MiFID II/MiFIR Framework Overview
The Markets in Financial Instruments Directive II (MiFID II) and its accompanying Regulation (MiFIR) represent the cornerstone of EU financial markets regulation. Implemented on January 3, 2018, this comprehensive framework governs how investment firms operate, how financial instruments are traded, and how investors are protected across the European Union.
For trading platforms operating in or seeking access to EU markets, understanding MiFID II is not optional - it is fundamental to lawful operation. The directive applies to investment firms providing investment services and activities in relation to financial instruments, and the regulation establishes uniform requirements directly applicable across all EU member states.
Key Legislative Instruments
- MiFID II (Directive 2014/65/EU): Framework directive requiring national implementation
- MiFIR (Regulation 600/2014): Directly applicable regulation on transparency and market structure
- IFD (Directive 2019/2034): Investment Firm Directive - prudential requirements
- IFR (Regulation 2019/2033): Investment Firm Regulation - capital requirements
- Delegated Regulations: RTS 1-28 providing detailed technical standards
Scope of Application
MiFID II applies to investment firms authorized in the EU that provide investment services or perform investment activities. The core services and activities covered include:
- Reception and transmission of orders - Receiving client orders and transmitting them for execution
- Execution of orders on behalf of clients - Acting to conclude agreements to buy or sell financial instruments
- Dealing on own account - Trading against proprietary capital to fill client orders
- Portfolio management - Discretionary management of client portfolios
- Investment advice - Providing personal recommendations on financial instruments
- Underwriting/placing - Underwriting or placing financial instruments
- Operation of MTFs/OTFs - Operating multilateral or organized trading facilities
Financial Instruments Covered
The directive covers a broad range of financial instruments defined in Annex I, Section C of MiFID II:
- Transferable securities (shares, bonds, depositary receipts)
- Money market instruments
- Units in collective investment undertakings
- Derivatives (options, futures, swaps, forwards, CFDs)
- Emission allowances
- Structured deposits (when distributed by investment firms)
MiFID II Applicability Decision Flowchart
Investment Firm Categories (IFD/IFR)
The Investment Firm Directive (IFD) and Investment Firm Regulation (IFR), effective since June 26, 2021, introduced a new prudential framework specifically designed for investment firms. This replaced the previous approach of applying banking rules (CRD IV/CRR) to all investment firms.
The framework categorizes investment firms into three classes based on their size, activities, and systemic importance. Understanding your firm's classification is essential as it determines capital requirements, reporting obligations, and governance standards.
Class 1 - Systemic Investment Firms
- Threshold: Assets over EUR 30 billion (or EUR 15 billion with NCA discretion)
- Regulation: Full CRD/CRR bank-like regime
- Authorization: Must be authorized as credit institution
- Capital: Subject to full bank capital requirements
- Examples: Large dealing-on-own-account firms, major clearing members
Class 2 - Standard Investment Firms
- Threshold: Exceeds any of the Class 3 thresholds
- Regulation: Full IFD/IFR requirements
- Capital: K-factor requirements (K-AUM, K-CMH, K-ASA, K-COH, K-DTF, K-NPR, K-CMG, K-TCD, K-CON)
- Reporting: Full quarterly supervisory reporting
- Remuneration: Full remuneration requirements apply
Class 3 - Small, Non-Interconnected Firms
- Thresholds: AUM < EUR 1.2bn, COH < EUR 100m/day, ASA < EUR 30m, etc.
- Regulation: Simplified IFR requirements
- Capital: Higher of: permanent minimum, fixed overhead, or K-factor sum
- Reporting: Annual reporting only
- Benefits: No K-factor calculation, simplified governance
K-Factor Requirements (Class 2 Firms)
Class 2 investment firms must calculate capital requirements using K-factors, which measure risks based on the firm's activities. K-factors are grouped into three categories:
| Category | K-Factor | What It Measures | Coefficient |
|---|---|---|---|
| Risk-to-Client (RtC) | K-AUM | Assets under management | 0.02% |
| K-CMH | Client money held | 0.4% (segregated) / 0.5% (non-segregated) | |
| K-ASA | Assets safeguarded and administered | 0.04% | |
| K-COH | Client orders handled | 0.1% (cash) / 0.01% (derivatives) | |
| Risk-to-Market (RtM) | K-NPR | Net position risk | CRR calculation |
| K-CMG | Clearing member guarantee | Alternative to K-NPR | |
| Risk-to-Firm (RtF) | K-TCD | Trading counterparty default | CRR-based |
| K-DTF | Daily trading flow | 0.1% (cash) / 0.01% (derivatives) | |
| K-CON | Concentration risk | Large exposures-based |
ESMA Guidelines Reference
ESMA35-36-2858: Guidelines on certain aspects of the MiFID II remuneration requirements for investment firms classified as Class 2 under IFD/IFR. Provides clarity on proportionality and specific remuneration rules.
Best Execution Requirements (RTS 27/28)
Best execution is a cornerstone obligation under MiFID II, requiring investment firms to take all sufficient steps to obtain the best possible result for clients when executing orders. This obligation applies across all financial instruments and has been significantly enhanced compared to MiFID I.
Core Best Execution Obligations
Article 27 of MiFID II establishes the framework for best execution. Firms must:
- Establish and implement an execution policy covering each class of instruments
- Consider price, costs, speed, likelihood of execution and settlement, size, nature, and other relevant factors
- Give appropriate weight to factors based on client characteristics, order characteristics, and instrument characteristics
- Not receive any remuneration for routing orders unless it demonstrably improves execution quality
- Monitor effectiveness of execution arrangements and correct any deficiencies
RTS 27/28 Suspension Update
Note that RTS 27 (execution venue reporting) was suspended by the European Commission from February 2023 as part of the MiFID II/MiFIR review. RTS 28 (execution quality reports) remains in effect but is under review. Trading platforms should monitor the MiFID III/MiFIR review developments for permanent changes to these requirements.
Execution Factors and Their Prioritization
| Factor | Description | Priority for Retail | Priority for Professional |
|---|---|---|---|
| Price | The price at which the instrument is bought or sold | High | High |
| Costs | All expenses incurred in execution, including venue fees | High | Medium |
| Speed | Time taken to execute the order | Medium | High (for HFT) |
| Likelihood of execution | Probability that the order will be executed | Medium | High |
| Size | The size of the order and market impact | Low | High (for large orders) |
| Settlement | Likelihood and timing of settlement | Medium | Medium |
Execution Policy Requirements
Investment firms must establish an order execution policy that includes:
- Information on venues where the firm executes orders for each class of instruments
- The factors affecting the choice of execution venue
- How execution factors are prioritized for different client categories
- How client-specific instructions affect the policy
- Mechanisms for monitoring execution quality
- An annual review and update process
Specific Client Instructions
When a client provides specific instructions regarding order execution, the firm must follow those instructions. However, this may prevent the firm from achieving best execution for some factors. The execution policy must clearly explain how specific instructions affect the best execution obligation.
RTS 28 Annual Reporting
Investment firms must publish annual reports on the top five execution venues used for each class of financial instrument, including:
- Volume and number of orders executed on each venue
- Percentage of passive vs. aggressive orders
- Percentage of orders executed at market makers
- Information on securities financing transactions
- Qualitative assessment of execution quality obtained
Transaction Reporting (RTS 25)
MiFID II significantly expanded transaction reporting requirements compared to its predecessor. Investment firms must report complete and accurate details of transactions to competent authorities, enabling market surveillance and detection of market abuse.
What Must Be Reported
Transaction reports must include 65 data fields covering:
- Firm identification: LEI, branch identification, trader identification
- Client identification: Client LEI or national identifier, decision maker details
- Transaction details: Venue, instrument identification (ISIN), price, quantity
- Date and time: Trading date/time, settlement date
- Capacity: Whether acting as principal, agent, or both
- Short selling indicators: Whether the sale is a short sale
- Waiver indicators: Any pre-trade transparency waivers used
Reporting Timeline and Mechanism
Transaction reports must be submitted:
- Deadline: As soon as possible, no later than the close of the following working day (T+1)
- Mechanism: Via an Approved Reporting Mechanism (ARM) or directly to the NCA
- Format: ISO 20022 XML format
- Corrections: Errors must be corrected and resubmitted promptly
Enforcement Focus
National Competent Authorities have made transaction reporting accuracy a priority enforcement area. Fines for reporting failures have been significant. Firms should implement robust data quality controls and regular reconciliation processes to ensure compliance.
RTS 25 Clock Synchronization
RTS 25 establishes strict requirements for clock synchronization to ensure accurate timestamps in transaction reports:
| Activity Type | Maximum Divergence from UTC | Timestamp Granularity |
|---|---|---|
| High-frequency trading | 100 microseconds | Microseconds or better |
| Trading on voice systems | 1 second | Seconds |
| Other trading activities | 1 millisecond | Milliseconds |
| Trading venues | 100 microseconds | Microseconds |
ESMA Guidelines Reference
ESMA/2016/1452: Guidelines on transaction reporting, order record keeping and clock synchronisation. Provides detailed technical guidance on compliance with RTS 25 requirements.
Product Governance (Target Market & Distribution)
MiFID II introduced comprehensive product governance requirements to ensure financial products are designed and distributed to appropriate clients. These rules apply throughout the product lifecycle, from conception to distribution.
Manufacturer Obligations
Firms that create, develop, issue, or design financial instruments (including advising issuers) must:
- Identify target market: Define the group of end clients for whom the product is compatible
- Assess compatibility: Evaluate the product against client needs, characteristics, and objectives
- Stress testing: Conduct scenario analysis to assess product performance in various conditions
- Distribution strategy: Determine appropriate distribution channels
- Product review: Regularly review products to ensure they remain compatible with the target market
- Information sharing: Provide distributors with all necessary target market and product information
Target Market Definition
The target market must be defined using these categories:
| Category | Considerations |
|---|---|
| Client type | Retail, professional, eligible counterparty |
| Knowledge and experience | Basic, informed, advanced |
| Financial situation | Ability to bear losses (none, limited, significant, no capital guarantee) |
| Risk tolerance | Risk profile compatibility (low, medium, high) |
| Objectives and needs | Investment horizon, growth, income, hedging, speculation |
Distributor Obligations
Firms that offer or recommend financial instruments to clients (distributors) must:
- Obtain target market information from manufacturers
- Define their own target market based on client base knowledge
- Identify clients for whom the product is NOT compatible (negative target market)
- Assess product compatibility during distribution
- Regularly review products distributed
- Provide feedback to manufacturers on products distributed
Best Practice: Product Governance Framework
Establish a formal product governance committee with representation from product development, risk, compliance, and distribution. Document all target market assessments and distribution decisions. Maintain audit trails of manufacturer-distributor information exchanges.
ESMA Guidelines Reference
ESMA35-43-3448: Guidelines on MiFID II product governance requirements. Provides detailed guidance on applying the product governance framework, including practical examples of target market identification.
Client Categorization
MiFID II requires investment firms to categorize clients into three categories, each receiving different levels of regulatory protection. Proper categorization is fundamental to determining the applicable conduct of business rules.
The Three Client Categories
Retail Clients
- Definition: Any client not classified as professional or eligible counterparty
- Protection: Highest level of regulatory protection
- Suitability: Full suitability assessment required
- Information: Comprehensive pre-trade disclosures
- Best Execution: Total consideration (price + costs) primary factor
- PRIIPs: KID document required for packaged products
Professional Clients
- Per Se Professional: Credit institutions, investment firms, insurers, pension funds, governments, large corporates
- Elective Professional: Retail clients who meet 2 of 3 criteria and opt up
- Criteria: 10+ transactions/quarter, EUR 500K+ portfolio, 1+ year financial sector experience
- Protection: Reduced conduct rules, assumed to have knowledge
- Opt-down: Can request higher protection for specific services
Eligible Counterparties
- Definition: Most sophisticated market participants
- Categories: Investment firms, credit institutions, insurers, UCITS, pension funds, market makers
- Protection: Minimal - best execution and conduct rules largely disapply
- Activities: Only for reception/transmission, execution, dealing on own account
- Not available for: Portfolio management, investment advice
Client Re-Categorization Procedures
Clients may request to be treated as a different category (opt up or opt down):
Retail to Professional (Opt Up)
- Client makes written request to be treated as professional
- Firm assesses that client meets at least 2 of 3 quantitative criteria
- Firm conducts qualitative assessment of expertise and experience
- Firm provides clear written warning of protections lost
- Client confirms in writing they understand the consequences
- Firm documents assessment and retains records
Professional to Retail (Opt Down)
- Professional clients may request higher protection at any time
- Firm must accept the request (not at firm's discretion)
- Can be for all services or specific services/products
- Client must enter into written agreement specifying scope
Documentation Requirements
Firms must maintain comprehensive records of all client categorization decisions, including the basis for categorization, any re-categorization requests, assessments conducted, and client acknowledgments. These records are subject to regulatory review and must be retained for a minimum of 5 years (10 years for transaction-related records in some member states).
Inducements & Research Unbundling
MiFID II introduced strict rules on inducements (third-party payments received by investment firms) and requires the unbundling of research costs from execution costs. These provisions aim to eliminate conflicts of interest and improve transparency.
General Inducement Rules
Under Article 24(9) of MiFID II, investment firms providing investment services must not accept or retain any fees, commissions, or non-monetary benefits from third parties unless:
- The inducement is designed to enhance the quality of service to the client
- It does not impair the duty to act in the client's best interest
- The existence, nature, and amount is clearly disclosed before service provision
Independent Advice Prohibition
Firms providing investment advice on an independent basis, or portfolio management services, are prohibited from accepting inducements entirely (with narrow exceptions for minor non-monetary benefits).
What Is Prohibited
- Retrocessions from product providers when providing independent advice
- Volume-based commissions from trading venues
- Payment for order flow (in most EU member states)
- Research bundled with execution costs (see below)
- Any payment that could compromise best interest duty
Research Unbundling
MiFID II requires that investment firms receiving execution services and research must pay for them separately. This can be achieved through:
| Payment Method | Description | Considerations |
|---|---|---|
| Direct payment from P&L | Firm pays for research from its own resources | Full transparency, no client charge |
| Research Payment Account (RPA) | Separate account funded by agreed client charge | Strict governance requirements apply |
| Combined approach | P&L for some, RPA for others | Common for varying research types |
RPA Requirements
If using a Research Payment Account:
- The RPA must be funded by a specific research charge to clients
- The charge must be based on a research budget set by the firm
- The budget must be reviewed regularly and linked to research value
- Full disclosure to clients required before charges are made
- Annual disclosure of total costs and payments to research providers
- Written policy on research procurement required
ESMA Guidelines Reference
ESMA35-43-3163: Final Report on MiFID II inducements. Clarifies the scope of inducement rules, acceptable minor non-monetary benefits, and research unbundling requirements in practice.
Comparison with US Regulations
Trading platforms operating in both the EU and US markets must navigate two distinct regulatory frameworks. While both aim to protect investors and ensure market integrity, their approaches differ significantly.
| Aspect | EU (MiFID II) | US (SEC/FINRA) |
|---|---|---|
| Regulatory Structure | Harmonized EU framework with national implementation by NCAs | Federal SEC oversight + FINRA self-regulation + state regulators |
| Best Execution | Prescriptive rules, detailed disclosure requirements, RTS 28 reporting | Principles-based, FINRA Rule 5310, order routing disclosure |
| Client Classification | Three tiers: Retail, Professional, Eligible Counterparty | Primarily: Retail vs. Institutional; Accredited Investor for offerings |
| Suitability | Comprehensive suitability for advice, appropriateness for execution-only | FINRA suitability rule, Reg BI for broker-dealers (2020) |
| Research Unbundling | Mandatory separation of research and execution costs | Not required; soft dollar arrangements permitted under Section 28(e) |
| Payment for Order Flow | Effectively prohibited in most member states | Permitted with disclosure (under SEC review) |
| Transaction Reporting | T+1 to ARM, 65 data fields | Various: CAT, OATS (deprecated), Form 13H, etc. |
| Capital Requirements | IFD/IFR K-factors for investment firms | SEC Net Capital Rule (15c3-1) |
| Product Governance | Comprehensive manufacturer/distributor obligations | Limited; focus on disclosure rather than target market |
| Inducements | Strict limitations, outright prohibition for independent advice | Disclosure-based approach, conflicts management |
Key Operational Differences
US-based platforms seeking to serve EU clients often find MiFID II more prescriptive than US rules. Particular challenges include: research unbundling (if the firm uses soft dollars in the US), PFOF restrictions, more detailed transaction reporting, and the comprehensive product governance framework. Many firms maintain separate compliance programs for each jurisdiction.
Regulatory Equivalence Status
The EU equivalence framework allows third-country firms to provide services to EU clients under certain conditions. As of 2025:
- US: No general equivalence decision for investment services
- UK (post-Brexit): Temporary equivalence expired; no permanent decision
- Switzerland: Limited equivalence for certain services
- Australia, Hong Kong, Singapore: Partial equivalence in specific areas
Third-Country Firm Access Post-Brexit
Since January 1, 2021, UK firms are treated as third-country firms under MiFID II, having lost EU passporting rights. This section examines the framework for third-country access to EU markets, with particular attention to UK firms navigating the post-Brexit landscape.
Third-Country Access Routes
Non-EU investment firms seeking to provide services to EU clients have limited options:
1. EU Branch Establishment
- Establish a physical presence in an EU member state
- Subject to MiFID II authorization by the host state NCA
- Can provide services only in the member state of establishment (no passporting for branches)
- Must meet local capital, governance, and conduct requirements
2. EU Subsidiary
- Incorporate a fully-capitalized EU subsidiary
- Obtain MiFID II authorization as an EU investment firm
- Full EU passport available for cross-border services
- Most robust but most resource-intensive option
3. National Reverse Solicitation
- Where client exclusively initiates contact with the non-EU firm
- No marketing or solicitation by the firm in the EU
- Strictly interpreted; documentation burden on the firm
- ESMA scrutinizes potential abuse of this exemption
4. Article 47 MiFIR Registration (Professional Clients Only)
- Available where EU equivalence decision exists for the third country
- Firm registers with ESMA to provide services to per se professional clients and eligible counterparties
- Currently not available for US or UK firms (no equivalence decision)
UK Firms: Post-Brexit Reality
UK financial services firms lost EU passporting rights on December 31, 2020. Despite ongoing EU-UK regulatory dialogue, no equivalence determinations have been made for investment services. UK firms must now either establish EU entities, rely on national exemptions (where available), or limit activities to reverse solicitation from per se professional clients.
Member State National Regimes
Some EU member states maintain national third-country regimes that may permit limited services without full MiFID II authorization:
| Member State | Third-Country Regime | Key Conditions |
|---|---|---|
| Germany | Section 32(1) KWG exemption | Notification to BaFin, professional clients only, no regular activity |
| Netherlands | AFM simplified license | Professional/institutional only, specific services |
| France | No third-country exemption | Full licensing or reverse solicitation only |
| Ireland | Limited reverse solicitation | Strict interpretation, documentation required |
| Luxembourg | Professional client exemption | Notification to CSSF, specific conditions |
Cost and Timeline Estimates
For non-EU firms considering EU market entry:
ESMA Guidelines Reference
ESMA35-43-2502: Statement on reverse solicitation under MiFID II. Emphasizes narrow interpretation, documentation requirements, and enforcement priorities regarding potential circumvention.
MiFID II Compliance Checklist
Essential MiFID II Compliance Items
- ☐ Authorization Status: Confirm MiFID II authorization from home state NCA or valid exemption
- ☐ Firm Classification: Determine IFD/IFR class (1, 2, or 3) and applicable capital requirements
- ☐ Client Categorization: Implement and document client categorization procedures
- ☐ Suitability/Appropriateness: Establish assessment procedures appropriate to services provided
- ☐ Best Execution Policy: Document and publish execution policy for each instrument class
- ☐ Transaction Reporting: Establish ARM connection and data quality controls
- ☐ Clock Synchronization: Implement RTS 25 compliant time synchronization
- ☐ Product Governance: Define target markets, establish review procedures
- ☐ Inducement Policies: Document and implement inducement handling procedures
- ☐ Research Unbundling: Separate research costs or establish RPA
- ☐ Conflicts of Interest: Maintain conflicts register and management procedures
- ☐ Complaints Handling: Establish compliant complaints procedure
- ☐ Record Keeping: Implement retention systems meeting MiFID II requirements (5-10 years)
- ☐ Remuneration Policy: Align compensation structures with IFD requirements
- ☐ Supervisory Reporting: Establish capital adequacy and other NCA reporting
- ☐ Client Disclosures: Provide all required ex-ante and ex-post disclosures
Key ESMA Guidelines Summary
ESMA has published numerous guidelines and Q&As to support MiFID II implementation. Key references for trading platforms include:
| Reference | Topic | Key Points |
|---|---|---|
| ESMA35-43-349 | Suitability | Requirements for suitability assessments including automated advice |
| ESMA35-43-620 | Product Governance | Target market identification and product review procedures |
| ESMA35-43-1163 | Complex Instruments | Guidance on assessing complexity for appropriateness |
| ESMA70-872942901-35 | Transaction Reporting | Technical guidance on reporting fields and validation |
| ESMA35-36-2858 | IFD Remuneration | Application of remuneration rules to Class 2 firms |
| ESMA35-43-2502 | Third-Country Access | Reverse solicitation interpretation and enforcement |
Stay Current: MiFID III/MiFIR Review
The European Commission is conducting a comprehensive review of MiFID II/MiFIR. Proposed changes include modifications to best execution reporting, payment for order flow prohibition clarification, consolidated tape provisions, and simplification of certain disclosure requirements. Trading platforms should monitor these developments and prepare for implementation expected in 2025-2026.