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Putting the e in audit

Published in Automated Trader Magazine Issue 17 Q2 2010

There’s more to MiFID than just putting a best- execution policy on paper. As European trading gets more complex and European regulators demand greater transparency, what role could automation play in compliance? Claudia Coleman spoke to Wolfgang Fabisch, CEO of b-next Group.

Claudia Coleman

Claudia Coleman

Claudia Coleman: Terms such as 'fragmentation' and 'consolidation' are more and more widely used to describe trading in Europe. They describe a situation that seems to have regulation - MiFID, obviously - as one of its main causes. With this in mind, it could be argued that regulation steers the way that Europe is evolving. Do you agree?

Wolfgang Fabisch: At least in terms of the fragmentation of trading venues and the consolidation of prime brokerage that we have been seeing over the past two years, the answer is clearly yes. On the one hand, regulatory changes have opened the door to new, non-exchange trading venues, while on the other hand, MiFID has imposed requirements for best execution which are all the harder to comply with in this fragmented trading environment. Take the simple example of reference prices for measuring best execution, it is clear that comparing with exchange prices alone is not enough. To put this another way, fragmentation of trading venues means also the fragmentation of market information. It takes increasingly sophisticated technology to comply with these new regulations, particularly for best execution, and until we have some kind of comprehensive consolidated tape, this is just going to get tougher for banks.

Claudia Coleman: But are the regulators really playing 'catch-up', reacting to emerging issues, or are they trying to shape the banking industry for the better?

Wolfgang Fabisch: Both, but financial regulation inevitably involves more of the former, particularly with newer financial products. In any case, whether by the intention of the regulators or not, regulations such as MiFID are indeed changing the structure of the European banking industry. As I said, we're seeing not only fragmentation of trading venues but also consolidation of prime brokerage as a direct result.

This, in turn, has ripple effects throughout the financial sector, not only on the sell side but also on the buy side. For example, selecting prime brokers has indeed become more complex for asset managers, and the consequences of not doing it right are that they pay too much for their trading, or that they get inferior execution, both of which are a drag on portfolio performance.

Claudia Coleman: What do you see as the regulators' key aims? Where do you think they want us to go?

Wolfgang Fabisch: Beyond the three stated EU objectives for improving financial markets - efficiency, transparency, and regulation - I think it's clear that the regulators want to achieve two key things: First, they want to make Europe more competitive in the global marketplace, and second, they want to protect the European public.

One could argue that these objectives contradict each other, but I don't think so because both of these objectives are built on a common critical factor: confidence. If regulators can manage to improve long-term confidence in the European financial markets in a sustainable and balanced way, that should be good for all sides. Transparency and efficiency are a big part of this, and for that you need sophisticated technology.

Claudia Coleman: How would you compare MiFID's aims with its achievements? How far has it been a success? Where has it failed?

Wolfgang Fabisch: I would call it a preliminary success, but with more to be done. It clearly has not yet led to the desired end result, but if one views it as a first round, it certainly has succeeded in imposing some structure on banks to deliver better for customers - not to mention in bringing down the high costs of European exchange trading. Now, our banks at least have best execution policies, even if they aren't there yet in terms of checking against them, using them, and optimising around them.

MiFID has also fragmented trading venues, which can be a good thing or a bad thing, but in any case it's a more complex thing. This means that banks need better technology and better information to manage fragmented trading venues. It's not so much a failure as an unintended consequence. I'm not sure the regulators understood how the fragmentation of venues would make best execution so much more complex, particularly in the absence of a consolidated tape.

Claudia Coleman: What areas/issues have the regulators missed? Do you foresee any problems in the future? What will be the next 'crisis'?

Wolfgang Fabisch

Wolfgang Fabisch

Wolfgang Fabisch: Aside from specific products that need to be addressed, the lack of adequate transparency in the new dark pools is the most urgent issue. The regulators will at the very least have to ensure post-trade transparency. Another area that is getting a lot of attention is how to best supervise international banking groups within Europe, and how to balance the roles played by the parent-country regulator and the local regulators.

I'm not sure what the next crisis will be, but failures in trading control seem to be a regular occurrence. No bank wants to be the next headline, and this is another area where technology from specialised providers can help.

Claudia Coleman: Have you seen a greater concern for effective risk management since the recession?

Wolfgang Fabisch: Yes - although not necessarily matched by a willingness to invest right now. The benefits are enormous, not only in terms of ensuring regulatory compliance but also in documenting superior performance to customers and thus using best execution for competitive advantage.

Another point which often gets forgotten is that good trading control software can also help catch front-office errors more quickly. We have a major international customer who did some calculations and figured that, by helping them correct mistakes before financial losses arise, our software saves them something like €0.50 per transaction on average. That adds up to a big number.

Claudia Coleman: What impact do you think that increased regulation will have on firms in 2010 with regard to risk management?

Wolfgang Fabisch: Financial institutions will have to get more serious about MiFID. Until now, most seem to view it as a legal exercise, in putting a best execution policy to paper. I think the focus will move to monitoring and verification at a trade-by-trade level. I'm reminded of the famous quote from Reagan to Gorbachev, "Trust but verify."

The same is true here. Can the prime broker actually fulfil the various components of its best execution policy? Is there a structured process for monitoring order execution? Is the prime broker able to provide reporting on actual execution performance to customers as well as its own senior management, and does this include composite graphics for quickly tracking overall performance? These are questions that we will hear more of in 2010.

Claudia Coleman: Do you think that market abuse and insider trading is becoming more of an issue for the industry?

Wolfgang Fabisch: Changing markets mean that the danger of market manipulation will continue to rise significantly. The OTC markets are particularly prone to these risks. Insider trading risks will also be greater than ever, as mega-acquisitions resulting from the financial crisis dramatically expand the number of people and parties who are insiders. It will be essential to use highly efficient and proactive mechanisms to ensure that the number of trading violations is as small as possible, and that a greater proportion of these violations can be successfully remediated.

This is a great opportunity right now for banks to reduce risks, gain customer trust and ultimately improve business performance by strengthening their own internal "regulation" and "market supervision" systems. This also reduces the risk of onerous over-regulation being imposed from the outside, while protecting well-functioning markets. These measures must, however, go beyond just well-intentioned corporate policies. They need to be translated into proactive and effective internal "regulation" of the bank's day-to-day trading activities, and this requires a solution which spans the whole group.

Based in Herford, Germany, b-next Group is a provider of software solutions for trading control
and compliance to the European financial sector.