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 Department

Central Europe and the Baltics Country Department

Europe and Central Asia Region

World 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 Houerou
Country Director: / Peter Harrold
Sector Director: / Gerardo Corrochano
Sector Manager: / LalitRaina
Task Team Leader: / John Pollner/TanjaBoskovic

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.
  1. 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.
  1. 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 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 andprovide recommendations for future actionsto assure full adherence to the implementation aspects of the MiFID directive.
  1. 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.
  1. 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.

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

  1. 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 arestill on a very small scale and further development of these instruments would need to be supported by revisions in regulatory framework.
  1. 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 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
Source: / 1. Croatia and Serbia as of 12/2009, other countries as of 12/2010
2. NYSE Euronext includes Amsterdam, Brussels, Paris, Lisbon.
3. Source:
  1. 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.
  2. 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 JDD[1] 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 50percent of market capitalization and more than 70percent of turnover, the de-listing trend will further increase market concentration.
  1. 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. Theoverall 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 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

Figure 2. Capitalization on capital markets, Zagreb Stock Exchange data, end of period
Sources: Zagreb Stock Exchange, Croatian Bureau of Statistics
  1. 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.
  1. 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
Note: 2008 for all the countries, except Bulgaria, Croatia, Serbia. Source: World Bank / Note: 2008 for all the countries, except Croatia. Source: World Bank,
  1. 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.
  1. 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 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

  1. 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.
  1. 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.
  1. 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 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.

MiFID: Main Concepts explained:

The EC’sMiFID 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 securities[2], 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 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 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.