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Playing the field

Published in Automated Trader Magazine Issue 21 Q2 2011

Sorry. It’s MiFID again. Europe’s playing-field levellers are having another go. MiFID 1 made life on the markets rather too interesting, so here comes another attempt to achieve the European trading equivalent of living happily ever after – by order. We sent cub reporter David Dungay (who retained an inconvenient degree of youthful idealism) to face the Directive known as MiFID 2 and report back on its likely impact on European trading. David has returned, a sadder and wiser European Trading Correspondent, and this is what he has to say.

Two and a half years ago, we were promised a utopia. A newly minted Europe that knew no bounds. A level playing field transparent for all to see. A trading environment free of inefficiency and ill will, where costs were low and profit opportunities both multiple and various. Transparency in thought, word and TCA. The new continent was to be delivered and underpinned by a rather weighty piece of legislation called MiFID.

And now, just those two-plus short years later, MiFID has come to pass and we're all living happily ever after. Proof, if proof were needed, that market evolution can be dictated by central bureaucracy. Never again do we have to worry about devious counterparties, hidden costs, opacity, complexity.

MiFID has come among us, and we're all living happily ever after. The fairytale continues to cause concern, as do complexity, fragmentation, darkness (in several senses of that word) and a lot of difficulty around the achievement - and even identification - of best execution.

What do you do when your legislation produces unintended consequences? This is Europe. You legislate. More of the sa - no, we're not going to say it. But the (not very) long-awaited solution to all the "We didn't mean it to happen this way" aspects of the post-MiFID world are to be addressed in a rather weighty piece of legislation called MiFID.

Two. Not MiFID again. Sorry. Slip of the keyboard. This time, the rather weighty piece of legislation slouching towards Brussels to be born has the (nick)name MiFID 2. Totally different. Not the same thing at all. It's a completely different initiative to (re)direct market evolution by central bureaucracy. Don't stop me if you've heard this before, but MiFID 2 promises market harmonisation and a more effective regulatory regime. This time, there will be no unintended consequences and we will all live happily [Careful. Ed] while watching very carefully to assess the market impact and likely real-world consequences of MiFID 2.

Because, seriously, and this hardly needs spelling out (does it?) today's post-MiFID European trading environment has its distinctly good points, and even where it hasn't, by now most of us have developed strategies and tools for dealing with the range of market 'distortions' (a loaded word, but let's use it) brought into being by MiFID. If MiFID 2 achieves what MiFID was meant to achieve, that wouldn't necessarily be a good result. Now that we're here, we don't want to go there any more.

So what are they doing, and will that adversely affect Europe as we know it?

First off, we have a newly formed EU body: ESMA. Newly formed in the sense that it's effectively an old body, CESR, that changed its name and moved to Brussels. But that's a detail. ESMA is an independent EU body charged with - wait for it - protecting investors and safeguarding our markets. Quelle surprise, non? The idea being - you won't have heard this before - that ESMA can reach all corners of Europe and bring us all to the same place, regulatorily speaking, at the same time. Oh and this time around the EC have stipulated that EMSA will become a regulator and what were guidelines under CESR will be law under ESMA. That frees things up, doesn't it?

ESMA is the European Securities and Markets Association, CESR is the Committee of Securities Regulators, the toe bone is connected to the foot bone, and all's right with the world.

Going into the dark

Lower costs with a dash of competition were the conspicuous menu items for MiFID the First. Have the EC kept to the same underlying theme with MiFID the Second? Not exactly. As the EC's lawmakers scramble to un-cause the market phenomena caused by their first effort, the signs are that such - what shall we call them? - unintended happy accidents as the OTC markets and dark pools are likely to un-happen.

"The first MiFID directive was about diversity, competitiveness and choice; our concern is that MiFID2 may be a step back from that," Anthony Belchambers, CEO at the FOA, says. "Choice of execution in the OTC arena could progressively be removed from the market." To some degree, surely, the notion of a regulated OTC market is an oxymoron? But if such a market does, ah, re-happen in the form that the regulators intend, ha ha, one thing is - well, if not certain, then likely. Belchambers says: "There is no doubt that OTC products are going to be much more expensive moving forward." But don't worry - you can still choose to pay the extra.

Dark pools were another gift of the MiFID-makers, two and that inconvenient half years ago. They weren't intended to happen, and although they weren't part of the landscape until MiFID brought them into being, you could say that they're one of the truly unequivocally good things to have been gifted to us by the Bruxelloisie. Bradley Duke, Managing Director of Knight Capital says: "The buyside are united in their appreciation of the existence of dark pools, which allow them to execute large orders with reduced market impact."

Duncan Higgins, Director, Head of Electronic Sales, ITG, says: "Studies show that there is a positive impact on liquidity on lit books when there are transactions on dark order books." Faced with two such unequivocal statements of support for dark liquidity, the astute reader will perhaps not need to be told that the MiFID review, and thus MiFID 2, is against. But this is where the satirical, point-scoring, "we like it, so they're blocking it" tone of this article becomes difficult to sustain. Because transparency is a virtue, too, and it would be unreasonable to demand a regulatory framework to encompass both darkness and transparency. Wouldn't it?

This is, if you'll forgive the cliché, a grey area. The dark pools are under (typically, welcome) pressure to cooperate with the regulators, to ensure that any regulatory shifts are based on good information and beneficial, but they are also, by definition, dark and obligated to their constituencies to remain dark. If they release too much information into the public domain, they could trigger a detrimental impact on their own competitiveness - and on the market in general. If they don't open up, they're giving up any chance of influencing their own future. Uh oh.

The granularity factor

The significant question here is broader than the obvious one. It's not just what the dark pools do and how the regulators react to what they do, but this: how good are the regulators, across the board, at identifying, appreciating and addressing this kind of complexity? Much of it wasn't there until MiFID turned up, after all, and although they might have brought it into being, they didn't - no criticism intended - know what they were doing. The signs are not altogether bad. Jack Vensel, Managing Director, Head of Electronic Trading EMEA, Citi, says, first: "I am very optimistic about the way the regulations are developing." Vensel then goes on to explain: "It's hard to say they [the regulators] know everything that is going on in all the dark pools. I will say we have been incredibly transparent and will continue to be so because I want the regulators to know what I am doing. If it is something they don't want to have happening I would rather know now than find out later on."

Perhaps it is possible to be transparently dark. But there is another factor here. Discussing transparency in general, Higgins says: "The increase in the granularity of data and being able to identify what type of trade an OTC trade is, whether it be a trade that was just a give-up transaction or if it was actually new incremental executed business, will be very beneficial for anyone looking to analyse their own performance versus the trading that went on in the market."

Interesting. Consider this: we have all learned a lot in two (and a half) years. We are much more sophisticated in our TCA and other oversight methodologies. The regulators are regulating experts in handling darkness, fragmentation, et cetera, and there is some evidence that they know it. Belchambers says: "I think the regulators needs to - and they have said they will - look at each market and each asset class and decide with the industry where more transparency is needed." And by implication: decide where more transparency is not needed.

Of course, there's also cost. Higgins says: "It's excellent that there is a focus on the cost of data. The EC are looking at what reasonable cost means and how they can apply that across venues. It is important that they don't just look at the post-trade environment and look at the pre-trade environment also." Cost, significantly, is the most readily detectable client issue as well as a practitioner issue - even if you're not fussed about best execution, you still have to pay the bill. This matters.

In the new regulatory world, clients - investors, the buyside - are becoming more aware of what is happening to their orders. That's a cost-driven change and it's introducing a new element into the mix. Educating clients is the new solution to complexity/ opacity offered by many firms. As Higgins says: "It will help them to understand better how their orders are being executed in a broker crossing network. This can only be a good thing."

Business without risk or risky business?

One year on from the flash crash and the high frequency guys are still taking heat. No surprise, then, that the MiFID review addresses HFT. "There have been two enquiries into the flash crash and no one has come up with a hard reason as to why it has happened. I think the potential for another thousand-point drop is still there," says Tony Moulange, senior business development manager, Colt. "The technology put in place such as the circuit breakers I think will help and the regulators and liquidity pools are trying to pay more attention to systemic risk but I don't think anyone has a single explanation for the flash crash," Moulange continues.

Who should be ultimately responsible for the risk management on this type of trading activity? Regulators? The venues themselves? As the latency race continues everyone has a keen eye on the measures that are set to put the breaks on these types of activity. "There is one school of thought with the HFT debate. All of the venues have created a faster and faster track to attract liquidity onto their platforms so surely the responsibility for putting the tyres on the corners, in case people crash off, should lie with the venues and not the regulators or the brokers," says Steve Grob, director of group strategy, Fidessa.

The latency race is becoming a mere blur. We've gone from microseconds to nanoseconds and some firms are still confident that there is room to grow in the high frequency low latency sector. As an inevitable evolution of our markets it looks as though HFT will remain but the details of how it will be regulated remain uncertain. Ganesh Iyer, Senior Manager, Product Marketing, IPC, talks about having a well-rounded holistic approach to latency and HFT. Iyer says: "There needs to be a holistic approach because it is not only about speed. It's also about being able to get the right price discovery, get the best execution and capture liquidity at the best available price also."

If that suggests HFT as a template for regulation across trading in general, Grob delivers a useful parting shot. Grob says: "One of the things I worry about is that regulation needs to stay out of the detail. Regulators should be shaping the path rather than getting bogged down in the nitty gritty."