How the MiFID II review and Covid-19 are reshaping the hedge fund operational landscape

Global transparency

With certain aspects of the EU’s ongoing MiFID II review affected by the coronavirus pandemic, Hedgeweek explores how a fresh overhaul of the framework may further impact hedge fund operations, and why the Covid-19 crisis may provide an easing of the regulatory burden.

Introduced in January 2018, the European Union’s Markets in Financial Instruments Directive (MiFID) II brought sweeping changes to transparency rules and transaction reporting requirements across the financial markets spectrum.

Among the major reforms impacting hedge funds was a package of measures covering third party research. These included extra scrutiny over the ways that asset managers pay for sell-side analysis, and the unbundling of research from brokerage fees, a move aimed at curbing inducements to trade.

Almost three years on, industry consensus indicates MiFID II has led to a reduction in hedge fund research spend. But anecdotal evidence also suggests portfolio managers have sought to capitalise on the reduced amount of stock analysis with targeted research budgets to help them gain an edge.

The European Commission kicked off an industry-wide consultation on its planned MiFID II review in February this year. But certain parts of the review have been delayed as a result of the Covid-19 pandemic, with ESMA expected to report back on these in early 2021.

With the EU still in the process of reviewing several planks of the MiFID II rules, attention has turned to how the European Securities and Markets Authority - the pan-EU financial watchdog tasked with overseeing and implementing the review’s findings – might bring about further regulatory changes, and what that might mean for hedge funds.

‘Extraordinarily focused’

The industry on the whole has adapted and pivoted to meet MiFID II requirements, according to George Ralph, managing director, RFA, which provides IT, financial cloud and cyber-security services to investment management firms.

There has also been a closer focus among hedge funds and other asset managers on moving towards more robust systems and reporting, well as ensuring continued training around both policies and restrictions.

“They have invested in more advanced technologies to ease regulatory burdens and there has been a move towards outsourcing for access to subject matter experts,” Ralph told Hedgeweek.

Chris Hollands, head of European and North American sales at multi-asset class order and execution management system (OEMS) provider TradingScreen, says MiFID II has forced buyside firms – be they hedge funds or long-only asset managers – to become “extraordinarily focused” on best execution.

“These best execution obligations span not just the equity world but also other instrument classes; foreign exchange and listed derivatives,” he says.

Hollands believes that MiFID II has increased many buyside firms’ desire to use electronic execution, due to the “inherent audit trail that comes from trading electronically, and consequently the ease of proving best execution.”

Easing the burden?

With the framework’s review still ongoing, “top of the list” for the asset management industry is a potential shake-up to rules covering UK firms with European operations and exposures, says Ralph, given that the regulatory framework between the UK and EU will look markedly different post-Brexit.

Elsewhere, there has been much discussion around what financial instruments should be included in pre- and post-data reporting, and how such reporting may work in practice, as well as further discussion around an EU-wide consolidated tape.

Current reporting guidelines for investors might also change, Ralph adds, as might operational due diligence (ODD) requirements.

The combination of the MiFID II review and the impact of the Covid-19 pandemic could see an “easing off” on certain aspects of the framework’s RCS27 and 28 reporting requirements, as well as a “lightening” of unbundling obligations relating to certain fixed income instruments and smaller cap stocks, suggests Hollands.

When the MiFID II rules first kicked in, some managers feared that restricted research budgets, combined with stricter rules on paid third-party analysis, would squeeze the ability of smaller start-up hedge funds to gain an informational edge.

“One of the perhaps unfavoured implications of unbundling has been the marginalisation in some cases of the smaller research providers, which has reduced not only the overall level of competition for provision of research but also the coverage itself. That’s obviously not good if you’re a smaller company,” Hollands observes.

Should there be a pull-back here, there would likely be a “greater desire and willingness” among many smaller hedge funds to rely on third party research more, he continues.

Ralph adds: “In terms of the impact from Covid-19, it has forced fluidity and amended some rules from regulators. We could see continued change in this area as the effects of the pandemic become clearer as time goes on.”

Practical implications

“I think they’re trying to be pragmatic,” says Hollands, reflecting on the ongoing review process. “Where some of the originally intended consequences have not necessarily come to fruition, there is perhaps a greater willingness - using the umbrella of allowing markets to operate in difficult times, because of Covid-19 - to perhaps retrench on some of the more onerous policy changes that came about in January 2018.”

Turning to the practical implications of MiFID II on compliance and operations processes and budgets, Ralph says hedge funds have begun to address and embrace new technologies and alternative working, pointing to a need to strengthen knowledge and understanding around IT, cybersecurity, cloud and data management “as a way to improve workflow and manage costs.”

He believes the industry is increasingly focused on greater use of data warehousing, data ingestion and data analytics, as well as automation around decision making, trend analysis and portfolio performance processes.

Hollands adds there is “definitely a desire” to tighten up disparate systems.

“Operational risk is very acutely felt especially when you have a hybrid model that has some traders working from home and others in the office and they might be moving in and out. That can make it harder to keep an eye on things. That’s a priority,” he notes.

“The policy and the drive towards it was already happening, but Covid-19 has just accelerated it to a degree. One thing we have seen in some respect is the desire for even larger hedge funds and asset managers to move more and more of their systems into the cloud.”