Globalisation and Capital Markets: A Legal and Financial Perspective, Appunti di Diritto

Scarica Globalisation and Capital Markets: A Legal and Financial Perspective e più Appunti in PDF di Diritto solo su Docsity! ADVANCED CORPORATE MARKETS LAW Market Infrastructure Financial Directive = MIFID Two main areas: the global financial system and the EU capital market law. 1. The global financial system – basic information There is a problem with respect to globalisation while studying law. It is easy to talk about global market or global economy, but the world “law” is strictly connected to a single state into borders. Law system is the opposite of globalisation by its definition itself. This is the starting point to understand why it is so difficult talking about globalisation and law together. Even in EU, where we do not have physical borders, if me, Italian citizen, buy a car in France, that contract is governed by French law on the basis that I have signed the contract in France. The same counts for a Frenchman that buys something in Italy. Otherwise, take the concept of real property: our concept of property does not exist legally in the same way in UK. In England they have the concept that all immovable property belongs to the crown. Even if you buy something immovable, it has to return to the crown by a hundred of years. In Italy you can divide property into shares. If you have full ownership of shares you can get eventual dividends. If you split and become “nudo proprietario”, you are not more entitled to the dividends. The one that takes the dividends is called “usufruttuario”. These are called “diritti reali di godimento”. But this idea is not spread abroad. Otherwise take marriage: in Italy you cannot be bigamous. Here you don’t have a principle called “stare decisis”  if a judge in Italy makes a sentence, another judge is not bound to follow the sentence by judging another case. Following judges in Italy are not bound by precedent cases. In UK and USA, instead, the second judge is bound to follow the decision of the first one. All legal systems are different and valid in their state. In Italy we have Vatican City and San Marino republic that are two different states into the state. How could we talk about globalisation in terms of law? In globalisation the basic meaning should be “no borders”. In Italy, before 1942 (Italian civil code enacted), when someone committed a crime, apart from throwing him in jail, there was an option called “confino”. Sending someone to confino meant a place, like a small village, and you were there and you couldn’t go outside. Why cannot he be banned? Because the state has no powers outside, there should be international agreements. International law is basically the block of relations between the states, but international law is not globalisation. International is when a state tries to enter into an agreement with another state to found rules that are enforceable for both states. Imagine that nation and state mean the same thing. Inter + national = between + states. International has nothing to do with globalisation: in globalisation we do not have states. The image of globalisation is a globe without borders. International is a step away from globalisation, because international accepts the idea of borders and different nations. A good image of globalisation is financial capital market . In legal system we don’t have globalisation, but we have an exception: capital markets law is the only branch of law that is globalised. This happens because of: • Language  if you’re studying Italian private law in English and you find the world “contract”, you translate in Italian like “contratto”, but this in Italian law has a specific meaning provided by Italian civil code. In order to find out what an Italian contratto means I have to search for the civil code. Otherwise, the world contract in English has a different meaning because it has a different definition. In capital markets there is the financial jargon, that is the same for everyone. It is still English, but to be understandable, you need specific economic knowledge (like “cap- and-floor”: specific financial meaning). “Upfront” = sort of payment at the beginning of the derivative contract. “Underline” = stocks or shares. • Sources of law (le fonti del diritto): in the normal legal system we have the hierarchy of the sources of law. For example, in Italy we have first Italian Constitution, then the law, then the regulations, the consuetudini (common practices). This list is in order of importance. This is useful when we have the problem of inconsistency between the sources of law. The problem is when you have two inconsistent rules on the same level. When one is on the same level of the other, but it is more specific, the more specific wins and the more generic loses. Criteria: 1) the rule of higher grade shall amend or repeal the lower grade one 2) The rule of lower rank cannot amend or repeal the higher grade one 3) Two equal rules may change according to the chronological order 4) The latest rule changes or repeals the previous one of the same grade And if the inconsistency exists between two standards belonging to the same sources? It must be applied the “consecution”: the law enacted afterwards always prevails on the law enacted earlier. Do all legal systems have this kind of ranking? We have first law, then regulations and last common practices. It would be impossible having a ranking like this into global law. How does it work if there is not ranking in the source of law? Which are the sources of the law? Example: if you owns more than a certain amount of shares of a listed company, you have to declare to the public how many shares you have (in Italy this threshold is 3%)  this disclosure rule exists in every law system in very similar terms. How is it possible having extremely similar rules in so many different markets while the meaning of property in Italy is different from the one in USA? How does capital markets work? Do they work according to economic and financial principles and hypothesis? It is a financial and economic issue, it has nothing to do with law. Being economic and financial, it means that all capital markets into the world would work according to financial and mathematical principles. According to the theorem of price discovering, we have a market where we have listed shares, and then we have the world of information. There is a strong relation between prices and information. When the information is published, price maybe can change. Otherwise, if the information is not published, the price does not move. How fast will the information be incorporated by the price? In a perfect world the market is efficient and the information is incorporated into the price very quickly. At this • Language • Financial instruments (most important) • Sources • Master agreements Usually the objective of the contract and the meaning of the contract are unique in the legal system. What are financial instruments? Into the markets, what is listed and exchanged is a financial instruments. There are many different kinds of financial instruments: derivative contracts, stocks, bonds… The object of a trade is a financial instrument. All set of rules, negotiation procedures… are all focused on financial instruments. Three big families: stocks, bonds or obligations, derivatives. We might have simple options, or futures, or weather derivatives…even the one of the bonds is a world by itself: clean, subordinated bonds… The definition of financial product for the Italian law is established in “Testo Unico della Finanza” (TUF) Art.1, comma 1, let. U: “"prodotti finanziari": gli strumenti finanziari e ogni altra forma di investimento di natura finanziaria; non costituiscono prodotti finanziari i depositi bancari o postali non rappresentati da strumenti finanziari.” (financial instruments and any other form of investment with financial nature; bank or postal deposits, that are not financial instruments, do not constitute financial products). Financial products are tradable on the market, throughout all the markets. In terms of law, it is really interesting that the nature of financial instruments does not depend on the legal system. It doesn’t matter if a future is regulated by Italian or American law, because the nature of the future is expressed in a mathematical way, so it is the same in all the world. It doesn’t employ juridical terms. This counts for futures, swap derivatives, options…Many financial instruments are simply exactly the same in all the world. The consequence is that, if we don’t have a legal burden on the product, it can move around the world easily. In Civil Law countries, the law is based on typical contracts, many kind of contracts are regulated by the law. Instead, a contract of leasing didn’t exist in Italy into the ’80  we had to import this kind of contract from USA and UK. Divide the contract in two big families: is it a kind of contract (tipico) already regulated by the law or for which exists something similar in the market? (like banking contract, compravendita, locazione…)? The first family is closed and only the lawmaker can add something to this list. The second family is the one of contratti atipici, not provided into the civil code, but they have to complain with one main principle to be valid: if someone invents a new contract that is not provided by the law, this contract has to comply with Italian mandatory rules, so basic principles. If the contract does not satisfy basic principle of the law, the contract is illegal. In the late ’80, we had this new contract of leasing, because some financial firms started making new business. When the parties went before the judge there was a problem: the judge must apply rules to the contract  what kind of rules will the judge apply to this new contract? There should be a matching between the type of contract and the set of rules. Otherwise, if it is a new contract, how can I find out which type of rules to apply? The judge found out that the leasing was half a contract of sale and half a rent. At the end of the period you can redeem the car by payment or give the car back. Actually, at the beginning you don’t buy the car, because its owners is the leasing company, formally. At the end, you have option to purchase the car. Do you need to apply rules for sale or rent? The judge thought that the most important part of the contract was the sale, so he had to regulate it with sale regulations. We didn’t create leasing contract: we imported it from common Law countries. With derivatives all this mess doesn’t take place: all these legal concepts have not to be applied to derivative markets. For what concerns financial instruments, like an interest rate swap, the international regulation is the same in all the world. The core part for the interest rate swap is the mathematical formula, not the legal nature: legal features don’t give shape to the product. There are not legal barriers. An interest rate swap is an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Fixed amount of money is exchange for variable amount of money. An IRS is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another. They are used for hedging and speculating. This kind of contract was created by the financial system to allow the “money move” between banks without a physical move of the money. It is an exchange of banks’ needs and a financial transaction since the aim of the bank is speculating. Behind the concept of IRS there are not legal concept implied, there is not a peculiar legal system… so it is a contract according to what? When the IRS is listed on an exchange it is no more a contract but a product: it can be bought with an offer and it is not necessary to sign a product. We can say if a country “invented” a certain typical contract (USA, leasing), but this is impossible with derivative contracts: financial market invented them, maybe because it needed a determined type of contract. To build a proper financial system, we’d need judges and courts. We still have many local courts. The most important courts in the financial world are London, New York and Chicago. The Italian financial markets is capitalised as 700 billion of euros. Apple alone is worth 780 billion of euros. The financial instruments are regulated by contracts anyway: the 99% of the derivative contracts of the world are regulated by the same MASTER AGREEMENT. Then there are some attachments to it offering some specifications. The ISDA Master Agreement is the most commonly used master service agreement for OTC derivative transactions internationally. It is part of a framework of documents, designed to enable OTC derivatives to be documented fully and flexibly. The framework consists of a master agreement, a schedule, confirmations, definition booklets, and credit support documentation. The ISDA master agreement is published by the International Swaps and Derivatives Association. The master agreement is a document agreed between two parties that sets out standard terms that apply to all the transactions entered into between those parties. Each time that a transaction is entered into, the terms of the master agreement do not need to be re-negotiated and apply automatically. Although it is often viewed as a tool for banks and financial institutions, the Master Agreement is widely used by a wide variety of counterparties. Distinction between applicable law and jurisdiction. Applicable law is the law the parties have decided to apply to regulate the contract. Usually, if the parties belong to the same state, they’d choose the law of the country. Otherwise, when the counterparties are from different countries, according to MASTER AGREEMENT, you can choose between English or New York state law. Then there is the concept of value and jurisdiction. There is a principle, valid for all legal system, usually set into Latin: IURA NOVIT CURIA (the court knows the law). The point is that the court knows all laws that are applicable, not just Italian, if we are in Italy… Example: the parties choose English law, but they are Italians and they have to have their judgement in front of an Italian judge. Italian judge is in this case asked to apply English law. How is it possible that an Italian judge is going to apply English law? How could the judge be aware of the foreign law? The burden of the proof of the law is on the two parties: they have to provide the foreign law and demonstrate how it could be applied. Usually the Italian judge demands for an expert (consulente tecnico) that has to explain to him how to apply English law. The judges technically are not part of the global system, but we have in the world many cases of financial subjects judged in very similar ways. We had the same case because the product, interest rate swap, was the same, so we can compare all these cases. What is different? The applicable law, because Italian judge has to judge this case according to Italian applicable law… the difference is the specific rule applied by the judge, according to law traditions of the country. We can identify certain products whose content may differ under distinct regulations. On the contrary, we do not observe this with derivatives: to understand what a derivative product is, it is sufficient to understand its financial function, since its distinctive features have an economic and not a legal nature. Observing the use of certain financial terms in the market practices, we noted that, when a financial instrument or a transaction is mainly characterized by its financial content (rather than its regulation), such words are homogeneously used in different markets. On the contrary, when the regulation is what characterizes the instrument or the transaction, the same terms, used in different markets, may instead refer to different phenomena and, moreover, the meaning of the terms characterized by their legal discipline is often debated also within the same jurisdiction. Such phenomenon of alignment in derivatives, of the use of financial terms, is , in our opinion, the result of two major causes: 1- The predominance of the financial content over the legal discipline, which facilitates the use of the same terms in different countries. 2- A recurrent absence of a juridical system of origin. Indeed, such terms are generally not crafted by legislators or regulators, but come into being in the financial market praxis and activities, which often involve more than a market at a time. In this sense, we call such phenomenon the “stateless finance”, which is growing fast and it is contributing to develop a cross-border market where the players use the same language and often face the same problems. Division between the banking system as a system for financing firms and capital markets. 80% of money allowed to companies comes from banking system in Europe; while in USA it is much more common going public: asking money to the public instead of banks. As an example, in Italy we have crowdfunding rules. Share = scrip, equity or stocks. Two different worlds: the real one, with products, and the markets, with financial instruments. The focus of the capital markets is how the markets work and how is trading on financial markets. In the European Union law, the definition of financial instrument is any form of investment that has financial nature. Imagine that A purchases a house for two main reason: the first is that he just needs a house; the second is for making an investment: he is buying this house because he wants to resell it at a higher price to B. The first option is made by buying a single contract, a contract of sale MiFID II and MiFIR provide an updated harmonised legal framework governing the requirements applicable to investment firms, regulated markets, data reporting services providers and third country firms providing investment services or activities in the Union. To determine which firms are affected by MiFID and which are not, MiFID distinguishes between "investment services and activities", listed in Section A of Annex I) and "ancillary services", Listed in Section B of Annex I. If a firm only performs ancillary services, it is not subject to MiFID. MiFID covers almost all tradable financial products, listed in Section C of Annex I MiFID II and MiFIR aim to enhance the efficiency, resilience and integrity of financial markets, notably by: 1. Achieving greater transparency for equities and non-equities trade regimes; 2. Bringing more trading onto regulated venues; 3. Fulfilling the Union’s G20 commitments on derivatives: o mandatory trading of derivatives on regulated venues, o introduction of position limits and reporting requirements for commodity derivatives, o broadening the definition of investment firm to capture firms trading commodity derivatives; 4. Facilitating access to capital for SMEs; 5. Strengthening the protection of investors; 6. Regulating technological development: algorithmic traders and high-frequency trading; 7. Introducing provisions on non-discriminatory access to trading and post-trading services in trading of financial instruments notably for exchange-traded derivatives; 8. Strengthening and harmonising sanctions. As regard the second point, to bring more trading onto regulated venues, the legislation will introduce a new type of trading venue, the organised trading facility (“OTF”), to capture multilateral trading in non-equity instruments that does not currently take place on regulated markets (“RMs”) or multilateral trading facilities (“MTFs”). The requirements for MTFs have been aligned with those of RMs so that investment firms and market operators operating an MTF will be required to have (a) systems and measures in place to manage, identify and mitigate risks, (b) effective arrangements for the efficient and timely finalisation of transactions and (c) sufficient financial resources for its orderly functioning. Unlike RMs and MTFs, operators of OTFs will have discretion as to how to execute orders, subject to pre-transparency and best execution obligations. Moreover, RMs and MTFs are not allowed to execute client orders against proprietary capital, or to engage in matched principal trading, while it is permitted in some cases with client consent in OTFs. We have some big areas inside the MIFID: what investment firms are? How they are regulated inside Europe? How do investment firms provide investment funds to the public?  a bank is a kind of investment firm, like a financial intermediary. Investment firms could only do business about investment services. It is a closed number of services: ex. Managing and advising about portfolios, financial advices to clients. This is a reserved area of business: to provide investment services you have to be authorized. Investment firms provide financial services like financial instruments to the public. MIFID is a single directive, but there are other different European regulations and technical standards (so a package of rules) that are to be executed together from 2018. Regulated markets means a multilateral system. Multilateral system means any system in which multiple third parties buying and selling in the system are able to interact in the system. It is hard to find legal terms in this definition. We are to trade a financial instrument at the same table. We start a negotiation and we decide the price into a contract of sale of the shares. This contract of sale is perfectly valid. Anyway, this contract of trading does not fall into the definition: it has something that is missing with respect with what happens into a financial market  in the example we do not have a financial market. In financial market you do not know who is the counterparty. When you trade on the market, you just insert your order into the system, then your offer is matched with someone and you have automatically the matching of the transaction. In the first example the matching was not automatic. The market is the system between the seller and the buyer. A contract is an agreement between two parties, where a party makes a proposal and the other accepts. When you buy the newspaper or you buy something in the supermarket, you are executing a contract of sale with the counterparty. If you move on the financial market and you do not know your counterparty, there is a multilateral system between the two. If there is not a market there is just A and B, a proposal and an acceptance, and nothing more between them. If we are on the market, we have a computer system where B puts his offer, that enters into the market, and because of the market, it ends to A  there is not a direct confrontation between A and B. There is a book on the system that is divided in two. Ex.: the price of an Apple stock is 120$ per share. On the left of the book, someone sells 500 shares at the price of 121$. On the right of the book, there is a guy that wants to buy 500 shares at 119$  here there is not market. Then there is a guy on the left that wants to sell 300 shares at 121,5$ and, on the right, someone that wants to buy 300 shares for 118,5$. The more you continue reading the book forward the bottom, the higher the prices for the sellers (left) and the lower the price on the right (buyers). If the first guy on the right decides to accept the offer buying 500 shares for 121$, the first guy on the right and the first on the left disappears from the book and price evolves. Liquidity is given by the number of shares and how fast the price is matched. This is the way a trader moves into a multilateral system. What is mainly traded are interests. The only exchanges are the ones happening on the top of the book. (19) ‘multilateral system’ means any system or facility in which multiple third-party buying and selling trading interests in financial instruments are able to interact in the system; (21) ‘regulated market’ means a multilateral system operated and/or managed by a market operator, 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 trading under its rules and/or systems, and which is authorised and functions regularly and in accordance with Title III of this Directive; If the list is not moving fast, it means that there is not so much market for that stuff  if the book is reliable it contains much information. For example, I put on the left a big order of 1000 shares for 121$  this information can be useful, because it can say how the market is about to move. This technique is a manipulation of the market to buy shares at a lower prices  to make sellers lower their price. After you cancel the order to avoid manipulation of the book that now is illegal. Regulated market, multilateral trading facility and organised trading facilities = three different types of trading venues. 22) ‘multilateral trading facility’ or ‘MTF’ means 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 Title II of this Directive; Non-discretionary rules = no man intervention. A very simple rule is that the higher offer is the first to be listed into the book. In a regulated market we only have market operators, whilst in 22) we can have market operators and investment firms. The difference between 21) and 22) is in rules applied in the market. 23) ‘organised trading facility’ or ‘OTF’ means a multilateral system which is not a regulated market or an MTF and in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact in the system in a way that results in a contract in accordance with Title II of this Directive; 39) ‘algorithmic trading’ means trading in 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, and does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions; We have computers that decide automatically to buy or to sell by an algorithm. In the last seven years, most of the trade have been made by computers. More than 60% of the trades in New York stock exchange were made by high frequency algorithmic trading. (40) ‘high-frequency algorithmic trading technique’ means an algorithmic trading technique characterised by: (a) infrastructure intended to minimise network and other types of latencies, including at least one of the following facilities for algorithmic order entry: co-location, proximity hosting or high-speed direct electronic access; EN L 173/384 Official Journal of the European Union 12.6.2014 (b) system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders; and (c) high message intraday rates which constitute orders, quotes or cancellations; First of all, the ESMA estimated in his 2014 report the overall level of HFT activity in their sample, explaining which type of market participant acts as HFT. They observe that HFT activity accounts for 24% of value traded for the HFT flag approach and 43% for the lifetime of orders approach. The HFT flag approach provides the lowest estimates for HFT activity, while, under the lifetime of orders approach, most of the trading activity carried out by HFT firms is identified as HFT activity. Therefore, the difference between the two approaches, 19%, is mainly explained by HFT activity of investment banks. They found similar results for the number of trades and orders. Once an investment firm is authorised, certain on-going compliance requirements, such as the obligation to store, for at least 5 years, accurate and time-sequenced records of all the orders placed by the firm in an approved form and make available to the competent authority on request. Moreover, a firm engaging in algorithmic trading will be required to have in place effective systems and risk controls to ensure that its trading systems are resilient and are subject to appropriate thresholds, which prevent sending erroneous orders. The aim of these rules, together with the introduction of automated trading stops, the increase of minimum tick size, cancellation restrictions and enforcement minimum holding period, is to limit the HFT phenomenon, since it can have a large role in stock market crashes. One of the first market crash, in which HFT played an important role contributing to it by demanding immediacy ahead of other market participants, is the “Flash Crash” of May 6, 2010. Tick size rule  which is the minimum offer possible to buy or to sell something? If you have 10 euros, can you offer 10,01? It depends on the rule about thick size. If the rule says that the minimum tick size is 0,50 cents, you can only offer 0,5. Higher the thick size, slower is the HFT. A tick size is the minimum price movement of a trading instrument. If a stock has a tick size of 0,50$, and a current price of 20$; the associated price can move to 20,50$, but cannot move to 20,25$. Collocation is one of main rules of MIFID2: fiscally all participants to the market must have the same proximity to the market servers. Anyone that wants to have a direct access must be guaranteed to have the same access as anyone else. Two main techniques to avoid HFT excessive trading: tick prices and minimum holding period. US Commodity Futures Trading Commission (with SEC): flash crash on the markets in 2010 because of HFT techniques. 10 pages about executive summary + chapter1 (page 9) Trading in a broad market + chapter2 Market participants and liquidity. E-mini are a kind of derivative contracts. 31/3/2017 What happened in 2017? Stock prices during the day of the flash crash. NB: almost everything happened at 14:30, during 30 minutes. During these 30 minutes we can see the collapse of the market index. This happened because of the HFT. Huge collapse of 4-5% points of D&J index occurred in few minutes. Such a big collapse is really rare, especially in such a short time. As quickly as the collapse it returned at the same level. Quick and wild movement in few minutes. The Down- Jones index was reflecting what happened in the E-mini market. E-mini market is composed of derivative trading values where the HPD were trading derivatives contracts. The E-mini is called E-Mini500 because the underline of that derivative contracts are the first Down-Jones 500 stocks. There is a connection between the trading-values, like E-mini trading-values, that are specialised in derivative contracts, and the regulated market, where we do not have derivative contracts, but only stocks. Otherwise, if you have a derivative, you have to hedge your position by acquiring fiscally the underlying. This is the connection between the regulated market and the smaller E-mini market. All the regulated markets are connected. You can have a trading value specialised on some kind of derivatives, or only on some types of companies… but they are all connected. A trading machine is used to trade at the same time in more than one trading values. The May 6, 2010, Flash Crash was a United States trillion-dollar stock market crash, which lasted for approximately 36 minutes. The joint 2010 report by SEC (Securities and Exchanges Commission) and CFTC (Commodity Future Trading Commission) portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral. They highlighted how a large mutual fund firm selling an unusually large number of E-Mini S&P contracts first exhausted available buyers, and then how HFT started aggressively selling, accelerating the effect of the mutual fund's selling and contributing to the sharp price declines that day. May 6 started as an unusually turbulent day for the markets. Since the very beginning, there was unsettling political and economic news concerning European debt crisis. At about 1pm the euro began a sharp decline against both the US dollar and the Japanese yen. By the early afternoon broadly negative market sentiment was already affecting an increase in the price volatility of some individual securities. Therefore, "a large fundamental trader initiated a sell program to sell a total of 75,000 E-Mini S&P contracts, valued at approximately $4.1 billion, as a hedge to an existing equity position. This large fundamental trader chose to execute this sell program via an automated execution algorithm that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time. A similar size sell order was executed in the E-Mini in the 12 months prior to May 6 by the same firm, but through a combination of manual trading and several automated algorithms taking into account price, time, and volume, which took 5 hours to be completed. However, on May 6 the Sell Algorithm chosen by the large trader to only target trading volume, completing extremely rapidly in just 20 minutes. This sell pressure was initially absorbed by high frequency traders. High frequency traders accumulated a net long position of about 3,300 contracts. However, between 2:41 pm and 2:44 pm, high frequency traders aggressively sold about 2000 E- mini contracts in order to reduce their temporary long position. In the report, they described two liquidity crises: one at the broad index level in the E-Mini, the other with respect to individual stocks. In the first one, the combined selling pressure from the sell algorithm, HFTs, and other traders drove the price of the E-Mini S&P 500 and the price of SPY S&P 500 indexes, due to cross- market arbitrageurs, down approximately 3% in just four minutes. Still lacking sufficient demand from fundamental buyers or cross market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other due to insufficient demand, generating a “hot- potato” volume effect. As prices in the futures market fell, trading on the E-Mini was paused for five seconds when the Chicago Mercantile Exchange ('CME') Stop Logic Functionality was triggered in order to prevent a cascade of further price declines. In that short period of time, sell-side pressure in the E-Mini was partly alleviated and buy-side interest increased. When trading resumed, prices stabilized and shortly thereafter, the E-Mini began to recover, followed by the SPY. The E-mini and SPY are the two most active stock index instruments traded in the electronic futures and equity market. Both are derivative products designed to track stocks in the S&P 500 Index, which in turn represents approximately 75% of the market capitalization of US listed equities. The second liquidity crisis occurred in the equities markets. Automated trading systems used by many liquidity providers temporarily paused in reaction to the sudden price declines observed during the first liquidity crisis. Based on their respective individual risk assessments, some market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets. HFTs in the equity markets traded proportionally more as volume increased, and were overall net sellers in the rapidly declining broad market along with most other participants. Even though prices in the E-Mini and SPY were recovering from their severe declines, sell orders placed for some individual securities and ETFs (Exchange Traded Funds) found reduced buying interest, which led to further price declines in those securities. As liquidity completely evaporated in a number of individual securities and ETFs, participants instructed to sell (or buy) at the market found no immediately available buy interest (or sell interest) resulting in trades being executed at irrational prices as low as one penny or as high as $100,000. These trades occurred as a result of so-called stub quotes, which are quotes generated by market makers at levels far away from the current market in order to fulfil continuous two-sided quoting obligations. After a short while, as market participants had time to react and verify the integrity of their data and systems, buy-side and sell-side interest returned and an orderly price discovery process began to function, and by 3:00 p.m., most stocks had reverted back to trading at prices reflecting true consensus values. Nevertheless, between 2:40 p.m. and 3:00 p.m., over 20,000 trades were executed at prices 60% or more away from their 2:40 p.m. prices. After the market closed, the exchanges and FINRA (Financial Industry Regulatory Authority) met and jointly agreed to cancel (or break) all such trades. Since the E-mini and SPY both track the same set of S&P 500 stocks, cross-market arbitrage between these two products kept their prices closely aligned during their rapid declines. However, in the moments before prices of the E-Mini and SPY both hit their intra-day lows, the E- Mini suffered a significant loss of liquidity during which buy-side market depth was not able to keep pace with sell-side pressure. Four minutes later, when prices in the E-Mini and SPY were recovering, buy side market depth for SPY reached its daily low. There does not appear to have been a fundamental liquidity event in S&P 500 stocks that preceded and drove price declines in the E-Mini and SPY. (5), (6), (7) and (10) of Section C where these are connected to the provision of investment or ancillary services. Section C: financial instruments: 1. Transferable securities (valori mobiliari) Valori mobiliari. If something is a financial instrument, we have to apply MIFID. We can use the world “negotiation”, to mean that the transfer occurs into the market, while the world “transfer” means something that could happen even outside of the market. In a face to face transaction, technically meaning, you do not have a negotiation, because it does not happen in the market. When it is just face to face, you can say that it is a transaction. Security is split in Testo Unico between equity instruments (transferable) and debt instruments (transferable)  shares and bonds. In order to distinguish between shares and bonds, we could use a proper legal view or a finance view. All the companies have share capital. According to which type of capital, you have different minimum level of capital required by law. When we speak about equity we are in the world of shares capital, that can be normal shares  the shareholder is entitled to receive the dividends. The risk is given by the fact that the value of the shares is connected to the ongoing of the company business. I have two ways to obtain shares: the first is to buy the shares on the market (we are talking about listed company). The second way is to give money when new shares are issued. Otherwise, the bonds represent a credit that the subscriber holds towards the company. Convertible bond: when the investment period is going to end, the convertible bond can be converted into a share, after the life of the bond. Italian Testo Unico Finanziario: Articlo1: definition of financial instruments (strumenti finanziari)  this definition is not in the MIFID, as in the MIFID we just have the list. Here instead we have a definition: “gli strumenti finanziari sono prodotti finanziari e ogni altra forma di investimento di natura finanziaria”  Financial products are financial instruments and any other form of investment of financial nature. For “valori mobiliari” we mean types of securities which could be negotiated into a capital market. Transferable means broadly “which could be negotiated on a capital market”. A share that is not listed, generally could be listed and negotiated, so it is transferable. Even if a specific bond is not listed, but could be listed and negotiated, it is transferable. Take for example a contract of sale of commodities, executed over the counter or face to face. The contract itself is not listed, and therefore it is not transferable, according to MIFID. The first meaning of transferability is the possibility for a given instrument to be negotiated into the market, that is the multilateral system. What are transferable securities for Italian Testo Unico? a) Azioni di società (company shares) b) Bonds (obbligazioni) c) Whatever securities negotiated For us transferable securities are shares and bonds listable in the market and certificates negotiated into the market, representing the right to buy shares or bonds. Inside the big box of financial products, we have a smaller box composed of financial instruments. Financial products means financial instruments + every other form of financial investments. Inside financial instruments we have transferable securities, instruments of monetary market and derivative contracts. What is different from MIFID is financial products which are not financial instruments. Any other form of investment of financial nature that is not a financial instruments. It is not a share, or bond or derivative nor option. Derivative contracts: we have to take in mind some differences into derivative world. The first is the difference between what is called derivative instrument and what is called derivative contract. The term instrument means that the derivative is listed into the market (like options on listed shares). Options on listed shares are a kind of derivatives which are listed themselves. If the derivative contract is listed, we are talking about derivative instruments. The difference among derivative contracts listed and not listed is due essentially to two factors. The first is liquidity, the second is pricing. Pricing and liquidity characterises derivatives that are listed. We have a distinction both in the MIFID and in the Testo Unico between derivative contracts listed and not listed. How do you enter a not listed derivative contract? We do not have a proper capital market in this case. You are on the market when you have a process of negotiation on not discretionary basis. Even if you want to buy a listed share, you can conduct a transaction face to face outside the market. We are two parties interested in buying Mediaset shares. I have shares and I want to sell. You want to buy and you have two possibility to do it: negotiate in the market or negotiate with me outside the market. The private price that we decide is different from the price in the market. When we have taken our decision, we inform the regulator of this exchange at that price. Otherwise, this is not the case of our derivative contract, as the share of Mediaset is listed, while the derivative contract is not listed. 2. Money-market instruments; EN 12.6.2014 Official Journal of the European Union L 173/481; 3. Units in collective investment undertakings Quote di organismi comuni di investimento 4. Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, emission allowances or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash; Many kinds of derivative contracts 5. 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; 6. Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market, a MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled; 7. Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point 6 of this Section and not being for commercial purposes, which have the characteristics of other derivative financial instruments; 8. Derivative instruments for the transfer of credit risk; 9. Financial contracts for differences; 10. Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates or inflation rates or other official economic statistics 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, as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market, OTF, or an MTF; 11. Emission allowances consisting of any units recognised for compliance with the requirements of Directive 2003/87/EC (Emissions Trading Scheme) We don’t have a legal definition of what a derivative contract is  actually the world of derivative contract is really big and we have new types of derivative contracts on a daily basis. A derivative contract is a contract which value is related to an underlying. For example, the value of a pen is its price, to which it can be sold. If I have a contract, whose value is related to an index, the value of this certificate depends on the value of the underlying, that is the index. Even the real value of bank notes is a derivative that depends on a series of economic indexes. Even the value of shares is linked to the value of the firm  a broad definition will encompass everything and won’t work well. Preappello 31 maggio 7/4/2017 Derivatives contracts  two subjects: OTC contract and ISDA master agreement model. Basic scheme: investment firms, licensed to provide a certain number of financial contracts, that have as basis financial instruments. The client enters a contractual relation with the financial firm. A derivative instrument is usually listed on the market (like stocks and bonds), and can be negotiated on the market. Otherwise, a contract can be executed outside the financial market, without being negotiated. Then we have the world of OTC, that is bigger than the market world. And maybe we have a third world: retail client world. So, we have OTC, retail client and market: in all these it is possible to buy and sell derivative contracts. Technically the OTC is when the derivative contract is not listed. We have the master agreement itself (clauses and rules), then we have attachments added during the time in order to govern single transactions. We have three kinds of documents, which are transactions, schedules and confirmations. All these documents are combined with the master agreement, in order to have the full regulation of every single transaction. Between all these documents, we properly mean master agreement the combination of the schedules and the master agreement itself. What is the ISDA Master Agreement? Outside of the Financial Market there is the Over The Counter (OTC) Market, not regulated as the transactions of the Financial Market. The Financial Market in fact is a “System”, regulated for example by the MIFID, while in the OTC there are only traders speaking together, one by one, deciding the terms of the contract. For transactions related to derivative contracts, in the OTC, there is the ISDA master agreement, an instrument used to standardize the terms of the contracts and make easier to regulate the interests of the transactions, especially in the international transactions. This master (standard) agreement, published by the International Swaps & Derivatives Association, is a document agreed between two parties that sets out standard terms that apply to all the transactions entered into between those parties. The Master Agreement is particular important in the international transactions, because they normally involve conflict of law. The ISDA prevent these conflicts of law (theoretically, in practise not at all) for example making people choose both the applicable law and the jurisdiction, or giving standard definitions (Section 14) of terms like bankruptcy or general business day, preventing conflicts between national laws. It is part of a framework of documents, designed to enable OTC derivatives to be documented fully and flexibly. The framework consists of a master agreement, a schedule, confirmations, definition booklets, and a credit support annex. The schedule, that is part of the ISDA master agreement, is used to make all amendments (modifiche) to and customisations (personalizzazioni) of the Master Agreement, so parties choose whether and how certain provisions in the 2002 ISDA Master Agreement will apply. It contains the elections of the various options referred to in the Master Agreement (such as the Applicable law, the jurisdiction, the payment measures and methods, or in part 1(a) the thresholds relating to certain events of default), any amendments that the parties agree to make to the terms of the Master Agreement, and any additional provisions that the parties want to include, (ex. set-off clause between close-out amounts and amounts owing under other contracts). Summarising, the parties can alter or amend the provisions of the printed form as they wish, both by selecting between alternative provisions and by adding provisions of their own. The suggestion is to retype the schedule, but never retype the main body of the MA, to not lose the advantages of standardization. Confirmation: the purpose of the confirmation is to confirm the conditions and the economic terms of the derivative transactions entered (or already entered, given that is often the case that parties enter into transactions prior to signing the Master Agreement), and this document is not a part of the MA. Derivatives transactions are usually entered into (stipulate) orally or electronically and the contract between the parties is formed at this time. The evidence of the terms of the transaction is contained in this confirmation (also known as a trading advice or contract note), usually a short letter, fax or email. The form of the confirmation is set out in the Master Agreement and a limited period of time is usually allowed for objections or amendments to the confirmation after its receipt. Confirmations are usually very short (except for complex transactions) and contain little more than dates, amounts, and rates. Definitional Booklets (opuscolo di definizioni): many of the derivatives transactions are addressed to definitional booklets. Some of the more common transactions are for example basis swaps, bond options, commodity derivatives, CDS, currency swaps and equity options. Why is useful? The huge values and volumes in the OTC market increases the pressure on traders to make sure they are not exposed to unknown risk, which is something that can easily happen in two party negotiations. Using the ISDA Master Agreement in derivatives trading has other several advantages. It provides both parties with clear definitions of all contract terms, and because it can take a long period of time to negotiate, both parties are likely to be very familiar with its material. Using a master agreement keeps the two parties from having to enter into new rounds of negotiations for future transactions, which saves time and legal fees. The master agreement also aids in reducing disputes by providing extensive resources defining its terms and explaining the intent of the contract. History: At the core of the ISDA documentation framework is the 1992 Agreement. There is also a Local Currency – Single Jurisdiction version of the 1992 ISDA Master Agreement, but characterized by a limited use. The Multicurrency - Cross Border version is the most versatile, and, although it can be used between parties in the same jurisdiction for transactions involving a single currency, has been particularly designed for transactions between parties in different jurisdictions and/or which involve more than one currency. The 2002 Agreement updates the 1992 Agreement and includes some modified provisions and certain new provisions; some example of these new provisions are new methodology for close-out calculations, new provisions for Termination Events and Bankruptcy Events of Default and a set-off provisions. Termination and close-out netting (compensazione in itinere) One of the biggest advantages of the Master Agreements is the ability of the parties to terminate all outstanding (in sospeso) transactions if certain specified events occurs; this termination is known as a close-out. The Master Agreements provide a mechanism for the calculation of the present value of all obligations in respect of outstanding transactions, and finally the single net obligation of one party to make a payment to the other. Capital adequacy and netting (compensazione alla fine) There are several requirements which normally need to be met before a bank or other financial institutions can use close-out netting provisions in an agreement as an effective means of reducing credit exposures. The requirements are: 1) The party seeking to rely on the netting agreement for capital adequacy purposes must hold reasoned legal opinions on the enforceability of the close-out netting provisions in each relevant jurisdiction. ISDA have commissioned numerous legal opinions on the enforceability of these provisions (under English law and New York law), and these opinions are addressed to ISDA and may be relied upon by members of ISDA. 2) The netting agreement must not contain a “walk-away clause - i.e. a clause which permits a non- defaulting party not to pay a net sum which it may be obliged to pay to a defaulting party on early termination after the close-out netting calculation has been made. Sections: (1, 3, 5, 13, 14) Heading (intestazione) is an important part of the contract. The heading contain the identifying information: the name of each party and, if desired, the form and jurisdiction of its organization must be specified on the first page of the main text as well as in the heading of the Schedule. The weight of the preamble is quite important because the parties here declare the reasons why they entered into the contract, and normally this is the best point of view to understand the contract. The heading underlines that the contractual relationship of the parties will be governed by both the MA (which includes the Schedule) and, in the case of any transaction, any document and other confirming evidence exchanged between the parties. Section 1 (Interpretation). In the first part of the contract we have general clauses about the contract: the first one is called “interpretation of the contract”. We have a list of rules in order to find out the proper interpretation method. Section 1 sets forth certain rules of Interpretation, and is subdivided in two paragraphs: a) Definitions, b) Inconsistency. a) “The terms defined in section 14 and elsewhere in this MA will have the meanings therein specified for the purpose of this MA”. Terms defined in Section 14 and in the Schedule are to apply to the Master Agreement. The applicable ISDA Definition booklet is also likely to be incorporated into each Confirmation, and together (Definition booklet and Confirmation) will be incorporated into the Master Agreement, since they form part of the same single agreement (is like a single agreement btw the parties). Paragraph B is inconsistency (incongruenza), between the provisions of the schedules and the other provisions of this master agreements schedules will prevail. b) This paragraph set forth what happens in case of inconsistency (discrepanza) between documents of the ISDA Master Agreement. Where there are discrepancies, the Schedule prevails over the printed terms of the Master Agreement, and, for a particular Transaction, the relevant Confirmation over the printed terms and Schedule. Therefore it is possible to vary the standard terms either for all Transactions between the parties (by introducing changes to the printed terms in the Schedule), or for a particular Transaction (by the provisions of the relevant Confirmation). The MA is the weakest document. In the event of any inconsistency between the provisions of any confirmations and the master agreements, confirmations will prevail. We might have different schedules and different confirmations that could have been attached during the time to the master agreement. We might have that some specific provisions in this document could be different from the provisions set in the master agreement. As an example, there is an interest rate swap agreement, where, every 30 days, part A has to pay part B or vice-versa, according to net incorporation agreement. A has to pay to B, but when exactly? It is important to find out the proper term as, if A does not pay in that term, A is in default  two consequences: 1- part B goes to the judge to oblige part A to pay 2- maybe there are interests to be added to the payment for delay The unique possibility is that part A is in default, but you must have in mind the terms of A. If A, notwithstanding the order of the judge, fails, there is an event of termination of the contract. Probably there would be another judgment before default, stating not only that A has to pay the amount of the netting plus interest, but even plus damages; because of early termination of the contract, that caused damages to B. Events of default: here we have definitions which enumerates the situations that will constitute an Event of Default under the agreement. In general, the clause includes defaulting on any notes or loan agreements, violating any representations and warranties, and failing to perform obligations. Example: failure to pay or deliver, breach of Agreement, Misrepresentation, rules of default under specific transactions, but we will analyse the bankruptcy (vii). 5- VII Bankruptcy: it is a legal definition. Bankruptcy is one termination clause. The bankruptcy essentially deals with the insolvency of a party, its Credit Support Provider or Specified Entities. Under US or UK law there is a variety of events associated with bankruptcy or insolvency proceedings, but we must recognize that market participants are located in and organized by different countries laws. Accordingly, the Bankruptcy event of default has been drafted with the intention that it could be broad enough to be triggered by analogous proceedings or events under any bankruptcy or insolvency laws pertaining to a particular party. The meaning of bankruptcy in this kind of agreement is wide, and it has nothing in common with the civil legislation of countries. It's important to say that whether a party is organized in a jurisdiction other than US or UK, market participants may, in certain cases, wish to modify this event of default to refer to specific insolvency concepts relevant in other jurisdictions. Il concetto è che nel MA viene usata una definizione di “bankruptcy” molto ampia, che comprende un sacco di eventi, una sorta di mix di US e UK laws, ma comunque diversa! Nel caso qualcuno avesse scelto per esempio l’Italia come applicable law (strano), si userebbe la definizione data dalla legge italiana di bancarotta. Se no quella dell’ISDA (dissolution, insolvency, petition presented by a third party, etc.) Termination Event: For the purposes of these provisions it is important to note which party is to be treated as the “Affected Party”, and also which Transactions are to be treated as “Affected Transactions”. “Affected Transactions” is defined in Section 14 and means all transactions affected by a Termination Event. A termination event means an illegality, a Force Majeure event, a tax event, a tax event upon merger or if specified to be applicable, a credit event upon merger or an additional termination event. Force Majeure Event differs from an illegality because it covers events which are outside from the definition of illegality, but which still hinder performances. 13- Governing law and jurisdiction: which is the difference? You might have an Italian judge applying English law in a specific case. The burden of the proof of foreign law is on counterparties, and the judge usually asks for an expertise about the law he has to apply. a- Governing law: “This Agreement will be governed by and construed in accordance with the law specified in the Schedule” “Governed" = every system of law has its rules to be interpreted, "construed" Interpretation. This section 13 states that the parties select a governing law for the 2002 agreement in the Schedule (This is one of the few elections in the Schedule without which the Master Agreement cannot operate) The governing law may be English or the laws of the State of NY. Parties that wish to select a governing law for the 2002 agreement other than UK or NY law should carefully consider such an election with their legal advisers. The meaning of governing law is that different countries have different laws and their content can vary. We have to state which set of laws will govern the contract. b- Jurisdiction  legal action to be brought before the judge. If we choose English law, the jurisdiction is English court, if we choose New York state law, then the jurisdiction is Manhattan court. Section 14 (Definitions) This Section contains most of the definitions used throughout the Master Agreement. Example local business day: - In relation to any obligation set in section 2, a General Business day in the place or places specified in the relevant confirmation and a day on which a relevant settlement system is open or operating as specified in the relevant Confirmation. The settlement system if not specified it can be agreed by the parties in writing. - For the purpose to determine when a waiting period expires, a General Business Day in the place where the event of illegality/force majeure occurs. - In relation to any other payment, a General/ Business Day in the place where the relevant account is located and, if different, in the principle financial centre. - In relation to-any notice or other communication, o General business day in the place specified In the address for notice provided by the recipient and in the place where the relevant new account is to be located - A General business day in the relevant ideations for performance with respect to such specified transaction. 21/4/2017 The master agreement is untouched by the parties because all the specific details are in the contract arranged. Section 13 of master agreement is governing law and jurisdiction. Why are we before the New York court? Has the New York judge jurisdiction on this case? Master agreement orders to follow New York law, but in confirmations is written that the contract will follow English law. In continental Europe, the court and the judge do not meet the parties themselves, face by face, but just the lawyers. In common law countries, the judge is used to have a quite direct knowledge of the case even from the parties. Case of Comune di Prato A barrister is lawyer which is able to speak to the judge. In civil law countries every lawyer is allowed to defend his client in front of the judge. In common law countries only some lawyers are allowed. In order to speak to the judge a client and his lawyer need to have the bar. Usually the barrister means the client’s lawyer, not the client himself. Usually barristers work alone, without legal firms behind. A QC is a particular kind of barrister. The parties are free to pick the law they wish (whatever different law the parties have agreed to choose). International conventions (Convenzione di Roma) entered between states help deciding how to solve eventual conflicts between law and jurisdiction. The parties are free to choose the law they wish. We have a second principle in the case the parties have to go before a court. Jurisdiction of the main state involved (usually the state of the seller  convention) is referred to in this case. In the convention of Rome there is another principle: if the parties belong to the same state, so they wouldn’t have reason to choose a foreign law, they are anyway free to choose a foreign law, apart when this foreign law is against mandatory rules of their state. Ex.: bigamy. We do not have a proper legal definition of mandatory rule, but usually it is a very specific and important rule with a huge weight in defining the system. Prato, being a legal entity, needs to make “appalto”  a public tender in order to establish the best offer. The case is between Dexia Crediop S.p.A (an Italian bank), and Comune di Prato. Dexia is the claimant (querelante), the Comune is the defendant (accusato). “In the high court of Justice Queen’s bench division commercial court” two Italian parties judged in UK, Nottingham. English law and English jurisdiction. Why? Simply because the parties chose English law as the governing law in their ISDA master agreement (maybe because the bank is more comfortable in a finance jurisdiction like the UK one). Overview of the case: in order to restructure Comune di Prato debts, Comune di Prato made an auction, and Dexia won. In 2002 Dexia restructured Comune di Prato’s debt also with 6 interest rate swaps. One ISDA agreement, one Schedule and at least 6 contracts, confirmations, related to these 6 swaps. On 13 December 2010, Prato wrote to Dexia that it was in difficulty on paying the swap number 6 and it didn’t want to pay. 1) Initially the Comune says that, being a public entity, it could not enter in a derivative contract, because a public entity has not the legal capacity. The legal capacity of Comune di Prato is governed by Italian laws. So the English judge, for this aspect, has to apply the Italian law. Why? Because Italy and UK executed the Convention of Rome of 1980, that states that if the parties are both Italian parties, and the contracts are stipulated in Italy, the English judge has to comply with ALL Italian mandatory rule (the Italian mandatory rules can’t be violated). The legal capacity is one of the mandatory rule. The client is interested into the value of the shares, but has not the right to vote. The effect of an equity swap does not fit the meaning of holding a participation. Normalmente le società si quotano nei mercati regolamentati per avere una certa visibilità. Invece, i derivati vengono perlopiù negoziati in MTF o OTF. Nel mercato regolamentato c’è vigilanza da parte della CONSOB e viene applicata la MIFID. 27/4/2017 UK regulation, Italian regulation and USA federal regulation about disclosure of shareholdings. We are to compare three different system of law regulations. Because of the global financial system, we can compare a civil law country regulation with a common law one. Common points: product  the equity swap. It is the key product in order to understand how these three different rules are connected to each other, even if they belong to different legal systems. Under Italian law we have only one about equity swaps. For all the cases the financial product is the same: equity swap. All the presidents are comparable because all are about equity swap, even if they are in different countries. The equity swap mirrors the status of a shareholder, even if the party in the equity swap is not a shareholders. The short party pays an interest to the bank. The bank pays dividends, if there are. We have the underlying, that is equity  shares of the company. The only contact between this contract and the shares is because the bank, in order to hedge this positions, buys the underlying. However, the client does not have any type of direct link with the shares, as none share is in the client portfolio. By using equity swap, the client is not required to employ the full amount of money. Here the client is not using capital. There is a big save on the transaction costs. In terms of law, the position of the client is as if he was a shareholder, even he is not. Being a shareholder you are entitled to vote. The only party here entitled to vote would be the bank, as it possess the shares. If the value of the shares has increased the bank is to pay the difference. This rule is set for the usual ownership of shares. In equity swap, the client does not own the shares, so he has no reason to disclose. The bank would be eligible to make the disclosure. However, there is something that does not work well. The bank that should make the disclosure is not the real party that has interest in the underlying, but only an intermediary. The only real interested party here is the client. Before an equity swap did not follow the definition of 120. In reality every person would escape the disclosure rule by entering into an equity swap. In this way, we had many hedge funds hiding their participation into eligible companies. Which is the interest not to be disclosed as a relevant shareholders? To not interfere with the price of an underlying. If a hedge funds is interested in taking over the shares of the company, according to disclosure rules, the price of shares will increase. As the bank has to disclose to the market, I could employ five different banks splitting the underlying. None will have to disclose the threshold alone. This kind of practice has been on the hedge of legality for many years, between legality and illegality. Security act- 13D  regulates USA financial market at federal level (for every state). Any person who, after acquiring directly or indirectly the beneficial ownership of any equity security of a class that is specified, is directly or directly the beneficial owner. Owner means legally “proprietario”. Beneficial owner is not like being an usual owner, as beneficial owner would have some beneficial issue from ownership, even if he is not full owner. If in a family a father is going to buy a car for his son and is going to give him when he’ll be 18th. Legally the only legal owner of the car is the father, but which the position of the son? He is the one that does not hold a legal right of the car, but he owns an interest on the car. In common law, the son is the beneficial owner of the car, as he has an interest, as he is the one that will own the car by two years. His position is protected by common law countries. In civil law countries, the son cannot have complaints as his father is not treating the car properly. The plantif is the party that brings the case before the judge. The defendence are the two hedge funds. The most important case on U.S. market is CSX Corporation v. The Children Investment Fund Management. The defendants, TCI and 3G, amassed a large economic position in CSX Corporation, one of the nation’s largest railroads. However, they did so in close coordination with each other and used Total Return Swaps to side- step public disclosure requirements enacted under the Williams Act. The swap agreements at issue in this case are cash-settled TRSs entered into by TCI with each of eight counterparties, most significantly Deutsche Bank and Citigroup, and by 3G with Morgan Stanley. The plantif is CSX corporation. Defendances are some hedge funds: Children investment funds. TCI began in October 2006 and continued to build its position through additional swaps, reaching 8,8% by November and acting as major shareholder with CSX’s CEO and chairman. During December 2006, TCI began to investigate the possibility of a leveraged buyout, but the proposal was rejected. By February, TCI reached 13,6% of shares and started to buy shares directly on market, putting more pressure on CSX. TCI seeks other allies for the operation, sending another LBO proposal. Finally, during April, TCI started to execute TRES and putting more pressure with some request in the form of open letter. Meanwhile, TCI renegotiates TRES to guarantee that none of the investment banks would have bought more than 5% of CSX, since over 5% the bank must disclose the position to SEC. The other mutual fund, 3G, started to develop a position in CSX at the beginning of 2007, reaching in November an aggregate economic exposure of 4,9% of the company, composed by 4,1% of the shares outstanding and swaps referencing 0,8% of shares outstanding. TCI and 3G have had a long-standing relationship. TCI and 3G thus are well known to and communicate regularly with each other. 3G learnt of TCI’s interest in CSX and they discussed their activity in CSX. In December 19th 2007, TCI and 3G and others filed a Schedule 13D with the SEC, disclosing the formation of a formal group. Both disclaimed beneficial ownership of the underlying shares referenced by their TRSs, 11% TCI and 0,8% 3G. At the end, the two hedges funds launched the proxy fight with the objective to amend the CSX bylaws, giving the ability to call a special meeting to shareholders holding with at least 15 percent of all shares outstanding, for any purpose permissible under Virginia law. CSX contends that: 1- TCI violated Section 13(d) of the Exchange Act by failing to disclose its beneficial ownership of shares of CSX common stock referenced in their TRSs 2- TCI and 3G violated Section 13(d) by failing timely to disclose the formation of a group 3- It argues further that TCI and 3G violated Section 14(a) of the Exchange Act because their proxy statements were materially false and misleading TCI argued that it was not the beneficial owner of the shares referenced by its Total Return Swaps and therefore the swaps did not require TCI to publicly disclose that it had acquired a stake of more than 5% in CSX. The United States District Court rejected this argument and enjoined TCI from further violations of Section 13(d) Securities Exchange Act and the SEC-Rule promulgated thereunder. There are substantial reasons for concluding that TCI is the beneficial owner of the CSX shares held as hedges by its short counterparties. The definition of “beneficial ownership” in Rule 13d-3(a) is very broad, as is appropriate to its object of ensuring disclosure “from all . . . persons who have the ability [even] to . . . influence control.” It does not confine itself to “the mere possession of the legal right to vote [or direct the acquisition or disposition of] securities,” but looks instead to all of the facts and circumstances to identify situations in which one has even the ability to influence voting, purchase, or sale decisions of its counterparties by “legal, economic, or other[]” means. On this record, TCI manifestly had the economic ability to cause its short counterparties to buy and sell the CSX shares. The very nature of the TRS transactions required the counterparties to hedge their short exposures. By spreading its swap transactions among eight counterparties they avoid any one hitting the 5% disclosure threshold and thus triggering its own reporting obligation. Thus TCI patently had the power to cause the counterparties to buy CSX. And once the counterparties bought the shares, TCI had the practical ability to cause them to sell simply by unwinding the swap transactions. Civil law system is not so rich: EU changed the law about disclosure. Regolamento Intermediari 119 (issued by CONSOB): Criteri di calcolo per le partecipazioni in strumenti finanziari (not in shares, but in financial instruments). Shares belong to the bigger family of financial instruments, that encompass even derivatives. There are two provisions: the old one on the shares and the new one about options and equity swaps, that have shares as underlying. The only difference is that threshold for shares is 3%, while the one for financial instruments is 5%. 28/4/2017 Importance of good credits: bank makes money by lending money, with interest rate. Bank must respect a ratio between its own assets and credit. If the credit is not good, the amount of assets bank needs is higher. The higher is the credit rate, less part of assets needs to be settled. When the ratio is completely fulfilled, the bank cannot lend more money. The bank does not hold the loan in its account for more than the time requested or do the securitisation transfer the credit to another party. The bank would sell the loan to an investment bank. What happens into the balance sheet of the bank? We do not have the credit any more, but we have the money. Where does the investment bank take the money from? From investors. The investment bank buys hundreds of loans from banks. The investment bank buys many loans, then sell the CDOs to investors. Bank has 1000000 of loans. The investment bank would issue a specific product, called CDO, for 1000000$. They find investors, who would pay 10000000 in the CDO  this money goes to investment bank that uses it to buy 10000000 of loans from the bank. The creditor is the CDO holder, and not the bank anymore. The source of income always comes from the families. The client could even ignore who is the creditor: so many transfers of credit that the client is not aware who is to receive the money. In case of default of the client we have the value of the real estate. There is an important relation between assets and clients. A credit default swap is a sort of insurance. It says that, if the credit you own is not repaid, they repay it. Think there is a bond issued by a company and, if you add a fee, you can even have a credit default swap. If the company defaults in paying the obligation, you can ask for your insurance. Biggest investors in USA are investment funds. They need to make safe investments. They make the market as they are very big. The problem of securitization is that you are changing rules: you are no more interested in creditworthiness of the clients as you are to sell that credit to a third party. Obviously there is a relation between the creditworthiness and the credit, but the point is that the bank is not taking any risk coming from the default of the borrower. Theoretically ability to hedge a risk makes a good bank, but if you are to sell credits you are no more interested in correct evaluation of risks. This financial crisis was avoidable (for example, the Fed could have done a set of prudent mortgage-lending standards). We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets (the SEC could have required more capital and stopped risky practices in the big investment banks but it did not and the policymakers could have stopped the runaway mortgage securitization). Dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis (too many institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding). We conclude that a combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis. The government was ill prepared for the crisis, and its inconsistent response added uncertainty and panic in the financial markets. (People thought the risk was diversified but in truth it had been concentrated and there was no strategic plan to contain that risk since policymakers and obviously the clients lacked a full understanding of the risk and interconnections in financial markets). There was a systemic breakdown in accountability and ethics. Collapsing mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis. Over-the-counter derivatives contributed significantly to this crisis: 1- credit default swap or CDS helped the diffusion of the mortgage securitization; 2- CDS were essential to the creation of CDOs; 3- when the bubble popped and the crisis followed derivatives were in the centre of the storm The failures of credit rating agencies were essential cogs in the wheel of financial destruction. (the crisis could not have happened without the rating agencies) Securitization: pensiamo alla banca come un hotel "the bank hotel" Prima domanda: quanti clienti può ospitare questo albergo? Dipende dal numero di clienti che l'albergo accetta per stanza ma è comunque finito (c’è un massimo). Per essere un "bank hotel" deve avere un certo rating (ad esempio per l’hotel indichiamo un 4 stelle). La banca sa quanti clienti può ospitare e quanto può spendere. Pensiamo al mobilio etc. come PATRIMONIO DI PRIMO LIVELLO: la banca erogherà un certo livello di credito a seconda del patrimonio che ha (a seconda a delle stanze e del mobilio). II cliente entra nell'albergo, viene registrato ma il portiere non gli dà subito la stanza, si siede nell’atrio, chiama altri alberghi. II cliente se ne va. La banca ha guadagnato qualcosa avendo registrato il nome: ha fatto una operazione di credito TEMPORANEA. I crediti non restano nel bilancio della banca a lungo  la banca li cede poco dopo aver registrato il credito, ma se scelgo di fare così la banca dovrà avere una hall grande per ospitare tutti: la soluzione è la "sliding door", il cliente entra ed esce velocemente. Questa è la porta girevole del sistema creditizio. Ma il cliente dopo dove va? Il sistema dipende da quanto velocemente posso cedere i miei crediti e quanto velocemente il mercato li assorbe. A questo punto però le forniture dell’hotel non servono più (il patrimonio o capitale di vigilanza): conviene solamente tenere la sliding door. Le operazioni di erogazione non hanno più un rapporto reale con il patrimonio della banca e non è più necessario un grande patrimonio. The Bank pull together credits (loans) and look for a buyer of these credits establishing a price. The bank sells the credits (no more credits in the account of the bank) and receive the cash so it can restart the process. SPV (special purposes vehicles) are created by the bank only as an empty vehicle with few dollars of capital, so these vehicles collect money from the market and use the money to buy the credits (it’s an intermediary). The SPV issues instruments (bonds or derivative) which are subscribed by the investors and the cash raised with this process goes to the bank (the SPV buys credit). The SPV can buy credits from different banks, and one time that credits are acquired, and the bonds are issued, the credit are transformed in an negotiable instrument. The risk that the investor has taken is EQUAL as it purchased the credit! The risk goes on the investor and no more to the bank. In sintesi: la crisi è notoriamente partita dai mutui sub-prime. Una persona che desiderava acquistare una casa senza alcuna disponibilità finanziaria otteneva un mutuo ipotecario senza alcuna garanzia al di fuori dell’immobile. Il mutuo in media era di 30 anni a tasso fisso. Lo strumento usato è stata la securitization o cartolarizzazione ovvero la trasformazione dei mutui in prodotti finanziari negoziabili sul mercato (un prodotto di questo tipo è il cosiddetto Residential Mortagage Backed security o RMBS). La banca cede ad una società appositamente costituita (SPV) una massa di mutui. L’SPV emette dei titoli di debito che più o meno replicano l’andamento dei mutui sottostanti, con il denaro raccolto dall’emissione dei titoli paga alla banca l’acquisto dei mutui. La banca così non deve contabilizzare quei crediti e può erogare nuovi crediti ai nuovi clienti. I flussi degli RMBS restano ancorati ai debitori originari i quali attraverso il pagamento delle rate (ora alle SPV) reggono i flussi finanziari dell’intera posizione. Tutto il meccanismo gira però grazie alle banche di investimento che si interpongono tra le banche originanti il credito ed il mercato attraverso l’ideazione, l’attuazione e il collocamento dei RMBS. Questi RMBS poi potevano essere cartolarizzati a loro volta in CDO e garantiti da CDS. Il meccanismo poteva funzionare in America dato che la legge che regola la rivendita degli immobili consentiva alle banche di rivendere la casa in un periodo breve (in Europa invece è molto più lungo). Negli USA infatti le banche controllavano solo il valore dell’immobile e non la capacità dell’individuo di poter ripagare il debito. La garanzia basata solo sul real estate veniva applicata a una moltitudine di prestiti quali ad esempio il NINJA o l’ARM che venivano venduti, proposti e riproposti ai clienti in maniera continuativa generando enormi debiti a carico di famiglie e soggetti. Nel momento in cui però il mercato immobiliare rallentò (anche dovuto all’aumento dei tassi di interesse da parte della FED) molte famiglie preferirono non pagare il debito (ormai più grande del valore della casa) e si generò un’offerta di case che mandò in crisi prima il mercato immobiliare e poi quello bancario. US system to issue loans: value of guarantee  legal inefficiency in Italy To estimate the value of a debt are taken into account: the creditworthiness’, the financial situation of the subject and the value of the house as a guarantee. Obviously if the debtor became insolvent the Bank can sell the house to repay the debt but this process is different between US and EU and this difference is fundamental in terms of valuation by the banks. In Italy for example the bank cannot sell immediately the house but it must start a process with a judge that on average usually ends with the sale of the real estate through a public auction after 7 years In media i soldi recuperati sono 45€ for 100€ di loan concesso, quindi non è efficiente come sistema perché il loan-to-value, rapporto usato per valutare il credito emesso rispetto al prezzo di mercato della garanzia, è diverso da quello che ho quando devo vendere The European Directive 17 of 2014 put a common set of laws, regulations, for all European countries in issuing mortgages to consumers. http://www.dirittobancario.it/sites/default/files/allegati/lupoi_a._circolazione_e_contrabbando_del_ rischio_nei_subprime_loan_2015.pdf We spoke about sliding doors but the bank is a sort of enter gate: how can the bank check if the client (borrower) is eligible for credit? Is it legal to overpass the check? Considering a period of strong growth of the real estate prices, why I have to check the owner? I can just do a due diligence on the real estate rather than on the buyer of the house. trasparenza in capo a tutti i soggetti eroganti o venditori dei loan, così però creando i presupposti, verso tali soggetti, di “unknown and possibly unlimited amount of damages”. Di conseguenza Standard & Poor’s e Fitch Ratings dichiararono che la tipologia di loan disciplinati in quella legge non sarebbe stata più oggetto di rating, dati i potenziali rischi legali in capo ai soggetti creditori. 12 EARLY 2007: SPREADING SUBPRIME WORRIES (from page 233) “In late 2006 and early 2007, some banks moved to reduce their subprime exposures by selling assets and buying protection through credit default swaps. Some, such as Citigroup and Merrill Lynch, reduced mortgage exposure in some areas of the firm but increased it in others. With such uncertainty about the market value of mortgage assets, trades became scarce and setting prices for these instruments became difficult.” In December 2006, following the initial decline in ABX BBB indices and after consecutive days of trading losses on its mortgage desk, executives at Goldman Sachs decided to reduce the firm’s subprime exposure. Goldman has been criticized—and sued—for selling its subprime mortgage securities to clients while simultaneously betting against those securities. In addition to selling its subprime securities to customers, the firm took short positions using credit default swaps; it also took short positions on the ABX indices and on some of the financial firms with which it did business. As the crisis unfolded, Goldman marked mortgage-related securities at prices that were significantly lower than those of other companies. Goldman knew that those lower marks might hurt those other companies—including some clients—because they could require marking down those assets and similar assets. In addition, Goldman’s marks would get picked up by competitors in dealer surveys. As a result, Goldman’s marks could contribute to other companies recording “mark-to-market” losses: that is, the reported value of their assets could fall and their earnings would decline. The markdowns of these assets could also require that companies reduce their repo borrowings or post additional collateral to counterparties to whom they had sold credit default swap protection. The first significant dispute about these marks began in May 2007: it concerned the two high-flying, mortgage-focused hedge funds run by Bear Stearns Asset Management (BSAM) (a New York- based global investment bank and securities trading and brokerage firm that failed in 2008 as part of the global financial crisis and recession and was subsequently sold to JPMorgan Chase.). At the time, hedge funds were concerned about Bear Stearns’s financial health. They were attempting to get other Wall Street firms to take their place in trades with Bear Stearns on credit- default swaps used to short mortgage-backed securities, in a trade known as a “novation.” Those trades would reduce or eliminate a hedge fund’s exposure to Bear Stearns. The Commission concludes that entities such as Bear Stearns’s hedge funds and AIG Financial Products that had significant subprime exposure were affected by the collapse of the housing bubble first, creating financial pressures on their parent companies. 13 SUMMER 2007: DISRUPTIONS IN FUNDING The Commission concludes that the shadow banking system was permitted to grow to rival the commercial banking system with inadequate supervision and regulation. That system was very fragile due to high leverage, short-term funding, risky assets, inadequate liquidity, and the lack of a federal backstop. When the mortgage market collapsed and financial firms began to abandon the commercial paper and repo lending markets, some institutions depending on them for funding their operations failed or, later in the crisis, had to be rescued. These markets and other interconnections created contagion, as the crisis spread even to markets and firms that had little or no direct exposure to the mortgage market. In addition, regulation and supervision of traditional banking had been weakened significantly, allowing commercial banks and thrifts to operate with fewer constraints and to engage in a wider range of financial activities, including activities in the shadow banking system. The financial sector, which grew enormously in the years leading up to the financial crisis, wielded great political power to weaken institutional supervision and market regulation of both the shadow banking system and the traditional banking system. This deregulation made the financial system especially vulnerable to the financial crisis and exacerbated its effects. 14 LATE 2007 TO EARLY 2008: BILLIONS IN SUBPRIME LOSSES The Commission concludes that some large investment banks, bank holding companies, and insurance companies, including Merrill Lynch, Citigroup, and AIG, experienced massive losses related to the subprime mortgage market because of significant failures of corporate governance, including risk management. Executive and employee compensation systems at these institutions disproportionally rewarded short-term risk taking. The regulators—the Securities and Exchange Commission for the large investment banks and the banking supervisors for the bank holding companies and AIG—failed to adequately supervise their safety and soundness, allowing them to take inordinate risk in activities such as nonprime mortgage securitization and over-the-counter (OTC) derivatives dealing and to hold inadequate capital and liquidity 15 MARCH 2008: THE FALL OF BEAR STEARNS The Commission concludes the failure of Bear Stearns and its resulting government-assisted rescue were caused by its exposure to risky mortgage assets, its reliance on short-term funding, and its high leverage. This was a result of weak corporate governance and risk management. Its executive and employee compensation system was based largely on return on equity, creating incentives to use excessive leverage and to focus on short-term gains such as annual growth goals. Bear experience runs by repo lenders, hedge fund customers, and derivatives counterparties and was rescued by a government-assisted purchase by JP Morgan because the government considered it too interconnected to fail. Bear’s failure was in part a result of inadequate supervision by the Securities and Exchange Commission, which did not restrict its risky activities and which allowed undue leverage and insufficient liquidity 16 MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS The Commission concludes that the banking supervisors failed to adequately and proactively identify and police the weaknesses of the banks and thrifts or their poor corporate governance and risk management, often maintaining satisfactory ratings on institutions until just before their collapse. This failure was caused by many factors, including beliefs that regulation was unduly burdensome, that financial institutions were capable of self-regulation, and that regulators should not interfere with activities reported as profitable. Large commercial banks and thrifts, such as Wachovia and IndyMac, that had significant exposure to risky mortgage assets were subject to runs by creditors and depositors. The Federal Reserve realized far too late the systemic danger inherent in the interconnections of the unregulated over-the-counter (OTC) derivatives market and did not have the information needed to act. 17 SEPTEMBER 2008: THE TAKEOVER OF FANNIE MAE AND FREDDIE MAC Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) — i.e., private companies sponsored by the government — in the U.S. home mortgage industry. Though separate companies that compete with one another, they have the same business model, wherein they buy mortgages on the secondary mortgage market, pool those loans together, and then sell them to investors as mortgage-backed securities in the open market. The main difference between Fannie and Freddie comes down to who they buy mortgages from: Fannie Mae mostly buys mortgage loans from commercial banks, while Freddie Mac mostly buys them from smaller banks that are often called "thrift" banks. The Commission concludes that the business model of Fannie Mae and Freddie Mac (the GSEs), as private-sector, publicly traded, profit-making companies with implicit government backing and a public mission, was fundamentally flawed. We find that the risky practices of Fannie Mae—the Commission’s case study in this area— particularly from 2005 on, led to its fail: practices undertaken to meet Wall Street’s expectations for growth, to regain market share, and to ensure generous compensation for its employees. Affordable housing goals imposed by the Department of Housing and Urban Development (HUD) did contribute marginally to these practices. The GSEs justified their activities, in part, on the broad and sustained public policy support for homeownership. Risky lending and securitization resulted in significant losses at Fannie Mae, which, combined with its excessive leverage permitted by law, led to the company’s failure. Corporate governance, including risk management, failed at the GSEs in part because of skewed compensation methodologies. The Office of Federal Housing Enterprise Oversight (OFHEO) lacked the authority and capacity to adequately regulate the GSEs. The GSEs exercised considerable political power and were successfully able to resist legislation and regulatory actions that would have strengthened oversight of them and restricted their risk-taking activities. In early 2008, the decision by the federal government and the GSEs to increase the GSEs’ mortgage activities and risk to support the collapsing mortgage market was made despite the unsound financial condition of the institutions. While these actions provided support to the mortgage market, they led to increased losses at the GSEs, which were ultimately borne by taxpayers, and reflected the conflicted nature of the GSEs’ dual mandate. GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis. Underlying of derivative products: subprime mortgages, Automobile Title Loan, pay-day loans… pulled all together considering the risk of each one. “I prodotti derivati che hanno come sottostante altri derivati, che a loro volta ne hanno altri, sino ad arrivare ai vari loan (quali unità elementari della complessa costruzione) sono in grado di differenziare il rischio fra moltissime variabili compresa, infine, la variabile legata alla frammentazione della legislazione statale ed anche alla sua applicazione (in teoria). Separiamo in punto di analisi il sovrastante, il prodotto derivato in sé, ed il sottostante, i vari loans. Un RMBS o un CDO ha una pressoché identica struttura finanziaria in tutti i mercati, così pressoché identica è la sua struttura contrattuale attraverso l’impiego degli ISDA Master In February 2015 S&P pay 1.5bil dollars to the department of justice (USA) Goldman Sachs made an agreement with the department of justice (USA) in April 2016. GS create the derivatives (CDO) and sold them to other banks, so in 2005-6-7 pulled all kind of loans and sold this product to the market. It was a sort of broker. The financial crisis: study chapter1-2-3-5-8-18 Comune di Prato: [A1- fino al punto 14] + [C3.1] + [C4.1] C4.1  133 cannot happen in English law system. Highest court is Corte di Cassazione in Italy. 134: in Italy we have three levels: tribunal, court and then Corte di Cassazione. We do not have stare decisis principle. Corte di Cassazione could produce different judgments for similar disputes. D2- VI and 144, 147, 159, 160. According to the English judge, Prato was entitled to enter the swap contract, according to Italian law not. E1 208 All the elements of the relationship are located in one single state. We might have two parties on the same state, but the contract may provide rules for an international transaction. Which is the mandatory rule that Prato has skipped? E2. 216 5/5/2017 Relation between intermediary placing financial products and clients. MIFID: we have the client and the market, between we have the financial investment firm, providing services to the client. In this basic framework, the client has indirect access to the market through the investment firms. Most of the provisions are already implemented, because they are already in MIFID1. 1. Reception and execution of orders in relation to one or more financial instruments 2. Execution of orders on behalf of clients (basic service) One part gives an order to another party to execute a specific transaction on his behalf on the market  this is way retail client does not have direct access to the market. There are not many rules regulating this service. Part are in the civil code. 3. Dealing on own account 4. Portfolio management Client is not able to make proper decisions alone. The portfolio manager is an investment firm, and this activity is much more regulated than execution of orders on behalf of the client. Portfolio management and investment advice are the most regulated activities. 5. Investment advice 6. Placing of financial instruments MIFID1 required a questionnaire on portfolio management. In the beginning, it was just a statement that the client had enough financial knowledge, stated by the client. In reality declaration was made by the firm and submitted to the client. Because of this declaration, this client was less protected than the retail client. The client had to sign this because, in theory, if you sign this declaration, the range of operations that you can offer the client is much higher. The other scope of the questionnaire is to find out the level of financial risk that the client wants to take. We have to match the client risk profile with portfolio risk. We have low risk, medium risk and high risk, where risk means the same thing. You can use a numeric scale, from 1 (low) to 7 (high). This last way is what MIFID2 provides. We must bear in mind that this perfect matching between client and portfolio profiles is only provided by portfolio management and investment advices. Why do we have these differences between financial services? In number 4 the real decision about investment is not taken by the client, but by the firm. The guidelines on investment management choices are given by the client’s risk profile. The object of the advice must be a financial product. Financial advice: buy shares or not  this kind of service is regulated. You must comply with MIFID directive, you must be authorized and licensed by MIFID to offer investment advices. The advisor should submit the MIFID questionnaire to the client to find out his level of risk. The basic assumption of MIFID is that each client is a retail client. Execution with retail client is more protected than execution with non-retail client. Applicability of suitability (adeguatezza) rule for what concerns portfolio management and investment advice. It is a specific rule only applicable to these two services. What does retail client mean? A single declaration of the client to be a professional client is not enough. Professional clients: credit institutions, investment firms… Large undertakings: enterprises or companies. How can you assume that a large company has a proper knowledge of financial products? If you are large enough, you should have enough skilled managers. In the description there are not individual, physical people, but just legal entities. There is a specific information provided by the firm and addressed to the client that the client has to be treated as a professional client. Clients may be treated as professional on request. Identification criteria: maybe you are not a professional client, but you asked to be treated like one. The procedure is that the retail client ask to be treated like a professional client. Moreover, the law wants the investment firm to do a serious assessment about expertise, experience and knowledge of client, in order to understand if he is really able to understand the risk behind the transactions. (Annexe 2 MIFID2). Provisions to ensure investment protection to client (second part of MIFID2). Many cases in which the firms have placed to client many products that were not suitable to them  bank Etruria. You have a bank which would like to place its own bonds. Bonds are financial products in the definition of MIFID. Placement is a financial service  we can apply all the MIFID package. Big numbers are made by retail clients, much more than professional clients. In order to place these bonds to retail clients, you need to start a procedure, in order to assess the risk profile of clients and match it with bonds’ risk profile. The most important documentation is the prospectus. All the prospectus usually have the same kind of information. Other than the prospectus, that is a very difficult document for a retail client, we have another kind of document, that is called the KID information document. This is a document of no more than three pages. If the client approaches the bank asking for an investment, there is not solicitation. Otherwise, if the bank goes to the client, there is solicitation made by the bank to the client. Convertible bonds  if you invest 100 euros, you can have back 100 euros of shares back. Otherwise, you could even have 10 shares that now are value 10 euros each. Bonds by itself means nothing: it could be even a very dangerous thing. The duty of the bank is to find out the clients with the high level of risk, to invest in the high level of risk product. In reality, the bank needed to place the more bonds possible, while it should have done the best interest of the client. If you start thinking that you need to place bonds you are starting badly. The bank called all retail clients in order to place risky bonds. They changed risk profile of client from lowest to highest in order to associate then dangerous bonds. KID is key information document: flow of information between the firm and the client. Two MIFID basic provisions: article 24 and 25. 24 provides for the basic behaviour terms that an investment firm must have to protect the client. 25 is about some specific flow of information that investment firm must collect from and give to the client. Conflict of interest: the two parties have two opposite interests in the transaction. Usually it is normal  contract of sales. The buyer wants to reach the lower price and the seller the higher price. It is unusual when we have the bank and the client, as the bank has always to assure the interest of the client. It is much more normal between contractual counterparties  with bank we are not selling a product, but a service. Key information for the investors: the key information document is standard for all the European union. Article 24: provisions to ensure investment protection. Article 25  suitability and appropriateness. It is not given for granted that the firm has a full knowledge of the products it is going to sell. Tutti gli strumenti finanziari trasferibili possono essere in astratto anche negoziabili, ma questo non vale per tutto ciò che è trasferibile. CDS: Think about the usual relationship between the debtor and the creditor. The debtor has to pay the money back. The main interest of the creditor is the financial capacity of the debtor  he has an interest in the debtor ongoing business. He could be interested in supporting the debtor in order to move on: they are on the same side. With a CDS, if the debtor cannot pay, the creditor will call for the credit default swap  strong insurance on issued bonds. Otherwise, this product causes that the creditor is not interested any more in the debtor interested: he is no more interested in supporting debtor business. They are now on a different side.