Yes, the MiFID Review really is the big one in terms of market legislation," says Kay Swinburne, the European Conservatives and Reformists Group's co-ordinator on the European Parliament's Economics and Monetary Committee. As Swinburne says, the financial services industry in Europe faces a "tsunami" of regulation including the European Market Infrastructure Regulation (EMIR), the Market Abuse Directive (MAD) II, and a proposed financial transaction or "Tobin tax."
But MiFID II is the big one. Although the directive itself is unlikely to be implemented until the end of 2013 at the earliest, trading professionals are already anxious about its implications for the way multiple asset classes are traded and reported in Europe. Unlike the original 2007 MiFID, which focused on cash equities trading, "MiFID II tries to capture a lot more - particularly around fixed income and OTC derivatives, as well as some of the risks coming from algorithmic and high frequency trading," says Munib Ali, a director at PricewaterhouseCoopers.
In 2007, the original MiFID paved the way for the emergence of multilateral trading facilities (MTFs), which gave investors greater choice in terms of where their trades were executed. However, in its opening preamble to the MiFID II proposals published in October 2011, the European Commission (EC) points to "problems" that MiFID created - these "problems" include liquidity and data fragmentation across multiple equity trading venues, which have created greater complexity and less transparency.
Fair enough, although you might want to give some weight to the point that we've all adapted to these post-MiFID conditions. But the upshot of it all, from the EC's perspective, is this: "Previously held assumptions that minimal transparency, oversight and investor protection in relation to this trading is more conducive to market efficiency no longer hold. Finally, rapid innovation and growing complexity in financial instruments underline the importance of up-to-date, high levels of investor protection."
This is, to put it mildly, thought-provoking. But let's stick with the main point, as neatly summarised in a research report on MiFID II published by capital-markets consulting firm GreySpark back in June 2011. "The Commission's approach seems to favour transparency requirements across all products [bonds, structured products, derivatives, emission allowances] and conveys a belief that any standardised and liquid instruments should have to comply with adequate pre-trade transparency standards,"
MiFID II also aims to cast a light on less transparent segments of the trading landscape, including 'systematic internalisers', dark pools and the trading firms that regulators love to hate, high frequency traders (see the box "High frequency regulation?"). Some believe the sentiment now coming from Brussels represents a direct opposition to HFT and even possibly the current state of the "art" of automated trading in general, which saw multiple execution venues flourish under the 2007 Directive. "The regulators now seem uncomfortable with the level of democratisation that occurred under MiFID," observes Richard Balarkas, president and CEO, Instinet Europe.
The politics article on MiFID II and regulation almost writes itself. Freedom is the freedom to make mistakes as well as money, and the underlying euro-mindset not only seeks to impose control but also embarks from the premise that we know less about safe trading than a Brussels bureaucrat. And so on. Likeliest outcome: MiFID II's intended consequences will amount to a reversal of the actual (mostly unintended) consequences of MiFID. History won't quite be rewritten, but you might get that missing-step feeling that the new directive doesn't inhabit the same reality as you do.
Mind you. To adapt that remark of Warren Buffett's - tide goes out, you see who's been swimming naked - the intention of MiFID II will be to oblige us all to leave our swimming costumes on the beach. Probable unintended consequence - exciting new varieties of clothing for the purpose of going in the water. Words like "swimming" and "costume" not featuring on the label. Somehow, when you've got the authors of MiFID trying to rewrite reality again, it's impossible not to feel optimistic.
MiFID II, however, should not be viewed as just a euro-counterblast against all the fun we've been having since last time. It is not just a sequel to the 2007 Directive, but also the euro-expression of a heightened global regulatory focus on investor protection, risk mitigation and market transparency, which has resulted in such similar legislation in the US as the Dodd-Frank Act. It is an expression of a mindset that transcends the EU and might be expected to survive it.
In this respect, however, it represents a potential problem with current approaches to regulation worldwide, which is that the act of framing a comprehensible, if not actually simple, all-encompassing statement of a core regulatory intent - which is one way of describing a current approach to regulating our very, very complex world - can tend to have the effect of increasing rather than decreasing complexity. Consider: the idea is to impose clarity, transparency, and a compulsory lack of any confusion whatsoever.
Like Dodd-Frank, which talks about Swap Execution Facilities or SEFs, MiFID II talks about OTFs or Organised Trading Facilities, which according to GreySpark is an "umbrella term encompassing anything not traded on a regulated market or multilateral trading facility, or anything not traded on a venue subject to MiFID". According to GreySpark, an OTF excludes "pure OTC" bilateral trading done on an "ad-hoc" basis. But "derivatives that are sufficiently liquid and eligible for clearing" are likely to fall within its scope, as are broker-crossing networks and dark pools.
Already, a paper from MarketAxess has called for - yes - further clarification on the likely differences between MTFs and OTFs in Europe on the one hand, and SEFs in the US under Dodd-Frank on the other, warning that "divergent market structures" for derivatives trading between Europe and the US would create opportunities for "regulatory arbitrage." Already, buy-side firms have called for - yes, ditto - on some of the provisions relating to dark pools. [For example, Markus Ruetimann, COO, Schroder Investment Management, suggests that not permitting operators of dark pools to deal on them using proprietary capital will reduce their effectiveness and adversely impact liquidity. "This is viewed by the industry as a very big issue, both for equities and fixed interest," says Ruetimann.]
Somewhere, in some dusty attic in Brussels, there is a department tasked with inventing terms that everybody will accept and nobody will want to have further clarified. Those poor people.
There are substantive issues arising out of this. If a regulatory text cannot be relied upon to convey a single, universal meaning, it follows that a regulatory text cannot be expected to achieve a single, universal application. But that's just a fancy way of saying that the lesson not learned is: just because you legislate for it, doesn't mean you get it. And another one: if it ain't broke, don't fix it. The post-MiFID trading environment may not be as specified in MiFID, but it works. It's creative, innovative, and although it's a Bad Thing that not everybody makes money out of every deal, even the EC can't legislate for happy outcomes. For the EC, this is not a Throw Toys Out Of Pram situation; it's more like one of those Would Like/Will Settle For/End Up Getting progressions. Or rather, it should be.
Unintended consequences, right? Constantinos Antoniades, CEO of Vega-Chi, supports MiFID II's ambitions to bring greater transparency to the OTC markets, particularly broker crossing networks, where he says it is unclear whether they are actually providing clients with 'best execution,' that lovely concept enshrined in the 2007 MiFID Directive. However, he adds, there is a substantial gap between MiFID II's intentions and its implementation. "I cannot see how broker-crossing networks in the fixed income space can implement the proposals without radically changing their business models," says Antoniades. "A lot of banks may have to get out of their specific businesses or restructure them."
By proposing "certain restrictions" on OTFs or eligible trading platforms for OTC derivatives, the International Swaps and Derivatives Association (ISDA) says, MiFID II will hurt end-user choice and market liquidity. "These restrictions would, in essence, limit the types of trades that can be transacted on single-dealer platforms and would adversely affect the ability of firms to effectively manage their risks," ISDA states. And there is a danger of adopting a too prescriptive approach, which does not account for the nuances of how different asset classes are traded. "Any complex changes to the OTC model could see people back away from that section of the market until they are comfortable with it," warned David Holcombe, a specialist in trading at Rule Financial.
Mind you, the difficulties of maintaining a straight face while reading through the MiFID II proposals are nothing to the difficulties of arguing for the retention of the status quo in Europe. In change, as in volatility, lies opportunity. Hirander Misra, electronic trading consultant and former COO and co-founder of Chi-X Europe, concedes that banks with a strong franchise in OTC derivatives, such as interest rate swaps, are likely to resist moves to a central limit order book under MiFID II. However, Misra suggests, this does present opportunities for firms to "reinvent" themselves. "We are likely to see competition emerge in other sectors such as fixed income and new marketplaces for trading swaps," he says. "Another Chi-X may also come along in the corporate bonds market."
Pre- and post-trade transparency
MiFID II also represents an initiative to stop us keeping our ideas to ourselves. OTFs, alongside regulated markets and MTFs, will have additional pre-and-post-trade reporting obligations under MiFID II - which will require additional investment. All firms that execute trades will have to publish reports under MiFID for cash equities, as well as derivatives and fixed income. This is an issue across all asset classes, although GreySpark warns that pre-and-post-trade transparency requirements under MiFID II will have the greatest impact on non-equity markets (bonds, derivatives and OTC products) where relatively little transparency exists today.
Richard Baker, CEO of Cleartrade Exchange, which is based out of Singapore, agrees that the trade reporting requirements under MiFID II will be onerous. "The regulators are focused on everything from, do we know the origin of the trade as it happens? Is a trade appropriately tagged and where does it sit in processing and clearing?" Baker says this is complicated by the fact that regulators have not decided what will be the trade repositories for the different asset classes and different regulated geographies. It is tempting to summarise all this as a transition from "Be open" to "Tell everybody your strategy before you implement it".
Buy-side firms are concerned that greater pre-trade reporting obligations under MiFID II will make it more difficult for brokers who deal as principal to place their position into the market (because the disclosure would make their intended dealing apparent). This could mean that brokers will be less willing to use their own capital (or charge more for it), which would reduce liquidity and push up the cost of dealing. Makes you wonder where the liquidity's going to come from, if it has to be pre-disclosed.
MiFID II also talks about preset threshold limits, the ability to halt trading temporarily if there is a significant movement in prices, slowing down order flow and minimum tick sizes. Okay. Baker says the Singaporean authorities (MAS) that regulate its exchange already require pricing limits on some commodities contracts to mitigate risk associated to market volatility. "The industry gets a little worked up about position limits," he says. "I don't believe the regulators will come in and set a specific position limit. They are looking for appropriate policies to be set by exchange and marketplace operators."
But others insist that the regulators should leave it to the market to determine prices. "It's dangerous to step in and stop supply meeting demand," says Steve Grob, group strategy director at Fidessa. "Position limits could mean that changes in supply and demand are amplified." Another - more speculative - issue: it's not difficult to guess where this idea came from, but if a theme here is unintended consequences, doesn't it strike you that the causal link
is a little too neat? We're creative thinkers. Another of MiFID II's aims is to bring regulation up to date with technological changes by imposing various new obligations on markets and firms involved in algorithmic trading and direct electronic access. Under the MiFID II proposals, algorithmic firms will have to describe their trading strategies to regulators, ha ha, yet few understand how this will work in practice. "Trading firms could provide detailed code but the regulators won't know what to do with it," says Ali. "There is a risk that the regulators are going to be looking at something they don't understand." More on this in the box "High frequency regulation".
MiFID II also aims to provide a more "harmonised" framework regarding the treatment of non-EU third-party firms doing business with clients in the EU. More potential for confusion. Imogen Garner, a senior associate at Norton Rose, says some non-EU firms may have to register with the European Securities and Markets Authority (ESMA), while others may need to set up authorised branches in the EU. In all cases, however, she says rules in the home firm's jurisdiction will need to be "equivalent" to EU law in a number of respects. "It isn't clear how many jurisdictions are going to be able to jump that hurdle," she says.
Others fear that restrictions on third-party firms operating in Europe could result in reciprocal action by the US and Asia. "It's definitely worth noting that some very significant powers are being given to ESMA," says Garner. "National regulators are seeing their freedom and flexibility to govern their domestic markets reduced." MiFID II talks about ESMA being able to "temporarily ban products, practices and services" if there are concerns regarding investor protection, or threats to the "orderly functioning of financial markets." But it's a big ask to think the regulators will have the technical firepower to take a real time view of the entire market and understand, also in real time, what is going on in the order flow, and then pre-emptively act to stop something happening.
As it stands, MiFID II is a statement of good intentions - to reduce systemic risk and protect the end investor. That's reassuring. Holcombe says: "It is clear that market participants who are now successfully navigating crossing networks and dark pools in a post-MiFID I landscape, will lose access to a whole swathe of working, highly-liquid venues once proprietary dealer flows are removed from these venues by MiFID II."
If there was any real prospect of the European Union surviving in its present form, and if there was any real likelihood that the current MiFID II proposals would pass unscathed through the euro-legislative process, and then through ratification by all twenty-seven member governments, we should probably all settle down to have a good worry.
High frequency regulation?
Ever since the "flash crash" of May 2010, HFT has been on regulators' radar on both sides of the Atlantic. In the US, where TABB Group estimates that HFT accounts for more than 60% of US equity share volume, the Commodity Futures Trading Commission (CFTC) is investigating the impact of HFT on the commodities markets. The European Commission (EC) also has high-frequency traders clearly in its sights, including them in the revised MiFID II proposals that it announced in October 2011.
HFT was left out of the original 2007 MiFID Directive, but during the MiFID review process the "liquidity provision of such trading models" was reportedly a controversial topic. Regulators are concerned that beyond the top quartile of large public limited companies there is insufficient liquidity in low-traded stocks. MiFID II talks about a market-making obligation, which means anyone providing liquidity must stand behind firm quotes, at all times.
While many argue that HFT brings much-needed liquidity to the markets, firms are criticised for not providing prices round the clock. However, Richard Balarkas, CEO and president, Instinet Europe, says MiFID II is largely chasing an agenda created by the media. "You have to ask what is it about these activities, that warrant the amount of regulatory attention they seem to get? On the one hand the European Commission wants more competition among trading venues, but if that venue uses speed or price as its differentiator, maybe they don't like it too much."
Balarkas says, if market-making obligations are imposed on HFT firms under MiFID II, it could seriously undermine a number of firms and impact market liquidity. "It may be more difficult to get an institutional order done on the markets if they [HFT firms] are not there," he says. Imposing a requirement to quote continuously during market hours shows a limited understanding by the regulators as to how HFT firms operate, says Hirander Misra, independent electronic trading consultant and former COO and co-founder of European MTF, Chi-X Europe. "It is tarring them all with the same brush and ring-fencing them into a particular way of dealing."
David Holcombe, trading specialist at Rule Financial, believes the market-making obligation will be unenforceable. "What happens if a firm has switched off its machine or had a technical issue? It has not been fully thought through." But the problem with unenforceability is the potential to move from, as it were, stopping the action to banning the actor. Munib Ali, a director at PricewaterhouseCoopers, says HFT firms will need to rethink their models and whether they want to stay in the business. "There could be a reduction in liquidity as a result of MiFID II," he says, "so the regulators need to think about finding a balance between regulating HFT and killing it."