Such was the success of the first Markets in Financial Instruments Directive (MiFID), that they're preparing a second to tighten up the areas in which the real world failed to align itself with the regulatory vision. The regulators are determined that the real world will not fail again, and here, David Dungay examines the scale of the task that confronts them. How much work still needs to be done, and how will Europe's visionaries enforce happiness and harmonious trading upon us now and for evermore?
Quick history lesson, anyone? Once upon a time, there was a European Commission (EC) with an urge to harmonise trading across the range of national markets that made up its fiefdom. It was an inventive, idealistic, even hyper-active EC. There were roadmaps, timetables, directives, special exemptions for the really idiosyncratic bits of national we-do-it-this-way, and there was even talk of a single market. But market forces weren't forcing anything particularly fast, and it became clear to the EC that the inevitable progress of history towards harmony, transparency and the sunlit uplands of cheap electronic trading needed a little nudge.
So out came the EC's idea of a sledgehammer. First target was the primary exchanges. Competition was lacking between them and the primaries had omitted the words "cheap" and "bargain" from their vocabulary. Mark Howarth, former interim CEO of Chi-x Europe, remembers: "The rules effectively permitted monolopoly protectionism and it is interesting to examine the financial accounts of the existing national exchanges from the late 90s and early 2000. Some of those public exchanges were enjoying operating margins of 60-70% which, by any definition, would suggest monopoly pricing."
The sledgehammer was MiFID (the Markets in Financial Instruments Directive) and the key thing about it was that it simultaneously described the Europe the EC wanted, and regulated that it should come into being. It was a kind of "Let there be Light" with legislative back-up. MiFID achieved quite a lot of what it set out to achieve … and is about to be reborn.
MiFID born of MiFID
The EC has ordered a review of MiFID to be conducted in early 2010. MiFID was introduced to break down the monopolies of the primary exchanges, which it has done. However, the lesson of history that we can learn from MiFID is this. However explicitly you legislate for light and transparency, sometimes you get dark pools.
MiFID has come a long way, but problems endure, and some new issues have arisen. The European trading environment is no longer the rickety old fire hazard of an antique financial district that it used to be, but the term 'different' comes to mind more readily than 'much improved'.
The T word
"What we've seen is an increase in fragmentation which ultimately, if you are a buy side investor, can be seen as a negative consequence because life is harder now than it was when everything was centralised," says Lee Hodgkinson, CEO of SmartPool. But fragmentation isn't an effect of MiFID; fragmentation is a rational commercial response to the effects of MiFID.
Steve Grob, founder of the Fidessa Fragmentation Index, starts his analysis with a form of 'school report'. Grob says: "If you were to take a big step back from the whole thing and get your MiFID report card out it would get an A+ for breaking up the natural monopolies. It would probably get a C+, B- for lowering the cost of execution and it would get a D- for increasing transparency, and a must try harder next term."
Transparency, along with the various kinds of freedom that transparency allows, was the most significant objective of MiFID. Without effective transparency, there is no scope for oversight, and not really much scope for introducing (let alone enforcing) a level playing field in anything from transaction pricing, through cross-border trading, to regulatory oversight itself.
"It's not completely evident to the buy side, all the time, exactly what is happening to their order flow when they go into these dark pools." Grob explains. Some would say, that's the whole point of a dark pool. Yes. The issues are not clear-cut. But dark pools will almost certainly be up for review by the EC this year, within a larger examination of trade transparency. At the moment, for example, non-displayed venues can use MiFID pre-trade transparency waivers to avoid publishing quotes.
In real-world terms, of course, greater regulation of dark pools could diminish these venues' usefulness as a tool for minimizing market impact, potentially increasing the cost of trading for all. Richard Balarkas, CEO of Instinet, along with many others, feels that transparency needs to come from the post-trade arena. Balarkas says: "Not everyone can operate in the dark. Some people through urgency will have to disclose, and so you will always have lit books. There is no need to create this environment in which everything must be lit. It should be the other way around. You don't have to show anything to anyone."
Lee Hodgkinson disagrees, suggesting that equity trading is far more transparent than it used to be, while the big problem is inconsistent reporting. "I think the issue is seeing the wood from the trees. In the post trade arena, greater granularity of data is required with greater consistency of reporting and enhanced processes for trade data monitoring. To say it's not more transparent is wrong, I think it is much more transparent."
The lack of consistent trade reporting has been a particular issue for the buyside in post-MiFID Europe. Traders can struggle to piece together a complete picture of trading activity across the continent. The EC has not ruled out the adoption of a consolidated post-trade price source similar to the system used in the US. Some see a consolidated tape as a possible solution. We have also seen steps toward interoperability.
Clearing and Settlement: A Stunted Market?
Fragmentation has allowed a great diversity of venues, lit and dark, to establish themselves under various descriptive banners. Each of these venues has its own clearing procedure. This has made the process of clearing a complex one and thus clearing costs have increased dramatically. This cost has been passed back to the buy side and some could argue that they are in the same or worse position financially than pre-MiFID.
Grob says: "The problem is that no one doubts that the cost of execution has come down and trading fees have come down. But add back in the extra cost of technology to smart route, add back in the cost of more complicated clearing and settlement and is anyone really getting a better deal?"
Similarly, Balarkas says: "A lot of the front-office cost savings of executing orders on cheaper venues are immediately lost through the costs of clearing through four or five different locations. In fact our margins may have been hurt. But as to the health of our margins, competition between the MTFs has not had the dramatic effect many might assume." So that's an F for efficiency of clearing and settlement.
Diana Chan at EuroCCP is frustrated with MiFID. Chan says: "MiFID got clearing wrong. Although MiFID gave trading venues the right to appoint a CCP in a different Member State, it did not give CCPs the right to access the trade feeds of the trading venues they want to clear for. Firms are still required to clear through the CCPs designated by each trading venue; they cannot choose to concentrate their clearing in a CCP of their choice."
So there's a to-do list here for the EC. Emmanuel Carjat, CEO of Atrium Network, adds another item. "With particular regard to OTC, I think this is where there is going to be large technology demand to facilitate post-trade integration without compromising market impact. There is definitely going to be a lot of changes in that area depending on what the regulators decide to do."
Educate the regulator?
Knee-jerk regulation is top of most people's fear list right now. HFT, alternative venues, flash trading and dark pools have all prompted questions around the integrity of our markets. But the big danger is that we end up with regulation based on a toxic combination of fear and ignorance. Particularly, we need to guard against any confusion of 'new-style trading' and the credit crisis.
Balarkas agrees. "For those who want to punish financial institutions and certain methods of trading there is every excuse for them to do so. My fear is, we will have a whole series of ill thought out and knee-jerk reactions." Lee Hodgkinson adds: "We need to regulate in a way that is structured, measured and considered and doesn't stifle innovation and competition."
And that's going to happen. Isn't it?