New Regulatory Framework for European Securities Markets

Jesper Ulriksen Thuesen, Financial Markets

INTRODUCTION AND SUMMARY

In recent years a new EU regime for regulation of the European securities markets has been developed. The new directives and implementing measures entail very extensive changes that will affect the development in the capital markets. The work is currently being finalised. This article gives an overview of the most important changes, focusing on their impact on the various participants in the European securities markets.

In some areas, the new EU regulatory regime introduces completely new opportunities, while in others the focus is first and foremost on greater harmonisation of national legislation, so that EU regulation supports the continued progress towards a fully integrated securities market in the EU. The new regulatory regime is expected to augment competition among the various trading platforms in Europe, strengthen cross-border competition among securities dealers, and further harmonise the approach to investor protection.

Some aspects of the European financial markets and some market players are still not covered by EU regulation.

THE AMBITION OF A FULLY INTEGRATED SECURITIES MARKET

The free movement of capital and services is one of the cornerstones of the EU and the internal market. Business enterprises must have unrestricted access to raise capital throughout the EU, and investors must equivalently be able to invest across national borders. Securities dealers and providers of trading platforms and other infrastructures must be able to operate at the EU level just as they hitherto have operated in the individual member states.

In 1999 the ambition of a fully integrated financial market was expressed in the EU's Financial Services Action Plan^[1], which stated an ambitious timetable up to 2005 for the revision of the EU regulatory regime in the financial area, including the directives concerning the securities markets. The changes concerning the regulation of securities relate especially to the following directives^[2]:

• The Markets in Financial Instruments Directive, MiFID, (previously the Investment Services Directive).^[3]
• The Prospectus Directive.^[4]
• The Market Abuse Directive.^[5]
• The Transparency Directive.^[6]
• The Takeover Directive.^[7]

An important element of the overall initiative has been to strengthen the cooperation among the national supervisory authorities in the securities markets area in order to create a level playing field throughout the EU for markets and market players. This work is especially performed under the auspices of the Committee of European Securities Regulators, CESR^[8], with the participation of the Danish Financial Supervisory Authority.

SIGNIFICANCE TO MARKET PLAYERS

The two-fold objective of the revision of the EU regulatory regime for securities has been to ensure the framework for an efficient and well-functioning internal securities market, as well as a high degree of investor protection in connection with securities transactions at national and cross-border level within the EU. Completely new opportunities are introduced in some areas, e.g. new types of trading platform or new securities trading methods. In other areas, the focus of revision has been on harmonisation of national legislation. This e.g. applies to prospectuses, investor protection and best execution. These areas required harmonisation in order to support the progress towards an actual single securities market.

There is some variation in the adjustments required of market participants in the different member states as a consequence of the new regulatory regime. For most market participants, however, the adjustments are considerable. This applies especially to securities dealers. In the slightly longer term, the altered terms of competition will affect all market participants.

Trading platforms and methods
The new regulatory regime distinguishes between three principal types of securities trading:

• Regulated markets.
• Multilateral trading facilities, or MTFs.
• Systematic internalisation.

Securities can still be traded outside trading platforms as before, for example in the OTC market. Chart 1 shows the total market capitalisation on the European stock exchanges.

Regulated markets are securities trading platforms, in Denmark the stock exchanges and authorised marketplaces, e.g. the Copenhagen Stock Exchange, which is now owned by OMX, and Dansk AMP. In addition to requirements of corporate structure, initial capital endowment, etc., there are also requirements of the personal integrity and competence of the persons responsible for operating the regulated markets. Regulated markets are also subject to new EU rules to prevent market abuse, i.e. insider dealing and market manipulation.

The new regulatory regime does not entail an actual European passport for operators of regulated markets. Regulated markets thus cannot be operated across national borders on the basis of home-state authorisation and supervision. However, in practice the general right to operate and establish business activities across national borders within the EU will make it relatively easy to operate regulated markets on a cross-border basis.

In a regulation context, multilateral trading facility, MTF, is a new type of trading platform that is introduced with MiFID. As a trading platform that brings buyers and sellers of securities together, an MTF can be exactly like a regulated market. Establishment and operation of an MTF are, however, subject to slightly more lenient requirements, and first and foremost, different requirements are made of issuers and investors on the two types of trading platform. The new revised rules on market abuse, takeover bids and disclosure obligations, cf. below, do not apply to MTF activities. Securities admitted to trading on regulated markets, and other securities, i.e. unlisted securities, can both be traded on MTFs.

Examples of MTFs are various versions of MTS trading platforms on which much of the wholesale trading in European government securities takes place today. MTS platforms are currently regulated under different national legislation. 

MTFs can be operated by investment firms, credit institutions or operators of regulated markets. Operation of an MTF is regarded as an investment service activity, which implies that, in contrast to operation of regulated markets, MTF operators are subject to an actual European passport. A foreign enterprise that is authorised to operate an MTF in another EU member state may therefore also operate an MTF via a branch in Denmark, on the basis of its home-state authorisation and subject to home-state supervision.

The purpose of introducing MTFs was to strengthen competition among trading platforms and to attract some of the trading that currently takes place outside the established exchanges and authorised marketplaces, due to such factors as the costs of admitting securities to trading and the ongoing disclosure requirements for business enterprises traded on regulated markets.

Systematic internalisation is a new term introduced with the new regulatory regime. In some respects it is equivalent to the current Danish concept of real-time transactions, since the securities dealer executes client orders by dealing against his own portfolio on the basis of prices quoted by the securities dealer. Securities dealers that systematically execute client orders in this way outside regulated markets and MTFs are subject to a number of requirements, including procedures for handling conflicts of interest, transparency in quotes, and the information to be made available to clients.

Transparency in regulated markets and MTFs
The new regulatory regime introduces a clear distinction between the trading information to be published with a view to appropriate transparency in the securities markets, and the trading information required for market oversight, including monitoring of compliance with the rules on insider dealing and market manipulation. In principle, the transparency rules apply only to transactions in shares admitted to trading on regulated markets, but the member states may introduce national rules for other types of securities.

"On a reasonable commercial basis" regulated markets and MTFs are subject to pre-trade disclosure of bid and offer quotes and the volumes that can be traded at these prices (market depth). However, these provisions do not apply to particularly large-value transactions.

Likewise "on a reasonable commercial basis" , regulated markets and MTFs are subject to post-trade disclosure of prices, volumes and the times of execution of transactions.

For both pre-trade and post-trade disclosure, the markets may be exempted from their transaction disclosure obligations on the grounds of the nature or size of the transactions. The markets own their information and may therefore offer it for sale.

Chart 2 shows the development in annual turnover on the European stock exchanges.

Business enterprises – borrowers in the securities markets
The new regulatory regime is intended to enable securities issuers to raise capital in a single European capital market, i.e. across national borders and securities trading platforms.

Harmonised rules are therefore introduced for the contents of prospectuses for securities issues, as well as a European passport for prospectuses. This means that a prospectus approved by the competent authorities in one member state can be applied to issues anywhere in the EU. The harmonised prospectus rules apply to securities offered to the general public, including securities to be traded on a regulated market within the EU. The harmonisation comprises requirements of format, content and language. In order to support the uniform assessment of prospectuses in the various member states, after a transition period it will no longer be possible for the member states' authorities to delegate the work of approving prospectuses. In Denmark, this work was previously delegated to the Copenhagen Stock Exchange and Dansk AMP.

The new rules comprise harmonised requirements of the information that issuers of securities in regulated markets must disclose to the market on an ongoing basis. This includes an obligation to publish, without delay, all relevant internal knowledge of the enterprise, and to publish the board and management's personal transactions in the enterprise's shares and related securities. Furthermore, the harmonised rules specify which methods and media are acceptable for publication of relevant information, so as to ensure uniform treatment of investors.

Harmonised rules are also introduced concerning the obligations of issuers to publish accurate and timely information on annual and interim reports, purchase or sale of major shareholdings with appurtenant voting rights, the issuer's holdings of own shares in the enterprise, and other relevant information related to the securities in question. These rules apply to issues traded on regulated markets.

Investors and investor protection rules – lenders in the securities markets
Investor protection is a key aspect of the new regulatory regime for the securities market. To support confidence in the European securities markets, investors must be ensured an extensive harmonised degree of protection for securities transactions both within and across national borders in the EU, and irrespective of the nationality of the securities dealer who receives the order. These rules first and foremost entail a number of requirements to be met by the securities dealers so as to ensure that investors can place their funds on a fully informed basis, and subsequently receive documentation of execution of their orders on the agreed terms.

The securities dealers must take into account that not all types of client have the same securities trading expertise. Three types of client are described: retail clients, including some business enterprises, that will be subject to the most extensive investor protection rules; professional clients that will be subject to moderate investor protection; and eligible counterparties, including other securities dealers and others with special expertise in securities markets, to which no investor protection rules will apply. A securities dealer will have to classify all clients into these categories and inform each client of its category.

The obligations of the securities dealers to ensure protection of investors can be divided into three main groups: information to the client, knowledge of the client and best execution.

Information to the client entails that prior to the investment the client must receive adequate information about both the securities dealer itself and the products offered. This includes information to the client concerning any potential conflicts of interest, and concerning the efficient systems and control procedures that a securities dealer must have in place in order to prevent conflicts of interest.

Knowledge of the client means that the securities dealer must assess whether a given investment is profitable for the client on the basis of information from the client itself about its securities trading expertise, financial situation, etc. If the investment is not profitable, the client must be warned, but can naturally still choose to go through with the transaction. Transactions on behalf of the client can still be executed without this assessment, however, in which case they must take place at the client's initiative, and furthermore must not concern complex securities, and the client must be fully informed of the situation.

Best execution means that the securities dealer must take all reasonable measures to achieve the best possible result for the client on the execution of the transaction. This relates not only to the price and costs of the transaction, but also to other factors such as the speed and safety of execution and settlement. However, the securities dealer is always obliged to follow any specific instructions from the client.

The new regulatory regime also includes special rules for the protection of minority shareholders in companies whose securities are traded on regulated markets. These provisions are aimed at ensuring that all shareholders are given sufficient time and information to make investment decisions, and that the board and management act in the interests of the shareholders.

Securities dealers – intermediaries in the securities markets
The new regulatory regime further harmonises the requirements of European securities dealers and entails considerable adjustments. As described above, the investor protection provisions alone make high demands of how securities dealers conduct their operations.

Securities dealers are comprised by the European passport. This entails that they can offer services directly across national borders, or via branches in other member states on the basis of their home-state authorisation. It also entails access, on non-discriminatory terms, to regulated markets in other member states either directly via a branch, or as remote members. Furthermore, they are entitled to access to post-trade infrastructures in other member states, including clearing and settlement systems.

In addition to harmonised requirements of initial capital endowment, fit-and-proper provisions for owners and management, organisational structure, membership of an approved investor guarantee scheme, auditing requirements, etc., a number of completely new requirements are introduced, especially for how securities dealers must contribute to ensuring transparency in securities transactions.

Securities dealers performing systematic internalisation must publish pre-trade information as firm bid and offer prices, and post-trade information as the price, volume and time of the transaction. The transparency rules apply solely to liquid shares that are admitted to trading on a regulated market, and only to trades up to "normal market size" .

The securities dealers must ensure that relevant information on all securities transactions that they have undertaken for own account or for the account of a client is available for at least five years, with a view to inspection by the supervisory authorities.

AREAS REMAINING OUTSIDE THE COMMON REGULATORY REGIME

Self-regulation and market structure
The new directives for the securities area still to a large extent leave it up to each marketplace to define its own concrete trading infrastructure by means of locally determined regulations on e.g. enhanced pre-trade and post-trade transparency, market-maker schemes, matching systems and choice of electronic trading platforms. The individual marketplace can therefore still be adapted to the type of trading it seeks to attract. This is an important element of the competition among the different marketplaces.

Products and market participants outside the common regulatory regime
Large parts of the securities markets are still not covered by EU regulation. This applies to both products and market participants.

As described above, the new rules for market transparency in principle apply only to trading in shares that have been admitted to trading on a regulated market. This allows the member states and the individual marketplaces to draw up their own transparency rules for trading in other securities, i.e. both simple products such as bonds, and more complex financial instruments such as credit derivatives.

A large number of shares have not been admitted to trading on a regulated market, and are thus to a great extent still not covered by the common regulatory regime. This applies to shares and other equity held by venture companies and private equity funds that have played a larger role in the European securities markets in recent years. Chart 3 shows the development in European private equity.

Hedge funds have accounted for a rapidly increasing share of trading activity in the European and international securities markets. Many hedge funds restructure their positions relatively frequently, and on a global basis the assets administered by hedge funds are estimated to have reached more than 1,300 billion dollars. Hedge funds are not subject to EU regulation as either investment firms or as investors.

FUTURE WORK ON THE FRAMEWORK FOR EUROPEAN SECURITIES MARKETS

It is a fundamental EU principle that Community regulation should only be introduced when necessary to meet the ultimate objective of a fully integrated European securities market. Currently several areas are being investigated to identify the possible need for further Community regulation.

The progress of financial integration in Europe is generally more advanced on the wholesale than on the retail side. This also applies to the European securities markets, where a large part of the new regulatory regime focuses on the wholesale side. The European Commission has presented a White Paper^[9] that sets out the general policies for the work of the EU up to 2010. After the implementation of the many directives under the first Financial Services Action Plan, the focus has now turned to evaluation and adjustment, described by the Commission as better rather than more regulation. Furthermore, the retail side is now also in focus. This is for example illustrated by the designation of investment funds and mortgage credit as priority areas, and this work is in progress.

CESR has initiated the first stage of the gathering of experience as the subsequent basis for evaluation of the new regulation of the securities area. In the first stage, this gathering of experience relates to the Prospectus Directive.

Furthermore, the Commission has initiated the collection of information from markets and market participants regarding the possible need to expand the new transparency rules for shares to include bonds, or to establish common transparency rules for bonds at Community level by other means.

One of the largest remaining obstacles to a fully integrated securities market in Europe is the lack of integration of post-trade infrastructures, i.e. regarding clearing and settlement. The Giovannini reports^[10] identified the largest obstacles in this area, as well as a way to overcome them. Against this background, the European Commission has launched a wide range of initiatives to resolve the legal, technical and political issues related to ensuring that cross-border clearing and settlement take place on conditions equivalent to the national conditions, including the identification of the possible need for EU regulation. The latest information from the Commission is a statement by Commissioner McCreevy^[11] that proposes that the Commission should refrain from taking regulatory initiatives for the time being. Instead, the sector should create its own solutions based on a Code of Conduct^[12] published in November 2006 that among other things sets deadlines for specific measures towards closer integration.

The Commission has launched initiatives to map the significance of private equity and of hedge funds to the European financial sector and the European securities markets. In both areas, this has so far resulted in reports from expert groups, and the Commission will continue this work inter alia on the basis of the recommendations of these reports.

Work at Community level is also taking place in other areas, e.g. corporate governance, subject to the fundamental principle that Community regulation does not necessarily have to be introduced.