or partially exposed, directly or indirectly, to market fluctuations (Article 4((2)). The Regulation applies only to PRIIP distribution to retail investors (Article 1): ‘retail investor’ is defined as a retail client, in accordance with the MiFID II client classification regime; or, given the inclusion of insurance-​based investments, as a customer within the meaning of the 2016 IDD who would not qualify as a MiFID II professional client (Article 4(6)). The Regulation’s obligations apply to manufacturers of PRIIPs (any entity that manufactures PRIIPs or that changes an existing PRIIP, including by altering its risk/​reward profile or its costs)428 and to persons selling a PRIIP (any person offering or concluding a PRIIP contract with a retail investor): Article 4(4) and (5)). The wide scope of the PRIIPs regime means that it had on its implementation, and continues to have, troublesome and intricate interactions with other disclosure regimes. Where the distribution of a PRIIP falls within the prospectus regime, the prospectus requirements apply in parallel (Article 3(2)). The prospectus summary requirements have, however, been adjusted to reflect the interaction between the prospectus summary and the KID.429 Most difficulties attended the interaction between the PRIIP KID and the UCITS KIID, and the replacement of the KIID by the KID. While now of historical interest, following the replacement by the KID of the KIID from end December 2022, they illustrate the challenges in applying a disclosure measure across a universe of investment products. UCITS funds come within the scope of the Regulation as PRIIPs and are subject to the KID requirement. Market familiarity across the funds sector with the precursor UCITS KIID, the tailoring of the UCITS KIID to the features of the UCITS fund, and widespread experience with, and support of, the use of backward-​looking past performance disclosures in the KIID (these disclosures are prohibited under the KID which uses forward-​looking performance scenarios) combined to generate a weighty rear-​guard action against the PRIIP KID, which was perceived in many quarters as being flawed and inferior to the UCITS KIID.430 The Regulation permitted the use of the UCITS KIID to meet the PRIIPs KID requirement for a transition period extending, originally, until 31 December 2019. The subsequent reform of RTS 2017/​653 in 2021 by RTS 2021/​2268 was in part designed to support the movement from the KIID to the KID by making a series of UCITS-​related adjustments to the design of the KID. A final transition period, until 31 December 2022, was accordingly provided to allow the UCITS industry to adjust to the PRIIPs KID format, following the 2021 revisions. Alongside, the UCITS regime was amended to provide that the KID can replace the KIID as regards the UCITS regime’s disclosure obligations, to avoid two short-​form documents operating in parallel for a UCITS and the related risk of investor confusion.431 The PRIIPs 427 Legislative clarification has yet to be provided, but the ESAs have sought to clarify that the Regulation does not apply to specified bond asset classes, given evidence that the potential application of the KID requirement to direct holdings of ‘simple’ bonds was leading to a contraction in the retail bond market: section 5.4. 428 The 2017 Commission Guidelines (n 422) specify that listing an existing PRIIP on a secondary market would not automatically imply its risk/​reward or cost profile had changed. 429 See Ch II section 4.9.8. The Regulation also applies in parallel with the insurance-​specific requirements applicable under the insurance regime (Solvency II) (Art 3(2)). 430 eg, criticism of the PRIIP KID’s forward-​looking performance scenarios (which, as noted in section 5.4, proved highly problematic in practice, predicting outlandlishly high returns under certain scenarios) was rife. 431 This reform was achieved by Directive (EU) 2021/​2261 [2021] OJ L455/​15.

834  Retail Markets regime accordingly now governs short-​form UCITS disclosure, and contains related specifications and calibrations for UCITS funds, including as regards indirect access to the past performance information strongly associated with the KIID but which is prohibited for the KID (section 5.4).

IX.5.3.2 The PRIIPs KID: Format The novelty of the PRIIPs Regulation lies in the innovative and highly specified format it established for the PRIIP KID. The foundational obligation requires a PRIIP manufacturer, before a PRIIP is ‘made available’ to retail investors,432 to draw up for that product a KID in accordance with the Regulation and to publish the KID on its website (Article 5(1)).433 The KID must also be reviewed regularly by the manufacturer, revised where necessary, and the new version made available promptly (Article 10).434 A series of general principles apply to the KID. Echoing MiFID II, it must be ‘fair, clear and not misleading’ as well as accurate, provide key information, and do so consistently with any binding contractual documents, offer documents, and the relevant PRIIP’s terms and conditions (Article 6(1)). To signal its importance to retail investors and to support its processability, the KID must operate as a stand-​alone document, separate from marketing materials, and cannot contain cross-​references to marketing materials, although it may cross-​reference to other documents, including a prospectus where applicable (Article 6(2)). The KID is subject to a maximum coverage limit (it must be drawn up as a short document and in a concise manner, with a ‘three sides of A4 paper’ maximum limit) and must be presented in a way that is easy to read, focus on the key information that retail investors need, and be clearly expressed and written in a language and style that facilitates understanding of the information, in language that is ‘clear, succinct, and comprehensible’ (Article 6(4)).435 Like the prospectus summary, and reflecting its retail orientation, the KID must be translated where it is used cross-​border (into either the relevant official language or in another language accepted by the NCA of the Member State where the PRIIP is distributed (Article 7)). Marketing communications are also addressed, and integrated with the KID, being subject to the requirements that, where they contain specific information relating to the PRIIP, they not include any statement that contradicts the KID or diminishes its significance; and that they indicate that a KID is available and how to obtain it (Article 9). At the core of the KID’s regulatory design are the highly articulated legislative requirements that govern the format and content of the KID (set out in Article 8). An opening explanatory statement/​risk warning is required,436 followed by a standardized ‘comprehension alert’ (for complex PRIIPs),437 and then substantive coverage. The substantive coverage of the KID is organized around a series of blocks, designed as retail-​investor-​oriented 432 This trigger has not been amplified and has been the source of some industry concern, particularly where a distribution is targeted to professional investors. 433 A Member State where the PRIIP is marketed may require ex-​ante notification of the KID, by the manufacturer or the PRIIP seller, to its NCA (Art 5(2)). 434 RTS 2017/​653 Art 15 specifies the nature of the review, including whether the KID’s summary risk indicator needs to be adjusted, and its frequency. 435 The Art 6 general principles include that any colours and any corporate branding must not detract from comprehensibility: Art 6(5) and (6)). 436 RTS 2017/​653 Art 8 specifies the language of the warning. 437 In effect, the comprehension alert applies to products which do not qualify for execution-​only distribution under MiFID II: RTS 2017/​653 Art 1. The alert states that ‘You are about to purchase a product that is not simple and may be difficult to understand’.

IX.5  The PRIIPs Regulation, Disclosure, and the Retail Markets  835 questions. The coverage is opened by the ‘what is this product?’ block, which covers the type of PRIIP and its term; its objectives and means for achieving them (including, where relevant, environmental or social objectives); the type of retail investor to whom the PRIIP is intended to be marketed to, in particular in terms of ability to bear investment losses and the investment horizon (a requirement which aligns with the MiFID II product governance requirements); and, where relevant, details of insurance benefits. The next ‘what are the risks and what could I get in return?’ block addresses risks and includes the PRIIP summary risk indicator (including narrative disclosure as to its limits); information on the potential maximum loss of invested capital (including any additional financial commitments, including contingent liabilities); the (highly controversial) performance scenarios; and required taxation disclosures. The ‘what happens if the PRIIP manufacturer is unable to pay out?’ block requires a brief description of any investor compensation schemes, and is followed by the ‘what are the costs?’ block which requires costs disclosure as to direct and indirect costs (including one-​off and recurring costs), presented by means of summary indicators of these costs and, to ensure comparability, total aggregate costs (in monetary and percentage terms) to show the compound effects of the total costs of the investment. This block must also include a clear indication that the PRIIPs distributor will provide disclosures on its costs, so as to enable the retail investor to understand the cumulative effect these aggregate costs have on the investment’s return. The following block has an advisory orientation (‘how long should I hold it and can I take my money out early?’), requiring an indication of the recommended and, where applicable, required minimum holding periods, as well as, inter alia, disclosures on the potential consequences of cashing in the investment before the end of its term (or recommended holding period). The final two blocks address ‘how can I complain?’ and ‘other relevant information’. Article 8 has been amplified in formidable detail by RTS 2017/​653. RTS 2017/​653, as heavily revised in 2021 by RTS 2021/​2268, specifies the required KID disclosures, including the summary risk indicator, performance scenarios, and costs disclosures, in intricate detail. It also, since the 2021 reforms, adjusts the PRIIPs Regulation’s requirements to reflect the distinct features of UCITS funds. The RTS accordingly specifies the disclosures required for each block (including as regards UCITS funds)438, as well as the distinct requirements that apply to PRIIPs offering a range of investment options (MoPs),439 and includes a template for the KID.440 It also sets out in highly granular detail, in the Annexes to the RTS, the methodologies governing how the summary risk indicator is to be constructed and presented;441 the methodologies governing the construction and presentation of the highly contested performance scenarios, and also the related narrative disclosures required as to the limitations of the scenario disclosures;442 and the methodologies governing how costs

438 The ‘what is this product?’ block, eg, includes detailed specification of the information required on UCITS funds and incorporates disclosures provided under the UCITS KIID: RTS 2017/​653 Art 2. 439 In this case, a generic KID is required but also a KID for each underlying investment option. 440 RTS 2017/​653 Annex I. 441 The summary risk indicator is designed to capture credit, market, and liquidity risk and is based on a 1–​7 scale. Detailed methodologies govern how it is calculated and presented: RTS 2017/​653 Art 3 and Annexes II and III. 442 The performance scenarios (covered in Annexes IV and V and revised in 2021 to address the procyclical effect of the original methodology) must be prepared for favourable, moderate, unfavourable, and stress scenarios. Different calculation methods apply to different PRIIPs.

836  Retail Markets (and summary cost indicators) are to be calculated and presented.443 Delving deep into how risk is calculated and disclosed, the RTS can be characterized as an operating, and often highly quantitative, manual for designing KID disclosures. Its technical and highly standardized design, however, led to systemic difficulties when the methodologies governing performance scenario disclosures proved to be prejudicially procyclical in operation (section 5.4). The PRIIPs Regulation and the RTS do not expressly address sustainable finance, although, as noted above, the Regulation requires disclosure, where applicable, of specific environmental or social objectives targeted by the PRIIP.444 Following a 2016 Commission mandate, the ESAs adopted technical advice in 2017 regarding PRIIPs stating to have specific environmental or social objectives.445 While the Commission did not then adopt related rules, reforms can be expected under the forthcoming PRIIPs Regulation review, given the subsequent development of the EU’s taxonomy as regards sustainable finance.446

IX.5.3.3 The PRIIPs KID: Distribution The PRIIPs Regulation integrates disclosure design with distribution (echoing the integration of the MiFID II product governance regime with distribution). It requires that a person advising on or selling a PRIIP provide retail investors with the KID ‘in good time’447 (and free of charge (Article 14)) before those retail investors are bound by any contract or offer relating to the KID (Article 13). The KID distribution obligation applies to all MiFID II distribution channels, whether advised or non-​advised.448 The KID is a pre-​contractual document but it may, exceptionally, be provided after conclusion of the contract, and without undue delay, where the specified conditions are met.449 The

443 The cost disclosures are organized into a ‘costs over time’ table and a ‘composition of costs’ table, designed to show the impact of costs on returns: Art 5 and Annexes VI and VII. The 2021 reforms revised the methodology to align the disclosures more closely with the approach adopted under MiFID II to avoid investor confusion. 444 Art 8(3)(c)(iii). 445 Joint ESA Committee, Joint Technical Advice (PRIIPs with specific environmental or social objectives), July 2017. The ESAs recommended, inter alia, that the PRIIP manufacturer clearly disclose any environmental or social objectives and how they were to be achieved. The advice was cautious, reflecting the ESAs’ view that, given sectoral developments and the ongoing evolution of the approach to sustainable finance, it would not be proportionate to target specific and detailed obligations to PRIIPs that have environmental or social objectives, in particular as to do so could ‘chill’ the development of such products. 446 The ESAs’ 2022 technical advice to the Commission on review of the PRIIPs Regulation suggested that the KID have a new section to show where, in line with the 2019 Sustainable Finance Disclosure Regulation, a PRIIP has a sustainable investment objective or promotes environmental or social characteristics, and that related administrative rules be developed: Joint ESA Committee, Joint Technical Advice (Review of the PRIIPs Regulation), April 2022. 447 Amplified by RTS 2017/​653 Art 17 to require the distributor to take into account the knowledge and experience of the retail investor, the complexity of the PRIIP, and the urgency expressed by the retail investor (where relevant). 448 As was confirmed in the Commission’s 2017 PRIIP Guidelines (n 422), which specify that the Regulation does not distinguish between PRIIPs sold with or without advice provided to the retail investor, or acquired by the retail investor on its own initiative or otherwise. 449 The retail investor has chosen, on its own initiative, to contact the distributor and conclude the transaction by distance means, provision of the KID in advance is not possible, the distributor has informed the retail investor that provision of the KID is not possible and advised the retail investor that they may delay the transaction to receive and read the KID, and the retail investor consents to receiving the KID, without undue delay, after concluding the transaction, rather than delaying the transaction: Art 13.

IX.5  The PRIIPs Regulation, Disclosure, and the Retail Markets  837 medium in which the KID is delivered is also specified: paper is the default mechanism where the PRIIP is offered on a face-​to-​face basis (unless the retail investor requests otherwise), but delivery through another durable medium450 and via websites is also addressed (Article 14).

IX.5.3.4 The PRIIPs KID: Redress and Enforcement The single rulebook usually eschews private causes of action.451 The PRIIPs Regulation is unusual in putting in place a framework liability regime for retail investors, similar in design to that provided under the rating agency regime (Article 11).452 A civil liability action against the PRIIP manufacturer cannot follow solely on the basis of the KID, unless the KID is misleading, inaccurate, or inconsistent with the relevant parts of legally binding pre-​contractual or contractual documents or with the Regulation’s Article 8 format requirements. But where these conditions are met, and a retail investor can demonstrate loss, resulting from ‘reliance’ on a KID when making an investment into the PRIIP for which the KID was produced, the retail investor may claim damages from the PRIIP manufacturer for that loss, in accordance with national law. The Article 11 obligation cannot be limited or waived by contractual clauses. The modalities of any liability action follow national law; elements such as ‘loss’ or ‘damages’ are to be interpreted in accordance with the relevant national law (determined in accordance with private international law).453 Of likely greater relevance to enforcement, given the challenges retail investors are likely to face in taking liability actions, the KID is also situated within a public oversight framework,454 based on NCA supervision and enforcement. The KID is not subject to ex-​ante authorization, but NCAs are to be conferred with all supervisory and investigatory powers necessary to exercise their functions, which include enforcement of the Regulation’s requirements (Article 20). The Regulation follows the NCA enforcement and sanctioning model now in place across the single rulebook, specifying the breaches of the Regulation that must be subject to sanctions, how sanctions are to be applied, the suite of minimum sanctions which must be available to NCAs, including monetary penalties and their quantum,455 and related NCA disclosure and reporting obligations (Articles 22–​19).456

450 ‘Durable medium’ is defined by reference to the foundational definition of durable medium in the UCITS Directive which provides that a durable medium is an instrument which enables an investor to store information addressed personally to that investor in a way that is accessible for future reference for a period of time adequate for the purposes of the information and which allows the unchanged reproduction of the information stored: Art 2(1)(m). 451 See for discussion, in relation to the prospectus regime, Ch II section 4.12.4. 452 Recital 22 explains the liability reform by reference to the ‘significant responsibility’ PRIIP manufacturers have to retail investors in ensuring that KIDs are not misleading, inaccurate, or inconsistent with the relevant parts of the PRIIP’s contractual documents. 453 In this regard, the regime follows the rating agency model. See Ch VII section 15. 454 Requirements also apply regarding complaints and redress processes: Art 19. 455 For legal entities, a minimum upper threshold of €5 million or 3 per cent of turnover is imposed (or up to twice the amount of profits gained or losses avoided); for natural persons, a minimum upper limit of €700,000 applies (or up to twice the amount of profits gained or losses avoided). These thresholds are also used under the Prospectus Regulation. MiFID II, reflecting the wider potential impact of infractions, requires higher minimum thresholds of 10 per cent of turnover for legal persons and of €5 million for natural persons. 456 The Regulation also addresses ‘whistle-​blowing’ and the required procedures and protections (Art 28).

838  Retail Markets

IX.5.4  The PRIIPs KID in Action and Reform The PRIIPs Regulation promised much. Based on an unprecedented level of ex-​ante testing, strongly oriented towards processability, and highly standardized (including as regards firms’ processes and methodologies in relation to KID design), it heralded the prospect of a novel form of short-​form disclosure which would have enhanced the comprehensibility of the disclosures available to retail investors across the PRIIPs universe and supported comparability across a wide range of substitutable PRIIPs products. In practice, the PRIIPs KID has experienced multiple difficulties, including as regards its scope, its interaction with the UCITS KIID, and in particular as regards the methodologies underpinning the required performance scenario and cost disclosures.457 The difficulties were quick to emerge. The coming into force of the Regulation, originally scheduled for 31 December 2016, was extended by one year, following delays in the adoption by the Commission of RTS 2017/​653 (which was finally adopted by the Commission in June 2016), significant Parliament concern (which shaped its subsequent September 2016 veto of RTS 2017/​653), and Member State concern that additional time was needed for the major industry change exercise required.458 Prior to the Regulation’s coming into force, the Commission (unusually) adopted explanatory guidelines (soft law measures are typically the bailiwick of the ESAs), designed to facilitate the Regulation’s implementation, but also indicating some early confusion as to how it applied.459 Scope difficulties continued to bedevil the Regulation, however, in particular as regards the bond markets. The ESAs identified difficulties at an early stage, warning in July 2018 that market uncertainty as to the extent to which ‘simpler’ bonds came within the Regulation was leading to a contraction in bond distribution in the retail markets, and calling for Commission guidance.460 Resolution did not prove straightforward. While the ESAs had suggested a remedial approach based on identifying ex-​ante which bond products were not wrapped or packaged and so fell outside the Regulation,461 the Commission disagreed, finding that it was not possible or feasible to determine ex-​ante and in the abstract which products fell outside the Regulation.462 The ESAs ultimately adopted explanatory soft law which provided guidance

457 As these relate in part to the intricacies of the PRIIP KID’s methodologies for performance scenarios and cost disclosures, and to the complex interaction between the UCITS KIID and the PRIIPs KID, they are noted in outline only. 458 The application date was changed from 31 December 2016 to 1 January 2018 by Regulation (EU) 2016/​2340 [2016] OJ L354/​35. Given the severe time pressure (following the impact of the Parliament veto of the RTS), the adoption of the revising Regulation had to rely on the exceptional circumstances provision which allows for the lifting of the usual requirement that any draft legislation be placed before national parliaments at least six weeks before it is placed on the Council’s agenda for adoption. 459 2017 Commission Guidelines, n 422. The Commission characterized the Guidelines as ‘smoothing out potential interpretative divergences across the Union’. The Guidelines include a series of clarifications relating to the Regulation’s scope, including that the scope of the KID obligation extends to third country PRIIPs distributed in the EU by EU distributors. 460 The ESAs warned that product manufacturers were no longer making certain bond products available to retail investors, given concerns that the products might fall within the Regulation, and also reported on a 60 per cent reduction in the number and volume of low-​denomination issuances by non-​financial corporates in Q1 2018 as compared to Q1 2017, ascribed to KID requirement effects: Letter from the ESAs to the Commission, 19 July 2018. 461 The ESAs’ July 2018 Letter to the Commission set out a series of common bond types and indicated whether they were in or out of scope, suggesting that, given the definition of a PRIIP, perpetual, subordinated, fixed rate, and puttable bonds were not in scope; variable rate bonds and callable bonds could be out of scope, although this depended on their features; and convertible bonds were in scope. 462 Letter from the Commission to the ESAs, 14 May 2019.

IX.5  The PRIIPs Regulation, Disclosure, and the Retail Markets  839 on how different types of bonds could be analyzed for the purposes of whether they fell within the Regulation,463 but warned that legislative reform was necessary. In addition, the methodologies underpinning the KID proved problematic, with the KID performance scenario methodologies, in particular, generating a tidal wave of criticism: the design of the performance scenario methodologies, which had a procyclical bias as regards the data employed and the relevant time-​period to be used, meant that, given the historic strong market performance at the time, PRIIPs were being required to disclose potential high-​return performance scenarios that were in practice inconceivable.464 The difficulties led the UK regulator, following the UK’s departure from the EU, to remove the performance scenario requirement from its ‘on-​shored’ version of the Regulation, and to adopt instead a narrative approach to performance.465 Other difficulties emerged, including as regards the methodology for assessing how transaction costs (arising from trading in underlying PRIIP assets) were to be measured; and with the costs disclosures, with divergences between the MiFID II approach to costs presentation and the PRIIPs approach to costs presentation associated with creating undue costs for firms and generating investor confusion. Running alongside was the longstanding debate on the relative merits of evidenced, backward-​ looking past performance disclosures (the UCITS KIID model) as compared to speculative, forward-​looking performance scenario disclosures (the PRIIPs KID model) and, relatedly, on how UCITSs could be accommodated within the KID.466 Resolution proved difficult, with the ESAs’ efforts at resolution, through proposals for reform of RTS 2017/​653, becoming entangled with the Commission’s review of the Regulation (originally required by end 2018), the then-​ongoing difficulties as regards the transition arrangements for the UCITS KIID, and the debate on past performance disclosures. The ESAs initially sought to propose speedy and targeted adjustments, including to the risk warnings for the performance scenarios and as regards past performance disclosures, pending wider review of the Regulation by the Commission. Their related November 2018 consultation did not, however, meet with industry support, with widespread agreement that the Regulation required a full review and that technical adjustments to the RTS were accordingly premature. In the interim, the Regulation’s review was extended to end 2019, while the UCITS KIID transitional arrangement was also extended, to end 2022. The ESAs

463 ESA Joint Committee, Joint ESA Supervisory Statement: Application of Scope of the PRIIPs Regulation to Bonds (2019) (the Statement followed the approach adopted in the 2018 ESA Letter to the Commission (n 461)). By contrast, the UK FCA, in revising the ‘on-​shored’ PRIIPs Regulation post-​Brexit, and in order to support liquidity and choice in the retail bond markets, listed those features of debt securities that would not cause a debt security to come within the regime (a fixed rate, a floating or variable rate, a put option at a predetermined price, a call option at a price higher than or equal to par, a perpetual or indefinite term, and subordination): FCA, Policy Statement 22.2, PRIIPs. Scope Rules and Amendments to RTSs (2022). 464 Shortly before and after the Regulation coming into force, the generation by the Regulation’s methodologies of potential PRIIP returns, over certain performance scenarios, of in the region of millions of % raised widespread concern: eg Flood, C, ‘Mis-​selling Fears Erupt over Returns of 1m% Plus’, Financial Times, 14 January 2018 and EFAMA, EFAMA Alerts that the new PRIIPs rules will Confuse and Mislead Investors, December 2017. The industry subsequently produced a swathe of reports expressing concern. For an example, summarizing the extent and causes of market concern, see Petraki, A, Schroders In Focus Report, Fixing the PRIIP Key Information Document, September 2019. 465 2022 FCA Statement, n 463. In its earlier consultation paper, the FCA noted that while it supported the aims of the PRIIPs Regulation, the Regulation had generated serious concerns, including as to consumer harm, and in particular as regards the performance scenarios. 466 For a review see ECON Scrutiny Papers, PRIIPs: Revised DA/​RTS on Improved Disclosure Rules for Retail Investment Products, 26 October 2021.

840  Retail Markets accordingly opted to undertake a broadly based review of the RTS,467 but, in an effort to address the performance scenario problem speedily, adopted a soft ‘supervisory statement’ recommending that firms provide additional related risk warnings in the KID.468 Their subsequent October 2019 consultation addressed several proposed technical adjustments to the RTS, including calibrating the RTS to accommodate UCITS funds (including by reflecting the importance of past performance disclosure in the UCITS sector), refining the performance scenario methodology, and aligning the cost disclosures more fully with the MiFID II approach.469 Adding to the intricate technical design challenges, the institutional context proved complex, with some ESA-​Commission friction470 and also difficulties at the ESA level: the draft RTS reforms were agreed by EBA and ESMA (on a qualified majority vote), but were rejected by EIOPA,471 although the draft RTS was subsequently adopted by EIOPA (on a qualified majority vote).472 The long-​running saga was finally closed with the Commission’s adoption of the amending RTS (RTS 2021/​2268) in September 2021 and its coming into force on 1 January 2022. RTS 2021/​2268 is primarily concerned with reforming the KID methodologies. The performance scenario models have been revised to address procyclicality risks, and the related narrative risk warnings have been strengthened. The summary risk indicator has been revised to provide that a firm can increase the indicator’s value, if it considers that it does not adequately represent the PRIIP’s risk. Alongside, the cost indicators have been refined to facilitate investor understanding (and to align better with MiFID II), and the methodology governing the calculation of transaction costs has been refined. The RTS also addresses the incorporation of UCITS-​specific disclosures into the KID (which has now replaced the UCITS KIID), including by means of a requirement for UCITS KIDs to provide a link to a source of past performance information, a compromise designed to accommodate longstanding UCITS market practices regarding past performance information within the PRIIPs Regulation. The long-​awaited PRIIPs Regulation review remains, at the time of writing, outstanding, but may lead to significant reforms.473 467 For a review of the November 2018 consultation, the industry reaction, and the ESAs’ approach see ESA Joint Committee, Final Report (Amendments to the PRIIPs KID), February 2019. 468 ESA Joint Committee, Joint ESA Supervisory Statement concerning the Performance Scenarios in the PRIIPs KID, February 2019. 469 ESA Joint Committee, Joint Consultation Paper (Amendments to the PRIIPs KID), October 2019. 470 The Commission rejected three of the ESAs’ proposed consumer testing scenarios for the reforms (as addressing situations out of scope of the Regulation), leading the ESAs to notify the Commission of their disagreement: October 2019 Joint ESA Consultation Paper, n 469, 14. Alongside, the ESAs reportedly sought to accommodate past performance information in the KID, as a replacement for performance scenarios (for funds), but the Commission was reportedly opposed, given the design of the PRIIPs Regulation (which excludes past performance disclosures), even where past performance might have bettered capture market reality: Riding, S, ‘EU divided over reform to maligned fund performance rules’, Financial Times, 29 June 2020. 471 In part given the prohibition the PRIIPs Regulation places on the inclusion of past performance information in the KID, and also as the Commission’s review of the Regulation had by then yet to commence: ESA Joint Committee, Letter to the Commission (and draft RTS Annex), 20 July 2020. 472 Following subsequent Commission engagement with the ESAs, which included formally requesting adoption of the RTS but also providing reassurances that the review of the Regulation would be undertaken: ESA Joint Committee, Letter to the Commission (and final RTS), 3 February 2021. 473 Major reform may follow if the ESAs’ related advice is a reliable indicator. The ESAs encouraged a ‘broad review’ by the co-​legislators and delivered related and extensive technical advice in April 2022, recommending, inter alia, further consumer testing of the KID to identify enhancements; refinement of the KID in light of digitalization to accommodate visuals and layered disclosures and to require machine-​readability; the addition of ‘dashboard’/​summary disclosures; clarification of the treatment of bonds and more granular specification of the scope of the Regulation; a new section on PRIIPs with sustainable or environmental and social objectives; and, in two potentially major reforms, the introduction of past performance disclosures for investment funds and the recasting of the performance scenario disclosures to a more flexible requirement for ‘appropriate information on

IX.6  The Investor Compensation Schemes Directive  841 The PRIIPs Regulation saga is a story of weaknesses in regulatory design, of inter-​ institutional stasis and friction, and of intense stakeholder lobbying. It also underlines the significant risk of unintended consequences that arises with major, cross-​sector reform: the contraction in retail bond market size and liquidity associated with the PRIIPs reform, for example, underscores the need for careful ex-​ante design and speedy ex-​post rectification. Most fundamentally, it underlines the challenges in designing retail market disclosures which succeed in achieving the outcomes sought: it not clear that the KID is achieving tangible results in terms of facilitating the investor decision, although this is likely to take time and familiarity.474 But some hopeful observations can be made. Significant technocratic capacity was brought to bear on the initial development and subsequent reform of the KID. Solutions, if at times somewhat rickety given the dependence on ESA soft law, were found. Consumer interests were not overlooked, with consumer testing a feature of the reform process.475 A brave experiment in retail market regulatory design, the PRIIPs disclosure regime remains a striking innovation that grapples with the distinct risks faced by retail investors in navigating and comparing retail investment products. It will likely remain a work-​in-​progress for some time, but the prize is great.

IX.6  The Investor Compensation Schemes Directive IX.6.1  Compensation Schemes, Retail Investor Protection, and the EU Investor compensation schemes, by now a well-​established if somewhat controversial feature of the regulatory landscape, act as an ex-​post, last-​resort safety net for investors when investment firms fail. The financial crisis brought into sharp relief at the time the importance of deposit protection schemes. But deposit protection is of a fundamentally different nature to investor compensation. Deposit protection has a consumer protection dimension, but it is primarily a means for supporting financial stability by insuring against the risk of a run on a bank.476 The rationale for investor compensation schemes is less clear-​cut. On the insolvency of an investment firm, investor funds and assets should be available if the firm has complied with asset-​protection rules.477 They may, however, have been fraudulently misappropriated, or operational failures may have resulted in a failure to segregate funds and to record client performance’: Joint ESA Committee, Joint Technical Advice (Review of the PRIIPs Regulation), April 2022. In a further indicator of likely significant reform, Regulation 2021/​2259 (which provided the final extension for the UCITS KIID to KID transition to the end of 2022) noted that a series of concerns had arisen as regards the PRIIPs legislative framework, that these concerns needed to be urgently addressed, and that the Commission was expected to submit its review as a matter of urgency to the European Parliament and Council: recital 7. 474 The Commission’s 2020 consumer test in support of the RTS reform process found that investors generally chose ‘good’ PRIIP investment options, but did so independently of the KID and its design. It also found that past performance disclosures (excluded from the KID) typically performed well: Commission, Consumer Testing Service. Retail Investors’ Preferred Option Regarding Performance Scenarios and Past Performance Information within the KID under the PRIIPS Framework, February 2020. 475 For an account of the consumer testing see the Commission’s Explanatory Memorandum for RTS 2021/​ 2268: C(2021) 6325. 476 From an extensive literature see, eg, LaBrosse, J, Olovares-​Caminal, R, and Singh, D (eds), Financial Crisis Management and Bank Resolution (2009). 477 See Ch IV section 8 on asset protection.

842  Retail Markets assets. The client or investor will then simply have a claim in bankruptcy over part of the assets of the bankrupt firm. Compensation schemes typically intervene to short-​circuit bankruptcy proceedings (which are likely to be lengthy as well as to produce uncertain outcomes in terms of the retrieval of assets) and to return cash and/​or assets to investors. But the funds entrusted to investment firms are typically discretionary. The risks of systemic instability in the event of a loss of investor confidence related to investment firm failure are significantly less material as compared with the systemic risks associated with a bank run. Investor compensation schemes (like deposit protection schemes) can also generate moral hazard risk. Other distorting effects may arise. For example, where schemes are funded by a mandatory industry-​wide levy, this quasi-​taxation may result in sound, prudent firms underwriting improvident and reckless firms and/​or act as a barrier to new entrants. A more interventionist approach to retail market protection, however, suggests that retail investors are vulnerable to firm failure where assets and funds are entrusted to an investment firm, or where other claims are outstanding (including with respect to mis-​selling), and that a degree of protection in the form of a safety net is justified; a retail investor is unlikely to be in a position to assess the soundness and probity of a firm and to minimize the risks of an insolvency. Further, retail investor awareness and understanding of compensation schemes can be low, and compensation schemes are typically capped, making it less likely that schemes would disable retail investors’ incentives to take due care. There is also a financial stability dimension to investor compensation, although to a significantly lesser extent than with respect to deposit protection. Investor losses (or the potential for losses) related to firm insolvency run the risk of damaging confidence in market investment, particularly where there is a strong culture of mass retail participation in the financial markets. A harmonized EU regime for investor compensation schemes has been in place since 1997 under the Investor Compensation Schemes Directive (ICSD).478 Compensation scheme requirements were included among the prudential rules to be drawn up and applied by the Member States under the Commission’s original proposal for the 1993 ISD, but did not survive the negotiation process.479 Subsequently, the Commission’s 1993 proposal for the ICSD480 proved relatively uncontroversial, not least because at the time of the Proposal’s presentation all but two of the Member States had some form of compensation scheme.481 The adoption of the original Deposit Guarantee Directive482 in mid-​1994 triggered, however, a substantial reworking of the Proposal to align it to the DGD.483 The Proposal then stalled again due to the European Parliament’s concerns that it did not adequately protect investors, and it was further delayed by Germany’s European Court of Justice challenge 478 Directive 97/​9/​EC [1997] OJ L84/​22. See generally Wessel, N, ‘Directive on Investor Compensation Schemes’ (1999) 10 EBLR 103, Landsmeer, A and van Empel, M, ‘The Directive on Deposit-​guarantee Schemes and the Directive on Investor Compensation Schemes in View of Case C-​233/​94’ (1998) 5 EFSL 143, and Lomnicka, E, ‘EC Harmonisation of Investor Compensation Schemes’ (1994) 1 EFSL 17. 479 Member States were opposed to the difference in treatment between compensation arrangements for investment services carried out on a services basis, which were subject to the home Member State regime, and through branches, which were subject to the host Member State regime. Member States favoured home country control, as the home authorities were also responsible for investment firm authorization and prudential supervision, and the related harmonization of compensation schemes. The complexities involved in harmonizing compensation schemes meant, however, that to avoid further delays to the adoption of the ISD, compensation schemes were excluded from its scope and reserved for a future directive. 480 [1993] OJ C321/​15. Explanatory Memorandum at COM(93) 381. 481 Explanatory Memorandum, n 480, 14–​15. 482 Directive 94/​19/​EC [1994] OJ L135/​5. 483 [1994] OJ C382/​27. Explanatory Memorandum COM(94) 585.

IX.6  The Investor Compensation Schemes Directive  843 to the DGD. Following the Advocate General’s initial rejection of Germany’s challenge in late 1996,484 a compromise between the Parliament and the Council was reached, and the Directive was finally adopted in March 1997. The ICSD was primarily designed to support passporting by investment firms. Adopted before the retail market agenda subsequently took root over the FSAP period, it suffers from a number of design defects, particularly with respect to its scope, when regarded as a retail investor protection measure. Nonetheless, it remains a landmark measure in the development of EU retail market policy, in that it was the first EU measure specifically directed to retail investors.

IX.6.2  The 1997 ICSD IX.6.2.1 Scope and Claims By stark contrast with the single rulebook generally, and reflecting its adoption in an earlier era of EU financial markets regulation, the ICSD is a minimum-​standards measure and is not amplified by administrative rules. Member States are free to prescribe wider or higher coverage than the Directive’s minimum requirements, while the structure, funding, and operation of compensation schemes are not harmonized. Article 2(1) provides that each Member State must ensure that one or more investor compensation schemes are introduced and officially recognized within its territory. An investment firm authorized in that Member State may not carry on ‘investment business’485 unless it is a member of such a scheme. In parallel, MiFID II Article 14 provides that investment firms seeking authorization must comply with their ICSD obligations at the time of authorization. Credit institutions which come within MiFID II by providing investment services also come within the scope of the ICSD.486 MiFID II additionally specifies that where a credit institution issues structured deposits, the compensation scheme requirement is met where it is a member of a 2014 Deposit Guarantee Directive scheme (Article 14).487 The instruments and investment firms within the scope of the ICSD are thus aligned to MiFID II. The linkage between MiFID II activities and the ICSD’s scope means, however, that collective investment managers and depositaries are excluded from the ICSD; losses sustained in connection with the management of CISs through, for example, custody failures are not covered by the ICSD, although the enhanced depositary regime which applies to UCITS and AIFMD investments provides ex-​ante protection (Chapter III). ICSD compensation schemes are directed, in practice, to retail investors. Coverage extends in principle to the ‘investor’, broadly defined under Article 1(4) as ‘any person who has entrusted money or instruments to an investment firm in connection with investment business’. Under Article 4(2), however, Member States may exclude certain investors regarded 484 The Court would not deliver its judgment rejecting the challenge until May 1997: Case C-​233/​94 Germany v Parliament and Council (ECLI:EU:C:1997:231). 485 Defined under Art 1(2) originally by reference to the 1993 ISD. 486 Where a single scheme meets the requirements of both the ICSD and the DGD (n 487), it is not necessary that a credit institution belong to two separate schemes (ICSD recital 9). It may, however, be difficult to distinguish between funds held on deposit covered by the DGD and funds held in connection with investment business which are covered by the ICSD (recital 9). In such cases, it is within the discretion of the Member State to decide which scheme applies. In addition, double recovery under the DGD and ICSD is prohibited (Art 2(3)). 487 Directive 2014/​49/​EU [2014] OJ L174/​149. It replaced the 1994 Directive.

844  Retail Markets as sophisticated (listed in Annex I) from the scheme completely or limit their degree of protection.488 The ICSD’s retail orientation is also reflected in the minimum compensation requirement. A relatively low minimum level of compensation of €20,000 per investor was adopted (Article 4(1)), as this level was regarded as being ‘sufficient to protect the interests of the small investor’ (recital 11).489 Co-​insurance is also permitted. Under Article 4(4), Member States may, in the interests of promoting a degree of co-​responsibility among investors and ‘in order to encourage investors to take due care in their choice of investment firms’ (recital 13), limit the cover to a specified percentage of an investor’s claim. The percentage covered, however, must be equal to or in excess of 90 per cent of the claim where the amount claimed is under €20,000. Compensation is available in respect of two types of claim. Investors may request compensation for claims arising out of a firm’s inability to repay money owed or belonging to investors and held on their behalf in connection with investment business (Article 2(2)). Claims may also be made under Article 2(2) in respect of the inability of an investment firm to return to investors any instruments belonging to them and held, administered, or managed on their behalf in connection with investment business. Compensation is accordingly available only for a loss of money or instruments arising from the inability of the firm to meet its obligations to investors, whether that arises through fraud or operational failures. Investors may not claim in respect of damages for negligence, breach of statutory or fiduciary duty, or other forms of civil liability. Claims in respect of conflict-​of-​interest breaches, negligent advice (mis-​selling), or misleading advertising are all excluded. In all these cases, investors with a cause of action will simply have a claim over the assets of the bankrupt firm. The right to compensation is triggered when the relevant NCA determines that an investment firm appears for the time being, for reasons directly related to its financial circumstances, to be unable to meet its obligations arising out of investor claims, and has no early prospect of being able to do so (Article 2(2)). Compensation is also payable where a judicial authority makes a ruling, for reasons directly related to an investment firm’s financial circumstances, which has the effect of suspending the ability of investors to make claims against it (Article 2(2)). The earlier in time determination (whether by the NCA or the judicial authority) activates the compensation process. By severing the compensation process from formal bankruptcy procedures in this way, the ICSD speeds up the payment process. The procedures governing the calculation and payment of claims are largely left to Member State discretion.490

488 Annex I is closely related to the original 2004 MiFID I classification system and includes professional and institutional investors, governmental, local and municipal authorities, and larger firms. 489 This figure can be traced to the Original Proposal (1993) in which the Commission noted that a figure of 20,000 would only be significant for the small investor. The Commission also relied on evidence that individual holdings of securities in investment accounts tended on average to be greater than individual holdings of cash held on deposit with credit institutions. In order to protect the small investor, it was therefore essential that the level of compensation be at least as high as that originally set out in the DGD (€20,000): Explanatory Memorandum to Original Proposal, n 480, 8 and 10. 490 Only certain aspects are subject to minimum harmonization. Art 2(4) addresses the calculation of the value of claims; Art 8(1) addresses the aggregation of claims; Art 8(2) addresses claims related to joint business by more than one firm; and Art 9 imposes minimum time periods. Under Art 9(1) the time period within which a claim must be made cannot be less than five months from the determination of the firm’s inability to meet its obligations; Art 9(2) requires that eligible claims be paid ‘as soon as possible’ and within three months of the establishment of the validity of the claim, although a further three-​month extension can be applied.

IX.6  The Investor Compensation Schemes Directive  845 The ICSD also imposes information requirements. Member States must ensure that each investment firm takes ‘appropriate measures’ so that ‘actual and intending’ investors are aware of the compensation scheme to which the firm belongs (Article 10(1)). Information must also be made available concerning the provisions of the compensation scheme, including the amount and scope of cover. The ICSD further requires Member States to establish rules limiting the use in advertising of information relating to compensation schemes, in order to prevent such advertising from affecting the stability of the financial system or investor confidence (Article 10(3)). Alongside, MiFID II requires in-​scope firms to advise clients of the availability of compensation schemes.491

IX.6.2.2 Scheme Governance and Funding The governance and funding of schemes is largely left to the discretion of Member States. The ICSD does not, for example, require that the compensation scheme be placed on a statutory footing (it leaves the form of the scheme to the Member States)492 or address the composition and independence of the scheme’s governing bodies. The ICSD does, however, impose basic requirements regarding the obligations of investment firms covered by ICSD schemes. Under Article 5(1) where an investment firm does not meet the obligations of the scheme, the NCA which authorized that firm must, in cooperation with the compensation scheme, take all measures appropriate to ensure that the firm meets its obligations. If the default continues, the compensation scheme may (where permitted under national law and with the express consent of the NCA) give not less than twelve months’ notice of its intention to exclude the firm from the scheme (Article 5(2)). In the interests of investor protection, the scheme must continue to provide cover in respect of investment business transacted during this twelve-​month period. The ultimate sanction for failure to comply with scheme obligations is loss of authorization, as Article 2(1) sets out that an authorized investment firm may not carry out investment business unless it is a member of a recognized compensation scheme (as also required by MiFID II Article 14). The ICSD is similarly largely silent on the sensitive question of funding models. Recital 23 indicates that the cost of funding schemes be borne by the investment firms themselves, but this is not the subject of a binding provision. It also suggests that the funding capacities of a scheme must be in proportion to its liabilities and that the funding arrangements adopted must not jeopardize the stability of the financial system of the Member State in which the scheme is recognized. Schemes may as a result levy fixed or variable premiums. They may alternatively operate without premiums and levy charges based on the actual commitments to be met by the scheme. Risk-​weighting may or may not be adopted by schemes in assessing contributions. The right of investors under Article 13 to take action against compensation schemes where compensation is not forthcoming (in accordance with relevant national law—​the ICSD does not provide for a specific cause of action) suggests that schemes must be in a position to meet all investors’ claims up to the ICSD’s minimum threshold and, accordingly, that they may not impose maximum pay-​out limits for particular time periods. It is possible

491 Delegated Regulation 2017/​565 Art 47. 492 Article 13 stipulates, however, that Member States must ensure that the investor’s right to compensation may be the subject of an action by the investor against the compensation scheme, and its legal form must therefore allow such an action to be taken.

846  Retail Markets that a catastrophic series of investment-​firm failures could drain the resources of a scheme completely and place considerable funding strains on member firms. It is not entirely clear in such circumstances how the requirement that funding arrangements must not jeopardize the stability of the financial system and the apparent obligation on a scheme to meet all claims can be reconciled. The financial crisis led to wide-​ranging reforms being proposed to funding arrangements and to a significant increase in the level of prescription, but these reforms have since been abandoned.

IX.6.2.3 Cross-​border Claims The pan-​EU retail investment market remains an aspiration, for the most part, and so cross-​border claims are accordingly relatively unusual. Nonetheless—​and foreshadowing the stresses which the allocation of fiscal responsibility would place on the EU’s ability to respond to the financial crisis—​the Directive struggles to allocate responsibility between home and host schemes efficiently. The ICSD operates on a home Member State model. Under Article 7(1), an investor compensation scheme recognized in a Member State also covers investors at branches set up by investment firms belonging to that compensation scheme in other Member States. This model, combined with minimum harmonization, means that investors in the same Member State may be protected to varying degrees depending on whether the investment firm is authorized in that State, or passporting from another Member State, as the home and host schemes may have different coverage levels. Similarly, host Member State branches may suffer from a competitive disadvantage if they cannot offer the same level of coverage in an insolvency as firms authorized in the host State. Although the impact of the scale of the compensation available on the exercise of investor choice is debatable, and the level of cross-​border retail investor activity very low, the ICSD contains a ‘top-​up’ mechanism designed to address these potential distortions. Where the level or scope of the scheme offered by the host Member State exceeds the coverage of the home Member State’s scheme, the host Member State must provide that passporting branches may voluntarily join the host scheme (Article 7(1)). Despite its investor protection benefits, the top-​up rule nonetheless represents a distortion of the home Member State control principle. More generous host schemes are exposed to claims in respect of firms the solvency of which they are not in a strong position to monitor; claims may be made on the host scheme which have arisen due to a failure of supervision by the home NCA responsible for prudential oversight. The ICSD does, however, seek to reduce the risks faced by host schemes, in that a host scheme may subject the branch to objective and generally applied membership conditions and may, after a twelve-​month notice period, expel the branch from the scheme if it does not meet its obligations (Article 7(1) and (2)). Risks have also been reduced by the shift under MiFID I originally and since under MiFID II to branch control for some aspects of investment services supervision, and particularly conduct-​of-​business and record-​keeping rules, although prudential supervision remains a home NCA competence.

IX.6.3  Reviewing the ICSD The ICSD was untouched by the FSAP reform period, which followed shortly after its 1997 adoption, and was generally regarded as a robust measure until the financial-​crisis-​era period.

IX.6  The Investor Compensation Schemes Directive  847 It was first subject to extensive review in 2005.493 The review addressed how the ICSD had been implemented and was broadly positive, although it noted recurring procedural weaknesses, particularly with respect to the timeliness of compensation payments, and made a series of reform recommendations, relating in the main to the mitigation of delays in making payments, to supporting the resilience of schemes’ funding structures, and to assessment of the ICSD’s exclusion of claims relating to investment advice failures.494 The Commission’s response to the 2005 report was muted, reflecting the post-​FSAP and pre-​ financial-​crisis concern to minimize regulatory intervention. Characterizing legislative reform as a ‘last resort’, it supported dialogue between the Member States as the best means for enhancing national schemes.495 Immediately prior to the financial crisis, the ICSD was regarded as relatively resilient—​ although it was (and remains) something of an oddity as a minimum-​harmonization measure. A reform proposal was presented in 2010,496 primarily as a function of the spillover and momentum dynamics of the financial-​crisis-​era, stability-​related reforms to deposit protection which would ultimately lead to the adoption of the 2014 Deposit Guarantee Directive. The 2010 ICSD Reform Proposal, inter alia, extended the scope of the ICSD to cover custody failures by a UCITS depository or a third party custodian used by a MiFID firm, proposed an increase in the level of minimum compensation from €20,000 to €50,000, and removed the co-​insurance option. While these reforms were relatively uncontroversial, the Proposal’s adoption of the pre-​funding requirement adopted by the parallel 2010 proposal to revise the 1994 Deposit Guarantee Directive meant that it failed to garner support. While a revised Deposit Guarantee Directive was, after difficult negotiations on the pre-​funding requirement, finally adopted in 2014,497 and while discussions continue on a mutualized deposit protection scheme as part of Banking Union, the ICSD Proposal languished and since been abandoned.

493 Oxera, Description and Assessment of the National Investor Compensation Schemes Established in Accordance with Directive 97/​9/​EC: Report Prepared for the European Commission (2005). For the Commission’s response see Commission, Evaluation of the ICSD, DG Internal Market and Services—​Executive Report and Recommendations (2005). 494 The Commission interpreted the 2005 review as suggesting that compensation schemes were working ‘fairly well’ and played an important complementary role in providing last-​resort protection: n 493, 10. 495 n 493, 11. 496 COM(2010) 317; IA at SEC(2010) 845. 497 The 2014 DGD requires that Member States ensure that deposit guarantee schemes cover at least 0.8 per cent of the amount of covered deposits by 2024; bank contributions are calculated according to a risk-​based model.

X

THIRD COUNTRIES X.1  The EU, Third Countries, and the International Financial Market X.1.1  Introduction This chapter addresses how the EU manages access by ‘third country’ (non-​EU) financial market actors to the EU financial market. The EU’s engagement with third countries as regards financial markets, and so with the international financial market, has multiple dimensions. The EU, primarily through the Commission, the European Central Bank (ECB), and the European Supervisory Authorities (ESAs), is a key actor in international financial market governance, using its ‘regulatory capacity’, or its ability to shape regulation, to influence the international standards adopted by the International Standard Setting Bodies (ISSBs), including the International Organization of Securities Commissions (IOSCO), the major standard-​setter for financial markets.1 In addition, a web of supervisory cooperation and information exchange agreements tie together national competent authorities (NCAs), the European Securities and Markets Authority (ESMA),2 and supervisory authorities internationally. These agreements, a longstanding feature of international financial markets governance, are increasingly being mandated of NCAs by EU legislation and shaped by ESMA. Alongside, the single rulebook can have wide-​reaching extra-​territorial effects, applying outside the EU,3 although it also provides exemptions for specified third country entities.4 Conversely, the single rulebook imposes obligations on EU-​regulated actors as regards their activities in third country markets: among the many examples are the Markets in Financial Instruments Directive II (MiFID II) rules governing the outsourcing of functions to third countries,5 the Markets in Financial Instruments Regulation (MiFIR) post-​trade transparency reporting

1 For discussion of the EU’s influence on the international standard-​setting process and the related question of its ‘regulatory capacity’ see Moloney, N, ‘International Financial Governance, the EU, and Brexit: the “Agencification” of EU Financial Governance and the Implications’ (2016) 17 EBOLR 451 and, for a financial-​ crisis-​era perspective, Ferran, E, ‘Capital Market Openness after Financial Turmoil’ in Evans, M and Koutrakos, P (eds), Beyond the Established Legal Orders: Policy Interconnectedness between the EU and the Rest of the World (2011). An extensive political economy literature examines the dynamics of the EU’s regulatory capacity in international finance governance. See, eg, Quaglia, L, The European Union and Global Financial Regulation (2014), Mügge, D, Europe and the Governance of Global Finance (2014), and Bach, D and Newman, A, ‘The European Union as a Hardening Agent: Soft Law and the Diffusion of Global Financial Regulation’ (2014) 21 JEPP 430. 2 For discussion of ESMA’s role in international financial governance see Moloney, N, The Age of ESMA. Governing EU Financial Markets (2018) 326–​49. 3 The market abuse regime, eg, does not require a territorial link to the EU, while the short selling regime has a wide scope, reaching transactions carried out outside the EU, as does the EMIR regime for derivatives transactions. 4 Such as the exemption under the short selling regime for shares the principal venue for the trading of which is in a third country. Ch VI section 3.9. 5 Directive 2014/​65/​EU [2014] OJ L173/​349 (MiFID II). Its amplifying Delegated Regulation (EU) 2017/​565 [2017] OJ L87/​1 imposes specific obligations on MiFID II firms where they outsource functions to third countries (Art 32).

850  Third Countries requirements that apply to transactions in financial instruments ‘traded on a trading venue’, where that trading venue is a third country venue,6 and the Undertaking for Collective Investment in Transferable Securities (UCITS) Directive portfolio allocation/​eligible asset rules which impose conditions on third country investments.7 The focus of this chapter, however, is on how the EU manages third country actors’ access to its financial market. The third country access regime constitutes a small and sometimes highly technical and arcane segment of the single rulebook. The totemic ‘equivalence system’, a form of mutual recognition which supports EU-​level access arrangements for third country actors, is available for only a subset of the single rulebook’s measures. Most usually, access by third country actors is a function of Member State discretion and regulation. Nonetheless, the EU access rules can have outsize political effects, as was brought into sharp relief during the negotiations on the UK’s withdrawal from the EU and the adoption of the EU/​UK Trade and Co-​operation Agreement (TCA), considered in outline in section 11. The third country regime is also driving technocratic change to EU financial markets governance. ESMA is being conferred, incrementally but repeatedly, with a range of gatekeeper powers over third country actors, ranging from the certification/​registration of such actors to their full-​blown supervision, and which have the potential to increase its influence and capacity more generally. Given its political salience and technocratic significance, this final chapter accordingly outlines the main features of the third country access regime and its implications.

X.1.2  Access to Financial Markets Internationally International financial market governance is usually characterized as the system which develops standards for the global financial market and facilitates regulatory and supervisory coordination, primarily by means of the different measures adopted by the ISSBs, such as IOSCO.8 It also includes the multiplicity of arrangements states use to manage access to their financial markets. As domestic regulatory systems have become increasingly dense and intricate, and particularly since the financial crisis, states have constructed and finessed access-​related arrangements designed to facilitate international business, but also to secure the autonomy and efficacy of domestic regulatory systems and, by ensuring a level regulatory playing field, to protect the competitive position of domestic firms.9 These arrangements vary internationally, reflecting, inter alia, the preferences of the states concerned, the features of the relevant markets, and the institutional capacities of the

6 Regulation (EU) No 600/​2014 [2014] OJ L173/​84 (MiFIR) Arts 20 and 21 impose post-​trade transparency reporting requirements on transactions in financial instruments ‘traded on a trading venue’. ESMA has adopted an Opinion clarifying when transactions concluded on third country trading venues come within the scope of the obligation: ESMA, Opinion (Determining Third Country Trading Venues for the Purposes of Transparency under MiFID II/​MiFIR), 28 July 2020. 7 UCITS IV Directive (Directive 2009/​65/​EC [2009] OJ L302/​32) Art 50 requires specified UCITS ‘eligible assets’ issued by third country actors or traded on third country venues to meet high-​level equivalence-​style requirements. 8 Avgouleas, E, Governance of Global Financial Markets (2012). 9 See, eg, Hill, J, Regulatory Co-​operation in Securities Market Regulation: Perspectives from Australia’ (2020) 17 ECFR 11, Buckley, R, Avgouleas, E, and Arner, D (eds), Reconceptualising Global Finance and its Regulation (2016), and Verdier, P-​H, ‘Mutual Recognition in International Finance’ (2011) 52 Harvard Int’l LJ 56.

X.1  The EU, Third Countries, and the International Financial Market  851 regulators involved,10 but two main forms of access arrangement can be identified.11 First, under the ‘host’ state control or ‘national treatment’ approach, cross-​border actors (registered/​authorized in their ‘home’ state; in EU parlance, the third country) are subject to the regulatory and other governance (supervisory/​enforcement) regimes of the host state in which they provide cross-​border services or otherwise operate, although different forms of exemption or special treatment may be available, depending on the extent to which the host state accommodates some ‘deference’, in effect, towards the home state. A greater degree of deference to the home state is associated with the second form of access arrangement, which allows the cross-​border actor to operate in the host state under home rules, to some extent. It involves a degree of recognition by the host state of the home state regulatory system, based on some form of ‘equivalence’ assessment. This can assess, variously, the ‘adequacy’, ‘suitability’, or ‘equivalence’ of the home regime, and can be limited to rules only, or cover supervision and enforcement, but is typically outcomes-​based, with different measures used to assess whether the home regime achieves the outcomes sought by the host state in its regulatory scheme. Detailed cooperation and information-​sharing arrangements typically underpin these ‘mutual recognition’/​equivalence arrangements. They can require intricate engineering as they imply that the host state can be assured as to the relative quality of the home system; this can be a delicate exercise that requires judgments as to the comparative quality of regulatory but also supervisory and enforcement systems.12 Whatever the specificities in particular cases, these mutual recognition arrangements are usually bilateral. Multilateral/​regional arrangements are rare, with the EU single market ‘passport’ far and away the most advanced and extensive form of regional mutual recognition/​equivalence arrangement internationally.13 In the run up to the financial crisis, international financial relations between states, and as regards cross-​border access, could be associated, to a degree, with liberalization and so with mutual recognition, reflecting the pre-​financial-​crisis zeitgeist which privileged market ordering and investor autonomy. This dynamic can be illustrated in particular by the pre-​ financial-​crisis adjustment to the posture of the US, the classic ‘great power’ in international finance in terms of its ability to shape international finance governance,14 as regards financial market access. In particular, the US Securities and Exchange Commission (SEC) developed the mutual-​recognition-​like ‘substitute compliance’ mechanism for financial market

10 See Verdier, n 9 and Knaack, P, ‘Innovation and Deadlock in Global Financial Governance: Transatlantic Co-​ Ordination Failure in OTC Derivatives Regulation’ (2015) 22 Rev of IPE 1217. 11 For a policy-​oriented review see IOSCO, Market Fragmentation and Cross-​border Regulation (2019) and IOSCO, Task Force on Cross Border Regulation. Final Report (2015). 12 On the difficulties in comparing and assessing regulatory regimes see, eg, Jackson, H, ‘Substituted Compliance: the Emergence, Challenges and Evolution of a New Regulatory Paradigm’ (2015) 1 J of Fin Reg 169, Coffee, J, ‘Law and the Market: the Impact of Enforcement’ (2007) 156 U of Pa LR 229, and Jackson, H, ‘Variations in the Intensity of Financial Regulation: Preliminary Evidence and Potential Implications’ (2007) 24 Yale J on Reg 101. 13 Closest in design is the ‘Asia Region Funds Passport’, a multilateral regional mutual recognition/​equivalence regime for investment funds: Moloney, N, ‘Capital Markets Union, Third Countries, and Equivalence: Law, Markets and Brexit’ in Busch, D, Avgouleas, E, and Ferrarini, G (eds), Capital Markets Union in Europe (2018) 97. 14 On the influence exerted by major financial markets as ‘great powers’ see the classic account in Drezner, D, All Politics is Global: Expanding the Reach of International Regulatory Regimes (2007). International financial market governance (including as regards access arrangements) is, however, typically regarded as being shaped by a range of different preferences, including those of the domestic regulators that influence the national ‘great powers’ and that form influential epistemic communities internationally. See, eg, Newman, A and Posner, E, ‘Transnational Feedback, Soft Law, and Preference in Global Financial Regulation (2016) 23 Rev of IPE 123.

852  Third Countries access.15 In allowing home state regulatory and supervisory arrangements to substitute for host US requirements (following an SEC assessment of the relevant home state), substitute compliance represented at the time a major departure for the SEC. It did not have longevity: as the financial crisis intervened, the SEC retrenched.16 The financial-​crisis era then saw the securing of global financial stability through collective institutions, and the related adoption and oversight of common standards, become the major preoccupations of international financial relations. The G20 reform agenda dictated the outline shape of the reform process which was steered, through standard adoption and the monitoring of standard implementation, by the ISSBs, notably the Financial Stability Board (FSB).17 But notwithstanding this movement towards greater standardization, regulatory systems internationally differed in how they applied the financial-​crisis-​era reforms. This complicated cross-​border access arrangements, particularly as regards mutual recognition, and prompted a sharper focus by the ISSBs on international cooperation.18 The derivatives markets reforms posed particular challenges, leading to a 2013 G20 call for greater deference by states and regulators towards, and related wider mutual recognition of, their respective systems, which would facilitate cross-​border access.19 Since then, access arrangements for financial markets have become more strongly associated with deference, albeit that frictions and costs remain.20 The EU’s approach to third country access is idiosyncratic, being composed of Member State and EU-​level elements, but it is most strongly associated with mutual recognition and in particular equivalence arrangements, and so is oriented towards deference to the relevant home/​third country. The equivalence system is, however, becoming increasingly prescriptive and moving towards ‘on-​shoring’ in the EU, to some degree, the supervision of third country actors.

X.2  Access to the EU Financial Market X.2.1  The Access System The regime governing access by third country actors to the EU financial market has multiple components. At the base of the regime are the EU’s obligations as regards third country access under World Trade Organization (WTO) requirements, which are also articulated in EU trade

15 See Jackson, H, ‘A System of Selective Substitute Compliance’ (2007) 48 Harvard Int’l LJ 103 and Pan, E, ‘A European Solution to the Regulation of Cross-​Border Markets’ (2007) 2 Brooklyn J of Corporate, Financial & Commercial L 133. 16 The SEC entered into only one substitute compliance arrangement, with the Australian financial markets regulator (ASIC), in 2008. Exploratory talks with Canada and the EU foundered because of challenges raised by their federal/​supranational decision-​making structures. 17 See, from an extensive, predominantly international political economy, literature, Helleiner, E, Pagliari, S, and Zimmerman, H (eds), Global Finance in Crisis (2010). 18 eg Helleiner, E and Pagliari, S, ‘The End of an Era in International Financial Regulation? A Post-​Crisis Research Agenda’ (2011) 65 International Organization 169. 19 G20 St Petersburg Summit, September 2013, Leaders’ Declaration, 6 September 2013. For a political economy perspective see Quaglia, L, The Politics of Regime Complexity in International Derivatives Regulation (2020). 20 eg, identifying greater levels of deference by states but calling for further convergence as regards the design of access arrangements see IOSCO, Good Practices on Processes for Deference (2020).

X.2  Access to the EU Financial Market  853 agreements.21 The EU has not, up to now, provided access under its trade agreements to the EU financial market beyond the basic market access/​national treatment/​non-​ discrimination rights protected by WTO rules.22 These rights cover, in the main, the right to set up an establishment and to secure national treatment or protection from discrimination. They accordingly provide basic access rights for firms, including in relation to ‘commercial presence’ (or the right to establish subsidiaries).23 The WTO rules do not liberalize the domestic rules that states internationally apply to the authorization, regulation, and supervision of firms operating in the financial markets: the WTO ‘prudential carve out’ allows parties to provide that nothing in a trade agreement prevents either party from adopting or maintaining measures for prudential reasons, such as protecting investors, depositors, policy-​holders, or persons to whom a fiduciary duty is owed by a financial service supplier, or ensuring the integrity and stability of a party’s financial system.24 The parties’ respective ‘rights to regulate’ are accordingly protected and so the costs of regulatory compliance can be high for cross-​border actors. Building on these foundational rights, third country firms engaging in regulated financial market activities can, for example, establish an EU subsidiary which, as an EU legal person, is subject to the single rulebook (and its authorization requirements) but also benefits from passporting rights. But while such subsidiaries benefit from passporting and can facilitate business development (albeit that they are primarily associated with the EU banking market),25 they also generate costs and risks for firms, including as regards risk management, as splitting pools of capital and liquidity across jurisdictions and into legally ring-​fenced and separately authorized subsidiaries is costly. Subsidiaries can, however, delegate and outsource activities back to third country group entities, which can reduce the costs of subsidiarization by retaining functions at group level. This is permitted under the single rulebook, although constraints typically apply.26 The June 2016 Brexit referendum and the UK’s subsequent withdrawal from the EU has seen UK businesses use EU-​based subsidiaries to transfer operations to the EU and thereby to retain passporting rights (mainly to Amsterdam, Dublin, Frankfurt, and Luxembourg).27 Relatedly, Brexit has prompted a sharper EU supervisory focus on subsidiaries’ delegation and outsourcing practices and so on the sufficiency of subsidiaries’ EU operations. A raft of soft law from the ESAs and from the ECB (in its Single Supervisory Mechanism role as ECB Banking Supervision) has underlined that subsidiaries must not be shells for securing passporting

21 See further Lang, A, ‘The ‘Default Option’? The WTO and Cross-​border Financial Services Trade after Brexit’ in Alexander, K, Barnard, C, Ferran, E, Lang, A, and Moloney, N, Brexit and Financial Services. Law and Policy (2018) 157. 22 This is the case under the EU–​UK TCA and under the EU–​Canada Trade Agreement (CETA) (on CETA and financial services see Leblond, P, CETA and Financial Services. What to Expect? CIGI Papers No 91, February 2016). 23 Lang, A and Conyers, C, Financial Services in EU Trade Agreements, Study for the ECON Committee (IP/​A/​ ECON/​2014-​08) (2014). 24 Lang, n 21. 25 On incentives for subsidiarization see Kudrna, Z, ‘Governing the Ins and Outs of the EU’s Banking Union’ (2016) 17 J of Banking Reg 119 and Epstein, R, ‘When Do Foreign Banks ‘Cut and Run’? Evidence from West European Bail Outs and East European Markets’ (2014) 21 Rev of IPE 847. 26 eg, the constraints that apply as regards collective investment management. See section 5. 27 See Arnold, M, Keohane, D, and Sciorilli Borrelli, S, ‘Future of the City: Where Did All the Jobs Go?’, Financial Times, 13 December 2020. For a political-​economy oriented analysis of firms’ relocation decisions see Donnelly, S, ‘Post-​Brexit Financial Services in the EU’ (2022) 29 JEPP.

854  Third Countries rights; they must support a substantial presence in the relevant Member State, including as regards employees, balance sheets, capital, and risk management.28 Where a third country firm does not establish an EU subsidiary (and so seeks to operate through a branch or on a cross-​border services/​activities basis), it must be authorized to provide the relevant services or to conduct the relevant activities in each Member State in which it seeks to operate. Piecemeal Member State rules govern this process although, in some limited cases, harmonized requirements may frame Member State rules.29 Member State requirements for third country branches, in particular, can be significant, given the supervisory challenges third country branches can generate for the NCA branch supervisor, particularly as regards large and complex ‘systemic branches’, and given that prudential supervision typically rests with the third country.30 This Member-​State-​based route is also ‘landlocked’: any authorization a Member State may provide only covers business within that Member State. The transaction costs associated with this route are, accordingly, significant. A precarious access route is available through the ‘reverse solicitation’ process. Where a financial service is exclusively initiated by an EU client (the relevant third country firm cannot solicit clients or market additional services once solicited by the client), and then provided by a third country firm, it is not deemed to be provided within the territory of the EU.31 This route does not provide a stable legal platform for EU access, however, as its availability depends on how Member States individually interpret what kind of engagements are permissible as ‘reverse solicitations.’ It is also drawing close attention and may be reviewed. In January 2021, and in the Brexit context, ESMA issued a warning to third country firms that ‘questionable practices’ by firms (such as ‘pop-​up boxes’ leading clients to agree services were provided on their exclusive initiative) would not be tolerated and that administrative or criminal proceedings could follow at Member State level.32 Some EU wariness as regards reverse solicitation is also evident from the obligation imposed on the Commission in 2019 to review the reverse solicitation route as regards collective investment management 28 See, eg (as regards banks), ECB Banking Supervision, Newsletter, 18 November 2020 and, in the financial markets context, the series of Opinions on the Brexit relocation process adopted by ESMA in July 2017 (nn 85 and 277). 29 Most notably the requirements governing the establishment of third country branches under MiFID II (section 8.1.2). In an indication of the direction of travel, the Commission proposed in October 2021 that the rules governing branches of third country credit institutions be significantly tightened and subject to harmonization, as noted in n 162). 30 By way of example, within the EU, cross-​border, systemic branches of EU firms, although subject to specific treatment in the EU’s colleges of supervisors arrangements and under the CRD IV/​CRR prudential regime (Directive 2013/​36/​EU [2013] OJ L176/​338 (CRD IV) and Regulation (EU) No 575/​2013 [2013] OJ L176/​1 (CRR)), have attracted close attention from banking supervisors. See, eg, EBA, Guidelines on Supervision of Significant Branches (2017). In a high profile EEA example (the same rules apply within the EEA), Norway highlighted the supervisory challenges, and the risks which would be posed to its financial system, were the largest foreign bank in its financial system, an EU subsidiary which represented at the time 9 per cent of the Norwegian banking market and which was designated as a systemically important bank in Norway, to be transformed into a branch (as is permitted under EU/​EEA law) and so become subject to remote home supervision and not local host supervision in Norway: Norwegian Ministry of Finance, Home/​Host Issues for Significant Bank Branches, Letter to the European Commission, 21 November 2016. The branch transformation subsequently took place, with supervisory coordination managed through the bank’s supervisory college. See Alford, D, The Operation of Supervisory Colleges after the Single Supervisory Mechanism of the European Banking Union (2018), available via . As outlined in brief in n 162, third country branches of credit institutions look set to be subject to significantly more restrictive requirements. 31 The reverse solicitation route is expressly acknowledged under MiFID II/​MiFIR: section 8.1.4. 32 ESMA, Public Statement (Reverse Solicitation Reminder at the End of the UK Transition Period), 13 January 2021.

X.2  Access to the EU Financial Market  855 services.33 ESMA’s related 2021 report found that while there was little evidence from NCAs that this route was widely used in the marketing of collective investment schemes, several NCAs were of the view that reverse solicitation was being used to circumvent access requirements, and could generate investor protection risks as well as an unfair regulatory playing field between EU and third country collective investment managers.34 Finally, for those market segments for which an EU equivalence system is in place, where a third country regime is found to be ‘equivalent’, the third country firm is typically, although different procedural requirements apply, given ‘passport-​like’ access to the EU, on the basis of its home/​third country regime. Although strongly associated with access arrangements, the equivalence regime also shapes how EU firms engage with third country markets. Under MiFID II/​MiFIR, for example, the equivalence device is used to place ‘export’ constraints on EU firms’ execution of transactions in financial instruments on non-​ EU trading venues; in specified circumstances these must take place on ‘equivalent’ trading venues.35 The equivalence regime can also mitigate the extent to which EU requirements apply extraterritorially.36

X.2.2  The Equivalence Regime The ‘equivalence’ regime is a legal and procedural mechanism used to manage third country actors’ access to the EU financial market (and also to manage EU actors’ and counterparties’ interactions with third country entities; and to moderate the extraterritorial application of EU law to third country transactions and actors). While internationally oriented, it is powered by single market technology in that it is a function of the single rulebook and it deploys the EU’s supranational machinery, including the Commission, and, at the administrative level, ESMA. The regime is scattered across sectoral EU financial services legislation and over forty legislative measures.37 Although by 2019 some 280 equivalence decisions had been taken in respect of more than thirty third countries,38 many segments of the financial services sector are not covered, most significantly, the banking segment. In the financial markets segment, the main equivalence arrangements are those provided for issuer disclosure (2017 Prospectus Regulation and 2004 Transparency Directive); rating agencies (Consolidated Credit Rating Agency Regulation (CCRAR); investment services/​ trading venues (MiFID II/​MiFIR); OTC derivatives markets, including central counterparties (CCPs) and trade repositories (EMIR); central securities depositories (CSDs) (2014 Central Securities Depositaries Regulation) and benchmarks/​benchmark administrators

33 The obligation was imposed under the 2019 ‘Refit’ reforms (see Ch III on these reforms). 34 ESMA, Letter to the Commission (Reverse Solicitation), 17 December 2021. 35 See section 8.2. The equivalence system also supports exemptions for third country actors, notably the exemptions for equivalent central banks from MiFIR and from the market abuse regime. 36 This is also a feature of EMIR, eg, as regards its CCP clearing and risk management requirements, as outlined in section 9.4. 37 Previously an under-​researched aspect of EU financial services regulation, the equivalence regime became the subject of an extensive literature over the Brexit period. See, eg, Moloney, N, ‘Reflections on the EU Third Country Regime for Capital Markets in the Shadow of Brexit’ (2020) 17 ECFR 35; Berger, H and Badenhoop, N, ‘Financial Services and Brexit: Navigating Towards Future Market Access’ (2018) 19 EBOLR 679; and Ferran, E, ‘The UK as a Third Country in EU Financial Services Regulation’ (2017) 3 J of Fin Reg 40. 38 Commission, Equivalence in the area of Financial Services (COM(2019) 349).

856  Third Countries (2016 Benchmark Regulation).39 So far, only a small number of equivalence determinations have been made under these measures. The issuer disclosure equivalence decisions are primarily concerned with financial reporting and with the International Financial Reporting Standards (IFRS) status of third countries; only a small number of equivalence decisions have been made under the CCRAR as it typically operates, as regards third country credit rating agencies, through the ‘endorsement’ process, which does not require an equivalence decision; no equivalence decisions have been made, as yet, under MiFID II/​MiFIR as regards investment services access generally, although a series of equivalence decisions have been made in relation to the application of MiFIR’s Share and Derivatives Trading Obligations, and of MiFID II’s requirements for execution-​only services, specifically as regards the equivalence status of specified third country trading venues; only one temporary equivalence decision, since lapsed, has been made under the CSD Regulation (for a UK CSD in the context of Brexit); and only a handful of equivalence decisions have been made under the Benchmark Regulation. EMIR, which includes a number of different equivalence-​related regimes, accounts for the bulk of the decisions made so far, primarily in relation to CCP equivalence.40 Reflecting the different interests and dynamics that have shaped how the EU addresses third country access (section 4), the equivalence-​based third country access system for financial markets is partial, with some financial market measures containing no or only very limited EU regimes for third country access (such as the collective investment management regime). For those measures that do provide for equivalence-​based access, the extent to which some form of ‘gateway’ process is applied by ESMA, and the extent to which ESMA, relatedly, supervises the relevant third country actor, varies from no ESMA intervention (prospectuses) to full-​blown ESMA supervision (benchmark administrators). The legislative criteria against which equivalence is assessed also vary, as does the extent to which the Commission is conferred with a mandate to adopt administrative rules specifying the legislative criteria (as yet, where such a mandate has been given, the Commission has not adopted specific criteria in administrative rules; equivalence criteria are typically specified, however, in the mandate the Commission gives ESMA when asking for its advice on equivalence and are amplified in ESMA’s related assessments of third countries). Similarly, the articulation of the standard legislative requirement that third countries, to be equivalent, must comply with anti-​money laundering/​counter terrorism financing standards varies across the different equivalence regimes, albeit that it always imposed in some form. There are, however, commonalities. Typically, equivalence arrangements require some form of equivalence determination by the Commission as to the extent of the alignment between the EU’s and the third country’s rules, in accordance with the relevant legislative criteria; these criteria are typically not amplified in any detail, but usually require that the 39 Respectively: Regulation (EU) 2017/​1129 [2017] OJ L168/​12 and Directive 2004/​109/​EC [2004] OJ L390/​38; the EU’s rating agency regime is split across three legislative measures, consolidated in the Consolidated Credit Rating Agency Regulation (CCRAR) (ELI ); Directive 2014/​65/​EU [2014] OJ L173/​349 and Regulation (EU) No 600/​2014 [2014] OJ L173/​84; Regulation (EU) No 648/​ 2012 [2012] OJ L201/​1; Regulation (EU) No 909/​2014 [2014] OJ L257/​1; and Regulation (EU) 2016/​1011 [2016] OJ L171/​1. 40 The discussion in this chapter considers the nature of the equivalence decisions taken. Equivalence decisions are not easily accessible. They are included in the Commission’s websites which specify the administrative rules adopted under major legislative measures, but they are not regularly consolidated and updated. At the time of writing, the most recent (but outdated) summary was provided in: Commission, Overview Table, Equivalence Decisions Taken by the Commission, 10 February 2021.

X.2  Access to the EU Financial Market  857 third country’s regulatory and supervisory systems have ‘equivalent effect’ (or similar formulation) to those of the EU, and that enforcement of the equivalent third country rules can be ensured. Cooperation agreements with third countries, reciprocity obligations regarding access, third country compliance with different international/​OECD taxation cooperation requirements, and third country compliance with global anti-​money laundering/​counter terrorism financing standards also apply. Some form of ESMA-​based gateway registration/​ recognition process also increasingly governs access. Equivalence status is assessed through a unilateral EU process that can be intrusive in the degree of alignment it requires, at the outset, between EU and third country regulatory regimes. It is also contingent—​equivalence decisions can be withdrawn at the Commission’s discretion. Relatedly, equivalence status requires dynamic alignment between the third country rules and EU rules: a country’s equivalence status is monitored by ESMA and it can be withdrawn by the Commission. The equivalence regime constitutes, accordingly, an austere process through which the EU can impose its standards on third countries.41 But once the threshold equivalence decision is made, the equivalence-​based access system can be characterized as liberal, as it does not usually require full ‘on-​shore’ (in the EU) supervision of third country actors; neither does it apply EU rules directly. It accordingly can be regarded as a deference-​based access arrangement.42 In effect, the equivalence system allows relevant third country actors to operate, pan-​EU, based on third country rules and supervision and so represents a significant incursion into the autonomy of the single rulebook. There are three major exceptions: the MiFID II/​MiFIR regime for investment services; the EMIR regime for CCPs; and the Benchmark Regulation regime for benchmark administrators. These three equivalence/​access regimes have all, since their reform in 2019, taken a sharp turn towards requiring more intense on-​shore EU monitoring of third country firms, as well as the direct application of EU rules (even where the third country regime has been found to be equivalent). The procedural route to the equivalence determination and to the access it affords is broadly similar for each equivalence regime. Equivalence decisions are made by the Commission and are discretionary. The equivalence decision is made in the form of an implementing act, usually under the ‘examination procedure’ for administrative rule-​ making, derived from TFEU Article 291.43 In a limited number of cases, the TFEU Article 290 procedure for delegated acts is engaged.44 Technical advice is almost always provided to the Commission by ESMA, which engages in an extensive assessment of the relevant jurisdiction which it then publishes. The Commission typically follows ESMA’s advice, but it can engage in its own independent assessment of the relevant jurisdiction. The equivalence decision may be indefinite, time limited, full, partial, or subject to conditions. It can also be updated (usually, so far, to expand the coverage of the equivalence decision to cover additional actors). 41 Equivalence is therefore a means through which the EU imposes its preferences internationally, as has been extensively explored in the political economy literature (see, eg, Mügge, n 1). 42 ESMA Chair Maijoor noted that, after the extensive series of reforms adopted in March 2019 (noted in section 4 and including the requirement for certain third country CCPs to be supervised by ESMA), that ‘the underlying objective of an extensive use of deference by the EU has not changed’: Speech, 10 October 2019. 43 This procedure is ‘comitology’-​based, using a committee to provide Commission oversight, and not engaging the Council and European Parliament directly. 44 This procedure is based on oversight of the Commission by the European Parliament/​Council, through the non-​objection procedure.

858  Third Countries The equivalence assessment process is not fully transparent, but indications as to how it operates can be gleaned from the Commission’s decisions on equivalence and from the related (and usually extensive) ESMA technical advice, as outlined in the following sections. In its February 2017 Report on Equivalence,45 however, the Commission shed some light on the process generally. The Commission austerely characterized the equivalence process as an EU-​oriented process, primarily designed to safeguard the EU’s financial system and only secondarily concerned with market access. It described the equivalence assessment as being outcomes-​based and concerned with results, not ‘word for word sameness’ of legal texts; the process, per the Commission, extends beyond technical requirements and focuses on regulatory objectives pursued and outcomes delivered. The process is designed to be proportionate and risk-​based, with factors such as the size of the third country market, its importance to the functioning of the single market, interconnectedness to the third country market, or the risks of circumvention of EU rules all relevant to how the Commission exercises its discretion. The Commission also underlined that the equivalence decision is unilateral and discretionary and can be changed or withdrawn. In its subsequent 2019 Report on Equivalence, the Commission adopted a similar tone, emphasizing that the equivalence process was a risk management tool for supporting financial stability and investor protection, but designed to be risk-​based and proportionate in application, and underlining that the equivalence decision was discretionary and contingent.46 In both reports, the shadow of Brexit was clear, with the emphasis on risk-​based assessment, in particular, signalling that the potential outsize impact of the UK, as a systemic third country market, on the EU financial market implied a more intensive assessment. The challenges the equivalence process can generate have been well charted.47 These range from its siloed and partial nature; its procedural complexity; its slow pace; the open-​ textured quality of the criteria that usually apply to equivalence—​criteria such as ‘effective’, ‘appropriate’, and similar abound—​and the related risk of politicization (albeit that this risk is somewhat moderated by the extensive technocratic engagement by ESMA with the equivalence process);48 the contingent nature of the Commission equivalence decision; the risk of market disruption on a refusal or withdrawal of equivalence; and the risks it poses to the EU’s competitiveness if third country access is deterred. The challenges also include those related to the adequacy of legitimation and which flow from, for example, the opacity of the equivalence process, its limited justiciability, and the extent of the Commission’s control over what can be decisions of very high political salience.

X.3  The Institutional Context: The Commission and ESMA In practice, the Commission oversees the different equivalence regimes, once they are adopted by the co-​legislators, adopting the administrative equivalence decisions that open

45 Commission, EU Equivalence Decisions in Financial Services Policy: An Assessment (SWD(2017) 102). 46 n 38. 47 See, eg, the references at n 268. For a UK industry perspective, in the Brexit context, see International Regulatory Strategy Group, The EU’s Third Country Regime and Alternatives to Passporting (2017). 48 eg, the Commission’s politically freighted and closely observed post-​Brexit extension, in 2022, of its temporary equivalence decision for UK CCPs (to 2025) was accompanied by granular technical analysis by ESMA of the systemic importance of the relevant UK CCPs in a December 2021 report (n 221).

X.3  The Institutional Context: The Commission and ESMA  859 (or close) third country access. In its February 2017 Report on Equivalence, it asserted its institutional pre-​eminence, highlighting that any equivalence decision is unilateral and discretionary and can be changed or withdrawn as necessary ‘at any moment’.49 While the Commission usually calls on ESMA’s technical advice when making equivalence decisions, in areas of acute political salience the Commission can retain the equivalence process ‘in-​ house’. This was the case with its market-​critical 2017 US equivalence determination as regards the MiFIR Derivatives Trading Obligation (which requires that certain classes of derivative must be traded on an EU trading venue or on a trading venue operating in an equivalent regulatory regime). The Commission’s finding that certain trading venues supervised by the US Commodities and Futures Trading Commission (CFTC) met the equivalence criteria followed lengthy negotiations with the CFTC and the related adoption by the Commission and the CFTC of a ‘general approach’ to govern the application of the respective EU and US Derivatives Trading Obligations to EU and US trading venues.50 ESMA was not directly involved in this process, although it had earlier acknowledged market concern as to the potential disruption that failure to adopt an equivalence decision could have wrought.51 In cases engaging the highest political salience, the equivalence process can also involve direct political engagement by the EU.52 Nonetheless, it is clear that, since its 2011 establishment, ESMA has emerged as a pivotal player in the equivalence process. The 2019 ESA Regulation reforms strengthened and expanded ESMA’s powers as regards third country engagement,53 but these reforms form part of a wider pattern of intensifying reliance by the co-​legislators and by the Commission on ESMA to provide technocratic support to the equivalence process, as outlined in subsequent sections. Article 33 of the ESMA Regulation, as revised in 2019, is the foundational ESMA competence. It addresses international engagement by ESMA generally, conferring on ESMA the general competence to develop contacts and enter into administrative arrangements with third country authorities and administrations and international organizations, but it also expressly addresses the equivalence system. ESMA is required to assist the Commission in preparing equivalence decisions; and, underscoring the more interventionist turn the equivalence system has taken, to monitor regulatory and supervisory developments, enforcement practices, and market developments in third countries (found to be equivalent), to the extent they are relevant to risk-​based equivalence assessments, to verify whether the equivalence criteria and any relevant conditions on which equivalence decisions have been made, are still fulfilled, and to report to the European Parliament, Council, Commission, and the other ESAs accordingly, in particular with respect to the implications for financial stability, market integrity, investor protection, and single market functioning. Where developments arise that may affect EU or Member State(s’) financial stability, market integrity, investor protection, or market functioning, ESMA is to inform the Parliament, 49 n 45, 9. 50 Commission Implementing Decision 2017/​2238 [2017] OJ L320/​11. 51 ESMA, Final Report. Draft Regulatory Technical Standard on the Trading Obligation for Derivatives under MiFIR (2017). 52 In particular, the CCP equivalence discussions with the US were difficult and required high level EU/​US political engagement: House of Lords, EU Committee, 9th Report of Session 2016–​2017, Brexit: financial services (2016), para 49. 53 Adopted under the 2019 ESA Reform Regulation (Regulation (EU) 2019/​2175 [2019] OJ L334/​1). The ESMA Regulation as originally adopted (Regulation (EU) No 1095/​2010 [2010] OJ L331/​84) conferred powers on ESMA as regards international engagement (Art 33), but these were extended by the 2019 reforms.

860  Third Countries Council, and Commission without undue delay. In an indication of the sensitivity of these reports, but also of the opacity of the equivalence process, they are confidential. In addition, ESMA is conferred, by Article 33, with the competence to enter into cooperation agreements with the relevant third country authorities whose regulatory and supervisory regimes are recognized as equivalent; these agreements must cover the provision of information to ESMA which allows it to fulfil its equivalence monitoring obligations, as well as supervisory cooperation arrangements, including, where necessary, for on-​site inspections. Equivalence aside, ESMA is empowered to develop model administrative arrangements for third country cooperation, which NCAs are to ‘make every effort’ to follow. As outlined in the following sections, ESMA has, in particular through advising the Commission, come to exert material technocratic influence on the equivalence process, acting as the institutional pathfinder for how often politically sensitive equivalence assessments are constructed and delivered. Its approach can best be characterized as pragmatic and balanced. ESMA’s equivalence advice to the Commission typically frames equivalence in terms of the equivalence of substantive outcomes, and it has, for example, proposed the imposition of conditions on certain equivalence decisions, in order to achieve the requisite degree of outcome alignment in practice and thereby to avoid the disruption which a finding of no equivalence would generate.54 The equivalence process has also allowed ESMA to strengthen its capacity in EU financial markets governance more generally. Most significantly, ESMA’s executive competences over third country actors have been incrementally but persistently expanding. The series of 2019 reforms which conferred ESMA with direct oversight/​supervisory competences over third country investment firms, CCPs, and benchmark administrators, all areas freighted, if to different degrees, with political and market sensitivities, mark a waypoint in this regard.

X.4  The Evolution of the Third Country Regime The EU’s third country/​equivalence rules were, until the 2016 UK Brexit referendum, a relatively quiet corner of EU financial markets governance, although the third country regime is of relatively longstanding. Initially, third country arrangements for the EU financial market were primarily a function of Member State discretion, subject to Member State compliance with the EU’s WTO obligations. It was only with the Financial Services Action Plan (FSAP)-​era that equivalence-​based arrangements began to emerge, although Member States remained in control of third country actor access, for the most part. As regards investment services, for example, the 2004 MiFID I left the access decision to Member States, with the consequence that passporting rights were not available to third country firms.55 Under the 2003 Prospectus Directive,56 a more liberal approach was adopted in that an NCA could approve a third country issuer prospectus, prepared in accordance with third country rules, for use cross-​border, where, in the NCA’s determination, ‘equivalent’ rules

54 This was a theme of ESMA’s first set of equivalence advice to the Commission on CCP equivalence, in relation to which ESMA Chair Maijoor noted that ESMA sought to avoid a ‘zero sum’ approach: Speech, 17 October 2013. 55 Directive 2004/​39/​EC [2004] OJ L145/​1. 56 Directive 2003/​71/​EC [2003] OJ L345/​64.

X.4  The Evolution of the Third Country Regime  861 were followed; the notion of equivalence was not articulated in any detail or subject to EU-​ level decision-​making.57 The financial crisis led to a change in approach. Third country access increasingly became a function of harmonized requirements and of ESMA/​Commission oversight and subject to greater prescription, and the related equivalence process became a means for exporting the EU’s approach to regulation and for protecting the autonomy of the single rulebook. Discrete third country/​equivalence regimes were introduced for alternative investment fund management (the 2011 AIFMD),58 rating agencies (CCRAR), OTC derivatives markets (2012 EMIR), and investment services (2014 MiFID II/​MiFIR). The new arrangements had in common a significantly more articulated and centralized approach to third country access (with the exception of the AIFMD regime), but they varied in their design and their degree of liberality, reflecting the host of different interests that tend to shape third-​country-​related negotiations. Whether or not Member States are, for example, more or less in favour of competition and open markets, more or less concerned with internal financial stability and with protecting national markets, or have greater or lesser competitive territory at stake as regards the market segment in question can shape their approach to the negotiation of third country regimes.59 Prevailing market conditions also matter. The significant tightening of the third country rules over the financial-​crisis era, and the related ‘export’ of EU rules internationally, can be associated with the previously prevailing FSAP-​ era concern to promote competitiveness losing traction and being trumped by financial stability concerns.60 The 2016 Brexit referendum saw a reshuffling of these interests and conditions and a movement towards a more prescriptive, institutionalized (through ESMA), and ‘on-​shore’ third country regime. Immediately prior to the referendum, however, there were some indications, as the EU financial market recovered from the financial-​crisis-​era market and regulatory convulsions, and as political and institutional space opened up for reform, of a more liberal approach. The first iteration of the Capital Markets Union (CMU) Action Plan in 2015 brought a competitiveness-​oriented focus to bear on the third country regime and concern as to whether it sufficiently supported the EU in the global capital market.61 This proved short lived. As has been extensively documented, Brexit saw the third country regime become a vector across which competing EU and UK interests were mediated,62 and led to an associated tightening of the third country regime. The UK sought a bespoke form of access, based on a reformed equivalence regime which would accommodate UK regulatory autonomy, while the EU cleaved to the status quo, in order to protect the autonomy and 57 For a political-​economy-​oriented discussion of the pre-​financial-​crisis approach to third country access see Dür, A, ‘Fortress Europe or Open Door Europe? The External Impact of the EU’s Single Market in Financial Services’ (2011) 18 JEPP 619. 58 Directive 2011/​61/​EU [2011] OJ L174/​1. 59 See Quaglia, L, ‘The Politics of “Third Country Equivalence” in Post-​Crisis Financial Services Regulation in the European Union’ (2015) 38 Western European Politics (2015) 167, Spendzharova, A, ‘Banking Union under Construction: The Impact of Foreign Ownership and Domestic Bank Internationalization on EU Member States’ Regulatory Preferences in Banking Supervision’ (2014) 21 Rev of IPE 949, and Ferran, E, ‘After the Crisis: The Regulation of Hedge Funds and Private Equity in the EU’ (2011) 12 EBOLR 379. 60 Pagliari, S, ‘A Wall Around Europe? The European Regulatory Response to the Global Financial Crisis and the Turn in Transatlantic Relations’ (2013) 35 European Integration 391. 61 eg ECOFIN Council Conclusions on the Commission Action Plan on Building a Capital Markets Union, 10 November 2015 (Council Document 13922/​15), calling on the Commission to assess the impact of the different third-​country regimes on European capital markets and on financial sector competitiveness. 62 See the references at n 268.

862  Third Countries integrity of the single rulebook. While bespoke arrangements were not adopted for the UK (section 11), the period also led to a hardening of the EU’s approach to third country access more generally. Indications of a more restrictive approach came in December 2017, when the Commission adopted a restrictive and time-​limited (one-​year) decision on the equivalence of Swiss trading venues for the purposes of the MiFIR Share Trading Obligation.63 The decision, valid for one year only, made any further equivalence finding by the Commission contingent on resolution of a matter distinct from the single rulebook–​the establishment of a new EU/​Switzerland institutional framework for existing and future agreements relating to Switzerland’s single market relationships.64 Notwithstanding criticism from Switzerland and concern from the European Parliament,65 the equivalence decision duly lapsed in 2019, with some initial disruption to liquidity as trading in impacted shares migrated from Swiss to alternative trading venues.66 While specific to EU/​Swiss relations, it nonetheless indicated the unilateral and contingent nature of equivalence decisions. Albeit in a less febrile context, the Commission subsequently undertook its first mass withdrawal of equivalence decisions, as regards the rating agency regime, in summer 2019.67 A similar signal was sent by the Commission in its July 2019 report on equivalence.68 As it did in its similarly toned 2017 report,69 the Commission underlined that equivalence was a tool for supporting financial stability and investor protection, as well as for facilitating an open and globally integrated EU capital market, and that while equivalence could increase market access opportunities, it was primarily a risk management tool. A similar tone came from the European Parliament over this period. While its 2019 Resolution on third countries and financial services called for reforms, these were largely procedural and institutional in orientation, particularly as regards the transparency of the equivalence regime and an enhancement of Parliament oversight. The Resolution did not call for substantive reform and emphasized the conditional and contingent nature of equivalence decisions.70 The direction of travel as regards legislative reform, and so as regards the Member States’ preferences, was similar. The 2017 Securitization Regulation, adopted in the immediate aftermath of the Brexit referendum, did not include a third country access regime, reflecting political tensions relating to the precedent it could potentially have established for post-​Brexit UK access,71 while the 2017 Prospectus Regulation tightened the third country 63 On the Share Trading Obligation and equivalence see section 8.2. 64 Commission Implementing Decision 2017/​2441 [2017] OJ L344/​52. 65 European Parliament, Resolution of 11 September 2019 on Relationships between the EU and Third Countries concerning Financial Services Regulation and Supervision (P8_​TA(2018) 0326), noting the ‘clear political dimension’ of the Commission decision and calling for closer scrutiny by the Parliament. 66 ESMA reported in Autumn 2019 on the migration of trading from the EU back to Swiss trading venues: ESMA, TRV No 2 (2019), 14–​15. 67 See section 7. 68 n 38. 69 n 45. 70 n 65. The 2018 ECON Committee report on the Resolution was more ambitious, calling for the EU to give close consideration to the equivalence regimes between the EU and ‘high-​impact third countries’ in order to ‘develop stable and resilient regulatory relationships with those countries which have close financial links with the Union’, but did not find support in the Parliament. ECON Committee, Draft Report on Relationships between the EU and Third Countries Concerning Financial Services Regulation and Supervision (2017/​2253/​NI), April 2018. 71 Regulation (EU) 2017/​2402 [2017] OJ L347/​35. The omission was related to uncertainty as to how to deal with the UK as a future major third country in this area: Brunsden, J, ‘Plans to Boost Securitisation Market Stalls over Brexit’, Financial Times, 6 February 2017. The Commission, in its July 2022 review of the Securitization Regulation, concluded that it was premature to introduce equivalence arrangements, noting that no third country had a regime

X.4  The Evolution of the Third Country Regime  863 regime for prospectuses.72 The most revealing evidence as to the emergence of a more prescriptive approach, however, came from the package of measures adopted in March 2019 in the dying days of the 2014–​2019 Commission and European Parliament terms. The agreement by the European Parliament and Council on the Investment Firm Regulation (IFR),73 designed to enhance the prudential regulation of investment firms (see Chapter IV), also reformed MiFIR by adopting a significantly more prescriptive third country regime as regards cross-​border service provision (section 8).74 The agreement on the ESA Reform Regulation75 enhanced the EU’s monitoring of equivalence decisions by empowering ESMA in this regard (section 3); ESMA also acquired recognition and supervisory/​enforcement powers over third country benchmark administrators, taking over these powers from NCAs in 2022 (section 10). Finally, the agreement on the ‘EMIR 2.2’ reform76 is most revealing of a shift in approach, as it put in a place a new regime for ESMA-​based oversight of third country CCPs (section 9). Despite this hardening of the third country/​equivalence regime, the EU remains concerned to be open to financial market business from outside the EU, while the equivalence system continues to be based, for the most part, on deference to the relevant third country regime.77 For example, and as noted later in this chapter, there are few indications of any restrictive changes to the national private placement regime under which alternative investment fund managers operate, the 2017 proposal to centralize the approval of third country prospectuses through ESMA did not gather sufficient political support, and the currently wide reach of the Benchmark Regulation over third countries looks set to be narrowed. A potentially telling inflection point, however, came in the wake of the Covid-​19 pandemic when the EU’s ‘strategic autonomy’ globally came to the fore.78 Broadly concerned with strengthening the EU’s capacities and resilience, the ‘strategic autonomy’ priority led to a 2021 Commission Communication designed to reinforce the EU’s ‘open strategic autonomy’ in the macro-​economic and financial fields. The related initiatives focus primarily on promoting the international role of the euro and on improving the implementation and enforcement of EU sanctions.79 In the financial markets sphere, reinforcement of the EU’s open strategic autonomy appears to imply a commitment to ensuring that the EU’s financial markets remain competitive and attractive for international market participants, although the third country/​equivalence regime was not expressly addressed by the 2021 Communication. A broadly liberal approach also emerged from the 2020 CMU Action Plan

that could come close to being equivalent to the EU’s and, in particular, that the EU and the UK regimes were different: Commission, Report on the Functioning of the Securitization Regulation (COM(2022) 517). 72 Regulation (EU) 2017/​1129 [2017] OJ L168/​12. 73 Regulation (EU) 2019/​2033 [2019] OJ L314/​1. 74 The earlier proposals were reported as a significant toughening of the MiFIR equivalence regime: Brunsden, J, ‘Brussels Signals Tough Stance on UK Bank Bonuses after Brexit’, Financial Times, 19 December 2017. 75 Regulation (EU) 2019/​2175 [2019] OJ L334/​1. 76 Regulation (EU) 2019/​2099 [2019] OJ L322/​1. 77 ESMA Chair Maijoor noted in the wake of the March 2019 reforms that the EU was ‘the world leader’ in applying the deference principle: Speech, 10 October 2019. 78 eg, Commission, Europe’s Moment: Repair and Prepare for the Next Generation (COM(2020) 456). A series of initiatives have been developed to promote the EU’s ‘strategic autonomy’, including in relation to trade policy, the EU’s contribution to rules-​based multilateralism, and its digital and industrial strategies. 79 Commission, The European Economic and Financial Systems: Fostering Openness, Strength and Resilience (COM(2021) 32).

864  Third Countries which characterized CMU as being a precondition for Europe’s open strategic autonomy and asserted that vibrant, integrated, and deep capital markets would make the EU more attractive to global investors and also support the euro as an international currency.80 Nonetheless, open strategic autonomy can also be associated with a more exclusionary approach, notably as regards third country CCPs which have, since the Brexit referendum, become a lightning rod for EU/​UK friction over financial market access, given the EU’s strategic dependence on UK CCPs for euro-​denominated clearing of certain derivatives: the 2021 Communication related strategic autonomy to the EU weaning itself from its dependence on third country CCPs.81 While the CCP segment has idiosyncratic features tied to EU/​UK post Brexit relations, if it becomes a bellwether for the EU’s third country regime more generally, and for the articulation of ‘open strategic autonomy’ in the financial markets sphere, it may herald a move towards a more restrictive and exclusionary approach.

X.5  The Collective Investment Management Regime and Third Countries X.5.1  Delegation and the Collective Investment Management Sector The UCITS Directive/​AIFMD82 collective investment management (fund management) regime does not, unlike the MiFID II/​MiFIR regime for investment services generally, use equivalence-​related, passporting-​based, third country access arrangements. In practice, third country actor access in this sector is based on the delegation or outsourcing by EU-​based fund managers of functions to third country firms. Cross-​border passporting by third country fund managers and by third country funds (in practice, alternative investment funds (AIFs) under the AIFMD; UCITS funds must be authorized in the EU) is not currently supported. Equivalence-​based legal technology for passporting by third country alternative investment fund managers (AIFMs) and AIFs has been developed for the AIFMD, but has not been activated, as outlined in the following section. The third country debate in this sector, therefore, relates to the extent to which EU fund managers can delegate critical functions to third country firms, given, on the one hand, the potential supervisory risks in the EU when only minimal substance is retained in the EU; and, on the other, the dominance and longstanding nature of delegation arrangements (both intra and ex EU) in the fund management sector and the efficiencies they bring. As outlined in Chapter III, delegation by the fund managers of UCITS funds under the UCITS Directive and by the AIFMs of AIFs under the AIFMD of core functions, such as asset management, risk management, and internal controls, to third country entities is 80 Commission, A Capital Markets Union for People and Businesses. New Action Plan (COM(2020) 590) 5. Earlier, the Commission linked enhancing the global attractiveness of the EU capital market to the success of the CMU project and underlined the importance of the equivalence regime in this regard: Commission, Capital Markets Union: progress on building a single market for capital for a strong Economic and Monetary Union (COM(2019) 136). 81 Commissioner McGuinness similarly associated the EU’s strategic autonomy with a reduction in the concentration of critical infrastructures located outside the EU, albeit that the Commissioner also stressed that the drive to ‘open strategic autonomy’ did not imply protectionism and that the EU remained committed to international financial markets: Speech, 22 June 2021. 82 Directive 2009/​65/​EC [2009] OJ L302/​32 and Directive 2011/​61/​EU [2011] OJ L174/​1.

X.5  Collective Investment Management and Third Countries  865 permitted, albeit subject to controls designed to ensure adequate oversight of the delegated functions by the EU fund manager, as well as to the location in the EU of sufficient operational substance to ensure effective supervision. The UCITS and AIFMD regimes relatedly address the delegation process and the need for delegations to be justified, the avoidance of ‘letter box’ entities, the level of due diligence and oversight to be exercised by the fund manager over delegated functions, and organizational and operational requirements. The most stringent requirements apply under the AIFMD delegation regime which includes, unlike the UCITS regime, administrative rules.83 Also, specific third country requirements apply to the UCITS/​AIF depositary, including as regards the extent to which third country entities can act as depositaries, and as regards the use of third country sub-​custodians for custody functions.84 Brexit, and the relocation of fund management business from the EU to the UK, led to the adoption of an extensive 2017 ESMA Opinion on the extent to which delegation is permissible and on the nature of the oversight required of and by EU fund managers as regards delegation. While directed to the use of delegation to repatriate core activities from EU firms to UK firms, while retaining the EU passport, the Opinion addresses the risks of delegation to third country actors generally and calls for close NCA oversight.85 While delegation practices are long-​established and embedded within the fund management industry,86 the EU regulatory scheme remains unsettled, reflecting significant political contestation, particularly since the Brexit referendum, as to the extent to which delegation, including to third countries, should be permitted. A Brexit-​influenced attempt over the negotiations on the 2019 ESA Reform Regulation to impose restrictions on NCAs’ discretion to approve delegation arrangements (by means of an ESMA review mechanism) foundered in the face of significant opposition from Member States with large fund management markets.87 Since then, concerns that EU fund managers could become ‘shell’ operations, generating supervisory difficulties and investor protection and financial stability risks, which have been repeatedly raised by ESMA,88 have led to delegation reappearing on the reform agenda. The 2021 AIFMD Proposal reforms continue to permit delegation, but 83 The delegation requirements are set out in UCITS Directive Art 13 and AIFMD Art 20 (and in the related administrative rules under AIFMD Delegated Regulation 231/​2013 [2013] OJ L83/​1 Arts 75–​82)). See further Ch III. 84 AIFMD depositaries can take the form of third country entities, given that the AIFMD regime covers the management of third country AIFs: AIFMD Art 21. UCITS depositaries, however, must be established in the EU: UCITS Directive Art 23. The delegation requirements applicable to depositary functions are set out in UCITS Directive Art 22a and AIFMD Art 21. They are amplified by the detailed administrative rules applicable to depositaries and custody arrangements under AIFMD Delegated Regulation Arts 83–​102, which include specific requirements for third country depositaries (Art 84), and under UCITS Delegated Regulation 2016/​438 [2016] OJ L78/​11, which addresses UCITS depositaries. 85 ESMA, Opinion (Supervisory Convergence in the Area of Investment Management in the Context of the UK Withdrawal), 13 July 2017. ESMA warned that delegation to third country entities could make oversight and supervision of delegated functions more difficult, particularly where longer or more complex operational chains were used, and called on NCAs to be satisfied that such arrangements were justified, based on objective reasons (in accordance with the UCITS and AIFMD requirements). 86 Delegation arrangements have been described by a leading industry stakeholder as a ‘key pillar’ of the EU’s cross-​border investment model: International Capital Markets Association, Delegation—​the backbone of the European asset management industry (2018). 87 See Ch III section 4.7.1. 88 ESMA, Letter to the Commission (Review of the AIFMD), 18 August 2020. ESMA noted that management companies were delegating portfolio management functions ‘to a large extent’, with portfolio management functions often largely or entirely delegated outside fund management groups, and that, in light of Brexit, delegation to third country entities was likely to increase, with the majority of the resources needed for day-​to-​day operations potentially outside of the EU in some cases, bringing heightened operational, supervisory, and regulatory arbitrage risks. Among the reforms it sought was greater clarification on the ‘maximum extent’ of the delegation permitted,

866  Third Countries propose tighter restrictions on the extent to which fund managers can delegate functions (including by aligning the UCITS regime with the more detailed AIFMD regime), in order to ensure sufficient substance remains in the EU and that supervision can be effective.89 While the fate of the Proposal remains to be seen, the stickiness of the persistent contestation around fund delegation structures underlines how third country access arrangements can be both highly technical and deeply political.

X.5.2  The AIFMD Passport The AIFMD is more liberal than the UCITS Directive in that it has the potential to support EU access by third country AIFMs and AIFs, through equivalence-​based passporting arrangements, although the regime has yet to be ‘switched on’; the UCITS Directive does not. The negotiations on the AIFMD third country regime were among the most difficult of the financial-​crisis-​era negotiations.90 The initial Commission and Council access models—​in particular by their reliance on stringent equivalence requirements—​threatened to close off or at least severely limit third country AIF and AIFM access to the EU market and generated intense opposition.91 The third country access regime, as finally adopted,92 is complex and contingent, being based on national private placement regimes (NPPRs) initially, followed by the activation of full passporting rights.93 Two types of passport are envisaged: one (unusually) for EU AIFMs, already authorized and supervised in the EU, but in respect of their marketing of non-​EU AIFs, which do not currently qualify for passporting; the other (with a more usual scope) for non-​EU AIFMs, in relation to their marketing and also management activities. With respect to an EU AIFM marketing non-​EU AIFs which are managed by the AIFM (Articles 35–​6),94 very broadly, NPPRs (through which Member States can impose additional rules) still apply, albeit that the NPPR regime was designed to be transitional. The EU AIFM can market a non-​EU AIF (to professional investors only) under an NPPR and in so doing must comply with the AIFMD requirements for EU AIFMs generally (apart from the depositary requirements)95 (Article 36). Minimum harmonized requirements relating to

including quantitative metrics. The Commission’s subsequent 2021 Proposal (COM(2021) 721) proposed more extensive regulation, but did not propose limits on delegation: Ch III section 4.7.1. 89 COM(2021) 721. See Ch III section 4.7.1. 90 See, eg, Ferran, n 59. 91 The impact assessment prepared for the European Parliament, eg, warned that the equivalence model adopted in the Commission’s proposal was protectionist and could lead to retaliation: Report for the ECON Committee, Analysis of the Commission’s Impact Assessments of the proposed AIFM (2009) (IP/​A/​ECON/​2009-​3). 92 The Parliament supported a more liberal approach to passporting, but the Council struggled to reach a position, with France in particular seeking a restrictive, equivalence-​based approach. 93 The access regime is considered here in outline only. 94 The management by EU AIFMs of non-​EU AIFs is addressed by Art 34 which provides that EU AIFMs may manage such funds in the EU, as long as the AIFM complies with the AIFMD (the Directive’s depositary (see n 95) and annual report requirements do not apply), and appropriate cooperation arrangements are in place between the AIFM home NCA and the supervisory authority of the AIF third country. 95 Although an entity must be appointed to fulfil the depositary’s cash monitoring, custody, and oversight requirements, and the AIFM cannot perform these functions: Art 36(1).

X.5  Collective Investment Management and Third Countries  867 the AIF’s third country also apply.96 The AIFMD contains, however, the legal technology for a full passport, based on home NCA control and notification of host NCAs, which would allow EU AIFMs to market non-​EU AIFs cross-​border (Article 35).97 Access by non-​EU AIFMs (as regards the management of EU AIFs and/​or the marketing of any AIFs) is subject to a similar regime, being based initially on NPPRs (Article 42) and subsequently on the ultimate application of a full passport (the modalities of which are set out in Article 39–​41),98 after a transitional period. At the heart of the non-​EU AIFM passporting regime is the requirement that the non-​EU AIFM is authorized in accordance with the Directive before it can carry out marketing or management activities in the EU.99 Earlier versions of the third country regime were based on ESMA authorizing third country AIFMs, but this model foundered following significant political resistance.100 Authorization is accordingly to be carried out by the ‘Member State of reference’, which is determined according to a detailed and complex formula.101 Authorization is subject to the same conditions as apply to EU AIFMs under the AIFMD, but additional requirements apply, including with respect to the requirement for a legal representative, responsible for compliance, to be established in the Member State of reference; cooperation arrangements with the AIFM’s (home) third country supervisor; the effective exercise by the relevant EU authorities of their supervisory functions not being prevented by the legal or supervisory regime of the third country governing the AIFM; and additional information requirements. Authorized non-​EU AIFMs become subject to the AIFMD,102 although an exemption is available where legal conflicts arise between the Directive and the law to which the non-​EU AIFM (and/​or the non-​EU AIF marketed in the EU) is subject, as long as equivalent rules apply under the relevant law.103 These arrangements are supported by a set of ESMA powers designed to bolster NPPRs against arbitrage risks and to support the passporting system if it activates. They empower ESMA to request NCAs to take a series of actions to restrict the activities of non-​EU AIFMs in specified circumstances where risks are elevated (Article 47(4)). The AIFMD third country passport system has an equivalence dimension in that its activation is contingent on an equivalence-​style assessment. Under Article 67, the Commission is empowered under the AIFMD to activate the passporting regimes, by means of an

96 Art 36. Essentially, cooperation arrangements must be in place between the AIFM home NCA and the AIF third country authority, and the third country must comply with international obligations relating to anti-​money laundering and anti-​terrorism financing. 97 The Art 35 passport regime largely follows the same design as the Art 32 EU AIFM/​EU AIF passport (considered in Ch III), being based on host NCA notification and home NCA control. Additional cooperation obligations relating to the non-​EU AIF’s supervisory authority apply, as do requirements relating to the third country’s compliance with international anti-​money laundering and anti-​terrorism financing obligations, as well as with the OECD’s obligations regarding information exchange on taxation matters. 98 Art 39 (marketing passport for marketing EU AIFs, modelled on the Art 32 EU AIFM marketing passport for EU AIFs); Art 40 (marketing passport for marketing non-​EU AIFs, modelled on the Art 35 EU AIFM passport for non-​EU AIFs); and Art 41 (management passport for EU AIFs, based on the Art 33 EU AIFM management passport). 99 Arts 37(1) and 41(1). 100 De Manuel Aramendía, M, Third Country Rules for Alternative Investments: Passport Flexibility Comes at a Price. ECMI Commentary No 27/​16, December 2010. 101 Set out in the lengthy Art 37. Detailed rules govern the regime, and cover, inter alia, disputes between Member State NCAs as to the determination and related mediation by ESMA. 102 In relation to the AIFM’s management and marketing of EU AIFs and the marketing of non-​EU AIFs. 103 Art 37(2).

868  Third Countries administrative act,104 if ESMA finds there are no ‘significant obstacles’ impeding the application of the passports, an assessment that requires an equivalence-​like review (Article 67(4)).105 ESMA’s review was, as required by Article 67, carried out in 2015, two years after the coming into force of the AIFMD.106 ESMA assessed six jurisdictions (Guernsey, Hong Kong, Jersey, Singapore, Switzerland, and the US),107 following a methodology similar to that applicable to equivalence assessments,108 and finding that passporting arrangements could be ‘switched on’ for Guernsey and Jersey, and for Switzerland following reforms to its domestic legislation. ESMA did not reach a definitive view on the other jurisdictions, given concerns related to competition, regulatory issues, and a lack of evidence to assess the required criteria. Subsequently, and following a Commission request, ESMA issued a further report in 2016 which recommended that the passports be made available to Canada, Guernsey, Jersey, and Switzerland, and which made qualified recommendations in relation to Australia, Hong Kong, Singapore, and the US, in particular as regards competition risks.109 There has been little sign since then of the passport system being activated. It has not been associated with CMU or addressed by the 2021 AIFMD Proposal, and there is little evidence of any political urgency or of serious market disquiet: despite the intense contestation it generated, the AIFMD’s passporting technology lies dormant. In practice, the NPPR system has proved resilient and stable. NPPRs, where made available by Member States, have allowed third country managers and funds to access the EU market on a targeted, Member-​State-​by-​Member-​State basis, reflecting market structure and investor demand. The market appears to have adjusted to the NPPR system, which has the merit of not requiring third country firms to be authorized in the EU.110 The NPPR system is primarily

104 The Commission in so doing is to take into account the criteria which ESMA must consider in its related review (n 105) and the objectives of the AIFMD, including in relation to the internal market, investor protection, and the effective monitoring of systemic risk: Art 67(6). 105 Art 67(4) provides that ESMA can issue a positive opinion to activate the passports where there are no significant obstacles regarding investor protection, market disruption, competition, and the monitoring of systemic risk. Additional criteria apply under Arts 35 and 37 as regards the operation of the different passports, and in relation to supervisory cooperation with the third country and compliance by the third country with international anti-​money laundering/​terrorism financing and taxation-​related information exchange obligations. 106 ESMA, Advice to the European Parliament, Council, and Commission on the Application of the AIFMD Passport to non-​EU AIFMDs and AIFs, 30 July 2015. 107 Chosen given the scale of activity from these jurisdictions in the EU under NPPRs, NCAs’ knowledge and experience of dealing with authorities in these jurisdictions, and stakeholder support. 108 ESMA adopted a lengthy ‘Assessment Methodology’ to review the identified jurisdictions against the relevant criteria (based on Art 67(4) and Arts 35 and 37) which was designed to delve into the regulatory, supervisory, and enforcement systems of the relevant jurisdiction: 2015 AIFMD Passport Advice, n 106, 7–​14. 109 ESMA, Advice to the European Parliament, Council, and Commission on the Application of the AIFMD Passport to non-​EU AIFMDs and AIFs, 12 September 2016. In the case of the US, eg, ESMA found that there were no significant obstacles as regards investor protection and the monitoring of systemic risk which would impede the application of the passport. As regards the competition criteria, however, the application of the passport could, ESMA found, risk an ‘unlevel playing field’ between EU and non-​EU AIFMs as the conditions applicable to US funds in the EU would be different to and potentially less onerous than those applicable to EU funds in the US, as regards funds distributed through a public offering. 110 The British Venture Capital Association (the BVCA), a leading trade association for the alternative investment fund management sector, does not support activation of the passport as it would raise serious challenges for the UK industry and could lead to the removal of more accommodative NPPRs. See, arguing that a well-​ functioning NPPR system is ‘central to Europe’s financial regulatory architecture’, that, while there are some frictions associated with NPPRs, they have ‘proven a key channel for EU investors to access global funds and allowed non-​EU managers to access the EU market in a way that many have come to find manageable’, and that ‘the benefits of retaining NPPRs for the European economy are significant’, BCVA, Response to the European Commission Public Consultation on Review of the AIFMD (2021).

X.6  The Issuer Disclosure Regime and Third Countries  869 used for marketing non-​EU AIFs, the market for which is sizeable, representing more than 20 per cent of the sector’s net asset value in the EU,111 suggesting that the NPPR system is not leading to burdensome frictions. NPPRs carry the risk of regulatory arbitrage, and of systemic risk where Member State regulation is not sufficiently stringent, but there is little evidence of material risks emerging.112 The NPPR system has also led to a significant strengthening of the EU’s cooperation arrangements: ESMA coordinated the negotiation of the raft of required cooperation agreements with third countries, although they were executed bilaterally by the relevant NCA and the third country authority.113 Ultimately, the outcome of the AIFMD third country regime has been quixotic. A fiercely contested negotiation process led to the adoption of a hard-​fought compromise on passporting, but the transitional solution, based on NPPRs, has ended up prevailing. By sharp contrast with MiFID II/​MiFIR and EMIR, there is little evidence of any political appetite for further centralization of the AIFMD third country regime, whether by restricting the NPPR system or activating the passport regime. The regime exemplifies accordingly how political preferences can change and the market can adapt, as well as the extent to which contestation varies across the different domains of the third country regime, in accordance with the prevailing interests and preferences.

X.6  The Issuer Disclosure Regime and Third Countries By contrast with the collective investment management regime, the issuer disclosure regime does provide for passport-​based access for third country actors, based on equivalence. The regime is less articulated and institutionalized than the MiFID II/​MiFIR and EMIR systems and has not attracted the (primarily Brexit-​related) reform pyrotechnics that have attended those systems, being one of the quieter corners of the third country regime.

X.6.1  The Prospectus Regime The prospectus regime, while requiring, in effect, that third country prospectuses follow EU requirements, has not attracted significant contestation as regards third country access. This can in part be associated with the significant degree of convergence in prospectus disclosure requirements internationally, but also with the primarily intra-​EU nature of public offers and admissions to trading venues. CMU and Brexit have brought a sharper focus to bear on the attractiveness of the EU capital market to third country issuers, but this has 111 ESMA, Alternative Investment Funds. Annual Statistical Report (2022) 40. Most non-​EU AIFs marketed in the EU are either hedge funds (predominantly domiciled in the Cayman Islands) or US exchange traded funds (primarily equity funds). 112 The AIFMD required ESMA, as part of the preparatory process for ‘switching on’ the passport system, to review the operation of the NPPR system by 2015 (Art 67). ESMA’s 2015 report found that there was insufficient evidence to indicate that NPPRs had raised major issues, although it noted that the system had been place for only two years: ESMA, Opinion (Functioning of the AIFMD EU Passport and National Private Placement Regimes), 30 July 2015. Since then, major difficulties have not emerged and the risk profile of the non-​EU AIF sector is similar to that of the EU AIF sector: 2022 ESMA AIF Report, n 111, 41. ESMA has, however, suggested enhancements to the reporting required of funds operating under NPPRs: 2020 Commission Letter, n 88. 113 ESMA negotiated cooperation arrangements on behalf of NCAs and with thirty-​four of their global counterparts: ESMA Press Release, 30 March 2013.

870  Third Countries been more a function of enhancing the relative strength of EU market depth and efficiency internationally, and less a function of the operation of the third country regime. The regime has remained broadly consistent over time. It is based on third country issuers, like their EU counterparts, being required to have published an NCA-​approved prospectus prior to making a public offer of securities in the EU or admitting securities to trading on a regulated market (on the prospectus regime see Chapter II). Prior to the recasting of the regime by the 2017 Prospectus Regulation, the third country regime contained in the governing 2003 Prospectus Directive was based on the relevant EU home NCA being empowered to approve a prospectus where the prospectus was drawn up in accordance with the legislation of a third country, but only where the prospectus was drawn up in accordance with international standards set by international securities commissions (including the IOSCO disclosure standards) and where those disclosure requirements were ‘equivalent’ to those of the Directive.114 The prospectus passport then followed. Unusually, the equivalence decision lay with the relevant NCA. While the Directive empowered the Commission to adopt an equivalence framework, one was not put in place. In an early indication of its entrepreneurialism, ESMA established a process to support such equivalence assessments by NCAs,115 based on ESMA assessing the equivalence of a third country regime, and on relevant third country issuers being required to provide a ‘wrap’ for their prospectuses which set out the additional information required where the third country regime in question was deemed not to be equivalent to the EU regime;116 NCAs could then scrutinize the ‘wrapped’ prospectus for approval. Although it was not used frequently,117 a framework was therefore in place to support third country issuers. But while this regime was based on equivalence, it was also ‘on-​shored’ in the EU, in that third country prospectuses could not avoid the NCA approval process. This system remains more or less intact following the wider reform and recasting of the prospectus system by the 2017 Prospectus Regulation, albeit that, reflecting the post-​ financial-​crisis/​Brexit era tightening of third country arrangements, stricter conditions now apply, in particular as regards the need for cooperation arrangements with third country authorities.118 Two routes are available to issuers: one based on compliance with the Regulation (Article 28); the other based on compliance with relevant third country rules (Article 29). As regards the first, an issuer may, where it intends to offer securities to the public in the EU or seeks admission to trading of securities on a regulated market in the EU, draw up a prospectus in accordance with the Regulation and seek approval from the relevant home NCA (Article 28).119 Once the prospectus is approved by the NCA, the 114 2003 Prospectus Directive (Directive 2003/​71/​EC [2003] OJ L345/​64) Art 20. 115 ESMA’s initiative followed requests from third country issuers and the Commission’s earlier support for CESR to develop an equivalence framework (CESR, Statement of 17 December 2008 (CESR/​08-​972)). 116 ESMA Legal Opinion (ESMA/​2013/​317) (based on an earlier 2011 Public Statement). 117 ESMA’s first assessment (under an earlier version of the 2013 ESMA Opinion) was of the Israeli regime. It set out the wrap requirements which, if met, allowed NCAs to consider the regime to be equivalent and to proceed to scrutinize the prospectus (ESMA/​2011/​37). Subsequently, the Turkish prospectus regime was found to be equivalent to the EU regime and a wrap was not found to be necessary: ESMA, Opinion (Assessment of Turkish Law on Prospectuses), 8 February 2016. 118 Regulation (EU) No 2017/​1129 [2017] OJ L168/​12. The Commission’s earlier 2015 Proposal (COM(2015) 583) did not make approval of a third country prospectus contingent on cooperation arrangements being in place. It did, however, require third country issuers, where they prepared a prospectus in accordance with the EU regime, to designate a representative (in the form of an entity supervised under EU financial regulation) to act as a contact point. This requirement, which met with hostility from the industry, was removed over the negotiations. 119 The home NCA is, in effect, that of the Member State where the securities are to be offered to the public for the first time or where the first application for admission to trading on a regulated market is made (at the choice of

X.6  The Issuer Disclosure Regime and Third Countries  871 prospectus passport is available: all the rights and obligations that attend an approved prospectus under the Regulation follow, and the prospectus and its third country issuer are subject to all the provisions of the Regulation under the supervision of the home NCA. The second route (Article 29) is equivalence-​based, allowing the issuer to follow its third country rules, but in practice it is of limited value. The home NCA of a third country issuer may approve a prospectus for an offer of securities to the public or for admission to trading on a regulated market in the EU where the prospectus is drawn up in accordance with the national laws of the third country issuer, as long as two conditions are met: the third country disclosure requirements must be ‘equivalent’ to those of the Regulation—​the third country prospectus must therefore, in effect, be reviewed and approved by the NCA under the Prospectus Regulation;120 and cooperation arrangements must in place between the home NCA and the relevant third country authority that comply with the Article 30 requirements for cooperation arrangements (Article 29(1)). Once such a prospectus is approved by the home NCA, it can be passported, subject to compliance with the Regulation’s requirements relating to the production of an updating supplement where necessary, notification of the host NCA(s), and language (Article 29(2)). As under the precursor regime, and unusually, the equivalence decision lies with the NCA. The Commission can establish general equivalence criteria in this area (but is not required to), and it may also adopt jurisdiction-​level equivalence decisions (Article 29(3)). ESMA has advised the Commission against adopting equivalence criteria given the limited value of any such regime as in practice the Article 29 third country prospectus, while drawn up in accordance with third country rules, is scrutinized and approved under the Prospectus Regulation’s disclosure rules. ESMA further advised that the absence of an equivalence regime would not cause significant difficulties given the alternative Article 28 route, limited demand for an equivalence regime, and, given the absence of an equivalence regime under the precursor prospectus regime, no discontinuity in the EU’s approach.121 Subsequent to the adoption of the Regulation, the Commission’s 2017 ESA reform package proposed that ESMA be conferred with approval and supervisory powers over third country prospectuses,122 in what would have amounted to a material centralization of the regime. This reform did not survive the negotiation process given significant Member State resistance.

X.6.2  Ongoing Disclosures and IFRS An equivalence-​based regime is available to mitigate regulatory costs for third country issuers that come within the scope of the Transparency Directive’s ongoing disclosure obligations (see Chapter II section 5)123 by virtue of their securities being admitted to trading on a

the issuer, the offeror of the securities, or the person seeking admission of the securities to a regulated market): Art 2(m)(ii) and (iii). 120 ESMA, Letter to Commission, 31 January 2020. 121 2020 ESMA Prospectus Letter, n 120. Related refining reforms were proposed by the Commission in December 2022: COM(2022) 762. 122 COM(2017) 536. 123 Directive 2004/​109/​EC [2004] OJ L390/​38.

872  Third Countries regulated market. Home NCAs may exempt third country issuers from these disclosure requirements where ‘equivalent’ obligations are imposed in the third country (Article 23(1)). The nature of equivalence has been amplified in some detail by administrative rules, but the equivalence decision lies, as with the prospectus regime, with the NCA.124 In addition, and similarly designed to mitigate regulatory costs, an equivalence regime applies as regards the International Financial Reporting Standards (IFRS) system, a global standard which governs financial reporting in the EU as regards prospectuses and as regards the ongoing disclosures required of issuers admitted to regulated markets (Chapter II section 6). Under the Prospectus Regulation and the Transparency Directive, the IFRS requirement (where it would otherwise apply) does not apply to third country issuers’ prospectuses or other required ongoing disclosures where the relevant third country financial reporting system is ‘equivalent’ to the IFRS system. Given the relative novelty of the IFRS system when it was adopted as the EU financial reporting standard in 2002,125 the political sensitivities where major capital markets followed (and continue to follow) their domestic financial reporting systems (GAAPs—​Generally Accepted Accounting Principles) or the other dominant global standard, US GAAP, and the EU’s interests in driving the international uptake of IFRS, a discrete equivalence framework for IFRS was put in place in 2007 under Delegated Regulation 1569/​2007 which located the equivalence decision with the Commission.126 While the 2007 Regulation established principles for the determination of equivalence,127 it was also designed to encourage third country convergence towards IFRS by providing transitional periods over which local GAAPs could be used (without a positive equivalence determination), as long as the relevant third country was on a convergence programme towards IFRS adoption. By end March 2016, these transitional arrangements had all ceased.128 The first IFRS equivalence decisions were adopted in 2008, with the Commission declaring US and Japanese GAAP to be equivalent to IFRS.129 Since then, the Canadian, Chinese, and South Korean GAAP systems have also been found to be equivalent.130 Given the now global uptake of IFRS, the EU’s IFRS equivalence process has become of largely historical interest,131 but it remains an example of how the EU can, and does, use the equivalence process to export its approach to regulation, in this case the use of IFRS as the financial reporting standard for major public markets.

124 Delegated Directive 2007/​14/​EC [2007] OJ L69/​27 Arts 13–​23. Art 13, eg, sets out the equivalence requirements for the annual management report required in the annual financial report, while Art 14 sets out the equivalence requirements for the half-​yearly financial report. 125 Regulation (EC) No 1606/​2002 [2002] OJ L243/​1. 126 Commission Regulation (EC) No 1569/​2007 [2007] OJ L340/​66. 127 Article 2 defines equivalence as arising where an investor can make a ‘similar assessment’ of the assets and liabilities, financial position, profits and losses, and prospects of the issuer as it would under IFRS, with the result that the investor is likely to make the same decision about the acquisition, retention, or disposal of the securities of an issuer. The equivalence decision is made by the Commission, but follows an application by an NCA or a third country authority; the Commission may also act on its own initiative (Art 3). The equivalence decision is also dependent on EU issuers not being subject to reconciliation requirements in the third country (recital 3). 128 The transitional periods originally adopted under Delegated Regulation 1569/​2007 Art 4, and over which third country GAAPs could be used (as long as the relevant third countries were in IFRS convergence programmes), were extended for different third countries to reflect slippage in convergence timetables. A final deadline of 31 March 2016 was adopted in 2015, by which time all financial reporting by third country issuers had to be either under IFRS or under an ‘equivalent’ system: Delegated Regulation 2015/​1605 [2015] OJ L249/​3. 129 Commission Decision 2008/​961/​EC [2008] OJ L340/​112. 130 Commission, Table of Equivalence Decisions, 10 February 2021. 131 For extended discussion see the third edition of this book.

X.7  The Rating Agency Regime and Third Countries  873

X.7  The Rating Agency Regime and Third Countries X.7.1  The Legislative Scheme: Endorsement and Certification The credit rating agency (CRA) third country regime under the Consolidated Credit Rating Agency Regulation (CCRAR)132 is significantly more articulated and centralized than that governing issuer access to the EU financial market, not least as it draws in ESMA as a gatekeeper, with ESMA required to ‘certify’ certain third country CRAs. The sophistication of this third country regime reflects a host of factors, including the EU’s financial-​crisis-​era interests in exporting its regulatory approach to CRAs internationally, but also the dominance of the three major global CRAs (Standard & Poor’s (S&P Global), Moody’s, and Fitch) and the necessity, thereby, for some means of accommodating third country ratings. Two techniques are used: endorsement; and certification. As outlined in Chapter VII, one of the defining features of the CCRAR is that it requires the establishment within the EU of CRAs if their ratings are to be used for regulatory purposes in the EU.133 Ratings originating from third country CRAs, who are within a group with an EU CRA (such as one of the three major global CRA groups), can, however, be used, where those ratings are ‘endorsed’ by the EU CRA. The main conditions of the endorsement process are that the ‘requirements’ of the third country regime are ‘as stringent as’ the EU regime (an equivalence-​like assessment), that there is an objective reason for the rating to be elaborated in a third country, and that supervisory cooperation arrangements are in place (Article 4(3)). Where a rating originates from a third country CRA which does not have such a group connection to an EU CRA, that rating can only be used for regulatory purposes within the EU where significantly more onerous conditions are met: the legal and supervisory framework of the third country is ‘equivalent’ to the EU regime; cooperation arrangements are in place; the CRA does not have systemic importance for the stability or integrity of financial markets in one or more Member States; the rating relates to a non-​EU issuer or instrument; and the CRA is ‘certified’ by ESMA (Article 5). As regards the endorsement mechanism, the conditions are designed to ensure that the third country regime is broadly equivalent and that the EU CRA can accordingly endorse the rating (Article 4(3)(a)-​(h)). At the core of the conditions is that the third country CRA must be authorized or registered and subject to supervision in the third country, and that the EU CRA must verify, and be able to demonstrate on an ongoing basis, to ESMA, that the conduct of credit rating activities by the third country CRA resulting in the rating to be endorsed fulfils requirements which are at least ‘as stringent as’ specified core elements of the CCRAR.134 In addition, ESMA’s ability to assess and monitor the compliance of the third country CRA with these requirements must not be limited; and the ‘endorsing’ EU CRA must make available on request to ESMA all the information necessary to enable ESMA to supervise on an ongoing basis compliance with the Regulation’s requirements. Further, the third country regulatory regime must prevent interference by competent and public authorities with rating content and methodologies135 and appropriate cooperation 132 CCRAR, n 39. 133 EU-​established CRAs must also be registered with ESMA (in effect, authorized by ESMA) and comply with the CCRAR. 134 Exemptions apply, including with respect to ownership restrictions, rotation, and sovereign ratings. 135 This requirement is dis-​applied where a general equivalence decision has been adopted by the Commission (under the Art 5 procedure) in relation to the third country: Art 4(6)).

874  Third Countries arrangements must exist between ESMA and the relevant competent authority of the third country CRA.136 Also, there must be an objective reason for the rating to be elaborated in a third country. The endorsement process involves two stages in practice: ESMA’s assessment of the ‘as stringent as’ status of the legal and supervisory framework of the third country; and ESMA’s assessment of the specific conditions which the ‘endorsing’ CRA must meet.137 Once the rating has been endorsed, it is considered to be a rating issued by an EU-​established and registered CRA (Article 4(4)). Anti-​avoidance measures apply in that CRAs established and registered in the EU must not use endorsement to circumvent the Regulation (Article 4(4)). The endorsing CRA remains responsible for the rating (Article 4(5)). The certification regime (Article 5)—​which, by contrast, is equivalence-​driven—​allows a third country CRA, not part of a group with an EU CRA but whose activities are not considered to be of systemic importance to the financial stability or integrity of the financial markets of one or more Member States, to enable its ratings to be used for regulatory purposes in the EU. Article 5 therefore supports the use of ratings issued by smaller third country CRAs, who do not have the worldwide group operations of the CRAs addressed by the Article 4 endorsement process. Under Article 5, where ratings relate to entities established in third countries, or to financial instruments issued in a third country,138 and are issued by a third-​country-​established CRA but are not endorsed, they may still be used for regulatory purposes within the EU, subject to an equivalence-​driven procedure (Article 5(1)). The third country CRA must be authorized or registered and subject to supervision in the third country, the Commission must have adopted an equivalence decision relating to the legal and supervisory framework of the third country, and cooperation arrangements between ESMA and the third country authority139 must be in place (Article 5(1)). The ratings must additionally not be of systemic importance to the financial stability or integrity of the financial markets of one or more Member States (Article 5(1)). Finally, the third country CRA must also be ‘certified’ in accordance with Article 5(2): the certification process, which is based on ESMA ensuring compliance with the Article 5(1) conditions, is run by ESMA and follows similar procedural steps as apply to EU CRA registration. The necessary equivalence decision is taken by the Commission (Article 5(6)), where it is satisfied that the legal and supervisory framework of the third country ensures that CRAs comply with ‘legally binding requirements’ equivalent to the Regulation140 and are subject to ‘effective supervision and enforcement’ in the third country.141 136 The cooperation arrangements must cover a mechanism for the exchange of information and procedures governing the coordination of supervisory activities, such that ESMA can monitor, on an ongoing basis, the credit rating activities resulting in the issuing of the endorsed rating: Art 4(3)(h). 137 ESMA’s approach to the endorsement process is set out in ESMA, Guidelines on the Endorsement Regime under Art 4(3) of the CRA Regulation (2019, originally adopted in 2011). A requirement is regarded by ESMA to be ‘as stringent as’ the corresponding CCRAR requirement where it ‘achieves the same objective and effects in practice’. ESMA has also provided a non-​exhaustive list of alternative internal CRA requirements which it considers to be at least ‘as stringent as’ the relevant CCRAR provisions. 138 The certification regime cannot accordingly be used for ratings of EU issuers and instruments, in respect of which the Art 4 endorsement process or full EU establishment and registration is required. 139 The arrangements track those required under the endorsement mechanism: Art 5(7). 140 Exemptions apply, including with respect to the CCRAR’s requirements relating to ownership restrictions, rotation, and sovereign ratings. 141 Art 5 specifies that a third country regime can be considered equivalent where: CRAs are subject to authorization or registration and are subject to effective supervision and enforcement on an ongoing basis; CRAs are subject to legally binding rules equivalent to specified CCRAR requirements (Arts 6–​12 and Annex I; the core ongoing requirements imposed on CRAs); and the third country regime prevents interference by supervisory and other public authorities of that third country with the content of ratings and methodologies. A third country CRA seeking certification may apply for an exemption from the CCRAR’s operational requirements (Annex I section A)

X.7  The Rating Agency Regime and Third Countries  875 The combined effect of the Article 4 endorsement and the Article 5 equivalence/​certification regimes is to exert significant pressure on third country regimes to conform to the EU model—​not only with respect to regulation, but also with respect to operational supervision and enforcement.

X.7.2  The CRA Third Country Regime in Practice The third country regime has been relatively straightforward in practice, proving to be more a creature of technocracy than of politics, and with ESMA emerging as pivotal to its operation. The regime faced its first major test with the Article 4 endorsement process. Less cumbersome than the parallel Article 5 certification process and not requiring a Commission equivalence decision, the endorsement process was heavily relied on, as the new rating agency regime came into force, to ensure that ratings produced within the global CRA groups could be used for regulatory purposes in the EU. Despite significant market concern at the time as to the potential risk of disruption were the endorsement process to be delayed,142 and ESMA’s related warnings as to the need for precautionary action by market participants were all endorsement assessments not to be completed by the end-​April 2012 deadline for endorsement,143 ESMA found, by this deadline, that the relevant major jurisdictions as regards the endorsement process had requirements ‘as stringent as’ the EU requirements.144 Since then, the endorsement mechanism has been used to secure the continued use of UK CRA ratings for regulatory purposes in the EU: ESMA confirmed in 2020 that the UK legal and supervisory framework met the conditions for endorsement;145 and also reported that all previously ESMA-​authorized UK CRAs (bar one) had ensured that their ratings would be endorsed by an EU CRA.146 The Article 5 certification process has been much less widely relied on, with only three CRAs, each from three different jurisdictions (Japan, Mexico, and the US) so far certified.147 The related equivalence process, however, has been more wide-​ranging; a series of jurisdictions have been assessed for their equivalence status. These assessments saw the emergence of ESMA as something of a steward of the equivalence process, as it was in relation to these initial CCRAR equivalence assessments that ESMA first engaged in an extended series of third country reviews, and that its recommendations were, for the first time, followed by the Commission in a series of related equivalence determinations. ESMA undertook this

and the rotation requirements (Article 7(4)) where the CRA can demonstrate that the requirements are not proportionate given the nature, scale, and complexity of its business, and the nature and range of its issuing of credit ratings; and from the requirement for physical presence in the EU (where this would be too burdensome and disproportionate in view of the nature, scale and complexity of its business and the nature and range of its issuing of credit ratings). 142 Tait, N, ‘SEC and EU in Talks to Resolve Ratings Impasse’, Financial Times, 24 April 2011. 143 ESMA, Press Release, 22 December 2011. 144 ESMA, Press Release, 27 April 2012. ESMA urged financial institutions to take precautionary steps with respect to non-​endorsed ratings, given the CCRAR prohibition on the use of such ratings. 145 ESMA Public Statement (Endorsement of UK Credit Ratings After the Transition Period), 27 October 2020. 146 ESMA, Press Release, 4 January 2021. 147 The three CRAs were certified in 2011 (Japan), 2014 (Mexico), and 2014 (USA): ESMA, CRA Authorization Table, 24 March 2022.

876  Third Countries first series of equivalence assessments for the Commission over 2012–​2013.148 Its findings were all followed by the Commission in its subsequent equivalence decisions,149 with the extent to which the Commission followed ESMA’s advice amounting to something of an endorsement of ESMA’s approach to equivalence, at least in the CRA context. ESMA adopted a pragmatic, ‘objective-​based approach’ under which the capabilities of the jurisdiction in question to meet the objectives of the CCRAR were assessed from a holistic perspective.150 For example, ESMA’s assessment of the equivalence of the US regime (which was carried out by ESMA after the US had made changes to its regulatory framework to address equivalence gaps previously identified by CESR), found that the few remaining uncertainties were not capable of materially detracting from a positive equivalence finding; that ESMA had gained comfort from its discussions with the US regulator (the SEC); that the application in practice by firms of the relevant US requirements would lead to equivalence; and that its equivalence review involved an assessment of the combined effect of the requirements reviewed and not only of individual provisions. Subsequently, ESMA’s 2017 ‘second generation’ equivalence assessments (these assessments revisited the earlier equivalence assessments following reforms made to the CCRAR in 2013) were swingeing (ESMA found that four of the jurisdictions reviewed were not equivalent, following the CCRAR reforms), but its approach was, as over 2012–​2013, pragmatic and holistic. For example, ESMA found that certain jurisdictions’ regimes were still equivalent to the CCRAR even though their rules did not directly map on to the CCRAR: the overall outcome achieved was sufficiently similar.151 The CCRAR regime has also proved a pathfinder as regards the withdrawal of equivalence. The Commission engaged in its first mass withdrawal of equivalence decisions in summer 2019, following the failure by several jurisdictions to update their regimes in light of reforms to the CCRAR.152 The withdrawal was not, however, heavily contested or politicized.153 There had been extensive discussions between the Commission and the relevant jurisdictions over time; ESMA had, as noted, previously identified a lack of equivalence in its 2017 review; the third countries in question decided not to make the relevant reforms given the limited scale of the EU-​related rating activity affected; and the Article 4 endorsement regime provided a further access route.154 Nonetheless, the withdrawals indicated the Commission’s commitment to a muscular and unilateral approach to equivalence, as well 148 ESMA advised the Commission on the equivalence status of the US, Canada, Australia, Argentina, Brazil, Mexico, Hong Kong, and Singapore through a series of detailed technical reports: ESMA/​2012/​259 and ESMA/​ 2013/​626. 149 In October 2012, eg, the Commission adopted equivalence decisions relating to the Australian, US, and Canadian regimes: respectively, Commission Implementing Decisions 2012/​627/​EU [2012] OJ L274/​30, 2012/​628/​EU [2012] OJ L274/​32, and 2012/​630/​EU [2012] OJ L278/​17. ESMA also advised that the regimes of Argentina, Brazil, Mexico, Hong Kong, and Singapore were equivalent (ESMA/​2013/​626) and Commission equivalence decisions followed. 150 ESMA/​2012/​259. 151 eg ESMA found that while the new CCRAR rules on CRA cross-​ownership in other CRAs were not mapped in the US regime, the applicable US conflict-​of-​interest rules achieved the same investor protection outcomes sought by the EU: ESMA, Technical Advice on CRA Regulatory Equivalence—​CRA 3 Update (2017) 81. 152 Five states (Argentina, Australia, Brazil, Canada, and Singapore) lost their equivalence status. Four of these had earlier been identified by ESMA in its 2017 review as no longer being equivalent, while as regards the fifth (Canada), its status had been identified by ESMA as being contingent on reforms (which did not follow). 153 Although it was met with some trepidation in the UK: Brunsden, J, ‘EU Decision on Equivalence Set to Heighten UK Post-​Brexit Fear’, Financial Times, 28 July 2019. 154 See, eg, Commission, Press Release (Financial Services: Commission sets out its equivalence policy with third countries), 29 July 2019.

X.8  The Investment Services Regime and Third Countries  877 as its commitment to monitoring compliance with equivalence decisions. They underline, however, that while the EU has successfully exported its approach to CRA regulation by means of the endorsement and certification regimes,155 third countries can, and do, choose to constrain their access to the EU where domestic regulatory interests so dictate.

X.8  The Investment Services Regime and Third Countries X.8.1  MiFID II/​MiFIR and Market Access X.8.1.1 A Dynamic and Intensifying Regime MiFID II/​MiFIR, on its coming into force in 2018, brought material change to the precursor MiFID I regime governing third country access to the EU, primarily by centralizing the access process at EU level to a significantly greater extent. A series of reforms adopted in 2019 have since tightened the regime. Under MiFID I, access by third country investment firms to the EU market was primarily a function of national law. Third country access through branches and cross-​border service provision was the responsibility of the relevant Member State in which access was sought, but passporting rights were not available. Separate access authorizations were required for each Member State in which the firm operated and Member States were not subject to EU rules in granting authorizations. The adoption of the significantly more harmonized MiFID II/​MiFIR regime, albeit part of a wider financial-​crisis-​era trend to harmonize third country access requirements more fully, was not straightforward and saw a collision between the Commission and European Parliament (in favour of a harmonized approach and of limited Member State discretion) and the Council (in favour of Member State autonomy). The Commission had proposed that services-​based access (for services provided to eligible counterparties only) be an EU-​ level process and so subject to harmonized rules, a prior Commission equivalence decision, and ESMA registration of the relevant firm, albeit that a passport would then follow.156 Branch-​based access would similarly require a prior Commission equivalence decision, but branch authorization would remain a Member State competence, albeit subject to harmonized rules; branches would also benefit from a passport in that they could support pan-​ EU services provisions.157 The European Parliament supported this approach, which had the effect of limiting Member State engagement and discretion. The Council’s position was sharply different, reflecting Member State concern that the removal of Member State control would disrupt third country access.158 The Council therefore removed the harmonized services regime and very significantly revised the branch regime (removing the equivalence requirement, applying only a limited range of harmonized requirements to branch authorization, and removing branch passport rights).159 Following difficult trilogue negotiations, 155 The related reforms made by third countries included those under the 2010 US Dodd-​Frank Act. 156 2011 MiFIR Proposal (COM(2011) 652) Art 36. 157 2011 MiFID II Proposal (COM(2011) 656) Arts 41–​6. 158 Several Member States had ‘serious concerns’ and ‘strong reservations’ regarding the proposed third country regime, which they regarded as disproportionate and unnecessary: Danish Presidency Progress Report on MiFID II/​MiFIR, 20 June 2012 (Council Document 11536/​12) 13. 159 MiFID II Council General Approach, 18 June 2013 (Council Document 11006/​13) and MiFIR Council General Approach 18 June 2013 (Council Document 11007/​13).

878  Third Countries a compromise position was adopted under which the Commission’s harmonized model for service provision was retained, alongside the Council’s Member-​State-​led model for branches, although both the Commission and Council models were revised. A change in political conditions, which can be associated with Brexit dynamics, led to the adoption of extensive reforms to this regime in 2019. These came into force in June 2021 and have significantly tightened the conditions applicable to third country services. In addition to MiFID II/​MiFIR, a complex regime governs the application of the EU’s prudential requirements for investment firms, under CRD IV/​CRR and IFD/​IFR,160 as regards third countries,161 including with respect to the treatment of third country branches.162

X.8.1.2 MiFID II and Third Country Branches As regards branch access, Member States may permit the establishment of branches of third country firms,163 where so requested by the relevant firm. Passporting rights are not granted to the branch which is subject to the rules imposed by the Member State—​although a Member State may not treat any third country branch more favourably than an EU firm. The process is governed by relevant national rules, and the branch remains ‘landlocked’ within the Member State. In specified cases oriented to retail market services, however, a Member State may, at its discretion, require the establishment by a third country firm of a branch (where the firm may otherwise prefer to operate remotely through cross-​border services provision), in which case the MiFID II harmonized regime governing branches applies (Articles 39–​43). This regime has been strengthened by the 2019 reforms to require additional reporting by such branches as regards their EU footprint and activities and to strengthen supervisory coordination. Under this regime, Member States may, at their option, require that a third 160 Directive 2013/​36/​EU [2013] OJ L176/​338 (Capital Requirements Directive IV (CRD IV) and Regulation (EU) No 575/​2013 [2013] OJ L176/​1 (CRR); and Directive (EU) 2019/​2034 [2019] OJ L314/​64 (IFD) and Regulation (EU) 2019/​2033 [2019] OJ L314/​1 (IFR). 161 An extensive series of third country provisions, which use equivalence assessments to different degrees, govern the third country application of the CRD IV/​CRR and IFD/​IFR prudential requirements, including on a consolidated basis and to global groups. They apply with regard to, for example, disclosure requirements; capital treatment of exposures to third country entities and collective investment schemes; the calculation of market risk (and the offsetting of positions in third country entities); the liquidity coverage ratio requirements as regards third country assets; and the extent to which NCAs engage in supervision of third country group entities. These provisions are primarily concerned with calibrating the application of the EU prudential regime (to EU and third country actors) and not with access. Among the most significant provisions regarding investment firms is IFD Art 55 which addresses the supervision of investment firms with a third country parent. It provides that where two or more EU investment firms are subsidiaries of a third country parent, the relevant NCA is to assess whether the investment firms are subject to supervision that is equivalent to that under the IFD/​IFR. Where the equivalence test is not met, the NCA which would be the group supervisor were the parent an EU parent, may, after consulting with other relevant NCAs, apply ‘appropriate supervisory techniques’, including that a holding company be established in the EU. 162 The Commission’s October 2021 CRD VI/​CRR 3 banking package proposals significantly and controversially tighten the EU’s regulation of EU branches of third country credit institutions (their regulation is currently primarily a function of national law). The CRD VI Proposal (COM(2021) 663) proposes a significantly more harmonized regime that would require branch authorization, impose minimum regulatory requirements including as regards capital, liquidity, and firm governance, and address supervision. Its most contested requirement relates to the proposed mandatory power ‘to subsidiarize’ which would empower NCAs to require the most complex branches to become subsidiaries where certain criteria were met. At the time of writing it is not clear whether this reform would apply to the provision of investment services (certain investment firms now fall within the CRD IV/​ CRR regime for the purposes of authorization, as outlined in Ch IV section 9). 163 Defined as a firm that would be a MiFID II credit institution providing investment services or performing investment activities, or a MiFID II investment firm, if its head office or registered office was located in the EU (MiFID II Art 4(1)(57)).

X.8  The Investment Services Regime and Third Countries  879 country firm intending to provide MiFID II investment services to, or engage in investment activities with, retail clients or clients who request to be treated as professional,164 must establish a branch (Article 39(1)).165 If a Member State exercises this option, the branch must be authorized in accordance with the minimum conditions applicable, including in relation to the firm’s prior authorization and supervision in the firm’s home country as regards the services provided from the branch; cooperation arrangements between the branch NCA and the third country supervisory authority, including as regards information exchange; ‘sufficient initial capital’ being at the branch’s disposal; at least one person being responsible for the management of the branch and compliance with the MiFID II fitness and probity requirements; the firm’s participation in the EU’s investor compensation scheme system; and the third country’s compliance with OECD rules governing exchange of information on taxation (Article 39(2)). Minimum information requirements are also imposed on the application process, including as regards the firm’s management and shareholders and the branch’s programme of operations, organizational structure, any outsourcing of essential operating functions, and initial capital (Article 40). Authorization may only be granted where the Article 39(2) conditions are met; and where the NCA is also satisfied that the branch will be able to comply with the specified MiFID II/​ MiFIR obligations which become directly applicable to the branch (Article 41(2)), and with specified (Article 41(3), noted below) reporting obligations (Article 41(1)).166 Article 41(2) has the effect of applying almost the full range of MiFID II/​MiFIR organizational, conduct, transaction reporting, and trade transparency obligations to the third country branch. These requirements are supervised by the branch NCA. Following the 2019 reforms, branch NCAs, NCAs of entities that form part of the same group to which the branch belongs, and ESMA and EBA are to cooperate closely to ensure that all group activities in the EU are subject to ‘comprehensive, consistent, and effective supervision’, in accordance with MiFID II/​MiFIR but also the CRD IV/​CRR and IFD/​IFR prudential regimes for investment services (Article 41(5)). Also, and following the 2019 reforms, the branch must annually report to the branch NCA on a host of matters related to the EU footprint of the branch. This reporting obligation is similar to that applicable to cross-​border services supply by third country firms, but is calibrated to the integration of the branch into the host Member State (Article 41(3)).167 In a related 2019 reform, onward reporting by branch NCAs to ESMA is provided for as regards the footprint of the branch (Article 41(4)). The effect of these reforms is to embed third country branches more securely in the EU’s supervisory

164 See Ch IV section 6.2 on the retail/​professional classification. 165 The Commission originally proposed a mandatory branch requirement for retail-​oriented business, but this was resisted in the Council by some Member States as being overly restrictive of cross-​border business. 166 Conditions also apply to the withdrawal of authorization (Art 43) which specify when an NCA may withdraw the authorization (failure to use the authorization within six months; obtaining the authorization through irregular means; no longer meeting the authorization conditions; seriously and systematically infringing the Directive’s requirements; or falling within any of the cases provided by national law for withdrawal). 167 The branch must report annually to the branch NCA on: the scale and scope of the branch’s EU activities; as regards own account dealing, the firm’s monthly minimum, average, and maximum exposure to EU counterparties; the total value of financial instruments, originating from EU counterparties, underwritten or placed in the previous year; the turnover and aggregated value of assets relating to EU activities; and the branch’s investor protection (including as regards compensation scheme protections), risk management, and governance arrangements (including as regards key function holders), and any other information deemed necessary to enable ESMA and NCAs to carry out their tasks.

880  Third Countries arrangements, not least as the enhanced information flows to ESMA allow it to develop related supervisory convergence measures. The mandatory branch regime (for ‘Article 39 branches’), where it is applied by Member States, is onerous, but it reflects the more operational, risk-​oriented, and intrusive turn the third country regime has recently taken, as well as the related intensification of harmonization and dilution of Member State autonomy. These branches become subject to almost the full range of MiFID II/​MiFIR requirements (save as regards prudential supervision), and to branch NCA supervision, but do not benefit from a passport. An Article 39 branch can, however, support the cross-​border supply of wholesale market services (provided through the MiFIR services channel for third country firms), by acting as a ‘branch hub’ for the cross-​border provision of these services, as outlined in the next section in relation to the cross-​border services access route.

X.8.1.3 Cross-​border Service Provision Of significantly greater importance in practice, at least for third country wholesale market services, is the MiFIR access regime for cross-​border service provision.168 This route permits passporting, although it has become subject to tighter conditions and to enhanced monitoring following the 2019 reforms.169 Member States may, however, allow third country firms to provide investment services to/​perform investment activities with eligible counterparties or professional clients in their territories, and in accordance with their requirements, in the absence of the equivalence decision on which the MiFIR services route depends (including where an equivalence decision had previously been made but has lapsed), but these services and activities are landlocked within the Member State and cannot be passported (Article 46(4)). MiFIR Article 46(1) provides that a third country firm may provide MiFID II investment services to, or perform MiFID II activities with, eligible counterparties and professional clients170 in the EU, without a branch (in effect, remotely), as long as the firm is registered with ESMA.171 The regime provides an EU passport once its conditions are met (Article 46(3)). Such passported services (to the wholesale markets) can be based in an EU branch of the third country firm: Article 47(3) provides that a MiFID II Article 39 branch of a firm, from a third country jurisdiction declared equivalent under MiFIR, can provide services/​activities to eligible counterparties/​professionals in other EU Member States (where the activities in question are covered by the Article 39 branch authorization). The Article 39 retail-​oriented branch can therefore be used as hub from which to provide wholesale services pan-​EU. The 168 While it is most strongly associated with services-​based access, MiFIR also supports CCP/​trading venue access. MiFIR Art 38 provides that a trading venue established in a third country deemed equivalent (in accordance with the rules governing trading venue equivalence: section 8.2) can request access to an EU CCP, and that a recognized third country CCP, in an equivalent third country, can request access to an EU trading venue. Art 38 also addresses related rights for third country CCPs and trading venues relating to benchmarks. This regime intersects with the EMIR regime as it requires CCP recognition as well as third country equivalence. 169 The reforms, reflecting the Brexit-​era turn to a more precautionary approach to third country access, are designed to ensure investor protection and the stability of financial markets in the EU by addressing the potential risks third country firms may pose: IFR recital 45. 170 The access regime applies in relation to default professional clients (those that are professional by default, in accordance with the MiFID II classification system) and not those who are professional because they request such status). See Ch IV section 6.2. 171 Where firms are so registered and can provide services pan-​EU, risk warning disclosures are required in that they must inform clients that they can only provide investment services to/​conduct investment activities with eligible counterparties or professional clients and that they are not subject to supervision in the EU: Art 46(5).

X.8  The Investment Services Regime and Third Countries  881 MiFIR Article 46 services regime is accordingly significantly more liberal than the MiFID II branch regime in that it supports a passport. But it is also materially more onerous and institutionalized, being dependent on the third country firm registering with ESMA and being subject to ongoing ESMA monitoring; and requiring a positive equivalence determination by the Commission of the relevant third country regime. The ESMA registration on which access and the passport depends is subject to a series of conditions (Article 46(2)). Chief among these is that the Commission has adopted an equivalence decision in relation to the relevant third country, in accordance with Article 47 which governs the equivalence process. In addition, the firm must be authorized to provide the proposed services/​activities in the jurisdiction where its head office is established, and be subject to ‘effective supervision and enforcement ensuring full compliance with the requirements applicable in that third country’. Supervisory cooperation requirements must also be in place, in accordance with the enhanced conditions now applicable under Article 47 following the 2019 reforms (noted below). Alongside, and in another 2019 reform, the firm must have in place the necessary arrangements and procedures to make the ongoing reports to ESMA that are now required. The registration process, which can only be initiated once a positive equivalence decision is in place (Article 46(4)), is governed by administrative rules.172 Once a third country investment firm is registered with ESMA, additional and significant reporting requirements, introduced by the 2019 reforms, are imposed, many of which are directed to assessing the EU footprint of third country firms (Article 46(6a)).173 Annual reports must be provided to ESMA on the scale and scope of firms’ EU activities, including their geographical spread; firms’ monthly minimum, average, and maximum exposure to EU counterparties as regards proprietary dealing activities; the total value of financial instruments (originating from EU counterparties) underwritten or placed in the previous year; the turnover and aggregated value of assets relating to EU activities; and investor protection, risk management, and governance arrangements and any other information deemed necessary to enable ESMA and NCAs to carry out their tasks.174 ESMA is also conferred with a catch-​all information-​gathering power: it can, where necessary for the accomplishment of its tasks or those of NCAs, and also on the request of an NCA, request additional information from the firm (Article 46(6a)).175 Firms must also retain at ESMA’s disposal data relating to all orders and transactions in the EU for five years (Article 46(6b)).176 ESMA does not supervise these registered firms but it is conferred with investigatory and disciplining powers. It can carry out investigations and on-​site inspections (Article 47(2)) and can, in specified circumstances, temporarily prohibit or restrict a firm’s activities: under Article 49, as revised by the 2019 reforms and which addresses withdrawal of registration, ESMA may temporarily prohibit or restrict a firm from providing services or conducting 172 As regards the information required: RTS 2016/​2022 [2016] OJ L313/​11. 173 ESMA characterized the reforms as implying a ‘significant reporting flow’ from third country firms and requiring ‘granular information’ to be reported: ESMA, Final Report. Draft Technical Standards on the Provision of Investment Services and Activities in the Union by Third Country Firms under MiFID II and MiFIR (2020) 6–​7. 174 These requirements will be amplified by administrative rules. They are also likely to lead to an expansion of the registration information requirements imposed on firms, to ensure alignment between the registration process and the ongoing reporting requirement: 2020 ESMA Final Report, n 173. 175 ESMA is to communicate this information to NCAs of Member States where the firm operates. 176 ESMA may make this data available to NCAs on their request.

882  Third Countries activities where it does not comply with any exercise by ESMA, EBA, or an NCA of MiFIR product intervention powers,177 or with an ESMA information request (‘in due time and in a proper manner’), or does not cooperate with an investigation or on-​site inspection (Articles 46(6c)) and 49(1)).178 Registration can also be withdrawn in these cases, as well as under Article 49(2), which requires ESMA to withdraw registration where the firm is acting in a manner clearly prejudicial to the interests of investors or to the orderly functioning of markets or has seriously infringed the provisions applicable to it in the third country. Given the seriousness of a withdrawal of registration, including as regards the potential for market disruption, a series of conditions apply.179 ESMA registration is conditional on a positive Commission equivalence determination being in place. This decision, which is governed in some detail by Article 47 (as revised in 2019), is discretionary but, where a positive decision is made, must provide that the legal and supervisory arrangements of that third country ensure that firms authorized in that third country comply with legally binding prudential, organizational, and business conduct requirements which have equivalent effect to the requirements set out in MiFID II/​MiFIR, the CRD IV/​CRR regime, and (in a significant 2019 revision) the new IFD/​IFR regime; that firms authorized in the third country are subject to ‘effective supervision and enforcement’ ensuring compliance with the applicable legally binding prudential, organizational, and business conduct requirements; and that the third country provides for an ‘effective equivalent system’ for recognition of investment firms authorized under third country legal regimes (a reciprocity condition) (Article 47(1)). A risk-​based condition applies: where the scale and scope of the services provided/​activities conducted by a third country firm (following a positive equivalence decision) are likely to be of systemic importance for the EU,180 equivalence may only be granted after a ‘detailed and granular assessment’ by the Commission of the relevant rules; and, in a significant operational intensification of the equivalence assessment, supervisory convergence between the EU and the third country is also to be assessed (Article 47(1)). The Commission is further empowered, in relation to such ‘systemic firms’, to attach ‘specific operational conditions’ to equivalence decisions to ensure that ESMA and NCAs have the necessary tools to prevent regulatory arbitrage and to monitor firms’ activities by ensuring firms comply with requirements which have an equivalent effect to the MiFIR Share and Derivatives Trading Obligations, post-​trade transparency reporting requirements, and transaction reporting requirements (Article 47(1a)). These rules are, accordingly, in effect applied directly to third country firms by means of additions to the relevant equivalence decision. Prudential, organizational, and business conduct rules ‘may’ be considered to have equivalent effect where a series of open-​textured conditions, 177 See Ch IX section 4.12. 178 Conditions apply to the exercise of these powers which are directed towards ensuring their proportionate application by ESMA, and which include that ESMA inform the relevant third country supervisory authority, and take into account the nature and seriousness of the risk posed to investors and to the proper functioning of the market, having regard to the duration and frequency of the risk, whether serious or systemic weaknesses in the firm’s procedures have been identified, whether financial crime is involved, and whether the risk has arisen intentionally or negligently: Arts 46(6c) and 49(3). 179 Article 49(2) and (3) imposes a series of conditions, including as regards failure of the third country to take necessary action (once notified by ESMA), ESMA having ‘well-​founded’ evidence, and ESMA taking into account the nature and seriousness of the risk posed to investors and to the proper functioning of the market, having regard to the duration and frequency of the risk, whether serious or systemic weaknesses in the firm’s procedures have been identified, whether financial crime is involved, and whether the risk has arisen intentionally or negligently. 180 The nature of ‘systemic importance’ is to be amplified by administrative rules.

X.8  The Investment Services Regime and Third Countries  883 which allow the Commission significant discretion, are all met (Article 47(1b)): firms must be subject to authorization and ‘effective supervision and enforcement’ on an ongoing basis; ‘sufficient’ capital requirements and, where a firm engages in own account dealing or underwriting (activities which carry the highest capital charges), ‘comparable capital requirements’ to those applicable were it an EU firm; ‘appropriate’ requirements applicable to shareholders and management body members; and ‘adequate’ organizational and business conduct requirements. The third country must also ensure market transparency and integrity by preventing market abuse in the form of insider dealing and market manipulation. Where a third country is found to be equivalent, ESMA is required to establish cooperation arrangements covering, at least: information exchange, including access to all firm information requested by ESMA and onward sharing of information by ESMA with NCAs; notification of ESMA where a firm infringes authorization conditions or third country rules; procedures governing investigations and on-​site inspections; and procedures governing information requests made by ESMA of third country firms (Article 47(2)). That the equivalence regime is contingent is made incontrovertible by the requirement for ESMA to monitor regulatory and supervisory developments, enforcement practices, and relevant market developments in the third country in order to verify that the jurisdiction remains equivalent, and to monitor the systemic footprint of ESMA-​registered third country firms, and to report accordingly to the Commission (Article 47(5)). A related confidential report must be made by the Commission annually to the European Parliament and Council (Article 47(6)). The signalling of intent as regards the contingent nature of equivalence is clear. At the time of writing, the Article 46 cross-​border services regime had yet to be activated. But while its impact in practice remains to be seen (the adoption of a UK equivalence decision would be a ‘gamechanger’),181 its design suggests a materially more harmonized and less deferential approach to third country access. It does not require on-​shore supervision of third country firms by ESMA, and so is less intrusive than the EMIR regime, but it is significantly less deferential than the original MiFIR regime and entirely different in design to the precursor MiFID I regime.

X.8.1.4 Reverse Solicitation Where an investment firm does not wish to operate through a branch, or under the equivalence-​dependent MiFIR cross-​border services route, the ‘reverse solicitation’ channel may be available. MiFID II Article 42 specifies that a Member State cannot apply the Article 39 mandatory branch requirement where a retail or elective professional client182 initiates, at its own exclusive initiative, the provision of the service/​activity, but the firm (without prejudice to intragroup relations) cannot solicit clients or potential clients (including through an entity acting on its behalf or which has close links with the third country firm). Further, 181 Some indications of its potential impact, including as regards the likely consequent expansion of ESMA’s power and influence, can be gleaned from ESMA’s 2021 report on the resources it would need to meet its Art 46 responsibilities: ESMA, Report to the European Parliament, Council and Commission in accordance with Art 52(13) MiFIR (2021). ESMA’s analysis was based on the number of UK firms potentially seeking registration, assuming an equivalence decision. ESMA used two scenarios: 880 firms (an additional forty-​seven FTEs); and 550 firms (thirty FTEs)). 182 A client that requests to be treated as professional under the MiFID II classification system: Ch IV section 6.2.

884  Third Countries where services are solicited by clients, the firm cannot market new categories of investment product or services (otherwise than through an EU branch, where one is required). An investment service/​activity of this type is not deemed to be provided within the territory of the EU. Similarly, the requirements of the MiFIR Article 46 route can be avoided where the services flow from a reverse solicitation from an eligible counterparty or professional client (Article 46(5)). This route does not provide a stable legal platform for EU access as its availability depends on Member States’ national rules governing the nature of a ‘reverse solicitation’. There had long been indications that an ambitious approach by third country firms to ‘reverse solicitation’ would not be accommodated by Member State regulators,183 a posture confirmed by ESMA as the UK withdrawal was underway.184

X.8.2  MiFID II/​MiFIR and Export Effects MiFID II/​MiFIR also has significant ‘export’ effects in that it constrains how EU investment firms interact with third countries. It does so by applying equivalence requirements, in different ways, to certain transactions on third country trading venues. Under MiFID II Article 25(4) certain instruments traded on third country trading venues can qualify for ‘execution-​only’ distribution by EU investment firms (in that they can be sold without ‘know-​your-​client’ requirements applying), but only where the third country trading venue in question is an ‘equivalent third-​country market’. A specific procedure, directed to ensuring that execution-​only services are only provided in relation to instruments traded on third country venues where equivalent levels of investor protection apply to the relevant venues, applies to the determination of equivalence in this context. The procedure is triggered by means of a request from an NCA, which must indicate why the NCA considers that the legal and supervisory framework of the third country is considered to be equivalent, and provide relevant information. The Commission’s equivalence decision is to address whether the legal and supervisory framework of the third country of the trading venue in question ensures that a ‘regulated market’ (undefined) authorized in the third country complies with legally binding requirements equivalent to those applicable under MiFID II/​MiFIR, the EU’s market abuse regime, and the Transparency Directive, and which are subject to effective supervision and enforcement in the third country. A positive equivalence finding may be made where the trading venues in question are subject to authorization and effective supervision and enforcement on an ongoing basis, the venues have clear and transparent rules regarding admission to trading so that securities can be traded in a fair, orderly, and efficient manner and are freely negotiable, issuers are subject to ongoing disclosure requirements ensuring a high level of investor protection, and market abuse is prevented. Similar equivalence conditions apply to the MiFIR Derivatives and Share Trading Obligations (MiFIR Articles 28 and 23). The Derivatives Trading Obligation requires that derivatives specified as being subject to the Trading Obligation must be executed on EU trading venues. Third country venues may act as qualifying execution venues, but only

183 184

Norton Rose Fulbright, MiFID MiFIR Series, October 2014, 3. As outlined in section 2.1.

X.9  EMIR and Third Countries  885 where the Commission has adopted an equivalence decision determining that the legal and supervisory framework of the relevant third country ensures that a trading venue authorized in that country complies with legally binding requirements equivalent to the MiFID II/​MiFIR requirements for trading venues, and which are subject to effective supervision and enforcement in the third country; and where the third country meets a reciprocity condition (Article 28(1) and (4)).185 Similarly, transactions in shares subject to the Share Trading Obligation may be executed on third country trading venues, but only where the trading venue has been assessed as equivalent in accordance with the conditions applicable under the Article 25(4) execution-​only regime.186 The equivalence provisions governing the Derivatives and Share Trading Obligations have, reflecting their practical importance for firms, been tested in practice. Equivalence determinations have been made in relation to specified derivatives trading platforms in the US and Singapore, for the purposes of the Derivatives Trading Obligation,187 and in relation to specified venues in the US, Hong Kong, and Australia,188 for the purposes of the Share Trading Obligation. These equivalence decisions can have material market impact. The withdrawal of the equivalence status of Switzerland as regards share trading (in 2019) led to a diversion of trading activity from Swiss trading venues, while the absence of an equivalence finding for the UK had the effect of repatriating significant volumes of share trading from City of London trading venues to the EU in early 2022, following the December 31 2021 end of the UK’s transitional period following its withdrawal from the EU.189

X.9  EMIR and Third Countries X.9.1  The OTC Derivatives Markets, Third Countries, and EMIR The EMIR third country regime is the leviathan of the EU’s third country regime for financial markets.190 It addresses third country access as regards CCPs and trade repositories, but it also addresses how EMIR’s CCP clearing, reporting, and risk mitigation rules as regards derivatives markets apply where counterparties are established outside the EU. Multi-​ faceted and of significant complexity and granularity, the EMIR third country regime is the source of the great majority of equivalence decisions (so far) under the single rulebook (and

185 Article 28(4) specifies the conditions governing the equivalence assessment. These map those applicable under MiFID II Art 25(4) as regards execution-​only transactions. MiFIR also provides that the Commission may adopt an equivalence decision to the effect that a third country regime is, as regards the operation of its Derivatives Trading Obligation, equivalent to the EU regime. Such a decision has the effect that counterparties entering into the relevant transaction are deemed to meet Art 28 where one of those counterparties is established in the relevant third country: Art 33. 186 The 2021 MiFIR 2 Proposal (COM(2021) 727) if adopted would narrow the scope of the Share Trading Obligation to apply only to shares with an EEA ISIN, and to exclude shares traded on a third country venue in that country’s local currency, in response to difficulties that arose over the UK’s withdrawal and in response to ESMA’s related supervisory convergence mitigations: Ch V section 10. 187 Implementing Decision 2017/​2238 [2017] OJ L320/​11 (US: identifying over thirty Designated Contract Markets and Swap Execution Facilities as equivalent) and Implementing Decision 2019/​541 [2019] OJ L93/​18 (as amended) (Singapore: identifying eleven specified platforms, operated by approved exchanges and recognized market operators, as equivalent). 188 On the US, eg, Implementing Decision 2017/​2320 [2017] OJ L331/​94, specifying over fifty equivalent venues. 189 See Ch V section 10. 190 It is addressed here in outline only.

886  Third Countries so has acted as a laboratory in which ESMA has honed its approach to equivalence assessments).191 It also has, as regards third country CCPs, the most sophisticated supervisory superstructure of all of the EU’s third country regimes. The design and application of the EMIR third country regime has, to a greater extent than other aspects of the EU’s third country regime, been shaped by global political and market dynamics. The enmeshing of the EMIR third country regime, and its treatment of third country CCPs, in the EU/​UK negotiations on the future EU/​UK relationship provides the totemic example. But from the outset, the regime was located in a complex global setting. EMIR’s roots are in the G20 OTC derivatives markets reform agenda, which has been supported by a swathe of international standards, as well as by ongoing FSB monitoring. But this reform agenda generated, particularly as the reforms bedded in, complex extraterritorial effects, tensions, and risks, related to how jurisdictions, including the EU, addressed the cross-​border reach of the new rules and deployed related recognition and equivalence mechanisms.192 Initially, coordination and convergence was slow and elusive.193 The adoption of national rules more stringent than those contained in the relevant international standards, ‘first mover’ and competitive dynamics, and time-​lags between the development of the different regimes internationally all complicated coordination and convergence.194 In particular, the extraterritorial reach of the new CCP clearing obligations proved problematic globally,195 as it became clear that market actors could become subject to duplicative regimes and be exposed to related costs and legal uncertainties.196 Difficulties also arose with respect to whether jurisdictions required national registration and regulation of third country actors operating in their OTC derivatives markets or relied instead on recognition and/​or equivalence mechanisms to, in effect, dis-​apply national rules and allow reliance on the relevant third country regime; the US approach, which was more geared to national registration, was of particular concern. A November 2012 meeting of the major international regulators involved sought to generate some degree of consensus197 and was followed by a warning from the G20 for related reforms to be adopted by summer 2013.198 As regards EU/​US negotiations, some progress was made,199 but the difficulties remained 191 Over thirty EMIR equivalence decisions, each typically involving highly technical assessments of jurisdictions’ regulatory and supervisory regimes, and as regards different aspects of derivatives market regulation, have been adopted at the time of writing. 192 The difficulties at the outset led the IOSCO Chair to call for a new global watchdog with binding powers and competent to resolve disputes between regulators: Jones, H, ‘Global Watchdog Says New Body with Teeth Needed to Police Markets’, Reuters, 5 November 2013. 193 The FSB’s first monitoring report on OTC derivatives market reform warned of the significant divergences already emerging in national regimes: FSB, OTC Derivatives Market Reforms. Progress Report on Implementation. April 2011. 194 See Knaack, n 10. 195 eg International Centre for Financial Regulation, OTC Derivatives Regulation. Regulatory Briefing. July 2012. 196 See, eg, Valiente, D, Shaping Reforms and Business Models for the OTC Derivatives Markets: Quo Vadis? ECMI Research Report No 5 (2010). 197 In November 2012, the major regulators engaged with the reforms reached a ‘common understanding’ as to the potential conflicts, inconsistencies, and duplicative requirements within the new rulebooks internationally, and identified the areas in which further consultation was required on how divergences could be addressed: Press Statement on Operating Principles and Areas of Exploration in the Regulation of the Cross-​Border OTC Derivatives Market, 28 November 2012. 198 The September 2013 G20 Summit supported a deference-​based approach: St Petersburg G20 Summit, September 2013, Leaders’ Declaration para 71. 199 Agreement on a ‘path forward’ was reached between the EU and the US CFTC on the treatment of cross-​ border derivatives trading in July 2013, based on equivalence-​type mechanisms.

X.9  EMIR and Third Countries  887 considerable and were acknowledged during the 2013/​2014 negotiations on the EU–​US Transatlantic Trade and Investment Partnership.200 Since then, and following extensive assessments and negotiations internationally, friction has generally reduced. As regards the EU’s arrangements, a host of equivalence decisions and related access arrangements have been adopted, including with the US, albeit that equivalence arrangements with the US SEC have been the slowest to finalize.201 Overall, the EU’s approach has been to apply EMIR expansively, particularly with respect to CCPs and trade repositories, but to support international access to the EU market through equivalence-​based and other mechanisms. Brexit and the consequent outsourcing, in effect, of CCP clearing services in euro-​denominated derivatives to UK CCPs was the catalyst, however, for a more intrusive and on-​shored approach under the 2019 EMIR 2.2 reforms.

X.9.2  EMIR and CCP Access X.9.2.1 The Original Model As originally designed, third country CCP access to the EU was based on an ESMA ‘recognition’ mechanism. Third country CCP access was conditional on the CCP being ‘recognized’ by ESMA, which depended on a prior equivalence decision being adopted by the Commission. Additional conditions applied, including that the CCP in question was authorized in the relevant third country and, in ESMA’s judgment, subject to effective supervision and enforcement, ensuring full compliance with the third country’s prudential requirements. Appropriate cooperation arrangements were also required between ESMA and the relevant third country supervisor. ESMA was not empowered to supervise ‘recognised’ CCPs but was empowered to review and monitor the recognition conditions. In practice, ESMA claimed a form of supervisory oversight in that it monitored third country CCPs for stability and other risks posed to the EU financial market, in accordance with its general ESMA Regulation mandate to support financial stability.202 This regime was not significantly contested initially. ESMA recognized a first group of eleven third country CCPs in 2016 (following the related Commission equivalence decisions) and continued to recognize CCPs as subsequent Commission equivalence decisions were made.203 The related equivalence process, over which ESMA provided advice to the Commission, was likewise relatively straightforward, albeit that it was slow.204 It also posed challenges, particularly as regards the US. Following highly contested and lengthy negotiations, the US CFTC approved a ‘substitute compliance’ agreement for EU CCPs 200 EU-​US Transatlantic Trade and Investment Partnership, Co-​operation on Financial Services Regulation, 27 January 2014. 201 n 206. 202 ESMA, ESMA’s Supervision of Credit Rating Agencies, Trade Repositories and Monitoring of Third Country Central Counterparties. 2016 Annual Report and 2017 Work Programme (2017) 60–​5. 203 As at 2019, when the EMIR 2.2 reforms came into force, ESMA had recognized, under the original EMIR framework, ten additional third country CCPs and continued to assess applications: ESMA, ESMA’s Supervision of Credit Rating Agencies, Trade Repositories and Monitoring of Third Country Central Counterparties. 2018 Annual Report and 2019 Work Programme (2019) 58–​9. 204 The Commission’s CCP equivalence decision for Australia, eg, followed some thirteen months after ESMA’s advice: ESMA/​2013/​1159 (September 2013) and Commission Implementing Decision 2014/​755/​EU [2015] OJ L311/​66 (30 October 2014).

888  Third Countries in March 2016.205 The EU equivalence decision followed, but it would be some years before an equivalence decision was adopted in relation to the US SEC.206 ESMA, in advising the Commission as regards equivalence, adopted an outcomes-​focused, pragmatic, and proportionate approach to assessing CCP regimes internationally, which drew on compliance with international standards, and was open to accommodating distinct national approaches where they achieved similar outcomes to those sought by EMIR.207 In several cases, including as regards the US, ESMA made a finding of ‘conditional equivalence’, advising the Commission that it could consider the relevant regime to be equivalent, where CCPs ensured their internal rules and procedures reflected certain EMIR provisions. The Commission broadly followed ESMA’s approach, although it did not specify in its equivalence decisions the specific adjustments that ESMA recommended be made by CCPs in some cases, save as regards US CCPs. By 2022, twenty three equivalence decisions had been adopted for third countries, including two for Japan and the US, reflecting the organization of CCP regulation in these markets.208 The decisions typically emphasize that equivalence is dependent on the ‘substantive outcome’ of the third country’s legal and supervisory arrangements being regarded as equivalent to EU requirements in respect of the regulatory objectives they achieve, albeit that the decisions and ESMA’s related advice evidence a granular assessment of those arrangements.209

X.9.2.2 The EMIR 2.2 Reforms EMIR 2.2, adopted in 2019,210 radically reforms this system, albeit that the ESMA recognition process, and the requirement for a prior Commission equivalence decision, remain at its core. Designed to be risk-​based, the reforms provide for escalating levels of oversight over third country CCPs, depending on whether they are ‘Tier 1’, ‘Tier 2’, or ‘Tier 3’ CCPs. ‘On-​shore’ supervision by ESMA is required for third country CCPs that are systemically important, or likely to become systemically important, for EU (or one or more Member States’) financial stability (‘Tier 2 CCPs’).211 A new mechanism (yet to be used) provides for the mandatory relocation to the EU of the most systemically significant CCPs providing or seeking to provide clearing services to the EU (‘Tier 3’ CCPs).212 And the oversight of ‘Tier 1’ CCPs (in effect, CCPs that do not meet the Tier 2 test) is enhanced, primarily through new information-​request and fining powers for ESMA.213 The assessment of systemic status (the ‘tiering’ process) is designed to calibrate the degree of oversight to the level of financial stability risk posed and is carried out by ESMA, in a signal indication of the pivotal position 205 CFTC, Press Release PR7342-​16, 16 March 2016. 206 The first EU/​US equivalence decision addressed the CFTC regime, and was subject to CFTC-​authorized CCPs’ internal rules and procedures addressing specified requirements, including as regards initial margin: Implementing Decision 2016/​377 [2016] OJ L70/​32. The equivalence decision for the US SEC regime (the SEC also authorizes and supervises CCPs) would not follow until January 2021 and was likewise subject to conditions being met by SEC-​authorized CCPs: Implementing Decision 2021/​85 [2021] OJ L29/​27. 207 As is clear from its advice on the Australian regime: ESMA/​2013/​1159. ESMA stated that the ‘capability of the regime in the third country to meet the objectives of the EU Regulation is assessed from a holistic perspective’ and that the analysis of difference was carried out ‘as factually as possible.’ 208 Of these, most were adopted over 2014–​2016, save for the US SEC decision in 2021 and a subsequent series of decisions for six other jurisdictions, including China, in 2022. 209 eg, the equivalence decision for India: Implementing Decision 2016/​2269 [2016] OJ L342/​38. 210 Regulation (EU) 2019/​2099 [2019] OJ L322/​1. 211 Art 25(2b). 212 Art 25(2c). 213 Art 25f (information requests) and Art 25i-​j (fines).

X.9  EMIR and Third Countries  889 ESMA now plays in EU financial markets governance. Reflecting its sensitivity, the assessment is carried out in accordance with the criteria and consultation processes set out in EMIR and related administrative rules.214 By March 2022, all previously recognized CCPs had been classified and placed in either Tier 1 or Tier 2: of the 36 CCPs recognized at that point all bar two were classified as Tier 1; two of three UK CCPs were classed as Tier 2 (LCH Limited and ICE Clear Europe Limited, both of which are dominant as regards the clearing of euro-​denominated derivatives).215 These swingeing reforms reflect significant concern as to the lack of EU oversight over third country CCPs, under the original EMIR third country model, given the stability risks CCPs, as critical market infrastructures, pose:216 the 2017 EMIR 2.2 Proposal was designed to enhance the EU’s capacity to manage the stability risks posed by third country CCPs and, relatedly, to ensure a level playing-​field between EU and third country CCP.217 The reforms are, however, hard to disentangle from Brexit-​related interests in relocating CCP clearing business from the UK,218 although the implications for the CCP industry internationally, in particular as regards the Tier 3 relocation mechanism, prompted international concern.219

214 Art 25(2a) sets out the criteria for the Tier 2 assessment. They are in in outline: the nature, size, and complexity of the CCP’s business in the EU; the effect that the CCP’s failure or disruption could have; the CCP’s clearing membership structure; the extent to which alternative clearing services are available for clearing members; and the CCP’s relationships, interdependencies, or other interactions with other financial market infrastructures. These criteria have been amplified in detail by Delegated Regulation 2020/​1303 [2020] OJ L305/​7. It provides, inter alia, that ESMA may only determine that a CCP is a Tier 2 CCP, in accordance with these criteria, where at least one of the specified indicators relating to the minimum exposure of clearing members and clients established in the EU to the CCP is met (Art 6). These indicators, which act as a gateway requirement for Tier 2 classification, are in the form of quantitative metrics relating to: the maximum open interest of securities transactions or exchange-​traded derivatives denominated in EU currencies cleared by the CCP over a period of one year prior to the assessment (or intended to be cleared by the CCP over a period of one year following the assessment) is more than €1,000 billion; the maximum notional outstanding of OTC derivatives denominated in EU currencies cleared by the CCP over a period of one year prior to the assessment (or intended to be cleared subsequently) is more than €1,000 billion; the average aggregated margin requirement and default fund contributions for accounts held at the CCP by EU clearing members, calculated (on a net basis and at clearing member account level) over a period of two years prior to the assessment, is more than €25 billion; and the estimated largest payment obligation committed by EU entities, calculated over a period of one year prior to the assessment, that would result from a default of at least two of the largest clearing members in extreme but plausible market conditions is more than €3 billion. This requirement introduces a quantitative threshold to the Tier 2 assessment and prompted ESMA to raise concerns with the Commission that the thresholds could be ‘gamed’ to avoid Tier 2 classification, and to ask for yearly reviews (this was proposal not accepted by the Commission): ESMA, Letter to the Commission, 8 July 2020. The nature of the Tier 3 assessment is set out in Art 25(2c) (n 220). 215 ESMA, Public Statement (Updates on CCP Recognition Decision), 25 March 2022 and ESMA, List of Third Country CCPs Recognized to Offer Services and Activities in the EU, 23 March 2022. 216 The Commission warned of the risks to the EU from there being no direct involvement of EU supervisory bodies in the day-​to-​day supervision of third country CCPs, and of the imbalance between the EU’s reliance on third country supervisors and third country regimes’ insistence on direct oversight over third country (including EU) CCPs, particularly as the EU had the highest number of third country CCP access arrangements as compared to other jurisdictions internationally: EMIR 2.2 Proposal Impact Assessment (IA) (SWD(2017) 148) 42–​3 and 45. 217 EMIR 2.2 Proposal IA, n 216, 46. 218 The Proposal did not emphasize the Brexit context, although it identified the significant challenges which the future location of a substantial volume of euro clearing in the UK created for EU financial stability: EMIR 2.2 Proposal IA, n 216, 11. Shortly after its adoption by the Commission, political strains began to emerge with France and German signalling their support for a tougher approach to CCP relocation than that adopted by the Commission: Reuters, Market News, ‘France wants right to Veto Euro Clearing in the EU after Brexit—​EU Sources’ 6 September 2017. 219 The proposed empowerment of ESMA over third country CCPs also met with hostility from the international industry which was concerned as to potential fragmentation between NCA-​based (EU CCPs) and ESMA-​based (third country CCPs) supervision: Lannoo, K, ‘The EU’s Plan to Shift Clearing Out of London Risks Disaster’, Financial Times, 24 March 2018.

890  Third Countries The relocation mechanism for Tier 3 CCPs was at the time of its adoption, and remains, freighted with acute political salience (in particular for EU/​UK relations) but its importance, so far at least, is more a function of signalling than of substance. It is expressly designed as a ‘last resort’ mechanism and subject to extensive conditionality.220 ESMA’s closely watched December 2021 assessment of the two UK Tier 2 CCPs emphasized their systemic importance, identified the related financial stability risks to the EU, called for a lessening of EU dependence on these CCPs and for a strengthening of its powers, but did not recommend that they be de-​recognized and subject to relocation.221 The new supervisory regime for Tier 2 CCPs, by contrast, has brought substantial operational change as regards the supervision of third country CCPs, and a more austere and less deferential approach to third country CCP access, albeit that it incorporates liberal elements.

X.9.2.3 The EMIR 2.2 Regime Following the EMIR 2.2 reforms, the third country CCP access regime remains based on ESMA recognition and a related equivalence decision: a CCP established in a third country may only provide clearing services to clearing members or trading venues established in the EU where it is recognized by ESMA;222 and this recognition is contingent on an equivalence decision being in place, the CCP being authorized in the third country and subject to effective supervision and enforcement ensuring full compliance with the prudential requirements applicable in the third country, and cooperation arrangements being place (Article 25(1) and (2)).223 Recognition must be reviewed at least every five years, and also where the CCP intends to extend or reduce its activities in the EU, and it may involve a change of classification from Tier 1 to Tier 2, in which case ESMA must provide the CCP with a specified adaptation period (Article 25(5)). The related equivalence process was strengthened by the 2019 reforms including by a requirement for any equivalence decision to be contingent on ESMA being able to effectively exercise its responsibilities in relation to third country CCPs; tighter specification of the criteria governing equivalence; and a requirement for ESMA to monitor regulatory and supervisory developments in the relevant third countries and to report annually to the Commission and to the supervisory college required (under Article 25c) for a third country CCP, and, specifically as regards any developments that may impact 220 The relocation mechanism is governed by Art 25(2c) which empowers ESMA to make a determination (after consulting the ESRB and relevant central banks of issue) that a CCP (or some of its clearing services) is ‘of such substantial systemic importance’ that the CCP should not be recognized (and so not permitted to operate in the EU unless it relocates), and to recommend accordingly to the Commission. ESMA’s related assessment is to explain why compliance with the conditions for Tier 2 CCPs would not address the financial stability risks; describe the characteristics of the CCP; and provide a quantitative technical assessment of the costs and benefits of not recognizing the CCP. The Commission can ‘as a measure of last resort’ adopt an implementing act providing that, after a specified ‘adaptation period’ (not in excess of two years), the CCP can only provide some or all of its clearing services in the EU after it has been authorized under EMIR (which requires establishment). 221 ESMA, Assessment Report under Art 25 (2c) of EMIR. Assessment of LCH Ltd and ICE Clear Europe Ltd (2021). See n 228 on the subsequent ‘active account’ proposal adopted by the Commission in December 2022 and designed to ensure a minimum proportion of relevant clearing in the EU. 222 RTS 153/​2013 [2013] OJ L52/​41 governs the recognition process and the information required. ESMA has also adopted related ‘practical guidance’ for CCPs, which covers the tiering process: ESMA, Practical Guidance for the Recognition of Third Country CCPs by ESMA (2021). 223 The nature of the cooperation agreements is specified in some detail under Art 25(7), including as regards information exchange, investigations and on-​site inspections, and enforcement of decisions adopted by ESMA. The cooperation requirements are not ‘paper tigers’. In October 2022, and in a sign of the increasingly austere nature of the equivalence system, ESMA withdrew the recognition of six Indian CCPs as the required cooperation arrangements, compliant with EMIR, were not in place. The withdrawal was deferred to April 2023 to mitigate any adverse market impacts.

X.9  EMIR and Third Countries  891 on financial stability, to inform the European Parliament, Council, Commission, and the supervisory college (Article 25(6)–​(6b)). For Tier 1 CCPs, the EMIR regime remains deference-​ based, albeit that ESMA’s information-​gathering and related enforcement capacities have been strengthened. Specific requirements apply to Tier 2 CCPs (in practice, so far, two UK CCPs). Chief among them is that, in order to be recognized, Tier 2 CCPs must now comply directly with specific EMIR requirements, at the moment of recognition and on an ongoing basis (Article 25(2b)):224 the third country equivalence determination on which CCP recognition depends does not, accordingly, suspend the direct application of a swathe of EMIR rules relating to capital, organizational, conduct of business, prudential, and interoperability requirements. Further, ESMA is charged with ensuring ongoing compliance by Tier 2 CCPs with these directly applicable EMIR rules (Article 25b): supervision is therefore ‘on-​shored’ in the EU. ESMA has relatedly been conferred with an extensive set of direct supervisory powers over Tier 2 CCPs, including to make information requests (a power also conferred as regards Tier 1 CCPs); take investigatory actions; engage in on-​site inspections; and take enforcement action, including the issuing of public notices, the imposition of injunctions, fines (also conferred as regards Tier 1 CCPs), and periodic penalties, and the withdrawal of recognition.225 ESMA can also engage in stress tests of Tier 2 CCPs, through the regular stress testing exercise it runs for CCPs in the EU.226 In addition, ESMA is conferred with review powers that map those exercised by NCAs of EU CCPs, including as regards review of extensions to services provided by Tier 2 CCPs and of changes to their risk models. These operational supervisory reforms represented at their adoption a significant strengthening of ESMA’s supervisory powers generally, in a sector of acute economic and political salience. They also required a substantial reorganization of ESMA’s internal governance arrangements in order to accommodate the related decision-​making procedures, which include consultation with the relevant central banks of issue of currencies in which instruments cleared by the CCPs in question are denominated. ESMA’s supervision of Tier 2 CCPs is managed by its ‘CCP Supervisory Committee’ (set up following the 2019 reforms) through which NCA supervision of EU CCPs is coordinated, but which also prepares draft supervisory decisions, relating to third country CCPs, for subsequent adoption by the ESMA Board of Supervisors, and which carries out all supervisory tasks relating to third country CCPs, whether Tier 1 or Tier 2 (Article 24a(10)).227 Information-​sharing in support of ESMA’s supervision of third country CCPs, and in order to ensure adequate information flow to all NCAs who supervise actors potentially impacted by third country CCP activities, is coordinated through the third-​country CCP college which must be established for all third country CCPs (Article

224 Additional conditions apply, including that the CCP is in compliance with specified duties imposed by relevant ‘central banks of issue’ (central banks of issue of the currency in which the instruments cleared by the CCP is/​ are denominated) and, in order to support ESMA’s supervision, that the CCP consents to providing information to ESMA where it so requests and to allowing ESMA access to its business premises (this consent must be accompanied by a legal opinion confirming that it is valid and enforceable). 225 Set out in Arts 25e–​25q, including as regards the processes relating to ESMA’s power to impose monetary penalties. ESMA’s powers more or less follow the operational/​procedural template that governs its direct supervisory powers over rating agencies (under the CCRAR) and trade repositories (under EMIR). 226 See Ch VI section 5.9.1. 227 On the CCP Supervisory Committee see Ch VI section 5.9.1.

892  Third Countries 25c). Current indications suggest that this regime may be strengthened further, given ongoing concern as to the level of oversight over Tier 2 (in effect, UK) CCPs.228 The Tier 2 reforms represent a striking extension of the EU’s reach over third country CCPs by applying a swathe of EMIR’s rules directly. They also have the effect of shifting the CCP third country regime from being one previously based almost entirely on EU deference to home/​third country supervision (once the equivalence decision was made and the CCP was ‘recognized’ by ESMA), to an ‘on-​shored’ system, based on the direct application of EMIR and more intensive ESMA supervision and monitoring. Some elements of deference are, however, accommodated. Article 25a provides that a Tier 2 CCP can be deemed to satisfy the directly applicable EMIR requirements by complying with the rules and regulations of its third country, as long as ESMA adopts a finding of ‘comparable compliance’ as regards the relevant third country rules: a CCP can submit a ‘reasoned request’ to ESMA, asking that ESMA assess whether its compliance with identified third country rules is deemed to satisfy compliance with the directly applicable EMIR requirements. The related administrative rules (Delegated Regulation 2020/​1304)229 provide that this assessment is additional to the jurisdiction-​level equivalence assessment,230 is undertaken at CCP level, and involves a ‘detailed assessment’ of the relevant third country rules against the EU regime;231 and that comparable compliance is met where the CCP complies with the ‘comparable’ requirements indicated for the relevant EMIR rules.232 The assessment is designed to reduce administrative and regulatory burdens for Tier 2 CCPs, and is to take into account the extent to which a failure to grant comparable compliance would make it impossible for the Tier 2 CCP to satisfy EU and third country requirements at the same time.233 Much depends on how ESMA applies the comparable compliance assessment, but it may come to calibrate the ‘on-​shoring’ of EU requirements, and it also represents an innovation for the third country regime more widely.

228 ESMA called for an enhancement of its powers (2021 ESMA UK CCP Review, n 221), while 2022 saw the Commission consult on the adequacy of the EU’s treatment of third country CCPs, in the wake of its extension of the temporary equivalence decision, which supports the recognition of the UK CCPs, until 2025: Commission, Targeted Consultation on the Review of the Central Clearing Framework in the EU (2022). As this book went to press, the Commission adopted its related (December 2022) proposals. These primarily took the form of an interventionist requirement that counterparties subject to the clearing obligation hold ‘active accounts’ at EU CCPs for specified classes of derivatives of substantial systemic importance to EU financial stability (interest rate derivatives denominated in euro and Polish zloty; credit default swaps (CDSs) denominated in euro; and short-​term interest rate derivatives denominated in euro); and clear at least a certain proportion of such derivatives through EU CCPs (the proportion to be specified by ESMA): COM(2022) 697. ESMA had previously identified these derivatives as part of its 2021 assessment of the UK CCPs (n 221). The Commission was careful to emphasize that the reform was not a relocation requirement, and was being proposed to support financial stability where there was an ‘excessive’ concentration of clearing in third countries, and to secure the EU’s open strategic autonomy. The analysis in the Proposal also underlined the need to balance costs and benefits and to address any competitiveness risks to impacted counterparties. It represents nonetheless a muscular response to the concentration of certain clearing activities in the UK, which further embeds ESMA in the EMIR third country regime, and its fate over the legislative process remains to be seen. Alongside, however, the Commission also proposed a more proportionate approach to the CCP equivalence assessment for those third countries posing low risks to EU financial stability. 229 Delegated Regulation 2020/​1304 [2020] OJ L305/​13. 230 In developing the rules, ESMA rebuffed the frequently made argument from third country CCPs that the Commission’s jurisdiction-​level equivalence assessment sufficed for the purposes of comparable compliance. 231 Delegated Regulation 2020/​1304 recital 4. 232 Delegated Regulation 2020/​1304 specifies, eg, how EMIR’s capital requirements are to be assessed and, in Annexes I and II, the indicators for comparable compliance as regards other requirements. 233 Delegated Regulation 2020/​1304 recital 6 and Art 5.

X.9  EMIR and Third Countries  893 The EMIR 2.2 reforms, particularly for Tier 2 and Tier 3 CCPs, significantly recast the EMIR CCP third country system, at least in theory. In practice, the vast majority of third country CCPs continue to operate under a deference-​based system: only two recognized CCPs, both UK CCPs and both critical market infrastructures for the EU, have, at the time of writing, been classed as being within Tier 2, while the relocation mechanism for CCPs designated as being in Tier 3 is, so far at least and assuming no major change in market or political conditions, a last resort tool. It is hard to disaggregate the 2019 reforms from the specific market, supervisory, and political dynamics of the UK withdrawal and the systemic dependence of the EU on the two UK Tier 2 CCPs.234 The UK withdrawal has, however, left a significant legacy in the form of a EMIR third country regime for CCPs that has the capacity, at least, to become significantly more on-​shored, albeit that the conditions governing the classification of CCPs as Tier 1 or Tier 2, and the comparable compliance system, have moderating effects.

X.9.3  EMIR and Trade Repositories EMIR also contains an access regime for third country trade repositories. It is based on equivalence, ESMA recognition, and deference and, given the much lesser stability risks associated with trade repositories, has been stable since its adoption.235 A trade repository established in a third country may provide services to and engage in activities with entities established in the EU but only after it has been recognized by ESMA (Article 77(1)). ESMA recognition is conditional on the trade repository submitting to ESMA all the necessary information, including at least the information necessary to verify that the trade repository is authorized and subject to effective supervision in a third country which has been recognized by the Commission as being equivalent in accordance with EMIR, and appropriate cooperation arrangements being in place (Articles 77(2) and 75(3)). As yet, no third country trade repository has applied for ESMA recognition.

X.9.4  EMIR and Global Derivatives Markets EMIR’s CCP clearing, reporting, and risk mitigation rules (discussed in Chapter VI section 5) apply where one party to an OTC derivative contract is established outside the EU, and they can also apply where both parties are established outside the EU.236 There is, accordingly, significant potential for extraterritorial overreach and, relatedly, for undue costs and for uncertainty risks relating to duplicating and conflicting rules. EMIR addresses this in two ways.237 The first relates to the scope of EMIR. An OTC derivative contract within the 234 In an indication of the sensitivities, ESMA, in requesting the Commission to provide for an annual review of the exposure thresholds governing the Tier 2 assessment (see n 214), identified the risk of CCPs gaming the criteria to avoid Tier 2 classification, but acknowledged it understood ‘the political considerations’: 2020 ESMA Letter, n 214. 235 A parallel regime is available for securities financing transactions trade repositories under the 2015 Securities Financing Transactions Regulation (EU) 2015/​2365 [2015] OJ L337/​1 Art 19. 236 See Ch VI section 5.4 on the scope of EMIR. 237 An equivalence arrangement is also in place for the CCP clearing obligation that applies, in parallel with EMIR, to regulated-​market-​traded derivatives under MiFIR (Art 29): MiFIR Art 33.

894  Third Countries scope of EMIR is one the execution of which does not take place on an EU regulated market or, and of defining importance to the global reach of EMIR, on a third country market considered, in accordance with Article 2a, equivalent to a regulated market (Article 2(7)).238 A series of equivalence decisions have followed, identifying these equivalent third country markets and taking derivative contracts concluded on these markets outside the scope of EMIR.239 Second, a remedial mechanism is contained in Article 13 which empowers the Commission to adopt an equivalence decision providing that a third country’s legal, supervisory, and enforcement arrangements are equivalent to Articles 4 (CCP clearing), 9 (reporting), 10 (requirements for non-​financial counterparties), and 11 (risk mitigation), and are being effectively applied and enforced in an equitable and non-​distortive manner, so as to ensure effective supervision and enforcement in that third country. Where such a determination has been made by the Commission, the counterparties to the transactions are deemed to have fulfilled the EMIR requirements, as long as at least one of the counterparties is established in the third country.240 This equivalence process has proved lengthy and complex, reflecting the challenges associated with establishing deference between jurisdictions internationally as regards their respective implementation of the financial-​crisis-​era derivatives markets reforms, as well as delays in adopting the related international standards, particularly as regards bilateral margin requirements. A series of equivalence determinations have now been made, the majority in 2021.241

X.10  Central Securities Depositaries and Benchmarks and Third Countries Of the remaining third country regimes, those governing central securities depositaries (CSDs) and benchmarks are the most articulated. Both draw on devices developed previously by the EU: the CSD regime on ESMA recognition (as originally adopted under EMIR); and the benchmark regime on the endorsement device developed for the CRA regime but also on the more intrusive approach to third country actors that developed under EMIR.

X.10.1  CSDs and Third Countries Under the CSD Regulation (Article 25), a third country CSD can provide services in the EU through remote cross-​border services provision and also by means of branch 238 Art 2a provides that a third country market can be considered equivalent to an EU regulated market where it complies with legally binding requirements equivalent to those applicable to regulated markets under MiFID II, and is subject to effective supervision and enforcement in the third country on an ongoing basis. 239 Five such equivalence decisions were adopted in 2016, identifying specified markets in Japan, Australia, Canada, the US (those markets supervised by the CFTC only (Designated Contract Markets)), and Singapore as equivalent. A subsequent equivalence decision followed in 2021, updating the US DCMs deemed equivalent, while a 2022 decision found certain venues supervised by the US SEC to be equivalent. 240 The equivalence concession is subject to annual review and may be withdrawn: Art 13(4). 241 Relating to the Art 11 risk mitigation requirements. Initially, only the US and Japanese regimes were subject to equivalence determinations, but a series of equivalence determinations (for six other jurisdictions and also extending the original US determination from the CFTC to include derivatives transactions supervised by other authorities) followed in July 2021.

X.10  CSDs, Benchmarks, and Third Countries  895 establishment.242 Where the CSD provides the core functions of recording securities in a book entry system or of providing and maintaining securities accounts at the ‘top tier’ level,243 access is dependent on ESMA recognition,244 which in turn, as under EMIR, requires that an equivalence decision is in place. ESMA may recognize a third country CSD where the Commission has adopted an equivalence decision;245 the CSD is subject to effective authorization, supervision, and oversight (or, where the CSD is a securities settlement system operated by a central bank, only oversight) ensuring full compliance with the prudential requirements applicable in the third country; cooperation arrangements in accordance with Article 25 are in place;246 and, where relevant, the third country CSD takes the necessary measures to allow its users to comply with the relevant national law of the Member State in which it intends to provide services, including as regards the recording of security ownership rights in the CSD, and, in addition, the adequacy of those arrangements have been confirmed by the NCAs of the Member State in which the third country CSD intends to provide CSD services (Article 25(4)). The recognition process reflects the multiple and deep interconnections CSDs have with market participants and infrastructures, and their systemic importance to the securities settlement process, in that ESMA is to consult the NCAs of the Member States in which the CSD intends to operate, particularly as regards compliance with applicable national law, as well as the relevant third country authorities, as part of the recognition process (Article 25(5)). Similarly, NCAs of Member States in which the CSD intends to provide services are to assess the compliance of the CSD with relevant national law and must inform ESMA, through a fully reasoned decision, whether compliance is met, following receipt of the recognition application information from ESMA (Article 25(6)). These NCAs may also request, in ‘close cooperation’ with ESMA, the responsible third country authorities to report on specified aspects of the CSD’s operation (Article 25(7)). Once recognized,247 the CSD benefits from passporting rights and can provide services within the EU, including by setting up a branch (Article 25(11)). By contrast with EMIR, recognition under the CSD Regulation is primarily an ex-​ante process, empowering ESMA to review the CSD’s home regulatory scheme and ensuring cooperation arrangements 242 An EU CSD may also maintain or establish links with a third country CSD, subject to the requirements of CSD Regulation Art 48 (which addresses CSD links) being met. 243 The recognition requirement applies where the third country CSD provides these services, specified in the Annex to the Regulation, section A (1) and (2). As outlined in Ch V section 14, these two functions are at the core of CSD activity. 244 ESMA recognition, although not leading to ESMA supervision and enforcement (as under EMIR), is designed to ‘ensure an appropriate level of safety’ in the provision of CSD services (recital 34). 245 The equivalence assessment is to assess whether the third country’s legal and supervisory arrangements ensure that CSDs authorized in that country comply with legally binding requirements which are, in effect, equivalent to those of the CSD Regulation; that the CSDs are subject to effective supervision and enforcement on an ongoing basis; and that reciprocal recognition arrangements are in place. The Commission may also consider whether the third country regime reflects internationally agreed standards (adopted by CPSS-​IOSCO), as long as they do not conflict with the Regulation: Art 25(9). 246 These, reflecting third country cooperation arrangements generally, must cover information exchange; notification of ESMA where the CSD infringes an authorization condition or other applicable law; and the coordination of supervisory activities, including on-​site inspections: Art 25(1). 247 Recognition is to be reviewed where the CSD intends to extend the range of services provided: Art 25(8). As is standard, recognition is to be withdrawn where the recognition conditions are no longer met, as well as where the conditions governing withdrawal of authorization (of EU CSDs) are met as regards the recognition (these conditions relate to the authorization/​recognition not being used over a twelve-​month period, being renounced, or being acquired by unlawful means; the relevant conditions not being complied with; and serious or systematic infringements of the CSD Regulation (and of MiFID II/​MiFIR where it applies to the CSD)).

896  Third Countries are in place; it does not lead to the level of supervisory engagement by ESMA that follows under EMIR. Thus far, only one equivalence/​recognition decision has been adopted. A temporary equivalence decision, which expired in June 2021, was adopted for the UK, in part to allow time for the migration of securities and exchange-​traded funds (ETFs) issued under Irish law, but held in a UK CSD (Euroclear UK and Ireland—​which was also given temporary recognition by ESMA), to EU CSDs.248

X.10.2  Benchmark Administrators, Benchmarks, and Third Countries A complex and segmented regime applies as regards third countries under the Benchmark Regulation.249 The Regulation, which came into force in 2018, was originally, as regards third country access, nationally based (the gateway Commission equivalence decision aside), being based on a complex ‘Member State of reference’ system. It was almost immediately reformed, after its coming into force, to pivot to an ESMA-​based system. Given the cumbersome Member State of reference device,250 the cross-​border nature of benchmark use, increasing familiarity with ESMA as a technocratic support to the third country regime, and the limited fiscal implications, the 2019 ESA Reform Regulation revised the Regulation’s third country scheme to base it on ESMA registration and endorsement (the reforms came into force in January 2022). The regime as revised has strong resonances with the CCRAR third country regime for CRAs, reflecting the similarities between ratings and benchmarks, but has also been shaped by EMIR 2.2. It has three strands. It provides for ESMA registration of third country benchmark administrators, where an equivalence decision has been made (Article 30); for ESMA recognition of third country benchmark administrators, where an equivalence decision has not been made (Article 32); and for the endorsement by EU entities of a third country benchmark for use in the EU (Article 33). A third country benchmark must sit within one of these processes to be used in the EU. The regime is accordingly far-​reaching, capturing all third country benchmarks used by a supervised entity in the EU.251 There are, however, indications, given that the EU is something of an outlier internationally in its treatment of

248 The arrangement was also designed to allow the continuation of services in relation to depositary interests held through Euroclear UK & Ireland of underlying securities constituted under the laws of Cyprus, Luxembourg, and the Netherlands: ESMA, Press Release, 11 December 2020. A temporary UK equivalence decision was first adopted in 2018 to address the risk that the UK could leave the EU without an agreement, but never became applicable as the Withdrawal Agreement was adopted. Implementing Decision 2020/​1766 [2020] OJ L397/​26 (the temporary equivalence decision) was then put in place to allow time, over the UK’s transition period, for the migration of relevant Irish financial instruments to EU CSDs (recitals 4 and 13). The Decision came into force on 1 January 2021, when the UK’s transition period ended, and expired on 30 June 2021. ESMA’s temporary recognition of Euroclear UK & Ireland (which followed the equivalence decision, ESMA’s assessment of the UK regime, and the adoption of cooperation arrangements with the Bank of England) similarly expired on 30 June 2021. 249 Regulation (EU) No 2016/​1011 [2016] OJ L171/​1. The Benchmark Regulation is highly technical and segmented. See Ch VIII section 10.3 on its key governing concepts. 250 Recital 55 to the 2019 ESA Reform Regulation (which revised the Benchmark Regulation) notes that this system was ‘cumbersome and time-​consuming’ for applicants and NCAs, as well as open to the risk of supervisory arbitrage. 251 The Benchmark Regulation applies to benchmarks (and thereby to their administrators) used by supervised entities (essentially, regulated financial institutions) in the EU, as outlined in Ch VIII section 10.3.

X.10  CSDs, Benchmarks, and Third Countries  897 benchmarks in that it applies a widely cast and extensive regulatory regime, that it may be scaled back.252 Registration might be regarded as the foundation procedure. In order for a benchmark (or combination of benchmarks) provided by an administrator located in a third country to be used in the EU, the relevant benchmark and its administrator must be registered with ESMA (Article 30). Registration is dependent on a Commission equivalence decision being in place; the administrator being authorized or registered, and subject to supervision, in the third country; ESMA being notified that the administrator consents that its (actual or prospective) benchmarks may be used by supervised entities in the EU, of the list of relevant benchmarks, and of the administrator’s third country supervisory authority; and cooperation arrangements, in accordance with Article 30, being in place (Article 30(1)).253 The required equivalence decision and assessment (Article 30(2))254 is related to the third country’s administrators being subject to binding requirements equivalent to those of the Regulation, but is specific to the benchmark context in that the assessment is to take into account relevant international standards (the assessment is to take into account whether the legal framework and supervisory practices of the third country ensure compliance with the IOSCO Principles for Financial Benchmarks (2013) or (as relevant) the IOSCO Principles for Oil Price Reporting Agencies (2012), which have shaped regulation in this area internationally). Also, as is usual, the assessment must consider whether the third country’s binding requirements are subject to effective supervision and enforcement on an ongoing basis in the third country. As under EMIR, conditions can be attached to the equivalence decision: the Commission can attach conditions to the equivalence decision to ensure equivalent regulatory and supervisory standards on an ongoing basis, and the ability of ESMA to monitor the third country’s arrangements. An alternative equivalence process is made available, modelled on Article 30(2) but directed to more targeted equivalence decisions: the Commission may adopt an equivalence decision to the effect that specific administrators or benchmarks are subject to equivalent regulatory requirements and to effective supervision and enforcement on an ongoing basis (Article 30(3)). The ESMA registration process does not involve ex-​ante review and assessment and is deference-​based, reflecting the more limited systemic risks associated with benchmark administrators. Registration can, however, be withdrawn, subject to the conditions which reflect those applicable across the third country regime generally (Article 31).255 In the absence of an equivalence decision,256 the ESMA recognition process is available to allow the use of a benchmark in the EU (Article 32). It permits a benchmark provided by a third country administrator to be used in the EU, as long as the administrator is recognized by ESMA (Article 32(1)). With recognition, however, the third country regime turns away 252 See nn 264 and 265. 253 As is usual, the nature of these cooperation arrangements is specified, including that they cover information exchange, notification of ESMA where the administrator is in breach of third country requirements, and coordination of supervisory activities, including on-​site inspections (Art 30(4)). 254 As is the case with EMIR, the Commission may adopt administrative rules specifying the equivalence conditions to be applied. 255 Including that ESMA has ‘well founded’ reasons that the administrator is acting in a manner clearly prejudicial to the interests of users of its benchmarks or to the orderly functioning of markets or has seriously infringed relevant third country rules on the basis of which the equivalence decision was made, and the third country authority has been notified and failed to act. 256 At the time of writing, equivalence decisions had been adopted only in relation to Australia (Implementing Decision 2019/​1274 [2019] OJ L201/​9) and Singapore (Implementing Decision 2019/​1275 [2019] OJ L201/​13).

898  Third Countries from a deference-​based approach and requires ‘on-​shore’ supervision by ESMA: ESMA operates as the recognized administrator’s supervisor in the EU (Article 40(1)). Recognition brings with it the direct applicability of much of the Benchmark Regulation: the administrator must comply with specified requirements (in practice, most of the Regulation apart from, primarily, the provisions applying to critical benchmarks which are subject to discrete regulation), albeit that these requirements may be met by the administrator applying the relevant IOSCO Principles (noted above), as long as this is equivalent to compliance with the specified requirements (Article 32(2)).257 Recognition also requires that the administrator have a legal representative in the EU, responsible, together with the administrator, for performing the oversight functions relating to benchmarks performed by the administrator under the Regulation, and accountable to ESMA (Article 32(3)). Where the administrator is supervised in a third country,258 appropriate cooperation arrangement must be in place between ESMA and the relevant authority. Recognition is also dependent on the effective exercise by ESMA of its supervisory functions not being prevented by the third country’s legal/​regulatory regime or by limitations in the supervisory and investigatory powers of the relevant third country authority. As is usual, recognition can be withdrawn by ESMA when the relevant conditions are met.259 As the supervisory authority for recognized third country administrators, ESMA is conferred with a suite of direct supervisory and enforcement powers.260 These powers, while not as pivotal to EU financial stability as ESMA’s EMIR 2.2 powers over third country CCPs, are nonetheless significant in that they represent a further incremental strengthening of ESMA’s direct, executive supervisory powers, and thereby have a wider hardening effect as regards ESMA’s capacity and influence more generally. The extent to which ESMA may defer, in practice, to third country supervisors remain to be seen, although its commitment to a risk-​based approach may imply a relatively light touch approach.261 Finally, under Article 33, the Regulation provides for an endorsement process, managed nationally by NCAs (although ESMA must be notified of endorsed benchmarks), through which, in effect, an EU benchmark administrator or supervised entity can endorse a third country benchmark (or family of benchmarks) for use in the EU. The process is based on the ‘endorsing’ entity complying with a series of requirements relating to the provision of the benchmark fulfilling requirements at least as stringent to those of the Regulation, the endorsing entity having the necessary expertise to monitor effectively the provision of the

257 An innovative device is used to address this compliance in that ESMA may take into account an assessment by an independent external auditor or a certification provided by an administrator’s third country authority. 258 And so does not operate under self-​regulation. 259 Relating to acting in a manner clearly prejudicial to the interests of users of its benchmarks or to the orderly functioning of markets, seriously infringing the Regulation’s requirements, or making false statements or using other irregular means to obtain recognition: Art 32(8). 260 Art 40(1) provides that ESMA is the supervisory authority for third country administrators recognized under Art 32. ESMA’s powers, which broadly follow the template developed for ESMA’s supervision of CRAs and trade repositories, are set out in Arts 48a-​n. See further Ch VIII section 10.3 on ESMA’s supervision of EU critical benchmarks which engages the same set of powers. 261 As at January 2022, seven third country administrators (previously recognized by either the Irish or German NCAs) were recognized and supervised by ESMA. ESMA has characterized its approach to supervision as being ‘data-​driven, risk-​based, and outcomes-​focused’: ESMA, Annual Work Plan 2022 (2021) 17–​19. In its technical advice to the Commission on its related supervisory fees, it signalled a relatively light touch approach, noting that while adopting a risk-​based approach, it would engage in a minimum level of supervisory activities which warranted a minimum fee applying: ESMA, Final Report (Technical Advice on Fees for Benchmark Administrators (2021) 26–​7.

X.11  The UK as a Third Country and the TCA  899 benchmark in the third country and to manage the associated risks, and there being an objective reason to provide the benchmark in the third country and for it to be used in the EU. Once endorsed, the benchmark is considered to be provided by the endorsing entity, which remains responsible for compliance with the Regulation.262 The Benchmark Regulation’s third country regime has yet to activate fully. Reflecting industry concern as to the scale of the potential disruption to the use of third country benchmarks, given the wide extraterritorial reach of the Regulation and the extent to which the EU’s approach to benchmark regulation is not replicated internationally (making equivalence challenging),263 a 2021 revision to the Benchmark Regulation extended the original transition period for the use of third country benchmarks in the EU until end 2023.264 The reform also empowered the Commission to extend this period until end 2025. Current indications suggest that the reach of the third country regime may be scaled back, given indications of limited international equivalence with the EU’s regulatory approach, and the potential for consequential disruption to the EU financial market were third country benchmarks to be prohibited from being used in the EU. If this transpires,265 it would indicate some pragmatism in the EU’s approach to third country access, alongside the more restrictive turn it has recently taken. This blend is also evident in the EU’s approach to the equivalence of UK CCPs, as outlined in the following final section.

X.11  The UK as a Third Country and the Trade and Cooperation Agreement On 1 January 2021, following the end of the transition period provided for in the EU/​ UK Withdrawal Agreement and with the coming into effect of the EU/​UK Trade and

262 Endorsement may be withdrawn by the NCA where the endorsement conditions are no longer met. The Regulation’s requirements governing cessation of a benchmark (Art 28) then apply (these relate to the procedure to be adopted by the administrator and by supervised entities using the benchmark, including plans for alternative benchmarks). 263 See, eg the position paper by a group of trade associations: ISDA et al, Importance of Reforming the EU Benchmark Regulation, July 2020. 264 Regulation (EU) 2021/​168/​EU [2021] OJ L49/​6 (the transition period was originally until end 2021). Those third country administrators currently under ESMA’s supervision since January 2022 (n 261) have, accordingly, voluntarily elected to be recognized and supervised. The extension of the transition period reflected limited progress as regards equivalence (only conferred on Australia and Singapore to date), given significant differences between the coverage of the Regulation and of the benchmark regimes of third countries. The US, eg, has not regulated benchmark provision, while other jurisdictions regulate directly only those benchmarks deemed as ‘critical’ or similar. The 2021 reforms also smoothed the use of UK-​administered benchmarks in the EU: ESMA, Public Statement (Brexit and the Benchmark Regulation, 9 March 2021. The 2021 Regulation in addition excludes from the scope of the Benchmark Regulation certain spot foreign exchange benchmarks designated by the Commission. As many third countries do not regulate such benchmarks, meaning that equivalence cannot be achieved, the reform is designed to ensure that companies can continue to hedge foreign exchange risks, particularly as regards exports to emerging markets (recital 1). 265 The Commission launched a consultation in May 2022 on the operation of the third country regime which was notable for the extent to which it requested evidence on the related compliance costs: Commission, Targeted Consultation on the Regime Applicable to the use of Benchmarks Administered in a Third Country (2022). ESMA’s view was that aspects of the regime were not fit-​for-​purpose (given that very few jurisdictions globally followed the EU’s regulatory approach to benchmarks and that equivalence status would, accordingly, be difficult to achieve and there was a consequent risk of disruption to the use of third country benchmarks in the EU); it called for a more calibrated, risk-​based approach: ESMA, Response to the Commission Consultation on the Benchmark Regulation (2022).

900  Third Countries Cooperation Agreement (TCA), UK access to the EU financial market became dependent on the third country regime.266 The related change in the UK’s financial market access rights, from Treaty-​based passporting rights to third country access arrangements, marked the end of a turbulent period in EU/​UK relations as regards financial market access which had commenced some four-​and-​a-​half years earlier with the 23 June 2016 referendum decision that the UK would withdraw from the EU.267 The political, institutional, and market dynamics of this period as regards EU/​UK financial market access and the related negotiations (initially on the Withdrawal Agreement and subsequently on the TCA), and the potential implications for the EU financial market and its governance arrangements, have been extensively examined.268 They will not be rehearsed in this section which, by way of outline discussion of the TCA and its setting, seeks briefly to place Brexit in the context of the wider third country regime.

X.11.1  The Path to the TCA The June 2016 Brexit referendum was preceded and followed by extensive discussion of the deep interdependencies between the UK and the EU financial markets, interdependencies which are not replicated in any other EU third country relationship.269 For example, prior to the Brexit referendum, half of global financial firms had their European headquarters in the City of London; 37 per cent of assets under management in the EU were managed in the UK; and 46 per cent of equity funding raised in the EU was raised in the UK.270 In 2019, financial services exports to the EU from the UK amounted to £25.7 billion, some 20.5 per cent of all UK services exports to the EU.271 At the heart of the single financial market, the UK provided, in effect, a pipe-​line of finance to the EU, acting as the dominant supplier of wholesale market services, including in relation to risk management and hedging business 266 The UK ceased to be a member of the EU on 31 January 2020. The related Withdrawal Agreement provided for a transition period, until 31 December 2020, over which period EU law (including its passporting arrangements) continued to apply. The Trade and Cooperation Agreement came into effect on 1 January 2021 and into force on 1 May 2021. 267 For a book-​length legal treatment see Alexander et al, n 21. 268 See, eg, Howell, E, ‘Brexit, Covid-​19, and Possible Frameworks for Future UK/​EU Financial Governance Co-​ operation’ (2021) 84 MLR 1227 and id, ‘Post-​‘Brexit’ Financial Governance: Which Dispute Settlement Framework Should Be Utilised’ (2020) 83 MLR 128; Moloney, N, ‘Financial Services’ in Fabbrini, F (ed), The Framework of New EU-​UK Relations (2021) 115 (on which this section is based); Berger and Badenhoop, n 37; Ferran (2017), n 37; Moloney, N, ‘Bending to Uniformity: EU Financial Regulation with and without the UK’ (2017) 40 Fordham Int’l LJ 1335; and Armour, J, ‘Brexit and Financial Services’ (2017) 33 Ox J of Econ Policy S54. For a political economy perspective see, from an extensive literature, James, S and Quaglia, L, The UK and Multi-​level Financial Regulation (2020); Howarth, D and Quaglia, L, ‘Brexit and the Battle for Financial Services’ (2018) 25 JEPP 1118; Howarth, D and Quaglia, L, ‘Brexit and the Single European Financial Market’ (2018) 55 JCMS 149; Hix, S, ‘Brexit: Where is the EU-​UK Relationship Heading’ (2018) 55 JCMS 11; and James, S and Quaglia L, ‘The Brexit Negotiations and Financial Services: A Two-​Level Game Analysis’ (2018) 89 The Political Quarterly 560. 269 From the extensive policy and industry discussions, eg, see House of Lords, European Union Committee, 9th Report of Session 2016 2017, Brexit: Financial Services (2016); IMF, Financial Services Sector Assessment Program, Financial System Stability Assessment, IMF Country Report, UK (2016); The CityUK, The UK: Europe’s Financial Centre (2016); Lannoo K, EU Financial Market Access After Brexit, CEPS Policy Brief, September 2016; Oliver Wyman, The Impact of the UK’s Exit from the EU on the UK-​based Financial Services Sector (2016); and European Parliament, Briefing (Magnus, M, Margerit, A and Mesnard, B) Brexit: the United Kingdom and EU Financial Services (2016). 270 European Parliament Briefing, n 269. 271 House of Commons Library Briefing, Statistics on EU Trade, 10 November 2020.

X.11  The UK as a Third Country and the TCA  901 (derivatives services), dealing and broking, and asset management, and operating through (largely) legally frictionless passporting arrangements. The UK’s withdrawal from the EU meant that UK firms would no longer be authorized to operate in the EU and to use the single market passport, with potentially wide-​ranging consequences for the operation of financial markets, including as regards potential contractual continuity risks relating to the inability of UK firms to service ongoing EU-​based contracts, financial stability risks relating to the inability of UK CCPs to clear EU derivatives contracts, and liquidity and funding risks relating to the excision from the single market of UK trading venues, investment firms, and counterparties and of the related dealing capacity.272 The economic stakes for the EU and the UK were accordingly high. But while the risks attendant on an abrupt rupture were considerable, the UK withdrawal presented the EU with the opportunity to deepen the EU market and bolster CMU by strengthening EU capacity and limiting competition from UK firms, while the UK had similarly strong incentives to secure bespoke access arrangements to the EU given its pre-​eminent position as the dominant financial centre in the EU. Risk management and political calculations were accordingly enmeshed in the subsequent political negotiations on the future EU/​UK relationship, and in the related technocratic efforts to manage the withdrawal of the UK from the EU financial market with minimal risk. The June 2016 Brexit referendum launched a complex and wide-​ranging series of regulatory and market preparations to minimize market disruption, alongside the political negotiations on the future EU/​UK relationship. These preparations were carried out under the shadow of two ‘cliff edges’. The first cliff edge was created when the UK made its formal TEU Article 50 notification to the EU (as to its intention to withdraw) on 29 March 2017.273 This triggered a two-​year period for the negotiation of withdrawal arrangements, failing which the UK would leave the EU on 1 April 2019 without an agreement as to future arrangements, and potentially triggering widespread market disruption were contingency arrangements not in place. Ultimately, agreement on the 2019 Withdrawal Agreement (which followed three extensions, requested by the UK, of the Article 50 deadline (to 12 April 2019; 31 October 2019; and a final extension to 31 January 2020))274 obviated the need for the related contingency arrangements.275 The second cliff edge was created by the Withdrawal Agreement, which put in place a transition period at the end of which, on 1 January 2021, EU law would cease to apply to the UK. Failure to put in place a trade agreement over this period would similarly have led to an abrupt and potentially disorderly departure of the UK from the EU and related market dislocation. The December 2020 agreement on the TCA removed this cliff edge, with the TCA coming into effect at the end of the Withdrawal Agreement’s transition period. Over these two periods, a host of arrangements were made by EU and UK regulators, and by the market, to address the cliff edge risks, but also to place future UK access to the EU on a more secure footing. ESMA was pivotal to this process,

272 See, eg, Ferran, E, ‘Regulatory Parity in Post-​Brexit EU-​UK Financial Regulation: EU Norms, International Financial Standards, or a Hybrid Model’ in Alexander et al, n 21. 273 Letter from UK Prime Minister May to European Council President Tusk, 29 March 2017. 274 These extensions (the first two requested by Prime Minister May and the third by Prime Minister Johnson) were a function of domestic UK political considerations and exigencies relating to negotiation of, and local political resistance to, the Withdrawal Agreement. 275 Agreement on the Withdrawal of the UK from the EU [2020] OJ L29/​7. The Agreement came into force on 1 February 2020 and was earlier agreed on 17 October 2019.

902  Third Countries producing a swathe of soft law relating to the mitigation of cliff edge risks,276 but also relating to the arrangements being put in place to support UK firms’ future access to the EU, particularly as regards the use of outsourcing and delegation arrangements from EU subsidiaries.277 The mitigants were not always straightforward to design, given the heightened political tensions, reciprocity dynamics, and regulatory complexities. The scope of the MiFIR Article 23 Share Trading Obligation (which requires that EU shares can only be traded on third country trading venues where such venues are equivalent) proved noticeably troublesome. While a solution was found, the episode is emblematic of the tensions and of the pressure placed on soft law solutions.278 NCAs across the EU likewise adopted related arrangements, including temporary approval arrangements for and risk warnings to UK firms.279 Two temporary equivalence decisions were made by the Commission to minimize cliff edge disruption to the EU market as regards the 2019 and 2021 cliff edges: relating to the UK regime governing CCPs (this arrangement is still in force); and to the UK regime governing CSDs. In both cases, ESMA made related temporary recognition decisions (still in force for three UK CCPs). In addition, the market deployed a series of mechanisms, including private contracting arrangements, such as novation, the establishment of EU subsidiaries, and the use of delegation and outsourcing techniques to channel operations from EU subsidiaries (from which business could be passported) to UK entities. Over the parallel political negotiations on the future EU/​UK relationship, financial services were not, for the most part, to the fore. The UK industry sought a bespoke access regime, based on a retooled equivalence system founded on high-​level principles, dynamic alignment on outcomes, and tolerance of divergence,280 but financial services did not feature to any significant extent in the UK negotiating position, at least initially. When the sector finally gained some political traction in the UK,281 the UK sought a bespoke access arrangement, separate from the EU’s equivalence regime, and based on the UK and EU recognizing their respective regulatory regimes and on allowing regulatory divergence as long as high-​level outcomes converged.282 From the outset, the EU’s approach was consistent, rejecting any form of bespoke UK access to the single financial market and making access a function of the third country 276 The vast array of related ESMA measures, which extended from guidance on how the different third country regimes applied to UK firms, to operational guidance on how the MiFID II/​MiFIR transparency calculations were to be made without UK data, to the operation of the Share and Derivatives Trading Obligations, to cooperation agreements with UK authorities, to guidance to NCAs on how to address repatriation of business from the UK to the EU are located at . 277 Chief among these were the July 2017 series of Opinions that ESMA adopted on the relocation process. These were designed to prevent supervisory arbitrage and to ensure that common practices were being adopted by NCAs in authorizing and supervising the relocation of business from the UK to EU legal entities, given the risk of a supervisory competition to attract UK business. These covered investment firms, investment management, and trading venues and addressed, eg, the authorization process and the need for adequate substance to be based on the EU as well as outsourcing and delegation arrangements. 278 See further Ch V section 10 on the Share Trading Obligation and Brexit. 279 eg, the July 2020 Notice for UK investment firms from the Italian NCA, CONSOB: Consob Communication No 8/​2020, 23 July 2020. 280 See, eg, UK Finance, Supporting Europe’s Economies and Citizens: A modern approach to financial services in an EU-​UK Trade Agreement (2017), proposing a bespoke set of equivalence-​related arrangements, including liberal treatment for the wholesale financial market; and similarly, International Regulatory Strategy Group, The EU’s Third Country Regime and Alternatives to Passporting (2017). 281 For a political economy perspective on the limited capacity of the City to shape the political negotiations see James, S and Quaglia, L, ‘Brexit, the City and the Contingent Power of Finance’ (2019) 24 New Political Economy 258. 282 Set out in Prime Minister May’s ‘Mansion House’ Speech, 2 March 2018.

X.11  The UK as a Third Country and the TCA  903 regime. The March 2018 European Council Negotiating Guidelines for the future EU/​ UK relationship did not expressly reference financial markets, but stated that any future trade agreement in services must be consistent with the UK being a third country and operate on the basis of host state (EU) rules; and that any future framework must safeguard financial stability in the EU and respect its regulatory and supervisory arrangements.283 Similarly, the European Parliament warned that the EU’s third country regime must govern market access;284 and underlined that EU firms’ passporting rights were of a different order to equivalence-​related access arrangements and emphasized the unilateral and contingent nature of equivalence decisions.285 The Commission similarly rebuffed any suggestion of either bespoke-​to-​the-​UK or generalized reforms to the third country/​equivalence regime, and it also signalled (including outside the EU/​UK negotiations) that third country access was a function of EU law and that, where an equivalence-​related-​regime was available, equivalence was a unilateral and contingent process (section 4). The EU’s position persisted across the negotiations and into the TCA, despite the EU policy and political focus by that point on strengthening CMU, and on supporting the EU financial market so that private capital, alongside fiscal measures, could support the rebuilding of the EU economy post-​Covid. Relatedly, the December 2020 EU contingency arrangements to mitigate disruption in the event of failure to agree on a trade agreement did not cover financial services,286 albeit that, as noted below, temporary arrangements were (and remain) in place to support UK CCPs’ access to the EU market on financial stability grounds.

X.11.2  The TCA The TCA, agreed in December 2020, does not provide for specific equivalence arrangements or establish some other form of bespoke UK access arrangement for financial markets. In this regard it is like every other trade agreement adopted by the EU.287 As outlined in section 2, the EU has not, up to now, provided access under its trade agreements to its single financial market, beyond the basic market access/​national treatment/​non-​discrimination arrangements provided by WTO rules. The TCA ‘covers financial services in the same way as they are generally covered in the EU’s other FTAs [free trade agreements] with third countries’288 and accordingly affords UK firms the basic WTO rights that apply to services generally, particularly as regards establishment and national treatment. In effect, the TCA commits the EU and UK to maintaining their financial services markets open to operators from the EU and UK seeking to supply services through establishments of various kinds.289

283 European Council (Art 50) Guidelines of 23 March 2018. 284 European Parliament, Resolution of 14 March 2018 on the Framework of the future EU-​UK Relationship (P8_​TA-​PROV(2018) 0069). 285 European Parliament Resolution of 11 September 2019 on Relationships between the EU and Third Countries concerning Financial Services Regulation and Supervision (P8_​TA(2018) 0326). 286 Commission, Communication on Targeted Contingency Measures in the Absence of an Agreement with the UK on a Future Partnership (COM(2020) 831). 287 The TCA’s financial services provisions are broadly similar to those of the recent EU/​ Japan Trade Agreement: EU/​Japan Trade Agreement, Ch 8, s E, sub-​s 5, 8.58–​8.67. 288 Commission, Questions & Answers: EU–​UK Trade and Co-​operation Agreement, 24 December 2020. 289 n 288.

904  Third Countries UK firms can therefore establish themselves in the EU, for example through subsidiaries or branches, subject to the relevant authorization and other regulatory rules which apply. The specific financial services section of the TCA (Part Two, Heading One, Title II, Section Five, Articles 182–​9) is short and is limited to high-​level, coordination-​related obligations. It commits the parties to making their best endeavours to ensure that internationally agreed standards in the financial services sector are applied. The thin nature of this commitment is clear from the indicative standards noted, which include the high-​level and aspirational IOSCO Objectives and Principles of Securities Regulation. Certainly, compliance with these general standards could not reasonably be expected to sustain equivalence determinations. A general obligation to protect the confidentiality of information also applies. Specific provisions, familiar from the EU-​Japan Trade Agreement, address the obligation on each party to permit a financial services supplier from the other party established in its territory to supply any new financial services (apart from those provided through a branch) that it would permit its own financial services providers to provide, in accordance with relevant rules; engagement with self-​regulatory organizations; and access to payment and clearing services operated by public entities, and to official funding and refinancing activities available in the normal course of ordinary business, but not lender-​of-​last-​resort facilities. Most significantly, and as in all EU trade agreements, the financial services section applies the WTO ‘prudential carve out’. The carve out provides that nothing in the TCA prevents either party from adopting or maintaining measures for prudential reasons, such as the protection of investors, depositors, policy-​holders or persons to whom a fiduciary duty is owed by a financial service supplier or ensuring the integrity and stability of a party’s financial system. The parties’ respective ‘rights to regulate’ are therefore protected. The TCA does not therefore remove the authorization, regulatory, and supervisory requirements that apply to UK firms seeking to access the EU market and, relatedly, does not address equivalence: the Commission underlined on the TCA’s agreement that equivalence determinations ‘are unilateral decisions of the EU and are not subject to negotiation’.290 The change the UK withdrawal wrought for UK firms was alluded to by the UK Prime Minister who, at the time of the TCA’s agreement, noted that the TCA ‘perhaps does not go as far as we would like’ as regards financial services, and Chancellor of the Exchequer, who underlined that discussions would continue on financial services.291 The Commission similarly noted that: ‘the EU and the UK will form two separate markets; two distinct regulatory and legal spaces. This will create barriers to trade in goods and services . . . that do not exist today.’292 Given the absence of bespoke access arrangements in the TCA, UK firms must, as has been repeatedly emphasized by the Commission, use the access routes available under EU (and related Member State) law.293 The immediate impact of the UK’s withdrawal was muted, given the extensive preparations, which included repatriation of business to the EU, in advance of January 2021.294 The most dramatic effect was on share trading, with the first 290 Commission, EU-​ UK Trade and Co-​ operation Agreement. A new relationship, with big changes, December 2020. 291 Penny, T, ‘Brexit Deal Should Answer Concerns over Economy, Sunak Says’, Bloomberg, 27 December 2020. 292 Commission, Press Release, 24 December 2020. 293 eg Commission, Communication on Readiness at the end of the Transition Period between the EU and the UK (COM(2020) 324) 12–​15. 294 An EY Financial Services Brexit Tracker shortly before the end of the transition period reported that some £1 trillion in assets had migrated to the EU, while 40 per cent of the 222 firms monitored had or were moving operations to the EU: EY Financial Services Brexit Tracker, October 2020.

X.11  The UK as a Third Country and the TCA  905 day of trading after the end of the transition period seeing a large shift in liquidity from leading UK trading venues to EU venues as the MiFIR Share Trading Obligation took effect;295 this shift in liquidity became an early emblem of the impact of Brexit.296 The medium and longer term impact on the UK and on the EU will take some time to emerge,297 although legacy effects are already appearing, in the form of shifts in how EU financial markets governance is organized, including the more interventionist approach being taken under the third country regime, and some liberalization of UK governance.298

X.11.3  The Third Country Regime and the UK The UK’s departure from the EU came and went without the equivalence regime applying to the UK, save as regards the temporary equivalence arrangement in place for CCPs until 2025 (noted below).299 Other access routes to the EU were found, chief among them the establishment of subsidiaries and the delegation/​outsourcing arrangements deployed in the collective investment management sphere. This outcome stands in sharp contrast to the intense debate on the merits and drawbacks of, and potential for reform to, the equivalence system that the Brexit referendum generated, and to the general expectation that equivalence arrangements, in some form, would ground UK access. This did not transpire, and by end April 2022 the equivalence regime was being characterized as a ‘ship that has sailed’.300 In principle, equivalence should not represent an insuperable difficulty for the UK. Its financial markets rulebook, as at January 2021, based on ‘retained’ or ‘on-​shored’ EU financial regulation, was more or less identical to the EU rulebook, and there are strong incentives, in terms of transaction cost avoidance, for the UK not to diverge significantly from the EU rulebook, particularly as the UK has been a primary influence on it.301 The UK has, however, been consistent in its objection to the equivalence process on grounds of regulatory autonomy, both politically302 and at the technocratic/​regulator level.303 Nonetheless, 295 Almost €6 billion of share dealing in EU firms moved from the UK to EU trading venues and Amsterdam replaced the City as the major EU centre for EU share trading: Stafford, P, Fletcher, L, and Morris S, ‘London’s Sway in Europe Put to Test as Rival Hubs Make Trading Inroads’, Financial Times, 13–​14 February 2021. 296 The Financial Times described the move of share trading as a ‘stunning shift’ and reported on the related effects, including the removal by Euronext of its data centres from the UK to Italy: Fleming, S, Stafford, P, and Noonan, L, ‘The EU v the City of London: A Slow Puncture’, Financial Times, 10 January 2022. London ultimately reclaimed much of the lost volume ( Stafford, P, ‘London Reclaims Top Trading Status from Amsterdam’, Financial Times, 2 July 2021), although the waning of 2022 saw renewed concern as to the sustainability of London’s dominant position in share trading as evidence emerged of Paris beginning to close the previously significant gap with London as regards the market capitalization of shares traded, albeit that London attracted significantly more new listings: Flood, C, ‘France Challenges UK for Title of Europe’s Biggest Equities Market’, Financial Times, 17 November 2022. 297 Initial indications a year on suggested that while business was moving to the EU, the City remained Europe’s most significant financial hub in many areas of financial market activity, given the network effects flowing from the extensive liquidity pools in the UK. See, eg, the early 2022, cross-​sector survey by the Financial Times: Fleming et al, n 296. 298 See further Howell (2021) n 268. 299 A temporary equivalence decision was also in place for CSDs but expired in mid-​2021 (n 248). 300 City of London Corporation Policy and Resources Committee Chair McGuinness, reported in Thomas, D, ‘City’s Top Official Calls for Closer EU Co-​operation’, Financial Times, 30 April 2022. 301 Howarth and Quaglia (2018), n 268 and Moloney, n 268. 302 UK Parliament, Financial Services Update Written Statement from the Chancellor of the Exchequer (HCWS309). 303 UK regulators have consistently emphasized the risks of being ‘rule-​takers’. eg, Bank of England Governor Bailey, Treasury Select Committee Hearing on December Financial Stability Report, 6 January 2021.

906  Third Countries the initial political direction of travel in the UK in the immediate aftermath of the withdrawal from the EU was to cast regulatory divergence in terms of ‘what is right for the UK’, and not in terms of large-​scale deregulation, and to signal a commitment to ‘the highest international standards of financial regulation’,304 and UK regulators repeatedly cautioned against any expectations of a ‘bonfire of regulation’.305 A major regulatory and institutional reform programme, which will see divergence from the EU rulebook, is, however, underway, while political conditions, after a period of significant upheaval in the UK over 2022, are volatile and the UK’s future posture as regards EU relations and related regulatory reform is difficult to predict.306 From the EU side, there appears to be little appetite for conferring equivalence on the UK, including as regards the MiFIR Article 46 cross-​border services regime which could support much of the City’s export of investment services to the EU. The October 2019 Revised Political Declaration on the framework for the future EU-​UK relationship noted that the EU and UK should start assessing equivalence under their respective regulatory frameworks as soon as possible after the UK’s withdrawal in January 2020, and conclude the assessments before the end of June 2020.307 In its subsequent July 2020 Communication on readiness at the end of the transition period, the Commission noted that little progress had been made,308 and its statements after the conclusion of the TCA were similar.309 304 n 302, noting that ‘[n]‌aturally there will be some defined areas where it is appropriate for the UK—​as a large and complex financial services jurisdiction—​to take an approach which better suits our market.’ As noted below, the future political direction remains, however, unclear. 305 Bank of England, Financial Stability Report, July 2019. 306 At the time of writing, a major review of UK financial services/​financial markets regulation was underway which was in large part designed to assess where UK regulation, and its related institutional structures, should be reformed, given the regulatory flexibility available post Brexit and given political concern to enhance the competitiveness of the UK financial market as well as economic growth more generally. It included liberalization of the troubled PRIIPs Regulation (discussed in Ch IX) to simplify the disclosures it requires; large-​scale reform of the prospectus/​listing regime (see, eg, HM Treasury, UK Prospectus Regime Review. Review Outcome. March 2022); the Secondary Capital Raising Review (published in July 2022); the wide-​ranging Wholesale Markets Review (for the core principles of the Review see HM Treasury, Wholesale Markets Review. Consultation. July 2021); and the over-​arching Future Regulatory Framework Review (an extensive, system-​oriented review, in part designed to address the implications of the ‘on-​shoring’ of EU financial regulation and, relatedly, to reform the foundational Financial Services and Markets Act 2000, including as regards the mandates and accountability arrangements for the UK financial regulators who will also acquire enhanced rule-​making powers). In support, the July 2022 Financial Services and Markets Bill (2022–​2023) extensively revised the architecture of UK financial services regulation to grant more powers to the UK regulators as regards rule-​making (to manage the transfer of rule-​making competences from the EU system) and to revise their mandates (including by the addition of competitiveness objectives and of obligations to keep rules under review); to revoke and revise on-​shored (retained) EU financial regulation; and, relatedly, to apply the legislative reforms envisaged by the Future Regulatory Framework Review. If enacted, the Bill would be the most significant reform to UK financial services legislation since the original adoption of the Financial Services and Markets Act in 2000. A totemic step was taken in October 2022 with the announcement by then Chancellor of the Exchequer Kwarteng of the removal of the (on-​shored/​retained) CRD IV/​CRR ‘bonus cap’, a measure which the UK had, as an EU Member State, fiercely resisted, including by means of a Court of Justice challenge. On the substance of the reforms see, eg, Cheffins, B and Reddy, B, ‘Will Listing Rule Reform Deliver Strong Public Markets for the UK?’ (2022) 86 MLR 176. Sentiment in the City of London appears wary of large-​scale reform and divergence from the EU, however, given the associated transaction costs: Thomas, H, ‘A Post Brexit Bonanza Eludes Both the City and the EU’, Financial Times, 21 August 2022. 307 Revised Text of the Political Declaration setting out the framework for the future relationship between the EU and the UK (TF50(2019) 65), 17 October 2019, para 35. 308 COM(2020) 324. The Commission warned that the UK’s stated intention to diverge from the EU’s regulatory framework required the Commission to assess equivalence on a forward-​looking basis, and underlined that the degree of interconnectedness between the EU and UK markets required the Commission to be mindful of a series of risks, including as regards financial stability and investor protection. 309 eg the related Q&A (n 288) in which it noted that a series of further clarifications would be required from the UK, including as regards how it would diverge from the EU regime, how it would use its supervisory discretion regarding EU firms, and reciprocal rights for EU firms.

X.11  The UK as a Third Country and the TCA  907 The non-​binding Declaration on Financial Services annexed to the TCA commits the EU and UK to regulatory cooperation in the future and to adopting a Memorandum of Understanding (MoU), including as regards their respective equivalence processes, by March 2021. At the time of writing the MoU had not been finalized, amidst ongoing EU/​ UK tensions relating to the Northern Ireland Protocol.310 Throughout this period, the EU has also been consistent in underlining that its strategic interests will drive its approach to equivalence. This has been sharply clear in its contrasting approaches to the equivalence of two forms of UK market infrastructure: CCPs; and trading venues. The EU is strategically dependent on UK CCPs as regards the clearing of euro-​ denominated derivatives.311 The risks to financial stability from the major disruption to derivatives markets which would transpire if UK CCPs could not operate in the EU under EMIR’s equivalence-​related recognition arrangements for third country CCPs were frequently adverted to before and since the Brexit referendum.312 This strategic dependence shaped EU financial markets regulation in the form of the material strengthening of EMIR, by EMIR 2.2, in 2019 as regards the supervision of third country CCPs. But it also required an equivalence response from the EU if UK CCPs were to continue to operate in the EU, under EMIR’s recognition arrangements, and a disorderly disruption to CCP clearing to be averted, albeit that the timing and nature of this response became a function of the wider political context.313 As the first cliff edge loomed, the Commission adopted, in December 2018, a temporary and exceptional equivalence decision as to relevant UK law governing CCPs,314 to ensure that ESMA could, if necessary, recognize the three UK CCPs, and that the clearing of EU derivatives transactions could continue to take place in the UK, if withdrawal arrangements were not agreed. This temporary decision was renewed in April 2019, after the UK requested an extension period to its Article 50 notification, and again in September 2020 when the temporary equivalence decision was extended past the end of the transition period to June 2022. Relatedly, ESMA recognized the three UK CCPs in September 2020, in advance of the 31 December 2020 end of the transition period. In February 2022, a further extension of the temporary equivalence decision to June 2025 was adopted,315 albeit with warnings as to its contingent nature,316 and amidst significant market concern were the equivalence decision not to be extended.317 310 Commissioner McGuinness, eg, warned that ‘without trust, we are nowhere. And full implementation of the TCA and the Withdrawal Agreement, including the Northern Ireland Protocol, are prerequisites to that trust’: Speech, 22 June 2021. 311 LCH and ICE Clear Europe clear most of the euro-​denominated interest rate derivatives market (LCH, eg, clears some 90 per cent of the interest rate derivatives subject to the EMIR CCP clearing obligation): 2021 ESMA UK CCP Review, n 221. For an extensive review of the implications of the dominance of UK CCPs in clearing euro-​ denominated derivatives see Thomadakis, A and Lannoo, K, Setting EU CCP Policy—​Much More than Meets the Eye. CEPS-​ECMI Study (2021), reporting that EU-​based CCPs account for only some 6 per cent of the global euro-​ denominated interest rate swap market. 312 Including by the ECB. See, eg, ECB Executive Board Member Couré, Speech, 20 June 2017. The Commission adopted a series of related reports between 2017 and 2021, alongside the EMIR 2.2 reform process. 313 In its November 2018 Communication on preparations for the UK withdrawal, eg, the Commission noted the financial stability risks in a ‘no deal’ scenario arising from a disorderly close-​out of EU clearing members’ positions by UK CCPs, and that equivalence provided a mitigation to these risks, but noted that ‘should the Commission need to act, it will only do so to the extent necessary to address financial stability risks’: COM(2018) 880. 314 Implementing Decision 2018/​2031 [2019] OJ L325/​50. 315 Implementing Decision 2022/​174 [2022] OJ L28/​40. 316 The Commission warned that the equivalence finding was dependent on any future changes to relevant UK law not negatively effecting equivalence and leading to an un-​level playing field between UK and EU CCPs: recital 14. 317 The scale of the market concern was illustrated by the coordinated request by a series of leading market stakeholders (including the European Fund and Asset Management Association, the European Banking Federation, the

908  Third Countries All the indications suggest that this temporary equivalence decision is likely to be revoked when the EU’s capacity to clear has strengthened and that it is not designed to be a quasi-​permanent, liberally oriented mechanism for supporting UK CCP access to the EU. The Commission’s 2021 Strategic Autonomy Communication expressly referenced the need to develop the EU’s CCP clearing capacity,318 while the February 2022 extension of the temporary equivalence decision to 2025 referenced the ‘current over-​reliance’ of EU clearing members on UK CCPs as presenting a risk to EU financial stability and to the transmission and conduct of EU monetary policy, particularly in stressed conditions; and that it was designed to allow sufficient time to develop the EU’s clearing capacity and to significantly reduce the EU’s exposure to UK CCPs.319 The degree of discomfort with the temporary equivalence arrangement and with the dependence on UK CCPs is also clear from the indications, at the time of writing, that oversight over Tier 2 CCPs (a proxy for the two major UK CCPs) may be strengthened further. The extension to 2025 of the temporary equivalence decision followed the highly granular and closely watched December 2021 assessment by ESMA of the systemic importance of the two Tier 2 UK CCPs, and of whether they were of such significance that EMIR’s relocation mechanism should be activated. While ESMA concluded that relocation was not warranted, it recommended a series of enhancements to its oversight powers over Tier 2 CCPs.320 The Commission’s subsequent March 2022 consultation on the EU’s CCP framework similarly suggested a commitment to enhancing oversight over third country CCPs and to reducing the dependence on UK CCPs and related reforms were proposed in December 2022.321 A sharply different approach, however, was adopted as regards the equivalence of UK trading venues. Notwithstanding that the absence of an equivalence decision as regards UK trading venues could have generated significant market disruption risks on the UK’s withdrawal322 (although in the end it did not), the Commission did not adopt a temporary equivalence decision for UK trading venues. The contrast in interests appears clear: the CCP temporary equivalence decision was taken to secure EU financial stability; the trading venue equivalence decision was not taken given lower financial stability risks and, impliedly, the prospect of a repatriation of trading to the EU. The longer trajectory of EU and UK financial market relations can only be speculated on at present. In the short term, access arrangements are likely to remain exposed to prevailing political winds, particularly in the absence of institutional arrangements for cooperation. But while the treatment of UK CCPs will likely, given the scale of the interests at stake, remain a lightning rod for tensions,323 relations more generally can be expected to normalize,

Association for Financial Markets in Europe, and the International Swaps and Derivatives Association) to the Commission that the equivalence decision be extended beyond June 2022 and which warned of the significant risk of disruption to clearing: Joint Associations, Letter to Commission (Equivalence and Recognition in Relation to UK CCPs), 16 September 2021. 318 n 79, 13. 319 2022 Equivalence Decision recitals 18 and 19. 320 2021 ESMA UK CCP Review, n 221. 321 2022 Commission CCP Consultation, n 228. See n 228 on the subsequent December 2022 ‘active account’ proposal which followed, designed to ensure a minimum proportion of clearing takes place in the EU. 322 As was argued in the UK. See, eg, Bank of England: Bank of England, Financial Stability Report (July 2019) 6. 323 The Governor of the Bank of England, eg, warned the EU as to a serious escalation in tensions if it sought to repatriate UK clearing in euro instruments to the EU: Stafford, P, Strauss D, and Fleming, S, ‘BoE Governor Warns EU over Derivatives Clearing Power Grab’, Financial Times, 24 February 2021.

X.11  The UK as a Third Country and the TCA  909 particularly given the increasingly central role played by technocracy, in the form of ESMA. ESMA has, for example, adopted MoUs with the Bank of England (on the monitoring and supervision of CCPs established in the UK) and with the Financial Conduct Authority (on cooperation and information exchange generally) and, as the supervisor of the Tier 2 UK CCPs and charged with assessing their systemic status, can be expected to wield significant influence—​even if the CCP access issue is unlikely to become apolitical.324 If the equivalence process more generally loses some political salience over time and becomes primarily a function of technocratic dialogue and cooperation, it may become more relevant to EU/​ UK relations.

324 The importance of structured EU/​UK cooperation, in support of financial stability in particular, has been emphasized by the IMF: IMF, UK Financial Sector Assessment Program. Financial System Stability Assessment (2022) 22–​25.

Index For the benefit of digital users, indexed terms that span two pages (e.g., 52–​53) may, on occasion, appear on only one of those pages.  abusive conduct conflicts of interest  389 costs 685n.43 ex ante/ex post enforcement  725–26 FICC market  684n.39, 691–92 inside information  696–97, 720–21 insider lists  714–15 market integrity  680–82 market manipulation  683 market monitoring  484, 487 MAR and enforcement  732 multilateral trading facilities (MTFs)  487 NCAs and cross-border prevention of  727, 729, 730–31 prevention of  709 trading venues  484, 695 see also market abuse accepted market practices (AMPs) establishment 721 liquidity provision  201n.697 contracts  721–24, 723n.241 MAD 687 market manipulation  688, 689, 692–93, 718–19 NCA approaches to  693 trading venues  737–38 access to finance  12–13, 87–88, 236, 326 access to markets finance and funding  14–15, 68, 89–90, 95, 131–32, 199n.672, 201–2 Accounting Directive  69, 155–56, 160n.480, 164, 165, 176–77, 178, 180–81, 212, 382n.214, 587n.343, 658n.161 Accounting Regulatory Committee (ARC) 180 accounting standards see financial reporting systems; International Financial Reporting Standards acquisitions: notification 427–29 activism hedge funds  297n.365 ‘meme stock’  755n.1 social activist retail investors  755–56, 755n.1, 761 administrative rule-making process AIFMD 303–4 conflict-of-interest management  391–93 credit rating agencies  650–51 EMIR 600–2 EU financial markets governance  24–26 investment firms/services  385–88, 391–93 market abuse regulation  692–93

MiFID II/MiFIR  770–77 rulebook 362–64 Prospectus Regulation  99–101 Short Selling Regulation  559–61 Transparency Directive  160–62 UCITS regime  253–55 venue rulebook  464–66 administrative sanctions CCRAR 672–75 MiFID II  438–39 Prospectus Regulation  152–53 Transparency Directive  174–75 Admission Directive  91, 156–57, 193–94, 196 admission to official listing  69, 83, 91, 193–94, 196, 197 concept 69 admission to trading 190–202 multilateral trading facilities  487–88 regulated markets and perimeter control  193–94 securities 194–202 official listing  196–97 regulated markets  194–96 SME admission to trading  198–202 SME growth markets  198–202 trading venues: capital-raising 190–92 financial instruments  485 see also official listing advertising  142–43, 144–46, 150–51, 473, 844, 845 advertisement, definition of  145 Prospectus Regulation  144–46 advice see investment advice Agency for the Cooperation of Energy Regulators (ACER)  550n.122, 718n.217, 728n.275, 729–679nn.277–8 agency costs  245, 257n.181, 348–50, 419–20, 682 AIFMD see Alternative Investment Fund Managers Directive algorithmic trading  363n.98, 383, 455, 460, 464, 477, 480, 481–82, 486, 488, 489, 530–31, 533n.22, 684n.39, 688, 784n.193 high frequency technique  370–71, 371n.148, 540–43, 719n.222 market-making 543 MiFID II/MiFIR  540–43 alternative dispute resolution (ADR) 439–40 Alternative Investment Fund Managers Directive (AIFMD) 294325–26 authorization 307–12 AIFM authorization  307–8

912 Index Alternative Investment Fund Managers Directive (AIFMD) (cont.) de minimis AIFMs  308 EU AIFMs and the passport  309–10 facilitating the passport  310–12 Home Member State  307–8 Refit reforms (2019)  310–12 calibration 304–5 conceptual framework  305n.430 definitions 305n.430 AIF 305–6 AIFM 306 EU AIFM  309 depositary, the  319–21 differentiation 304–5 disclosure and supervisory reporting  321–23 ELTIF regulation  332–33 enforcement 325–26 evolution 297–98 global financial crisis  298–300 post-GFC agenda  300–2 pre-GFC era  297–98 leverage 316–19 loan origination  316–19 objectives 304 operational and organizational requirements 312–14 passport 866–69 private equity AIFs  323–24 regulatory and EU context  294–96 retail markets  324–25 risk management  315–16 macroprudential 316–19 rulebook 303–4 administrative rules  303–4 legislation 303–4 soft law  303–4 scope of  305–7 supervision 325–26 UCITS/AIFMD (2021) proposal  252–53 announcement: definition 145 anti-speculation agenda  297, 370, 530–31, 555–57 appropriateness: ‘know your client’ rules 792–98 Approved Publication Arrangements (APAs) 462n.123, 510, 512, 513, 514, 515, 516, 517–18 apps see trading apps arbitrage risks  19, 139, 148, 248, 275n.249, 298–99, 365, 368n.131, 459–60, 462, 465, 469, 473n.181, 475–77, 479–80, 493n.264, 494n.270, 499, 502–3, 540n.61, 555, 605–6, 721–22, 773, 774n.139, 779, 807–8, 820, 821n.363, 828, 829–30, 865–66n.88, 867 asset allocation ELTIF 333–35 UCITS see UCITS regime asset management UCITS see UCITS regime see also Alternative Investment Fund Managers Directive

asset protection  266n.220, 321, 348–49, 359–60, 362, 365n.117, 382, 385–86, 387–88, 790–91, 841–42 asset stripping regime  299, 324 Assets Safeguarded and Administered (ASA)  405n.316, 407n.324 Assets Under Management (AUM)  65n.361, 231, 260n.198, 404–5, 407, 587n.346, 783–84n.192, 900–1 auditors  63n.352, 67n.5, 74–75, 76, 146–48, 165, 171, 172–73, 176n.547, 203n.704, 290, 430–31, 432, 637, 639n.16, 671n.258, 728n.276 European Court of Auditors  9n.53, 44, 233n.19 authorized primary dealers: definition 563n.205   bail-in  106, 136–37, 763–64, 815n.333 bank finance  11–12, 16–17, 67n.1, 78, 87, 131 Bank Recovery and Resolution Directive 106n.250, 396n.270, 763–64, 794–95 bank rescues 19 Banking Co-ordination Directive (BCD II) 355 Banking Union ‘Comprehensive Assessment’  578 ‘Financial Union’  54–55n.300 legal constraints  53–55 mutualized deposit protection scheme  847 Single Supervisory Mechanism (SSM)  14–15, 27–1nn.160–1, 29–30, 55, 395, 396n.267, 396n.270, 415–16, 429, 434, 436, 624–25 spill-over effects  54n.298 supervision/ resolution reforms  53, 530 base prospectus regime  93, 95, 99–100n.217, 113–14, 117, 119, 120–22, 123, 123n.320, 124–25, 126, 129, 130n.349, 142n.404, 143, 144, 149n.426, 229 Basel II Capital Accord  397, 398, 640, 644–45 Basel III reforms  395, 397–99, 417–18, 591n.364 Basel Committee on Banking Supervision 10, 398n.278 benchmark regulation benchmark, definition of  739n.327, 743–44 Benchmark Regulation (2016)  741–53 approach 742–43 benchmark replacement  752–53 design 742–43 enforcement 748–50 evolution 741–42 supervision 748–50 sustainable finance and benchmarks  750–51 market abuse and benchmarks  740–41 benchmark abuse  739–53 reform context  739–40 principles governing benchmark production  741 third countries and benchmarks  896–99 benchmark administrators  896–99 benchmarks 896–99 best execution regulation 535 MiFID II/MiFIR  534–39 bilateral trading 466–67 bilateral margin  616–18

Index  913 equity markets transparency  499–502 deferrals 501–2 investment firms  501–2 post-trade transparency  501–2 pre-trade transparency  499–501 SIs 499–502 non-equity markets transparency 509–10 deferrals 510 investment firms  510 post-trade transparency and deferrals  510 pre-trade transparency and SIs  509–10 SIs 510 systems 469 Binding Technical Standards (BTSs)  21, 31–32, 33–34, 38–39, 45, 303n.411, 666, 694 biodiversity  61n.335, 61n.338 bitcoin see crypto-assets bond markets  12, 16, 85–86, 85n.134, 92–93, 95, 107, 120–21, 129, 135–36, 139, 163, 199–201, 199n.676, 226–27, 239n.46, 448–49, 457–58, 465–41nn.140–1, 516, 529, 647–48, 838–39 bond offers 98 ‘bottleneck’ problems  163, 164n.503, 166, 496–97, 522n.425 branch: definition 309n.458 Brexit AIF sector  233–34n.20, 296n.361 benchmark regulation  752n.410 capital-raising 223–24 CCPs  32, 55, 624–25, 863–64, 887, 889, 907 clearing thresholds  607 CMU agenda  14–1nn.83–4, 16 centralized supervision  53 CRA III reforms  667n.229 CSD regulation  855–56 data flows, impact on  619 data quality, impact on  631–32 delegation regime  275–76 EMIR  591, 598 enforcement priorities  185n.609 equivalence regime  855n.37, 860–61, 905 risk-based assessment  858 ESMA: ‘questionable practices’  854–55 supervised TRs  631–32 flexibility vs. uniformity  19n.121, 56–57, 906n.306 liquidity: contractions  238n.38, 296n.361, 634n.593 EU trading venues for derivatives trading 633–34 exemption for bonds  507 market abuse regulation  697n.113 MiFID II/ MiFIR regime: reforms post-Brexit  878 regulatory design  462–64 minimum tick size calculations  483n.235 NCAs: authorization 376–77 market-making exemption  563–64

official listing  192n.638, 196–97n.659 OTC trading  450n.43 passporting rights  853–54 PRIIPs Regulation  839n.463 prospectus rules  68n.10, 74n.59 mandatory requirements  105n.243 Q&A 101n.229 Securitization Regulation  862–63 share trading obligation  490–91, 902n.278, 904–5 soft law  490 supervisory focus  853–54 third country regime  860–62, 869, 870–71, 900, 905 ESA Reform Regulation  865–66 fund management business, relocation of 864–65 negotiations post-Brexit referendum  900–2 precautionary approach  880n.169 prospectus regime  869–70 withdrawal arrangements  901–2 unbundling reforms  209n.742, 209n.744 venue reporting requirement  537n.43 waiver use  497n.290 Broker Crossing Systems (BCSs)  456–57, 489–90 brokerage  2–3, 207–8, 284n.302, 307–8, 354n.45, 389, 393, 404–5, 408n.334, 471, 529, 534–35, 538–39, 771, 782–83, 800–1, 825n.386 payment-for-order-flow revenue models  348 prime brokerage services  295–96, 319, 347 buy-backs definition 725n.257 stabilization and  692–93, 724–25, 736   Capital Adequacy Directive  355, 397 capital markets issuer disclosure and  70–78 debate 73–78 market setting and regulation  70–73 see also capital-raising capital-raising 67–230 admission to trading see admission to trading background to  67–68 capital markets see capital markets digital finance see digital finance disclosure regime see disclosure discrete regulation  326 financial reporting see financial reporting systems; International Financial Reporting Standards investment research see investment research official listing see official listing Prospectus Regulation see Prospectus Regulation regulatory/institutional ecosystem  222–27 SMEs see SMEs trading venues  190–92 Transparency Directive see Transparency Directive see also admission to trading Capital Markets Union collective investment management  236–43, 252 credit rating agencies  648–50 EU financial market integration  11–17

914 Index Capital Markets Union (cont.) issuer disclosure regime: global financial crisis  85–87 MiFID II/MiFIR  780–82 Prospectus Regulation  95–97 retail markets  759–62, 767–69 Transparency Directive  159–60 Capital Requirements Directive see CRD IV/CRR regime cash-settled equity derivatives 167–68 CCRAR see Consolidated Credit Rating Agency Regulation (CCRAR) central banks  223–24, 374n.170, 388n.235, 409n.340 benchmark regulation  744n.360 CCPs  629n.566, 891–92 Covid-19 pandemic, intervention during  12, 238–39, 251–52, 341n.653, 344, 448n.41 CSDs 894–95 depositary regime  280 eligible counterparties  373n.167 EMIR and ESMA  591–92, 603, 619, 622–23 relocation mechanism  890n.220 equivalence system  855n.35 European Central Bank (ECB)  7–8, 107, 264, 297, 590, 849–50 European System of Central Banks (ESCB)  169, 369, 432–33, 586n.341, 622n.528, 623n.533, 624–25, 625n.547, 694n.102 funding 226n.853 FX Global Code  691–92 interest rates  703–4, 753n.414 liquidity support  712–13 quantitative easing  70–71, 449n.42 rating agencies  652–53 UCITS regime  281n.281, 306n.436 central clearing counterparties (CCPs) authorization 619–26 clearing members, definition of  602n.431 clearing obligation  608–15 allied supports  615 credit derivatives  611–13 identifying classes of derivatives  609–11 initial application  611–13 interest rate derivatives  611–13 scope 608–9 suspension 613–15 definition 602n.429 EMIR and  593–94, 608–15 access 887–93 EMIR 2.2. reforms  888–90 EMIR 2.2 regime  890–93 original model  887–88 institutional framework  619–26 non-CCP-cleared derivatives  615–18 bilateral margin  616–18 collateral exchange  616–18 risk management  616 scope 615–16 rulebook 626–30

supervision 619–26 see also European Market Infrastructure Regulation (EMIR) Central Securities Depositories (CSDs) 523–27 certificates: definition 469n.159 CESR see Committee of European Securities Regulators CfDs (contracts for difference)  19–20, 37, 158–59, 167–68, 170, 367, 695n.109, 736, 763–64, 771, 786, 789, 801n.277, 819–20, 823, 824, 825 ‘churning’ of portfolios  207–8, 389 CIS regulation see collective investment scheme regulation civil liability CCRAR 675–76 MiFID II  439–40 principle of  154n.456 Transparency Directive  174–75 Clearing Margin Given (CMG)  405n.316, 407n.324 clearing obligation see central clearing counterparties (CCPs) client: definition  366n.119, 602n.432 see also professional clients client classification  107–8, 358, 372–75, 786, 825n.384, 832–33 Client Money Held (CMH)  405n.316, 407, 407n.324 Client Orders Handled (COH)  404–5, 407, 407n.324 client suitability  433–34, 780n.170, 781, 782–83, 783n.188, 784n.196, 788, 792–98 climate change  58, 59, 61–2nn.338–9, 210, 213n.764 close links: definition 382 collective asset management  231, 294–326 see also Alternative Investment Fund Managers Directive; UCITS regime collective investment management 231–345 AIFMD see Alternative Investment Fund Managers Directive discrete regulation see discrete regulation EU rulebook  232–35 evolution of  235–43 Capital Markets Union  236–43 global financial crisis  235–36 non-bank financial intermediation  236–43 post-GFC era  236–43 stability risks  236–43 sustainable finance  243 technocracy 236–43 UCITS regime  235–36 money-market funds see money-market funds (MMFs) regulation 231–345 risk-spreading see risk-spreading rules sector 864–66 third countries  864–69 AIFMD passport  866–69 delegation 864–66 UCITS see UCITS regime

Index  915 collective investment schemes (CIS) regulation alternative investment segment see Alternative Investment Fund Managers Directive disclosure 284–85 eligible assets  266 UCITS see UCITS regime collective investment undertaking: concept 305n.430 comitology  33n.184, 857n.43 commission payments  763n.60, 779, 806, 807–8 see also incentive management; remuneration policy Committee of European Banking Supervisors (CEBS) 644n.56 Committee of European Securities Regulators (CESR)  33, 83, 456, 555–57, 644 commodity derivatives 544–50 definition 544n.87 ESMA powers  549–50 MiFID II/MiFIR  544–47 position limits  547–49 position management  547–49 quick fix reforms (2021)  544–47 trading agenda  544–47 Ukraine war (2022)  6, 19–20, 480–81, 529, 626n.551 see also MiFID II/MiFIR regime Company Law Directives  156–57, 178 compensation schemes see investor compensation; Investor Compensation Schemes Directive (ICSD) competence: law-making 22–24 competent authorities see national competent authorities competition 450–54 see also regulatory competition Concentration Risk (CON)  301–2, 321, 334, 403, 407n.324, 408–9, 412, 620n.522 conduct regulation  274–77, 393–94 conferral principle 22–23 conflicts of interest credit rating agencies  656–59 definition 390 investment research  205–7 management 388–93 administrative rulebook  391–93 legislative regime  388–90 MiFID II/MiFIR  801–8 commissions 801–4 independent investment advice  804–6 inducements 801–4 regulatory intervention  806–8 Consolidated Admission Requirements Directive  69, 196 Consolidated Credit Rating Agency Regulation (CCRAR)  1–2, 34–35, 39, 643–44, 648–78 administrative rules  650–51 benchmark regulation  896–97 breaches  672–73, 674 calibration 655

civil liability  675–76 Commission’s 2016 review  668 conflict-of-interest management  656, 658, 659, 663 CRA ratings and  662–63, 873–74 design of  670 differentiation 655 disclosure-related requirements  662, 667–68 enforcement 672–75 effectiveness of  675 equivalence regime  855–56, 875–77 ESMA, oversight by  660, 661, 668–69, 677–78 financial crisis, influence of  665, 861 legislative regime  648, 650–51 methodologies  659, 662 NCAs and ESMA, relationship between  669–70 organizational failures  664 over-reliance on ratings  665 periodic supervisory reporting  663 proportionality mechanism  667 registration process  655–56 regulatory perimeter  651–55, 666–67 revisions 648–49 rulebook 649–51 scope of  651, 652–53, 671 soft law  650–51 sovereign debt ratings  663–64 success of  649 supervisory framework  668–72 supervisory power  668 sustainability-related risks  677 Consolidated Tape Reform (CTP) 498–99 definition 517n.399 MiFID III/MiFIR 2 (2021) proposal  516–18 consumer protection  39–40, 46–47n.254, 841–42 see also investor protection contracts for difference (CfDs)  19–20, 37, 158–59, 167–68, 170, 367, 695n.109, 736, 763–64, 771, 786, 789, 801n.277, 819–20, 823, 824, 825 convergence of standards 79–80 convertible securities 106 Co-ordinated Market Economy (CME)  16–17, 21–22 COREPER 24n.144 corporate governance theory 378n.191 see also governance requirements counterparty credit risk: definition 610n.475 counterparty risk  254–55, 272, 445, 587n.345, 608n.463 see also central clearing counterparties Court of Justice  8–1nn.51–2, 44, 46–47, 103, 122n.315, 151–52, 154–55, 366n.118, 468, 576, 680–82, 685n.48, 686–87, 689n.80, 690–91, 696–97, 700, 701–2, 703–4, 704–5n.146, 707–8, 710–11, 719n.219, 733–34n.304, 810–11, 842–43, 906n.306 Covid-19 pandemic AIFMD 315–16 benchmark regulation  752 bond market liquidity  448n.41 downgrading of bonds  666

916 Index Covid-19 pandemic (cont.) central banks, intervention by  12, 238–39, 251–52, 341n.653, 344, 448n.41 CISs 232 CRAs  638–39, 642–43, 645, 649–50, 671n.255, 672 economic recovery  13–14, 56–57 reforms/recovery prospectus  16, 82, 104–5, 108–9, 111, 117, 189n.621, 360–61, 374n.173, 545–46, 552–53, 759–60, 814–15, 903 ESMA 507 issuer disclosure  161 public statements  48–49 supervisory convergence powers  149 EU equity-based funding  78–79 EU ‘strategic autonomy’  863–64 financial integration  81n.114 financial markets regulation  17–20 IFRS 9 standard  184–85 issuer disclosure regime: global financial crisis  85–87 market abuse regulation  687–92 market disruption  350 money-market funds  234–31nn.22–3, 251–52, 343–44 NCAs  385n.219, 433–34 post-execution reports  375n.177 Prospectus Regulation: recovery Prospectus  16, 82, 104–5, 108–9, 111, 117, 127–29, 211n.750, 230 retail markets  755–56, 757–58, 759–60, 761, 762, 797, 814–15 SFTR 588 short selling  557–58, 560–61, 570, 577, 579–80 SMEs  90, 97, 209 UCITS funds  244–45 volatility  6, 12, 71–72, 238–39, 301n.397, 446–47, 480–81, 492n.262, 529, 533, 592, 599–600, 617–18, 620–529nn.522–3, 626n.551, 631–32, 685n.46 CRD IV/CRR regime 413–24 design 413–14 enforcement 429 evolution of  397–400 executive remuneration  419–23 firm governance  419–23 investment firms  414–16 large exposures  418 leverage 418 liquidity 418 MiFID II/MiFIR and  429, 533–34 organizational requirements  418 own funds  416–18 public disclosure  423–24 risk management  418 scope 414–16 SREP process  434–36 supervisory reporting  423–24 sustainability-related risks  424 trading book risk  416–18 see also MiFID II/MiFIR; prudential regulation

credit default swap (CDS) market  532–33, 551, 666n.216, 688 definition 562n.200 uncovered sovereign CDSs  566–68 credit derivatives 611–13 see also central clearing counterparties (CCPs) credit institutions  29–30, 355, 396n.267, 396n.270, 403, 414 definition  27n.160, 378–79, 403, 414–15 credit rating agencies (CRAs) 637–78 calibration 655 CCRAR 648–78 civil liability  675–76 enforcement 672–75 supervisory framework  668–72 see also Consolidated Credit Rating Agency Regulation (CCRAR) conflict-of-interest management  656–59 credit rating activities, definition of  651n.111, 652–54 credit scores, definition of  652n.122 differentiation 655 disclosure 662–63 discrete regulation: GFC 663–65 securitization instruments  665 sovereign debt ratings  663–64 ESMA: CRA II  646–47 enforcement of  672–75 experience (since 2011)  670–72 supervision and  668–75 global financial crisis  645–46, 648–50 IOSCO Code and the EU  644–45 negotiations 646–48 reform 639–43 history of EU regime  644–50 CRA I (new regulatory regime)  646 CRA II (ESMA supervision)  646–47 CRA III (market structure risks)  647–48 market discipline  666–68 market structure  666–68 methodologies 659–62 organizational requirements  656–59 over-reliance 665–66 registration process  655–56 regulation 666–68 regulation and  637–43 gatekeeper function  637–39 GFC and reform  639–43 regulatory perimeter  651–55 rulebook 650–51 administrative rules  650–51 EU CRA rulebook  643–44 legislation 650–51 soft law  650–51 supervisory reporting  662–63 sustainable finance and  676–78 third country regime  873–77

Index  917 certification 873–75 endorsement 873–75 legislative scheme  873–75 in practice  875–77 criminal sanctions: market abuse regime 735–38 cross-border activity abusive conduct  727, 729, 730–31 investment services regime  880–83 cross-border claims 846 cross-border supervision  27–28, 292n.339, 292n.341, 312n.473, 321, 377 crowdfunding  14n.82, 36–37, 63n.352, 73–67nn.54– 5, 88–89, 108–10, 130n.351, 216–22, 768, 794–95 Crowdfunding Regulation 216–22 crowdfunding service: definition 218–19 crypto-assets  56–57, 64–65, 215–16, 442n.6, 446–47, 770n.116 bitcoin  64n.355, 215 asset market  65, 75n.67 Crypto-Assets Task Force  446n.34 crypto tokens  215n.776, 442n.6 definition  64n.355, 215n.772 Markets in Crypto-Assets Regulation (MiCAR)  75n.67, 215–16, 215n.774, 442n.6 see also digital finance   Daily Trading Flow (DTF)  405n.316, 407n.324, 408–9 ‘dark’ trading  443–44, 446, 448, 452–53, 454–55, 458, 459–60, 470, 472, 487, 492n.262, 497, 540–41 data collection: ESMA 51–52 data consolidation see data distribution data distribution 511–18 Consolidated Tape Reform (CTP)  516–18 enhancing the data framework  511–13 MiFID III/ MiFIR 2 Proposal (2021)  516–18 data publication 513 data quality  455, 458, 462, 473n.177, 498–99, 507–8, 511–12, 515, 516, 517–18, 521, 537n.43, 537n.46, 569, 588–89, 599–600, 619, 630, 631–32 data reporting services providers (DRSPs)  32, 35–36, 51, 52–53, 63n.352, 150–51, 190, 351–52, 512–13, 522n.429, 749 regulation of  514–16 de Larosière Group (DLG) Report 766–67 dealing on own account see own-account dealing dealing restrictions 716 debt securities  16n.94, 86–67nn.137–8, 98, 106, 107, 108–9, 117, 118, 120–21, 124–25, 126, 157n.468, 158, 162–63, 164, 166–67, 171, 179n.565, 196n.658, 197, 199–200, 226–27, 237–38, 251, 269, 457n.93, 516n.395, 569n.233, 649–50, 760–61, 839n.463 see also bond offerings decision-making  18n.113, 28n.168, 38, 40–41n.219, 49n.264, 50–51, 52–53, 58, 77, 189n.626, 244, 284–85, 376n.183, 380–81, 478–79, 478n.210,

549, 623–24, 750, 783, 791n.230, 804, 852n.16, 860–61, 891–92 Board of Supervisors (BoS)  31–32, 35–36, 38, 631 ESMA governance  35–36, 671 defaulter pays principle 617 deference principle 863n.77 defined investment policy: concept 305n.430 delegated powers  24–25, 40–41 see also administrative rule-making process deposit protection  339n.643, 530, 841–42, 847 depositary receipts: definition  367n.125, 469n.157 depositary regimes  278–80, 299, 319–231nn.521–2, 321, 843 AIFMD 319–21 central banks  280 UCITS reform  280–82 UCITS V reforms  278–80 deregulation  73, 89–90, 97–98, 102, 130–31, 781, 905–6 derivatives definition 470n.161 global markets  893–94 over-the-counter (OTC) markets: EMIR see European Market Infrastructure Regulation differentiation AIFMD 304–5 credit rating agencies  655 Prospectus Regulation  120 Transparency Directive  162–63 digital finance 215–22 Crowdfunding Regulation (2020)  216–22 financial markets regulation  62–65 issuer disclosure regime: digital assets  215–16 retail markets  769–70 see also crypto-currency Digital Operational Resilience Act (DORA) 235n.26, 384n.218, 480n.217, 627n.554, 657n.155, 747n.379 direct electronic access: definition 542n.80 disclosure ad hoc 175 admission to trading venues  227–30 AIFMD 321–23 alleviated disclosure, principle of  131–32 capital markets  70–78 debate 73–78 market setting and regulation  70–73 CIS 284–85 conflicts of interest see conflicts of interest credit rating agencies  662–63 digital assets  215–16 dissemination of ongoing issuer disclosure  188–90 ELTIF 335 EU context  78–82 EU Issuer Disclosure Rulebook  68–70 filing ongoing issuer disclosures  187 global financial crisis era  85

918 Index disclosure (cont.) Covid-19 pandemic  85–87 Capital Markets Union  85–87 reforms (2010)  94–95 harmonization, substantive and operational 186–87 history of the issuer disclosure regime  82–87 Capital Markets Union  85–87 Covid-19 pandemic  85–87 dynamic 82 early efforts  83–84 FSAP and reform  84 global financial crisis era  85 reforms (2010)  94–95 market abuse regulation  709–17 delaying Article 17(1) disclosure  711–13 insider lists  714–15 insider transactions  716–17 issuer disclosure  709–14 managers’ transactions  716–17 ongoing issuer disclosure and Article 17(1) 709–11 selective disclosure (Article 17(8))  713–14 SME segment  714 market finance and integration  78–82 market reform  227–30 MiFID/MiFIR 790–91 PRIIPs see PRIIPs regulation Prospectus Regulation  111–17 core obligation  111–12 final price  115–16 incorporation by reference  116–17 omission of information  115–16 risk factors  112–13 rulebook 113–15 short-form 284–85 sustainable finance  210–14 third countries  869–72 ongoing disclosure and IFRS  871–72 prospectus regime  869–71 Transparency Directive see Transparency Directive UCITS regime  282–90 CIS disclosure  284–85 KIID/KID 284–87 prospectus and ongoing  282–84 retail markets  284–85, 288–90 short-form disclosure  284–85 unlawful 704–5 discrete regulation capital-raising 326 credit rating agencies: GFC 663–65 securitization instruments  665 sovereign debt ratings  663–64 ELTIF see European Long Term Investment Fund (ELTIF) EuSEF see European Social Entrepreneurship Fund (EuSEF) EuVECA see European Venture Capital Fund (EuVECA)

fund vehicles  326 global financial crisis  663–65 securitization instruments  665 sovereign debt ratings  663–64 see also collective investment management discretion: OTFs 473–74 discrimination see non-discrimination principle dispute settlement see alternative dispute resolution (ADR) dissemination ESMA as a data-hub  572 ongoing issuer disclosure  188–90 Prospectus Regulation  118–19 Distance Marketing of Financial Services Directive  764–65, 775n.146, 788–89 Distributed Ledger Technology (DLT)  63n.349, 64, 215n.772 DLT financial instruments, definition of  65n.361 distribution regulation  135–36, 781–82 Insurance Distribution Directive  825–27 diversity boards  379n.196, 381, 420–21, 422 trading practices  468, 503–4 DLG Report 33–34n.188 Dodd-Frank Act (US)  135–36n.377, 530n.6, 553n.140, 877n.155 dotcom bubble  77, 84, 92, 202–3 double materiality principle 212–13 durable medium concept 118n.302 definition 837n.450   E Commerce Directive 764–65 EBA see European Banking Authority ECB see European Central Bank ECOFIN (Economic and Financial Affairs Council)  21n.129, 33n.187, 53–55, 297n.364, 298 ECON Committee  173n.537, 294n.347, 340n.649, 358–59, 581n.309, 601n.418, 625n.543, 672n.265, 764n.67, 808–9n.307, 830n.410, 862n.70, 866n.91 economic crisis see financial crisis Economic and Financial Committee (EFC) 9n.53 economic models 16–17 Economic and Monetary Union (EMU) 54–55n.300, 864n.80 Efficient Capital Markets Hypothesis (ECMH) 76–77 EIOPA (European Insurance and Occupational Pensions Authority)  1n.2, 2, 34n.189, 38–39, 49n.261, 64n.356, 189–90, 292n.341, 601n.420, 655n.142, 666n.214, 774–75, 791n.232, 810n.313, 816n.343, 831–32n.419, 839–40 electronic disclosure 188 eligible assets 264–68 CISs 266 deposits 266 financial derivatives  266–68 money-market instruments  264–66 transferable securities  264–66

Index  919 Eligible Assets Directive  253–54, 264, 265, 267, 272 eligible counterparties: MiFID II  372–74, 384n.216, 390, 391, 393–94, 470n.166, 474n.182, 489, 534–30nn.25–6, 777–78, 786, 787, 814–15, 877–78, 880–81, 883–84 definition 373n.167 eligible investment assets: definition 333–34 ELTIF see European Long Term Investment Fund embedded assets 265 EMIR see European Market Infrastructure Regulation emission allowances  358, 367, 368, 370–72, 414–15, 458–59, 469–70, 472–73, 474, 475, 504–5, 508, 509, 510–11, 522, 549, 689, 694, 700, 703, 704n.144, 705–6, 709–10, 712, 714, 715n.197, 716–17, 718–20, 736, 738n.321 commodities and  697–99 definition 470n.161 employee share offerings 94–95 endorsement mechanism IFRS regulation  180–83 principles  180, 181 enforcement AIFMD 325–26 EU financial markets governance  26–30 EU 26–29 supervisory and enforcement framework  29–30 investment firms/services  429–40 administrative sanctions  438–39 civil liability  439–40 CRD IV/CRR regime  429 IFD/IFR regime  429 MiFID II regime  429 market abuse regulation  732–38 criminal sanctions  735–38 MAR sanctions regime  733–35 Market Abuse Directive (2014)  735–38 Market Abuse Regulation  732 order execution venues  518–23 private enforcement  28, 30, 75–76, 151–52, 732n.292, 776, see also civil liability Short Selling Regulation  583 Transparency Directive enforcement  174–75 administrative sanctions  174–75 civil liability  174–75 UCITS regime  290–94 sanctions 293–94 see also European Securities and Markets Authority; national competent authorities; supervision; supervisory cooperation; supervisory convergence Enron scandal  77, 175n.544, 202–3, 204–5, 228n.861, 389, 639n.16, 640n.18, 644n.50 equal treatment principle 166–67 equality of access principle 101–2 equity markets 493–503 bilateral/OTC segment  499–502 deferrals 501–2 investment firms  501–2 post-trade transparency  501–2 pre-trade transparency  499–501 SIs 499–502

deferred publication  499 impact 502–3 MiFID II/MiFIR review  502–3 MTFs 493–99 OTFs 493–99 post-trade transparency  498–99 pre-trade transparency  493–94 waivers 494–98 RMs 493–99 see also non-equity markets; private market funding; public equity markets; transparency regulation equity securities: definition 105–6 equivalence assessment  40, 798n.267, 850–51, 858, 859–60, 867–68, 870, 875–76, 878n.161, 882– 83, 885–86, 892, 895n.245 equivalence regime 855–58 ESCB see European System of Central Banks ESFS see European System of Financial Supervision EU securities and markets regulation see securities and markets regulation Eurolist Directive 91 European Banking Authority (EBA)  1n.2, 2, 184–85 European Central Bank (ECB)  7–8, 107, 264, 297, 590, 849–50 European Economic and Social Committee (EESC)  9n.53, 23–24, 247n.101 European Enforcers Co-ordination Sessions (EECS)  95n.191, 161–62, 173–74, 185–86, 212–13, 351n.24 European Financial Reporting Advisory Group (EFRAG)  180, 181, 182, 183n.588, 184–85, 186, 213n.768, 214 European Financial Stability and Integration Reviews (EFSIRs)  11n.66, 16n.105, 81n.114, 82n.115, 761n.47 European Insurance and Occupational Pensions Authority (EIOPA)  1n.2, 2, 34n.189, 38–39, 49n.261, 64n.356, 189–90, 292n.341, 601n.420, 655n.142, 666n.214, 774–75, 791n.232, 810n.313, 816n.343, 831–32n.419, 839–40 European Long Term Investment Fund (ELTIF) 1–2, 234–35, 331–38 AIFMD and  332–33 asset allocation  333–35 experiment 336–38 product regulation  333–35 proposal (2021)  336–38 redemption restrictions  333–35 regulation 332–35 disclosure 335 regulatory design  332–33 European Market Infrastructure Regulation (EMIR) 589–635 CCP clearing obligation  593–94, 608–15 allied supports  615 credit derivatives  611–13 identifying classes of derivatives  609–11 initial application  611–13 interest rate derivatives  611–13

920 Index European Market Infrastructure Regulation (EMIR) (cont.) scope 608–9 suspension 613–15 CCPs 619–30 access 887–93 authorization 619–26 EMIR 2.2. reforms  888–90 EMIR 2.2 regime  890–93 institutional framework  619–26 original model  887–88 rulebook 626–30 supervision 619–26 clearing thresholds  605–7 derivatives trading obligation: MiFIR and  633–35 history of  594–600 global financial crisis  594–600 infrastructure regulation and supervision  619–30 TRs 630–32 non-CCP-cleared derivatives, risk mitigation obligation for: bilateral margin  616–18 collateral exchange  616–18 margin and collateral  615–18 risk management  616 scope 615–16 non-financial counterparties (NFCs)  605–7 OTC derivatives trading and the EU  589–94 distinctiveness of regime  589–92 features 593–94 regulation of  589–94 reporting 618–19 rulebook 600–2 administrative rules  600–2 legislation 600–2 soft law  600–2 scope of  602–4 small financial counterparties  605–7 third countries  885–94 global derivatives markets  893–94 OTC derivatives markets  885–87 trade repositories  893 see also central clearing counterparties (CCPs) European Parliament: role in legislative process 21– 22, 23–24 European Rating Platform (ERP)  650, 662–63, 668–69 European Securities and Markets Authority (ESMA) CCRAR framework  668–70 enforcement 672–75 credit rating agencies  668–75 CRA II  646–47 enforcement 672–75 supervision  646–47, 668–75 experience with the exceptional powers of intervention 582–83 financial markets regulation  31–55 centralized supervision  53–55 data collection  51–52

direct intervention  52–53 establishment 31–32 governance 38–39 influence 31 legitimation 40–44 origins and evolution  32–37 powers and tasks  39–40 regulatory governance role  45–49 risk monitoring  51–52 supervision 52–55 supervisory convergence  49–51 financial reporting systems: IFRS regulation  184–86 intermediary regulation powers 575–76 product intervention: intervention powers  821–22 MiFID II/MiFIR  776–77 supervisory convergence  433–34 third countries  858–60 transaction reporting  520–22 UCITS regime  291–93 European Securities Markets Expert Group (ESME)  457n.94, 687–88n.72 European Single Access Point (ESAP)  8n.50, 13–15, 31n.177, 37, 51, 82, 86, 118–19, 159, 160–61, 187, 189–90, 283–84, 323n.547, 572n.260, 709n.168 European Social Entrepreneurship Fund (EuSEF) 330–31 European Supervisory Authority (ESA)  150–51, 742, 775–76 European System of Central Banks (ESCB) 169, 369, 432–33, 586n.341, 622n.528, 623n.533, 624–25, 625n.547, 694n.102 European System of Financial Supervision (ESFS) 1, 643–44, 645–46, 687–88n.72, 696n.111 see also European Securities and Markets Authority; European Systemic Risk Board European Systemic Risk Board (ESRB)  2, 236, 348n.8, 432–33, 504n.324, 575–76 European Venture Capital Fund (EuVECA) 327–30 EuSEF see European Social Entrepreneurship Fund EuVECA see European Venture Capital Fund exchange-regulated markets  193, 198 exchange-traded funds (ETFs)  73, 89–90, 135– 36n.377, 209, 234n.23, 244, 250–51, 285n.305, 469–70, 569, 756n.4, 869n.111 definition 469n.158 execution see best execution regulation; order execution execution information 697 inside information  699 execution-only regime  274, 792–93, 798–800, 884–85 direct trading  800–1 distribution 798–800 external support: definition 341n.652 extraterritoriality Short Selling Regulation  583–84

Index  921 ‘fair, clear, and not misleading’ principle 788–89 fair treatment obligation  312, 322n.539, 373–74, 393, 537n.41, 787–88, 803 principle of fair treatment  623–24, 787, 788–89, 792–93, 801, 802, 825–27 fair value principle 182–83n.587 Forum of European Securities Commissions (FESCO)  33, 92, 686n.61 filing: ongoing issuer disclosures 187 Financial Conduct Authority (FCA) (UK) 74n.59, 207–8n.732, 209n.743, 209n.744, 238n.38, 449n.42, 491n.258, 549n.116, 580n.300, 680n.10, 685n.46, 697n.113, 747n.380, 752, 770n.119, 788n.215, 807n.302, 824n.378, 839n.463, 839n.465, 908–9 financial counterparties: definition 586n.340, 602n.427 financial crisis see global financial crisis (GFC) financial innovation  177–78, 348n.7, 442–43, 530– 31, 633, 640–41 financial instruments admission to trading  485 commodities and  694–95 definition  170n.531, 365, 696–97 insider dealing  696–97 MiFID II regime  367–69 order execution venues  469–70 Financial Instruments Reference Data System (FIRDS) MiFID II/MiFIR  352, 493 order execution  476–77, 520–22 RTS 2 liquidity assessment  506n.340 Financial Integration Monitor  246n.97, 762n.51 financial literacy  14n.81, 39–40, 135–36n.377, 759–62, 766n.84 financial markets regulation 1–65 Covid-19 pandemic  17–20 digital finance  62–65 ESMA 31–55 centralized supervision  53–55 data collection  51–52 direct intervention  52–53 establishment 31–32 governance 38–39 influence 31 legitimation 40–44 origins and evolution  32–37 powers and tasks  39–40 regulatory governance role  45–49 risk monitoring  51–52 supervision 52–55 supervisory convergence  49–51 EU financial markets governance  20–30 integration 6–17 Capital Markets Union (CMU)  11–17 financial market integration  11–17 law, role of  6–10 market finance  11–17 single market  6–10 treaties 6–10

law making process  20–26 administrative rules  24–26 law-making and the EU  20–22 legislation 22–24 objectives 2–6 Segré Report  17–20 supervision and enforcement  26–30 EU and  26–29 Supervisory and Enforcement Framework 29–30 sustainable finance  58–62 technological innovation  62–65 uniformity 56–57 financial reporting systems EU framework  176–78 IAS regulation  178–80 IFRS and  179–80 origins 178 IFRS see International Financial Reporting Standards Transparency Directive: periodic annual reports  163–64 periodic half-yearly reports  164–65 quarterly reporting  165–66 Financial Services Action Plan (FSAP) evolution of  247–48 post-FSAP era  248–49 investment firms/services  355–57 prospectus regulation  92–94 reform 84 retail markets  765–66 Transparency Directive  157–58 Financial Services Authority (FSA) 71n.39, 203n.710, 237n.31, 348n.7, 531n.12, 554–55, 641n.28 financial stability 250–52 Financial Stability Board (FSB)  6, 10, 210–11n.748, 234n.22, 237–38, 349n.16, 398–99, 446–47, 446n.32, 531, 642–43, 680n.10, 740, 742n.348, 851–52 Financial Transaction Tax (FTT) Proposal  10, 85, 530–31n.9 FIRDS see Financial Instruments Reference Data System fiscal responsibilities  52–53, 623n.534, 846 flagging requirement  481–82, 551, 553n.140, 553– 54n.142, 557, 569 forum shopping  376, 676 ‘four eyes’ principle 380 free movement of capital  7, 17n.107, 22–23 of funds  403n.306 of goods and services  7, 355n.51 guarantees 8–10 FSAP see Financial Services Action Plan FTT see Financial Transaction Tax (FTT) Proposal fund of funds programme 88n.153 funding 845–46 see also access to markets; crowdfunding; market funding

922 Index GAAP (Generally Accepted Accounting Principles)  155–56, 164, 176–78, 179–80, 872 Gamestop/meme-stock episode  32, 62–64, 71n.33, 135–36, 348, 447n.36, 529, 533, 536–37, 538– 39, 552–53, 557–59, 564n.211, 684n.38, 689, 720–21, 755–56, 777n.156, 800–1 see also social media gatekeeping credit rating agencies  637–39 investment research  202–4 see also credit rating agencies; investment analysts GDP (Gross Domestic Product)  16, 72n.47, 86–67nn.137–8, 222n.823, 225n.842, 228–29, 228n.861, 327n.570, 760n.37 Giovannini Reports 524–25 global financial crisis (GFC) AIFMD 298–300 post-GFC era  300–2 pre-GFC era  297–98 Capital Markets Union  252 collective investment management  235–36, 249–50 post-GFC era  236–43, 250–53 credit rating agencies  645–46, 648–50 reform 639–43 discrete regulation  663–65 securitization instruments  665 sovereign debt ratings  663–64 EMIR 594–600 2022 review  597–600 financial stability  250–52 issuer disclosure  85 Covid-19 pandemic  85–87 Capital Markets Union  85–87 reforms (2010)  94–95 market abuse regulation  689–92 MiFID II/MiFIR  780–82 legislative reform  360–61 negotiations 357–60 post-GFC era  360–61 pre-GFC era  355–57 prudential regulation  360–61 technocracy 360–61 Prospectus Regulation  94–95 retail markets  766–69 pre-GFC period  765–66 Short Selling Regulation  557–59 regulating short sales  554–57 Transparency Directive  158–59 UCITS/AIFMD (2021) proposal  252–53 Global Systemically Important Financial Institution (G-SIFI) 398–99 gold-plating 426–27 good governance see governance requirements governance requirements 378–81 see also corporate governance growth agenda  236, 326   harmonization mutual recognition see mutual recognition

operational 186–87 substantive 186–87 hedge funds  4–5, 235–36, 237n.36, 254n.159, 264, 265, 267–68, 272, 273, 274, 295–301, 302, 304, 305–6, 316, 320, 321, 324n.554, 348, 530nn.6– 7, 538n.49, 551–53, 684n.39, 869n.111 see also Alternative Investment Fund Managers Directive high frequency trading (HFT) regime 481n.225, 484n.238, 540–43, 719–20 definition 541–42 Himalaya Report 429n.424 home bias  8, 16, 81, 91–92, 761–62 home Member State control AIFM authorization and  307–8, 309–10, 319 capital-raising  79–80, 82, 93–94, 138 CCP supervision  624–25 cross-border claims  764, 846 definition  258n.182, 307 ELTIF 332 filing regimes  187 ICSD 846 interim management statements  165–66 language regime  143–44, 172 major holdings notification regime  168–69 market integration and  171–72 MiFID II  376, 425, 426–27 optional exemptions  372 passport rights  141–42, 425, 426 precautionary powers  144 principle  522, 846 RMs and market access  484 Transparency Directive  160, 162, 166–67, 171 ongoing issuer disclosure  188 UCITS  257–58, 259–60, 262–63, 278–79, 292 household investment  135–36, 138, 244, 245, 336, 761, 774–75 see also retail markets   IAS (International Accounting Standards) Regulation  1–2, 69, 84, 155, 157–58, 176–77, 178–79, 181, 182n.584, 189–90 IFRS and  179–81, 182, 184n.599 origins 178 see also financial reporting systems IASB (International Accounting Standards Board)  176–77, 178, 179–80, 181, 182–83, 184–85, 186 IBOR rates (interbank offered rates) 752 IFD/IFR regime 403–12 CRD IV/CRR regime and  429 evolution of  400–2 firm governance  409–12 K-factors 405–9 liquid assets  409 liquidity 409 MiFID II and  429 organizational requirements  409–12 own funds regime  405–9

Index  923 public disclosure  412 scope and classes  403–5 SREP process  437–38 supervisory reporting  412 sustainability-related risks  412 see also prudential regulation IFRS see International Financial Reporting Standards IMF (International Monetary Fund) 11n.65, 28n.163, 234n.22, 237–38, 374n.170, 595n.381, 900n.269, 909n.324 impact assessment  23–24, 45, 46–47, 60–61n.334, 109n.259, 181, 183, 248, 360–61, 385n.223, 401n.300, 454–55, 507, 557, 640–41n.23, 664, 685n.43, 700, 831–32, 866n.91 Implementing Technical Standards (ITSs) 21, 99–100, 352n.31, 362–63, 692–93 in-scope remuneration: definition 313n.482 incentive management 349 see also remuneration policy independent investment advice  393, 777–78, 779–80, 781n.172, 802, 804–8 regulatory intervention  806–8 inducements 801–4 information asymmetry  5, 63–64, 73–74, 212–13, 267, 581n.307, 756–57 information exchange  10n.61, 29, 49–50, 173–74, 206–7, 253–54, 290–91, 303, 325, 337n.632, 431n.434, 432–33, 434–35, 437, 467–68n.150, 526–27, 621n.525, 622n.529, 669–70, 691– 92n.96, 696, 728, 729, 749–50, 810n.316, 849– 50, 867n.97, 868n.105, 878–79, 883, 890n.223, 895n.246, 897n.253, 908–9 initial capital requirements  404n.309, 405–6 initial margin: definition 628n.558 initial public offers (IPOs)  16, 71–67nn.41–3, 73n.55, 81n.111, 86, 88n.154, 94n.180, 113, 118, 132, 192n.638, 203, 206–7, 228–29 innovation financial  177–78, 348n.7, 442–43, 530–31, 633, 640–41 technological  62–65, 783–85 inside information 696–702 commodities and emission allowances  697–99 definition  690–91, 696–99, 703–4, 709, 710–11 execution information  699 ‘not been made public’  701–2 precise nature of  699–701 significant effect on prices  702 see also insider dealing insider dealing dealing 704 financial instruments: definition 696–97 inducement of  704 legitimate behaviour  707–9 market soundings safe harbour  705–7 persons subject to the prohibition  703–4 prohibition on  696–709 rationale for  680–83

recommendation 704 unlawful disclosure  704–5 see also inside information Insider Dealing Directive  679, 686–87 insider lists  45n.246, 89n.155, 199n.675, 690n.84, 692n.97, 714–15, 733, 733n.298 disclosure obligations  714–15 insider transactions disclosure of  716–17 institutional investment  15, 236, 294, 338–39n.639 insurance-based investment product: definition 826n.393 Insurance Distribution Directive 825–27 Insurance Mediation Directive I (IMD I) 773, 774–75 Insurance Mediation Directive II (IMD II) 773, 774–75 integrated markets see market integration intent/intention: concept 691–92 Inter-institutional Monitoring Group (IIMG) 687n.69 interest rate derivatives 611–13 see also central clearing counterparties (CCPs) Interim Reports Directive  83, 157 interim statements: Transparency Directive 165–66 intermediaries 347–51 Internal Market White Paper  246–47, 355n.51 International Accounting Standards (IAS) Regulation  1–2, 69, 84, 155, 157–58, 176–77, 178–79, 181, 182n.584, 189–90 definition 179 IFRS and  179–81, 182, 184n.599 origins 178–80 International Accounting Standards Board (IASB)  176–77, 178, 179–80, 181, 182–83, 184–85, 186 international financial markets 849–52 access to  850–52 background 849–50 see also third countries International Financial Reporting Standards (IFRS) 178–80 Conceptual Framework (2018)  183 endorsement mechanism  180–83 ESMA and  184–86 EU financial reporting framework  176–78 IAS regulation and  179–80 issuer disclosure regime  871–72 ongoing disclosure  871–72 supervisory convergence  184–86 see also financial reporting systems International Monetary Fund (IMF) 11n.65, 28n.163, 234n.22, 237–38, 374n.170, 595n.381, 900n.269, 909n.324 International Organization of Securities Commissions (IOSCO) IOSCO Code of Conduct for Rating Agencies and the EU  644–45 Principles for Financial Benchmarks  897–98, 904

924 Index IOSCO see International Organization of Securities Commissions investment advice definition  366n.120, 782–83, 784, 805n.290 independent  393, 777–78, 779–80, 781n.172, 802, 804–8 ‘of an ongoing nature’, definition  407n.326 investment analysts  67n.5, 74–75, 76–77, 89–90, 103, 202–3, 206–7, 637, 699, 703–4, 705 Investment Firm Directive (IFD) see IFD/IFR regime Investment Firm Regulation (IFR) see IFD/IFR regime investment firms/investment services 347–440 Capital Requirements Directive see CRD IV/CRR regime MiFID II see MiFID II/MiFIR regime prudential regulation see prudential regulation see also IFD/IFR regime Investment Funds White Paper  248, 285n.311, 297–98 investment limits see UCITS regime investment products see PRIIPs regulation investment recommendations  203n.708, 204–6, 652–53, 654n.134, 705, 733, 776n.153, 783, 801n.279 Investment Recommendations Directive 204–5 investment research 202–10 conflict of interest management  205–7 cost of  207–10 definition  207n.728, 653n.124 EU response, evolution of  204–5 gatekeeping and  202–4 presentation requirements  205–7 regulation and  202–4 Investment Services Directive (ISD)  247, 354–55, 450–51, 450n.43, 764, 778 history 778–80 MiFID II, evolution of  354–55 investment services regime see third countries investor behaviour  134–35, 188n.618, 344n.670, 755–56, 757–58, 761, 765–66, 776n.153, 789, 801, 806–7 investor classification 786–87 investor compensation  383, 834–35 Investor Compensation Schemes Directive (ICSD) 841–47 claims 843–45 compensation schemes  841–43 cross-border claims  846 funding 845–46 retail investor protection  841–43 review of  846–47 scheme governance  845–46 scope 843–45 investor confidence  77–78, 158n.470, 680–82, 684–85, 686–87, 696–97, 713n.191, 719n.219, 765–66, 841–42, 845 investor protection 841–43 see also retail markets

issuer: definition  101, 162n.492 issuer-disclosure regime see disclosure ITSs see Implementing Technical Standards   K-factors: definition 407n.323 Katiforis Report  356n.59, 644n.55 Kay Review  72, 191–92 Key Information Document (KID)  284–87, 335, 811–41 Key Investor Information Document (KIID) 245–46, 253–54, 261n.201, 285, 765–66, 773–74, 828–30 key investor information, concept of  136–37 UCITS regime and disclosure  284–87 KID see Key Information Document KIID see Key Investor Information Document ‘Know your client’ rules: MiFID II 792–808 appropriateness 792–98 execution-only distribution  798–800 direct trading  800–1 suitability 792–98   Lamfalussy process  33, 83, 687 Lamfalussy Report  33, 84, 92, 193n.649, 524n.438, 687 language regime  93–94, 123, 220n.814 Prospectus Regulation  143–44 Transparency Directive  172 law and finance scholarship 16–17 law-making process 20–26 administrative rules  24–26 BTS see Binding Technical Standards EU financial market integration  6–10 law-making and the EU  20–22 legislation 22–24 legislative measures AIFMD 303–4 conflict-of-interest management  388–90 credit rating agencies  650–51 EMIR 600–2 EU financial markets governance  22–24 investment firms/services  383–85, 388–90 Market Abuse Regulation  692–93 MiFID II/MiFIR  770–77 rulebook 362–64 Short Selling Regulation  559–61 Transparency Directive  160–62 UCITS regime  253–55 venue rulebook  464–66 legitimate behaviour: insider dealing 707–9 Lehman collapse  339–231nn.642–3, 594–95, 763n.62 leverage levels 316–19 AIFMD 316–19 CRD IV/CRR regime  418 loan origination  316–19 macroprudential risk management  316–19 UCITS regime  272–73 Liberal Market Economy (LME)  16–17, 21–22 LIBOR rates  612, 614–15, 635n.601, 739, 739n.328, 740, 742, 743, 747–679nn.380–1, 752–53 LIBOR scandal  735–36n.312, 740–41n.337

Index  925 Liikanen Group report 530n.7 liquidity contracts 721–24 CRD IV/CRR regime  418 IFD/IFR regime  409 multilateral trading facilities  485–86 trading venues  480–83 Liquidity Coverage Requirement (LCR) 415n.361, 418 Listing Particulars Directive  83, 91–92 ‘lit’ trading  459–60, 467, 496n.277, 497, 541n.68 ‘locate’ rule 564–66 see also Short Selling Regulation long-term investment  1–2, 134–35, 234–35, 236, 326, 331–38, 332n.601, 333n.607, 759n.28, 768, 794–95   Madoff scandal  249–50, 279–80, 281, 291–92 management body: definition 380 management company: definition 256n.178 Management Company Directive  253–54, 271–72, 277n.257, 289–90 mandatory issuer disclosure see disclosure mark-to-market accounting 341–231nn.656–7, 595n.383, 607n.456, 616, 617n.508 market abuse Transparency Directive: ad hoc disclosure  175 see also insider dealing; Market Abuse Regulation (MAR); market manipulation Market Abuse Directive 2014: criminal sanctions 735–38 Market Abuse Directive  204–5, 679, 686–87 Market Abuse Regulation (MAR)  679–753 benchmark abuse  739–53 market abuse  740–41 reform context  739–40 Benchmark Regulation (2016)  741–53 approach 742–43 benchmark replacement  752–53 design 742–43 enforcement 748–50 evolution 741–42 supervision 748–50 sustainable finance and benchmarks  750–51 conceptual foundations  690–91, 692, 693 disclosure obligations  709–17 disclosure of insider transactions  716–17 insider lists  714–15 managers’ transactions  716–17 enforcement 725–38 context 725–26 criminal sanctions  735–38 MAR sanctions regime  733–35 Market Abuse Directive (2014)  735–38 Market Abuse Regulation  732 EU and market abuse prohibition  684–85 historical development  686–92 Covid-19 pandemic  689–92

global financial crisis era  687–92 Insider Dealing Directive  686–87 Market Abuse Directive  686–87 inside information  696–702 commodities and emission allowances  697–99 definition 696–97 execution information  699 ‘not been made public’  701–2 precise nature of  699–701 significant effect on prices  702 insider dealing prohibition  696–709 dealing 704 financial instruments, definition of  696–97 inducing 704 legitimate behaviour  707–9 market soundings safe harbour  705–7 persons subject to the prohibition  703–4 rationale for  680–83 recommending 704 unlawful disclosure  704–5 issuer disclosure  709–14 delaying Article 17(1) disclosure  711–13 ongoing issuer disclosure and Article 17(1) 709–11 selective disclosure (Article 17(8))  713–14 SME segment  714 market manipulation prohibition  717–25 accepted market practices  721–24 buy-backs 724–25 identification of market manipulation  717–21 liquidity contracts  721–24 rationale for  683–84 stabilization 724–25 regulatory context  679–80 rulebook 692–93 administrative rules  692–93 legislation 692–93 soft law  692–93 scope 693–96 financial instruments and commodities  694–95 jurisdictional scope  695–96 venues 695 supervision and prevention  725–31 context 725–26 NCAs 726–28 orders reports  731 suspicious transactions  731 supervisory co-operation  728–29 ESMA 729–31 market access multilateral trading facilities  486–87 trading venues  483–84 market discipline credit rating agencies  666–68 market efficiency theory 74–75 market failures  3–5, 75–76, 77–78, 207–8, 348, 349, 518, 684, 756–57, 767 market finance  11–17, 78–82 see also capital-raising

926 Index market funding  16–17, 81, 95–96n.194, 108–9, 228–29, 228n.866, 331n.597 market integration EU financial market  6–17 Capital Markets Union (CMU)  11–17 financial market integration  11–17 law, role of  6–10 market finance  11–17 single market  6–10 treaties 6–10 market finance and  78–82 see also Single Market market intensity 370 market-making definition  169n.530, 370n.145, 543n.84 MiFID II/MiFIR  543 Short Selling Regulation  562–64 market manipulation accepted market practices  721–24 buy-backs 724–25 definition 740–41 identification of  717–21 liquidity contracts  721–24 prohibition on  717–25 rationale for  683–84 stabilization 724–25 market monitoring  40, 316–17, 412, 423–24, 452–53, 491–92, 519–20, 570, 582–83, 666–67, 671n.254 abusive conduct and  484, 487 multilateral trading facilities  487 trading venues  484 market resilience 479 liquidity and  480–83, 485–86 multilateral trading facilities  485–86 trading venues  480–83 market soundings  86n.142, 199n.675, 681n.20, 688– 89, 691n.88, 692–93, 693n.101, 705–7, 714 definition 707n.160 market structure credit rating agencies  666–68 marketing communications definition 789n.220 MiFID II/MiFIR  788–89 Markets in Crypto-Assets Regulation (MiCAR)  75n.67, 215–16, 215n.774, 442n.6 Markets in Financial Instruments Directives I and II see MiFID I; MiFID II/MiFIR regime master-feeder funds  247, 263–64, 270 UCITS structures  270 matched principal trading: definition 474–42nn.185–6 maximum harmonization  93–94, 168, 303, 362, 733 media dissemination 720–21 see also social media Member State of origin principle 764–65 Memorandum of Understanding (MoU) 906–7 multilateral (MMoU)  729n.281

mergers and acquisitions (M&As)  71n.32, 111, 240n.58, 249n.122, 366–67n.123, 712n.181, 713n.189 UCITS mergers see UCITS Mergers and Master-Feeder Directive 253–54, 270n.228 Mergers and Takeovers Delegated Regulation 99– 100, 110n.265 Meroni ruling/doctrine  23n.137, 27n.160, 41–43, 46–47n.254, 576, 614, 646–47, 655, 668, 672, 673–74, 749, 816–17, 821–22 MiFID I competition 450–54 concentration 450–54 market impact  454–55 MiFID II/MiFIR and  355–60 review of  357–60, 456–58 MiFID II/MiFIR regime algorithmic trading  540–43 authorization process  375–83 firm governance requirements  378–81 home NCA  375–77 investor compensation schemes  383 jurisdiction to authorize  375–77 minimum initial capital  378 operational requirements  382 organizational structure  382 ownership structure  381–82 calibration under  369–75 client classification  372–75 exemptions 369–72 classification 785–87 commodity derivatives market  544–50 commodity derivatives trading agenda  544–47 ESMA powers  549–50 MiFID II/MiFIR  544–47 position limits  547–49 position management  547–49 quick fix reforms (2021)  544–47 conflict of interest management  388–93, 801–8 administrative rulebook  391–93 commissions 801–4 independent investment advice  804–6 inducements 801–4 legislative regime  388–90 regulatory intervention  806–8 coverage 777–78 CRD IV/CRR regime  429, 533–34 derivatives trading obligation  633–35 differentiation under  369–75 client classification  372–75 exemptions 369–72 disclosure 790–91 enforcement 518–19 EU investment firm rulebook  351–53 beyond MiFID II/MiFIR  353 organization of coverage  353 summary 351–53 evolution of  354–62 Financial Services Action Plan  355–57

Index  927 global financial crisis  355–61 initial developments  354–55 Investment Services Directive (1993)  354–55 legislative reform  360–61 MiFID I  355–57 MiFID I review  357–60 MiFID II negotiations  357–60 prudential regulation  360–61 sustainable finance  361–62 technocracy 360–61 fair treatment  787–88 high frequency trading  540–43 history of  778–85 Capital Markets Union  780–82 global financial crisis  780–82 ISD 778–80 IFD/IFR regime  429, 533–34 intermediation process  347–51 investment firms/services  347–440 regulation 347–51 investment services third country regime  877–85 cross-border service provision  880–83 dynamic and intensifying regime  877–78 export effects  884–85 market access  877–84 reverse solicitation  883–84 third country branches  878–80 ‘know-your-client’ rules  792–808 appropriateness 792–98 execution-only and direct trading  800–1 execution-only distribution  798–800 suitability 792–98 market-making 543 marketing communications  788–89 NCAs 429–33 delegation 429–30 designation 429–30 supervisory cooperation  431–33 supervisory and investigatory powers 430–31 negotiations 458–60 operating conditions: conduct regulation  393–94 multi-layered regime  383 trading rules  394 trading venues  394 transaction reporting  394 operationalization of  460–62 order execution process  534–40 best execution  534–39 order handling  539–40 payment-for-order-flow 534–39 order execution venues: asset classes  469–70 bilateral systems  469 bilateral trading  466–67 enforcement 518–19 financial instruments  469–70 MiFID III/MiFIR 2 proposal (2021)  460–64

MiFIR Article 26  519–20 multilateral systems  467–69 multilateral trading  466–67 negotiations 458–60 proposals 456–58 regulatory design  466–70 scope 466–70 supervision 518–19 ‘traded on a trading venue’  467–69 organizational and conduct requirements  383–88 administrative rulebook  385–88 legislative regime  383–85 passport mechanism  425–29 home NCA  425 host control  426–27 host NCA  426–27 notification process  427–29 passport rights  425 product governance  809–16 evolution of regime  809–11 experience with  814–16 reform 814–16 regime 811–14 product intervention  816–25 ESMA intervention powers  821–25 history of regime  816–17 NCA intervention powers  817–21 proposals 456–58 MiFID III/MiFIR 2 proposal (2021)  460–64 regulation of trading  533–50, 755–59 regulatory context  777–78 retail distribution  777–78 retail markets  777–827 retail participation  759–62 review 462–64 rulebook  362–64, 770–77 administrative rules  362–64, 770–77 ESMA 776–77 legislation  362–64, 770–77 silos 772–76 soft law  362–64, 770–77 supervisory convergence  776–77 scope  364–69, 782–83 financial instruments  367–69 functional approach  364–65 investment services and activities  365–66 segmentation 785–87 technological innovation  783–85 supervision 518–19 supervisory framework  429–34 ESMA 433–34 NCAs 429–33 sustainable finance  769–70 transaction reporting: MiFIR Article 26  519–20 transparency regulation: equity markets, impact of  502–3 non-equity markets  510–11 see also transparency regulation

928 Index minimum initial capital 378 minimum harmonization  18–19, 114–15, 156, 158–59, 160, 167–68, 171, 355–56, 738, 764, 825–26, 844n.490, 846, 847 minimum standards  80–81, 154n.456, 187, 188, 194, 196–97n.659, 261, 280, 303n.408, 310–11, 376, 584, 661, 732, 735, 750–51, 764, 789, 843 money-market funds (MMFs) 338–45 liquidity crisis (March 2020)  343–45 liquidity risks and  338–39 reform 343–45 regulation 340–43 see also UCITS regime money-market instruments: definition 367n.126 MTFs see multilateral trading facilities multilateral trading 466–67 facilities see multilateral trading facilities systems 467–69 concept  468–69, 471n.169 definition  467, 468 multilateral trading facilities (MTFs) definition 472 equity markets  493–99 deferred publication  499 post-trade transparency  498–99 pre-trade transparency  493–98 non-equity markets  503–9 deferred publication  509 post-trade transparency  508 pre-trade transparency  503–8 trading venues  485–88 abusive conduct  487 admission to trading  487–88 authorization 485 liquidity 485–86 market access  486–87 market monitoring  487 market resilience  485–86 ongoing requirements  485–88 operational requirements  485–86 transparency requirements  487 venue classification  472 see also transparency regulation mutual recognition principle 376   national competent authorities (NCAs) host NCA, definition of  425n.407 investment firms/services  375–77 home NCA  425 host NCA  426–27 Market Abuse Regulation: supervision and prevention  726–28 product intervention: in action  819–21 powers 817–19 Prospectus Regulation: designation of home NCA  138–40

Short Selling Regulation: experience with the exceptional powers of intervention 576–82 NCA action  578–82 NCA powers  573–74 overview 576–78 Transparency Directive: supervision 172–74 UCITS regime  290 NCAs see national competent authorities ne bis in idem principle 733 Net Asset Value (NAV)  195, 233, 244, 469n.158, 868–69 Net Position Risk (NPR)  405n.316, 407n.324, 408–9 Net Stable Funding Requirement (NSFR) 418 new governance 638 non-discrimination principle  197, 852–53, 903–4 non-equity markets bilateral/OTC segment  509–10 deferrals 510 investment firms  510 post-trade transparency and deferrals  510 pre-trade transparency and SIs  509–10 SIs 510 deferred publication  509 impact 510–11 MiFID II/MiFIR review  510–11 MTFs 503–9 OTFs 503–9 post-trade transparency  508 pre-trade transparency  503–5 liquidity waiver  506–7 NCA suspension power  471–72 SSTI waiver  507–8 waiver system  505–6 waivers 505–8 RMs 503–9 see also equity markets; transparency regulation non-financial counterparties: definition 586n.340 Non-Financial Reporting (NFR) Directive 59–60, 61, 155, 159, 176, 185n.606, 212–14 Notification and Information Exchange Regulation 253–54   offer of securities to the public: concept 103 official listing admission of securities to trading  196–97 concept  193–94, 196–97 see also admission to trading Omnibus Directive  189n.624, 190n.630 Omnibus Regulation  189n.624, 190n.630 order execution venues 441–527 authorization 488–89 abusive conduct  487 admission to trading  487–88 liquidity 485–86 market access  486–87 market monitoring  487 market resilience  485–86 MTFs 485

Index  929 ongoing requirements  477–88 OTFs 488 operational requirements  485–86 regulated markets  478–79 transparency requirements  487 background 441–42 competitive 491–92 CSDR 523–27 data distribution and consolidation  511–18 CTP 516–18 data publication  513 DRSPs, regulation of  514–16 enhancing the data framework  511–13 MiFID III/ MiFIR 2 Proposal (2021) 516–18 dealing on own account  489 enforcement 518–23 MiFID II framework  518–19 EU regulation  449–50 evolution of venue regime  450–64 flexible regime  477–78 MiFID I  454–55 competition 450–54 concentration 450–54 market impact  454–55 review of  456–58 MiFID II/MiFIR  534–40 asset classes  469–70 best execution  534–39 bilateral systems  469 bilateral trading  466–67 financial instruments  469–70 multilateral systems  467–69 multilateral trading  466–67 negotiations 458–60 order handling  539–40 payment-for-order-flow 534–39 proposals 456–58 regulatory design and scope  466–70 ‘traded on a trading venue’  467–69 MiFID III/MiFIR 2 proposal (2021)  460–64 data distribution  516–18 MiFID II/MiFIR review  462–64 post-trading 523–27 regulation of  442–50 regulation 445–47 trading process  442–45 transparency 447–49 venue regulation  447–49 settlement process  523–27 share trading obligation  489–91 supervision 518–23 MiFID II framework  518–19 transaction reporting  519–23 administrative amplification  520–22 convergence 522–23 cooperation 522–23 ESMA 520–22 FIRDS system  520–22

MiFIR Article 26  519–20 supervisory coordination  522–23 see also trading venues ordinary legislative procedure (OLP) 23–24 Organization for Economic Co-operation and Development (OECD)  91n.167, 107n.252, 448n.41, 649n.90, 856–57, 867n.97, 878–79 Organized Trading Facilities (OTFs) MTFs and  503–9 deferred publication  509 post-trade transparency  508 pre-trade transparency  503–8 RMs and  503–9 deferred publication  509 post-trade transparency  508 pre-trade transparency  503–8 trading venues: authorization 488 ongoing regulation  488 venue classification  472–74 discretion, exercise of  473–74 regime 472–73 OTC instruments see over-the-counter instruments OTFs see Organized Trading Facilities over-the-counter (OTC) instruments derivatives: definition 613n.490 EMIR see European Market Infrastructure Regulation order execution venues  488–89 dealing on own account  489 systematic internalizers  488 share trading obligation  489–91 own-account dealing  364n.112, 366, 370, 389, 392– 93, 394–95, 400–2, 403, 404, 405–6, 409n.339, 412, 414–15, 416, 534n.23, 562–63 definition 366 order execution venues  489 own funds: definition 405–6 ownership reporting 656n.149   packaged product disclosure  765–66, 772–73, 811n.321, 830–31 Packaged Retail and Insurance-based Investment Products see PRIIPs regulation Packaged Retail Investment Products (PRIPs) 766–67 pandemic see Covid-19 pandemic parity principle 23–24 Parmalat scandal  204n.716, 639n.16 payment-for-order-flow: MiFID II/MiFIR 534–39 peer review  31–32, 34–36, 39–40, 49–50, 52–53, 57n.317, 103, 115, 116, 148–49, 150–51, 173– 74, 185–86, 275–76, 291–93, 314n.495, 340, 377, 388, 433–34, 558–59, 563–64, 582n.312, 583, 600n.415, 620–21, 623–24, 631–32, 730–31, 776–77, 796 pension schemes  49n.261, 586n.340, 588n.349, 603, 604, 605, 830

930 Index portfolio management  245, 251–52, 256n.178, 257, 266, 270–72, 273, 274, 283n.290, 306, 308n.443, 314, 315, 341–42, 354n.45, 361–62, 374–75, 391–92, 535n.35, 587, 771n.122, 784n.196, 791n.231, 792–93, 865–66n.88 definition 366 post-trading 523–27 precautionary powers: Prospectus Regulation 144 precautionary principle 171 pre-marketing: definition 311n.466 precise: definition 701 price-formation mechanism  164, 680–82 price-sensitive information 703–4 see also insider dealing pricing mechanisms  76–77, 463n.130, 532–33, 568, 637–38 PRIIPs Regulation 828–41 context 828–29 coverage 828–29 definition  832–33, 838n.461 history of the PRIIPs regime  829–41 PRIIPs Regulation  829–31 PRIIPs KID: in action  838–41 distribution 836–37 enforcement 837 format of  834–36 redress 837 reform 838–41 RTS 2017/653  831–32 scope 832–34 prime broker: definition 313n.487 principles-based regulation  99–100, 103, 168n.518, 176–77, 194, 195, 200–1, 205n.720, 212–13, 226–27, 328, 329n.583, 354, 719–20, 741–42n.344 private enforcement  28, 30, 75–76, 151–52, 732n.292, 776 see also civil liability private equity funds  16n.95, 70–71, 85–86, 222, 228–29, 267–68, 269n.225, 296, 298–99, 302, 304–6, 324, 530n.6 see also Alternative Investment Fund Managers Directive private placements  69n.25, 72–73, 86n.142, 91–92, 93, 95, 98n.203, 106–9, 129, 295–96, 706–7, 863–64, 866 product governance see MiFID II/MiFIR regime product intervention 816–25 ESMA intervention powers  821–22 in action  823–25 MiFIR regime, evolution of  816–17 NCA intervention powers  817–19 in action  819–21 product-specific initiatives 828 professional clients  348–49, 360–61, 372–73, 391, 393–94, 825 definition  107–8, 786–87 MiFID II  107–8, 329n.582, 332n.603, 374–75, 390, 786–87, 790, 793n.239, 832–33, 880–81, 883–84 professional investor: definition 329n.582

proportionality principle  9, 22–23, 35–36, 40–44, 55, 57, 111–12, 278, 303, 305, 312–13, 386, 395–96, 399, 402, 404, 423, 437–38, 566–67, 601n.418, 655, 658, 662n.191, 665–66, 667, 675n.280, 705n.147, 733–34n.304, 741–42n.344, 746–47, 814–15, 824 proprietary dealing  203, 347, 349–50, 358, 459–60, 474, 475–76, 529, 881 Prospectus Directive  68–69, 78–79, 78n.89, 80–81, 82, 84, 85–86, 94–96, 101, 107, 111–12, 112n.273, 113n.276, 122n.315, 129n.347, 131– 32, 134, 136, 144–45, 146, 152–54, 157–58, 160, 163, 175n.544, 767, 860–61, 870 FSAP period  92–94 Prospectus Regulation 90–155 administrative rules  99–101 advertising 144–46 base prospectus  120–22 calibration 120 Covid-19 Recovery Prospectus  127–29 differentiation 120 disclosure 111–17 core obligation  111–12 final price  115–16 incorporation by reference  116–17 omission of information  115–16 risk factors  112–13 rulebook 113–15 dissemination 118–19 evolution 90–99 Capital Markets Union  95–97 characteristics 97–99 FSAP period  92–94 global financial crisis  94–95 initial efforts  90–92 Prospectus Directive (2003)  92–94 reforms (2010)  94–95 exempted transactions  109–11 format 117–18 multiple prospectuses  120–38 frequent issuers  110–11, 120–29 issuers, concept of  162 legislation 99–101 market integration and passport mechanism 138–44 designating the Home NCA  138–40 language regime  143–44 precautionary powers  144 prospectus approval  140–41 prospectus passport and notification  141–43 private markets and placements  106–9 public offers  103 publication 118–19 regulated markets  104–5 retail markets: summary 133–38 rulebook 99–101 securities 105–6 concept of  162 simplified disclosure regime  125–27

Index  931 SMEs: EU Growth Prospectus  130–33 soft law  99–101 standard form  117–18 supervision and enforcement  146–55 enforcement and civil liability  151–55 NCAs 146–47 supervisory convergence and ESMA  148–51 supervisory cooperation  147–48 supplements 119 third countries: prospectus regime  869–71 Transparency Directive  162 Universal Registration Document (URD)  122–25 validity 120 wholesale debt markets disclosure regime  129–30 prospectuses market integration  138–44 prospectus approval  140–41 prospectus passport and notification  141–43 prudential regulation 394–424 capital assessment see CRD IV/CRR regime conduct see conduct regulation distinctive regime  394–96 evolution of regime  397–402 CRD package  397–400 IFD/IFR regime  400–2 origins 397–400 Investment Firm Directive/Regulation see IFD/IFR regime MiFID II see MiFID II/MiFIR regime SREP process  434–38 CRD IV/CRR  434–36 IFD/IFR 437–38 public disclosure 568–72 CRD IV/CRR regime  423–24 IFD/IFR regime  412 public equity markets  16, 71–72, 73, 81, 85, 86n.138, 89n.161, 222, 228–29 public good concept 180–81 European notion of  184n.599 public interest  8–9, 31–32, 41–43, 116, 155, 176n.547, 181, 212, 445, 457n.92, 712–13 public offers  16n.95, 70–71, 72, 74n.59, 75–76, 91–92, 103, 130–31, 132, 135–36, 216n.781, 757n.12, 869–70 public offer of securities, definition of  83, 91–92, 103n.235, 107–8 Public Offers Directive  83–84, 91, 103n.235 public reporting obligation  159–60, 177–78, 293, 423–24, 438–39, 568–29nn.230–1 fitness check  156n.464 public statistics 698n.121   Q&As  21, 35–36, 44, 47, 101, 103, 122, 131–32, 161, 242, 254–55, 352, 363–64, 383, 433, 466, 476n.194, 492–93, 496–97, 522–23, 533, 560, 601, 631–32, 651, 668–69, 670, 690–91, 693, 720, 776–77, 780–81, 796, 832

qualified investor: definition 107–8 Qualified Majority Vote (QMV)  24n.144, 53–55, 358n.73 qualifying portfolio undertakings: definition 328– 29, 333–34 qualifying shareholdings 627 quasi-equity security: definition 328n.576   rated entity concept 652n.117 definition 652n.117 rating agency regime see credit rating agencies ratings outlooks: definition 652n.115 rationality  74n.63, 77 real asset: definition  334n.611, 337 real estate investment trusts (REITs) 267 ‘reasonable investor’  212, 697n.116, 702, 710, 711n.176 record-keeping  129, 206–7, 275n.243, 276n.254, 280, 281, 314n.488, 320–232nn.528–9, 372n.158, 382, 384–85, 386–88, 392–93, 426–27, 526n.450, 539n.59, 558–59, 623n.535, 627, 657–59, 663, 679, 727, 741–42n.344, 745, 790n.223, 846 regulated information: concept 187 regulated markets (RM) admission of securities to trading  194–96 concept  104–5, 193, 450n.46 definition  104, 193–94, 468n.151 non-equity markets  503–9 deferred publication  509 post-trade transparency  508 pre-trade transparency  503–8 order execution venues  477–85 admission of financial instruments to trading  485 abusive conduct  484 authorization 478–79 flexible regime  477–78 liquidity 480–83 market access  483–84 market monitoring  484 market resilience  480–83 ongoing regulation  479–85 operational requirements  479–80 suspension and removal of instruments  485 transparency rules  484 perimeter control  193–94 Prospectus Regulation  104–5 trading venues: authorization and ongoing regulation  477–85 transparency regulation  493–99 deferred publication  499 post-trade transparency  498–99 pre-trade transparency  493–98 waivers see waivers regulation see securities and markets regulation regulatory barriers  8, 9, 85–86, 240–41, 301, 330 regulatory competition  18–19n.115, 80–81, 139–40, 258n.182

932 Index regulatory design Benchmark Regulation  742–43 CRD IV/CRR regime  413–14 ELTIF 332–33 MiFID II/MiFIR regime  466–70 order execution venues  466–70 regulatory divergence  8, 9, 97–98, 160, 902, 905–6 regulatory intervention  8, 16–17, 21–22, 85, 216–18, 235, 645–46, 807–8, 847 investment advice market and  806–8 regulatory reforms  14–15, 87, 89–90, 95–96, 127, 192, 233n.19, 443, 449n.42, 764 Regulatory Technical Standards (RTSs)  21, 352n.31, 360, 692–93 remuneration policy  60–61n.334, 206–7, 254–55, 277–78, 307, 312–13, 360n.83, 361–62n.92, 364n.107, 379, 380–81, 410–12, 420, 421–22, 627, 802–3 reputational capital  76, 202–3, 638–40, 641–42, 663–64n.200 research see investment research residential-mortgage-backed securitizations (RMBS) 223n.830 resilience market see market resilience UCITS regime see UCITS retail cascades 101n.230 retail investor: definition  332n.603, 832–33 retail markets 755–847 AIFMD 324–25 Capital Markets Union  759–62, 767–69 challenges 762–64 digital finance  769–70 discrete regulation  335–36 distribution patterns  762–64 ELTIF 335–36 EU regulation, evolution of  764–65 initial developments  764–65 FSAP 765–66 global financial crisis  766–69 pre-global financial crisis period  765–66 investor compensation see Investor Compensation Schemes Directive MiFID II/MiFIR see MiFID II/MiFIR regime PRIIPs see PRIIPs Regulation Prospectus Regulation  133–38 UCITS regime  284–85, 288–90 protection 244–45 reverse solicitation: MiFID II/MiFIR 883–84 rights issues  94–95, 125, 126 ring-fencing proposals 530 risk conflicts of interest see conflicts of interest see also Risk Dashboard; risk management; risk monitoring; risk-spreading rules; risk-taking; risk-to-client (RtC); risk-to-firm (RtF); risk-tomarket (RtM); risk-weighting of assets (RWA); systemic risk Risk Dashboard  590n.358, 619n.518

risk management AIFMD 315–19 CRD IV/CRR regime  418 macroprudential 316–19 non-CCP-cleared derivatives  616 UCITS regime  271–72 risk monitoring: ESMA 51–52 risk-spreading rules 268–69 principle of risk-spreading  255, 268–69 risk-taking  277n.259, 313n.479, 347–48, 349n.15, 358, 378, 420, 422–23, 530, 617, 792n.237, 800–1 risk-to-client (RtC)  360, 403, 406–7 risk-to-firm (RtF)  403, 406–7 risk-to-market (RtM)  406–7, 408n.332 risk-weighting of assets (RWA)  397n.275, 397n.277, 413, 845 RM see regulated markets   sanctions administrative see administrative sanctions criminal 735–38 Sarbanes-Oxley Act (US) 203n.709 secondary markets  67, 73–74, 76–77, 96n.195, 103n.237, 191–92, 250n.134, 305n.426, 338–39, 352n.33, 442n.9, 443, 452–53, 487–88, 523, 563n.205, 833n.428 second-tier markets 88n.154 securities definition 105–6 see also capital-raising; equity markets Securities and Exchange Commission (US) 71n.39, 74–75, 251n.135, 446n.28, 538n.50, 851–52 Securities Financing Transactions Regulation (SFTR) 584–89 EU and  584–86 experience with the SFTR  588–89 regulation 586–88 securities and markets regulation enforcement see enforcement evolution: FSAP see Financial Services Action Plan financial crisis see global financial crisis (GFC) harmonization see harmonization single market see single market supervision see supervision see also law-making process securitization products credit rating agencies  665 mortgages 223n.830 Segré Report  7–8, 11, 17–20, 78–79, 80–81, 246, 354, 686, 764 self-regulation  197, 638, 641–42, 644–45, 898n.258 senior management: definition 656n.152 shadow banking  235–36, 237–31nn.31–2, 238–31nn.42–3, 251n.138, 273–31nn.235–6, 316n.505, 340 share capital: definition 569n.233

Index  933 shareholders communications 166–67 definition 168n.523 shareholders: qualifying holdings  381–82, 479 shares: Short Selling Regulation 569–71 short-form disclosure 284–85 Short Selling Regulation 551–84 enforcement 583 ESMA powers: ESMA as a data-hub  572 experience with the exceptional powers of intervention 582–83 intervention in exceptional circumstances 575–76 EU and  551–54 extraterritorial reach  583–84 history of  554–59 Gamestop 557–59 global financial crisis  554–59 intervention in exceptional circumstances  573–83 ESMA powers  575–76 NCAs 576–82 action 578–82 overview 576–78 powers 573–74 public disclosure  568–72 rulebook 559–61 administrative rules  559–61 legislation 559–61 soft law  559–61 scope of  561–64 market-making exemption  562–64 supervision 583 supervisory reporting  568–72 transparency: dissemination 572 ESMA as a data-hub  572 net short positions  568–72 regime 568–69 shares 569–71 sovereign debt  571–72 uncovered short sales  564–68 ‘locate’ rule  564–66 prohibition 564 shares and the sovereign debt crisis  565–66 uncovered sovereign CDSs  566–68 SIs see Systematic Internalizers simplified disclosure regime Prospectus Regulation  125–27 Single European Act  83–84, 354–55 single market 6–10 Single Resolution Mechanism (SRM) 396n.270 Single Supervisory Handbook 49–50 Single Supervisory Mechanism (SSM) 14–15, 27–1nn.160–1, 29–30, 55, 395, 396n.267, 396n.270, 415–16, 429, 434, 436, 624–25 size specific to the instrument (SSTI) 505–6 concept 509–10

deferrals 509n.356 waiver  506, 507–8, 509, 510–11 SMEs (Small and Medium-Sized Enterprises) admission to trading  198–202 agenda 87–90 definition  87n.146, 105n.246, 131–32, 199–200, 323n.549, 328–29 disclosure obligations  714 EU Growth Prospectus  130–33 Growth Markets: admission of securities to trading  198–202 Transparency Directive  162–63 social entrepreneurship funds  1–2, 231, 234–35, 326, 330 social media crowdfunding and  216n.781 disclosure, effect on  758–59, 769–70 marketing  784–85, 789n.220 technological innovation  783 dissemination of information  720–21, 770n.120 false/misleading 689n.79 gamification techniques  789n.220 influencers, effect of  758n.26, 783n.191, 788, 789n.220 investment recommendations  776n.153 mass trading campaigns  538n.49, 552–53 NCA action  579–80 retail investors, coordination by  538n.49, 552–53, 684n.38, 720–21, 755–56, 800–1 retail market regime  62–63 see also crowdfunding; Gamestop/meme-stock episode; media dissemination; tradingapps soft law AIFMD 303–4 credit rating agencies  650–51 EMIR 600–2 Market Abuse Regulation  692–93 MiFID II/MiFIR  770–77 rulebook 362–64 Prospectus Regulation  99–101 Short Selling Regulation  559–61 Transparency Directive  160–62 UCITS regime  253–55 venue rulebook  464–66 Solvency II regime  15n.89, 222n.824, 833n.429 sovereign debt crisis 571–72 ratings 663–64 definition  470n.162, 562n.199, 571n.248 sovereign issuers: definition  470n.162, 562n.199 sovereign ratings  663–64, 873n.134, 874n.140 definition 664n.204 spot commodity contracts: definition 698n.120 SREP see supervisory review and evaluation process SRM (Single Resolution Mechanism) 396n.270 SSM see Single Supervisory Mechanism SSTI see size specific to the instrument

934 Index stabilization  169, 223–24, 344n.679, 392–93, 683–84, 687n.71, 692–93, 736 destabilization of markets  482n.228 market manipulation  724–25 of securities, definition  725n.257 see also financial stability stakebuilding: definition 709n.164 standard market size (SMS) 500–1 stock exchanges  146, 146n.417, 190n.632, 193–94, 441, 443, 445, 450–51, 452–53, 471–72, 481n.224, 766n.89 stress testing  40, 59n.327, 63n.352, 225n.844, 226n.854, 239–31nn.47–8, 242, 252, 254–55, 272, 292, 300–1, 315–16, 342–43, 345, 380–81, 424, 435–36, 578–79, 601–2, 620–21, 623–24, 629–30, 891–92 structural reforms  530, 804–5 structured finance  237n.31, 458–59, 469–70, 472–73, 474, 475, 504–5, 508, 509, 510, 640–41, 647–48, 651–52, 665n.208 products, definition of  470n.160 subsidiarity principle  9, 22–24, 55, 56n.309, 150–51n.438 Substantial Shareholdings Directive  83–84, 157 suitability: ‘know your client’ rules 792–98 super-equivalence  160, 187 Super Tuesday  24n.145, 831n.413 supervision AIFMD 325–26 Benchmark Regulation  748–50 CCPs 619–30 CCP rulebook  626–30 institutional framework  619–26 TRs 630–32 cooperation see supervisory co-ordination convergence see supervisory convergence EU financial markets governance  26–30 EU 26–29 supervisory and enforcement framework 29–30 financial markets regulation  52–55 centralized supervision  53–55 Market Abuse Regulation  726–31 NCAs 726–28 orders reports  731 MiFID II supervisory framework  429–34 ESMA 433–34 NCAs 429–33 delegation 429–30 designation 429–30 supervisory and investigatory powers  430–31 supervisory cooperation  431–33 order execution venues  518–23 Prospectus Regulation  146–55 Short Selling Regulation  583 SSM see Single Supervisory Mechanism supervisory reporting see supervisory reporting Transparency Directive  172–74 convergence 172–74

cooperation 172–74 NCAs 172–74 UCITS regime  290–94 see also European Securities and Markets Authority; European Systemic Risk Board; national competent authorities supervisory convergence ESMA and  148–51, 729–31 financial markets regulation  49–51 MiFID II  433–34 UCITS regime  291–93 IFRS regulation  184–86 Market Abuse Regulation  729–31 MiFID II/MiFIR  776–77 Prospectus Regulation  148–51 transaction reporting  522–23 supervisory cooperation Market Abuse Regulation  728–29 MiFID II framework  431–33 NCAs 431–33 Prospectus Regulation  147–48 transaction reporting  522–23 UCITS regime  290–91 supervisory reporting AIFMD 321–23 CRD IV/CRR regime  423–24 credit rating agencies  662–63 IFD/IFR regime  412 Short Selling Regulation  568–72 supervisory review and evaluation process (SREP) prudential supervision  434–38 CRD IV/CRR  434–36 IFD/IFR SREP  437–38 supranational organizations  107–8, 373n.167, 374n.170, 674, 852n.16, 855 suspicious transaction reports  689, 692–93, 728, 730–31 Market Abuse Regulation  731 sustainability-related risks CRD IV/CRR regime  424 IFD/IFR regime  412 sustainable finance benchmarks and  750–51 collective investment management  243 credit rating agencies  676–78 financial markets regulation  58–62 issuer disclosure  210–14 MiFID II/MiFIR  361–62, 769–70 sustainable investment: definition 61n.335 Systematic Internalizers (SIs) deferrals 501–2 definition  465n.138, 467 equity market  501–2 investment firms and  501–2, 510 order execution venues  488 post-trade transparency  501–2 pre-trade transparency  499–501, 509–10 venue classification  475–77

Index  935 systemic risk  2, 3nn.17–18, 40, 251n.135, 295–96, 303n.412, 304, 305, 306, 308, 317, 319n.522, 322, 349n.16, 372, 378n.191, 404, 419–20, 424–25n.406, 445, 514, 529, 590, 593–94, 595, 604, 605–6, 607n.456, 609–10, 617, 620, 670–71, 753n.414, 841–42, 868–49nn.104–5, 868n.109, 869, 897   takeovers  99–100, 111, 708–9 Technical Expert Stakeholder Group (TESG)  23n.139, 89n.157 technocracy collective investment management  236–43 MiFID II/MiFIR  360–61 technological innovation financial markets regulation  62–65 MiFID II/MiFIR  783–85 terrorism anti-terrorism financing standards  329n.580, 334n.615 financing rules/standards  217n.788, 856–57, 867n.96, 867n.97, 868n.105 September 11th (2001) WTC attacks  687, 729n.281 third countries 849–909 Benchmark Regulation  894–99 benchmark administrators  896–99 benchmarks 896–99 CCP access and  887–93 EMIR 2.2 reforms  888–90 EMIR 2.2 regime  890–93 original model  887–88 Central Securities Depositaries  894–99 CSDs and third countries  894–96 collective investment management regime 864–69 AIFMD passport  866–69 delegation 864–66 sector 864–66 Commission 858–60 EMIR and  885–94 EMIR 2.2 reforms  888–90 EMIR 2.2 regime  890–93 global derivatives markets  893–94 OTC derivatives markets  885–87 trade repositories  893 ESMA 858–60 EU financial market, access to  852–58 access system  852–55 equivalence regime  855–58 historical development  860–64 institutional context  858–60 international financial markets  849–52 access to  850–52 background 849–50 investment services regime and  877–85 issuer disclosure regime  869–72 ongoing disclosure and IFRS  871–72 prospectus regime  869–71

MiFID II/MiFIR: cross-border service provision  880–83 dynamic and intensifying regime  877–78 export effects  884–85 market access  877–84 reverse solicitation  883–84 third country branches  878–80 rating agency regime  873–77 certification 873–75 endorsement 873–75 legislative scheme  873–75 third country regime in practice  875–77 third country firms, definition of  878n.163 Trade and Cooperation Agreement (TCA)  899–909 origins 900–3 provisions 903–5 UK 905–9 UK as a third country  899–909 third country regime and the UK  905–9 tied agents: MiFID II  311, 383, 384, 390, 427–28, 430 tracker funds 269 Trade and Cooperation Agreement (TCA) 899–909 historical development  900–3 provisions 903–5 third country regime and the UK  905–9 trade repositories (TRs) definition 602n.430 EMIR 893 infrastructure regulation and supervision  630–32 trading 529–635 apps see trading apps book see trading book EMIR see European Market Infrastructure Regulation (EMIR) MiFID II/MiFIR see MiFID II/MiFIR regime OTC derivatives market see European Market Infrastructure Regulation (EMIR) regulating trading  529–31 EU and  531–33 rules 394 short-selling see Short Selling Regulation venues see trading venues see also Securities Financing Transactions Regulation (SFTR) trading apps  4–5, 62–63, 348, 389, 538–39, 756–57, 761, 762, 769–70, 783–84, 800–1 trading book concept  169, 416n.365 definition  408n.332, 416n.365 risk 416–18 Trading Counterparty Default (TCD) 405n.316, 407n.324 K-TCD 408–9 trading venues authorization 478–79 capital-raising and  190–92 classification see venue classification concepts 193–94 definition 561–62

936 Index trading venues (cont.) EU regulation  449–50 flexible regime  477–78 formal vs informal  441n.1, 443, 444, see also ‘dark’ trading Market Abuse Regulation  695 ongoing regulation  479–85 abusive conduct  484 admission of financial instruments to trading 485 liquidity 480–83 market access  483–84 market monitoring  484 market resilience  480–83 operational requirements  479–80 suspension and removal of instruments  485 transparency rules  484 operating conditions  394 order execution venues see order execution venues rulebook 464–66 administrative rules  464–66 legislation 464–66 soft law  464–66 ‘traded on a trading venue’  467–69 concept of  520n.410 venue regulation  447–49 see also transparency regulation transaction reporting 519–23 administrative amplification  520–22 convergence 522–23 cooperation 522–23 ESMA 520–22 FIRDS system  520–22 MiFID II  394 MiFIR Article 26  519–20 supervisory coordination  522–23 Transaction Reporting Exchange Mechanism (TREM) 521–23 transferable securities definition  105–6, 255n.168, 265 UCITS regime  264–66 translation regime  130, 261n.203 transparency see Transparency Directive; transparency regulation; transparency requirements Transparency Directive 155–75 ad hoc disclosure: market abuse regime  175 administrative rules  160–62 differentiation 162–63 enforcement 174–75 administrative sanctions  174–75 civil liability  174–75 evolution 156–60 Amending Directive (2013)  158–59 Capital Markets Union  159–60 Directive negotiations (2004)  158 fragmented transparency  156–57

FSAP 157–58 global financial crisis era reform  158–59 initial efforts  156–57 limited transparency  156–57 exemptions 162–63 home mMember State control  171 issuer-disclosure regime  163–67 access to information for holders of securities admitted to trading on a regulated market 166–67 interim management statement  165–66 ongoing disclosure on rights attached to securities 166 periodic annual financial reports  163–64 periodic half-yearly financial reports  164–65 quarterly reporting  165–66 language regime  172 legislation 160–62 ongoing disclosure on major holdings  167–71 prospectus rules and: integrated regime  162 rulebook 160–62 scope 162 SMEs 162–63 soft law  160–62 supervision 172–74 convergence 172–74 cooperation 172–74 NCAs 172–74 transparency regulation 491–511 deferred publication  499, 509 equity markets  493–503 bilateral/OTC segment  499–502 impact 502–3 MTFs 493–99 OTFs 493–99 RMs 493–99 investment firms  501–2, 510 MiFID II/MiFIR review  502–3, 510–11 net short positions  568–72 non-equity markets  503–11 bilateral/OTC segment  509–10 impact 510–11 post-trade transparency: deferrals  501–2, 510 investment firms  501–2 MTFs  498–99, 508 OTFs  498–99, 508 RMs  498–99, 508 SIs 501–2 pre-trade transparency  493–94 MTFs  493–94, 503–5 OTFs  493–94, 503–5 RMs  493–94, 503–5 SIs  499–501, 509–10 waivers  494–98, 505–8 SIs  499–501, 509–10 transparency framework  491–93 competitive order execution  491–92

Index  937 transparency rulebook  492–93 transparency regime  568–69 see also waivers Treaty law: single market 6–10 Trends, Risks, and Vulnerabilities (TRV) 11n.66, 51n.278, 82n.115, 242, 251, 292, 525n.448, 560–61, 776n.150, 776–77n.154 Transatlantic Trade and Investment Partnership (TTIP) 886–87 ‘true and fair view’ principle 180–81 Turner Review  237n.31, 348n.7, 398n.279, 530–31, 594n.376   UCITS regime 244–94 AIFMD/UCITS (2021) proposal  252–53 asset allocation  263–74 dynamic regime  263–64 leverage 272–73 resilience of regime  273–74 risk management  271–72 collective investment management  235–36 definitions  257, 294 depositary: regime 280–82 UCITS V reforms and  278–80 disclosure 282–90 CIS 284–85 KIID/KID 284–87 prospectus and ongoing  282–84 retail markets  284–85, 288–90 short-form 284–85 eligible assets  264–68 CISs 266 deposits 266 financial derivatives  266–68 money-market instruments  264–66 transferable securities  264–66 enforcement 290–94 sanctions 293–94 evolution of  246–53 Capital Markets Union  252 early developments  246–47 financial stability  250–52 FSAP 247–48 global financial crisis era  249–50 post-FSAP 248–49 post-GFC period  250–53 UCITS III reforms  247–48 UCITS IV  248–49 UCITS/AIFMD (2021) proposal  252–53 investment limits: investment policies, disclosure of  270–71 investment policies  269–70 funds of funds  269–70 master-feeder funds  270 tracker funds  269 management company: authorization 259–60 ongoing regulation  274–78

organizational and conduct regulation  274–77 remuneration rules  277–78 UCITS V  277–78 market integration  257–63 authorization 257–60 management company  262–63 mergers 263 passport and notification  260–63 UCITS and  260–62 NCAs 290 regulatory context  244–45 EU context  245–46 retail market protection  244–45 risk-spreading rules  268–69 rulebook 253–55 administrative rules  253–55 legislation 253–55 soft law  253–55 scope of  255–57 defining features  255–57 exclusions 257 fund structure  256–57 redemption on demand  255–56 supervisory cooperation  290–91 supervisory convergence: ESMA 291–93 UCITS III reforms  247–48 UCITS IV  248–49 see also collective investment management uncovered short sales see Short Selling Regulation Universal Registration Document (URD) 122–25 Ukraine Russian invasion (2022): commodity derivatives markets  6, 19–20, 480– 81, 529, 626n.551 energy market, volatile effect on  532–33, 544n.89, 592, 607, 620n.522, 626n.551, 718n.217, 728n.275 ESMA 31 impact of  120n.308 issuers’ half-yearly reports  161 market volatility  70–71, 228–29, 232n.11, 372n.154, 446–47, 463–64, 480–81, 529, 532–33, 592, 599–600, 607, 626n.551, 689, 694n.104, 718n.217, 728n.275 sanctions against Russia  141n.398 Undertakings for the Collective Investment of Transferable Securities see UCITS regime Unfair Commercial Practices Directive 775n.146 United Kingdom (UK) EU withdrawal see Brexit FCA see Financial Conduct Authority market  507, 820–21n.358, 906–7 third country regime  905–9 Trade and Cooperation Agreement (TCA) 899–909 see also Trade and Cooperation Agreement (TCA) United Nations (UN): Sustainable Development Goals (SDGs) 210–11n.748

938 Index United States (US)  639n.13, 761n.42 economy 13–14 markets  13–14, 80n.103, 178, 225–67nn.841–1, 237n.31, 250n.133, 284–85, 327n.569, 447n.40, 448n.41, 512, 553n.140, 553–54n.142, 597–98, 641n.25, 685n.48 SEC see Securities and Exchange Commission   Value at Risk (VAR)  272n.232, 273, 322n.546, 398 Varieties of Capitalism (VoC)  11n.68, 16–17, 78, 145 venture capital funds  190–91, 236, 252, 326, 327n.567, 328–29, 330n.586 see also European Venture Capital Fund venue classification 470–77 classification system  470–71 investment firms  477 MTFs 472 OTFs 472–74 discretion 473–74 regime 472–73 regulated markets (RMs)  471–72 SIs 475–77 venue regulation see trading venues

waivers liquidity 506–7 NCA suspension power  471–72 pre-trade transparency  494–98, 505–8 SSTI 507–8 system 505–6 see also transparency regulation Washington G20 Summit  5n.32, 298, 446n.27, 763n.62 welfare concerns  7n.43, 347, 755n.1, 757–58, 759–60 whistle-blowing  430–31, 658–59, 731n.287, 837n.456 wholesale debt markets  107, 111–12, 123n.320 disclosure regime  129–30 World Bank 374n.170 World Trade Organization (WTO) 860–61, 903–4 ‘prudential carve out’  852–53, 904   zero-commission brokers  755–56, 776n.153 trading apps  755–56, 800–1