Technical Advisory Report

Advisory Service on the Implementation of the Markets in Financial Instruments

Directive (MiFID) in EU Candidate and New Member States

Case Study: Croatia

Financial and Private Sector Development DepartmentCentral Europe and the Baltics Country Department

69879

Europe and Central Asia RegionWorld Bank

April 2011

Table of Contents

Introduction............................................................................................................................ 3

Part 1: Current Stage of the Capital Markets Development in Croatia.................................. 5

Part 2: The Markets in Financial Instruments Directive (MiFID): Main Concepts...............12

Part 3: MiFID in Croatia – Analysis of the Results of the Self-Assessment Survey.............23

Part 4: Future Directions and Recommended Actions...........................................................32

Annex 1: List of EU Directives Transposed with the Capital Market Act............................38

References/Bibliography........................................................................................................42

Vice President: Philippe Le HouerouCountry Director: Peter Harrold

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Sector Director: Gerardo CorrochanoSector Manager: Lalit Raina

Task Team Leader: John Pollner/Tanja Boskovic

3

Introduction

1. The Markets in Financial Instruments Directive (MiFID) was adopted by the European

Parliament and came into force across EU Member States in 2007. It created a new

competitive framework among investment firms and securities exchanges across

member countries, as well as between securities exchanges and alternative trading

platforms within the EU single market.

2. MiFID raises major implementation challenges for securities market participants and

market regulators in EU New Member States and in EU candidate countries, and over

the medium term in Europe Neighborhood Policy (ENP) countries that plan to join the

single market in financial services. The challenge of adapting to EU MiFID

regulations goes well beyond the transposition of the Directive (defined as Level 1)

and of its implementing measures (defined as Level 2) into domestic legislation. More

fundamentally, MiFID introduces a new business model for the European securities

market with far-reaching implications for investment brokerage firms, regulated

markets and securities market regulators.

3. In the scope of AAA work the Bank has been involved in the assessment of MiFID

implementation in EU New Member States and EU candidate countries. In the first

phase of this work the ESCPF team produced a report comparing European and U.S.

Securities regulation, as well as the questionnaire for market participant and the

regulators in the form of self-assessment survey. In the second phase the

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questionnaire methodology has been administered in Croatia. The Bulgarian

authorities have also expressed strong interest in having this assessment done and this

might be considered as another case study. In this note we compile the results of the

Croatia questionnaires and analyze them in the framework of current stage of capital

markets development in Croatia and provide recommendations for future actions to

assure full adherence to the implementation aspects of the MiFID directive.

4. This technical assistance work aims to diagnose and reveal areas where

implementation of MiFID contains gaps and/or risks in its approach, and provide the

results of the analysis for the benefit of regulators, market participants and securities

exchanges. The analysis is not meant to be an enforcement tool as it is based on a

select limited, though varied sample of participants, but rather to provide insights as to

how public policy and regulatory/supervisory approaches can better track and provide

incentives to the industry to adapt more quickly to MiFID requirements.

5. The next part briefly describes the degree of development of capital markets in Croatia

and benchmarks it with other European and middle income countries. The following

section defines main concepts of MiFID. The results of the questionnaire are analyzed

in the third section. The last section concludes on future directions of capital market

development in Croatia and gives recommendations for future actions to realize the

full benefits of MiFID implementation.

5

Part 1: Current Stage of the Capital Markets Development in Croatia

6. Croatia’s capital market consist of equities, debt securities, collective investment

schemes and some derivatives. Equities are primarily traded on the regulated market,

although there are some OTC transactions. The debt market includes short and long

term debt (issued by the government, municipalities, banks and corporates) and all but

the government’s treasury bills, are listed on the stock exchange and traded in the

OTC market. Similarly, closed-end funds are listed on the stock exchange and traded

on the OTC. Simple, plain vanilla derivatives are primarily traded on the OTC

market. Some of the larger banks have launched structured products, but these are still

on a very small scale and further development of these instruments would need to be

supported by revisions in regulatory framework.

7. Growth rates in Croatia’s capital markets have significantly slowed down lately,

following the boom years in the period preceding the global financial crisis. Since

2001 until the end of 2007 market capitalization in the equities market more than

tripled on top of a string of Initial Public Offering (IPO) listings and increases in stock

prices, reaching HRK 352.2 million or 128 percent of GDP by December 2007 . The

2008 FSAP update raised concerns that high valuations that possibly have been a

result of combination of low supply and high demand from investors, posed a risk of a

serious correction. Indeed, the first blow of the crisis was felt with the bursting of the

stock market bubble in 2008 (Figure 1). The Croatian stock exchange index,

CROBEX, lost 67% of its value, about the same as in neighboring countries. At the

6

end of 2009, market capitalization stood at HRK 135.4 million or about 41 percent of

GDP (Table 1).

Figure 1. Evolution of Crobex Index Table 1. Equities Market Comparison

Market Cap/GDP Turnover/Market

CapSlovakia 4.2 0.2Romania 5.1 3.0Bulgaria 12.6 1.6Hungary 17.8 30.1Slovenia 23.3 2.0Czech Republic 18.6 15.9Poland 24.6 14.5Croatia 40.9 5.5Serbia 30.0 4.5Austria 30.6 16.5NYSE Euronext 51.9 45.6

Table 1. Equities Market Comparison

Source: www.zse.hr 1. Croatia and Serbia as of 12/2009, other countries as of 12/2010

2. NYSE Euronext includes Amsterdam, Brussels, Paris, Lisbon.

3. Source: www.fese.be, www.zse.hr. www.belex.rs

8. Croatia’s high market capitalization figures in comparison with peer countries

however, needs to be qualified. Prior to 2009 firms of all sizes were obliged to list

even if their shares did not trade as ‘free float,’ thus exaggerating market capitalization

levels reported. By mid-2009, new ZSE rules were introduced in the capital market,

changing the structure of the securities market by abolishing the quotation for all-size

public joint stock companies. The rules are in line with the new Capital Market Act,

which governs trading in financial instruments in the regulated market and via an

alternative less demanding market, the so-called multilateral trading facilities (MTFs).

MTFs envisage lower transparency requirements compared to the three tiers of the

Regulated market.

7

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9. The Regulated Market is now divided into the Regular Market, the Official

Market and the Prime Market. For regular market listings a minimum of 15% of

the shares need to be listed in free float (freely available for active trading), while for

the official market listing 25 percent of shares must be of free float and with a market

capitalization of at least HRK 8 million (US$1.4 million). However, by exception, it

is possible to list shares even if the percentage of shares and/or amount of market

capitalization is lower than prescribed if the Exchange determines that fair, regular and

efficient trading is possible at a sufficient presumed level of liquidity. For the prime

market listing, shares are subject to official market listing requirements along with

contracts having at least two specialists (market-makers) to conduct trading. As a

result of the new regulations, the stock market correction, as well as the abolishment

of the compulsory required JDD1 market listings which triggered a delisting trend,

market capitalization has decreased since 2007 (Figure 2). It should be noted that

since the Croatian market is already very concentrated with the top 10 companies

accounting for over 50 percent of market capitalization and more than 70 percent of

turnover, the de-listing trend will further increase market concentration.

10. Although market capitalization in Croatia remains higher than in many

countries in the region and comparable to that in advanced EU countries,

liquidity remains low. The overall turnover ratio averaged 5.5 percent of market

capitalization in 2009 (a drop from 8.1 percent in 2007), placing Croatia in the group

of the least liquid markets in the region (Table 2). Thus the active market is not as

1 The JDD market reflects all companies, typically smaller sized, with limited disclosure requirements, given the mandatory requirement to be listed (many do not offer shares for trading and for those that do, it is understood by investors that they are considered a higher risk market segment, generally not rated).

8

large as may first appear. The Zagreb Stock Exchange lists 340 securities, out of

which 257 are shares, 54 are bonds and 26 are commercial paper. Out of 257 shares,

only 19 are traded on the Official market, while the rest is traded in the Regular

market. There are no securities on the prime market. In November 2010, there were

178 securities traded at the ZSE, with overall market capitalization considering all

types of securities, at 51 percent of GDP. The stock market capitalization amounted

35 percent of GDP and almost 97 percent was traded on the Regulated market. Out of

this, 40 percent of stock market capitalization was from the Official market, while the

rest was from the Regular market.

Table 2. Comparison of Capital Market Indicators

Jun-10 Sofia Prague Zagreb Baltic capital market Budapest Warsaw Bucharest Bratislava Ljubljana

Average daily turnover, shares (in million EUR) 0.49 54.59 1.78 1.29 98.04 413.17 5.46 1.87 1.35Average daily turnover, bonds (in million EUR) … 90.71 4.65 0.69 3.45 1.30 0.10 20.82 0.62Turnovera/GDPc, annual level (%) 0.35 9.74 0.99 0.56 25.39 30.98 1.17 0.73 0.96Turnoverb/GDPc, annual level (%) … 16.18 2.58 0.30 0.89 0.10 0.02 8.13 0.43Turnover velocityd 2.66 27.66 2.59 5.98 126.02 59.38 7.28 14.29 4.53Market capitalizationa (in million EUR), eop 4,618 49,740 17,380 5,428 19,605 175,354 18,916 3,303 7,541Market capitalizationb (in million EUR), eop … … 5,788 2,154.0 34,430.3 … … 22,351.1 13,111.0Market capitalizationa/GDPc, eop (%) 13.2 35.2 38.3 9.4 20.2 52.2 16.1 5.1 21.2Market capitalizationb/GDPc, eop (%) … … 12.8 3.7 35.4 … … 34.6 36.8

Sources: Bloomberg; stock exchanges web sites; ZSE

a Shares; b Bonds; c Rolling GDP; d Annualised monthly share turnover x 100 / market capitalization of shares

9

Figure 2. Capitalization on capital markets, Zagreb Stock Exchange data, end of period

0

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120

140

2000

2001

2002

2003

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Stock market capitalisation Bond market capitalisation

Sources: Zagreb Stock Exchange, Croatian Bureau of Statistics

11. The market is dominated by equities. Despite the recent correction, the equities

market is still the most significant segment of Croatian capital market. The instability

that affected the global markets was also felt on the domestic bond market, but this

was significantly lower in intensity. The bond market capitalization amounted 15.9

percent of GDP in November 2010, as a result of Government financing on the

domestic market. However, the short-term government paper accounted for the

biggest part of it. The outstanding amount of government debt in short term T-bills

jumped by 23 percent at the end of 2008 compared to the same period in 2007. This

trend continued in 2009, resulting in 30.2 percent of annual increase in the government

outstanding debt in short term T-bills. At the same time the amount of outstanding

government debt in T-bonds increased by only 0.1 percent on annual level and

decreased by 0.1 percent in December 2009 compared to the same period in 2008.

10

12. The government also tapped international bond markets by issuing USD 1.5

billion in Eurobonds in November 2009. It is estimated that the corporate bond

market stood at HRK 4.8 billion in December 2009, which is equivalent to about 10

percent of the total bond market in Croatia and 1.3 percent of GDP, an increase from 7

percent of total bond market since the two years prior. Higher participation of the

private market thus comes as a result of downsizing in the government bond market,

rather than from new issuances. Non-favorable demand conditions contributed to

slowdown in the market. In terms of the size of the bond market Croatia does not

compare well internationally, especially in its corporate segment where Croatia ranks

only second from the bottom among the group of selected emerging markets and

advanced European economies (Table 2, and Figures 3 and 4 below). In addition,

liquidity in the secondary bond market remains very low.

Figure 3. Outstanding Gov’t. Debt in Local Currency Figure 4. Outstanding Private Debt in Local Currency

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Note: 2008 for all the countries, except Bulgaria, Croatia, Serbia. Source: World Bank

Note: 2008 for all the countries, except Croatia. Source: World Bank, www.zse.hr

11

13. The market is served by a large number of intermediaries. As of June 2009 there

were 48 financial intermediaries, of which 27 were brokerage firms and 21 were

authorized banks. This compares to 48 in 2007, out of which 31 were brokerage

firms. The number of players has been increasing rapidly until the end of 2007,

reflecting increasing opportunities and profitability in the industry as well as initially

lower capital requirements. However, the spillovers from the global financial crisis

and new regulatory requirements introduced with The Capital Market Act in January

2009 helped slowdown the growth in the last couple of years. The total investor base

of 12.7 percent of GDP is comparable to some advanced emerging markets, but is still

lagging behind advanced EU economies.

14. The regulatory framework has been undergoing substantial overhaul, to make it

increasingly consistent with the EU directives. With the enactment of the Capital

Market Act, which transposes 15 EU Directives on financial services, Croatia has

achieved impressive progress in harmonizing its capital market framework with the

single EU market. Successful implementation of the Act is a key to further

development of Croatia’s capital markets and integration with other European

markets. Other achievements include demutualization of the Zagreb Stock Exchange

(ZSE) and granting more regulatory and supervisory power to one competent authority

(HANFA) which should bring more transparency to capital markets and decrease

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instances of conflict of interest. The ZSE used to be owned by investment firms,

which at the same time were the ZSE members. The Exchange is now established as a

stock company. HANFA is given all supervisory and investigatory powers that are

necessary for the exercise of its functions.

Part 2: The Markets in Financial Instruments Directive (MiFID): Main Concepts

15. MiFID was adopted by the European Parliament and came into force across EU

Member States in 2007. It creates a new competitive framework among investment

firms and securities exchanges across member countries, as well as between securities

exchanges and alternative trading platforms within the EU single market.

16. MiFID raises major implementation challenges for securities market participants and

market regulators in EU New Member States and in EU candidate countries, and over

the medium term in Europe Neighborhood Policy (ENP) countries that plan to join the

single market in financial services. It also involves several requirements on risk

management controls and transparency for the conduct of securities trading.

17. MiFID is based on three pillars to ensure effective implementation:

a. Pillar 1: Strengthens the single passport for investment/brokerage firms. This

allows firms to provide investment services in the 27 EU Member States and the 3

European Economic Area (EEA) States on the basis of a single authorization using

home member State control. As a quid pro quo, MiFID imposes high standards of

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investor protection that are valid across EU Member States and EEA States.

Specifically, the Directive introduces strict rules on the authorization, internal

governance and risk management of investment firms, and harmonizes conduct of

business rules for securities trading by investment firms, including client

categorization, best execution of trades, and transaction reporting to the regulator.

b. Pillar 2: Abolishes the trade concentration rule. The rule had been established

under the Investment Services Directive and where member States could require

securities trades to be executed on the main domestic exchange. The abolition of the

trade concentration rule introduces free competition between regulated markets,

multilateral trading facilities (MTFs) and systematic internalizers for the trading of

transferable securities both within and across EU Member States. As a quid pro quo,

MiFID imposes strict authorization conditions for regulated markets and pre- and post-

trade transparency requirements for all equity securities markets. Pre- and post-trade

transparency requirements of the Directive do not apply to the bond market, however.

c. Pillar 3: Establishes the powers of securities market regulators and the

modalities of cross-border collaboration. MiFID specifies the minimum supervisory

and investigatory powers that Member States must ensure for securities market

regulators in the exercise of their functions. The Directive regulates administrative

sanctions, the right of appeal by market participants, consumer organizations and

professional organizations, the extra-judicial mechanism for investor complaints, the

professional secrecy of regulators, and relations between regulators and auditors. It

also regulates the cooperation between regulators of different EU Member States and

third country regulators.

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MiFID: Main Concepts explained:

The EC’s MiFID Directive 2004/39/EC:

The Markets in Financial Instruments Directive provides a unified

framework for securities: It encompasses investment firms,

Multilateral Trading Facilities (MTF), Regulated Markets (ie

exchanges) and financial instruments (transferable securities2,

money-market instruments, units in collective investment

undertakings and derivatives, excluding bonds and securitized

debt).

The Directive, referred to as “Level 1” due to its mode of adoption

jointly by the EU Parliament and the Council, sets principles. It

needs to be transposed. It is complemented by “Level 2” texts

which consist of implementing measures.

Investment firm: Any legal person whose regular occupation or business is the

provision of investment services to third parties and/or the

performance of one or more investment activities on a professional

basis. Member states may include under this definition

undertakings which are not legal persons, provided that (i) their

2 Securities negotiable on the capital markets, with the exception of instruments of payment such as shares in partnerships and depositary receipts, bonds and securitized debt, other securities giving rise to a cash settlement determined by reference to other transferable securities, currencies, interest rates, commodities.

15

legal status ensures a level of protection for third parties interest

equivalent to that afforded by legal persons; and (ii) that they are

subject to equivalent prudential supervisions appropriate to their

legal form.

Systematic internalizers (SI):

An investment firm which, on an organized, frequent and

systematic basis deals on its own account by executing client orders

outside a Regulated Market or MTF. Concretely, investment firms

declare themselves SIs for selected equities (self-certification

regime), and route most orders to other trading venues including

their own platform. SIs are associated with the trading in shares,

and regulated under article 27 of the MiFID Directive.

Multilateral Trading Facility (MTF):

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 to non-discretionary rules. They are basically

alternative trading platforms to exchanges, often created by banks

to process their trades such as ‘Turquoise’ as regards equities. The

MTF concept is similar to the Alternative Trading Systems (ATS)

widely developed in the US (see Section 2.2).

Regulated Market (RM):

A multilateral system (i) operated and/or managed by a market

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operator, (ii) which brings together multiple third-party buying and

selling interests in financial instruments –in the system and in

accordance with its discretionary rules – in a way that results in a

contract in respect to the financial instruments admitted to trading

under its rules and/or systems and (iii) which is authorized and

functions regularly. RMs correspond to the major securities

exchanges in the EU, but not all exchanges are RMs, some of them

are regulated as MTFs. The main difference between a RM and a

MTF remains the non-application of the Prospectus Directive

(2003/71/EC), the Transparency Directive (2004/109/EC) and

subsequently the IFRS to MTFs.

Fit and proper requirements

Propriety and fitness test of persons who direct the business:

The regulator must ensure that the persons who effectively direct

the business of an investment firm are of sufficiently good repute

and experience so as to ensure the sound and prudent management

of the firm. The regulator must ensure that the management of the

investment firm is undertaken by at least two persons. The

investment firm must regularly disclose to the regulator of any

changes to its management.

Suitability test of shareholders and

The investment firm must disclose to the regulator the identity of

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members with qualifying holdings:

the shareholders or members, whether direct or indirect, natural or

legal persons, that have qualifying holdings in the firm, and the

amount of these holdings. Qualifying holding means any direct or

indirect holding in an investment firm which represents 10% or

more of the capital or the voting rights, or which makes it possible

to exercise a significant influence over the management of the

investment firm in which that holding subsists. The regulator must

ensure that the above persons are suitable, taking into account the

sound and prudent management of the investment firm.

Relationship with third parties:

The regulator must ensure that the existence of close links between

the investment firm and other natural or legal persons does not

prevent the effective exercise of its supervisory functions. Close

links means (i) participation, i.e., ownership, direct or by way of

control, of 20% or more of the voting rights or capital of an

undertaking; (ii) control, i.e., relationship between a parent

undertaking and a subsidiary as defined in Directive 83/349/EEC,

or a similar relationship between any natural or legal person and an

undertaking, any subsidiary undertaking of a subsidiary undertaking

also being considered a subsidiary of the parent undertaking, which

is at the head of those undertakings. A situation where to or more

natural or legal persons are permanently linked to one and the same

person by a control relationship is also regarded as constituting a

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close link between such persons.

Acquisitions/Disposals of a qualifying holding:

Any natural or legal person that proposes to acquire or sell, directly

or indirectly, a qualifying holding in an investment firm must notify

the regulator in advance of the size of the resulting holding. The

same applies in case the acquirer proposes to increase its existing

holding above a certain threshold (20%, 33%, 50%). The regulator

may oppose such a plan if it is not satisfied as to the suitability of

the acquirer. In case the acquirer is a financial institution registered

in another Member State, or a person controlling such financial

institution, the regulator of the other Member State must be

consulted prior to approving the acquisition.

Capital

Requirements:

The regulator must ensure that the investment firm has sufficient

capital in regard to the nature of the investment service or activity

provided, in accordance with Capital Market Act (transposition of

MIFID in Croatia). Capital requirements rules stipulate the

minimum amounts of own financial resources that credit institutions

and investment firms must have in order to cover the risks to which

they are exposed. The aim is to protect clients and the stability of

the financial system. The capital requirement rules are currently

under review in the EU, to better account in particular for large

exposures, securitization exposures and risks to the trading book.

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Organizational Requirements:

Investment firms must satisfy a number of organizational

requirements, i.e., to establish and maintain adequate procedures as

regard decision making, internal control mechanism, internal

systems and procedures, expertise of personnel, accounting policies,

business records, personal transactions, conflict of interest, risk

management, safeguard rules regarding client funds and account,

etc.

Conflict of Interest: Investment firms must take all reasonable steps to identify conflicts

of interest between themselves (including their managers,

employees and tied agents, or any person directly or indirectly

linked to them by control) and their clients or between one client

and another. They should also establish and maintain adequate

conflict of interest policy.

Conduct of Business Obligation

Client suitability test: When offering investment advice or portfolio management, the

investment firm must obtain the necessary information regarding

the client’s or potential client’s knowledge and experience in the

investment field relevant to the specific type of product or service,

his/her financial situation and his/her investment objectives so as to

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enable the firm to recommend the investment services and financial

instruments that are suitable for him/her.

Product appropriateness test:

When offering other services, the investment firm must ask the

client or the potential client to provide information regarding

his/her knowledge and experience in the investment field relevant

to the specific product or service offered or demanded, so as to

enable the investment firm to assess whether the investment service

or product is appropriate for the client. In case the product or

service fails the appropriateness test, the investment firm must warn

the client or potential client accordingly. If case the client decides

not to provide the above information or provides insufficient

information about his/her knowledge and experience, the

investment firm must warn him/her that his/her decision may

prevent the firm from assessing the appropriateness of the

investment service.

Best execution rule: Investment firms must take all reasonable steps to obtain, when

executing orders, the best possible result for their clients taking into

account price, costs, speed, likelihood of execution and settlement,

size, nature or any other consideration relevant to the execution of

the order. However, if there is a specific instruction from the client,

the firm must execute the order following this instruction.

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Investment firms must establish and implement an order execution

policy to comply with the best execution rule. Appropriate

information about the firm’s best execution policy should be

provided to their clients and their prior consent of the order

execution policy should be obtained. In case the order execution

policy provides for the possibility that client orders may be

executed outside a regulated market or a MTF, investment firms

must inform their clients about this possibility. Investment firms

must obtain the prior consent of their clients before proceeding to

execute their orders outside a regulated market or a MTF.

Market transparency and integrity:

Investment firms must keep the relevant data relating to all

transactions in financial instruments at the disposal of the

regulators. These records must contain all the information and

details on the identity of the client and the information required

under the Anti-Money Laundering Directive.

Admission of financial instruments to trading:

Regulated markets must have clear and transparent rules regarding

the admission of financial instruments to trading. These rules must

ensure that financial instruments admitted to trading in a regulated

market can be traded in a fair, orderly and efficient manner and, in

the case of transferable securities, are freely negotiable. A

regulated market must maintain effective arrangements to verify

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that issuers of transferable securities that are admitted to trading on

regulated market comply at all the times with their obligations in

respect of disclosure obligation. There must be effective

arrangements in place to facilitate members and participants of

regulated market in obtaining information which has been made

public in accordance with the national law. A regulated market

must publish public without delays the information on suspension

and removal of instruments from trading.

Access and membership to the regulated market.

A regulated market must establish and maintain transparent and

non-discriminatory rules, based on objective criteria, governing the

access to or membership of the regulated market. A regulated

market must make sure that the investment firms comply with these

requirements when being admitted to regulated market: (1) persons

are fit and proper; (2) they have sufficient level of trading ability;

(3) firms have in place adequate organizational requirements; (4)

firms have sufficient resources for the role they perform.

Access rules should allow for direct and remote participation of

investment firms and credit institutions from member countries.

There should be effective arrangements and procedures in place to

monitor compliance of participants with rules of regulated markets

and to report non-compliance or disorderly trading to the competent

authority.

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Part 3: MiFID in Croatia - Analysis of the Results of the Self-Assessment Survey

18. This section of the paper provides analysis of MiFID implementation in Croatia, based

on Bank team meetings with market participants in Zagreb and the self assessment

surveys that the team conducted. Participants in the survey included the capital

markets regulator/supervisor (HANFA), the regulated market (Zagreb Stock

Exchange) and six investment firms. Investment firms in the sample included

brokerage departments of international and local bank groups and large, medium and

small sized independent investment/brokerage firms. In terms of variety of financial

instruments and trading venues, the Croatian market is at an early stage of

development compared to some advanced EU economies. For example, at this stage

there are no active MTFs in Croatia3 and the concept of systematic internalizer as a

trading venue will come into existence only upon the accession to EU. This will also

determine to some extent, how some MiFID concepts, such best execution or trade

reporting, are applied in Croatian market.

19. Fit and proper requirements. Investments firms and regulated markets that

participated in the survey demonstrated a good understanding of the suitability and

professional requirements that have to be met by management, shareholders (and

persons with qualifying holdings) and of persons who may have significant influence

over management, though not necessarily based on the ownership structure. The

regulator has enhanced the approval procedures and qualifying requirements for board

members and other parties. All the survey participants have at least two members of

3 Although ZSE has a license for managing MTFs.

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the executive management that satisfy the suitability and professional requirements.

As part of the application process to get re-authorized to conduct business under the

Capital Markets Act, they provided information about the management, shareholders

and persons with significant influence over the management (if these exist) to the

Supervisory Agency4 and have mechanisms in place to regularly inform the Agency

about the changes in the structure of management and shareholders. The changes are

either communicated in the annual financial and management reports or more

frequently in three-monthly reports, or through the firms’ website updates. The

Agency suggested that more effort might be needed to investigate ultimate

‘controllers’ and their influence over management. Market participants noted that

small market size and legal provisions that empower the regulator to investigate

investment firms’ offices at any time, significantly mitigate any risk of misreporting.

Market participants are aware of the necessity to inform the Agency about their

intentions to acquire/dispose any qualifying holding in another investment firm. The

Agency does not see any risk in this regard. So far the Supervisory Agency, has had

little experience in collaborating with foreign regulators as regards to a possible

acquisition or disposal, but established cooperation agreements with a number of

regulators already exist and should mitigate any risk.

20. Capital requirements. The Capital Markets Act includes provisions which transpose

the EU Capital Requirements Directive into Croatian market. With these provisions

new minimum capital requirements are set up for investment firms depending on the

scope of investment services they are involved in. Provisions also include detailed

4 HANFA

25

explanations on how to calculate own funds and set the minimum amounts of own

funds on a risk adjusted basis. Capital adequacy supervision will now be risk based as

well. Investment firms are required to set up a risk management department to review

and estimate risks constantly and maintain adequate capital levels. They will have to

publish risk analyses and capital adequacy in annual reports. Investment firms were

given a transitional period until March 2010 to comply with requirements. Although

all the survey participants met initial capital requirements and set up the risk

management function, there is a concern that smaller players will be forced to get out

of the business. Some firms that were involved in proprietary trading, in addition to

trading for clients, sold portfolios because they were not able to meet higher capital

requirements. The regulator and surveyed firms are confident about their capacity to

perform good risk management functions, but this will need to be monitored.

21. Organizational requirements. Surveyed firms and the regulated market established

internal books of procedures and adequate rules regarding personal transactions.

Personal transactions are reported and monitored. Firms have established independent

and permanent compliance, risk management and internal audit functions. Most of

them chose the in-house approach, while a few decided to outsource the audit

function. Although all the firms generally agree that these functions are useful, they

noted that ensuring compliance was costly and burdensome given the limited supply

of professionals in these areas. For example, the auditing profession in Croatia still

lacks adequate skills, and professionals trained in established audit companies are not

numerous. Some firms noted that outsourcing was also costly and time consuming,

26

especially for small firms, which can hardly devote time to explain the details of

operations to somebody outside of the firm. Overall, these requirements put much

more pressure on smaller firms, especially in an environment of low margins and

significant correction in market prices.

22. Conflict of interest. All the surveyed firms have established conflict of interest

policies and the compliance and internal control functions are in charge of maintaining

the policy and monitoring compliance. The firms seem to be aware of different

aspects of conflicts of interest that might be detrimental to a client. However, the new

requirements are much more complex than the previous regulation in this area and

compliance professionals hired by the firms do not necessarily have specific securities

trading related experience. Therefore assuring adequate implementation of the

regulatory framework through supervision is important. The Supervisory Agency is

addressing this issue by further strengthening on site supervision in relation to conflict

of interest, making it the main point of supervision in the future.

23. Conduct of Business Obligations. Survey results suggest that all the firms act

honestly, fairly and professionally, when providing investment services to clients. All

the firms have had quite detailed know your client rules in place before the new

requirement came into force. Hence, this has not been a problematic area for firms to

assure compliance. Firms categorize the clients (retail, professional clients or eligible

counterparties) and inform them about their respective categories, rights and

associated risks. Firms involved in portfolio management and investment advice

27

services engage in assessing the suitability of products and services for their clients

when required. Firms involved in other investment services (execution, transmission)

engage in assessing the appropriateness of products and services for their clients.

Most of the investment firms surveyed provide execution or transmission services and

primarily work with retail clients and hence conduct the appropriateness test. Given

that retail clients usually have less knowledge and experience in the investment field,

there is less room to apply exemptions from the appropriateness test. However, one

should bear in mind that products offered in the Croatian market are relatively simple

and in case of equities mostly traded on regulated markets, which is often enough to

make the case for exemption of conducting an appropriateness or suitability test5. As

required, all the surveyed firms said they had in place and shared with their clients

order execution policies. When it comes to best execution, firms take into account

several criteria (price, speed of execution, costs, etc) in order to make sure that the

order is executed in terms most favorable to clients. Again, it is important to note that

applying best execution in Croatia is much simpler than in more developed markets

that have larger variety of investment venues. Also, some of the survey participants

suggested that assuring best execution for trading in a foreign market would be a

challenge, in terms of the ability of Croatian firms to get good information about

different execution criteria in other markets. Therefore, as the market develops and

firms become more frequently involved in trading outside Croatia, the regulator shall

make sure that lack of business practice does not become an impediment for the

effective business conduct practice.

5 Under MiFID there is a broad range of possibilities to get exemption from conducting the appropriateness and suitability test, especially for simple vanilla products and in the case of professional clients.

28

24. Market Transparency and Integrity. Surveyed firms keep records of transactions in

all the instruments admitted for trading on regulated markets. This includes

information on the instruments, the quantity, dates and times of execution, prices and

means to identify the firms. Also, firms publish and make available to clients pre and

post trading information for the shares admitted to trading on regulated markets. ZSE

makes public bid and offer prices and depth of trading interest for shares admitted to

trading, as well as data on volume and prices of transactions and the time of execution.

Members communicate their data to ZSE though the trading system and these are then

published on ZSE monitors and through the data vendor’s distribution network.

Comparable to EU countries, there is no pre and post trading requirements for bonds,

which are traded on OTC market. The Capital Markets Act requires firms to report

transaction to the Supervisory Agency no later than one business day (T+1 rule), and

subsequent to this review, in May 2010, the platform for reporting transactions to

competent authorities was in place. Although the Supervisory Agency has not set up a

full interface for reporting transactions in all relevant instruments admitted to trading

on regulated markets (RM), some firms are generating reports and delivering them to

the Agency by through proprietary software. All the firms, including those that do not

send daily reports to the regulator, make copies and back up relevant data, so the

regulator can access them on request. Records are compliant with the money

laundering and anti-terrorist financing act.

29

25. Admission of financial instruments to trading. The Zagreb Stock Exchange (ZSE)

prescribes clear and transparent rules for admission of financial instruments to trading.

Also, rules on disclosure of information for listed securities are aligned with legal

requirements. The ZSE trading system is advanced and makes it possible for the ZSE

to keep market participants informed about suspensions and removal of instruments

from trading and other information required by the Capital Markets Act.

26. Access and membership to the regulated market. The ZSE has in place transparent

and non-discriminatory rules which govern access and membership to the regulated

market. Membership is conditional on meeting all the requirements (fit and proper,

organizational, etc) set up in the Capital Markets Act. Also, arrangements are in place

to inform the Supervisory Agency about non-compliance or disorderly trading. For

now ZSE is not able to offer remote membership to investment firms (though will be a

transitional period for this, to be established), which makes the market somewhat

protected from foreign competition.

General Comments

27. Delay in re-authorization process. After the Capital Markets Act came into force in

January 2009, investment firms had six months to put together applications to become

re-authorized and work under the new Act. All the firms that the team visited

submitted their application by the deadline, but among independent investment firms

only three of them were re-authorized by January 2010, which was the official

deadline. As discussed with the firms, the re-authorization process has not been a one-

30

way communication. They received the feedback from the Supervisory Agency to

double check on submitted information or fill the gaps. Although some smaller

players complained about not having clear guidelines from the regulator, the general

impression is that there were plenty of opportunities to ask questions and get answers

either from the Agency or though the Association of Brokers. At the beginning of the

implementation, the Agency conducted monthly meetings with investment firms to

clarify the process. These meeting are still held, but on quarterly basis. Delays are

most probably result of a combination of factors, including many aspects of the

regulation being new both to the firms and the Agency, and requiring therefore longer

than anticipated time to get through the process. The Bank team concluded that the

Agency could have benefited from sharing experience and exchanging information

with competent authorities in the EU Member States which went through the same

process. In June 2010, the team learned from HANFA that the application processing

was completed during the first half of 2010. Out of all the firms who submitted their

applications, two did not meet requirements of the Capital Market Act. Two

additional firms stopped their activities shortly after being re-authorized. A total of

eight firms did not submit the application for re-authorization.

28. The Supervisory Agency enjoys a high degree of independence and its capacity is

adequate, but more staff and training will be required to assure that it deals

effectively with implementation of new regulations and its more powerful role in

the new framework. There is a large pool of experienced and technical staff assisted

by low employee turnover, as well as adequate salary and training policies. However,

31

the adoption of the EU directives places heavy demands on the skill requirements of

the staff. The Agency has recognized this and responded adequately by hiring 10 new

staff in supervisory role in the course of 2010. The effort should be made in order to

assure that adequate capacity is established and sustained.

29. Remaining issues. With the adoption of the Capital Markets Act, 15 EU Directives

were transposed in Croatia. Almost 60 by-laws were adopted at the same time.

According to market participants some major laws such as for example the Company

Law, have still to be harmonized with the new legislation, which causes confusion for

business players. Another concern is that as the new and more costly requirements

came in force during the crisis, the benefits from the new legislation were seen as

somewhat reduced. For example, some companies decided to de-list from the stock

exchange, as disclosure requirements became too costly and companies were simply

not enjoying the benefits of being in the market during the period of scarce liquidity.

Some firms suggested that there should have been a better campaign in place to make

sure that companies understood the long-term benefits of staying listed, such as for

example access to a broader investors base. Another unresolved issue is a requirement

for investment firms to use Croatian custody at all times, which means that the firms

need to have two custodians in the event of trading in foreign market (where foreign

custodians should also be able to operate in the Croatian market), therefore making

trading more expensive and non-competitive. This will have to be resolved before the

MiFID password provision becomes effective in Croatia to allow non-Crotian

established custodians to operate in Croatia.

32

Part 4: Future Directions and Recommended Actions

Future Directions

30. The Croatian security market is undergoing a significant change. Spillovers from

the financial crisis, accompanied with costs associated with implementation of the new

regulatory framework, are putting significant pressure on businesses. This trend is

likely to continue, as some regulatory requirements have been postponed until the EU

accession. For example the MiFID “password” provision will increase competition, as

it becomes easier for foreign established firms to trade in the Croatian market. Several

investment firms that were surveyed said that they were looking to respond to these

developments by expanding regionally in smaller Balkan markets (Serbia, Bosnia,

etc). These smaller markets will be implementing MiFID and other European

directives at later stage. Hence, such a move could help Croatian players establish a

strategic position in a regional market and benefit from the economies of scale, by

leveraging the already borne costs of compliance with MiFID, and benefiting at the

same time from a larger revenue base.

31. Adaptation via Mergers. One should also expect a wave of mergers and acquisitions

among (a) either local firms, in order to better deal with increasing costs and establish

a stronger position in more competitive market, or (b) with foreign partners.

32. Changes in MiFID at the European Level in the Post-Crisis Period. The European

Commission has announced a list of initiatives to frame changes in the regulatory

33

environment for the financial markets of the EU. Following, are the initiatives that are

likely to effect the implementation of the new capital markets framework in Croatia

and the role of the Supervisory Agency:

33. Proposed Revisions to Markets in Financial Instruments Directive (MiFID).

Under the proposed revisions to MiFID, the Commission plans to increase

transparency in trading of financial instruments (pre and post-trade transparency) and

improve consolidation of market and trading data. This will allow regulators and

market participants, such as investors, issuers of securities or investment firms, to have

a more accurate overview of the way different instruments trade across Europe. This

emphasizes the importance of the recommendations in this report, and, since May

2010 the regulator set up an interface for investment firms to report transactions to the

Supervisory Agency for instruments admitted to trading. Regarding the consolidation

of market and trading data, this has been one of the major areas where the European

system is lagging behind competitors, such as the U.S. for example. While in the

current form MiFID encourages competition through allowing trading in alternative

trading systems, it also introduces fragmentation since it has no provisions on

consolidation of data from different sources. This should not be a major issue in

Croatia where the number of trading vehicles is limited, but it should be monitored

down-the-road, as alternative trading systems enter the market. The adoption of the

MiFID revisions by the Commission is scheduled to take place in the Spring of 2011

and political agreement expected by year end.6

6 Source: The European Union's Road Map for Financial Reform and COM (2010) 301 Final.

34

34. Proposed Revisions to Market Abuse Directive and Investor Protection. The

Commission is proposing to increase the powers of regulators to investigate and

penalize market abuse, by, for instance, setting a minimum amount for administrative

fines. The Market Abuse Directive will be revised with an attempt to deter

engagement in insider dealing and market manipulation by the threat of effective

investigations and severe sanctions. Although the Revisions of the Market Abuse

Directive were proposed to be adopted by the Commission by the end of 2010 and

political agreement achieved by end of 2011, there has been no announcement on the

approved revisions yet. The Supervisory Agency should follow the Commission’s

revisions as they are likely to set new requirements for the Agency in terms of

capacity to conduct investigations and apply sanctions for market abuse, and ensure

minority investors are protected.

35. Legislation on Corporate Governance. The Commission has announced the

introduction of the new legislation in the area of corporate governance. This will

involve strengthening of some of the MiFID provisions, such as limiting the number

of mandates board members may hold, improving the fit and proper test to require

more expertise for specific issues such as risk management, or mandating supervisors

to conduct interviews with board members to check that they are sufficiently

independent to challenge management effectively.

Norms on Risk Management. The Commission also plans to strengthen the risk

management culture at all level of financial institutions, and increase the involvement

35

of shareholders in corporate governance. The Corporate Governance Code, prepared

by the Supervisory Agency and ZSE, became effective in January 2011 in Croatia.

The Supervisory Agency should follow the Commission activities in this area, as

additional provisions might be needed in legislation to further strengthen corporate

governance practices in Croatia and more capacity built into the Agency to be able to

interview board members and supervise risk management and corporate governance

practices. The legislation on corporate governance is scheduled to be adopted by the

Commission in the spring 2011 and political agreement achieved by the end of 2011.

36. Complex Financial Instruments, Derivatives and Securitizations. Complex

financial markets instruments and derivatives are currently not present in Croatia and

the existing regulatory framework is not developed in this area. Nevertheless, the

Supervisory Agency and other responsible bodies (Ministry of Finance) should follow

any revisions in the EU legislation in this segment, to make sure that new regulation

supports development of derivatives and other complex financial instruments if and

when these appear on the market, but also prevents the excessive accumulation of

risks in the capital markets. If these instruments were to develop, the Commission’s

recommendations on increasing their trading (particularly derivatives) on organized

markets, will be an additional factor in market infrastructure and policy for the

financial authorities to consider.

36

Recommended Actions to Ensure Implementation of MiFID and the Integrated Market:

a) The capacity of the Supervisory Agency needs to be enhanced and sustained to deal

with fit and proper requirements, including methods for investigating and mapping

the ultimate controllers of firms regardless of whether they are listed as share owners

or managers, in order to identify the source of corporate decision making. As well,

this will require cooperation with foreign regulators on the cross-border acquisition

and disposal of qualified holdings.

b) More real time electronic reporting and supervisory tools for the Agency will be

required to verify the existence of real asset balances as part of the effort to monitor

the ability of investment firms to perform their risk management functions and

adequately maintain risk based capital cushions including during periods of high

market volatility.

c) Monitoring capability should be built up to ensure that investment firms maintain an

effective audit and compliance function, including internal risk management

procedures and functions and an ex post internal audit practice.

d) The Supervisory Agency should strengthen the on-site supervision process supported

by off-site intelligence and information so as to develop flags and tracking methods

to identify and detect conflicts of interest in securities transactions. HANFA has

already hired 10 new people in the supervision department in 2010. Effort should be

made so that this capacity is well established and sustained.

e) The Agency should ensure that investment firms respond effectively in the area of

business conduct to optimize trading and value to end customers (including suitability

37

and appropriateness tests, best execution, etc.) as the market develops, and

particularly as more complex instruments and trading venues come into play – some

of which could entail partnership arrangements with well established and larger

cross-border market institutions.

f) A proper interface for investment firms should be set up to report transactions to the

Supervisory Agency in all relevant instruments admitted to trading on the regulated

market, and to count on a modernized technology and communications infrastructure

to assess risk concentrations in as close to real time as feasible (following the review,

Hanfa reported this action as completed).

g) The Supervisory Agency should ensure that companies are aware of the benefits of

staying listed on the market including the different levels of listing categories and

their relation to best practice standards and normative requirements in the EU single

market, given Croatia’s impending EU Accession.

38

Annex 1

List of EU Directives Transposed with the Capital Markets Act

1. Council Directive 89/117/EEC of 13 February 1989 on the obligations of branches

established in a Member State of credit institutions and financial institutions having their head

offices outside that Member State regarding the publication of annual accounting documents

(hereinafter: Council Directive 89/117/EEC);

2. Directive 97/9/EC of the European Parliament and of the Council of 3 March 1997 on

investor compensation schemes (hereinafter: Directive 97/9/EC);

3. Directive 2001/34/EC of the European Parliament and of the Council of 28 May 2001 on

the admission of securities to official stock exchange listing and on information to be

published on those securities (hereinafter: Directive 2001/34/EC);

4. Directive 2003/6/EC of the European Parliament and of the Council of 28 January 2003 on

insider dealing and market manipulation (market abuse) (hereinafter: Directive 2003/6/EC);

5. Commission Directive 2003/124/EC of 22 December 2003 implementing Directive

2003/6/EC of the European Parliament and of the Council as regards the definition and public

disclosure of inside information and the definition of market manipulation (hereinafter:

Directive 2003/124/EC);

39

6. Commission Directive 2003/125/EC of 22 December 2003 implementing Directive

2003/6/EC of the European Parliament and of the Council as regards the fair presentation of

investment recommendations and the disclosure of conflicts of interest (hereinafter: Directive

2003/125/EC);

7. Commission Directive 2004/72/EC of 29 April 2004 implementing Directive 2003/6/EC of

theEuropean Parliament and of the Council as regards accepted market practices, the

definition of inside information in relation to derivatives on commodities, the drawing up of

lists of insiders, the notification of managers' transactions and the notification of suspicious

transactions (hereinafter: Directive 2004/72/EC);

8. Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003

on the prospectus to be published when securities are offered to the public or admitted to

trading and amending Directive 2001/34/EC (hereinafter: Directive 2003/71/EC);

9. Directive 2004/109/EC of the European Parliament and of the Council of 15 December

2004 on the harmonisation of transparency requirements in relation to information about

issuers whose securities are admitted to trading on a regulated market and amending Directive

2001/34/EC (hereinafter: Directive 2004/109/EC);

10. Commission Directive 2007/14/EC of 8 March 2007 laying down detailed rules for the

implementation of certain provisions of Directive 2004/109/EC on the harmonization of

40

transparency requirements in relation to information about issuers whose securities are

admitted to trading on a regulated market (hereinafter: Directive 2007/14/EC);

11. Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on

markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and

Directive 2000/12/EC of the European Parliament and of the Council and repealing Council

Directive 93/22/EEC (hereinafter: Directive 2004/39/EC);

12. Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006

relating to the taking up and pursuit of the business of credit institutions (recast) (hereinafter:

Directive 2006/48/EC);

13. Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on

the capital adequacy of investment firms and credit institutions (recast) (hereinafter: Directive

2006/49/EC);

14. Directive 2006/73/EC of the European Parliament and of the Council of 10 August 2006

implementing Directive 2004/39/EC of the European Parliament and of the Council as regards

organizational requirements and operating conditions for investment firms and defined terms

for the purposes of that Directive (hereinafter: 2006/73/EC);

15. Directive 2007/44/EC of the European Parliament and of the Council of 5 September 2007

41

amending Council Directive 92/49/EEC and Directives 2002/83/EC, 2004/39/EC,

2005/68/EC and 2006/48/EC as regards procedural rules and evaluation criteria for the

prudential assessment of acquisitions and increase of holdings in the financial sector

(hereinafter: Directive 2007/44/EC);

(2) This Act regulates in more detail implementation of the following EC Regulations:

1. Commission Regulation (EC) No. 2273/2003 of 22 December 2003 implementing

Directive 2003/6/EC of the European Parliament and of the Council as regards exemptions for

buy-back programs and stabilization of financial instruments (hereinafter: Commission

Regulation (EC) No. 2273/2003);

2. Commission Regulation (EC) No. 809/2004 of 29 April 2004 implementing Directive

2003/71/EC of the European Parliament and of the Council as regards information contained

in prospectuses as well as the format, incorporation by reference and publication of such

prospectuses and dissemination of advertisements (hereinafter: Commission Regulation (EC)

No. 809/2004);

3. Commission Regulation (EC) No. 1287/2006 of 10 August 2006 implementing Directive

2004/39/EC of the European Parliament and of the Council as regards record-keeping

obligations for investment firms, transaction reporting, market transparency, admission of

financial instruments to trading, and defined terms for the purposes of that Directive

(hereinafter: Commission Regulation (EC) No. 1287/2006).

42

References

Bibliography

Biais, Declerck, Dow, Portes: European Corporate Bonds Market: Transparency, Liquidity

Efficiency, 2006

CESR, Impact of MiFID on Equity Secondary Markets Functioning, 10 June 2009

CESR, Questions and Answers on MiFID, May 2009

Croatia, Financial Sector Assessment Update, Non-bank Financial Institutions and Capital

Markets, February 2008

EC Directive 2004/109/EC of 15 December 2004 on the harmonization of transparency

requirements in relation to information about issuers whose securities are admitted to trading

on a Regulated Market

EC Directive 2006/49/EC of 14 June 2006 on the capital adequacy of investment firms and

credit institutions

EC Directive 2004/39/EC of 21 April 2004 on markets in financial instruments

EC Directive 2006/73/EC of 10 August 2006 implementing directive 2004/39/EC of the

European Parliament and the Council as regards organizational requirements and operating

conditions for investment firms and defined terms for the purpose of that directive

43

MiFID readiness Assessment Concept Note, Technical Annex I: Key Provisions of the

Markets in Financial Instruments Directive (MiFID) (2004/39/EC), December 2009

www.hanfa.hr

www.zse.hr

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